Creating the foundations for broader-based economic development

Although economic expansion slowed in 2013 as construction on ExxonMobil’s $19bn Papua New Guinea liquefied natural gas (LNG) project wound down – albeit from 9.1% in 2012 to a still healthy 5.2% in 2013, according to the Bank of PNG (BPNG) – the country stands on the cusp of rapid resource-led growth. Despite ranking as the world’s 115th-largest economy with GDP of PGK34.6bn ($14.1bn) in 2013, according to the Department of Treasury, the economy has achieved 5.8% real annual growth in the last decade and a full 12 years of uninterrupted expansion. A heavyweight among Pacific Islands states, PNG, together with Fiji, accounted for 80% of regional GDP in 2013, as per UN figures. Investors attracted by ample mineral resources face the capacity constraints of a small economy. The formal sector encompasses only 12.5% of the population, and PNG remains reliant on trade and investment for successful execution of large-scale projects.

The country’s young population of 7.8m (in 2013), half of which is below the age of25, has doubled in size every 23 years, causing real per capita GDP growth to trend at a lower 5% in 2007-12, as per research from ANZ, and is set to continue expanding at 3.1% annually, according to the Department of National Planning and Monitoring. Eager to avoid the “Dutch disease” of commodity exports crowding out non-mineral sectors, the authorities aim to drive diversification through ambitious public spending plans on infrastructure and human development. This will be key to capitalising on PNG’s potential demographic dividend, in a country with per capita GDP of $2200 in 2013, according to Standard & Poor’s (S&P), ranking 156th of 187 in the UN’s 2013 Human Development Index (HDI). Improving the public sector’s capacity to deliver both on infrastructure and social services will be a priority, so will the ability to continue to draw frontier foreign investors to the mining, oil and gas sectors, as well as in agriculture, fisheries and light industry.

Decade’s Growth

While the 5.5% real rate of economic expansion achieved in 2013 was a slowdown on the last decade, it remains above the 4.5% growth in emerging economies and was second regionally only to Timor-Leste’s 8.2% in 2013, according to the Asian Development Bank (ADB). Annual growth of 7.4% in the five years to 2013, comparable to India’s growth rate in this period, was a full 4.5 percentage points higher than the average for Pacific Islands states. Indeed, the natural trajectory of PNG’s non-resource growth is roughly 4.5% annually, according to the IMF. Buoyed by high hard-commodity export revenues and, since 2009, the development of the largest project in the country’s history, the ExxonMobil-operated PNG LNG development, annual growth has remained above the 6% mark since 2007, reaching 8.9% in 2011 and 8.1% in 2012, according to figures from S&P.

As progress on the PNG LNG project reached the 90% mark by end-2013, the economy was in a “lull phase” at the tail end of a construction boom funded by foreign direct investment (FDI) but before the start of LNG exports in the second half of 2014, said Daniel Wilson, a Singapore-based economist at ANZ. The downward drift in prices for key commodity exports from PNG since the second quarter of 2012 has only compounded the loss of momentum. While this new export driver will ratchet up to plateau production in 2015, growth is expected to accelerate from 6.2% in 2014 to 21.1% in 2015, when GDP should reach PGK39.5bn ($16.1bn), according to Treasury forecasts in February 2014. As non-mineral growth slows and runs the risk of being crowded out by the impact of surging mineral exports, the government is pursuing an expansionary fiscal policy focusing on key development enablers, including infrastructure, health and education, to sustain growth in the interim and build the foundations of broaderbased growth. “We are in a transition stage characterised by massive potential only a year away and slowing growth buffered by a fiscal boost,” Wilson wrote in a November 2013 STRUCTURE: While dynamic, PNG’s economy is characterised by a two-tier structure: a formalised sector driven by natural resource extraction and a largely informal sector consisting of 87.5% of the population engaged in subsistence agriculture. Exact figures remain challenging to source, however, given that the National Statistics Office has not produced updated official national accounts since 2006, although the Department of Treasury and BPNG produce extrapolated figures for more recent years. Nonetheless, the formal sector remains driven by mining, oil and extractive industries, which together accounted for 15% of GDP in 2012, while the outsized construction sector, driven by the development of PNG LNG, reached 20% of GDP, according to figures from S&P. Strong growth in mining and construction has had knock-on effects on trade (both wholesale and retail), manufacturing and transport, which accounted for 9%, 7% and 4% of GDP, respectively, in 2012. Agriculture, fisheries and forestry still account for the largest part of the economy, however, at 29% in 2012, although the UN Economic and Social Commission for Asia-Pacific (UNESCAP) has said that these figures may not adequately account for the weight of subsistence farming.

