Papua New Guinea and the IMF

News Brief: IMF Concludes Fourth Review of Papua New Guinea Program, Approves US$24 Million Credit

Country's Policy Intentions Documents

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Papua New Guinea— Letter of Intent

August 31, 2001

The following item is a Letter of Intent of the government of Papua New Guinea, which describes the policies that Papua New Guinea intends to implement in the context of its request for financial support from the IMF. The document, which is the property of Papua New Guinea, is being made available on the IMF website by agreement with the member as a service to users of the IMF website.

Mr. Horst Köhler
Managing Director
International Monetary Fund

Dear Mr. Köhler:

The attached Memorandum of Economic and Financial Policies supplements the understandings specified in our letters and attached memoranda to Mr. Fischer on March 20, 2000, and to you on October 2, 2000 and on April 6, 2001. It also describes the recent progress in implementing the economic policies and attaining the economic objectives of the Government of Papua New Guinea, which are supported by the Stand-By Arrangement approved by the Fund on March 29, 2000. As indicated in the Memorandum, we remain committed to achieving a sustainable fiscal position, reducing inflation, strengthening international reserves, and implementing structural reforms.

In support of these policies, the Government of Papua New Guinea hereby requests completion of the fourth review and the fifth and last purchase under the arrangement. The Government of Papua New Guinea also requests waivers for the nonobservance of the performance criteria for end-June 2001 on the floor of the net international reserves of the central bank of Papua New Guinea (BPNG) and the ceiling on the net domestic financing of the government. These criteria were not met largely as a result of a shortfall in tax revenue and the later-than-expected disbursement of the floating tranche under the World Bank's Governance Promotion Adjustment Loan.

In line with the commitment specified in our letter of intent of April 6, 2001, the Government of Papua New Guinea has decided to cut expenditure by K 80 million from the levels agreed at that time in order to offset in part the lower tax revenue now projected for 2001. Most of the cuts (K 47 million) became effective on July 21, with the remainder to be implemented in early September 2001. The Government agrees that implementation of these cuts will be a prior action for completing the fourth review under the program. Also, the Government will continue to adhere to the guidelines introduced in 2000 for the operation of the Rural Development Program, which are aimed at improving governance and the quality of expenditure.

The government remains committed to privatisation, including of the Papua New Guinea Banking Corporation (PNGBC), which was brought to the point of sale in April 2001 (prior action for the completion of the second and third reviews).

The Government of Papua New Guinea recognizes the importance of a close relationship with the Fund, among other things, to facilitate continued donor support, particularly in view of the country's vulnerability to shocks. The Government of Papua New Guinea will stand ready to take any additional measures necessary to keep the economic program on track, and it will remain in close consultation with the Fund, in accordance with Fund policies.

In the interest of solidifying private sector confidence through a commitment to transparency, the Government requests that the Fund publish the attached Memorandum.

Sincerely yours,

Hon. Sir Mekere Morauta, Kt, MP
Prime Minister and Treasurer
Mr. L. Wilson Kamit, CBE
Governor, Bank of Papua New Guinea



Supplementary Memorandum of Economic and Financial Policies
Fourth Review Under the Stand-By Arrangement

I. Introduction

1. The Government's policies continue to be guided by the macroeconomic adjustment and structural reform program described in the March 2000 Memorandum of Economic and Financial Policies and the October 2000 and April 2001 supplements. The Government's economic program continues to be developed in consultation with multilateral and bilateral donors.

II. Performance Under the Program

2. Policy implementation in the first half of 2001 remained generally satisfactory. While indicative targets for end-March and the quantitative performance criteria for end-June on the Bank of Papua New Guinea's net international reserves (NIR) and on the Government's net domestic financing (NDF) were not observed, the deviations resulted largely from a shortfall in tax revenue and the later-than-expected disbursement of the floating tranche under the World Bank's Governance Promotion Adjustment Loan (GPAL). The performance criterion on the Bank of Papua New Guinea's net domestic assets (NDA) was observed. Weaker-than-expected economic activity contributed to the revenue shortfall while complications in meeting World Bank conditionality delayed to mid-July the release of the floating tranche.

3. Inflation has continued to decline, with the 12-month rate falling further to 9 percent for the quarter ending March 2001. Economic activity, however, has remained weak. Both tax and monetary indicators point to a contraction in business activity despite recent declines in interest rates. The coffee industry has been adversely affected by depressed international prices, rising costs, deteriorated infrastructure, and the lack of bank credit due to a weakening in debt-service capacity. With mineral output expected to fall markedly and most nonmineral activities projected to stagnate, overall real GDP growth is likely to contract by 2 percent in 2001.

