Optimism continues to run high about PNG’s development prospects.

The last eight years have seen sustained growth across the PNG economy – the first time since independence. It is also the first time that real per capita incomes have begun to increase after a 30 year period of stagnation. Formal sector employment across all industries is now at record levels.

Much of this success is attributed to high international commodity prices which have fuelled rapid output and revenue growth. But the growth also reflects increasing output from a variety of sectors and has taken place across a number of regions. Success has not been siloed. Sustained growth has also continued throughout the global financial crisis and despite natural declines in output from maturing mining activities.

The biggest cause of optimism in the PNG economy is the upcoming LNG gas project which comes online in 2014. At its peak, the project is expected to increase real GDP by 25 per cent.  In 2010 revenues attributable directly to mining activities comprised 21 per cent of domestic revenue. By 2018 – once a large portion of concessional taxation arrangements are exhausted – that proportion could be as high as 50 per cent.

In this context, the 2011 Budget seeks to map the transition of the economy from that of moderate to that of high resource dependence. This involves the creation of a new sovereign wealth fund which aims to sterilise export earnings from appreciating the Kina exchange rate and promote a greater level of accountability over fund usage. The Government seems willing to learn from past mistakes.

At a record $3.5 billion, the 2011 Budget also continues the process of scaling up the funding of key service delivery priorities identified in the Government’s Medium-Term Development Plan (MTDP) 2011- 2015. Key beneficiaries include health, education, infrastructure and law and order.

None of this optimism should diminish the development challenges that PNG will face over the coming years.

Despite large funding increases, service delivery is still chronically inadequate for a large part of the population. This is in some measure because of weak public sector capacity to implement expenditure plans. It is also because real per capita expenditures on items such as health and infrastructure have only now reached levels comparable to those obtained in the late 1980s. Real education expenditure per capita is still only half of what it was before huge cuts were made in the late 1990s under the Skate Government.

The prospect of LNG revenues also emphasises the need for further microeconomic reform. A key determinant of the broad based growth experienced to date has been the success of reforms to sectors which generated benefits across the economy – the introduction of competition in the Telecommunications and Airlines industries being the prime examples. As these gains moderate, new microeconomic reforms will be needed to spur on the non-mineral sector.

The largest development risk facing PNG, however, is that with the focus now fixed on long term LNG opportunities there is the potential for insufficient attention to be given to a much nearer term threat – inflation.

Since 2008, consumer price increases have been rising. Official figures put CPI growth in 2010 at 6.5 per cent with an 8.2 per cent outlook for 2011. If inflation is again let to spiral into double digit levels, it will quickly undo many of the development gains made over the last decade. Real per capita incomes will fall – especially for poorer cash income earning sections of society who have a weaker ability to index earnings. This will exacerbate issues of inequality and contribute to the poor law and order situation.

The task facing the Central Bank is not a straightforward one.

Treasury expects inflationary pressures to moderate following an economic slowdown between now and 2014 – mainly from a wind down in LNG construction and declining production from maturing mining activities such as Ok Tedi.

For these reasons the Budget forecasts inflation to return to 5 per cent by 2014. This is highly optimistic.

Current official figures are almost certainly an understatement. The deficiencies in PNG’s CPI basket are well known – it has not been updated since the 1970s and excludes amongst other things housing and rental costs which have been soaring for over 6 years.

Treasury also notes that Budget 2011 alleviates inflationary pressures by investing in productivity enhancing sectors like infrastructure and education. But expenditure composition is a long term solution to a short term threat.

A further threat is the ability of Government to return a balanced budget over coming years. The Budget forecasts a 7 per cent decline in real revenues between now and 2015 (ADB calculations). In contrast, expenditure plans outlined in the MTDP are based on expectations that revenues will increase by 57 per cent between now and 2015 – underpinned by more optimistic GDP forecasts.

The capacity of Government to keep a lid on expenditure in lieu of raised MTDP expectations will be severely tested. The upcoming elections in 2012 will only further weaken the Government’s ability to remain fiscally prudent.

The Central Bank’s task is further complicated by the fact that controlling price levels in an economy that has 80 per cent of the population engaged in subsistence agriculture and a high marginal import propensity has meant that the biggest source of inflation has traditionally been from imported sources.

As a result, since exchange liberalisation in 1994, interventions have typically focused on stabilising or appreciating the Kina – with considerations of domestic factors often secondary to monetary policy decisions.

With the Kina likely to remain strong for the foreseeable future, the economy already experiencing significant skills shortages and continued rapid liquidity growth, addressing the current pressures will thus likely require a rebalancing of monetary policy priorities to a more domestic focus.

PNG has made large development gains over recent years – but the road to sustained high growth is long. Implementation rather than funding continues to be the biggest constraint on Government’s expenditure plans translating into improved service delivery.

Getting price growth under control between now and when LNG extraction begins will be a key determinant of the Central Banks ability to managing the inflation threat over the medium to long term. The lack of coherence in GDP and revenue forecasts across the 2011 Budget and the MTDP exacerbates the uncertainty of this task.

It is likely that a more interventionist monetary policy stance that pays more attention to domestic factors will be required in the coming years.

Aaron Batten completed his PhD in the Crawford School at the ANU, where he continues to be an Associate of the Pacific Program, and currently works in the Malawi Ministry of Finance.

This is part of a special feature: 2010 in review and the year ahead.

