## _cr09113

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---

### The global financial turmoil: impact on Papua New Guinea’s financial sector — introduction & scope
- Despite rapid growth, Papua New Guinea’s financial system is likely to remain relatively immune from the turmoil in global financial markets.
- Since 2000, favorable external conditions and financial sector reforms provided a strong foundation for financial sector expansion.
- The chapter assesses vulnerabilities given global capital market conditions, focusing on liquidity and asset quality.

### Financial sector reforms, size, and composition
- Legal and regulatory changes:
  - Central Banking Act, Banks and Financial Institutions Act, Superannuation and Life Insurance Act gave BPNG independent monetary, regulatory, and supervisory roles.
  - Prudential rules consistent with international best practices introduced for banks, superannuation funds, and other financial institutions.
- Growth and size (since 2000):
  - Total financial sector assets almost quadrupled to kina 19 billion.
  - Banking sector assets comprise more than 60 percent of total financial sector assets.
  - Total financial sector assets ≈ 90 percent of GDP.
- Key institutional facts:
  - 4 commercial banks; 10 superannuation funds; other nonbank financial institutions regulated by BPNG.
  - General insurance regulated by the Insurance Commission; stock exchange regulated by the Securities Commission.
  - Largest banks: Bank of South Pacific (BSP), ANZ subsidiary, Westpac subsidiary, Maybank.
  - National Development Bank (state-owned, non-deposit taking) has assets of about ½ percentage point of total banking assets.
  - Nonbank sector: roughly kina 6 billion in assets; ASFs hold about 65 percent of nonbank financial assets.
  - Among ten licensed ASFs: Nasfund kina 1.2 billion and Nambawan kina 2.3 billion — together ≈ 87 percent of total superannuation fund assets.
- Financial soundness indicators (as of November/September 2008 datapoints):
  - Nonperforming loans/total loans: 16.9 percent in 2000 → 1.3 percent in September 2008.
  - Return on assets: 1.2 percent in 2000 → 1.6 percent in September 2008.
  - Return on equity: 61.4 percent as of September 2008.

### Vulnerabilities — liquidity
- Funding structure:
  - Deposits account for more than 80 percent of banks’ liabilities.
  - BSP holds over 50 percent of total deposits.
  - About 95 percent of total BSP deposits denominated in kina; most remainder in U.S. dollars or Australian dollars.
  - Australian subsidiaries: local currency deposits > 80 percent of total deposits.
- Liquidity levels (as of November 2008):
  - Roughly 60 percent of total assets were liquid (BSP 55 percent; ANZ and Westpac 60 percent).
  - Of the 60 percent liquid assets: about 70 percent are government securities and 10 percent are deposits with the BPNG.
- Foreign currency deposits:
  - Foreign currency deposits are a small and relatively stable share of total deposits.
  - ANZ holds 56 percent of foreign currency deposits; Westpac and BSP roughly share the balance.
  - No government deposit guarantee in place; Australian government does not guarantee deposits of the two Australian subsidiaries.

### Vulnerabilities — asset quality and nonbank exposures
- Lending and loan performance:
  - Lending increased to 20 percent of GDP from about 15 percent over the last eight years; lending represents 35 percent of total bank assets.
  - Nonperforming loans/total loans: 1.3 percent in September 2008 (down from 16.9 percent in 2000).
  - Provisions/nonperforming loans rose from 16 percent to 150 percent.
  - Caveat: nonperforming loans are lagging indicators; loan quality could deteriorate as borrowers’ debt-servicing capacity weakens.
- Direct exposures and external linkages:
  - Almost no direct exposures to troubled international financial institutions.
  - Funding structure of Australian subsidiaries rules out exposure via Australian parent banks.
- Reported credit ratings (Standard and Poor’s):
  - Bank of South Pacific: B+ / Stable / B
  - ANZ Bank: AA / Stable / A-1+
  - Westpac Bank: AA / Stable / A-1+
  - Maybank: A- / Stable / A-2
- Superannuation funds and equity exposure:
  - Stock market capitalization: ≈ 50 percent of GDP in 2002 → almost 200 percent of GDP in H1 2008.
  - Kina Securities Index (KSI) dropped by more than 40 percent since its peak in late-June 2008.
  - For Nasfund and Nambawan, equities were the largest exposure and accounted for bulk of 2007 returns.
  - As of end-September 2008 both funds show a decline in equity share; funds expect 2008 returns to remain positive but significantly lower than in 2007.
  - Nasfund reported after tax net surplus kina 74 million in 2008, compared to kina 321 million in 2007. Nambawan had not reported 2008 results at time of reporting.

### Superannuation funds — exact portfolio allocations and values
- Nambawan Super: Investment Guidelines (In percent)
  - Equities (Listed and Unlisted): 30 50
  - Fixed interest: 15 35
  - International: 15 25
  - Cash: 0 5
  - Property: 10 30
- Nasfund: Investment Guidelines (In percent)
  - Equities (Domestic & International): 30 60
  - Government Securities & State Grants: 10 30
  - IBD & Treasury notes: 5 30
  - International fixed interest: 0 10
  - Property: 10 20
- Nambawan Super: Portfolio Value (Sep-08; Dec-07) — (In million of kina; Percent)
  - Fixed Interest: Sep-08 634; Dec-07 260; Sep-08 percent 25.6; Dec-07 percent 13.5
  - Equities: Sep-08 1,286; Dec-07 1,083; Sep-08 percent 52.0; Dec-07 percent 56.4
  - Property: Sep-08 256; Dec-07 248; Sep-08 percent 10.4; Dec-07 percent 12.9
  - International Equities: Sep-08 211; Dec-07 248; Sep-08 percent 8.5; Dec-07 percent 12.9
  - Fixed (other): Sep-08 87; Dec-07 23; Sep-08 percent 3.5; Dec-07 percent 4.3
  - Total: Sep-08 2,475; Dec-07 1,920; Total percent 100 100
- Nasfund: Portfolio Value (Sep-08; Dec-07) — (In million of kina; Percent)
  - Fixed Interest: Sep-08 481; Dec-07 256; Sep-08 percent 31.5; Dec-07 percent 21.3
  - Equities: Sep-08 587; Dec-07 476; Sep-08 percent 38.4; Dec-07 percent 39.6
  - Property: Sep-08 246; Dec-07 168; Sep-08 percent 16.1; Dec-07 percent 14.0
  - International Equities: Sep-08 216; Dec-07 301; Sep-08 percent 14.1; Dec-07 percent 25.0
  - Equities (foreign component): Sep-08 193; Dec-07 247; Sep-08 percent 12.6; Dec-07 percent 20.6
  - Fixed (other): Sep-08 235; Dec-07 41; Sep-08 percent 5.1; Dec-07 percent 4.5
  - Total: Sep-08 1,530; Dec-07 1,200; Total percent 100 100

