Papua New Guinea faces tough economic headwinds

 

The economy of Papua New Guinea is decelerating, with the GDP growth rate expected to fall by half in 2016 to 4.3% and by nearly half again to 2.4% in 2017. A combination of the end of the construction phase of the PNG Liquefied Natural Gas (LNG) project and an unexpected drop in energy prices has resulted in a significant decline in business activity and a dramatic decrease in government revenues. The country was further hit by a drought, which affected agricultural production, as well as the shutdown of one of its major mining projects.

A shortage of dollars, which followed stricter foreign exchange policies initiated by the central bank in 2014, and the cancellation of a bond issue in late 2015 made the situation even worse, as the country lacked hard currency for imports. “The private sector is facing a tough year,” Ivan Pomaleu, managing director of the Investment Promotion Authority, told OBG. “There will be belt tightening.”

Reasons For Optimism

Nevertheless, many reasons for optimism remain. Hydrocarbons prices have stabilised, while it turns out that PNG LNG has some of the cheapest energy development costs in the world, suggesting that the project will do well regardless of global market conditions. The government was also quite successful in slashing its budget in 2015, imports have fallen and the country’s current account balance is coming back into line. Despite reports to the contrary, international financing is still in the works (see analysis). More importantly, new projects are going forward and there are more in the pipeline.

The PNG LNG project’s success has sent a positive signal to global players in the extractive industries that the country is a place where big energy projects can be planned and completed on time without an undue blowout in costs. Mark Baker, managing director PNG at ANZ Banking Group, told OBG, “The run on the board shows it can be done.”

Highly Volatile

PNG’s GDP growth rates have been far less than originally expected. At one point in early 2015 the Asian Development Bank (ADB) estimated that economic growth for the year would be 21%. However, estimates fell as LNG prices declined, and the final number was 9.9%. This followed on GDP growth of 13.3% in 2014. The decline is likely to continue for some time, with the ADB forecasting the GDP growth rate dropping to 4.3% in 2016 and 2.4% in 2017.

In July 2012 the Japan LNG price for imports was as high as $18.11 per million British thermal units (mBtu); however, it has since dropped to as low as $6.25 as of June 2016. A further drop over the next few years is anticipated, with pricing of $4-5 per mBtu possible. The central bank, Bank of PNG (BPNG), had forecast an LNG price of $15.50 for 2015, but the average was $9.70 for the full year. BPNG’s 2016 prediction for the price of LNG (made in early 2016) at $8.30 is still short as LNG prices continue to fall. Regional LNG prices are not only moving in harmony with hydrocarbons prices, but closer to other world benchmarks.

LNG prices in Asia are no longer disproportionately higher than elsewhere. Buyers in Japan, South Korea and China are all expected to reduce their purchases in the coming years. And while many of these buyers have and will continue to negotiate fixed-priced contracts, the low prices have put them in stronger negotiating positions, allowing them to cut deals that were not possible before. They are, for example, no longer signing indexed contracts or contracts that do not allow for the resale of LNG. Sellers are also being compelled to sign with less-creditworthy buyers, and that could make it more difficult to finance projects.

The country has taken significant hits elsewhere. An extended drought caused by El Niño has resulted in a decline in agricultural production and water shortages, which has reduced incomes and taken a toll on exports. Some of the decline in GDP growth and exports can also be attributed to the shutdown of Ok Tedi. The mine, the country’s largest, was closed in 2015 due to low water levels on the Fly River and the fall in copper prices. Not only did the closure result in lost mining revenues for the country; it also put an estimated 15% of the formal workforce out of work. Growth in the agricultural sector fell from 3.3% in 2014 to 2.1% in 2015, while the mining sector contracted 3.7% in 2015.

Structural Issues

The imbalances and dislocations in the economy are evident in a breakdown of GDP figures. According to the IMF’s November 2015 Article IV consultation for the country, the resources sector saw growth of 134.2% in 2014 and 60.2% in 2015. The growth rate is then expected to fall to 0.1% in 2016, after which the resources sector is likely to decline slightly every year through to 2020. Resource revenues to the government as a percentage of GDP have followed a similar arc, rising from 1.9% in 2013 to 3.1% in 2014, and then falling again to under 2% in 2015 and 2016. PNG is one of the most resource-dependent economies in the world, with natural resources-based rents accounting for 29.6% of GDP, placing the country alongside the likes of Oman, Iran and Qatar.