1. India: sustaining high growth needs new reform momentum
2. On the brink of success – Papua New Guinea’s economic revival
3. The long and rocky road to global recovery

The PNG economy continued to perform well in 2009. Despite declines in the oil and gas sector, lower commodity prices, and reduced international demand because of the global financial crisis, real GDP grew by a solid 4.5 per cent. This growth was also relatively diversified with a 4 per cent increase in formal non-mining sector jobs adding further to the large employment gains made since 2005.

The government’s management of the economic expansion has been mixed, however. The fiscal surpluses of previous years have eroded, with this year’s budget recording a 0.4 per cent of GDP deficit after a 2.2 per cent of GDP deficit in 2008. But with nominal government revenues falling 12 per cent between 2007 and 2009 this situation could have been much worse. The major fiscal management problem in 2009 was a large draw down on the savings accumulated over previous commodity boom years. This included the injection of K1.7 billion (8 per cent of GDP) from trust accounts into expenditure.

Much of this additional expenditure was justified on the grounds of fiscal stimulation in the wake of the global financial crisis. The majority of funds were indeed allocated to new investments, underpinning a massive 60 per cent overall increase in development budget expenditure between 2008 and 2009. However, the size and speed with which this draw-down occurred suggests that it might have been done too hastily. With many sectors of the economy already operating at close to full capacity, this type of demand stimulus is likely to have some negative consequences on the economy, such as putting upward pressure on interest rates, generating higher imports and potentially crowding out private sector investment. The costs of the stimulus can seen in the Central Bank’s 9.5 per cent inflation forecast for next year. This will erode incomes, particularly diminishing the welfare of the poorest segments of society.

In 2009 PNG came one step closer to the commencement of Exxon Mobile’s $16 billion Liquefied Natural Gas (LNG) project. To its credit, the government has continued to manage the myriad challenges associated with the venture—which many feared would derail the project before it commenced. Production is expected to begin in 2014, and the LNG project’s success will reshape the PNG economy and the government’s fiscal resource envelope.

Resource extraction comes with significant risks. The 2010 Budget highlights some of these, discussing the consequences of Dutch disease, and the inevitable adjustment costs associated with an appreciation in resource exports and the Kina exchange rate. As the Budget also outlines, many of these consequences can be minimised by careful fiscal management. Sovereign wealth funds can sterilise export earnings, and foreign debt can be repaid by continued budget surpluses — although the latter has proven in the past to be a less reliable option.

The consequences of large resource projects such as this manifest themselves in many ways, of which Dutch disease is only one small element.

As PNG becomes an increasingly resource dependent economy, it will have to remain vigilant against the negative patterns of political and institutional behaviour that are encouraged by large inflows of funds from resource extraction.

It is well known that the easy money which resource extraction brings, combined with a lack of accountability over fund usage, makes government finances highly susceptible to misuse and exploitation. This can breed a culture of corruption and undermine domestic institutional processes.  Large resource rents can also remove incentives to reform other sectors of the economy. This means that growth can become siloed in resource extraction activities with limited positive spill-over effects for other, more labour intensive, sectors.

PNG’s history bears these risks out all too well. Those provinces which have recorded the largest earnings from resource extraction have been plagued by the weakest governance, the poorest levels of service delivery and in many cases by violence. In contrast, the resource poor areas of the country have tended to have more stable communities and better development outcomes – despite significant fiscal inequities.

Another danger is that, as with past resource developments, the LNG project will soak up a large proportion of the government’s scarce institutional capacity and that, because of this, important reforms will be delayed or abandoned. PNG still ranks as the least friendly and most costly business environment in Melanesia, and ranks far behind other regional competitors in East Asia. Law and order issues as well as land access constraints contribute to this situation. But the situation is also caused by sustained government policies related to the regulatory environment which have created a web of trade tariffs, tax concessions and operating subsidies to criss-cross all aspects of PNG business activities. Widespread wealth creation will depend on further progress with the microeconomic reform agenda.

As the government finds itself less dependent on external assistance because of the upsurge in resource earnings, PNG’s development partners will face a number of issues. Donors’ impacts on economic management and development outcomes will rely increasingly on the quality of their advice and the respect they obtain from the PNG Government, rather than on the persuasion of their cheque books.

Overall, 2009 was another small step forward for PNG. Fiscal discipline slipped as the government dipped excessively into its trust funds. This will have a number of negative economic consequences. With the large decline in nominal revenue this situation could have been much worse. Expecting politicians to resist the temptation of spending when an unprecedented opportunity for ‘fiscal stimulus’ is presented is probably holding the bar a little high for any country.

The discussion of resource revenue management in the 2010 Budget suggests that the Treasury Department at least is taking the potential risks from the LNG project seriously. Whether this translates into political action remains to be seen. PNG’s experience with past resource projects illustrates that the most important factor in transforming resource revenues into improved development outcomes is the strengthening of domestic accountability mechanisms at all levels of government. This must include a strengthening of the institutional arrangements guiding the allocation and expenditure of these revenues. Equally important is that the PNG government makes further progress on the microeconomic reform front. It must untangle the current web of domestic and international trade distortions, to unleash the productive potential of its own citizens.

This is part of the special feature: 2009 in review and the year ahead.

Aaron Batten completed his PhD in the Crawford School at the ANU, where he continues to be an Associate of the Pacific Program, and currently works in the Malawi Ministry of Finance.

1. On the brink of success – Papua New Guinea’s economic revival
2. Trust accounts and the management of Papua New Guinea’s commodity boom
3. Papua New Guinea: from economic boom to gloom?

There are many reasons to be optimistic about the PNG economy over the coming years. Its relative insulation from the global financial crisis combined with substantial savings still remaining in trust from the commodity boom period leave it well placed to sustain moderate rates of economic growth. This growth will build on the considerable macroeconomic improvements made in recent years particularly in terms of employment creation and business confidence. Optimism is further buoyed by the prospect of new investment in a range of extractive industries – especially the upcoming LNG project.

