Port Moresby, Papua New Guinea
April 6, 2001

Mr. Horst Köhler
Managing Director
International Monetary Fund
Washington, D.C. 20431

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. It also describes the progress made to date 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 are 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 second and third reviews and the third and fourth purchases under the arrangement. All quantitative performance criteria for end-September 2000 were observed. The Government of Papua New Guinea also requests waivers for the nonobservance of the performance criteria for end-December 2000 on the floor of the net international reserves of the central bank of Papua New Guinea (BPNG), the ceiling on the net domestic assets of the BPNG, and the ceiling on the net domestic financing of the government. These criteria were not observed largely as a result of a shortfall in external financing relative to the program under the Stand-By Arrangement.

The Government of Papua New Guinea requests a waiver for the nonobservance of the structural performance criterion on bringing Finance Pacific Group (FPG) to the point of sale by end-December 2000. Preparations for divesting assets forming part of FPG--including a large commercial bank (PNGBC) and an insurance company (MVIL)--have taken longer than anticipated. However, the Government of Papua New Guinea is committed to divesting these assets in the period ahead. The Government of Papua New Guinea proposes that bringing PNGBC to the point of sale will be a prior action for completing the second and third reviews. Also, it proposes that rescinding the central bank guarantee recently extended to PNGBC be a prior action for completing the second and third reviews.

The Government of Papua New Guinea acknowledges the risk that persistence of a slowdown could result in lower tax revenue than programmed. Therefore, it has decided to take compensatory measures for any underperformance through June 2001. Taking such measures will be a prior action for completing the fourth review under the Stand-By Arrangement.

The Government of Papua New Guinea recognizes the importance of a close relationship with the Fund including to facilitate continued donor support, particularly in view of the country's vulnerability to shocks. Consequently, the Government of Papua New Guinea requests a four-month extension of the current Stand-By Arrangement to September 28, 2001, with the last purchase contingent on observance of performance criteria for June 2001. Following successful completion of the present arrangement, the Government of Papua New Guinea will consider requesting a successor arrangement. We suggest to commence discussions on options in late June or early July 2001.

During the remaining period of the arrangement, the Government of Papua New Guinea will stand ready to take any additional measures necessary to keep the program under the Stand-By Arrangement on track, and it will remain in close consultation with the Fund, in accordance with Fund policies. A fourth review under the Stand-By Arrangement will be carried out by the Fund before September 28, 2001.

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,

Supplementary Memorandum of Economic and Financial Policies Second And Third Reviews 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 its October 2000 supplement.

II.  Performance Under the Stand-By Arrangement

2.   Macroeconomic and structural performance in the second half of 2000 remained generally good. While all quantitative performance criteria for end-September were observed, a shortfall in external financing during the last quarter of 2000 was the main cause of the nonobservance of performance criteria on the net international reserves of the Bank of Papua New Guinea (BPNG), the net domestic assets of the BPNG, and the net domestic financing of the government for end-December 2000. This shortfall was partly related to delays in preparations for the privatization of a large bank (PNGBC). However, the Government is committed to bringing PNGBC to the point of sale (prior action for the completion of the second and third reviews) and maintaining a macroeconomic policy framework consistent with the achievement of program objectives under the stand-by arrangement. The Government's program continues to be developed in consultation with multilateral and bilateral donors.

3. Generally tight monetary and fiscal policies helped bring down inflation to 10 percent by end-December 2000, albeit by less than envisaged under the program. The fiscal situation turned difficult in the last quarter of 2000, in part due to a shortfall in external financing relative to program projections. However, the overall government deficit narrowed markedly in 2000, reflecting broad adherence to expenditure targets and better-than-expected mineral tax revenue. Monetary conditions remained tight during the year, with monetary aggregates growing broadly in line with targeted inflation. A poor coffee crop and the trend decline in oil output were major factors in the slowdown of economic activity in 2000. Depressed import demand by the nonmining sector and the relatively high export price for oil contributed to a substantial increase in the external current account surplus. As a result, the net international reserves of the central bank (NIR) rose by over $70 million in 2000, notwithstanding the large shortfall in external financing. The kina strengthened during the first half of the year following Board approval of the Fund program, but weakened subsequently, with the decline in coffee exports.

4. Economic conditions have remained difficult during the first quarter of 2001. Oil prices have weakened and oil output is trending downward. In this context, the kina depreciated by 6-7 percent through end-March 2001. In addition, central bank intervention mainly to address strong pressures related to noneconomic factors resulted in substantial losses in net international reserves. In early March 2001, the central bank reduced the Kina Facility Rate by 50 basis points following the news of the fall of inflation registered by end-December 2000 and in overseas interest rates.