In the near term fiscal constraints will slow non-resource-related growth, weak global growth will keep commodity prices low, and discoveries and new developments in Australia could bring significant competition into the market. The country also faces serious long-term structural issues, according to the IMF, with its growth remaining highly volatile due to fluctuations in commodity prices and the construction, start-up and stoppages at major resources projects. Finance is also a problem identified by the IMF, as the lack of relevant services has held back non-resource-related developments, while security concerns have made the establishment of new businesses difficult. The IMF is expecting slow growth for some time, with real GDP growth in 2021 forecast to be 3.2%.

Underlying Strengths 

Despite the volatility, PNG has underlying strengths that suggest an economy that can make it through difficult times and thrive during a recovery. The country may have had trouble in developing non-resource-related business, but where they do exist they have done well. The rest of the economy is growing steadily and is set to outperform resources in the near future. In 2015 utilities grew 6% and transport was up 5%, according to the ADB. Underlying growth that excludes the mineral sector is set to remain steady at 3.4% in 2016 and 3.6% in 2017. This provides some, albeit limited, countercyclical support.

And despite the trouble in the commodities sector, PNG is doing relatively well with its resources assets. The PNG LNG project has been a star performer. In the first quarter of 2016 it achieved record production of 8m tonnes per annum (at an annualised rate), which is 16% higher than its nameplate capacity, according to Oil Search. It also turns out that the project is one of the most efficient of its kind in the world. While the company has said that it is taking a careful look at further reducing costs, it added that it would remain profitable as long as oil traded above $20 a barrel.

Due to the start-up of the production phase of PNG LNG, the current account balance crossed into positive territory for the first time since 2008. The current account swung from a deficit in 2013 of PGK7.8bn ($2.7bn) to a surplus of nearly PGK6bn ($2.05bn) in 2014. PNG also recorded a surplus in 2015 of PGK13.4bn ($4.6bn), and a surplus of PGK7.9bn ($2.7bn) is expected for 2016. The IMF sees the economy stabilising somewhat, with both GDP and inflation rates hitting levels that are within an acceptable range. In 2014 the consumer price index rose to 6.6%, up from 4.7% in the previous year, came in at 6.4% in 2015 and is expected to be 6.5% for 2016, according to BPNG. While high, these levels are good for a country that has averaged a rate above 7% over the past four decades and experienced a high of 23% in 1995.

Next Phases 

To a great extent, the economy is doing what it should. Consumption is reducing and imports are declining, which has resulted in an improved trade balance and a better current account situation overall. Some executives have noted that what happened in PNG is to be expected, given the construction of a large project followed by an unexpected downturn in commodity markets. The economy is now adjusting to these circumstances. Baker said, “You have a project worth more than the GDP, so you are going to have some dislocations on the way up and on the way down. Probably where the global environment has really hurt is in terms of the commodity price collapse. It is symptomatic of what has been happening globally, and magnified because this is a small economy. The country has had a number of challenges generally not of its own making. It is responding to global events. That is really where we are today.”

There are also a number of future drivers. The country will host the Asia-Pacific Economic Cooperation summit in 2018, which should help boost the economy, as major infrastructure investments such as the upgrading of the airport are made in preparation for the meeting. But most importantly, a number of resource projects are being considered. While these will take some time to get up and running, they will have significant impacts on the country. Like PNG LNG, they will bring cash into the economy through the various stages of development and construction, and will ultimately pay out to the government in the production phase. The key projects in the pipeline include the second phase of PNG LNG at P’nyang field and a new project known as Papua LNG, being led by France’s Total. The latter could involve an investment of $10bn.

Prime Minister Peter O’Neill has also noted that the takeover of InterOil by Oil Search would, if approved, be significant for the country and the economy. In May 2016 he released a statement that said the merger would lead to increased efficiencies and lower costs, and that the combined entity would be a significant regional player that would benefit from its size and influence in the market. Prime Minister O’Neill added that the merger opened a way towards closer cooperation between the country’s two major projects, PNG LNG and Papua LNG. As part of the transaction, Oil Search bid $2.2bn for InterOil in early 2016.

