With a strong economy in recent years, the GDP growth rate rose to a high of 8.9% in 2011, after stagnating in the early 2000s, only to fall back in 2013 to around 5% and then rise again to more than 8.4% in 2014, according to the Bank of Papua New Guinea (BPNG), the central bank. Construction work on the PNG liquefied natural gas (LNG) project led to the economic boom in 2011, while the slowdown was the result of the end of that phase and the hiatus before production. But with production now taking off, it is not clear what exactly will happen to GDP and to the economy as a whole. The price of LNG has been falling along with commodities worldwide, and this will feed through to PNG’s returns from the project in the near term. While some protection may be provided by long-term contracts with LNG purchasers, these obligations generally offer only a partial hedge from volatility.
A Very Wide Range
GDP growth estimates for 2015 have varied widely, as well as declining over time as the reality of lower commodity prices sets in. In its “Asian Development Outlook 2014”, the Asian Development Bank (ADB) expected 21% growth in 2015 based on the first full year of LNG production. However, in its “Asian Development Outlook 2015”, this figure was reduced to 15%. The World Bank forecasted 16%, while BPNG was expecting 9% growth as of early 2015.
Sceptics have been warning that the country must prepare for disappointment. In a December 2014 paper entitled “PNG’s Vanishing LNG Export Boom”, Paul Flanagan, a visiting fellow at the Development Policy Centre at Australian National University’s (ANU) Crawford School of Public Policy, argued that GDP growth will come in at about 6.9% in 2015 as a result of a 35% drop in world oil prices. Policymakers have also advised caution and saying the government needs to start working with more realistic projections. “Things have changed. Revenue inflows will be lower,” Loi Bakani, BPNG governor, told OBG. “I warned that we have to manage expectations – that was even before the drop in oil prices.”
The exact decline in revenues due to the drop in energy prices is a matter of speculation. The price of LNG has indeed fallen since peaking in February 2014. World Bank figures indicate that the Japan LNG import price – a benchmark relevant to PNG – is down considerably, declining from a high of $18.11 per million British thermal units (mBtu) in 2012 to as low as $9.50 per mBtu in April 2015. PNG had been expecting to get more. The central bank reported in early 2015 that the average price was $16.70 in 2014 and that the forecast was $15.50 for 2015.
Experts advise caution, however, in making simple predictions about gas prices and that, given the nature of the market and of the purchasers, the correlation between falling oil prices and LNG prices is not direct, despite the fact that the latter has fallen in line with the former. “Taking a deeper look at the market, a more complex picture emerges in which crude prices have had, at best, a minor and mostly psychological impact on the spot market for LNG,” energy sector analysis firm Platts said in early 2015. It is also not clear how sensitive PNG LNG sales will be to price shifts. In the first quarter of 2015, only seven of 26 PNG LNG cargoes were sold on the spot market, according to Oil Search. However, the exact terms of existing contracts are not known and best guesses suggest their existence provides little long-term security. Paul Barker, executive director of the Institute of National Affairs (INA), said that while much LNG trading is done on long-term contracts, these deals are linked to the spot price and adjusted periodically. He also noted that contracts of this kind can be renegotiated and cancelled, providing very little comfort that PNG will be insulated from declines in the spot market.
Officials have been warning of exactly this kind of problem. While PNG LNG paid a PGK415m ($157.03m) dividend to the government in April 2015, Frank Kramer, chairman of the National Petroleum Company of PNG, stated that because of current market conditions the public should not expect such sizeable dividends in the near future.
The potential gains accruing to PNG from the project are significant. In early 2014 the estimated income over the 30-year life of PNG LNG was $31bn, with about one-third of that staying in-country as a result of dividends, royalties, taxes and other payments. The pay-out also rises over time, with the country projected to receive $ 600m775m annually during early phases of the project and $1.58bn per year in later phases as depreciation drops. The problem is that those numbers are based on previous assumptions of higher LNG prices. In addition, early payments may not go directly into the economy or be available for the government. PNG will likely need to repay the $1.2bn it borrowed to finance a purchase of 10% of Oil Search, and it is also setting up a sovereign wealth fund (see analysis).