III. Macroeconomic and Structural Policies for 2001

5. Notwithstanding the difficult economic environment, the Government remains committed to macroeconomic stabilization, public sector reform, tax reform, financial sector reform, and other actions to improve transparency and enhance confidence. While output in the mineral sector is projected to decline markedly, output in the nonmineral sector is expected to experience a recovery in 2001, with overall real GDP growth of 0.3 percent. In the medium term Papua New Guinea's oil production is projected to decline and world prices for most of Papua New Guinea's export commodities are expected to remain low. A projected fall in mineral exports would be reflected in a significant deterioration of the external current account in 2001, which would be covered in part by external government borrowing, including unidentified exceptional financing ($15 million). The Government has initiated discussions with the AsDB on program support and will seek additional donor assistance in a Consultative Group meeting currently planned for May 2001.

6. Against this background, the Government's financial policy objectives are to: (1) contain the second-round price effects of the exchange rate depreciation and recent increases in the domestic price of imported fuel so as to reduce the rate of inflation to 8 percent by end-2001, and (2) achieve an increase in NIR to $300 million (three months of nonmineral imports) by end-December 2001, commencing with a recovery of the NIR by end-June 2001 of at least $15 million to $232 million. Any net privatization revenue will be used to retire debt or to increase government deposits at the central bank.

Monetary and exchange rate policy

7. Monetary policy will continue to focus on the reduction of inflation. Following a contraction in 2000, reserve money is projected to grow by close to 10 percent in 2001, in line with projected nominal nonmineral GDP growth of 10 percent. Broad monetary aggregates are expected to grow with the monetary base. Growth of net bank credit to government will be limited to under 5 percent in 2001, which will permit an expansion of credit to the private sector of about 10 percent. The central bank agrees that inflation must be set firmly on a declining trend before there can be a significant decline in interest rates and is prepared to allow interest rates to firm, if necessary, to achieve the program targets.

8. To improve efficiency in its monetary operations, the central bank introduced a new benchmark interest rate on February 2001. On the first Monday of each month, the central bank will announce the Kina Facility Rate (KFR) to provide a signal of policy intentions and help improve management of bank liquidity.

9. Expectations for lower mineral exports along with unfavorable market sentiment related to noneconomic factors have placed downward pressure on the kina. The central bank sought to reduce volatility of the currency as it depreciated in response to these external shocks, and the kina has stabilized in recent weeks. Nevertheless, the central bank remains committed to meeting the program's targets on NIR and to limit its foreign exchange interventions to reducing short-term volatility.

Fiscal policy and development spending

10. The overall government deficit is projected to widen to 2.3 percent of GDP in 2001. In view of a lower real GDP growth projection, the Government has revised downward revenue estimates in the budget for 2001, which was prepared in line with understandings with the Fund. The Government has decided to defer expenditure under the District Development Program (formerly the Rural Development Program) by K 30 million (about 0.3 percent of GDP). In addition, the Government will refrain from wage increases beyond existing commitments as well as increases in staffing (except for priority areas, namely education, health, revenue collection, law and order, infrastructure, and primary industries), which will help avoid any rise in the government wage bill in relation to GDP. This will allow purchases of goods and services to be restored to a level that will enable the Government to meet its core functions without incurring arrears.

11. The Government will continue to implement a responsible budget while attending to the fundamental development needs of the country. The composition of expenditure is programmed to shift in 2001 away from current expenditure, with development spending rising by over 1 percent of GDP. The Government's development budget for 2001 addresses the deterioration of infrastructure by substantially increasing road maintenance expenditure. The Government is committed to adequately fund departments providing priority services, and will continue to improve financial management, particularly to avoid arrears. In this regard the Government will strengthen enforcement of the Public Finance Management Act, which stipulates penalties for financial mismanagement.

12. A number of risks apply to the fiscal plan. It is expected that a decrease in mineral sector revenues will be offset by higher collections from other tax sources reflecting a pickup in activity in the nonmineral sector and improvements in tax administration as a result of additional resources, particularly in inspection, audits, and the prosecution of delinquencies. Recognizing the risk of underperformance in tax collections, the Government agrees that if at the time of the fourth review, tax revenue trends through end-June 2001 cast doubt about projected performance during the remainder of the year, compensatory measures (prior action for fourth review) will be taken before that review may be completed. More generally, the revenue, expenditure, and financing situation will 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 following an independent tax review, further adjustment measures, if needed, would focus on reductions in spending.