Certainly, dangers to the relative sense of macroeconomic stability exist. The government is having difficulty reigning in expenditures in light of reduced domestic revenues. This has raised concerns about a return to sustained budget deficits between when the trust accounts run out and the LNG revenues start to flow. The final few years of the commodity boom period also saw a considerable growth in the types of wasteful expenditure patterns that have plagued past governments – in particular large increases in salaries and wages and the emergence of increasing numbers of special interest projects. This, in turn, has limited the growth in funding to core development priorities like health and education.

Perhaps the most important challenge facing the PNG Government however, to ensure future growth leads to widespread wealth creation, is that it must begin to make further progress in improving the conditions for  new and existing business enterprises and to competition amongst them.

PNG still ranks as the least friendly and most costly business environment in Melanesia and far behind other regional competitors in East Asia.

Law and order issues as well as land access constraints contribute to this situation. But it is also a result of sustained government policies related to the regulatory environment which have created a web of trade tariffs, tax concessions and operating subsidies criss-crossing all aspects of the PNG business environment.

Without correcting these distortions productivity growth is likely to remain sluggish and upcoming resource extractions have the potential to lead to the types of concentrated, poorly distributed, economic growth of the past.

Reducing the cost of goods and services in PNG is also closely linked to the direct burden which government bureaucracy places on private sector activity. Perhaps somewhat surprisingly, PNG actually compares quite favorably in terms of the fees and license charges which it imposes on business activities. The reason it ranks so poorly on cross country comparisons of regulatory performance relates the large number of procedures and the lengthy time delays which occur when carrying out these procedures. Addressing these institutional constraints to business activity should thus be at the forefront of the microeconomic reform agenda.

Trade facilitation can also play a key focus for reducing the costs of goods and services in PNG. One avenue which deserves much more attention over the coming years is the expansion of trade routes with Asian markets. In particular, tapping into Indonesia through the land border with West Papua offers a potentially vibrant source of trade. The low cost business inputs and services which these markets offer could dramatically lower the cost of goods in PNG, stimulating new business activity and a more internationally competitive private sector.

Whichever avenue the PNG Government choses to take, it is clear that the net welfare gains from unilateral trade liberalizations and regulatory reforms are enormous. The dilemma facing the government  is whether the benefits are worth bearing against the political cost of overcoming the numerous vested interests which the policies in place now have created.

1. On the brink of success – Papua New Guinea’s economic revival
2. Papua New Guinea: from economic boom to gloom?
3. Papua New Guinea’s development success depends on learning from its past

PNG had another interesting year in 2008. The first half of the year saw economic growth remain strong as the country continued to benefit from yet another boom in the price of its commodity exports. High resource prices underpinned a significant expansion in the manufacturing, construction and agriculture sectors. Towards the middle of the year, however, poor monetary responses to a prolonged growth in domestic liquidity, coupled with a continued strong external sector, meant that inflationary pressures began to increase, with inflation rising to 13.5 per cent in September 2008.

September, of course, also marked the onset of global financial crisis. Barring a couple of jitters on the PoMEX, PNG’s economy weathered the direct impacts of the crisis relatively unscathed. In large part this was because of the healthy supply of foreign exchange reserves and domestic bank liquidity built up over previous years which gave the financial sector sufficient flexibility to cope with any adjustment costs.

The flow on effects of the crisis have led to a large downturn in the price of many of PNG’s key commodity items which had been driving revenue and output growth. This has had an immediate impact on the Government’s fiscal position with the 2009 Budget predicting a 25 per cent overall decline in domestic tax revenue.
In last year’s PNG economic update, Bob Warner and Eric Omuru warned that PNG would one day face this situation, highlighting the need for commodity boom revenues to be invested in productivity enhancing sectors which can generate long term economic benefits for the country. The global financial crisis appears to have brought that day to the present. The question is, however, has PNG made the requisite reforms and investments in human and physical capital to withstand a global economic downturn? Or will this commodity boom follow the path of previous decades and be followed by an economic bust?

Unlike previous booms, the Government has a large supply of unspent windfall revenues which it will be able to use to maintain expenditure levels at commodity boom levels for a number of years. Indeed, this will be the case in 2009 with the Budget foreshadowing a K600 million drawdown from Trust. Perhaps the most important difference between this and past bust cycles is the prospect of the ExxonMobil LNG Project. In the event that this project comes on-stream, and this is looking increasingly likely, the nature and structure of the PNG economy will fundamentally change. Although weaknesses in these calculations exist, ExxonMobil modelling predicts that the size of the PNG economy will more than double over the medium term, rising in real terms from K8.65 billion in 2006 to K18.2 billion. Oil and gas exports would increase more than four-fold, with the LNG project contributing an additional K11.4 billion, compared to total PNG oil and gas exports of K2.6 billion in 2006.

Significant reforms have been made this year to the system of intergovernmental financing. Following reforms to the Organic Law on Provincial Governments and Local-level Governments in July, new measures were introduced in the 2009 Budget to reduce the difference between each provincial government’s service delivery costs and the amount of revenue which they receive. This is a positive step forward as continued progress on this front, combined with improved accountability mechanisms, will bring provinces to a similar level of fiscal capacity to meet the costs of delivering a comparable set of basic services.