However, according to Barker, the country has been pre-borrowing from the fund, which means it will have to pay back these loans before it can begin to fill the fund. According to the Development Policy Centre, the Treasury has been noting for a number of years that the mega-project will add little net to the economy, as it will be largely replacing revenue that is being lost elsewhere.
The INA agreed, noting that the percentage of GDP contributed to the economy by the agriculture, fishing and forestry sectors has been declining steadily since 2002, and that this decline is expected to continue – falling from almost 40% of GDP to just above 20% in 2015. Mining has also been falling as a percentage of the total since 2006, with copper and gold all down over the long term.
More Signs of Trouble
The potential shortfall in revenue from PNG LNG could have a serious impact on the government’s financial position, which has not been good in recent years and is in need of the balancing impact of LNG inflows. In 2010 the country had a fiscal surplus of PGK186.3m ($70.5m), which was subsequently followed by a string of deficits. The shortfall totalled PGK65.7m ($24.86m) in 2011, PGK339.4m ($128.43m) in 2012, PGK2.63bn ($995.19m) in 2013 and PGK2.99bn ($1.13bn) in 2014, according to BPNG.
The higher deficits were largely the result of countercyclical spending, which was designed to prop up the economy between the construction and production phases of PNG LNG and some on-offs, such as construction projects for the 2015 Pacific Games in Port Moresby. Some line items have also grown over the past few years, such as development expenditure for provincial projects, while overall financing has shot up quickly to cover these costs in the absence of revenue increases.
Domestic borrowing more than doubled between 2012 and 2014, while tax proceeds were up only about 5% annually between 2010 and 2013, and appeared to stagnate in 2014, according to PwC’s budget reviews. The budget deficit came in at 7.3% of GDP in 2014, according to BPNG. Concerns about the country’s debt are starting to increase. So far, PNG has done well in keeping its obligations under control. It was able to get its debt-to-GDP ratio down from 62% in 2004 to 27% by year-end 2012. But the ratio started to climb back to 32.6% in 2013 and then to 35.5% in 2014, as the country recorded three years of heavy budget deficits. The plan is to get the deficit down, retire debt and have a balanced budget by 2017. The budget deficit is expected to be 4.4% of GDP in 2015 and the overall debt-to-GDP ratio should fall to 23.6% by 2019, according to the 2015 budget. But these projections are now regarded as ambitions, especially in light of the lower LNG prices. “A failure to consolidate the fiscal position would result in unsustainable debt dynamics,” the IMF noted in its 2014 Article IV consultation, adding, “The government needs to adhere to its existing debt targets while focusing on improving spending quality to make the most out of a restrained resource envelope in meeting the country’s development needs.”
International and local institutions are worried about the implications of this deficit. Not only are they concerned about the cost of servicing the debt burden, but they also see the higher levels of borrowing possibly causing rates to rise as the government is forced to sell more debt into the market. This could have a further negative impact on the domestic economy. Already, rates are starting to increase. The 182-day Treasury bill went from 1.82% in April 2013 to 4.51% in September 2014, while the 364-day bill increased from 1.96% to 7.3% in that time. “Rapid spending growth over the past three years has required a significant increase in government borrowing, some 70% from local capital markets. This has the potential to crowd out finance for local investment and has begun to push up local interest rates. Government borrowing costs for long-term domestic debt reach 14% per annum in 2014,” according to ADB’s “Asian Development Outlook 2015”.
Some analysts have added up the moves and events of recent years and seen signs of concern. Writing in February 2015, Stephen Howes, director of the Development Policy Centre at ANU’s Crawford School of Public Policy, believes a recent intervention in the foreign exchange market, the loan to buy Oil Search shares and the fact that the BPNG said in late 2014 that it would be a buyer of last resort for government bonds could result in problems down the road. More specifically, if the situation is handled poorly, he believes PNG could return to the problems it saw in the past, such as high interest rates, high inflation and a serious drop in foreign exchange reserves.
The positive projections being offered up by the Treasury rely largely on LNG revenues and on the ability of the government to rein in spending. The former is not at all certain given fluctuations in commodity prices, the slowdown in China and the unpredictability of Japan’s energy policy. Flanagan estimated that the recent drop in LNG prices will translate into PGK1.4bn ($529.76m) in revenue loss for 2015 and PGK2.5bn ($946m) less than expected for 2016. Looking further, he expects the budget deficit to rise to 10% of GDP and the debtto-GDP ratio to increase to 75% by 2017.
