Last week the PNG government released  its budget for 2016, taking extreme measures to move expenditure back in line with dramatically reduced revenue.

The good news is this budget has staved off a full-blown cash flow and macroeconomic crisis. The bad news is the government avoided many hard choices, making deep cuts to core services while protecting big-ticket items. Much also remains unknown or unanswered. I will leave it to others to analyse the budget on a more forensic level, but below are my key takeaways.

The good: the fiscal adjustment PNG needed to have

Building off of the stark figures released earlier in the year and the recently released medium-term budget strategy, Treasury has acknowledged that the resource boom is well and truly over.

The revised GDP figures in the Budget reflect a more restrained growth trajectory. It's important to emphasise the PNG economy has experienced significant growth in recent years, expanding (when adjusting for inflation) by 38% between 2011 and 2015.

Revised GDP growth figures for PNG

Source: PNG budget documents. Full dataset for charts and tables available here

The collapse in global commodity prices has hit the government’s bottom line hard. Originally predicting a 10% growth in revenue this year, the supplementary budget for 2015 (not yet released to the public)  shows a drop of 12%. This drop comes even after the government raised an extra 1 billion Kina in revenue from PNG's State Owned Enterprises. The government forecasts revenue to remain flat in 2016. Overall, while GDP has grown by almost 40% after inflation in the past five years, revenue has only increased by 12% over the same period. Why such a period of rapid economic growth was not better reflected in revenue collection is a subject for further analysis, and it is a shame tax reform did not receive more attention in the budget.

In response to its sharp and shocking reversal in fortunes, the government has drastically adjusted expenditure to rein in the 2015 deficit from an un-fundable 9.4% to a more credible 4.9%.  Continued spending cuts are expected to take the 2016 deficit to  3.8%, and the government is aiming for a balanced budget in 2020, as seen in the chart below. While unpalatable, a fiscal adjustment was undoubtedly necessary to maintain cash flow and avoid a  full-blown macroeconomic crisis.

PNG's revised fiscal position (adjusted for inflation)

Overall the macro picture for this year’s budget appears solid. The government has  done well to avoid past mistakes by keeping revenue projections pessimistic and making it clear the years of rapid expenditure increases have come to an end. Cuts of this magnitude, particularly when adjusting for inflation, invariably bring with them tough decisions. It's when we dig a little deeper into the nature of the cuts that the veneer of fiscal responsibility starts to chip away.

The bad: core services cut while big-ticket items remain

Tough times are ahead for PNG government expenditure which is expected to fall as a share of GDP from 30% in 2015 to 23% in 2020. The government made lofty promises about preserving core services, as well as O’Neill’s big-ticket items of free primary education and health, large investments in infrastructure, and major increases in provincial and parliamentarian funding. The reality is that, given expenditure was cut (when adjusting for inflation) by 8% in 2015 and will fall again by 8% in 2016, trade-offs had to be made. Unfortunately it appears that big-ticket items have won out to the detriment of core government services.

When adjusted for inflation,  which is expected to remain steady at roughly 5% for the foreseeable future, the cuts become even more severe, as seen below.

PNG sectoral spending and cuts (adjusted for inflation)

Note: percentage values in brackets show year on year cuts for each sector, adjusted for inflation

The biggest losers have been transport, administration and education, where budgets are being reduced in real terms by more than 20%. It is particularly disappointing to see recurring expenditure for universities cut and funding to church delivered health services slashed. Economic investments, tourism and utilities all received a boost, but when looking at the forward estimates, these increases appear to be one-year benefits only. More alarmingly, interest repayments have increased by almost 25% and will account for 10% of the 2016 budget. Provincial funding (which includes funding to controversial  constituent development funds that still account for 10% of total expenditure) that often cannot be properly accounted for, has also disappointingly increased as a share of government expenditure, and now makes up close to one third of the total budget.

The unknown – what’s happening off budget, the sovereign bond, funding for drought relief

Long-term observers of the PNG economy know the formal budget process is only half of the story when it comes to public expenditure. State Owned Enterprises, where the controversial Oil Search loan resides, also account for a lot of spending. How much SOE revenue was raided to shore up the 2015 budget, how much these enterprises are spending on infrastructure (particularly around Port Moresby to prepare for the 2018 APEC summit) and the underlying health of their balance sheets all warrant  attention. Of critical importance is how much debt has been taken on by SOEs as the 2016 budget already pushes PNG’s debt beyond the legislated debt limit of 35% of GDP, as shown below.

PNG's debt position

Another major point of discussion at the Budget lock-up I attended last week was the government's plan to launch PNG’s first sovereign bond. This is not a new concept for PNG, but it is still untried and  the government is putting a lot of faith in the bond generating US$1 billion (2.8 billion Kina) to restructure short term debt. In principle, there is nothing wrong with a sovereign bond. It has the potential to reduce PNG’s debt servicing burden in the medium term while shoring up the country’s depleted foreign reserves. The bond will only be of value, however, if the government secures favourable terms, and it is not exactly approaching the negotiations from a position of economic strength. There also doesn’t seem to be a Plan B to deal with PNG’s foreign reserves challenges if the bond doesn’t pay off. It’s a risky move at a time of economic fragility for the country.

Finally, and in many ways most importantly, very little mention was made in the 2016 budget about how the government will respond to what could be the worst drought in the nation's history.  At the budget lock-up, much attention was given to the impact the drought has had on government revenue, and it was mentioned that 220 million Kina (roughly A$110m) would be allocated to drought relief through provincial expenditure. There was, however, no explicit mention of the coordinated national level response that will be required, regardless of what international assistance is inevitably provided. It was noteworthy that APEC 2018 garnered more attention in the budget documents.

It is fair to describe this is an emergency budget for PNG. A collapse in revenue resulting in harsh spending cuts, as the government flirts with its legislated debt limit, has left it little room to manoeuvre. For better or worse, the path forward for expenditure is  clear. The true test of this government's convictions will be whether it sticks to this new and frugal path.