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p. 59 of 77 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 Republic of Palau Papua New Guinea Samoa Solomon Islands Democratic Republic of Timor-Leste Tonga Tuvalu Vanuatu III. Promoting competition for long-term development Statistical appendix

Asian Development Outlook 2005 : II. Economic trends and prospects in developing Asia

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Papua New Guinea

The economy grew at a modest rate in 2004, inflation fell substantially, and financial conditions improved. The outlook is for continued modest economic growth, provided that fiscal gains are consolidated and structural reforms aimed at stimulating private sector-led growth in nonminerals are implemented.

Macroeconomic assessment of 2004

GDP increased by 2.6% in 2004, slightly down from 2.8% in 2003. The agriculture, forestry, and fishing sector was the primary engine of growth, expanding by 3.0% as weather and commodity prices remained generally favorable. Within the minerals sector (mining plus oil and gas), the mining subsector grew by 3.3%, stimulated by higher gold and copper prices and aid-funded road maintenance and upgrading projects. However, the oil and gas subsector contracted by 5.8% despite higher oil prices because reserves extraction fell. The minerals component of GDP therefore increased by just 0.1%. Manufacturing expanded by 2.8%, construction by 3.2%, and electricity, gas, and water by 2.5%. The services sector as a whole grew by 2.0%, but there was variation in subsector performances: transport grew fastest at 3.0%, followed by trade at 2.6%, finance, real estate, and business services at 2.5%, and community, social, and personal services at 1.5%.

Economic growth barely kept pace with that of the population. Similarly, although the relatively labor-intensive nonminerals component of GDP rose faster in 2004 (2.8%) than in 2003 (1.7%), job growth did not match the growth in labor supply. Formal private sector employment in the quarter to June 2004 was barely 0.1% higher than that in the year-earlier period. The only significant expansion in nonminerals employment was seen in the manufacturing, retail and finance, and other business sectors, with declines in all others. Minerals sector employment increased by 8.2%, but this was entirely because of expansion at one gold mine. On a regional basis, the most worrying outcome in 2004 was the decline in employment in the two rural regions (Momase and the Highlands) that together hold approximately three quarters of the poor in Papua New Guinea.

The 2004 budget balance officially was expected to be a surplus of 1.1% of GDP, compared with an original budget target of a deficit of 1.5%. Total revenues and grants exceeded the budget projection by 11.6%, largely because of unexpectedly high mining and petroleum tax and dividend receipts. The temporary 1% import levy introduced in the 2004 budget also raised more revenues than anticipated, but only partly offset a decline in receipts from log export duties. Total expenditures and net lending exceeded the original budget estimate by 2.4%, with total recurrent spending in line with the budget projection, and development spending exceeding the projected level by 7.0%. Lower interest rates meant that government servicing of its debt was 40% below the budget projection. The consequent savings permitted a reallocation of public resources toward development expenditures, and were also used to pay off arrears and cover the costs of certain verified legal claims against the Government.

Spending on goods and services was over a third higher than the budget projection, while, accounting for 42.9% of total recurrent spending, the wage bill was 2.9% above the projected level. In accordance with the Public Finances (Management) Act, 90% of the unexpectedly strong mining and petroleum revenues were used to retire government debt. Total public debt was projected to be 54.6% of GDP at the end of the year, compared with 59.7% at the end of 2003. Domestic debt fell to 22.5% of GDP at end-2004, with a lengthening of the maturity of the debt as the Government implemented its Inscribed Stock Issuance Program and retired short-term treasury bills. External debt fell from 35.5% of GDP at end-2003 to 32.1% at end-2004, reflecting the valuation effect of currency appreciation and an outflow on net external financing.

Inflation in 2004 fell sharply to 2.9%, compared with 14.7% in 2003. This drop was largely attributable to the lagged effects of currency appreciation in late 2003 and, in 2004, the combined effect of higher commodity prices and tighter fiscal management on the exchange rate, which appreciated further (with the latter damped by central bank intervention). The strengthening of the kina prompted Standard & Poor’s to raise its country rating from stable to positive at year-end. Falling inflation in the context of balance-of-payments strength encouraged the Bank of Papua New Guinea (BPNG) to ease monetary policy through the first 10 months of 2004. Official interest rates dropped substantially, with interest rates on 182-day treasury bills down from 17.0% in January 2004 to 3.1% in November. However, commercial bank lending rates declined only marginally from 13.9% to 13.1% during this period, indicating a lack of competition in the banking sector. Broad money supply increased by 17.7% because of a rise in net foreign assets. Domestic credit fell by 1.0% because of a 2.5% decline in credit to the private sector, suggesting a lack of effective demand for funds from business.

