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p. 54 of 69 BACK | NEXT Foreword, Acknowledgments, Acronyms and Abbreviations, Definitions 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. Foreign Direct Investments in Developing Asia

Asian Development Outlook 2004 : II. Economic Trends and Prospects in Developing Asia

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Papua New Guinea

The economy emerged from recession to record modest, broad-based growth in 2003 and improved public finances. Moderate expansion in the medium term is achievable, but will require strengthened performance from the nonmining sectors and implementation of difficult fiscal adjustments.

Economic Assessment

After 3 successive years of contraction, GDP rose by 2.0% in 2003 (Figure 2.31), and was relatively broad based. Output of the oil and gas and of the mining sector, which together account for one quarter of GDP, picked up by 3.4% in response to rising minerals and metals prices. The nonmining sectors edged up by 1.7%. The agriculture, forestry, and fishing sector expanded by 1.6%, aided by favorable weather, an early coffee harvest, and generally strong commodity prices. Manufacturing and construction both climbed by close to 5%, the latter sector stimulated by investments in a new oil refinery and a tuna processing plant, and improvements to the Highlands Highway. Services grew by 2.3%.

The pickup in economic activity was reflected in employment growth in both the mining and nonmining sectors, with the private sector employment index rising by 8.9% between June 2002 and June 2003. Employment rose strongly in construction, but less so in cocoa, palm oil, vanilla, and tuna production. Nonetheless, with private sector investment remaining subdued and annual new entrants to the labor market totaling an estimated 80,000, the greater labor demand fell well short of the expansion in supply.

The 2003 budget deficit was officially estimated at 1.7% of GDP, compared with an original budget target of 2.0%. Total revenues and grants amounted to 31.7% of GDP and exceeded budget expectations, largely because of unexpectedly high receipts from mining and petroleum tax and dividends. These receipts more than compensated for a shortfall in indirect tax revenues, which was attributable to stagnant domestic consumption. Higher revenues permitted the Government to retire some domestic debt. Total expenditures and net lending exceeded the original budget estimate, reaching 33.4% of GDP. Development spending fell by even more than the budgeted amount, but recurrent expenditures exceeded the budget estimate by 6.7%. This stemmed largely from increased expenditures on domestic debt servicing. The wage bill of national departments was relatively well controlled, but still constituted 49.3% of their total recurrent expenditures. With asset sales falling short of the budget figure, and negative external financing generated by amortization of loans from bilateral and multilateral creditors, the budget deficit was financed by short-term government domestic borrowing. In consequence, total public domestic debt rose to 27.3% of GDP, from 23.5% in 2002. However, the stock of external debt fell from 48.0% of GDP at end-2002 to 47.0% at end-2003.

Inflation in the year to September 2003 edged down to 11.8% from 12.3% in the same period in 2002. The rate accelerated in the first quarter of 2003, primarily as a result of the lagged effects of currency depreciation in late 2002 (particularly against the Australian dollar), as well as higher domestic food prices, an increased tobacco excise rate, and higher school fees consequent upon the Government’s removal of education subsidies. In response, the central bank tightened monetary policy. A reduction in inflationary pressures after midyear led the bank to reduce the official Kina Facility Rate to 14.0% in October, when the bank also reduced the cash requirement rate from 5.0% to 3.0%. Treasury bill rates dropped to 16.95% in December and commercial banks reduced their weighted average lending rate to 13.4% in November.

A cautious monetary policy stance was maintained for the purposes of exchange rate stability as well. Money supply fell by 8.4%, largely because of a drop in credit to the private sector. Tighter macroeconomic policies and stronger export revenues underpinned a relative stabilization of the kina in 2003, which appreciated against the US dollar, yen, and pound sterling, but depreciated by 9.0% against the Australian dollar by year-end (for a 20% depreciation since January 2002). Given that about half of the country’s imports are denominated in the Australian currency, this depreciation was a major reason for recorded price level rises.