### Conclusions on financial sector resilience and risks
- Stabilizing features:
  - Primarily domestic-deposit-based funding.
  - High level of liquidity and large holdings of liquid assets.
  - Improved financial soundness indicators.
- Risks and caveats:
  - Large share of liquid assets implies banks could withstand sizable reductions in domestic liquidity.
  - Rapid external deterioration expected to reduce borrowers’ debt-servicing ability and likely worsen loan quality.
  - Provisioning is substantial: provisions/nonperforming loans rose to 150 percent.
  - Superannuation funds’ equity exposure will notably reduce returns in 2008 relative to prior years, though returns appear poised to remain positive in 2008.
- Portfolio allocations (September 2008):
  - Nambawan: International 17 percent; Property 10 percent; Equities 52 percent; Fixed Interest 26 percent.
  - Nasfund: International 14 percent; Property 16 percent; Fixed Interest 31 percent; Equities 39 percent.

### Exchange rate developments and reserves
- Historical and recent exchange rate movements:
  - 1993–2002: kina depreciated substantially vs US and Australian dollars.
  - 2003–September 2008: kina appreciated by 54 percent against the U.S. dollar, then depreciated by about 6 percent over October 2008–February 2009.
  - Kina/Australian dollar: stable 2003–June 2008, then kina appreciated about 40 percent against AUD.
  - Effective terms: kina relatively stable since 2002, then appreciated significantly since July 2008.
  - July–December 2008: kina appreciated by 20 percent in nominal effective terms, and 27 percent in real effective terms.
- Reserves:
  - Foreign official reserves rose to US$2.8 billion by August 2008, then drawn down to about US$2 billion at end-2008.

### Methodologies used for exchange rate assessment
- Two approaches: macro-balance (MB) and reduced-form equilibrium real exchange rate (ERER).
- Dataset: unbalanced panel of 55 countries, annual observations 1973–2007.
- Estimation: OLS and GMM, with country fixed effects and corrections for cross-section specific unconditional heteroskedasticity.
- MB dependent variable: current account balance/GDP (deviation from trading partners); requires GMM for consistent decomposition.
- ERER dependent variable: real effective exchange rate (REER); explanatory variables include terms of trade, real output per worker, government consumption relative to GDP and trading partners, net foreign assets.

### MB approach — key panel econometric results
- Sample observations: OLS 1,090; GMM 1,036.
- Adjusted R2: OLS 0.59; GMM 0.46.
- Coefficient highlights (relative to trading partners):
  - Fiscal Balance to GDP: OLS 0.2; GMM 0.18 *** / 0.14 * (text reports range "0.14–1.8" percent points).
  - Old-age dependency ratio: OLS -0.73 ***; GMM -0.89 ***.
  - Population growth: OLS -1.06 ***; GMM -5.34 *.
  - Oil trade balance to GDP: OLS 0.36 ***; GMM 0.28 *; for oil exporters OLS 0.55 ***; GMM 0.74 ***.
  - Output growth: OLS -0.16 **; GMM -0.58 ***.
- Semi-elasticity of CA/GDP with respect to REER for Papua New Guinea: -0.4.

### ERER approach — key panel econometric results
- Observations: OLS 710; GMM 666.
- Adjusted R2: OLS 0.50; GMM 0.53.
- Coefficient highlights:
  - Terms of trade (log): OLS 0.35 ***; GMM 0.40 *** (10 percent increase in terms of trade → ≈ 4 percent equilibrium appreciation).
  - Real output per worker (log, PPP): OLS 0.23; GMM 0.20.
  - Government consumption to GDP (relative): OLS 1.67 ***; GMM 1.01 ** (1 percentage point increase → about 2 percent appreciation of equilibrium REER).
  - Net foreign assets to GDP: OLS -0.10 **; GMM -0.13 ***.

### Exchange rate assessment for Papua New Guinea — application and scenarios
- MB application:
  - Use projected CA for 2013 corresponding to -3.1 percent in 2013 (staff macroframework) and GMM estimates to compute CA norm.
  - Exchange rate adjustment = current account gap divided by semi-elasticity (-0.4).
- ERER application:
  - Equilibrium REER estimated using GMM panel coefficients.
  - Overvaluation measured relative to January 2009; IMF projects REER constant so expected REER in 2013 equals current value (January 2009).

### Baseline scenario results
- MB approach baseline: overvaluation of 3 percent (REER adjustment = 3 percent). Table entries: MB approach REER NormProj.2/Overvaluation: -1.9 -3.1 3.0 (all in percent).
- ERER approach baseline: overvaluation of 16 percent. Table entry: ERER approach Overvaluation 16.3 (percent).

### Terms-of-trade shock scenario (20 percent decline)
- MB approach under shock: overvaluation of about 26 percent. Table entry: MB approach REER NormProj.2/Overvaluation: -1.9 -12.5 26.5 (percent).
- ERER approach under shock: overvaluation of about 24 percent. Table entry: ERER approach 23.8 (percent).
- Both approaches indicate much larger overvaluation under a 20 percent terms-of-trade decline.

### Decomposition of determinants
- MB approach: demographic factors and high trade oil surpluses are main determinants of equilibrium current account.
- ERER approach: terms of trade changes and government consumption are key determinants of equilibrium REER.

### Caveats and possible model extensions
- Interpret results with caution due to uncertainty around medium-term projections and wide model estimate ranges; analysis is diagnostic not precise.
- Standard model specs may not be tailored for exhaustible-resource-rich and low-income countries like Papua New Guinea.
- Possible modifications:
  - Use non-mineral fiscal balance to separate mineral revenues from nonmineral fiscal effects.
  - Include measures of mineral wealth to capture intertemporal saving motives and need for larger surpluses to finance net foreign asset accumulation.