The Budget

For 2015 the budget deficit came in wider than expected, totalling PGK2.5bn ($853.4m), or 5% of GDP, according to BPNG. This is lower in both nominal and percentage terms than in 2014, when the deficit totalled PGK2.9bn ($990m) and 6.9% of GDP. However, the 2015 figures were still higher than forecast, as the total shortfall had been set at PGK2.2bn ($751m) and 4.5% of GDP. A fall in tax inflows was largely to blame, with government revenue for 2015 being 21.3% lower than the originally planned PGK2.9bn ($990m). Expenditures were also significantly reduced, with planned expenses being reduced from the original PGK16.2bn ($5.5bn) down to PGK13.5bn ($4.6bn). However, outlays did not come down fast enough to make up for the decline in revenues.

Some tax revenues held up well, with personal income tax in particular coming in at slightly over PGK3bn ($1bn), down only 8% from the budgeted amount, while corporate tax inflows totalled PGK2.4bn ($819.3m), down from the originally budgeted PGK2.7bn ($921.7m). Gaming tax take was actually up both year-on-year and on the budgeted amount at PGK162.1m ($55.3m), and interest withholding tax was also a strong performer, totalling PGK66m ($22.5m). However, other lines on the income statement came in far short of original estimates. Mining and petroleum tax revenues were only PGK195.4m ($66.7m), compared with the budgeted PGK1.7bn ($580.3m) and the 2014 total of PGK794.2m ($271.1m).

In some areas, the cuts have been quite severe. Education spending was down 30%, health care was cut by 37.1%, and transport and infrastructure were down by 36%, according to the PNG Treasury. Australia’s ABC News has reported on signs of extreme fiscal stress, such as the salaries of public servants being delayed and government cheques bouncing. The news agency also reported that in December 2015 teachers did not receive payments for their home leave holiday fares. Australian daily The Saturday Paper reported in April 2016 that government cheques issued in December 2015 have simply been dishonoured.

Looking At Funds

Some concerns have also been raised about the country’s superannuation funds. In December 2015 Don Polye, former treasurer and current opposition leader, issued a statement that local superfund Nambawan Super is owed $825m by the government and that state employees seeking to withdraw funds from their retirement accounts are only allowed to take out what they have contributed, while employers’ contributions and the interest earned on it is being withheld. Polye added that he was concerned and that the country could be facing a repeat of the 2000 collapse of the National Provident Fund.

Nambawan Super has also confirmed that it is underfunded and faces arrears. The bank said in early 2016 that it was owed PGK2.07bn ($706.6m) by the government due to less than full contributions being made for 1991-2008. It added that it would not be paying out the government portion of the benefits after December 1, 2015. The fund, however, did note that the lack of government contribution payments would no longer be a problem, as deductions are now being made electronically at the source and going straight to accounts.

Debt 

Government debt has also been ballooning. According to IMF figures, debt-to-GDP increased from 23% in 2011 to an estimated 39.4% in 2015. It is expected to rise to 41.1% in 2016. Official reserves dropped from five months of imports in 2012 to 3.1 in 2015. Contingent liabilities are also significant. Total debt is above 50% when superannuation arrears and the loan to purchase Oil Search shares are factored in. The government borrowed about $1.2bn from UBS in March 2014 in order to acquire a 10% stake in Oil Search. The loan is off balance sheet, but is considered publicly guaranteed external debt by the IMF, and is highly significant. It makes all the difference to the government’s credit situation. If it is viewed as an official obligation, the country’s debt burden breaks certain thresholds. If not, the debt load is considered manageable. The lack of transparency is generating some concern.

In February 2016 Moody’s issued an announcement on the country. It said it was reviewing PNG for a possible downgrade. Lower oil prices, the ratings agency said, were leading to fiscal problems for the government and an economic slowdown. The budget was based on an assumed oil price of $60 per barrel, and while expenditure cuts had been made, they were not enough. The election in 2017 will add to the difficulties as expenditures are likely to increase ahead of the vote, while Moody’s added that the high interest rate environment in PNG further challenges the national accounts.

Then in April 2016, the ratings agency downgraded the country from B2 to B1. It noted that foreign currency reserves had fallen to $1.69bn by the end of 2015 and that the central bank had intervened aggressively, utilising a total of $828.5m in the process. Moody’s added that government revenues as a percentage of GDP had fallen to 17.1% in 2015, the lowest level in a decade, while short-term debt was at 48.1% of the domestic market total, and interest payments as a ratio of total revenue had climbed from 5.3% in 2013 to 9.8% in 2015. The ratings agency also said BPNG was buying a full 21% of all government bonds sold, up from 7.1% in 2013. However, the outlook was set at stable.