The ADB has already started to notice a problem in terms of difficulties servicing debt. In its “Asian Development Outlook 2015”, it estimated that the cost of paying obligations will rise from 5.5% of domestic revenue in 2013 to 9.2% in 2015.
On the spending side, Flanagan believes the government has set ambitious targets that it is unlikely to achieve even under the best of circumstances. He calculated that the government will have to cut expenditures 9.2% in 2016 and 6.2% in 2017, and noted that the government has failed to meet spending targets in the past. He also doubts whether the government will be able to cut health care and education spending as much as proposed given the need for development in these two vital sectors.
Ratings analysts agree. “Government revenue will fall short of the medium-term projections in the 2015 budget due to the impact of lower prices for petroleum, natural gas and other commodities on royalties, dividends and the profitability of associated companies. However, the government has not formulated a policy response that would realign expenditures to conform to the planned glide path to a balanced budget by 2017,” Moody’s credit rating agency stated in May 2015.
Sticking to a Plan
“The message is clear,” Bakani told OBG. “We have to cut somewhere.” Some numbers are looking good and have demonstrated the economy’s fundamental strengths. Inflation has fallen dramatically, from double digits in 2008 to around 5% in 2013 – although rebounding to 6.6% in 2014 on high economic growth and the weakening kina. Wages, however, have risen nicely over that time. The minimum wage increased from PGK37.20 ($14.08) per week in mid-2009 to PGK128 ($48.43) per week in mid-2014, although the Treasury pointed out that the real spending power of wages has been eroded due to inflation. At the same time, the country has moved steadily from a current account deficit to a quarterly surplus in the third quarter of 2014. In part, this is the result of a decline in imports, particularly manufactured goods.
The economy has been greatly affected in the short term by aggressive policy. As the kina has weakened, the BPNG has been intervening, spending its foreign reserves to buy kina in support of the currency. It has also been taking direct action to influence the structure of the market to maintain order. When the exchange rate reached PGK2.80:$1 in spring 2014, the central bank took the extraordinary action of narrowing the trading band, stating currency had to exchange hands within 75 basis points of the official reference rate. While the action was taken to force banks to deal in currencies at rates that were more favourable to customers, according to the central bank, it also had the effect of instant appreciation. The kina jumped immediately back above PGK2.45:$1. The move has been criticised by the country’s trade and investment partners, as it brings into question the independence of the bank and the commitment of the country to free markets. The IMF said that it has to evaluate the move to see whether the country is still in compliance with its obligations to the fund.
The band also has real world, practical consequences for the economy. Holders of foreign currencies have been hesitant to sell, while importers are having trouble obtaining foreign exchange and liquidity has been significantly reduced in the market. While Moody’s affirmed the country’s “B1” rating in early 2015, it had some concerns related to the measures taken in the currency markets and revised the country’s rating to a negative outlook. It noted that what the central bank had done resulted in a loss of hard currency reserves, failed to halt the slide and left the country still facing a “mechanical deterioration” in debt ratios. Moody’s added that it believed PNG’s short-term external debt was greater at that time than its foreign currency reserves.
The economy outside of the resources sectors has been mixed. The construction sector saw a decline after the end of the construction phase of PNG LNG, contracting 6.4% in 2014, according to the ADB. However, the non-resources sector as a whole is expected to grow by 4% in both 2015 and 2016. The ADB estimated that wholesale and retail trade will grow at about 5.5% a year, financial services will increase by 4.5%, and the agriculture, forestry and fishery sector by 3.6-3.7%. “In contrast with mining and petroleum, activity in the rest of the economy is expected to remain modest,” wrote the ADB. Overall, the bank described the country as becoming increasingly dependent on commodities.