### Policy implications and recommendations
- Assessment suggests the kina is somewhat above its equilibrium value.
- Given sharp commodity price declines, the currency should be allowed to adjust to help offset impact on export incomes.
- Policy recommendations:
  - Increase flexibility of the exchange rate regime while ensuring maintenance of a credible anchor for monetary policy.
  - Greater exchange rate flexibility would help safeguard official foreign currency reserves and cushion the impact of falling external demand.
- Emphasis: terms of trade play an important role in determining equilibrium exchange rate and current account; high commodity price volatility amplifies uncertainty in the assessment.

### Selected empirical data and key numeric statistics (selected tables and figures)
- GDP by Sector at Current Market Prices, 2003–07 (In millions of kina)
  - Nominal GDP: 2003 12,567; 2004 12,652; 2005 15,195; 2006 17,132; 2007 18,716.
  - Mineral: 2003 2,252; 2004 2,391; 2005 3,555; 2006 4,685; 2007 4,897.
  - Non-mineral: 2003 10,316; 2004 10,261; 2005 11,640; 2006 12,448; 2007 13,819.
  - Mineral share of GDP (percent): 2003 17.9; 2004 18.9; 2005 23.4; 2006 27.3; 2007 26.2.
- Real GDP at 1998 constant prices (In millions of 1998 kina; annual % change)
  - Real GDP levels: 2003 7,896; 2004 8,111; 2005 8,402; 2006 8,619; 2007 9,180.
  - Real GDP annual % change: 2003 2.2; 2004 2.7; 2005 3.6; 2006 2.6; 2007 5.
  - Non-mineral real GDP growth rates: 2003 2.1; 2004 3.1; 2005 3.4; 2006 3.8; 2007 7.3.
- Production of major commodities, 2004–08 (In millions of U.S. dollars)
  - Crude oil volumes (millions of barrels): 2004 12.6; 2005 13.3; 2006 14.5; 2007 13.8; 2008 Sept. 8.6.
  - Crude oil values: 2004 513; 2005 735; 2006 967; 2007 1,018; 2008 Sept. 1,002.
  - Copper values: 2004 479; 2005 806; 2006 1,414; 2007 1,424; 2008 Sept. 1,110.
  - Gold values: 2004 862; 2005 914; 2006 998; 2007 1,254; 2008 Sept. 1,258.
- Central Government Budget 2004–07 (In percent of GDP)
  - Revenue and grants: 2004 34.1; 2005 34.9; 2006 36.7; 2007 37.3.
  - Tax (percent of GDP): 2004 25.4; 2005 24.6; 2006 28.9; 2007 31.3.
  - Mineral taxes: 2004 5.8; 2005 7.6; 2006 11.7; 2007 12.8.
  - Expenditure: 2004 32.4; 2005 31.2; 2006 30.0; 2007 29.2.
  - Overall balance (from above the line): 2004 1.7; 2005 3.7; 2006 6.7; 2007 8.2.
  - Nominal GDP (millions of kina): 2004 12,652; 2005 15,195; 2006 17,132; 2007 18,716.
  - Nonmineral fiscal balance: 2004 -6.3; 2005 -4.7; 2006 -7.6; 2007 -6.8.
- Monetary survey, 2004–08 (In millions of kina; end of period)
  - Net foreign assets: 2004 2,165; 2005 2,929; 2006 4,648; 2007 7,073; 2008 6,204.
  - Broad money: 2004 3,915; 2005 5,069; 2006 7,041; 2007 8,995; 2008 10,017.
  - Narrow money: 2004 2,232; 2005 3,017; 2006 3,792; 2007 4,923; 2008 5,520.
  - Narrow money growth rate (y/y): 2004 30.8; 2005 35.2; 2006 25.7; 2007 29.8; 2008 12.1.
  - Broad money growth rate (y/y): 2004 14.8; 2005 29.5; 2006 38.9; 2007 27.8; 2008 11.4.
  - Private sector credit growth rate (y/y): 2004 0.9; 2005 23.7; 2006 38.2; 2007 34.4; 2008 41.0.
- Balance of Payments, 2003–07 (In millions of U.S. dollars)
  - Current account balance: 2003 159; 2004 88; 2005 205; 2006 128; 2007 112.
  - Mineral current account contribution: 2003 728; 2004 866; 2005 1,072; 2006 1,401; 2007 1,368.
  - Non-mineral current account contribution: 2003 -569; 2004 -778; 2005 -867; 2006 -1,273; 2007 -1,255.
  - Exports (f.o.b.): 2003 2,153; 2004 2,554; 2005 3,278; 2006 4,207; 2007 4,750.
  - Imports (c.i.f.): 2003 -1,435; 2004 -1,794; 2005 -2,462; 2006 -2,805; 2007 -3,331.
  - Net international reserves (end-year, millions of U.S. dollars): 2003 399; 2004 599; 2005 765; 2006 1,425; 2007 2,083.
  - Gross official reserves (end-year, millions of U.S. dollars): 2003 523; 2004 663; 2005 765; 2006 1,427; 2007 2,087.
  - Oil price (average of 3 spot prices; US$/BBL): 2003 28.93; 2004 37.85; 2005 53.46; 2006 64.37; 2007 71.1.
  - Copper price (grade A, LME spot price, US$/MT): 2003 1,779.4; 2004 2,863.5; 2005 3,676.5; 2006 6,731.4; 2007 7,131.6.
  - Gold price (London 3 PM fixed price, US$/troy ounce): 2003 363.5; 2004 409.2; 2005 444.9; 2006 604.3; 2007 696.7.
- External debt, 2003–07 (In millions of U.S. dollars)
  - Total external debt: 2003 2,308; 2004 2,159; 2005 2,048; 2006 2,176; 2007 1,999.
  - Public external debt: 2003 1,614; 2004 1,492; 2005 1,273; 2006 1,196; 2007 1,105.
  - Total public external debt (percent of GDP): 2003 39.0; 2004 34.9; 2005 25.4; 2006 21.1; 2007 16.7.

