Public Information Notice No. 03/78

Public Information Notice: IMF Concludes 2003 Article IV Consultation with Papua New Guinea

June 25, 2003

On June 4, 2003, the Executive Board of the International Monetary Fund (IMF) concluded the 2003 Article IV consultation with Papua New Guinea.¹

Background

Real GDP growth in Papua New Guinea slowed in the second half of the 1990s, reflecting growing governance and law and order problems, lack of new mineral exploration activities, deteriorating physical infrastructure in the rural areas that inhibited agricultural production, and the decline in export prices during the Asian crisis. As investor confidence evaporated, private capital outflows intensified, the kina depreciated, and international reserves fell sharply.

During 2000-01, efforts to stabilize the economy in the context of a Fund-supported program helped to overcome the serious macroeconomic imbalances, with a reduction in the inflation rate and an increase in the level of net international reserves. However, the pace of structural reform was slower than envisioned and, when combined with the gradual winding down of existing mining projects, the economy continued to contract. During 2002, real GDP is estimated to have declined by a further 3 percent. Production of crude oil and gold fell sharply mainly because of the continued depletion of reserves at existing projects, the effects of drought on river-based ore shipments, and election-related violence.

In the lead-up to the June 2002 election, the deficit reached nearly 4 percent of GDP by midyear because of unbudgeted expenditure and cost overruns, notably on a bridge program approved outside of the regular 2002 budget, overspending on the national elections and the wage and salary bill, excessive disbursements under the rural development program, and the elimination of school fees. In late August, the new government passed a supplementary budget that sought to contain the 2002 deficit to 3.4 percent of GDP by curtailing current and development outlays. While this target was overly optimistic, the size of the deficit was contained to 5.5 percent of GDP in 2002, although the authorities' deficit estimate is only 4.1 percent of GDP derived from the recorded above-the-line outturn.

For much of 2002, monetary policy was expansionary in order to finance the fiscal deficit. Given these excess liquidity conditions, the kina exchange rate against the U.S. dollar depreciated by 12 percent in the ten months to October, despite frequent intervention by the central bank. Further, consumer prices rose by almost 15 percent in the year to December 2002, reflecting fiscal slippage and the pass-through of the kina's sharp depreciation.

The current account deteriorated sharply in 2002, falling from a surplus of 6 percent of GDP in 2001 to an estimated deficit of 2½ percent of GDP. The large decline in the volume of mineral exports was only partly offset by higher commodity export prices and lower import demand. As in 2001, the capital account was also in deficit. Large net government debt repayments, lower inflows of direct investment, and increased commercial bank holdings of foreign assets, were only partially offset by higher private sector inflows to the mining sector. As a result, the overall balance of payments showed a deficit, compared with the surplus recorded for 2001. The public debt-to-GDP ratio increased to 74 percent at end-2002, reflecting the expanding budget deficit and the kina depreciation.

Fiscal and monetary policies were tightened towards the end of the year. The 2003 budget was passed in November, which targets a fiscal deficit of 2 percent of GDP, primarily through sizable cuts in goods and services expenditure. The Bank of Papua New Guinea also began to tighten monetary conditions in November. Correspondingly, treasury bill yields increased, pressure in the exchange market eased, and the level of international reserves stabilized. Nonetheless, preliminary data indicate the fiscal deficit measured on a financing basis was around 2 percent of GDP in the first quarter and inflation was over 20 percent in the year to March 2003.

Executive Board Assessment

Directors noted that adverse exogenous shocks, as well as domestic policy shortcomings, have slowed economic activity markedly and resulted in macroeconomic imbalances and structural weaknesses. Real GDP declined for the third consecutive year in 2002, which, in light of high population growth, has implied a considerable drop in per capita income and a worsening of social and poverty indicators. Directors noted that the fiscal discipline Papua New Guinea displayed under the Fund-supported program, which ended in 2001, was not sustained in the lead-up to the general election in mid-2002, with the fiscal deficit widening, inflation pressures increasing, official international reserves declining, and a depreciation in the exchange rate. While they acknowledged the action taken by the new government on coming into office, particularly the introduction of a supplementary budget, they expressed concern about the growing fiscal pressures and rise in inflation over the course of 2003. Directors underscored that, unless necessary reforms are successfully implemented, economic and poverty-reduction prospects for the medium-term would continue to be weak, given the projected decline in mineral output and structural problems that affect both rural and urban areas.