The trade surplus in 2003 is estimated to have surged from the 2002 level as a result of strong growth in oil and gold exports and a fall in merchandise imports. In 2003, the US dollar prices for oil and gold were up by 15.9% and 17.3%, respectively, from the average prices recorded in 2002. The current account moved from a deficit of 4.6% of GDP in 2002 to an estimated surplus of 9.1% in 2003. However, the capital account went in the opposite direction, as net outflows of both direct and portfolio investment were recorded, with a withdrawal of foreign investments in the minerals sector and a rise in foreign asset holdings by resident companies. The overall balance of payments moved from an officially estimated deficit of 2.2% of GDP in 2002 to a surplus of 2.8% in 2003. Foreign reserves at end-2003 provided 5.0 months of total import cover, compared with 4.2 months a year earlier.

Policy Developments

Consistent implementation of sound macroeconomic policies has been undermined in the past by political instability, and several political measures were undertaken in 2003 to remedy this, though many unresolved issues remain.

While the 2004 budget strategy continues the "stabilization with growth" approach introduced in 2003, a lower budget deficit of 1.5% of GDP is targeted for 2004, and is to be funded by domestic borrowing. External financing is again negative; the Government plans to meet the amortization due on previous commercial and concessional loans by undertaking relatively costly new external commercial borrowing (equivalent to 1.6% of GDP), in addition to anticipated external concessional borrowing (1.3% of GDP).

The main 2004 budget initiatives on the revenue side include the imposition of a temporary 2% import levy (for 2004 only) and a reduction in income tax rebates for dependents. These initiatives, alongside improved tax compliance, are expected to offset a drop in revenues from the mining and oil and gas sectors, which is mainly attributable to a budget forecast that the oil price will fall by 7% in 2004. However, if the oil price stays close to 2003 levels, the revenue outcome will be stronger than anticipated. Expenditure control measures include continuing the public service recruitment freeze, with the exception of more recruitment of teachers; cleansing the payroll of ghost workers; terminating the contracts of nonessential casual employees; and granting what in theory are "minimal" wage increases. However, these increases actually involve a budget provision for a 6.7% rise in the wage bill of national departments, so that keeping recurrent expenditures close to the 2003 level is to be achieved by cutting national departments' goods and services expenditures, reducing grants to provincial governments, and paying less in domestic debt servicing as a result of lower interest rates on treasury bills. Development spending is forecast to rise, with the bulk of it going on infrastructure and social development. However, the forecast appears unrealistic in view of the country's limited absorptive capacity. Overall, the 2004 budget maintains aggregate fiscal discipline but does little to improve the strategic allocation of public resources. A public expenditure rationalization review has been completed and work on the medium-term fiscal framework is continuing. Additionally, a public sector reform program has been drafted, and the 2004 budget states the Government's intention to downsize the public service head count by at least 10% over a 3-year period.

In 2003, the central bank demonstrated its capacity to conduct an independent monetary policy aimed at protecting foreign reserves and stabilizing the kina, and thereby built confidence among the business community. However, the scope for monetary easing and interest rate reductions is limited both by the risk of capital flight and consequent currency depreciation, and by the domestic financing requirements of the 2004 budget deficit.

The medium-term development strategy for 2003-2007 and the long-term national poverty reduction strategy were still being formulated at the end of 2003. A key issue for the medium to long term is how to accelerate income growth, improve equity, and reduce poverty in a context of a probable secular decline in oil and gas production and slow growth in mineral production. This contrasts with the fact that exploration has increased as a result of the phaseout of the Government's mining levy, and that the Highlands gas project has moved further toward commercial viability. An expansion of private sector activity in the nonmining sectors is needed, and the Government has introduced a tax incentive package aimed at encouraging investment in agriculture. However, private business remains concerned at the lack of law and order and the uncertainty of the political environment. The absence of personal security is a major obstacle, affecting in particular the development of tourism.

