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Asian Development Outlook 2002 : II. Economic Trends and Prospects in Developing Asia

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Papua New Guinea

The combination of a sharp decline in mining, weak domestic demand, and poor industrial profitability kept the economy in recession in 2001. There may, however, be some improvement in economic growth in 2002 as agriculture expands, though it may take longer for economic fundamentals to improve and for growth to be sustained.

Macroeconomic Assessment

GDP contracted in 4 of the 5 years 1997–2001, the key contributors being poor macroeconomic management, drought, the Asian financial crisis and, most recently, slower growth in the world economy and low commodity prices. Earlier expectations of growth in GDP in 2001 did not materialize, partly due to delays in starting a gas pipeline project and a nickel-cobalt project in Ramu. In 2001, total and nonmining GDP contracted by 3.3% and 1.8%, respectively (Figure 2.33). The largest contractions by sector were seen in construction (9.3%); mining (9%); and transport, storage, and communications (7.4%). Sectors estimated to have expanded over the year are electricity, gas, and water (7.9%); finance, real estate, and business services (3.8%); and agriculture, forestry, and fisheries (0.9%).

A general decline in world commodity prices constrained most sectors over 2001, notably the mining and oil sector. World prices of coffee and copra fell by about 30%, and of copper and oil by about 10%. As a result, the export sector failed to realize the full potential benefit of a weaker kina.

The Government faced major difficulties in managing its finances in the first half of 2001. This was due to repeated problems in accessing all the external extraordinary financing from various donors due to a delay in meeting a major milestone for readying the country’s largest bank—the Papua New Guinea Banking Corporation—for privatization. At the same time, tax revenues were lower than expected due to continuing problems with the implementation of VAT, falling oil prices, and a weak domestic economy. The Government had to cut back expenditure and put tight controls in place in the middle of the year. Overall, the budget recorded a deficit equal to 1.8% of GDP in 2001, which was mainly funded by an eventual drawdown on the external extraordinary financing in the second half of 2001. Foreign debt rose by 5.6% in 2001.

Despite the poor growth outcome, there were some important achievements in 2001. By the end of the year, inflation had fallen to below 10% due to tight monetary policy and weak demand. This was reflected in the movement of interest rates as inflationary expectations subsided. The official interest rate was reduced to 10%, a fall of about one third over the previous year’s level. The weighted average of commercial bank lending rates also dropped from 16.9% in June to 14.7% in November 2001. The weighted average term deposit rate was 4.5% at the end of November 2001. Broad money supply (M2) rose by about 10% over 2001, with increases of 13.0% and 15.3% in net credit to the private sector and net foreign assets, respectively. Net credit to the Government climbed by about 4.5%.

Exports and imports declined by 6.3% and 2.2%, respectively, in 2001, reflecting weak global and domestic activities. As a result, both the trade and current account surpluses shrank, the latter from $352.6 million in 2000 to $221.3 million in 2001. The capital account deficit also fell from $234.7 million to $115.5 million in 2001, reflecting the large inflow of external extraordinary financing. The overall balance-of-payments surplus declined from $130 million in 2000 to $105.8 million in 2001. At the end of 2001, gross international reserves were around $400 million, sufficient to cover more than 5 months of imports or about 7 months of nonmining imports.

The annual average exchange rate of the kina against the dollar depreciated by about 20% in 2001 from the previous year’s level. Due to the continuing long-term downward trend in the kina exchange rate, the business sector experienced pressure on profit margins due to the higher costs of imported inputs. The fall in the kina is triggering structural change as new operators emerge or as businesses seek to increase local content and find cheaper sources of production inputs.

Policy Developments

A continuation of the decline in GDP and per capita income has increased social tensions and unrest. This was reflected in a series of events during 2001, including student protests against privatization and temporary halts in production at important mining and oil projects caused by landowners’ actions. Increased political activities in the run-up to the elections in mid-2002 have made the situation more volatile. This is adversely affecting business and investment activities, as businesses adopt an extremely cautious attitude to expansion. Such an attitude can be expected to last at least until a new government is formed in the second half of the year.