According to Stephen Grey, the CEO of JDA Applus+ Velosi, an international manpower consultancy, “The rising living standards as a result of the PNG LNG projects clearly had impact on the local economy and its momentum to hire personnel. Now it remains to be seen if it will continue over the years ahead.”

Sector experts say the job market has also become more dynamic as a result of the PNG LNG project. “The rapid development that we have seen over the last few years has created a dynamic job market and we are confident that it will continue to thrive despite the completion of the LNG project. A lot of people have been trained over the last few years in technical and managerial positions, significantly increasing their employment opportunities,” Peter Garnsey, executive director of Vanguard International, a firm providing human resources management services, told OBG.

Indeed, while an emerging middle class has begun developing, estimated by local investors to be in the hundreds of thousands, on the back of FDI-driven construction of key resource projects, there is a parallel economy in which 28% of the population lives on less than $1.25 a day, according to ADB estimates in 2009. This is compounded by high inequality, with a Gini coefficient of 50.9 in the last available year (1996), more extreme than China’s, according to UNESCAP.

Shifting Gears

Following a decade of resource-driven growth, PNG’s economy has been shifting gears since 2013 as commodity prices took a toll on exports while imports remained driven by the last phase of PNG LNG construction and government demand. PNG is highly exposed to fluctuations in global commodity prices. Oil and minerals accounted for 78.2% of exports in 2012, according to BPNG, two-thirds of which were gold, copper and oil. In the first three quarters of 2013 alone prices for gold fell a further 20%, copper by 12% and oil by 6%, according to the central bank. Exports slumped by 9.1% year-on-year (y-o-y) in the first half of 2013, while imports continued to rise 13.4% y-o-y, causing the trade surplus to contract by 80.75% to PGK382m ($155.3m), according to ANZ. The current account deficit, which had surged from 23.5% in 2011 and 50% in 2012, narrowed to 26.8% in 2013 as imports related to LNG construction tapered. “The sheer size of the PNG LNG project has engendered economic imbalances,” Craig Michaels, S&P’s sovereign credit analyst for PNG, wrote in a January 2014 ratings update. Although the significant current account deficit was largely financed through foreign inflows, FDI has slowed in line with project completion, causing the kina to fall some 25% in 2013 (see analysis).

Despite declining terms of trade, 2013 growth beat initial Department of Treasury forecasts of 4% as mineral output and construction expanded. Growth was driven by a 13% jump in the mineral sector in 2013, spurred by the Ramu nickel and cobalt mine, developed by China Metallurgical Group Corporation, ramping up production over the year, as well as fresh output from existing gold mines, according to BPNG. While this was partly offset by declining oil production, the construction sector grew by 12%, driven by the tail end of PNG LNG construction in the second half of 2013 particularly, according to the Treasury. Meanwhile, agriculture, which had contracted by 1.6% in 2012, expanded by 0.5% in 2013, benefitting from improved terms of trade spurred by the kina’s devaluation. But while the nonextractive sector grew by 4.7% in 2013, this is expected to slow to 1.6% in the 2014 budget. Completion of construction on the PNG LNG project in the first half of 2014 is a cause for concern for the authorities, with the Treasury forecasting non-mining growth at just 1.6% in 2014. “In the medium term, there is the risk of the current long-anticipated cyclical slowdown in the economy will become a return to the structurally slower growth rates PNG experienced through much of the 1980s and 1990s,” Tim Bulman, the World Bank’s country economist for PNG, told OBG.

Development Enablers

Conscious of the need to pick up the slack from the decline in private investment and to implement broad structural reforms, the administration of Prime Minister Peter O’Neill has pursued fiscal expansion plans since taking office in 2012. “The government’s expansionary fiscal policy is key to stimulating economic activity and therefore it is important that it fully implements the budget effectively and efficiently,” Loi M Bakani, governor of the BPNG, wrote in a September 2013 monetary policy statement. Framed by the long-term PNG Vision 2050 – which was launched in 2009 and aims to rank PNG among the 50 highest in the UN’s HDI – and a mid-term National Development Strategy Plan to 2030, the government’s five-year Medium Term Development Plan to 2015 focuses on five key development enablers while decentralising more spending to the district level. The five enablers are free education (extended from 2013), improvements in free basic health services, strengthening of law and order, rural development projects funded by allocations of PGK10m ($4.1m) to each of PNG’s 87 districts annually, and infrastructure development.