Official budget projections show a 15.1% rise in the trade surplus in 2004 and the current account surplus remaining virtually unchanged as a share of GDP at 3.7% against 3.8% in 2003. Balance-of-payments data for the first 3 quarters suggest that the projections may have overestimated the trade and current account surpluses because of unexpectedly strong growth in general imports and mining-related investment expenditures. The current account in the first 3 quarters recorded a small deficit of US$18 million, equivalent to approximately 0.5% of GDP, though during this period there was a net inflow on the financial account of US$61 million, as mineral producers drew down their foreign currency accounts, trade credits to domestic residents rose, and foreign investment flowed into a mining venture. The overall balance-of-payments surplus in the first 3 quarters thus increased over the corresponding period in 2003, and foreign reserves rose to US$589 million at end-September, equivalent to 4.6 months of total import cover and 5.3 months of nonmineral import cover. The domestic currency, the kina, appreciated by 2.5% against the US dollar and 1.2% against the Australian dollar in 2004.

Macroeconomic policy developments

The 2005 budget passed by Parliament in November 2004 continues the implementation of the Government’s medium-term fiscal strategy, which aims at progressively reducing the deficit until budget balance is achieved in 2008, and at reallocating expenditures to the five priority areas identified in the Medium Term Development Strategy, 2005-2010, namely rehabilitation and maintenance of transport infrastructure, generation of income-earning activities, basic education, primary and preventive health care, and law and justice. The fiscal strategy also aims at reducing the Government’s outstanding liabilities, maintaining existing tax levels without introducing new taxes, and sustaining institutional and policy reform.

An overall budget deficit of 1.0% of GDP is targeted for 2005, and is to be funded by domestic borrowing, with the Government continuing to shift the debt balance from short- to longer-term securities. Net external financing is an outflow equivalent to 1.3% of GDP, with anticipated new concessional and commercial loans more than offset by amortization on existing loans. Revenues (including grants) are projected to be 8.3% greater than in 2004, primarily because of an anticipated increase in project grants mainly associated with the Enhanced Cooperation Program with Australia. Nontax revenues are projected to rise as dividends from BPNG and the National Fisheries Authority accrue, but tax revenues are projected to fall by 4.6% because of the ending on 1 January 2005 of the temporary import levy as planned, the continuing phased reduction of the mining levy, and lower oil and copper prices. There are no asset sales included in the budget projections, but if any occur, the proceeds would be used to retire debt and rehabilitate state assets. The sale of 51% of Telikom PNG limited that was to occur in 2004 was delayed and then canceled in mid-December, signaling some government hesitancy in the implementation of the privatization policy and provoking a legal response from the overseas tenderer.

Total expenditures and net lending are projected to rise by 15.7% in 2005. Total recurrent expenditures are budgeted to go up by 4.6% from the 2004 level, largely because of a 9.2% rise in the wage bill, which is presented as a calculated and responsible component of the public expenditure review and rationalization program. Expenditures on goods and services are projected to increase by less than 1% from the unusually high level of 2004, when outstanding state liabilities were settled; but there is provision for structural adjustment payments arising from public sector reform and for increased resource allocation to provincial departments so as to improve service delivery.

Development expenditures are projected to rise by 38.3% from the estimated 2004 level as a result of grant-funded expenditures under the Enhanced Cooperation Program, project grants from the Japan International Cooperation Agency, increased government drawdowns of concessional loans, and increased provision of tax credits for infrastructure expenditures. As in the past, the real issue is whether the budget is implemented as planned in a fragile political environment characterized in 2004 by threats of no-confidence motions in the prime minister, suspension of Parliament, and major cabinet reshuffles.

In 2004, BPNG continued to demonstrate its capacity to conduct an independent and prudent monetary policy aimed at protecting foreign reserves and stabilizing the kina. The kina’s stabilization contributed to an increase in business confidence, according to an independent business survey (Economic Insights 2004), but midyear BPNG predictions of significant growth in private sector credit during the second half of 2004 seemed overoptimistic. Correspondingly, excess liquidity likely did not pose an imminent threat to exchange rate stability. Nonetheless, BPNG strengthened its capacity to control liquidity through open-market operations by introducing an additional policy instrument in August. The new “central bank bill” has the same features as treasury bills and is traded at weekly auctions. The insolvent Rural Development Bank underwent a change of management and an external review in 2004, with the intention of formulating and implementing a financial recovery plan.

Reversing the decline in lending to the private sector is crucial to improving medium- to long-term growth prospects (Figure 2.30). A reduction in lending rates in line with official interest rate falls would facilitate such a reversal, as would reductions in the costs of doing business. According to the World Bank’s Doing Business Indicators, the country rates poorly in the time taken to start a business (56 days), the costs of establishing a business (30.7% of per capita income), the time to enforce a contract (295 days), and the time to process an insolvency (2.8 years).

More fundamentally, it is likely that a sustained turnaround in private sector borrowing requires political stability and significant progress in addressing long-standing law-and-order and governance problems. The survey referred to above showed that the cost of finance was seen as a constraint to business, but one that rated below weak private sector demand, poor security, and general uncertainty. Major new natural resource development projects would also boost investment. The presence of Australian police, defense personnel, and technical advisors under the Enhanced Cooperation Program is expected to reassure investors, but how much this reassurance will translate into actual borrowing and investment remains to be seen.