4. The fiscal deficit was lower than programmed in the first half of 2001, but the domestic borrowing requirement was higher than expected. Expenditure restraint helped address cash flow difficulties arising from the shortfalls in tax revenue and external financing relative to program projections. Nevertheless, the Government had to resort to larger-than-planned domestic borrowing, which led to a breach in the central bank's lending limit to the Government in March. To remedy this situation, the Government secured early release of the second tranche ($10 million) of the budgetary support loan from Australia that was tied to the completion of the second review under the Stand-By Arrangement (SBA). Even though the third tranche of the loan from Australia ($10 million) was received following completion by the Fund Board of the second and third reviews of the SBA, a substantial placement of government securities in the domestic market was required to fund government operations in the first half of 2001.

5. Volatility in market sentiment has contributed to exchange rate fluctuations in 2001. Due to noneconomic factors, the kina came under pressure in February and March, but pressures eased somewhat during the second quarter, as confidence recovered with the announcement of the financing from Australia and the Fund purchases associated with the second and third reviews.

6. The central bank has viewed delays in external financing and noneconomic events affecting market sentiment as temporary in nature, selling foreign exchange to dampen exchange-rate volatility. While this intervention contributed to a reserve loss of $29 million through end-March, net purchases permitted a recovery of NIR of around $13 million during the second quarter to $240 million.1

7. The central bank has reduced its benchmark interest rate in recent months. In response to the decline in inflation in the six-month period through end-March 2001, and cuts in interest rates in key partner countries, the central bank lowered the kina facility rate (KFR) on several occasions. As a result, commercial bank lending and deposit rates fell, and interest rates on treasury bills declined across all maturities. However, in the context of continued weak activity, monetary aggregates have grown at a relatively slow rate, with base and broad money both increasing by around 6½ percent over the year ending June 2001. Excluding a large loan extended by a single bank, bank credit to the private sector has grown by only 2½ percent during the same period.

8. The external current account surplus is expected to decline to about 4 percent of GDP in 2001. Both mineral and nonmineral exports are projected to decline as a result of lower coffee and oil production and depressed coffee prices. Also, imports are expected to fall as a result of weaker economic activity, including declining investment in the mineral sector. The capital account deficit is projected to moderate mainly as a result of a substantial increase in net official capital inflows. In all, the balance of payments is projected to remain in surplus, permitting a gain in NIR of $33 million in 2001, $10 million less than previously targeted under the program.

9. The Government has moved forward with its privatisation agenda in recent months despite difficult circumstances. The Papua New Guinea Banking Corporation (PNGBC) was brought to the point of sale in early April 2001, when the Government issued an Information Memorandum for the sale of PNGBC, advertised in the international press its decision to proceed with this sale, and solicited bids with the assistance of international financial advisors. Also in April, the Government, in consultation with the World Bank, formulated a plan for the privatisation of Motor Vehicle Insurance Limited. In early July, the Government took action that permitted the lifting of a court injunction against the sale of PNGBC. The injunction was issued in May in the context of a civil claim on PNGBC's parent company, Finance Pacific Limited, by a former executive. Preparations have continued for the privatisation of state enterprises, especially the development of the regulatory framework for the electricity, water, telecommunications, and port industries. The sale of Air Niugini, originally planned for March, was postponed because bids received were judged to be unsatisfactory, reflecting in part difficulties in the international airline industry. Subsequently, however, the Government initiated discussions with bidders on ways to involve private sector participation in the company.

10. Progress has continued in public sector reform. Functional reviews have been completed for the Departments of Finance and Treasury, Prime Minister and National Executive Council, Personnel Management, and Foreign Affairs, as well as for the National Fisheries Authority. In line with the recommendations emanating from functional review of the Foreign Affairs Department, three missions abroad were closed in July 2001. This, along with retrenchments of public servants in December 2000, should help rationalize expenditure and raise efficiency. A contract for a new integrated human resources management system was awarded in August to replace the outdated payroll system and personnel records. Adherence to the guidelines governing the implementation of the Rural Development Program (RDP) has improved governance and is expected to result in a more efficient use of resources, and current delays in project execution are likely to diminish as parliamentarians gain experience with the procedures. However, the Government remains concerned about these delays, and will seek to improve the pace of project execution in consultation with the World Bank.