The administration aims to devote two-thirds of budget resources to the five development enablers by 2017, up from 20% in 2003, 40% in 2013 and 45% in 2014. As such, public spending has risen significantly in the past two years, accelerating from 7.2% growth in the 2012 budget to 30.5% in the revised 2013 budget and 18.4% in 2014. The priority has been on investment, with capital expenditure rising 55.26% to PGK5.9bn ($2.4bn) in 2013, outpacing 16% growth in recurrent spending to PGK7.2bn ($2.9bn). The 2014 budget includes increases of 11.8% for education (to PGK1.5bn, or $609.8m), 26.9% for health (PGK1.38bn, $561m), 26.7% for law and order (PGK1.29bn, $524.4m) and 58.2% for agriculture (PGK780m, $317.7m). The largest components, however, are devoted to infrastructure with a PGK2.72bn ($1.1bn) budget, up 46%, and transfers to the provinces of PGK3.64bn ($1.5bn), up 0.5% y-o-y. Among the largest infrastructure investments are PGK3.1bn ($1.3bn) for rehabilitation of the Highlands Highway, PGK500m ($203.2m) for Port Moresby roads, PGK760m ($308.9m) for facilities to host the 2015 Pacific Games in Port Moresby and rehabilitation of hydroelectric plants by PNG Power. Authorities expect multiplier effects from these investments.

In a bid to boost the low budget execution rates for public investments, typically around the 50% mark, the government introduced multi-year budgeting in 2013. In its 2013 Article IV consultation, however, the IMF encouraged authorities to improve the quality of spending rather than increase budgeted amounts.

Fiscal Sustainability

Improving execution while reining in further spending increases will be key to insuring fiscal sustainability. While spending has grown apace, government revenue has disappointed given worsening terms of mineral trade, with growth in total receipts of only 2.8% and 8.8% in 2012 and 2013, according to the Treasury’s 2013 “Mid-Year Economic and Fiscal Report” (MYEFO). Annual budget deficits have thus swelled from 3.3% of GDP in 2012 to 7.9% in 2013 and 5.9% in 2014, according to the Treasury. Public finances have significantly improved since 2002, when governments began following medium-term fiscal strategies, capping annual non-mineral budget deficits at 8% of GDP, with PNG’s stock of debt falling from 74% of GDP in 2002 to 27% by 2012.

While debt rebounded to 31% of GDP in 2013 the government maintains its expansion will be temporary. “One of the most notable elements of the 2014 budget is the reaffirmation of the medium-term debt strategy, which provides a fiscal anchor,” Bulman told OBG. The 2014 budget plans for 21% rise in revenues, driven by a 13% growth in tax receipts, with the emphasis on improved collection. While the debt ceiling will be lowered to 30% from 2015, rapid LNG-driven growth and a 5% cap on spending increases from 2016 should ensure the government meets its targets of returning the budget to a primary surplus by 2018.

Although Treasury forecasts revenues from PNG LNG to fluctuate between PGK1.6bn ($650.4m) and PGK2bn ($813m) annually for the first seven years from 2015, the World Bank estimates a share of these receipts will simply replace revenue from declining oil production. Meanwhile, the PGK650m ($264.2m) to PGK800m ($325.2m) in annual dividends from the government’s 16.8% equity stake in the project will initially be used to pay off the $1.6bn in loans used to finance the stake. The majority of PNG’s debt, or 24.6% of GDP in 2013, according to the MYEFO, is denominated in local currency, while development partners and donors hold all of the 8.1% of GDP in foreign debt. Despite initial attempts to float a $400m Eurobond in the first half of 2013 and discussions with China’s EXIM Bank for a $2.6bn line of credit, the Treasury has followed BPNG’s advice to issue local-currency securities to finance the budget deficit and soak up abundant domestic liquidity. “While the government may have considered looking to foreign markets to help fund its fiscal deficit in 2013, the central bank has encouraged the government to issue bonds domestically to soak up banking sector liquidity and improve the transmission mechanism of monetary policy,” S&P’s Michaels said.