*Source: Fund staff estimates and analysis in the provided content unit.*

### 1. Gross Domestic Product by Sector at Current Market Prices, 2003–07....................21

### 1. Gross Domestic Product by Sector at Current Market Prices, 2003–07

### The global financial turmoil: impact on Papua New Guinea’s financial sector — Introduction & scope
- Despite rapid growth in the last few years, Papua New Guinea’s financial system is likely to remain relatively immune from the turmoil in global financial markets.
- Since 2000, a favorable external environment and the introduction of financial sector reforms provided a strong foundation for financial sector expansion.
- The chapter examines potential vulnerabilities in Papua New Guinea’s expanded financial sector given the current state of global capital markets, with particular focus on liquidity and asset quality.

### Overview of the financial sector: reforms, size, and composition
- Legislative reform (including the Central Banking Act, the Banks and Financial Institutions Act, and the Superannuation and Life Insurance Act) gave the Bank of Papua New Guinea (BPNG) an independent role as monetary authority, financial regulatory, and supervisory authority.
- Prudential rules consistent with international best practices were introduced, covering banks, superannuation funds, and other financial institutions.
- Since 2000:
  - Total financial sector assets almost quadrupled to kina 19 billion.
  - Banking sector assets comprise more than 60 percent of total financial sector assets.
  - Total financial sector assets have grown to roughly 90 percent of GDP.
- As of November/September 2008 datapoints:
  - Ratio of nonperforming loans to total loans declined from 16.9 percent in 2000 to 1.3 percent in September 2008.
  - Return on assets rose from 1.2 percent in 2000 to 1.6 percent in September 2008.
  - Return on equity was 61.4 percent as of September 2008.
- Institutional composition (selected facts):
  - 4 commercial banks, 10 superannuation funds, and a number of other nonbank financial institutions licensed and regulated by BPNG.
  - General insurance companies regulated by the Insurance Commission and a stock exchange regulated by the Securities Commission.
  - Nationally owned Bank of South Pacific (BSP) is the largest bank, followed by subsidiaries of Australia and New Zealand Banking Group Limited (ANZ) and Westpac Banking Corporation (Westpac), and Maybank.
  - National Development Bank (state-owned, non-deposit taking) has assets of about ½ percentage point of total banking assets.
  - Nonbank sector: roughly kina 6 billion in assets; authorized superannuation funds (ASFs) hold about 65 percent of total nonbank financial assets.
  - Among ten licensed ASFs: Nasfund and Nambawan have kina 1.2 billion and kina 2.3 billion in assets respectively (together holding approximately 87 percent of total superannuation fund assets).

### Vulnerabilities to global turmoil — liquidity
- Two key areas of vulnerability identified globally are liquidity and asset quality; the chapter assesses these for Papua New Guinea.
- Funding structure:
  - Banks are funded primarily by deposits; deposits account for more than 80 percent of liabilities.
  - BSP holds over 50 percent of total deposits.
  - About 95 percent of total BSP deposits are denominated in kina; most of the remainder in U.S. dollars or Australian dollars.
  - Australian subsidiaries also rely primarily on domestic funding, with local currency deposits of more than 80 percent of total deposits.
- Liquidity levels:
  - As of November 2008, roughly 60 percent of total assets were liquid (55 percent for BSP, and 60 percent for ANZ and Westpac).
  - Of the 60 percent of total assets that are liquid, about 70 percent are government securities and 10 percent are deposits with the BPNG.
- Foreign currency deposits:
  - Foreign currency deposits are a small and relatively stable share of total deposits.
  - ANZ holds 56 percent of foreign currency deposits; Westpac and BSP roughly share the balance.
  - There is no government deposit guarantee in place; Australian government does not guarantee deposits of the two Australian subsidiaries.

### Vulnerabilities to global turmoil — asset quality and nonbank exposures
- Lending and loan performance:
  - Lending increased to 20 percent of GDP from about 15 percent over the last eight years, representing 35 percent of total bank assets.
  - Ratio of nonperforming loans to total loans: 1.3 percent in September 2008 (down from 16.9 percent in 2000).
  - Ratio of provisions to nonperforming loans increased from 16 to 150 percent.
  - Caveat: nonperforming loans are a lagging indicator; loan quality could deteriorate as the external environment weakens borrowers’ debt-servicing capacity.
- Direct exposures:
  - Almost no direct exposures to troubled international financial institutions.
  - Funding structure of the Australian subsidiaries rules out exposure via the Australian parent banks.
- Commercial banks’ reported credit ratings (Standard and Poor’s):
  - Bank of South Pacific: B+ / Stable / B
  - ANZ Bank: AA / Stable / A-1+
  - Westpac Bank: AA / Stable / A-1+
  - Maybank: A- / Stable / A-2
- Superannuation funds and equity market exposure:
  - Stock market capitalization rose from about 50 percent of GDP in 2002 to almost 200 percent of GDP in the first half of 2008.
  - Kina Securities Index (KSI) dropped by more than 40 percent since its peak in late-June 2008.
  - For the two biggest funds (Nasfund and Nambawan), investment in equities is the largest exposure and accounted for the bulk of returns in 2007.
  - As of end-September 2008, both funds show a decline in equity share; funds expect returns in 2008 to remain positive but significantly lower than in 2007.
  - Nasfund reported after tax net surplus of kina 74 million in 2008, compared to kina 321 million in 2007. Nambawan had not yet reported 2008 results at the time of reporting.