With the ramping up of PNG LNG, the percentage of economic activity from the resources sector will rise from 12% to 22% over the span of a year. Similarly, the ADB said the percentage of the budget from mining, oil and gas will jump from 11% to 20%. It added that other sectors will continue to lag and, as new projects come on-line, the country’s dependence will only increase. The ADB noted that this will leave PNG ever more exposed to exogenous shocks and that the country needs to focus on improving its fiscal situation in order to become stronger and better able to withstand instability outside its borders. Much of the growth of the economy outside of resources is related directly to government spending. The construction sector, for example, has been helped by the 2015 Pacific Games, which required an estimated PGK1.2bn ($454.08m) to build a swimming centre, a stadium, the games village and other related infrastructure, such as a new ring road.
Bond in the Works
Given the situation with respect to the fiscal deficits and the costs of servicing the debt, an international debt issue might be the best solution, according to the BPNG and Australian bank ANZ PNG. The former sees the need for $2.5bn and suggested the best route would be a syndicated loan or a eurobond, while the latter calculated that if the government fails to sell off state assets, the fiscal deficit will balloon to above 8% of GDP. The government would be forced to raise funds in the more expensive local market, increasing its costs and further crowding out local investment, as well as putting the government in a position where it may not be able to make the necessary investments in infrastructure and transportation. The Australian bank stated that countries with credit ratings similar to PNG are able to raise funds in the international markets at under 6%, while local currency funds are costing the government twice that.
An international bond would also have the effect of making the fundraising process less political and more transparent. The loan from international bank UBS to buy Oil Search shares, as well as the PGK6bn ($2.27bn) soft loan from China, caused considerable turmoil domestically. If a bond were sold into global markets, it would be well and publicly documented and transparently traded after the initial sale.
While PNG is a resources-dependent economy and is set to become more so over time, the development of other sectors is also key to future growth. Manufacturing, services, construction, agriculture and finance have the potential to provide long-term, sustainable growth, albeit at a slower pace than minerals, oil and gas. They are also able to provide employment to a wide range of people, both skilled and unskilled. It is investment in these areas that will guarantee economic growth between projects, during times of low commodity prices, and beyond the era of oil, gas and minerals.
Agriculture is and will always be a major part of the economy. It is at least one-third of GDP and employs almost three-quarters of the population. The sector has been a steady contributor to exports for years. Agriculture exports as a percentage of total exports has held steady at 20% since about 2010, and fisheries products have more than doubled in that time – though they remain a small portion of total exports, now at about 2.5%. The country’s biggest agricultural export in kina terms has been palm oil, selling almost PGK1bn ($378.4m) overseas in 2013. The country ranks as the sixth-largest exporter of palm oil globally.
The agricultural sector is also seen as having additional potential. The country has abundant water resources – five times as much renewable water as Australia – a growing and increasingly affluent Asian market nearby and domestic resources that have not yet been fully exploited. As of 2013, PNG was using only 150,000 ha for all its palm production despite the fact that the country has an estimated 5.1m ha that could be developed. “PNG’s soft commodities sector faces many opportunities due to increased demand for food throughout Asia,” according to ANZ’s paper “Bold Thinking: Imagining PNG in the Asian Century”.
PNG has also underutilised water supply and land that could readily be converted from less productive forms of agriculture to export cropping. The country has ambitious targets for the sector and is aiming to increase its exports five-fold from 2010 levels for 2030. Targets for coffee, cocoa and palm are set at 11.3%, 8.8% and 5.8%, respectively, to 2030, according to the ANZ paper. The IMF said that while agriculture has held up well as a percentage of total GDP in the country, it remains relatively underproductive and not a major force in the global commodities markets. Palm oil yields are below those in Malaysia, coffee yields are below those in Brazil and cocoa yields are below those in Indonesia, while tuna catches need to be better managed. The sector will need to invest in productivity and logistics, as well as better manage its output, if it is to differentiate its products in international markets and get the most from the sale of commodities.
Manufacturing is another important focus. It is a small part of the overall economy at an estimated 9% of output, but it is seen as vital to the country’s economic future. The sector enjoyed a small boom during the construction phase of the PNG LNG project, but experienced lower sales growth as the production phase began. Manufacturers said the falling kina has both hurt and helped business, as it has made the cost of some imported inputs and parts more expensive, while making locally produced goods more competitive with imported goods.
