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p. 49 of 68 BACK | NEXT I. Developing Asia and the World II. Economic Trends and Prospects in Developing Asia East Asia Southeast Asia South Asia Central Asia The Pacific Cook Islands Fiji Islands Kiribati Republic of the Marshall Islands Federated States of Micronesia Nauru Papua New Guinea Samoa Solomon Islands Democratic Republic of Timor-Leste Tonga Tuvalu Vanuatu III. Competitiveness in Developing Asia Statistical Appendix

Asian Development Outlook 2003 : II. Economic Trends and Prospects in Developing Asia

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Papua New Guinea

Outside the mining and oil sectors, economic activity increased in 2002 as improved conditions in the agriculture sector, election campaigning, and a relaxation of fiscal policy boosted consumer spending. Continued expansion will rest heavily on the Government's ability to reduce structural constraints and risks to macroeconomic stability, as well as on renewed international support.

Macroeconomic Assessment

GDP fell by 0.5% in 2002, in the prolongation of a recession from 2000 and 2001, when GDP contracted by 1.2% and 3.4%, respectively (Figure 2.29). The fall in 2002 stemmed mainly from the continued contraction of the mining and oil sector, which accounts for above 20% of GDP. However, the nonmining sector grew by 2.4%, after contractions of 0.5% in 2000 and 4.2% in 2001. The improvement in the nonmining sector is in part a result of a turnaround in the prices of key agricultural commodities, notably palm oil, cocoa, and, to a lesser extent, coffee. Construction shrank by 2.1% in 2002. Overall, the decline in economic activity occurred despite both a rise in consumer demand in the nonmining sector due to political campaigning in the lead-up to the national election of June-July 2002 and the stimulus provided by a large budget deficit.

As of end-June 2002, the recorded budget deficit was equal to the budgeted deficit for the full year. High government expenditures in the first half of 2002 were accompanied by the release of considerable funds held over from previous years in the trust funds of parliamentarians. Stronger domestic expenditures lifted manufacturing output by an estimated 7.5% over the year, as it did the transport and services sectors to a degree. This surge in activity, however, was largely met with existing capacity. Consequently, business investment outside the mining and oil sector remained subdued, with business lending from commercial banks declining by approximately 4% as of September 2002 over the year earlier level. In August 2002, the new Government announced an impending budget deficit for 2002 of 7.7% of GDP and brought in a supplementary budget to correct the fiscal position. The supplementary budget set a revised deficit target of 3.4% of GDP, which was subsequently revised to 3.8% of GDP. The budget deficit was funded entirely by domestic resources. The need to repay extraordinary finance from previous structural adjustment programs and rising debt repayment obligations on concessional loans led to negative external financing for 2002 in the order of 0.7% of GDP.

The Bank of Papua New Guinea (BPNG) reacted to downward pressure on the local currency, the kina, by selling its international reserves and buying kina. The combination of selling reserves and the absence of a net inflow of external financing produced a marked decline in international reserves in the second half of the year, from US$490 million by end-June 2002 to less than US$350 million by end-December.

The central bank's intervention helped keep the kina reasonably steady against the US dollar for much of the year, but did little to stem a decline against the Australian dollar near the end of the year. The average value of the kina against the US and Australian dollar in 2002 was 13.6% and 18.2%, respectively, below the average value for 2001. BPNG tightened monetary policy over the second half of 2002 as improved demand conditions and downward pressure on the kina led to concerns of a prospective rise in inflation. Inflation rose to 11.8% in 2002 from 9.3% in 2001. The key official interest rate, the Kina Facility Rate, was unchanged during the first two quarters of 2002, but increased by 2 percentage points to approximately 14% in the final two quarters. The commercial banks made adjustments with a lag. The weighted average lending rate as of end-2002 was approximately 13.8%, below the 14.6% rate at the start of the year. The weighted average deposit rate was 5.6% as of end-2002, implying a large negative real interest rate.

The commercial banks faced weak private demand for lending in 2002, with private sector credit at year-end 2002 approximately 4.6% below the level at the start of the year. Official liquidity requirements for commercial banks were unchanged over the year, and the banking system remained characterized by high levels of excess liquidity. The money supply (M3) increased by approximately 9.4% over the course of 2002. With private sector credit declining during this period, the rise was attributable to a rise in net credit to government of more than 80% from January to December.

In 2002, total merchandise exports fell by 14.7% from the previous year's level. The decline was caused mainly by a 24.3% fall in oil exports, reflecting the natural decline in output of the major field of Kutubu. While landowner action cut production at one of the major gold producers (Porgera), and drought reduced shipments from the second major producer (Ok Tedi), gold exports rose by 6.5%, reflecting higher international prices. Agricultural exports rose by 35.5% from the 2001 level, helped by higher world prices for major agricultural commodities. Log exports increased by 16.5%, largely as a consequence of a delayed wet season that improved access to logging areas.

Total merchandise imports fell by 12.8% in 2002, reflecting the depreciation of the kina and continued weakness in the economy. As a result, the trade surplus declined to US$591 million in 2002 from US$717 million in 2001. Combined with higher service payments, the current account deteriorated and turned to a deficit of 1.1% of GDP. The capital account also recorded a deficit, leading to an overall balance-of-payments deficit of K239 million in 2002 (or about US$61.5 million).

Policy Developments

Periods of weak fiscal management that trigger macroeconomic instability have been a feature of the economy since the 1990s, and the medium-term outcome has remained highly dependent on the fiscal stance. After the supplementary budget in the second half of 2002, the 2003 budget marked a further positive step toward fiscal consolidation. The budget announced a commitment to reduce the budget deficit to 2.3% of GDP in 2003 and 1.8% of GDP in 2004.