Against this background, Directors welcomed the intention of the new government to address these challenges in the framework of the country-owned Medium-term Development Strategy. They encouraged the authorities to strengthen budget finances and to tackle the deep-seated structural impediments to growth in order to achieve their medium-term objectives of macroeconomic stability and poverty alleviation, while ensuring a manageable external debt burden. Directors also stressed the importance of improving the environment for private sector activity and of further diversifying the economy.

Directors emphasized the critical need to ensure that the targeted fiscal consolidation in 2003 is achieved. They cautioned that, without forceful measures, the budget deficit would not be brought back in line with the authorities' target of 2 percent of GDP, especially given adverse trends in the first quarter. Directors suggested that early additional actions—including a supplementary budget—might be needed, in particular targeted toward lasting reductions in the civil service salary bill and in less efficient development expenditure.

Directors supported the authorities' intention to pursue its Medium-term Fiscal Strategy, which provides a forward-looking framework within which the country's development objectives can be achieved. In this context, they stressed that achieving an average fiscal deficit over the medium term of around 1 percent of GDP is essential to reduce the debt burden and its associated vulnerabilities. To meet this goal, most Directors said that measures to augment revenues were required, including the reversal of tax incentives to the mineral sector. Most importantly, Directors encouraged the authorities to improve expenditure control and redirect spending toward infrastructure, health, education, and poverty-alleviation. These actions should be guided by the findings of the Public Expenditure and Rationalization Review, to be completed soon with support from the World Bank, the Asian Development Bank, and AUSAID.

Directors commended the authorities for the tightening of monetary policy in recent months, which had been crucial to limit pressures on the exchange rate and external reserves, in view of fiscal and inflation developments. If inflation were placed on a firm downward path, and an appropriate degree of fiscal consolidation were achieved, interest rates could be gradually reduced, which would help to promote private sector activity.

Directors agreed that the present floating exchange rate regime is appropriate to help maintain competitiveness, especially given Papua New Guinea's vulnerability to terms of trade shocks. However, further weakening of the kina would exacerbate external debt dynamics. Against this background, Directors emphasized the need to expedite the implementation of fiscal and structural reforms to safeguard Papua New Guinea's external position.

In the structural area, Directors were encouraged by the ongoing steps aimed at enhancing public sector efficiency and reducing regulatory impediments to private sector activity. They also stressed in particular that early and determined measures are needed to reduce corruption, improve governance, strengthen law and order, and enact land reform. Directors welcomed the establishment of the Independent Consumer and Competition Commission to depoliticize changes in utility and other controlled prices; commitments to progress in the multi-year trade reform program; planned measures to improve rural infrastructure; and the enactment of the Organic Law on the Integrity of Political Parties. They also endorsed the authorities' intention to improve the efficiency of assets under state management, with the view toward their accelerated privatization, provided that undue injections of public funds were avoided. While they noted that the financial system is generally sound, Directors said that steps to strengthen bank supervision are still necessary, in line with Fund technical assistance recommendations. The authorities were also encouraged to further strengthen their framework for combating money laundering and the financing of terrorism.

Directors stressed that, in line with the extensive technical assistance provided by the Fund, more and better quality economic statistics, including regular reconciliation of above- and below-the-line fiscal data, are important for properly monitoring developments.

Directors considered that decisive and comprehensive implementation of the authorities' reform program, which should include the governance area, could provide the basis to initiate negotiations on a Fund arrangement to assist the authorities in improving the economic outlook. The Board agreed to the authorities' request to extend their repurchase expectations to the Fund, in light of the deterioration in key external indicators and weakness in Papua New Guinea's balance of payments position.