Macro Stability

As locally funded government spending has gradually replaced FDI-funded project developments, pressure on the balance of payments grew in 2013. Given the domestic market’s limited production capacity, both FDI projects and public spending generate significant demand for imports. While the current account deficit has narrowed from 50% of GDP in 2012 to 26.8% in 2013, the tapering of inward FDI linked to the LNG project and lower export earnings caused a 25% depreciation in the kina-US dollar rate over 2013, according to IMF data. The depreciation reversed some of the kina’s 40% appreciation between 2009 and its peak in September 2012, according to ANZ (see analysis). In PNG’s environment of abundant domestic liquidity, with roughly PGK1bn ($406.5m) held in government trust accounts at commercial banks and some PGK4.5bn ($1.8bn) in central bank bills (CBBs) by September 2013, the transmission mechanism between movements in the benchmark interest rate, the Kina Facility Rate (KFR), and the real economy remains weak, with Treasury bill rates consistently below the KFR. Although BPNG recommendations since 2011 for the Treasury to move trust accounts to the central bank have remained largely unheeded, with 76 such accounts still in operation in 2013, BPNG has resorted to hikes in banks’ cash reserve requirements from 3% in 2010 to 8% in June 2012, and open market operations such as issuing CBBs to mop up excess liquidity. “However, excess liquidity has remained, and changes to policy rates have not had a strong impact on retail lending rates,” Michaels noted in January 2014.

While imported inflation has traditionally been the key driver of domestic price movements in PNG’s small, open economy, domestic supply-side constraints played a growing role from 2010 onwards as LNG construction stimulated associated sectors from real estate to trade. Nonetheless, the pass-through effect of the kina’s appreciation until late 2012 affected domestic prices with a lag, coupled with one-off impacts from the scrapping of school tuition and extension of health care subsidies, with inflation dropping from 8.5% in 2011 to 2% in 2012, according to the IMF. Inflation figures are an inadequate reflection of price movements, however, given that the weighting of the consumer price index was last changed in 1976, although a new basket is expected in 2014. Nonetheless, the fall in inflation allowed the apex bank to cut the KFR from a September 2011 peak of 7.75% to 6.75% in September 2012 and 6.25% in March 2013, the lowest level since June 2008. As the impact of one-off policies faded and power prices rose by 5.9% in January 2013, inflation rebounded to 3.2% y-o-y in the second quarter and 3.5% in the third quarter of 2013, according to the IMF. The central bank expects inflation to accelerate to 6.5% in 2014 and 5% in 2015 with the inflow of LNG proceeds, the lagged impact of the kina’s depreciation and supply constraints on government spending.

Relying on open-market operations to smooth over short-term currency fluctuations, BPNG has drawn down significantly on its foreign-currency reserves. Reserves had risen from the equivalent of two months of current account payments in 2006 to 3.6 months in 2012, according to S&P. Supported by FDI inflows for the LNG project, the central bank started using these reserves to support the currency in 2013. Its reserves declined from a peak of $4.26bn in December 2011 to $2.80bn by February 2014, enough to cover 7.2 months of imports, according to BPNG. While the pace of reserve drawdown has been rapid, rating agencies do not see cause for concern given the expected inflows of LNG revenues in 2014, which will partly be used to rebuild BPNG’s reserves. In an effort to slow further depreciation of the kina, in June 2014, BPNG implemented a 150-basis-point trading band restriction, which saw the currency’s value jump by 18% (see analysis).

Public-Sector Reform

The government is pursuing wide-ranging public-sector reform in an economy where state-owned enterprises (SOEs) still dominate. Most pressingly, authorities are striving to improve public sector service delivery and tax collection to reduce fiscal leakages and enhance budget execution (see analysis). Over the longer term the prime minister’s office is steering reform of SOEs that will gradually corporatise them and improve their profitability, preconditions for eventually privatising stakes in them. The SOEs’ economic weight is considerable, with combined assets estimated at PGK9.5bn ($3.86bn), or 31% of GDP. State equity in 10 SOEs is managed through the Independent Public Business Corporation (IPBC), established in 2002, which also holds a 17.6% stake in Bank South Pacific (BSP) and a 14.7% stake in Oil Search. While the IPBC manages roughly 85% of total SOE assets, according to a 2012 ADB report, the state also owns several resource SOEs directly, including Ok Tedi Mining and Petromin, set up in 2007 to hold government interests in mining and hydrocarbons. However, the National Petroleum Company PNG, a subsidiary of IPBC, was established in 2009 to hold the state’s 19.4% equity stake in PNG LNG. Although IPBC manages all public utilities, its SOEs are also active in aviation, telecoms and finance.