This optimism does mask some important challenges facing the country over coming years. The onset of the LNG project will create classic Dutch disease effects and put further pressure on the rural sector, which creates wealth and livelihoods for the vast majority of Papua New Guineans. The massive growth in output is also likely to spur on more growth in domestic liquidity and inflation. Again, this will disproportionately impact on the welfare of the poor.

More fundamentally, the LNG Project is likely to perpetuate what is already a highly commodity dependent economy. This has diverted, and is likely to continue to divert, much needed attention and focus away from more important economic challenges such as lowering the costs of the PNG’s pervasively expensive business and investment environment. Some progress was made in the airlines sector this year with the entrance of a Virgin Blue/Airlines PNG partnership dramatically lowering the cost of international flights. Nevertheless, national investment policies continue to be dominated by subsidies, concessions and monopoly trading rights. As a result, PNG fell back another 9 places in the 2009 World Bank Cost of Doing Business survey, now ranking 91st out of 121 developing countries.

Further microeconomic reform is needed if PNG is to set itself on a long term sustainable growth path.

–

Aaron Batten is PhD candidate in Economics the Australian National University. He is currently based at the National Research Institute in Port Moresby, Papua New Guinea.

This is part of the special feature: Reflections on developments in Asia in 2008 and the year ahead

1. Managing the boom in mineral revenue in Papua New Guinea
2. Papua New Guinea: The informal economy and the resource boom
3. On the brink of success – Papua New Guinea’s economic revival

The 2009 Budget sets several records for PNG’s fiscal management under the theme, ‘Empowering and Transforming the Rural Economy’. Foreshadowed is the PNG Government’s contribution to the Development Budget which is a massive K1385 million ― an increase from K526 million in 2008.

This unprecedented increase in the Development Budget means that, for the first time since independence, PNG’s development expenditure appropriation will be larger than total donor funding of K974 million.

With the unfolding financial crisis, the 2009 Budget may also herald the official end to the commodity price boom which has been driving PNG’s growth and revenue since 2002. As a result, total tax revenue is expected to fall by almost 25 percent. Despite this fall in revenue, and increase in development expenditure, the Government still plans to maintain a relatively balanced budget ― a deficit of K10 million ― in the coming financial year. So where did all the Kina come from? and perhaps more importantly, where is it all going?

Where did all the kina come from?

For the most part, the decrease in tax revenue has been offset by the government’s decision to transfer K600 million that was held in trust for equity in the gas project, into consolidated revenue. In the event that commodity prices fall further, expenditures will also be funded out of the almost K3 billion that has been held in other trust accounts, which currently hold unspent windfall revenues.

These trust accounts have played a central role in the government’s ability to manage the current decline in revenue. The 2009 Budget also continues to improve the transparency of these funds with the publishing of trust account details in the Mid-Year Economic and Fiscal Outlook and now the annual budget documents. However, unclear management responsibilities and governance arrangements still surround these funds. Given the amount of savings that are still held, the 2009 Budget also presents another missed opportunity for the Government to articulate a strategic vision concerning its plans to store, maintain, and utilise these revenues over a longer timeframe.

Where is all the kina going?

One of the biggest winners in the 2009 Budget are the district administrations, with District Support Grants totalling K356 million, building on the K900 million that those administrations received in 2007 and 2008.

In the past, the effectiveness of district allocations has been seriously undermined by a lack of accountability. Substantial evidence reveals that there has been widespread misuse of these public funds. However, there was no mention of improving accountability for these funds in the 2009 Budget, except to signal a shift in their management from the Department of Treasury and Finance to the Department of National Planning and Monitoring. Although no reason was given for this change, further separating financial and accounting controls from the Department of Finance is, at best, unlikely to improve the management or effectiveness of these funds.

The health sector appears to be one of the biggest losers in the 2009 Budget, with a minimal increase to its development funding. Although the Government injected some K46 million of recurrent funds for hospital management services, this was offset by a reduction of 17 percent in funding for the Department of Health, to K131 million. In addition, despite being an MTDS priority, domestic funding for HIV and AIDS activities has declined from K17 million in 2008 to only K5 million in 2009. Given that HIV and AIDS represent perhaps the single biggest threat to social and economic progress in PNG, this is a significant misallocation of government funds. Undoubtedly, the Government also understands that donors are likely to cover any funding shortfalls in this area, which leaves them to spend their money elsewhere.

In the education sector, the Government has maintained its K143 million Education Subsidy Program from 2008. However, total recurrent funding for educational services is well below past levels. Although, progress has been made in increasing gross primary school enrolment rates from 61 percent in 2005 to 80 percent in 2007, significantly more funds will be required if the Government is to even come close to achieving its target of Universal Primary Education (UPE) by 2015.

As always, much of the recurrent budget continues to be absorbed by the public sector wage bill, which is excessive considering the size and income of PNG. The 2009 Budget has made a modest attempt to reduce this expenditure, but much of the proportioning is simply hiding the government’s transfer of the full cost of superannuation liabilities to forward years. This highlights the need for further public sector reforms, both in terms of the wage bill and the sector’s performance orientation in efficiency and outputs.

For the first time, PNG has pledged more development resources to the MTDS priorities than donors.

While an important milestone, this allocation masks the fact that 87 percent of these funds have been allocated to just two priorities ― transport rehabilitation and maintenance, and income-earning opportunities. In reality, aid agencies continue to dominate funding in key sectors, such as health, education, and law and justice. A productive working partnership between donors and the PNG Government is likely to be best established when they all engage cooperatively in these development sectors on an equal footing. All of these parties have much to learn from each other. However, if parties continue to set apart or silo their contributions to certain development priorities, the 2009 Budget has the potential to undermine these objectives.