Structural reform policies

13. The Government's record demonstrates its commitment to implement economic reforms within the broad framework of its structural adjustment program. The reform agenda includes safeguarding the sustainability of the fiscal position over the medium term, improving the effectiveness with which government funds are deployed, and improving conditions for private sector development. Additional reforms aimed at improving public service delivery and enhancing accountability and transparency in the public sector are under way with support from multilateral and bilateral donors.

14. Progress is being made on a comprehensive public sector reform program aimed at ensuring efficient use of budgetary resources and improving public service delivery. The program, which was endorsed by the National Executive Council (Cabinet) in late August 2000, specifies reform goals, a timetable, and the roles to be played by multilateral agencies and bilateral donors. Functional and expenditure reviews have been completed in various departments; and the Government intends to move forward with reviews of priority agencies. These reviews will involve net fiscal savings over the medium term resulting from the recent decision to close eight diplomatic representations. To improve efficiency in service delivery, the Fisheries Authority was restructured in late 2000 and the Civil Aviation Authority was established on January 1, 2001. The Government will continue to implement the District Development Program in accordance with guidelines designed with support from the World Bank in 2000.

15. The Government remains committed to improving the efficiency of the civil service and the management of human resources. The Government retrenched about 1,700 civil servants in 2000, mainly unattached officers or civil servants older than 50 years of age, and initiated a plan to remove additional uniformed and civil servants from the Defense Department payroll. About 240 soldiers were repatriated to their villages in 2000 and about 650 soldiers will be repatriated in the first half of 2001. The Government is committed to replacing the payroll system and manual personnel records by an integrated payroll and human resources management system. The Government has committed K 5 million for the new system, and a tender will be awarded by end-June 2001.

16. Privatization is a main pillar of the Government's strategy to improve the efficiency of the public sector. In the first half of 2000, the Government identified enterprises to be privatized, approved a privatization policy, and made amendments to the Privatization Commission Act to enhance accountability. An International Advisory Group is providing assistance with the implementation of the privatization strategy. The Privatization Commission has appointed project managers to prepare enterprises for sale and oversee the necessary legal and financial due diligence. To enhance transparency in the privatization process, the Privatization Commission has recently appointed an Independent Probity Officer, who will monitor the tender process and work to ensure its integrity.  

17. The Government will bring PNGBC to the point of sale by issuing an Information Memorandum satisfactory to the Fund by mid-April 2001 (prior action for the second and third reviews). Due diligence of PNGBC by major international accounting and legal firms has been completed and an Information Memorandum and supporting documentation for the offering will be issued shortly, including specification of the Community Service Obligations (CSOs) of PNGBC. The Government will ensure that any expenditure to defray the cost of meeting the CSOs will be fully reflected in the budget, and will take compensatory measures to ensure that the original budget targets can be achieved.

18. The Central Bank has rescinded a guarantee extended earlier this year to provide support for PNGBC (prior action for the second and third reviews). This guarantee was extended to alleviate perceived uncertainties in the financial system and facilitate bringing PNGBC to the point of sale. On March 8, 2001, the Government extended a guarantee to the state-owned Motor Vehicle Insurance Ltd. (MVIL) for compulsory third party insurance claims and an indemnity to PNGBC for any future claims of MVIL creditors. While the Government is of the view that this guarantee will not involve any fiscal costs, it will take compensatory measures if any such costs materialize. The Government intends to terminate this guarantee as soon as MVIL is privatized, which should be facilitated by the expected improvement in its financial position following the recent increases in insurance rates.

19. The Government has brought Air Niugini to the point of sale, and has called for expressions of interest. Audits of Telikom, Elcom, and Harbours Board are in the process of being completed. In addition, to facilitate the sale of key state-owned enterprises, the Government has engaged a reputable international firm through public tender to develop regulatory frameworks and community service obligation arrangements. A final report has been completed.

20. The Government has addressed the solvency problems of the National Provident Fund (NPF). The latter involved reaching understandings in December 2000 with employers and unions on equitable and affordable burden-sharing to deal with the NPF's poor past performance. As part of the agreement, members' accounts in the NPF have been written down by an average of 15 percent, employer contributions relative to the payroll were raised by 2 percentage points (for three years), and legislation was enacted to provide an annual government grant to the NPF of K 4 million (K 3 million in 2001) for 15 years, indexed to the CPI. This permitted the resumption of payouts, beginning in January 2001, that had been suspended in October 2000. Funding for the Government's contribution to the NPF resolution is available within the agreed budget for 2001.