Although IPBC-held SOEs reported combined dividends of PGK239.1m ($97.2m) in 2012, representing 3.2% return on assets as per IMF figures, over 81% of this came from the Ok Tedi mine and minority stakes in BSP and Oil Search, according to the ADB. The bank’s 2012 study of SOEs, the first to track their performance from 2002 to 2011, found that average return on equity of 4.2% and return on assets of 2.4% over this period was driven by “substantial fiscal transfers and subsidies”. While $1 investment by non-SOEs is estimated to add $0.83 to GDP, the equivalent investment by an SOE adds only $0.12, the lowest multiplier effect reported in the study. The public firms represent a contingent liability for the state, although given the absence of public figures estimates vary between 2.5% and 5% of GDP, according to S&P in January 2014, excluding the sovereign guarantee on the PNG LNG project equivalent to 15% of GDP, according to the IMF.

The government’s reform programme, with technical assistance from the ADB, aims to restructure SOEs to separate their regulatory functions from operations, corporatise the firms and sell stakes to the private sector. Re-establishing the Department of Public Enterprises in 2012 to steer reforms, the administration plans to restructure the IPBC and other SOEs into a single Kumul Trust, modelled on Singapore’s Temasek Holdings. While details are still being determined, the trust would adopt a unique governance structure where government officials would be shareholders while all former prime ministers would hold golden shares yielding veto power on key decisions. Although the structure has the potential to increase SOEs’ transparency and efficiency, according to the IMF’s 2013 Article IV, “The success of this initiative will hinge on adoption of governance structures at the trust and in affected companies to ensure their independence from political interference and focus on stated corporate goals.”

Authorities have begun to unbundle assets from regulator, establishing the new PNG DataCo in February 2014 to hold the fibre-optic cable assets of PNG Telikom. The same month, Prime Minister O’Neill announced plans to sell a 50% stake in Air Niugini to raise PGK500m ($203.3m) to finance the purchase of two new Boeing 787 planes and for sales of minority stakes in PNG Power and PNG Telikom later. In parallel, the ADB has also worked on guidelines for SOEs’ community service obligation as part of the reform, although these are still pending in 2014. Indeed, despite their economic weight, the quality of services delivered by SOEs remains poor, with only 12% of households and 15% of schools connected to grid electricity in 2013, according to the IMF.

Towards PPPs

Corporatising the SOEs is an integral part of broader efforts to attract private investment and competition in infrastructure via public-private partnerships (PPPs) and enhance growth. The government estimates that the introduction of competition in telecoms boosted growth by 2.5 percentage points in the three years following Digicel’s entry in 2007, according to ANZ. The ADB and IFC have provided technical assistance in developing the PPP policy issued in December 2008, with particular focus on transport and power infrastructure. A draft PPP bill was approved by the Cabinet in mid-2013 and presented to Parliament in May 2014. The ADB and IFC are ready to extend guarantees for up to 50% of debt for such projects.

While any project over $50m could qualify for a PPP structure, the government has focused on the planned PGK2bn ($813m) Ramu 2 power plant and upgrades to Port Moresby’s power generation. Also in power, the ADB has highlighted potential PPPs including the $100m 80-MW Naoro-Brown hydropower project and the 1800-MW Purari hydropower system.

In transport, the pipeline of projects includes two phases of concessions for the Lae container port, a concession for Port Moresby’s container port, and the $500m terminal and airside development of Port Moresby’s Jackson International Airport. Development partners see the greatest potential in the Lae port given that it could act as a regional trans-shipment centre, although the concessioning of shipping franchises for passenger and cargo transport are also envisaged. In the longer run, the government hopes to attract PGK250m ($101.6m) in private financing for building and rehabilitating schools and health clinics.

Outlook

In 2014 PNG’s economy is navigating the lull period following a decade of rapid economic expansion and on the cusp of a resource-led boom. As authorities seek to channel investment to infrastructure upgrades to sustain growth and create the foundations for broader-based economic development, the priority will be to improve the quality and effectiveness of spending. Meanwhile, both fiscal and monetary authorities are focusing on establishing the instruments required to manage the large foreign-currency inflows from the ramp-up of LNG exports. Stimulating the non-mineral sectors, whose natural longer-term growth trend sits at around 4.5% annually, according to the IMF, will require significant private investment in production and infrastructure. While attracting private investment will depend on successful implementation of public-sector reform, the government will need to strike a balance between conducive investment policies and the need to protect domestic enterprise.