The Government falls well short of making substantial progress in key service delivery sectors such as health and education. The large injection of funds into the 2009 Development Budget also signals a significant decline in 2010, with development expenditures falling by 35 percent. With the commodity boom coming to an end, the Government needs to develop a more coherent strategy to manage the funds that remain in trust, before they are whittled away through unproductive expenditure.

Funding is important. However, implementation remains a key issue. The declining capacity of the public sector to implement the government’s fiscal strategies has continually limited the impact of government expenditure allocations. Key reform initiatives should continue to aim at improving the performance of public sector workers in order to improve the quality of their outputs and encourage efficiency.

1. Trust accounts and the management of Papua New Guinea’s commodity boom
2. Debt and exit in India’s 2010 Budget
3. On the brink of success – Papua New Guinea’s economic revival

Much has been said about the financial crisis and its potential impact on PNG. Both the Minister for Finance and Treasury and the head of one of the country’s major superannuation funds say that the economy will be relatively immune.

Yet, the Secretary of the Treasury and now the Bank of PNG have voiced concerns about the negative impact of falling GDP growth, reduced export and Government revenue, and a reduction in foreign investment. What should we make of the situation in PNG, and how is this crisis likely to affect the country over coming months and even years?

The good

Things are not all doom and gloom. Many domestic policy makers are even talking positively about the affects of the crisis.

The positive interpretation is partly justified by the huge volumes of foreign exchange reserves built up over the past 6 years meaning that the economy is unlikely to suffer a repeat of the foreign exchange shortages of the 1990s. It is also widely thought that a slowdown in the global economy may help to cool off Government revenue growth, which has been increasing at a dramatic rate since 2002. This would require the Government to consolidate on its recent revenue gains and also help to dampen inflation which has recently reached double digit levels. PNG is also much less dependent on both remittances and tourism revenue than other countries in the region. These two ‘advantages’ mean that it is unlikely to feel any significant pain from a drop in earnings from both activities.

In terms of the stock market, the initial phase of the crisis also left the POMEX relatively unaffected – despite some sensationalist headlines in local newspapers. The small decline which did occur during August and early October resulted mainly from those stocks which are double listed on both the POMEX and ASX markets, and the corresponding falls in their Australian listing.

A significant Kina appreciation against most of PNG’s major trading partners over the last two months will also help to curb rising domestic inflation a large portion of which has been from imported sources. The Kina has appreciated against the Australian Dollar by as much as 45 per cent since August this year. This change will also help lower the Governments foreign debt repayment obligations.

And the global drop in oil and gas prices will be warmly received by many in PNG who have been struggling with higher fuel and energy costs.

The bad

But the argument that PNG is immune from the current crisis overrates the resilience of the economy. The exchange rate appreciation has dramatically reduced the competitiveness of PNG exports; particularly exports of labour-intensive products from manufacturing and agriculture (coffee, copra and oil palm). Stagnation in these sectors will dampen the already minimal employment creation from the recent commodity boom.

If global oil and gas prices continue to remain low, or decline further, question marks may begin to emerge on the viability of the PNG gas pipeline project. The project entails over US$1 billion of investment by the Government, and a cancellation or delay in the project would be a disaster for current fiscal policy and future revenue growth.

Perhaps the most important impact of the crisis however relates to PNG’s ever fluctuating foreign exchange reserves. Concerns about falling foreign exchange earnings have been dismissed on the basis of current earning levels and the large stock of reserves which have been built up since 2002. This is certainly true. PNG currently has record levels of foreign exchange and any drop in earnings would have to be large and sustained for any negative side effects to emerge. But this underestimates how quickly circumstances can change in the land of the unexpected.

A large portion of PNG’s foreign exchange reserves are currently invested by a number of international investment firms. A portion of these asset values have declined substantially over the past months both from exchange rate revaluation and share price losses. Central Bank Governor, Wilson Kamit, has also highlighted the potential impact that the crisis may have on the earnings of PNG’s superannuation funds. Both Nambawan Super and Nasfund have approximately 20 per cent of their assets invested in off-shore equities. The affects of this on their balance sheets will also be combined with a loss in value of many of PNG’s dual listed companies, which have recently begun to fall prey to the crisis.

Potentially, the biggest risk to reserve levels will be if, over the longer term, PNG’s key export markets, Asia in particular, begin to implode. As the ADB recently announced in its latest Pacific studies series, ‘PNG’s commodity price boom is over’. Profits for a number of major mining companies are expected to decline substantially this financial year and this will have obvious consequences on both government revenue and export earnings. The true extent of these effects will be difficult to tell until the BPNG releases its Annual Monetary Policy Statement at the end of the year.

The ugly

Even more worryingly, despite its initial resilience, in the last week the PNG stock market has begun to feel the fallout from the global turmoil. In one week the share market dropped 13 per cent as Oil Search shares plummeted by K3.40 (34 per cent) amidst expectations of a slowing global economy. While share prices recovered in the following week, this volatility demonstrates that PNG is not immune from the crisis and almost certainly reflects the markets’ increased understanding of the consequences of a sustained downtown in the global economy.

Liquidity is not a major issue in the region at present, though the Bank South Pacific with a credit rating of B+ (S&P) could in future face a ‘run to quality’ given the AA (S&P) ratings of its major competitors, ANZ and Westpac. The recent deposit guarantee provided by the Australian PM to the latter two may exacerbate these pressures with a flow of funds out of the Pacific towards safer Australian shores.

Tighter global and regional credit markets will also increase the cost of obtaining international finance and are likely to reduce private investment flows to PNG. Higher borrowing costs in turn will limit potential funding for new projects. The fall in global commodity prices will make many commodity-based projects appear less profitable, further restricting growth across a number of sectors of the PNG economy.

