Mission Concluding Statement 

Papua New Guinea-- 2011 Article IV Consultation Preliminary Concluding Statement of the IMF Mission

February 22, 2011

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 and financial stability in the face of a substantial demand shock—associated with the construction of the Papua New Guinea Liquefied Natural Gas(PNG LNG)—and ensure that revenues from exhaustible resources are used effectively to raise living standards on a sustainable basis.

1. Papua New Guinea has enjoyed 10 years of solid economic growth. An unprecedented achievement for the country that owes a lot to greater political stability, sound macroeconomic policies, and improved public finances. Higher commodity prices and the construction of a PNG LNG project—a 190 percent of GDP investment—are boosting an economy facing capacity constraints. As a result, rising consumer and asset price inflation is threatening macro-economic stability. To lower the risk of overheating firmer fiscal and monetary policies are required.

2. Rich natural resources provide an opportunity to notably raise long-term growth and living standards. To ensure that the opportunity is not wasted, sound policy frameworks and implementation will be essential. In particular, strict adherence to the rules embodied in the Medium-term Fiscal Strategy (MTFS), close coordination of monetary and fiscal policy, and the integration of a sovereign wealth fund (SWF) into the macro framework should help maintain macroeconomic stability. Improvements in public financial management and structural reforms are needed to ensure that development objectives are achieved.

Macroeconomic Outlook and Risks

3. Growth is projected to remain strong and inflation to accelerate. Real activity is boosted by the construction activity associated with the large PNG LNG project, favorable commodity prices, and strong investor confidence. Domestic demand pressures, combined with the rise in international food prices, and the depreciation of the kina in 2010, in particular against the Australian dollar, will fuel inflation. Near-term risks to growth and inflation are tilted to the upside. Upside risks include higher commodity prices and a related increase in mining activity, an early start of a second LNG project, stronger-than-expected private sector investment, and additional fiscal spending from trust accounts. Downside risks include possible disruptions in mining and delays in the PNG LNG project, mainly related to land disputes, social tension that may be created by rising income inequality, and a possible correction of very high real estate prices in Port Moresby and Lae.

Fiscal Policy

4. We commend the authorities for their commitment to a medium-term fiscal framework aimed at increasing macroeconomic stability by insulating the budget from volatility in mineral revenue. In 2010, the previous year’s large fiscal stimulus was appropriately unwound and fiscal policy has moved toward meeting the principles of the MTFS. However, spending out of trust accounts may again exceed 4 percent of GDP, and none of the windfall revenues was used for debt reduction. Instead the government modified the (70/30) MTFS rule to allow 100 percent of above-normal mineral revenues in future budgets to be devoted to public investment, as long as debt stays below 30 percent of GDP. It would be prudent to include contingent liabilities in the calculation of the debt ceiling. In this context, the allocation of funding to meet the government’s annual superannuation obligations and settle some of its arrears is welcome and will raise policy credibility. We recommend developing a payment schedule for the remaining unfunded superannuation liabilities.

5. The 2011 budget strikes a balance between fiscal restraint in an economy that faces capacity constraints, and pre-commitments and development needs. It is an appreciable achievement given the expenditure pressures in a pre-election year. However, the government’s budget balance excludes spending out of trust accounts. Including trust-account spending, staff projects an overall deficit of 2.7 percent of GDP. Moreover, a significant portion of previous years’ withdrawals from trust accounts may still be in the spending pipeline. As a result, the pace of overall public spending risks exacerbating inflationary pressures at a time when business activity associated with the construction of the PNG LNG is expected to peak.

6. Judicious implementation of the budget would help mitigate inflationary pressures. Savings opportunities should be rigorously exploited and the typical year-end spending rush avoided. Instead, under-spent resources could be reallocated next year if needed. The budget is appropriately based on prudent assumptions, including regarding commodity prices. Windfall revenues may accrue should commodity prices expected by markets eventuate. Any such windfalls could suitably be used for debt reduction, or set aside to cover future liabilities related to participation in PNG LNG and to pre-finance pressing rehabilitation and maintenance needs of public infrastructure. Some development projects are currently facing inflated prices as they are competing for scarce resources with the PNG LNG project and other private sector construction activities. Delaying these projects to 2013-16, in particular those which have not yet been subjected to rigorous cost-benefit analysis, would lower demand pressures, raise value for money, and help achieve better service delivery.

7. The PNG LNG and other resource projects provide an opportunity to notably raise long-term growth and living standards. However, expectations about future income flowing from the projects need to be well managed, given the inherent uncertainties and risks surrounding resource revenues. Once public revenue from PNG LNG can be affirmed, there may be some limited room for additional borrowing, preferably from multilateral or bilateral donors at below-market rates, for well-identified development projects. To avoid excessive lending, gross and net public debt-to-GDP ratios of below 25 percent (around current levels) could serve as medium-term fiscal anchors. Over the longer term, part of the resource revenue should be set aside to pay down high-interest rate public debt.

8. The decision to move all new trust accounts to the Bank of Papua New Guinea (BPNG) is welcome and improves fiscal and monetary policy coordination. It gives the BPNG better control over liquidity in the banking sector and market interest rates. Monetary policy will become more effective and the net cost to the public reduced by limiting the need to use high-cost central bank bills to mop up excess liquidity. Once the SWF is established, all existing trust accounts should be consolidated with the fund.