A small number of new revenue measures were announced in the 2003 budget to help correct the fiscal position, notably an increase in the company tax rate and an emphasis on improved tax compliance. But the improved fiscal stance was to be largely achieved through expenditure measures. Some expenditure cuts were made, notably in goods and services and the education subsidy. The recent growth in the public sector wage bill was to be curbed. In real terms, total expenditures were projected to fall over the medium term.

Whether the tight expenditure targets are achieved depends on the Government's ability to control a tendency to overspending, and great effort will be needed to improve expenditure administration. Initiatives to do this announced in the 2003 budget include the appointment of financial controllers in the larger agencies; a freeze on government engagement of casual and part-time employees; tighter scrutiny of consultancies; more concerted action to contest court cases against the state; introduction of legislation to remove a state obligation to pay for unauthorized expenditures by civil servants; and an intention to take legal action against civil servants who make such expenditures.

Fiscal management is also to be enhanced by the proposed adoption of a medium-term fiscal framework, which is intended to help move the fiscal system from one based on a single-year perspective to one based on a multiple-year perspective, and provide for a smoother flow of resources over time, subject to a hard budget constraint. The fiscal framework is also to be linked to a new medium-term development strategy and, through this strategy, to the country's poverty reduction strategy.

The existing medium-term development strategy provides both a framework for government operations and an identification of high-priority budget areas focused on the delivery of basic services. The priority areas are basic education, primary and preventive health care, maintenance of transport infrastructure, law and order, and private sector development. The strategy provides a sound basis for development planning but effective implementation remains critical. Its success will rest heavily on priority areas of government receiving a preference in the budget process.

Against a background of an enhanced medium-term fiscal framework, the 2003 budget announced a few new initiatives to help improve private sector confidence. These include the provision of funding for the Highlands Highway, the country's main road; support for small-scale agriculture through microfinance and extension services; and the provision of tax concessions to the mining and oil sector in an effort to promote exploration.

A recovery from the current difficult fiscal situation will also depend on the Government's ability to secure international support, which is important in allowing the central bank to rebuild reserves, in providing a focus for important technical support, and in helping build confidence among private sector investors. The 2003 budget foreshadowed action to secure external deficit financing to reduce the macroeconomic pressures created by the high level of domestic financing, and discussions with the international community have been initiated.

BPNG's own legislation limits it to buying treasury bills for monetary stabilization purposes only and not for deficit financing, but BPNG was, in fact, a source of such financing in 2002, when it breached legislative controls on the provision of short-term finance to the Government via a temporary advance facility. Further, the current status of compliance is obscured by a shortage of published data.

In 2002, BPNG frequently supported the kina with a view to stabilizing prices. The hard line taken on kina stability may be difficult to sustain over the medium term in the absence of any highly favorable economic developments or the early provision of international support. The management by BPNG of the trade-offs it faces will be the key monetary policy development to monitor over 2003.

The falling kina seen in recent years and continued external borrowing have been factors in the ratio of external debt to GDP rising from 31.0% to 46.4% over the 5 years to 2002. This, combined with high domestic interest rates, has raised debt service costs. However, the weaker kina has also boosted the domestic currency value of the large foreign grants and of mining and oil revenues received by the Government. This natural hedge characteristic of revenues and the concessional nature of most of the external debt provides some comfort that the debt position can be sustained in the medium term. However, the Government needs to remain cautious in accumulating additional debt.

Outlook for 2003-2004

GDP is projected to grow by about 1% and 2% in 2003 and 2004, respectively, on the basis of an improved outlook for commodity prices, a trend increase in the output of most agricultural commodities, and prospects of improved macroeconomic stability. These forecasts have been framed on the basis of a steady depreciation of the kina, but at a slower rate than seen in recent years. Consistent with the forecast improvements to the fiscal position, economic activity, and somewhat greater stability of the kina, the forecasts point to a decrease in inflation (to about 5% by 2004) and interest rates. The external current account is expected to remain in deficit in 2003 and turn into a small surplus in 2004. The overall balance of payments is projected to be in deficit both years.

Several important risks to these forecasts should be considered. The nonmining sector faces, in 2003, the contractionary effect of a reduction in the real value of government expenditures and the absence of the boost to private consumption provided by the 2002 election.

Increased private sector activity will rest on confidence in the ability of the Government to deliver on the commitments of the 2003 budget and the proposed medium-term fiscal framework. It also requires confidence that the structural problems, notably law and order problems and the deteriorating road network, will be addressed over the medium term. If BPNG intervenes in the foreign exchange market at the rate it did in the second half of 2002, its international reserves could be largely eroded by the end of 2003.

The increased competitiveness provided by the steady depreciation of the kina since 1994 has initiated some changes. There are some signs of local products displacing imports, particularly in fresh and processed foods, but also in new areas of economic activity (e.g., in oil refining, for which the country's first oil refinery is now being constructed.).

Also, new export-oriented ventures have been established in recent years to draw on the rich natural resource base and on increasingly competitive labor costs (e.g., a tuna factory employing 2,000 women, a slipway attracting ships from the region for maintenance works, and a new palm oil plant).

The most likely source of a favorable economic outcome is continued higher prices for gold and oil. This can provide a boost to government revenues and lessen macroeconomic pressures. The forecasts are based on the assumption that no major new projects, such as the proposed gas pipeline to Australia or the Ramu nickel project, begin construction over the medium term.

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