Easily the biggest threat to PNG’s continued economic expansion, however, is that the regulatory and institutional environment raises costs prohibitively, in particular for small scale investments. PNG now ranks second last out of ten Pacific Island countries in the World Bank’s 2009 Cost of Doing Business index, sliding back from position 89 to 95 in the world over the last year. For the most part, medium to large scale investment activities have overcome the high costs of operating in PNG’s regulatory and institutional environment by obtaining tax concessions and operating subsidies from the Government. These options are generally not accessible to smaller scale entrepreneurs who face the full cost of the PNG business environment. This has dramatically limited the flow on or ‘trickle down’ effects of PNG’s post 2002 economic boom which has been driven by large scale enclave development in mining and resource extraction. Without broad based growth and a diversification of export and government revenue sources away from mining and resource extraction PNG will continue to remain highly vulnerable to external shocks to the global economy.

Conclusion

PNG has made significant gains in its macroeconomic and fiscal position over recent years, and the risks to macroeconomic stability in the short to medium term are in all likelihood not that large, provided Asia holds up. But a sustained slow down in the global economy is a large longer term risk for PNG and the brunt of the current crisis is likely to be felt most heavily by rural and agricultural workers who find that they are no longer competitive in international export markets.  The impact of a global slowdown will be on the poor.  Those at the margins risk falling into poverty.  The plight for the already poor will get a lot worse.

A reduction in commodity prices will significantly cut government revenues and Secretary Tosali’s concern about the potential impact of the crisis on PNG’s fiscal position is real. Fiscal belt tightening, and more importantly, prioritization of expenditures towards productivity enhancing sectors will be required to help lessen adverse impacts of the global slowdown.

Until the PNG Government addresses the structural constraints on growth by reducing the formidable costs of doing business in PNG the gains from episodic resource booms will continue to remain fragile.  This is one reason why the much talked about macroeconomic improvement has failed to translate into improvement in the wellbeing of the population at large.

1. Chinese Growth and the Financial Crisis
2. China not immune from the US financial crisis
3. India: Confronting the Global Financial Crisis

Just like the 1990’s trust accounts are shaping up to be a defining component of how PNG manages its resource revenues in this decade. Unlike the 1990’s however current revenues are being channeled into numerous smaller trust accounts instead of the single consolidated Mineral Resource Stabilization Fund (MRSF). Has PNG learnt from its mistakes or is it heading towards a repeat of the past? To answer these questions it is necessary to understand why these trust accounts have increased so much in prevalence over the last few years and what implications this has for fiscal management.

Some Background

Trust funds have played a significant role in the management of fiscal resources in PNG since independence, especially in relation to absorbing the volatile revenue streams generated by mineral and resource extraction. With the commencement of the Panguna Copper Mine in Bougainville the Government created the Mineral Resource Stabilization Fund (MRSF) with legislation coming into force in 1974. The MRSF was designed to receive all of the Government’s revenue derived from mining taxes rather than having them flow directly onto the Budget. The Fund was then used to distribute these revenues to ensure a smoother allocation of resources over time and so that they could be used more effectively.

Despite a promising start the MRSF was however notoriously mismanaged. Even prior to the closure of Bougainville Copper in 1989, moves were made to relax the provisions of the Act in 1986 to give Government greater discretion in making withdrawals from the Fund. By 1998, the draw down from the MRSF to the public account totalled K330.1 million comprising 18 per cent of the government’s domestic revenue. Then in 1999 a decision was made to draw down the entire remaining balance of the fund (a total of almost K1 billion) to cope with a looming public debt crisis.

In addition to withdrawing excessive amounts from the Fund, successive governments paid little attention to providing processes and policy settings to ensure revenue was spent on building infrastructure or other productivity and capacity enhancing projects. Following the emptying of the Fund a decision was made to repeal the MRSF legislation, which became effective in December 2000.

Current Trust Account Usage

This situation is now having consequences for the current fiscal management of resource revenues. Government held trust accounts are held by agencies across the PNG public sector and were initially established to hold counterpart funding between PNG and donor agencies but their roles have varied over the years. The Department of Finance holds upwards of 29 accounts, the most important of which are the Supplementary Budget accounts where funds are transferred when revenue receipts are above those estimated in the Budget – which has been the case since 2002.

By the end of 2007 windfall revenues in Trust which had been designated for future investment reached about 17 per cent of GDP. As of 31st May for example the 2006, 2007 and 2008 Supplementary Budgets had appropriated K476.9 million to the health sector. Of this just 28.6 million (6 per cent) had been spent with the remaining K354.3 million paid into trust. Similar figures exist in the education and law and justice sectors. In total, if total unspent funds were treated as savings for the 2007 Budget this would have raised the estimated budget surplus to 11.4 per cent of GDP.

Is this sensible economic policy?

Why are Trust Accounts becoming so important to PNG Fiscal Management?

The major advantage of using these trust accounts is that they allow the Government to smooth their expenditures over time. This limits the impact of the current revenue boom on the already stimulated levels of aggregate demand, helping to curtail inflationary pressures which have recently reached double digits.

A slower release of mineral funds also improves the ability of the bureaucracy with its limited implementation capacity to focus on the quality of expenditures as well as limit the amount of economic rent seeking occurring within the economy. Another advantage of these trust funds over a consolidated fund such as the MRSF is that they allow additional unspent revenues to be allocated to a specific purpose whereas expenditures financed from the MRSF tended to fund general government consumption.