### Superannuation funds: portfolio composition (selected exact allocations and values)
- Nambawan Super: Investment Guidelines (In percent)
  - Equities (Listed and Unlisted): 30 50
  - Fixed interest: 15 35
  - International: 15 25
  - Cash: 0 5
  - Property: 10 30
- Nasfund: Investment Guidelines (In percent)
  - Equities (Domestic & International): 30 60
  - Government Securities & State Grants: 10 30
  - IBD & Treasury notes: 5 30
  - International fixed interest: 0 10
  - Property: 10 20
- Nambawan Super: Portfolio Value (Sep-08; Dec-07) — (In million of kina; Percent)
  - Fixed Interest: Sep-08 634; Dec-07 260; Sep-08 percent 25.6; Dec-07 percent 13.5
  - Equities: Sep-08 1,286; Dec-07 1,083; Sep-08 percent 52.0; Dec-07 percent 56.4
  - Property: Sep-08 256; Dec-07 248; Sep-08 percent 10.4; Dec-07 percent 12.9
  - International Equities: Sep-08 211; Dec-07 248; Sep-08 percent 8.5; Dec-07 percent 12.9
  - Fixed (other): Sep-08 87; Dec-07 23; Sep-08 percent 3.5; Dec-07 percent 4.3
  - Total: Sep-08 2,475; Dec-07 1,920; Total percent 100 100
- Nasfund: Portfolio Value (Sep-08; Dec-07) — (In million of kina; Percent)
  - Fixed Interest: Sep-08 481; Dec-07 256; Sep-08 percent 31.5; Dec-07 percent 21.3
  - Equities: Sep-08 587; Dec-07 476; Sep-08 percent 38.4; Dec-07 percent 39.6
  - Property: Sep-08 246; Dec-07 168; Sep-08 percent 16.1; Dec-07 percent 14.0
  - International Equities: Sep-08 216; Dec-07 301; Sep-08 percent 14.1; Dec-07 percent 25.0
  - Equities (foreign component): Sep-08 193; Dec-07 247; Sep-08 percent 12.6; Dec-07 percent 20.6
  - Fixed (other): Sep-08 235; Dec-07 41; Sep-08 percent 5.1; Dec-07 percent 4.5
  - Total: Sep-08 1,530; Dec-07 1,200; Total percent 100 100

### Conclusions on financial sector resilience and risks
- Key stabilizing features:
  - Primarily domestic-deposit-based funding arrangement.
  - High level of liquidity and large holdings of liquid assets.
  - Improved financial soundness indicators.
- Risks and caveats:
  - Large share of liquid assets implies banks could withstand sizable reductions in domestic liquidity.
  - Rapidly deteriorating external environment is expected to reduce borrowers’ debt-servicing abilities and loan quality will likely deteriorate.
  - Provisioning against default is substantial (ratio of provisions to nonperforming loans rose to 150 percent).
  - Superannuation funds’ exposure to equities will notably reduce returns in 2008 relative to previous years, though returns appear poised to remain positive in 2008.
- Portfolio allocations (September 2008):
  - Nambawan: International 17 percent; Property 10 percent; Equities 52 percent; Fixed Interest 26 percent.
  - Nasfund: International 14 percent; Property 16 percent; Fixed Interest 31 percent; Equities 39 percent.

*Prepared by Erdembileg Ochirkhuu (Asia and Pacific Department). Sources: Bank of Papua New Guinea; Kina Securities Ltd.; Fund staff calculations; Nambawan Super; Nasfund; Standard and Poor's.*

### 5.       Taking a longer view, on a bilateral basis, the kina depreciated substantially

### _cr09113 - 5.       Taking a longer view, on a bilateral basis, the kina depreciated substantially

### Exchange rate developments and reserves
- During 1993–2002, the kina depreciated substantially against the US and the Australian dollars.
- During 2003–September 2008, the kina appreciated by 54 percent against the U.S. dollar, before depreciating by about 6 percent over October 2008–February 2009.
- The kina/Australian dollar exchange rate remained stable during 2003–June 2008. Since then, the kina appreciated dramatically (about 40 percent) against the Australian dollar.
- In effective terms, the kina remained relatively stable since 2002, but started to appreciate significantly since July 2008.
- During July–December 2008 the kina appreciated by 20 percent in nominal effective terms, and 27 percent in real effective terms.
- Foreign official reserves rose to US$2.8 billion by August 2008, then were drawn down to about US$2 billion at end-2008.

_Source data cited: Bank of Papua New Guinea; IFS; Fund staff estimates._

### Methodologies used
- Two complementary methodologies: the macro-balance (MB) approach and the reduced-form equilibrium real exchange rate (ERER) approach.
- Dataset: an unbalanced panel of 55 countries, annual observations covering 1973–2007.
- Estimation methods: ordinary least squares (OLS) and generalized methods of moments (GMM), with country fixed effects and corrections for cross-section specific unconditional heteroskedasticity.

### Macroeconomic balance (MB) approach — specification
- Dependent variable: current account balance/GDP (in deviation from trading partners).
- Explanatory variables include:
  - Fiscal balance as percent of GDP (relative to trading partners).
  - Old-age dependency ratio (ratio of retirement age population to working age population).
  - Population growth rate.
  - Growth rate of income per capita.
  - Ratio of oil balance to GDP, with multiplicative dummy for oil-exporting countries.
- GMM is required for a consistent decomposition of misalignment due to endogeneity concerns.

### MB approach — key econometric results (panel estimates)
- Sample observations: OLS 1,090; GMM 1,036.
- Adjusted R2: OLS 0.59; GMM 0.46.
- Coefficient highlights (relative to trading partners):
  - Fiscal Balance to GDP: OLS 0.2; GMM 0.18 *** / 0.14 * (positive — a 1 percentage point increase in government budget balance leads to 0.14–1.8 percentage point increase in CA/GDP depending on technique; text reports range "0.14–1.8" percent points).
  - Old-age dependency ratio: OLS -0.73 ***; GMM -0.89 *** (a 1 percentage point increase deteriorates CA by about 0.7 to 0.9 percent of GDP).
  - Population growth: OLS -1.06 ***; GMM -5.34 * (a 1 percentage point increase deteriorates CA norm by 1 percent to 5 percent of GDP).
  - Oil trade balance to GDP: OLS 0.36 ***; GMM 0.28 * (for oil exporters, oil trade balance to GDP coefficient OLS 0.55 ***; GMM 0.74 ***; text notes for oil-exporting countries a 1 percentage point increase in oil trade balance → 0.9 percentage point increase in CA/GDP under OLS decomposition).
  - Output growth: OLS -0.16 **; GMM -0.58 *** (a 1 percentage point increase in real GDP growth reduces CA/GDP by 0.16 to 0.58).
- Semi-elasticity of CA/GDP with respect to REER for Papua New Guinea is estimated to be -0.4.

### ERER approach — specification and results
- Dependent variable: real effective exchange rate (REER).
- Explanatory variables (medium-term fundamentals): terms of trade; real output per worker; government consumption relative to GDP and relative to trading partners; net foreign assets (NFA).
- Panel estimation highlights:
  - Observations: OLS 710; GMM 666.
  - Adjusted R2: OLS 0.50; GMM 0.53.
  - Terms of trade (log): OLS 0.35 ***; GMM 0.40 *** (a 10 percent increase in terms of trade implies an equilibrium appreciation of about 4 percent).
  - Real output per worker (log, PPP): OLS 0.23; GMM 0.20.
  - Government consumption to GDP (relative to trading partners): OLS 1.67 ***; GMM 1.01 ** (a 1 percentage point increase in government consumption/GDP → about 2 percent appreciation of equilibrium REER).
  - Net foreign assets to GDP: OLS -0.10 **; GMM -0.13 *** (coefficient on NFA is negative in this panel).

