Part 1 of this series on the PNG economy looked at the double dilemma of an overvalued currency and falling foreign reserves. This second and final part examines the urgent need to reset fiscal policy.

When Papua New Guinea's budget for 2015 was handed down in November last year it contained many big-ticket items. Anticipating a wave of revenue from the US$19 billion ExxonMobil LNG project, the budget continued the O'Neill Government's trend of spending big on infrastructure (particularly ahead of the Pacific Games held in Port Moresby in July), education, and decentralised funding to provincial, district and local levels of government. 2015 was PNG's largest ever budget and the Government was buoyantly optimistic about its soon-to-be riches.

Then, in late 2014, global commodity prices collapsed and so did the Government's fortunes. PNG was not the only country caught by surprise, but it is one of the countries most dependent on natural resources in the world. With commodity prices expected to remain flat for some time, the O'Neill Government is watching its expected wealth slip away. As this first graph shows, global commodity markets can be a cruel mistress:

Growth in PNG primary commodity prices

Source: IMF (2015). Dataset here.

The most important line to pay attention to in the graph above is the oil price, which has collapsed in the last year. While oil and gas prices do differ, they are closely linked. The Bank of PNG put the July LNG price at 45% below its price in November 2014, when the budget was handed down. By latest estimates it is now more than 50% below the November 2014 price, which was bound to have a huge impact on expected revenue from the new LNG project.

The full, dramatic impact of the drop in commodity prices became clear in August when the government delivered its mid-year economic forecast (MYEFO).

The MYEFO contained some frightening figures. Instead of revenue increasing this year by the 15% (after inflation) originally forecast, it has collapsed to 6% below 2014 levels, leaving a 20%-plus funding gap in the 2015 budget. This means revenues are back (when adjusted for inflation) to 2011 levels, while expenditure is now 50% higher.

By the MYEFO's own account, (and it did not update expenditure), this has left the PNG budget with a deficit of close to 9.4% of GDP.

PNG government revenue and expenditure (adjusted for inflation, in 2014 prices)

Sources: PNG budget documents, PNG 2015 MYEFO and IMF. Dataset here.  See below for notes*.

This all couldn't have come at a worse time for PNG. The Government has run significant deficits since 2011 with the expectation that massive LNG revenues would be flowing into its coffers around about now. Also, in March 2014, the O'Neil Government made a controversial decision to take out a loan of about 3 billion kina (US$1.2 billion, about 8% of GDP) to buy shares in Oil Search, whose share price has since dropped by about 17%.

PNG is dangerously close to its legislated debt limit and any further lending on commercial markets could result in unsustainable levels of debt servicing. This leaves the Government with a deficit that looks impossible to finance without significant raiding of long-term assets.

PNG certainly isn't the first country in the world to put the cart ahead of the horse when it comes to expenditure and predicted revenue. Indeed, some degree of expansionary fiscal policy was probably sensible considering the looming LNG project and PNG's human development constraints. However, luck has clearly not been on its side and the Government faces some tough choices. How it acts will be the true test of its mettle.

The first necessary step is to cut spending. This has to be done in a systematic way that protects primary services. With a budget that has near doubled (or increased by half when accounting for inflation) since 2011, the Government should have a lot to work with and it does appear to be taking action. It has announced there will be a supplementary budget later this month (just weeks before the 2016 budget is expected to be brought down), and this should show steps taken to reduce expenditure.

Specifically, some of the O'Neill Government's flagship initiatives, in particular the District Services Improvement Program (which John Momis, one of PNG's founding fathers, recently called the 'legalised bribery' of PNG MPs), should be reconsidered. With revenue collapsing, these initiatives are competing for the same funds as primary services, which need to be prioritised. News of ambulance services shutting down and clinics being forced to close due to a lack of government funding are cause for concern.

The second action required is to develop a credible medium-term fiscal framework. The Government's current target is to return to a balanced budget by 2017. Clearly this is no longer plausible. The necessary adjustment must begin in the 2016 budget and should continue with a more substantial five-year spending plan. A mix of expenditure restraint and a slower return to a balanced budget is essential.

The third leg is broader economic reform. An economic crisis should never go to waste, and there are many reform levers that can be pulled to improve and diversify PNG's economy. Low hanging fruit include getting the just-legislated Sovereign Wealth Fund up and running before the next big LNG project, privatising state owned enterprises, and giving serious consideration to the recommendations from the soon-to-be-handed-down tax review.

None of this is very palatable for a Government with an election looming in 2017, however it is all necessary.

PNG has been dealt an awful hand by the global economy, and is being further battered by the El Nino drought, but the Government's deficit and exchange rate woes are short-term challenges that, with the right policies, can be fixed. With substantial resource wealth, bountiful (and growing) human capital and an emerging educated and active middle class, the future is bright for PNG. The only risk to that future would be the Government's failure to act.

* Up to 2014 is budget actuals; 2015 revenue estimated from 2015 budget (continuing red line) and MYEFO (green line). There was no revised expenditure estimate in the MYEFO. Graph does not account for off-budget expenditure through state-owned enterprises such as the construction of the new port in Port Moresby and two new power generators.