21. The Government is taking steps to reform and strengthen the pension industry. In December 2000, Parliament passed the Life Insurance and Superannuation Acts that provide a comprehensive framework for the regulation and supervision of these industries.

22. A taxation review was completed and endorsed by Cabinet in November 2000, and its recommendations have been incorporated in the 2001 budget. These include: (a) adjusting personal income tax brackets for inflation; (b) reducing the cost of compliance for corporate income taxpayers; (c) changing the mining and hydrocarbon tax regime to encourage development of marginal projects while adequately taxing highly profitable ones, and removing tax loopholes; and (d) simplifying the excise tax regime.

23. The Government will allocate sufficient resources to support revenue collection. In particular, resources will be made available to strengthen the administration of the VAT and to increase the number of tax audits. The Government intends to redeploy staff to support tax and nontax revenue collections.

24. The Government recognizes that the current form of price regulation has created uncertainty in parts of the business community. The Government is carrying out a review of its competition policy, including price regulation, and is working toward the repeal of recent amendments to the gazetted list of declared goods and services for the purposes of the Price Regulation Act.  

IV.  Program Monitoring

25. Quantitative performance criteria for end-June, 2001 have been set as follows: (i) a ceiling on net domestic assets of the central bank; (ii) a ceiling on net domestic financing of the Government; (iii) a floor on the net international reserves of the BPNG; (iv) ceilings on new short-term and medium- and long-term external nonconcessional debt, including loan guarantees; and (v) the continuing nonaccumulation of external payments arrears.

26. The following quantitative benchmarks will be observed at the levels specified in Table 4: (i) the floor on mining and petroleum tax receipts; (ii) the floor on nonmining and petroleum tax revenue; (iii) the limit on total central government noninterest recurrent expenditure; and (iv) the limit on central government wages and salaries. No domestic government arrears have been or will be incurred in 2001.

27. Despite recent progress, including compilation of a full set of national accounts for 1993-98, the Government recognizes that remaining statistical weaknesses hamper policy formulation. Particularly important are the shortcomings in price, government finance, balance of payments statistics, and contemporaneous indicators of economic activity. The Government will 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 addition, the Government will take early action to improve the statistical coordination between the Departments of Finance and Treasury and the Central Bank, and has requested technical assistance from the Fund for this purpose. The recommendation of the recent PFTAC mission will be considered as part of a strategy designed to strengthen the institutional framework of the statistical system. The Government intends to request technical assistance from the Fund to further improve compilation of the balance of payments. Also, it will implement the recommendations of the recent PFTAC report, including on ways to improve the compilation of the CPI. In addition, the Government will seek donor support for conducting a household income and expenditure survey in the second half of 2001 that should permit the improvement of the CPI in 2002.

28. The Government has made substantial progress in improving fiscal reporting during the last 12 months. Nevertheless, it is committed to improving fiscal information to the public and will introduce a new monthly bulletin containing data on payrolls, arrears, cash flows, and more general reporting on the activities of the Government. The Government is working to create a database that captures external financial and operational leases. In this regard, it has requested departments and statutory bodies to report on financial and operational leases, focusing on those with a value of $0.5 million and above.

29. The Central Bank will reintroduce an electronic registry for treasury bills. Besides enhancing efficiency and clarity of reporting, this will facilitate the introduction of a secondary market for treasury bills.

30. The Bank of Papua New Guinea has provided the information requested by the Fund for its safeguards assessment, including audited financial reports and management letters for 1997 and 1998. The 1999 audited reports will be provided by mid-April 2001, and for subsequent years, audit reports will also be provided to Fund staff.

Attachments (Please use the free Adobe Acrobat Reader to view the following Tables)

Table 1.	Papua New Guinea: Performance Criteria and Indicative Targets Under the Stand-By Arrangement, 2000
Table 2.	Papua New Guinea: Performance Criteria and Indicative Targets Under the Stand-By Arrangement, 2001
Table 3.	Papua New Guinea: Prior Actions, Structural Performance Criteria, and Benchmarks Under the Stand-By Arrangement, 2000–01
Table 4.	Papua New Guinea: Quantitative Benchmarks Under the Stand-By Arrangement, 2000–01