### Exchange rate assessment for Papua New Guinea — methodology application
- MB approach: use projected CA for 2013 as the underlying current account (corresponds to -3.1 percent in 2013 consistent with the macroframework in the staff report) and GMM estimates to compute the CA norm; exchange rate adjustment = current account gap divided by semi-elasticity (-0.4).
- ERER approach: equilibrium REER estimated using GMM panel coefficients; exchange rate adjustment = difference between estimated equilibrium REER and current value (overvaluation assessed relative to January 2009). IMF projects constant REER; expected REER in 2013 equals its current value (January 2009).

### Baseline scenario results
- MB approach baseline: overvaluation of 3 percent (REER adjustment = 3 percent), which is not significantly different from zero given statistical uncertainty. Table shows MB approach REER NormProj.2/Overvaluation: -1.9 -3.1 3.0 (all results in percent; note projection of underlying CA/GDP in 2013 and semi-elasticity used).
- ERER approach baseline: overvaluation of 16 percent (overvaluation assessed relative to January 2009). Table shows ERER approach Overvaluation 16.3 (expressed in percent).

### Terms-of-trade shock scenario (20 percent decline in commodity prices)
- MB approach under shock: overvaluation of about 26 percent. Table reports MB approach REER NormProj.2/Overvaluation: -1.9 -12.5 26.5 (all results in percent; staff projection of CA/GDP in 2013 under terms-of-trade shock).
- ERER approach under shock: overvaluation of about 24 percent (table reports 23.8 percent).
- Conclusion: both approaches indicate a much larger overvaluation under a 20 percent terms-of-trade decline.

### Decomposition of determinants
- MB approach: demographic factors and high trade oil surpluses are main determinants of equilibrium current account.
- ERER approach: changes in terms of trade and government consumption are key in determining equilibrium exchange rate.

### Caveats and possible model extensions
- Results should be interpreted with caution due to uncertainty around medium-term projections and wide model estimate ranges; analysis is diagnostic rather than a precise yardstick.
- Standard model specifications may not be tailored for exhaustible-resource-rich and low-income countries like Papua New Guinea.
- Possible model modifications:
  - Use non-mineral fiscal balance to separate mineral revenues from nonmineral fiscal effects.
  - Include measures of mineral wealth to capture intertemporal saving motives and the need for larger surpluses to finance accumulation of net foreign assets.

### Policy implications and conclusions
- The assessment suggests the kina is somewhat above its equilibrium value.
- Given the sharp decline in commodity prices, the currency should be allowed to adjust to help offset the impact on export incomes.
- Policy recommendations:
  - Increase flexibility of the exchange rate regime while ensuring maintenance of a credible anchor for monetary policy.
  - Greater exchange rate flexibility would help safeguard official foreign currency reserves and cushion the impact of falling external demand.
- The analysis confirms the importance of terms of trade in determining equilibrium exchange rate and current account, while emphasizing that high commodity price volatility amplifies uncertainty in the assessment.

*Source: Fund staff estimates and analysis in the provided content unit.*

### References

### _cr09113 - References

### References
- Bems, Rudolfs, and Ireneu de Carvalho Filho, 2008, Savings and Precautionary Motive for Exporters of Exhaustible Resources, Power point Presentation, (Washington: International Monetary Fund).
- ––––––, Box 6.1 Current Account Determinants for Oil-Exporting Countries, “Financial Stress, Downturns, and Recoveries, October 2008,” World Economic Outlook, (Washington: International Monetary Fund).
- Edison, Hali, and Francis Vitek, 2009, “Australia and New Zealand Exchange Rates: A Quantitative Assessment,” IMF Working Paper No. 09/7 (Washington: International Monetary Fund).
- Isard, Peter, Hamid Faruqee, Russell Kincaid, and Martin Fetherston, 2001, “Methodology for Current Account and Exchange Rate Assessments,” IMF Occasional Paper No. 209 (Washington: International Monetary Fund).
- Isard, Peter, and Hamid Faruqee, 1998, “Exchange Rate Assessment. Extensions of the Macroeconomic Balance Approach,” IMF Occasional Paper No. 167 (Washington: International Monetary Fund).
- Kauzi, Gae, and Thomas Sampson, 2009, “Shock Exposure-Commodity Prices and Kina,” forthcoming as Bank of Papua New Guinea Working Paper.
- Lee, Jaewoo, Gian Maria Milesi-Ferretti, Jonathan Ostry, Alessandro Prati, and Luca Ricci, 2008, “Exchange Rate Assessments. CGER Methodologies,” IMF Occasional Paper No. 261 (Washington: International Monetary Fund).
- Ricci, Luca, Gian Maria Milesi-Ferretti, and Jaewoo Lee, 2008, “Real Exchange Rate Fundamentals: A Cross Country Perspective,” IMF Working Paper No. 08/13 (Washington: International Monetary Fund).
- Thomas, Alun, Jun Il Kim, and Aqib Aslam, 2008, “Equilibrium Non-Oil Current Account Assessments for Oil Producing Countries,” IMF Working Paper No. 08/198 (Washington: International Monetary Fund).

### Appendix: Data set and Model Specifications
- Country coverage:
  - Algeria, Argentina, Australia, Austria, Belgium, Brazil, Canada, Chile, China, Colombia, Croatia, Czech Republic, Denmark, Egypt, Finland, France, Germany, Greece, Hong Kong SAR, Hungary, India, Indonesia, Ireland, Israel, Italy, Japan, Korea, Luxembourg, Malaysia, Mexico, Morocco, Netherlands, New Zealand, Norway, Pakistan, Papua New Guinea, Peru, Philippines, Poland, Portugal, Russia, Saudi Arabia, Singapore, Slovak Republic, South Africa, Spain, Sweden, Switzerland, Taiwan POC, Thailand, Tunisia, Turkey, United States, United Kingdom, Venezuela.
- Sub-group of oil-exporting countries includes:
  - Algeria, Egypt, Indonesia, Malaysia, Papua New Guinea, Russia, Saudi Arabia, and Venezuela.
- Data sources:
  - IMF World Economic Outlook Database: Current account balance, fiscal balance, real GDP at purchasing power parity, oil trade balance, real per capital GDP growth; and population growth.
  - World Bank World Development Indicators Database: Population over 65 years, and economically active population, i.e., population between 15 and 64 years old.