The government emphasised the manufacturing sector in its Medium-Term Development Plan 2011-15, with some support for small manufacturers, but the main goal was to develop downstream processing and export products made from local natural resources, such as timber, palm oil, copra and tuna. “With the commencement of production and export of LNG, the government should use the opportunity to invest in the non-mineral export sectors, especially agricultural, fisheries and forestry sectors, to broaden the export base of the economy and reduce the economy’s dependence on the mineral sector. This would also assist in providing employment opportunities, increasing the government’s revenue base and reducing the impact of the Dutch disease, especially in the agriculture sector,” according to the BPNG’s March 2015 monetary policy statement.
Industry is somewhat optimistic about the future. While the production phase of PNG LNG will not have the same direct impact as the construction phase, some money will be flowing into the economy over time. If the project does in the end help government finances, or if the government is able to sell an international bond, this could result in additional infrastructure spending that will benefit the local economy. Some companies, such as Goodman Fielder, Prima Smallgoods, Paradise Foods and KK Kingston, have all made additional investments in their local operations in recent years.
While consumer spending has stalled as the economic growth rate has declined, long-term trends are still good and remain optimistic. The country’s PPP GDP per capita finally regained its 1994 level in 2011 and has been rising steadily since, despite the slowing growth. PNG now has its own emerging middle class, and companies are investing in relevant opportunities. The CPL Group, which runs City Pharmacy, Stop N Shop, Bon Café, Eagle Boys Pizza and Paradise Cinemas, is continuing to grow and introduce new businesses to the country. Papua New Guineans, while very price conscious, are still active consumers. “People are not shy to spend,” Sumu Bhattacharya, general manager of Coca-Cola Amatil PNG, told OBG. Labour rates have been increasing, but costs are still low and businesses report few problems in finding workers. PNG even has a surplus of people available for training and work.
Infrastructure & Reform
Infrastructure spending could also potentially play an important role in economic growth. Already, the government has made a significant commitment. Expenditures on land transport have risen dramatically in recent years, according to the IMF, with outlays increasing from less than 4% of total expenditures in 2008 to around 15% in 2014. The new budget also makes a heavy commitment to infrastructure, and the expectation is that spending on roads, ports and other facilities will continue into the future. This will bring employment and indirect economic activity that will help to counter any slowdowns between projects or as a result of falling commodity prices.
However, the IMF warned that the country needs to develop the right sort of capacity to effectively implement relevant projects so that the money is spent in ways that yield the maximum benefit to the economy. A number of reforms have been undertaken, or are in the works, and are expected to have a significant impact on the economy. The country started lowering tariffs in 2002 and is scheduled to take the intermediate rate from 12.5% to 10% by 2015. The protective rate will converge with the intermediate rate in 2018, according the Treasury. The programme has been a success in terms of allowing for easy and competitive access for importers and reducing costs for consumers, but it has also had an impact on domestic manufacturers, who say it is tough to stay in business given the flood of cheap imports from Asia.
Another reform that has been suggested is the privatisation of public companies. PNG Power, which has been taken over by the government after the declaration of a state of emergency, is in need of immediate help, while Air Niugini is seen as a prime asset for a strategic partner. Such sales would help the government to cover shortfalls and improve the functioning of key assets, which in turn could improve the business environment. The private sector also seems to be becoming somewhat more competitive on its own, which should help economic growth. While the three major banks still control almost all the deposits and loans in the country, the rise of microbanks, the increasingly competitive stance of Westpac PNG and the purchase of the Maybank licence by the Kina Group suggests that the situation could be changing in the sector. Already interest rates spreads are narrowing, the gap between three-month time deposits and the average loan rate going from above 10% in early 2014 to below 9% in 2015, and service has improved considerably with more electronic offerings and a more concerted effort to reach rural and poor clients.
The headline GDP number will continue to fluctuate as commodity prices vary and as the government refines its budget. At times, the situation could become difficult and the government may face some tough decisions, but PNG is likely to avoid the major crisis being predicted by some observers and is expected to enjoy relatively high rates of growth and some stability. Cash flow from the LNG project will begin to help in the repayment of debts and other obligations, and funds will begin to build up and counter losses elsewhere. The key for the country is the development of infrastructure and the non-mineral sectors, which will require careful spending and a measured, but proactive, policy.
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