Development Strategy

9. The government’s new development plan correctly focuses on addressing current supply constraints, while raising the effectiveness of core service delivery. In an important advance, it shifts PNG’s planning process from expenditure-based to policy-focused, with line agencies made accountable for achieving sector targets. But realizing the plan’s goals will require marked gains in the effectiveness of public spending. Final spending, especially from trust funds, is often not monitored by central agencies, and can differ markedly from budgeted purposes, as audits repeatedly report. The government is addressing these issues, including through investments in stronger financial management, monitoring, and reporting systems. Meanwhile skilled staff retention is a growing constraint to achieving this agenda.

10. Addressing current supply constraints also requires a more supportive environment for the private sector, and a revival of the structural reform agenda. The government has taken steps to do this. It is developing a national community service obligation framework for state-owned enterprises, to introduce competition into this sector and improve their capacity to respond to current strong demand growth. It is investing considerable resources in land titling and making more land available for economic activity. And it has made welcome moves to consider adoption of the Extractive Industries Transparency Initiative.

Sovereign Wealth Fund

11. Staff supports the authorities’ decision to manage all resource revenues through an SWF, comprised of a consolidated pool of three offshore funds. All expenditures should be fully integrated into the budget process. In many countries, such an arrangement has been helpful to manage the volatility of mineral revenues and contain real exchange rate appreciation, improve transparency, accountability, and good governance.

12. Drawdown arrangements from each fund will need to be coordinated and guided by the absorptive capacity of the economy. We commend the authorities for the consultative approach they have taken to lay the groundwork of the SWF, and the creation of a Secretaries Committee and interdepartmental working group, chaired by Treasury, to oversee the establishment of the SWF is encouraging. As to the drawdown rate, the potential growth rate of the non-mineral economy, which staff sees in a range of 3-6 percent per annum, may provide one guidepost. The positive experience with the spending limits of the MTFS, which implies an 8-percent-of-GDP ceiling for the non-mineral deficit, could serve as a second guidepost. However, this number might need to be adjusted downward in 2015 to reflect the fact that GDP will jump by more than Gross National Income (GNI), as a significant fraction of the income generated by PNG LNG will go abroad. 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 also be sourced, including those that reflect the Internationally Accepted Santiago Principles.

Monetary Policy and the Exchange Rate

13. Inflation is expected to increase sharply in 2011. Domestic demand is increasingly becoming a major driver of core inflation, and headline inflation could temporarily rise into double-digits. Inflationary pressures are exacerbated by planned increases in public spending, higher wage costs–resulting from a shortage of skilled labor–and rapidly increasing prices associated with the use and development of land. The outlook for inflation calls for a tighter stance of monetary policy to provide some insurance against the risk of higher inflation becoming entrenched in expectations.

14. The BPNG has taken a cautious approach by keeping its policy rate constant at 7 percent since end-2009. However, a weaker exchange rate and falling treasury rates indicate that monetary conditions have eased while excess liquidity in the banking system continues to reduce monetary-policy effectiveness. Raising the Kina Facility Rate (KFR) well above expected core inflation would provide an important signal. However, the policy interest rate seems to have only limited sway over market rates as long as liquidity remains abundant. The increase in the cash reserve requirement to 4 percent in October goes in the right direction and further increases should be considered. Liquidity could be reduced further by raising the central bank bill (CBB)rate gradually back to just below the KFR.

15. The exchange rate is estimated to be broadly in line with fundamentals and reserves remain adequate to address potential balance of payments needs. However, uncertainties surrounding the estimation of equilibrium exchange rates imply that the exchange rate assessment provides only rough guidance. Staff would advise to move to a more market-determined exchange rate, which would help cushion the impact of large demand shocks. The BPNG should tightly limit foreign exchange intervention, to avoid boosting liquidity in the banking system, and allow market-driven appreciation of the Kina to help reduce inflationary pressures from the PNG LNG boom and from higher food prices.

16. The increase in PNG 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. Nevertheless, debt sustainability analysis shows a moderate risk of debt distress under a combination of negative shocks. This strengthens the case for a prudent approach to borrowing and enhanced fiscal discipline.

Financial Sector

17. The Financial Sector Assessment Program (FSAP) mission in May 2010 found that the financial sector is well capitalized and highly profitable. Since then some indicators have strengthened further. System capital ratios and conventional liquidity ratios are high, while asset quality is sound. However, these strong statistics mask some critical challenges in the banking sector, including the absence of an effective secondary market for government securities, high depositor and borrower concentrations, and limited access to term funding. The lack of an inter-bank real-time payment system with collateralized liquidity management creates systemic risks and inefficiencies. And improving access to financial services remains a significant developmental challenge. Stress-tests, undertaken during the FSAP mission, indicate that the banking system should be able to withstand moderate shocks.

18. Banks should maintain strict lending standards given the likely increases in credit demand associated with resource projects’ business activities. Banks will also have to prepare for a loss of low-yielding government deposits (trust accounts) by adjusting their refinancing structure and lending policies. Authorized superannuation funds, as well as banks, need to guard against over-exposure to the housing sector, which has seen sharp price increases and may be subject to a correction when the PNG LNG construction activity unwinds.