Public Information Notice No. 06/20

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with Papua New Guinea

February 24, 2006

On February 13, 2006, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Papua New Guinea.¹

Background

From the mid-1990s until the early years of 2000, Papua New Guinea's economic and social performance had been poor. Real GDP was broadly unchanged since the early 1990s and per capita income little higher than at the time of independence in 1975, as political instability and a rapid succession of governments hampered the implementation of appropriate economic policies. Private activity was stagnant, poverty increased and social indicators, already among the worst for comparable countries, further deteriorated.

The current government, led by Prime Minister Sir Michael Somare, has made strides in addressing the economic challenges that it inherited since taking office in 2002. It progressively tightened fiscal policy, in tandem with supportive monetary policy, in a bid to support growth while putting the economy on a more stable footing for the future. As a result, and aided by improving global commodity price developments, the country's economic position has improved and macroeconomic stability has been restored. Real GDP growth turned positive in 2003, after contracting in the previous three years, and inflation dropped sharply. The government additionally set out a medium-term development strategy focusing on economic reform needed to boost growth to a higher sustainable level.

The economy is now performing well as the recovery maintains its momentum, the external position remains healthy, and inflation is low. Real GDP rose by about 3 percent in 2004, in line with the previous year, and a similar rate of growth is expected for 2005. The mining and agricultural sectors were the initial drivers behind the recovery, boosted by an upswing in commodity prices and improved weather. Fiscal and monetary discipline, together with exchange rate appreciation, led to a sharp reduction in average CPI inflation in 2004 to around 2 percent from 14.7 percent in the preceding year, and inflation is estimated to average 1 percent in 2005. The external accounts are expected to be in surplus in 2005, buoyed by high commodity prices for minerals and oil, but also reflecting the start of oil refinery operations and increased non-mineral export volume.

The government continued to consolidate the fiscal position in 2005, with the projected outcome for the year stronger than budgeted. High mineral and non-mineral revenue (buoyed by continued high commodity prices and stronger than expected growth), and lower than expected expenditure (including on interest payments) generated net savings for the year of about 5 percentage points of GDP. Under the authorities' revised budget, about half the savings was used to reduce the stock of domestic arrears and increase spending in priority areas. Another 2.5 percent of GDP of savings were set aside for a future equity acquisition in the Highlands-Queensland gas pipeline project and recorded as an expenditure. As a result, the authorities estimated a budget deficit of 0.6 percent compared to the original budget projection of a deficit of 0.9 percent of GDP. Adjusting for the funds set aside but not actually spent in 2005 (although these funds will be spent in 2006), the staff estimates the budget balance to be significantly stronger than official estimates. The improved fiscal outcome resulted in a further reduction in total public sector debt, about half of which is external debt, to 49 percent of GDP in 2005 from 72 percent in 2002.

As monetary policy has been relaxed in line with the tightening of fiscal policy, credit to the private sector revived while inflation remains low. In the absence of inflationary or exchange rate pressure, the central bank progressively lowered the signaling Kina Facility Rate from a 16 percent peak in July 2003 to 6 percent in September 2005. Broad money is expected to rise by over 13 percent in 2005, reflecting increased net foreign assets. In response to lower interest rates, abundant liquidity and more stable economic and political conditions, private sector credit picked up for the first time in four years, increasing by about 20 percent from a low base.

Over the past two years, the kina has remained roughly unchanged on a real effective exchange rate basis, while external reserves have increased. The kina appreciated against the U.S. dollar by about 15 percent in nominal terms during this period, mainly reflecting strong export receipts along with a gradual restoration of confidence in economic management. Gross international reserves are expected to close 2005 at 5.5 months of non-mineral imports. External competitiveness appears adequate, given increased non-mineral export volume and a relatively stable share of total Papua New Guinea's exports in total world exports.

The authorities have taken steps to improve public sector efficiency and the investment environment, but overall progress in implementing structural reform has been slow. Positive steps have been made through the adoption of stricter controls on recurrent public expenditure and some reduction in the wage bill. However, advancement of the broader reform of the public sector was slow, particularly in revenue administration and provincial government operations. Movement on infrastructure investment and land reform also was limited and privatization stalled. The financial system overall remains healthy. The financial condition of the government-owned Rural Development Bank has improved somewhat, but it remains to be seen whether sufficient measures are in place to avoid a return to past financial difficulties.

Executive Board Assessment

Executive Directors commended the authorities for the impressive progress made in reversing the difficult macroeconomic conditions inherited earlier this decade. In 2005, real GDP growth remained at 3 percent, inflation declined further from its already low level, the fiscal and external positions strengthened, and public debt indicators declined.

Directors considered that the key challenge going forward will be to sustain recent gains while moving the economy to a higher growth path to reduce poverty. Achievement of these objectives will require the authorities to accelerate fiscal reform and to persevere with fiscal prudence, a supportive monetary policy, and structural reform to encourage private investment. Strengthening the non-mineral sector will be key to diversifying the export and revenue base, and promoting private sector job opportunities. Directors welcomed the commitment to these policies in the government's Medium-Term Development Strategy (MTDS), and called for their resolute implementation.

Directors commended the authorities for the strong fiscal outcome in 2005. They welcomed the re-orientation of government expenditure toward needed infrastructure and social spending and encouraged rapid follow through with plans to reduce the wage bill and streamline the government. It was noted that, in implementing such streamlining, the authorities should be mindful of safeguarding the overall quality of the public service as well as the efficient delivery of services. Directors noted that the 2006 tax policy package improves incentives for private sector activity, but cautioned that the non-mineral revenue base should be strengthened in parallel through improved tax administration. In the event that mineral revenues remain high and surpluses emerge over the medium term, Directors recommended the continued use of such resources for priority infrastructure and social spending and to repay government debt. The authorities will also need to be cognizant of the importance of containing any fiscal risks in the run-up to the 2007 election.

Directors noted the progress in public expenditure control and debt management. They encouraged further strengthening of budget management in line with the recommendations from the Public Expenditure and Rationalization Review. Directors also highlighted the need to strengthen the management and transparency of expenditures at the sub-national level. In addition, they endorsed the authorities' medium-term debt strategy, and underscored the importance of continued close cooperation with donors. They urged the authorities to avoid nonconcessional borrowing, including to finance the gas pipeline project.

Directors welcomed the central bank's continuing focus on maintaining low inflation. They welcomed the recent increase in private sector credit from a low base. However, in view of the high liquidity in the economy and low interest rates, they supported the authorities' intention to monitor developments closely and tighten monetary policy as necessary. Directors also encouraged the central bank's ongoing efforts to strengthen monetary policy tools. They viewed the current floating exchange rate arrangement as appropriate, given its role in helping promote adjustments to economic shocks. Directors welcomed the authorities' commitment to intervene in the foreign exchange market only to smooth volatility.

On structural issues, Directors noted that higher growth, employment creation, and poverty reduction over the longer term will depend on stronger private sector activity. Thus, an accelerated and strengthened implementation of the MTDS is needed, including, in particular, actions to increase competition in the public enterprise sector, improve law and order, strengthen governance and increase transparency and accountability, upgrade infrastructure, and simplify investment regulations. While observing that significant progress has been made in strengthening the financial sector, Directors urged that necessary steps be taken to consolidate the rehabilitation of the Rural Development Bank. Directors also recommended that rapid action be taken to address continued weaknesses in data provision.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.