Following three years of sharp appreciation, Papua New Guinea’s currency, the kina, reversed course from late 2012 as construction on the PNG liquefied natural gas (LNG) project began to taper and commodity export revenues contracted. Fiscal spending, largely financed in kina, continued to drive demand for imports and compounded the currency’s fall in 2013. The Bank of PNG (BPNG) has used open-market operations to cushion the fall, although its impact on imported inflation is expected to trickle through in 2014.

Although the start of LNG exports in May 2014 will strongly stimulate economic growth, the effect on the current account remains less clear given the limited repatriation of earnings onshore during the project’s cost-recovery phase. While a share of the proceeds will be used to rebuild the central bank’s depleted foreign-exchange reserves, the currency’s outlook depends on the establishment of the sovereign wealth fund and prospects for new foreign direct investment (FDI).

BOP Pressures

In an economy valued at $8bn in 2008, the sheer size of the LNG project, whose costs rose from an initial $15.7bn to $19bn by 2013, has caused imbalances. The current account swung from a surplus of 7.3% of GDP in 2008 to deficits of 13.3%, 18.1%, 23.5% and 50% in the four subsequent years, according to data from Standards & Poor’s (S&P). While construction drew in significantly more imports, this was largely financed through FDI and foreign debt, easing the pressures on the balance of payments: PNG’s net external liabilities rose from 55% of current account income in 2007 to 440% in 2013.

Meanwhile, although volumes of key commodity exports declined over the past decade, foreign exchange revenues were bolstered by the upswing in commodity prices. The volume of PNG’s crude oil exports dropped from 150,000 barrels per day (bpd) in 2002 to 10,000 bpd in 2011, while volumes of copper and gold exports declined by 15% and 12%, respectively, in the same period, according to the Institute of National Affairs. Despite this drop, however, rising international prices drove higher oil export revenues, from PGK1.43bn ($581.3m) in 2002 to PGK2.43bn ($987.8m) in 2011, while copper and gold exports grew 199% to PGK3.05bn ($1.2bn) and 160% to PGK5.97bn ($2.4bn), respectively, in the same period, according to BPNG.

The current account deficit retreated to 26.8% of GDP in 2013, but the tapering of inward FDI flows associated with impending completion of the LNG project meant the deficit was no longer funded through external inflows from 2013. “Although PNG has been running a current account deficit for a number of years, a large proportion of deficit was likely through FDI and the currency has not reacted negatively until more recently with a slowing of investment inflows,” Daniel Wilson, an economist at ANZ, wrote in the November 2013 ANZ “2014 Pacific Outlook”.

Meanwhile, while exports slumped by 9.4% year-on-year (y-o-y) in the first half of 2013 driven by disruptions in OK Tedi output and falls of 25% in the gold price and 11% in the copper price in the year to October 2013, imports continued to grow by 13.4% y-o-y thanks to imports for the LNG project and the impact of government capital investment. While import growth slowed by 3.6% y-o-y in the third quarter of 2013, compared to a contraction of 2.1% in exports, the capital and financial account surplus of PGK6.4bn ($2.6bn), estimated for 2013 as a whole, was insufficient to cover the current account deficit of PGK6.99bn ($2.8bn), according to BPNG. With fiscal spending financed in local currency replacing the stimulus from foreign inflows from 2013, government spending has compounded balance of payments pressures.

Currency Drop

Foreign currency inflows from 2010 caused a 30% appreciation in the kina’s real effective exchange rate in the three years to its peak in September 2012, according to the IMF, and 40% in nominal terms against the US dollar, as per ANZ figures. The kina outperformed most other commodity exporters’ currencies given stronger FDI inflows relative to the size of the economy, according to the World Bank. Although the kina’s 8.7% fall in the year to September 2013, as per BPNG figures, was broadly in line with similar drops in other commodity exporters as the US dollar strengthened against most emerging market currencies and as dollar-denominated commodity prices slumped, the depreciation accelerated from September onwards. By the end of November 2013 the kina had fallen a full 25% year-to-date against the US dollar, according to the World Bank, while other commodity-dependent currencies had halted their slump.