Domestic politics places a high priority on allocating available funds to particular activities. A number of political difficulties would arise if the Government was seen to be ‘holding on’ to these revenues without any plans for their expenditure. Specific purpose trust funds are also much less visible than a consolidated fund which history has shown tends to attract a large amount of pressure for higher expenditures making it more difficult for inter-temporal expenditure smoothing. In essence, these trust funds are allowing the Government to allocate funds without actually spending them which is appealing in both an economic and a political sense.

What Issues has this created for Fiscal Management?

The first and most obvious disadvantage of this approach is that holding such a large amount of revenues in trust for extended periods is clearly a second best policy to simply repaying the declining, but still high, levels of Government debt. New borrowing into the future would then allow inter-temporal expenditure smoothing and forego current debt repayment obligations.

The political reality of PNG fiscal management however suggests that this would be a difficult approach. The Government is already allocating a large portion of its resources to debt repayment in line with the Medium Term Debt Strategy, and it must be seen to be making new large scale productive investments in the physical and human capital of the country. Trust funds allow the Government to do this whereas debt repayments do not.

Another issue to be considered is that the opportunity cost of keeping this money in trust accounts is high. The numerous accounts which these funds are being held in also means that they have limited potential to generate higher rates of return from a more diversified portfolio base. Ex-Treasurer and now Opposition leader, Bart Philemon picked up on this issue in his reply to the Somare Government’s 2008 Budget. In it he highlighted that a total of K4.67 billion in public money was sitting in various trust accounts ‘doing nothing’. This included K515 million in the Bank of Papua New Guinea, K400.9 million in the Bank South Pacific, K197.1 million in ANZ (PNG) Ltd and K186.6 million Westpac (PNG) Ltd.

Perhaps the most important issue to be raised by the dramatic increase in the usage of these trust funds is the unclear management responsibilities and governance arrangements which surround their usage. In the 1990s and early 2000s trust accounts were the source of widespread misuse and extortion of government funds. During this period there were an estimated 3,000 separate accounts which combined with poor financial controls meant that it was difficult to trace or prevent illegal activities. Following a review in 2004, Treasurer Philemon declared a large portion of these to be redundant and the number was brought down to an estimated 300. Whilst the reduced number of accounts and improved financial controls will help prevent further misuse, confusion over their number, size and management still exists and may reduce their effectiveness and create further bottlenecks in financial control.

Some progress has been made in terms of transparency with the publishing of trust account details in the 2007 Mid Year Economic and Fiscal Outlook (MYEFO) but this is not a legal requirement and in the event that politicians wished to start hiding activities could be easily stopped. The Government’s Medium Term Fiscal Strategy (2008-2012) also places a limit on spending from trusts with total expenditures not too exceed 4 per cent of GDP. This may help to limit a potential raiding of these accounts but the threshold has not been reached yet and therefore whether it is binding has not been tested.

Finally, the Government has not articulated a strategic policy to address the implementation bottleneck in the system of government. Whilst holding onto revenues to limit their inflationary impact is important, much of the current lack of disbursement almost certainly reflects limited public sector capacity. For this to change a more competitive system of public sector employment conditions needs to be implemented so that the bureaucracy is more capable of managing productive investments which expand the supply of physical and human capital in the economy.

Concluding Remarks

Government held Trust accounts are playing an increasingly important role in the fiscal management of PNG. This approach of smoothing expenditure allocations from the current revenue boom offers a number of advantages but is probably the second best option in lieu of simply repaying government debt and borrowing into the future. The development of this approach has also been relatively ad-hoc at best and the management responsibilities are still unclear and need considerable improvements. If trusts are going to hold such a significant portion of government revenue then they need to improve their transparency and much of the confusion around their governance and accountability structures needs to be clarified, both to Parliament and bureaucrats.

1. Managing the boom in mineral revenue in Papua New Guinea
2. Papua New Guinea: from economic boom to gloom?
3. Papua New Guinea: The informal economy and the resource boom

PNG is often seen by Australia as a fragile state dependent on foreign assistance with limited economic prospects. It was even described some years back as being on ‘the brink of collapse’. Since 2002 however our 6 million northern neighbours have been experiencing somewhat of an economic revival. While this has been driven by surging commodity prices it has also been underwritten by considerable improvements in macroeconomic and fiscal management. GDP growth rates have been high and the budget has been in surplus for 5 consecutive years – a record for PNG. The question on everyone’s lips however is; is this trend sustainable?

Last year Patrick Pruatich was appointed Minister for Treasury and Finance, having moved from his previous role as Minister for Forestry. Many feared that this was an attempt by the National Alliance Party to allow them greater access to government funds for pork barrelling in the lead up to the 2007 elections. These fears have not as yet been realised.

Expenditures remained relatively restrained in the lead up to the election. The Government recorded a budget surplus equal to 1.7 per of GDP in 2007 albeit on the back of continued oil and mining revenues and a 6 per cent GDP growth rate. The current government has also brought national debt levels down from a record 72 per cent of GDP in 2002 to approximately 35 per cent of GDP this year.

To try and ensure the government doesn’t fall into the trap of previous decades the Treasurer and his Department are currently developing an updated Medium Term Fiscal Strategy (MTFS 2008-2012) to act in conjunction with the Fiscal Responsibility Act (FRA 2006) to make a number of changes to both the revenue and expenditure priorities of the Government and to place restrictions on the extent of its fiscal austerity. The draft MTFS effectively targets an underlying balance for government expenditure which is exclusive of the amount of mineral revenue deemed to be over and above a normal level. The document proposes that any additional revenue which exceeds this amount be allocated in ways which free up resources into the future rather than commit the government to future spending obligations. This includes approximately 60 per cent of additional mineral revenue being used for public investments and 40 per cent for debt prepayment. Whether or not the Government accepts these specific proposals is uncertain but it is certainly talking and thinking about the right issues.

