Papua New Guinea—2010 Article IV Consultation, Preliminary Concluding Statement of the IMF Mission

March 5, 2010

Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.

February 22, 2010

This statement contains our preliminary policy recommendations following discussions with the Papua New Guinean authorities and a range of other institutions. The discussions focused on maintaining macroeconomic stability and fostering broad-based growth given the challenges and opportunities presented by the Liquefied Natural Gas (LNG) projects.

1. Strong terms of trade, an insulated financial sector, and effective implementation of sound policy frameworks left Papua New Guinea well positioned at the onset of the global financial crisis. As a result, growth slowed only modestly. Recently, however, policy implementation has weakened as spending in 2009 from accumulated above-normal mineral revenue was far above the limit set out in the Medium-Term Fiscal Strategy (MTFS). Further, no above-normal mineral revenue was directed toward debt reduction in the 2010 budget, which is also inconsistent with the MTFS. Nor at this point has the government met its legislated obligation to fully fund its 2009 and 2010 public sector pension contributions. In addition, lack of coordination between monetary and fiscal policy undermined the effectiveness of monetary policy.

2. The LNG projects provide an opportunity to notably raise long-term growth and living standards. To ensure that the opportunity is not wasted, now is the time to strengthen policy frameworks and implementation. In particular, strict adherence to the rules embodied in the MTFS, close coordination of monetary and fiscal policy, and the integration of a Sovereign Wealth Fund (SWF) into the macro framework will help maintain macroeconomic stability and ensure that development objectives are achieved. The LNG projects will launch Papua New Guinea onto the world stage and, consequently, international scrutiny will increase. Adherence to sound policy frameworks will be essential for the country to build the international credibility that will allow it to fully reap the benefits.

Macroeconomic Outlook and Risks

3. Growth and inflation are projected to rebound in 2010. The LNG construction phase and its impact on domestic confidence will stimulate growth and strain domestic capacity. These domestic demand pressures combined with the recovery in international commodity prices and the depreciation of the kina against the Australian dollar in 2009 will fuel a pickup in inflation. Although a weaker than expected recovery in the world economy presents some downside risk, overall the risks are tilted strongly to the upside on both activity and inflation. The direct and indirect impacts from the LNG construction phase could be larger than expected and public spending, particularly from trust accounts held outside the budget, could add more demand and inflation pressures than forecast.

Fiscal Policy

4. We commend the authorities for maintaining a medium-term fiscal framework aimed at increasing macroeconomic stability by insulating the budget from volatility in mineral revenue. However, recent slippages in the implementation of the framework have undermined its stabilization objective and fiscal credibility. Owing largely to spending from accumulated mineral revenue far in excess of the framework’s 4 percent of GDP limit, the fiscal stimulus in 2009 was much larger than warranted by the underlying strength in the economy. Although the 2010 budget reduces the stimulus, the planned level of spending is likely to be too expansionary given the expected strength in private activity. Further, spending from trust accounts outside the budget will add to demand pressures. With the LNG projects absorbing resources in the construction sector, delaying some infrastructure spending should be considered. This would ease overall demand pressures and help ensure that good value is achieved from this spending.

5. The construction phase of the LNG projects will increase the difficulty of maintaining macroeconomic stability and enhancements to the MTFS could be helpful to meet the challenges. First, it would be prudent to lower the assumption of normal mineral revenue to 3 percent of GDP between now and 2014, when LNG production is expected to commence. This would reduce pressures from public spending during a period of strong private spending and the increased public savings could be used to finance currently unfunded government liabilities, such as those associated with the LNG projects. Second, spending from above-normal mineral revenue needs to be more responsive to the cyclical position of the economy. Annual consultation between the monetary and fiscal authorities should determine how much of the 4 percent of GDP limit from above-normal mineral revenue can be spent.

6. Closer coordination of monetary and fiscal policy is desirable. Public trust accounts should be moved to the Bank of Papua New Guinea (BPNG) and procedures to automatically deposit above-normal mineral revenue with the central bank should be introduced. This will give the BPNG better control over domestic liquidity conditions and market interest rates, strengthening the effectiveness of monetary policy. Also, the net cost to the public sector would be reduced by limiting the need to use high-cost central bank bills to remove excess liquidity.

7. Overall the implementation of the MTFS needs to be strengthened. The hard-won fiscal credibility built during years of adherence to the framework can be easily lost, reducing long-term growth prospects. Strict adherence to the framework will also help deliver the fiscal prudence required to guard against unfavorable public debt dynamics from vulnerabilities such as those arising from potential LNG project delays, lower commodity prices, and weaker external demand.

8. To achieve Vision 2050, it will be essential to better align development spending with priorities and reinvigorate the reform process. There has been some progress on reform, with increased competition in telecommunications, aviation, and power. However, more needs to be done, particularly with those state-owned enterprises that will see considerable increases in demand from the LNG projects. The government’s commitment to implement a public-private-partnership policy is encouraging and could potentially facilitate significant private investment in infrastructure. Improvements to security and the business environment, such as access to credit and enforcement of contracts, would also yield significant benefits.

Monetary Policy and the Exchange Rate

9. Although inflation declined sharply over 2009, monetary policy needs to be forward looking and focused on emerging inflation pressures. Compared to the recent episode of high inflation, domestic demand will play a more important role in driving inflation up, which implies a greater risk that high inflation could become entrenched in expectations. The central bank needs to be prepared to respond quickly to contain inflation and manage inflation expectations.

10. The increase in LNG related imports is expected to widen the current account deficit over the next few years, however, it is expected to be financed with foreign direct investment without significant implications for external stability. The exchange rate is estimated to be broadly in line with fundamentals and reserves remain adequate to address potential balance of payments needs.

Sovereign Wealth Fund

11. With LNG projects underway, now is the time to develop a SWF to manage resource revenue. Given their responsibility for maintaining macroeconomic stability, a key SWF objective, the BPNG and the Treasury should lead the design process through wide stakeholder consultations. International experience and the expectation that the fund will have both stabilization and saving objectives suggest that a financing fund is the best way forward. Financing funds direct all public spending through the budget, enhancing macroeconomic stabilization and helping to ensure high quality spending aligned with development objectives. To maximize the long-run development impact of LNG income, domestic absorption capacity will need to guide the rate of drawdown. Further, to minimize the potential for currency appreciation that would undermine the welfare of rural populations that depend on agriculture exports, the fund’s resources should be retained offshore. To effectively achieve its objectives, the SWF needs to be integrated into the macro framework and thereby supported by other fiscal institutions, such as the MTFS and the Fiscal Responsibility Act. The wealth of international expertise in SWF design should be heavily relied on in the fund’s development.

Financial Sector

12. Indicators suggest that the financial sector remains sound. However, to safeguard financial health, banks should be encouraged to maintain strict lending standards as credit demand increases in line with opportunities associated with the LNG projects. Furthermore, all financial institutions need to guard against overexposure to a property sector that, given supply constraints, could become significantly overvalued during the LNG construction phase.


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