Although the currency stabilised somewhat in the last two months of 2013, foreign-exchange bid/ask spreads have widened to around 10% in each direction in light of PNG’s foreign-currency glut. Even at PGK1:$0.413 against the US dollar in December 2013, the kina was still trading above its 10-year average, according to the World Bank. ANZ forecast an 8-10% depreciation against the US dollar in 2014. While the currency’s depreciation has been sharp, volatility in fluctuations have also increased markedly. “The nature of PNG’s foreign exchange market is different from that in more liquid markets,” Eric Kramer, chief operating officer and portfolio manager at PacWealth Capital, told OBG. “It is driven by trade flows and a lack of participation in the market.” Higher volatility has prompted the central bank to intervene through open-market operations to smooth out short-term fluctuations and soften the impact on PNG’s economy.

BPNG Intervention

In light of the weak transmission mechanism between movements in the benchmark interest rate, the Kina Facility Rate, and domestic interest rates given excessive liquidity, BPNG has traditionally used open-market operations and hikes in banks’ reserve requirements as its key monetary policy instruments. The drawdowns on BPNG’s foreign-currency reserves provide a proxy for the bank’s open-market operations, although valuation effects also play a role, according to ANZ. The central bank’s intervention efforts have focused on the US dollar rate. While reserves peaked at $4.32bn in December 2011 and remained above $4bn until January 2013, their depletion accelerated substantially to $3.18bn in June, $3.06bn in September and $2.80bn by February 2014.

The sharpest drops in reserves of $483m in the second quarter and $256m in the fourth quarter reflect the more aggressive BPNG interventions in the market and the kina’s subsequent relative stabilisation. A much larger intervention than that by other commodity exporters with floating exchange rates, the roughly $1bn in interventions in 2013 represented half of PNG’s current account deficit, according to the World Bank. Rating agencies such as S&P have not raised concern on the rapid depletion of foreign reserves, however, given that BPNG is expected to rebuild them once proceeds from the LNG project start flowing onshore.

Meanwhile, the central bank is expected to continue intervening in the market to smooth out extreme fluctuations, but not the currency’s direction. “We believe the bank is comfortable with unwinding the appreciation driven by the LNG construction phase,” Wilson wrote in November 2013. “We believe the end result will be the PGK/US dollar mid-rate around the mid-0.30s level to help combat ‘Dutch Disease’.”

In June 2014, BPNG introduced a 150-basis-point exchange rate trading band, which allowed currency traders to buy and sell the kina either 75 basis points above or below the official inter-bank rate. As part of its news release, BPNG reaffirmed that the floating exchange rate regime would continue. The move saw the value of the kina jump by 18%.

Winners & Losers

While a lower currency will support efforts to diversify the economy over the longer run, the short-term impact of the kina’s depreciation has been mixed. The biggest benefits have accrued to the agricultural sector, which consumes more imports produced locally than the mining sector, which is highly dependent on imported equipment, fuels and skilled labour, according to the World Bank. Although global agricultural prices have weakened markedly, the falling kina has cushioned the blow for local producers. As per World Bank estimates, although Arabica coffee prices fell 32% between September 2012 and November 2013, the currency depreciation narrowed the decline to 13.7% in kina terms and thus helped to reduce the number of coffee growers falling into hardship.

The start of LNG exports in 2014 will return the current account to a surplus in 2015, forecast as high as 12.1% of GDP before returning to 9.1% in 2016, according to S&P, but the longer-term outlook for the currency is mixed. While the goods balance is forecast to revert to a strong surplus from 2014, the deficit in the services current account is expected to persist given the scale of planned investments in infrastructure, according to an ANZ presentation in March 2014. Although the initial start will have a buoyant effect on the economy, the level of inflows actually coming onshore will be relatively low for the first seven years, but they will allow BPNG to rebuild its depleted foreign currency reserves. Thereafter, much will depend on the performance of Asian LNG prices, given the indexation of PNG LNG contracts to the Asian benchmark.