A feature of the Government’s medium-term projections is an increase in the budget deficit to 2% of GDP in 2002, before a turnaround begins in 2003. While revenues and grants are projected to remain fairly stable, a cut in government expenditures is assumed after 2002. Privatization is expected to provide the main source of financing this year. However, the Government’s domestic debt will have to rise thereafter, as increased domestic financing is required to offset rising external obligations. Risks to the 2002 projections arise from the possibility that the baseline assumptions on expenditure cuts, privatization receipts, correction of VAT implementation problems, continued high revenue collection from the forestry sector, and growth of personal and company tax payments may not hold good. If the hoped-for turnaround in the budget deficit does not materialize, reliance on domestic financing may be even greater than currently predicted, adding to the potential for renewed macroeconomic instability.

Over recent years, the main role of monetary policy has been to compensate for the expansionary fiscal policy. Since 2000, the Bank of Papua New Guinea has had a legislated obligation to target price stability and has enjoyed greater independence from the Government in meeting this objective. In the past, the Bank adopted a policy of tightening the money supply as the exchange rate fell with a view to controlling inflation and curbing import demand. This approach will likely continue over the medium term, so as to break down inflationary expectations.

Many of the ongoing externally supported adjustment programs closed in 2001. Thus, the management of the balance-of-payments account and the maintenance of stable or orderly movements of the kina will be a major challenge in the medium term. The medium- and long-term prospects of the economy depend on how quickly the fall in the kina brings about structural change, thereby building the capacity to export and replace imports.

Major adjustments are required in the economy, which faces the grim prospect of substantial depletion of mining and oil resources within a decade. Continuing weaknesses in physical and social infrastructure add to the adjustment difficulties. It is important that the Government address these two areas. In addition, adoption of an acceptable reform of the land laws is critical as the present situation underlies both the social unrest and business risk perception in the country. Improved availability of credit through expansion of the capital market in rural areas is also crucial for long-term growth and poverty reduction prospects.

Outlook for 2002-2003

The Government expects the economy to rebound moderately in the medium term, with GDP growth of 1.2% and 1.8% in 2002 and 2003, respectively. The strongest expansion is expected in agriculture, forestry, and fisheries, at 5.1% and 3.6%, respectively, in these two years. The contribution of the mining and oil sector to GDP is projected to weaken over the medium term as mining and oil resources are depleted. Inflation is projected to fall to 8.3% and 5%, respectively, in 2002 and 2003, while the current account surplus is forecast to stay at about 2.7% of GDP this year, widening to 5.7% in 2003.

The Government’s forecast for economic expansion rests on growth in the agriculture sector. The projected growth for 2002 is mainly attributed to non-export activities, which largely means expansion in the domestic economy, particularly agricultural production. By 2003, improved exports are projected, with an expansion in output volumes of all major tree crops.

Palm-oil production is rising strongly, but other agricultural exports are suffering from a number of structural problems, which could derail the forecast expansion over the short to medium term. For example, the coffee harvest has been constrained by a deteriorating road network (attributable to a long-term shortfall in the funding of road maintenance) and law and order problems. Growth of the copra industry is limited by a poorly managed statutory market authority. Low world copra prices are further hampering incentives for farmers. Although a moratorium on the release of new timber areas was lifted in late 2001 and the 2002 budget reduced export taxes by around 13%, most logging operations will continue to suffer losses due to current low world timber prices. Much of the logging industry’s heavy equipment is reaching the end of its useful life, and the industry is probably not making enough profit to encourage the reequipment required to meet even the minor expansion slated in government forecasts. Should the fiscal position not stabilize as projected, macroeconomic instability—including high inflation—is a possibility. Thus, there are major risks to the Government’s medium-term projections and, while the economy is better placed now than it was 12 months ago, structural adjustment is still in its infancy, and the economy remains weak and very exposed to macroeconomic shocks.

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