### Macroeconomic Balance (MB) Approach — key structure and variables
- Basic building blocks:
  - Estimate an equilibrium relationship between the current account balance and macroeconomic fundamentals.
  - Use coefficients and medium-term values of fundamentals (i.e., the WEO projections for 2013) to compute an estimated equilibrium current account balance (i.e., norm).
  - Calculate the real exchange rate adjustment needed to close the gap between the estimated current account norm and the underlying current account balance projected over the medium term—horizon over which domestic and partner-country output gaps are closed and the lagged effects of past exchange rate changes are fully realized—at prevailing exchange rates.
- Degree of exchange rate misalignment:
  - Calculated by dividing the difference between the underlying current account and the estimated current account norm, by country-specific elasticities of the current account with respect to the real exchange rate.
  - Note: In the model used in this chapter, the elasticity of the current account to ERER is endogenously estimated for each country. For Papua New Guinea the elasticity of the current account to ERER is equal to -0.4.
- MB estimated panel equation:
  - ,,,,,titi T i0ti xCAεββ++=  where ti,CA, is the current account as a share of GDP; i0,β represent country fixed effects; ti,x, denotes vector of explanatory variables; and ti,ε is the error term.
- Interpretations of determinants:
  - Fiscal Balance: A higher government budget balance raises national savings and therefore increases the current account balance.
  - Demographic variables: Higher old-dependency ratio and higher population growth rate reduce national savings and decrease the current account balance.
  - Oil balance: Higher oil prices increase the current account balance in oil exporting countries and decrease it in oil-importing countries.
  - Economic growth: The deviation of the real per capita GDP growth rate from its trading-partner average captures relative economic growth; the current account balance is expected to decline with relative growth.
- Ricardian equivalence caveat:
  - Only in the case of full Ricardian equivalence (i.e., the private saving fully offsets the change in public savings), there would be no link between the government fiscal balance and the current account balance.

### Equilibrium Real Exchange Rate (ERER) Approach — specification and fundamentals
- Estimated equation:
  - ,ln ,, , ti ti i0 xQ ε β β ++ =  where i0,β denotes country-specific fixed effects; ti,Q, _ln is the logarithm of the real effective exchange rate; ti,x, denotes vector of explanatory variables; and ti,ε is the error term.
- Explanatory variables (medium-term fundamentals):
  - Terms of trade (expressed in logarithms): Higher terms of trade should appreciate the real effective exchange rate via real income or wealth effects.
  - Real output per worker: Proxy for productivity and Balassa-Samuelson effects; increases should appreciate the real effective exchange rate.
  - Government consumption relative to GDP and relative to trading partners: Proxy to capture Balassa-Samuelson effects; higher government consumption likely appreciates the real exchange rate to the extent it falls more on nontradables.
  - Net foreign assets (NFA) to GDP: Debtor countries are predicted to need a more depreciated real exchange rate to generate trade surpluses necessary to service liabilities.