International Doubts

The PNG economy has faced significant criticism from abroad, with analysts and journalists, particularly from Australia, raising the alarm for a number of years, especially since mid-2015. The notion of the country as a failed state has received considerable press and is the subject of much debate. Prime Minister O’Neill has disagreed with and criticised these assessments. In August 2015 he issued a statement that the debt-to-GDP ratio is low, that much of the debt is domestic and that the entire world is facing economic headwinds. Loi Bakani, the governor of BPNG, also took exception to comments that were being made in the media and online in his October 2015 opening address at an executive-level meeting. He said despite analysis to the contrary, the situation was under control and he was confident that the government would be able to come through the difficult times and make the right adjustments. Bakani called many of the comments misleading.

However, criticism has continued into 2016. A January 2016 report from the Australian Financial Review noted that the country, in addition to its many other problems, was facing budget cuts more severe than those undertaken by Greece under its austerity programme. The report added that it is wrong to solely blame falling commodity prices, as it was a failure in governance that had exacerbated the problem. The government’s “shoot the messenger” approach was also described as having delayed the formulation of a proper response.

Foreign Exchange

Central bank policy has been steady, in terms of benchmarks at least. BPNG has held the kina facility rate at 6.25% since lowering it from 6.75% in February 2013. In March 2016, however, it noted that because of high liquidity in the banking sector, transmission from the facility rate has been poor. As a result, it has decided to use the 63-day Treasury bill rate to signal its monetary policy stance. The BPNG has intervened repeatedly to increase liquidity in the foreign exchange market, but the efforts have not helped much. Since its revaluation in mid-July 2014, the kina fell against the dollar by some 30% as of July 2016.

In the March 2016 Monetary Policy Statement from the central bank, Bakani stated, “The central bank has to tread a fine line between movement of [the] kina exchange rate and being responsible for its monetary policy objective of price stability, both of which have been and are taken into account in its decisions on the conduct of monetary policy. The conduct of monetary policy is a challenge, given the above issues and when one of the channels of transmission of monetary policy does not work as efficiently as it should. Given the oligopolistic nature of the banking system in PNG, the transmission of monetary policy through the interest rate channel has been weak, especially under the prevailing high liquidity condition. The bank is therefore considering an alternative monetary policy mechanism in the conduct of monetary policy that would enable a better transmission from the policy rate to market interest rates.”

The Proceeds

While PNG LNG is benefiting the country, the dividend payments remain a bit of a mystery. In 2014 the National Petroleum Company PNG (NPCP) paid PGK415m ($141.7m) to the state-owned Independent Public Business Corporation. In July 2015 this was followed by an additional PGK86.4m ($29.5m), and another payment of PGK450m ($153.6m) was made at the end of 2015. Frank Kramer, then chairman of NPCP (now Kumul Petroleum) and now CEO of Kramer Ausenco, warned that the first payment may not be repeated, as LNG prices were relatively high when the project opened. Funds from the dividend will most likely have to go towards paying down the UBS loan, and it may be some time before the government can utilise its full share of the cash-flow.

Opposition leaders have said the government take from the project should be in the range of billions of dollars given the amount of LNG that has been exported. The government has responded that the project must first pay the banks that issued a loan for the project, then pay operational costs and then pay a dividend. Originally, the country had expected to see revenues of PGK1. 7bn-2.2bn ($580.3m-751.01m) from the project each year over the next decade, followed by an increase as development costs depreciated. While the country’s sovereign wealth fund law was passed in July 2015, critics have said the fund is starting from less than empty. In an opinion piece published in Business Advantage PNG in March 2014, Paul Barker, executive director of PNG’s Institute of National Affairs, argued that the loan taken out to fund the purchase of Oil Search shares essentially amounted to borrowing against the fund before it even existed, and that the debt will have to be paid off before money can be added.

Outlook

The PNG economy is in for a rough few years as it adjusts to the drop in LNG prices and awaits the start of the next major project. However, barring any further dramatic declines in the price of LNG, growth will remain positive and the government will be able to bring its spending closer in line with revenues. The next few years will be a challenge, but a manageable one. If and when an international bond is issued or a project gets under way, many of the problems the country is currently facing will resolve themselves. Improvements in governance are also seen as important, though, so that when the funds start to flow again they are utilised efficiently and in a transparent manner.

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The Report: Papua New Guinea 2016

Economy chapter from The Report: Papua New Guinea 2016

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