Papua New Guinea is on track to have the highest rate of GDP growth in the world this year. So why is it struggling to pay its bills and restricting foreign exchange access? This two-part series looks at the external shocks and poor fiscal management that have put the country into such a difficult position.
PNG Kina vs $US: May 2006 to August 2015
Dashed line denotes introduction of exchange rate rationing. (Source: OANDA monthly bid averages; dataset here.)
Exchange rate management isn't a topic I expect will vault me to the top of The Interpreter's most-read, but it is of vital importance to the health of PNG's economy. PNG's exchange rate soared in 2011 and 2012 on the back of high commodity prices and as the construction phase of a huge LNG project entered full swing. In 2013, however, the PNG currency, the kina, began depreciating as high levels of government spending injected more money into the economy. The exchange rate slipped even more rapidly in 2014 thanks to a combination of lower commodity prices (that reduced the value of PNG exports), a higher US dollar, and the end of LNG construction, all of which helped reduce international demand for the kina.
In reaction to this sharp drop in the exchange rate, in June 2014 the PNG Central Bank implemented a trading band that immediately increased the kina's exchange rate with the US dollar by 16%, well above the market exchange rate (see graph above). The move was arguably justified to prevent excess profits, inject confidence into the business community by removing a degree of volatility, and allow the kina to depreciate at a controlled rate. Why the Central Bank actually introduced the band remains unclear. The steady decline of the exchange rate since may be evidence of this policy at work, or it may simply reflect a steadily appreciating US dollar.
While a controlled depreciation of an exchange rate can almost be justified, however, it is not without economic consequences.
The inflated exchange rate is being managed by a rationing of foreign exchange, demonstrated by the K1.5 billion in outstanding import bills waiting to be processed as of March 2015. Such controls can significantly undermine private sector performance.
A recent ANZ business survey found that '88% of firms highlight difficulties (accessing foreign exchange), with 49% of them noting that it is a “significant” cost to business.' The most high-profile example came last month when PNG's largest petrol retailer, Puma Energy, stopped providing gas to petrol stations as it lacked access to sufficient foreign exchange to pay its suppliers. While the fuel is flowing again,such extreme controls on private sector operations are no doubt undermining the O'Neill Government's reputation as pragmatic and private sector friendly.
This controlled depreciation has also not occurred in a vacuum. While PNG's exchange rate is steadily approaching its pre-trading band levels, the global collapse in commodity prices (particularly oil) has shifted the market-clearing exchange rate even lower. Recent research into the 15 most resource-dependent countries that have floating exchange rates (a group that includes PNG) shows an average depreciation in their exchange rates versus the US dollar of 14.5% since May 2014. This suggests the kina still has a long way to fall before it hits a market clearing level, a depreciation which will hurt both exporters (it makes their products less globally competitive) and importers (because many are struggling to access foreign exchange). If global trends are anything to go by, PNG's exchange rate will have to continue to fall for the rationing of exchange to stop, as was noted by the IMF in late 2014.
Adding to the issue of PNG's overvalued exchange rate, foreign exchange reserves held by the Central Bank have halved since 2012 from US$4 billion to just above $2 billion on the back of higher import demands from the Government's expansionary fiscal policy. This was one of the primary reasons cited by Moody's when it recently downgraded PNG's credit rating outlook from stable to negative. While foreign exchange reserves appear to have stabilised at $2 billion, enough to cover eight to nine months of imports, this calculation does not take into account the outstanding import bills mentioned above. If those still haven't been cleared, PNG could have as little as four to five months of import coverage.
Foreign exchange reserves and coverage
Dashed line denotes introduction of exchange rate rationing. (Source.)
Incoming revenue from the LNG project should have boosted foreign exchange reserves, but the decline in global oil prices (which I will discuss further in part two of this series) has led to diverging forecasts for PNG's reserves. The PNG Central Bank unrealistically expected reserves to increase by 45% this year alone, but last month it adjusted its forecasts and now expects reserves to stay flat for at least the next two years. ANZ, by contrast, expects reserves to stay steady in 2015 and increase by 40% in 2016, while others see the downward trend persisting and completely depleting reserves over the next two years.
Whatever the exact figure, management of the foreign exchange system in PNG doesn't look to be getting any easier in the short term. The central bank needs to act by allowing the exchange rate to depreciate at a more accelerated pace towards a market clearing rate. While this may further reduce the central bank's reserves in the short term as back orders for foreign exchange are cleared, it will give business a much needed boost in confidence as additional controls over their operations are lifted. It is also entirely possible the depreciation will have little impact on reserves as imports (now at their lowest levels since 2005) become more expensive. This, however, will hurt the middle class (the government’s primary support base) as staple goods such as rice become more expensive making the exchange rate saga one of politics versus business for the O’Neill government. In the land of the unpredictable, it’s unclear which side will win.