### Selected empirical data and key numeric statistics for Papua New Guinea (extracted tables)
- Table 1. Papua New Guinea: GDP by Sector at Current Market Prices, 2003–07 (In millions of kina)
  - Nominal GDP 2003: 12,567; 2004: 12,652; 2005: 15,195; 2006: 17,132; 2007: 18,716.
  - Mineral 2003: 2,252; 2004: 2,391; 2005: 3,555; 2006: 4,685; 2007: 4,897.
  - Non-mineral 2003: 10,316; 2004: 10,261; 2005: 11,640; 2006: 12,448; 2007: 13,819.
  - Memorandum (percent of GDP) — Mineral shares: 2003: 17.9; 2004: 18.9; 2005: 23.4; 2006: 27.3; 2007: 26.2.
- Table 2. Papua New Guinea: GDP by Sector at 1998 Constant Prices, 2003–07 (In millions of 1998 kina; Annual percentage change)
  - Real GDP levels: 2003: 7,896; 2004: 8,111; 2005: 8,402; 2006: 8,619; 2007: 9,180.
  - Real GDP (annual percentage change) 2003: 2.2; 2004: 2.7; 2005: 3.6; 2006: 2.6; 2007: 5. 
  - Non-mineral real GDP growth rates: 2003: 2.1; 2004: 3.1; 2005: 3.4; 2006: 3.8; 2007: 7.3.
- Table 3. Papua New Guinea: Production of Major Commodities, 2004–08 (In millions of U.S. dollars)
  - Crude oil production volumes (millions of barrels): 2004: 12.6; 2005: 13.3; 2006: 14.5; 2007: 13.8; 2008 Sept.: 8.6.
  - Crude oil production values: 2004: 513; 2005: 735; 2006: 967; 2007: 1,018; 2008 Sept.: 1,002.
  - Copper values: 2004: 479; 2005: 806; 2006: 1,414; 2007: 1,424; 2008 Sept.: 1,110.
  - Gold values: 2004: 862; 2005: 914; 2006: 998; 2007: 1,254; 2008 Sept.: 1,258.
- Table 4. Papua New Guinea: Employment by Sector, 2004–08 (March 2002=100, annual average)
  - Total index values: 2004 March: 778.0; 2005 March: 778.7; 2006 March: 800.8; 2007 March: 809.3; 2008 March: 870.3.
  - Memorandum item weights (percent): Total 100.0; Food and Beverages 40.9; Clothing, Footwear and Betelnut 20.0; Rents, Fuel, and Power 6.2; Household Equipment and Operations 7.2; Transport and Communication 5.3; Misc. Comm. 13.0; Others 7.5.
- Table 6. Papua New Guinea: Central Government Budget 2004–07 (In percent of GDP)
  - Revenue and grants: 2004: 34.1; 2005: 34.9; 2006: 36.7; 2007: 37.3.
  - Tax (percent of GDP): 2004: 25.4; 2005: 24.6; 2006: 28.9; 2007: 31.3.
  - Mineral taxes: 2004: 5.8; 2005: 7.6; 2006: 11.7; 2007: 12.8.
  - Expenditure (percent of GDP): 2004: 32.4; 2005: 31.2; 2006: 30.0; 2007: 29.2.
  - Overall balance (from above the line): 2004: 1.7; 2005: 3.7; 2006: 6.7; 2007: 8.2.
  - Financing: 2004: 0.0; 2005: -3.8; 2006: -5.6; 2007: -7.2.
  - Memorandum: Nominal GDP (in millions of kina): 2004: 12,652; 2005: 15,195; 2006: 17,132; 2007: 18,716. Nonmineral fiscal balance: 2004: -6.3; 2005: -4.7; 2006: -7.6; 2007: -6.8.
- Table 7. Papua New Guinea: Central Government Revenue and Grants 2004–07 (In millions of kina)
  - Total revenue and grants: 2004: 4,315; 2005: 5,307; 2006: 6,288; 2007: 6,986.
  - Tax revenue: 2004: 3,220; 2005: 3,744; 2006: 4,945; 2007: 5,854.
  - Taxes on income and profit: 2004: 2,223; 2005: 2,771; 2006: 3,824; 2007: 4,491.
  - Mineral and petroleum taxes: 2004: 634; 2005: 1,077; 2006: 1,947; 2007: 2,334.
  - Indirect taxes: 2004: 997; 2005: 973; 2006: 1,121; 2007: 1,363.
  - Nontax revenue: 2004: 245; 2005: 279; 2006: 429; 2007: 411.
  - Foreign grants: 2004: 850; 2005: 1,283; 2006: 915; 2007: 721.
- Table 9. Papua New Guinea: Monetary Survey, 2004–08 (In millions of kina; end of period)
  - Net foreign assets: 2004: 2,165; 2005: 2,929; 2006: 4,648; 2007: 7,073; 2008: 6,204.
  - Broad money: 2004: 3,915; 2005: 5,069; 2006: 7,041; 2007: 8,995; 2008: 10,017.
  - Narrow money: 2004: 2,232; 2005: 3,017; 2006: 3,792; 2007: 4,923; 2008: 5,520.
  - Memorandum narrow money growth rate (year-on-year): 2004: 30.8; 2005: 35.2; 2006: 25.7; 2007: 29.8; 2008: 12.1.
  - Broad money growth rate (year-on-year): 2004: 14.8; 2005: 29.5; 2006: 38.9; 2007: 27.8; 2008: 11.4.
  - Private sector credit growth rate (year-on-year): 2004: 0.9; 2005: 23.7; 2006: 38.2; 2007: 34.4; 2008: 41.0.
- Table 15. Papua New Guinea: Balance of Payments, 2003–07 (In millions of U.S. dollars)
  - Current account balance: 2003: 159; 2004: 88; 2005: 205; 2006: 128; 2007: 112.
  - Mineral current account contribution: 2003: 728; 2004: 866; 2005: 1,072; 2006: 1,401; 2007: 1,368.
  - Non-mineral current account contribution: 2003: -569; 2004: -778; 2005: -867; 2006: -1,273; 2007: -1,255.
  - Exports (f.o.b.): 2003: 2,153; 2004: 2,554; 2005: 3,278; 2006: 4,207; 2007: 4,750.
  - Imports (c.i.f.): 2003: -1,435; 2004: -1,794; 2005: -2,462; 2006: -2,805; 2007: -3,331.
  - Net international reserves (end-year, millions of U.S. dollars): 2003: 399; 2004: 599; 2005: 765; 2006: 1,425; 2007: 2,083.
  - Gross official reserves (end-year, millions of U.S. dollars): 2003: 523; 2004: 663; 2005: 765; 2006: 1,427; 2007: 2,087.
  - Oil Price (average of 3 spot prices; US$/BBL): 2003: 28.93; 2004: 37.85; 2005: 53.46; 2006: 64.37; 2007: 71.1.
  - Copper Price (grade A, LME spot price, US$/MT): 2003: 1,779.4; 2004: 2,863.5; 2005: 3,676.5; 2006: 6,731.4; 2007: 7,131.6.
  - Gold Price (London 3 PM fixed price, US$/troy ounce): 2003: 363.5; 2004: 409.2; 2005: 444.9; 2006: 604.3; 2007: 696.7.
- Table 16. Papua New Guinea: Exports of Major Commodities, 2003–07 (selected lines)
  - Total exports (in millions of U.S. dollars): 2003: 2,153; 2004: 2,554; 2005: 3,278; 2006: 4,207; 2007: 4,750.
  - Minerals and petroleum: 2003: 1,635; 2004: 1,863; 2005: 2,467; 2006: 3,391; 2007: 3,709.
  - Non-mineral exports: 2003: 518; 2004: 690; 2005: 811; 2006: 815; 2007: 1,042.
- Table 19. Papua New Guinea: External Debt Outstanding, 2003–07 (In millions of U.S. dollars)
  - Total external debt: 2003: 2,308; 2004: 2,159; 2005: 2,048; 2006: 2,176; 2007: 1,999.
  - Public external debt: 2003: 1,614; 2004: 1,492; 2005: 1,273; 2006: 1,196; 2007: 1,105.
  - Memorandum (percent of GDP) — Total public external debt: 2003: 39.0; 2004: 34.9; 2005: 25.4; 2006: 21.1; 2007: 16.7.
- Table 20. Papua New Guinea: Public External Debt Service, 2003–07 (In millions of U.S. dollars)
  - Total public sector debt service: 2003: 182.7; 2004: 241.1; 2005: 212.1; 2006: 158.3; 2007: 208.2.
  - Central government debt-service principal and interest components and creditor breakdowns are reported in the table (see source file for full breakdowns).

### Methodological and empirical notes (as stated in the unit)
- Medium-term projections referenced use WEO projections for 2013 when computing equilibrium current account norms.
- Elasticities of the current account with respect to the real exchange rate are estimated endogenously in the chapter’s model and are country-specific.
- The MB and ERER approaches rely on country fixed effects in panel regressions and use standard macroeconomic fundamentals consistent with CGER methodologies.

*Italicized: IMF staff compiled references, country coverage, model specifications, and Papua New Guinea tables and figures as presented in the source unit.*

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