Outlook for 2005-2007 and medium-term trends

On the assumptions that global economic growth will slow in the medium term, that commodity prices generally will weaken from the historical highs of 2004, and that the Government’s economic and public sector reform strategies will be implemented successfully within a stable macroeconomic and political environment, GDP growth is forecast to be 2.4% over 2005-2007, though subject to volatility because of the vagaries of weather, commodity prices, and natural resource discoveries. This aggregate growth forecast was made by government officials in the 2005 budget papers and by external agencies, including IMF and ADB.

Export-led growth in agriculture is expected to accelerate to over 3% a year as improved law and order and transport infrastructure increase producers’ access to markets; and fisheries production is forecast to grow in response to expanded domestic processing capacity. However, log exports are likely to decline as governance of the sector improves, so that agriculture, forestry, and fishing as a whole is forecast to grow at an average annual rate of 3.2% in 2005-2007.

The oil and gas subsector is expected to recover from its 2004 contraction in 2005 as investment in the Moran oil field increases access to resources. Thereafter, depletion of reserves at the Kutubu and Gobe fields will cause a drop in production, with the impact of any new projects likely to be felt in the longer term. The decision by Exxon Mobil to proceed with a US$100 million front-end engineering and design study of the Southern Highlands gas project is encouraging, but there are still insufficient customers at the Queensland, Australia end of the proposed gas pipeline to ensure project viability. In the absence of this project, oil and gas is forecast to decline at an average annual rate of 4.0% in 2005-2007.

Mining production is expected to stagnate over the medium term after expanding significantly in 2005 as a result of increased production of copper and gold, the latter reflecting the start of production at two new, relatively small gold mines and the expansion of existing mines (except Misima). In 2006, reserves depletion at the Porgera gold mine and Ok Tedi copper mine, and the impact of an expected declining copper price, are forecast to cause a contraction in sector output.

The net result for the oil and gas and mining subsectors together is that output in 2007 is expected to be 0.6% below the 2004 level.

Manufacturing is forecast to grow at annual rates of just below 3% in 2005-2007, on the basis that domestic demand will strengthen in the context of a stable macroeconomic environment and improvements in law and order and governance. Construction is forecast to grow at rates slightly in excess of 3% annually as a consequence of increased public expenditures on transport infrastructure development and a pickup in private investment. The electricity, gas, and water subsector in services is also expected to make a positive contribution to growth as SOEs invest in the rehabilitation and expansion of infrastructure. The services sector as a whole is forecast to grow at an average annual rate of 2.3%, with growth in transport heavily reliant on an increase in agricultural production for domestic and export markets.

The main risks to the growth forecasts are that the macroeconomic policies, public sector reform plans, and development strategies of the incumbent administration will not be implemented for political reasons, or will not elicit the expected response from the private sector. The Enhanced Cooperation Program offers some insurance against economic mismanagement and further deterioration in the law-and-order situation, but cannot by itself guarantee the private investment that underpins sustained and broad-based economic growth. These forecasts may be exceeded on the upside if commodity prices turn out higher than expected, and if major natural resource development projects such as the Ramu nickel and cobalt project are under way within the forecast period.

The official government medium-term fiscal outlook is for a reduction in the budget deficit to 0.2% of GDP in 2007. A fall in tax revenues from the oil and gas sector is the main reason for a projected drop in revenues and grants from 31.2% of GDP in 2004 to 29.7% in 2007, while expenditures and net lending are projected to fall from 30.1% of GDP in 2004 to 29.9% in 2007. The latter fall requires substantial savings still to be identified through the public service rightsizing and public expenditure review process, so that there is a possibility that budget targets could be overshot. However, provided that the targets are met, total public debt is forecast to decline to 50.9% of GDP in 2007, with declines in domestic public debt to 23.3% and external public debt to 27.6%.

Monetary policy is expected to remain broadly accommodative in the medium term, on the assumption that sound fiscal management and modest wage rises underpin exchange rate stability and inflation below 5%. The current account on the balance of payments is forecast to weaken in the medium term as merchandise import growth outpaces export growth, and increased deficits on the services and income accounts outweigh a rise in transfers. Export growth will be reduced by the impact of lower oil and copper prices and production, and would be even lower in the absence of an increase in agricultural exports, which are forecast to exceed mineral exports by 2007. Forecasting capital account transactions is difficult because of uncertainties over flows of concessional finance, but it is expected that balance-of-payments strength will be maintained and that foreign reserves will remain high enough to provide at least 4.5 months of nonmineral import cover.

The ability of the economy to generate agricultural growth in the context of declining petroleum output is crucial to the macroeconomic outcomes forecast for 2005-2007. Nonmineral output growth is essential for employment generation, but even if the forecasts prove accurate, growth remains too slow for substantial inroads to be made into the un- and underemployment problems. The country’s growth rate needs to at least double before this can happen.

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