People are invariably wary of these successes, not least because in the past, commodity booms have led to rapid expansions in government expenditure and on 3 separate occasions a lack of fiscal discipline has brought the country to the brink of bankruptcy.

None of this should also understate the huge development challenges facing the country. A major threat to the ability of economic success to improve living standards in PNG is rising inflation. Unofficial forecasts put inflation at close to 8 per cent this year, but this is most likely an understatement.

The Central Bank has been lacklustre in its response to an overheating economy. Real interest rates remain negative (the 28 day CBB rate is about 5.4 per cent) and it has shown little inclination towards reigning in rapidly growing domestic credit levels. The Bank’s foreign exchange reserves are now also at remarkably high levels. Many people have even been suggesting that the BPNG has actually started behaving like a profit making entity rather than a monetary authority. This is a poor performance from an institution which in the past has prided itself on being the bastion of economic stability in an otherwise volatile country. In the Central Bank’s defence, inflation is being largely driven by rising food and oil prices which are set on world markets and hard to curtail. But without adequate monetary responses these effects are being amplified, particularly as the economy steams ahead.

Another major challenge for PNG is that in spite of the commodity boom and an increasingly development focussed fiscal policy the supply side of the economy has shown minimal response. A couple of resource projects are coming on-line but these were in development prior to the commodity boom. A decline in global demand for these commodities would not only lead to a large scale reduction in foreign exchange earnings but place a disproportionate burden on government revenue. If recurrent expenditures are allowed to grow within the budget this could subsequently lead to another blow out in expenditure levels – as has been learnt by the lessons of the 1990s in particular.

Poor supply side responses necessitate a renewed commitment by the government to address many of the structural constraints on growth present within the economy. These include, high rates of crime, unreliable and expensive services from basic utilities, poor transportation infrastructure limiting market access, low public sector capacity to provide services, unclear and rigid regulation policies, low levels of human capital, and land tenure issues. These issues have meant that both domestic and foreign investment have remained limited outside of the mineral sector and this constitutes the biggest constraint on the recent macroeconomic success leading to more improvements in development outcomes across the country.

1. Papua New Guinea: from economic boom to gloom?
2. Papua New Guinea’s development success depends on learning from its past
3. Papua New Guinea’s economic outlook

The recommendations of the recently completed Growth Commission funded by the World Bank and led by Nobel laureate Michael Spence have been the subject of considerable debate – and by some authors ridicule. But for all its limitations, the Commission did make some important commentary in particular on the development challenges facing small States such as those in the Pacific and how progress might be made.

The Report highlights that some small states have been successful in pooling their efforts and outsourcing public services (with the help of IT advances). The Central and West Africa region, for example, relies on multi-country central banking, as does the Eastern Caribbean. The Eastern Caribbean has also managed to develop a single telecommunications authority and a united Supreme Court, which covers eight independent states.

Sadly, these examples are in very stark contrast to the small states of the Pacific, which possess in various forms many of the institutions typical of a large country – embassies abroad, central banks, regulatory authorities, multiple tiers of government etc. – which are expensive to run. To an extent, Australia bears much of the responsibility for the emergence of these institutional structures within the region (particularly in Melanesia), but domestic politics has now embedded them as national icons and change is inherently difficult.

As a solution, the Growth Report recommends greater regional economic integration within the Pacific region, and a spreading of the burden of public services, through a type of partial political union, helping reduce the high per capita costs of effective government. A more viable long-term model for the Pacific states it proposes would be a self-governing structure in association with Australia or New Zealand.

I believe that there are a lot of merits to this type of proposal but there are questions over whether Australia, let alone the highly nationalistic governments in the region, would be willing to commit to such an arrangement.

A logical first step in the process would be the opening up of temporary labour mobility between Australia and the Pacific. This would allow a greater interaction between Australia and the region which for the last decade has seen its relationship flounder under the weight of various political animosities. In addition to the economics the most beneficial aspect of such a scheme would be to increase the limited Australian understanding and acceptance of our Melanesian neighbors.

Hopefully the Rudd Governments upcoming announcement on the potential piloting of such a scheme recognizes this.

1. Does APEC matter?
2. Opportunities for Growth: Australia’s economic future
3. China’s new National Energy Commission

The Brenthurst Foundation published an interesting Discussion Paper last week drawn from the 2008 Tswalu Dialogue on ‘Towards Conflict Resolution Best Practice’. The dialogue consisted of key leaders who have been involved in institutional development and conflict resolution across the African region.

Amongst the groups more interesting findings was the importance placed on seeing the resolution of conflict and progress in institutional development as a long-term process rather than an event in itself. The report also highlighted the ability of donor interventions to ‘freeze’ rather than resolve ‘conflict’ situations.

Such lessons from Africa should be taken seriously in our own region as Governments go about supporting institutional development in fragile states within the Asia-Pacific. It also ties in nicely with work being done by Satish Chand and Ruth Coffman from the Centre of Global Development (CGDEV) estimating the length of time donors can expect to be required to establish stability in a post-conflict society. The answer to this question is ‘many decades’ suggesting that ‘long-termism’ in project design is perhaps the most important element of any fragile state intervention or support offered by the region.

1. China’s rise and the importance of Australia-China youth dialogue
2. Priming the economy: short term versus long term
3. Pakistan’s clash of institutional authority