Outlook for 2004-2005

GDP is forecast to grow by 2.8% in 2004 and 1.7% in 2005. Agriculture, forestry, and fishing is forecast to expand by 3.0% and 3.4% in these years, as production of major crops and logs picks up in response to generally higher US dollar commodity prices and as tuna production rises in response to demand from the new processing facility. Achieving these rates requires favorable weather conditions, realization of planned expansion in palm oil production, and continued efforts to encourage smallholder coffee production. The provision of better transport infrastructure and an improvement in market access are also needed. With the effective ending of a moratorium on issuing new timber licenses, the growth forecast also assumes a return to logging at rates recorded in the mid-1990s, thus raising renewed concerns about the sustainability of the harvest.

The oil and gas sector is expected to grow strongly in 2004 as the Moran oil field reaches full production. In contrast, mining output is expected to contract in 2004, with the cessation of operations at the Porgera and Misima gold mines outweighing the stimulus of a forecast 7.5% rise in the gold price. Output is then expected to grow slowly in 2005 as the Kainantu gold mine begins operations and the Ok Tedi copper mine steps up production. The net result for the oil and gas and mining sectors together is that real output in 2005 is projected to be just 0.1% above the 2003 level. However, this official forecast is based on the assumption of declining US dollar prices for oil in 2004-2005, a drop in the gold price in 2005 after the 2004 rise, and a 7% rise in the copper price in the next 2 years. In fact, oil and metals (especially copper) prices in 2004-2005 are most likely to be significantly higher than the budget forecasts, such that the official growth projections for these two sectors are conservative. Stronger expansion in mining GDP could push the aggregate growth rates toward 3.0% in 2004 and 2.0% in 2005.

Manufacturing is forecast to grow by 2.2% in 2004 and 2.8% in 2005 on the basis that tighter government budgets will be counterbalanced by some strengthening in private sector domestic demand as inflation drops into the 8-10% range, interest rates fall (to about 12% for treasury bills), and the exchange rate remains stable. Stronger domestic demand is also expected to stimulate modest growth in the services sector. The official forecasts for the manufacturing and services sectors seem plausible, but the private sector response to improved economic management has historically been sluggish. Growth in the construction sector is forecast to slow to 3.0-3.5% in 2004-2005.

Aside from adverse external shocks, the main risk to the official growth forecasts is that the present administration will fail to convince the private sector and potential overseas investors that it is capable of addressing the country's economic and social problems over the medium to long term and that, in consequence, there will be no substantial or sustained revival of business confidence and investment. On the other hand, there has been some investor response to opportunities in the traded goods sector created by the trend depreciation of the kina, as evidenced by expansion of palm oil production and a start of palm oil and tuna processing operations. Moreover, the 2003 budget outcome and control of wage expenditures suggest that economic management has improved.

The official projections of a medium-term decline in inflation and interest rates, and of exchange rate stability, depend on fiscal tightening, disciplined monetary policy, and wage restraint. The budget deficit is projected to fall to 1.1% of GDP in 2005, on the assumption that total expenditure and net lending can be reduced from 33.4% of GDP in 2003 to 29.5% in 2005. This reduction would more than offset an anticipated drop in total revenues and grants from 31.7% of GDP in 2003 to 28.4% in 2005, which is attributable to declines in mining and petroleum taxes and in dividend payments. A shortfall in expenditure savings would jeopardize the targeted reduction in total public debt to 68.3% of GDP in 2005 and place a heavier burden on monetary policy. Additionally, increased pressure for cost of living adjustments for public service workers would make it difficult to achieve the expenditure targets.

A failure to secure the anticipated fiscal improvements would increase pressure on the price level, balance of payments, and exchange rate. The external current account surplus is forecast to decline to 3.2% of GDP in 2005 as oil exports fall, and the overall balance of payments is expected to move into deficit, with import cover in 2005 reduced to 4.6 months.

Even with economic growth at the officially projected rates, job creation will continue to fall well short of providing paid employment to all new entrants to the labor market. This, in turn, will mean higher urban unemployment rates and increased pressure on the semisubsistence agriculture sector on which the vast majority of the poor depend for their livelihood.

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