III. Policies for the Remainder of 2001

11. The Government remains committed to macroeconomic stabilization and economic reform. The Government is determined to persevere with program implementation to help solidify confidence and create the conditions for an economic recovery. Consequently, it will adhere to the fiscal path agreed under the program and will work to meet multilateral conditionality on a timely basis. This is expected to facilitate the release of external assistance, including that envisaged for the remainder of 2001 to be disbursed by the World Bank, the Asian Development Bank, Japan, the European Union, and China.

12. Notwithstanding the difficult economic environment, the Government's financial policy objectives remain broadly unchanged. Policies continue to be aimed at reducing the rate of inflation to 8 percent by end-December 2001, and to further strengthen the international reserve position of the country. However, due to the weaker activity projected for 2001 and its adverse effect on the government finances, the fiscal deficit will now be slightly higher at 2.6 percent of GDP compared to 2.3 percent of GDP previously agreed, as full compensation for revenue underperformance will not be feasible. Nevertheless, this fiscal outturn will permit an increase in NIR to $290 million by end-December 2001, compared to the $300 million originally envisaged. In line with the commitment in the letter of intent of April 6, 2001, any net privatisation proceeds will be used to reduce net government debt.

Fiscal policy

13. Early action to cut government expenditure will help limit the fiscal deficit to 2.6 percent of GDP in 2001. In the absence of measures, the fiscal deficit would reach 3.4 percent of GDP in 2001, raising the domestic borrowing requirement substantially and thus placing pressure on credit and foreign exchange markets during the remainder of the year. Consequently, the Government has decided to cut K 80 million from the programmed level (one-third from goods and services and the remainder from development and other programs). Most of these cuts (K 47 million) became effective on July 21, with the remainder to be implemented in early September (prior action for the completion of the fourth review), following consultations with government departments to ensure adequate funding for essential services. Notwithstanding these cuts, government expenditure is projected to increase from 31 percent of GDP in 2000 to 32½ percent of GDP in 2001. In addition, the Government will refrain from wage increases beyond existing commitments as well as from increases in staffing (except for priority areas, namely education, health, revenue collection, law and order, infrastructure, and agriculture), which will help avoid a further rise in the government wage bill in relation to GDP.

14. The revised fiscal plan for the second half of 2001 will allow the Government to meet its core functions and obligations without incurring arrears. As the programs selected for cuts were underexecuted in the first half of the year, the expenditure reductions will help maintain quality control by avoiding too fast an acceleration in the budget execution rate, given limited implementation capacity. Further scope for expenditure reductions would occur during the second half of the year, if execution of the RDP continues to be slow. This would be in addition to the deferral of K 30 million of RDP expenditures adopted by the Government prior to the completion of the second and third reviews.

15. The Government is committed to improving tax administration. While lower output and imports and higher value-added tax refunds were key factors behind the revenue underperformance, slower-than-envisaged recovery of tax arrears also played a role. To improve conditions for tax administration, the Government will submit to Parliament by end-2001 legislation to increase penalties on tax evasion, and will also allocate additional staff to the Internal Revenue Commission, which will permit strengthening inspections, audits, and the prosecution of delinquencies. The Government will initiate a review of taxation of the forestry industry aimed at designing an equitable revenue-sharing arrangement among operators, landowners, and the State that fosters resource sustainability, the viability of the industry, and environmentally sound management.

16. A number of risks apply to the fiscal plan. A further weakening of economic activity could lower tax revenue from revised targets and delay dividend payments to the Treasury by selected enterprises. On the financing side, delays in the release of external resources ($85 million) envisaged to materialize late in the year would considerably increase the domestic borrowing requirement and lead to higher interest rates. More generally, the revenue, expenditure, and financing situation will need to be monitored very closely in the months ahead, with additional measures taken, if necessary, to achieve the fiscal targets for 2001. Given the Government's intention to maintain a stable tax system, further adjustment measures, if needed, would focus on reductions in spending.

Monetary and exchange rate policies

17. BPNG will maintain monetary policy focused on attaining price stability. While the support of fiscal policy is needed for achieving NDA and NIR targets, the central bank will stand ready to conduct open market sales to ensure adherence to these targets, even if interest rates need to firm. Treasury and BPNG will strengthen coordination with regard to short-term cash flow, debt, and liquidity management, which should prevent breaches of the limit on central bank lending to the government.

18. BPNG will intervene in the foreign exchange market to smooth short-term volatility of exchange rates, while facilitating achievement of the NIR target.

Structural reform policies

19. The Government remains committed to the privatisation program. In the weeks ahead the Government will provide qualified parties interested in purchasing PNGBC with the additional information necessary for conducting due diligence and preparing bids. The Government expects the sale of a controlling interest in this bank to take place during November or December 2001. The Government plans to divest through a People's Unit Trust (PUT) part of its remaining shares in PNGBC and shares in public utilities and other public enterprises. Buying shares sold by PUT would enable the general public to acquire a financial interest in privatised enterprises. As part of the work to develop the regulatory framework for utilities, the Government plans to establish early in 2002 a single authority to regulate these industries. The Government is also committed to formulating policy to ensure adequate provision of utility services to the rural areas.

20. Further progress will be made on the Public Sector Reform Program, which is aimed at ensuring efficient use of budgetary resources and improving public service delivery. During the second half of 2001 functional and expenditure reviews will be completed for the Departments of Health, Works and Transportation, Lands and Physical Planning, National Planning and Monitoring, and the Attorney General. Recommendations contained in reviews completed by October 2001 will be incorporated in the budget for 2002. The Government will continue to implement the RDP in accordance with guidelines designed with support from the World Bank in 2000.

21. The new Superannuation and Life Insurance Acts, which were passed by Parliament in December 2000, will be gazetted by the end of 2001. A task force has been established to draft necessary regulations in consultation with the industry and the BPNG, the supervising authority. Pension funds are preparing to meet the new requirements, which include the appointment of qualified trustees, and professional investment management. The National Provident Fund, which was in financial distress, has repaid its debt, and is expected to continue to improve its operations.

IV. Policies for 2002

22. The Government will press forward with stabilization and reform in 2002. To this end, it will formulate the budget for 2002 in a manner consistent with prudent fiscal management. Taking into account the need to facilitate an economic recovery, the Government intends to aim policies in 2002 to further reduce inflation and increasing NIR. Efforts in the structural area will continue to focus on improving governance, including through public sector reform, privatisation, and other efforts to facilitate private sector activity. Against the backdrop of the declining trend in mineral output, overall real GDP is expected to grow moderately on the strength of nonmineral output growth. In this context, the fiscal deficit will be reduced in order to limit the domestic borrowing requirement to a level consistent with adequate bank credit to the private sector. As mineral tax revenue is likely to fall in relation to GDP in 2002, overall expenditures will need to be restrained to ensure sustainability over the medium term. The external current account balance is projected to register a small surplus aided by a projected recovery in export prices for agricultural commodities, and a contraction in imports by the mineral sector.

V. Statistical and Technical Assistance Issues

23. The Government recognizes that statistical weaknesses hamper policy formulation. It intends to seek donor support to strengthen the capacity of the National Statistical Office to compile the national accounts and the price statistics, along the lines of recent recommendations from PFTAC. Priority will also be attached to conducting a household income and expenditure survey in the second half of 2001 that should permit the reweighting of the CPI in 2002. The Government will continue to work to implement the recommendations of the FAD mission that visited Port Moresby in December 2000 to address inconsistencies in the coverage and timing between monetary and fiscal statistics. In this regard, the BPNG will finalize and implement shortly a revision of the Manual of Reporting Framework for commercial banks that will improve the classification of government deposits in the monetary survey. The manual will be discussed with an FAD expert expected in the weeks ahead. This, along with the introduction of an electronic registry of government securities planned for 2002, will help improve the compilation of the monetary survey and reconciliation of government financing data. Efforts are under way to compile a database of financial and operating leases contracted by the public sector.

24. BPNG will consider implementation of the recent MAE mission recommendations to improve monetary policy formulation and management. In this regard, a draft of the proposed Master Repurchase Agreement has been circulated to the commercial banks for comment, and is expected to be adopted in the coming months. BPNG has changed the procedures for its weekly government securities auction to allow additional sales of oversubscribed maturities, subject to the overall amount remaining unchanged.

25. With regard to the Fund's Safeguards Assessment, BPNG has provided its 1999 audited accounts to the Fund staff, and is committed to continue to provide audit reports to Fund staff on a timely basis.

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1 Valued at program exchange rates, NIR at end-June was $235 million.