The Papua New Guinea authorities should allow the currency to fall to its market level to make foreign bond raisings less risky says economist Rohan Fox. He tells Business Advantage PNG that domestic banks are reaching the limits of their capacity to take on government debt, which is increasing the pressure to raise capital internationally.
Rohan Fox Credit: Rohan Fox
Fox is Visiting Lecturer and Research Fellow at the University of Papua New Guinea’s Division of Economics. His comments relate to an intense debate in the country about how PNG can solve its foreign exchange crisis, which is having an adverse effect on many businesses.
The Governor of the Bank of Papua New Guinea, Loi Bakani, is on the record questioning claims that allowing the kina to weaken—at the moment the Bank manages the level of the currency—will solve the foreign exchange problem.
Bakani also stated, however, that he is ‘determined’ to get more foreign exchange in. The government is reported to be looking to raise capital with a sovereign bond.
It is here that Fox’s argument comes in. He argues that if the kina is allowed to weaken, it would reduce some of the risks associated with borrowing internationally.
Supply and demand
To understand the argument, consider that when a currency falls, the cost of its foreign borrowings rise. If, for example, $US1 billion is raised when the kina is trading at US 0.30 then the debt at the time will translate into K3.3 billion. But if the kina later falls to US 0.20, then the local currency debt will rise to K5 billion.
‘If the kina depreciates now, then the government will get substantially more kina when it converts the foreign exchange from the bond,’ says Fox. ‘This removes substantial foreign exchange risk.
‘The banks have reached their specified limits to the previous offerings of government debt.’
Fox acknowledges that allowing the currency to weaken will ‘sadly cause hardship for some’ adding that it is ‘not a panacea’. But he says allowing supply and demand to set the exchange rate—with the implication that the kina will weaken—’is one of the few clear policy levers available to the government.’
Banks
Kina-US$ exchange rate. Source: Devpolicy blog
The need to get in more foreign exchange is not the only reason pressure is rising to raise money internationally. The ability of domestic banks to fund the government’s debt is also coming under question.
Fox says the domestic banks are reaching the limits of their capacity to take on more government debt. Consequently, they have not been taking up ‘normal’ bond offerings from the government.
‘The commercial banks may not disclose their limits for exposure to government bonds at a particular price, but they “reveal” their overall limits as a sector when government securities stop getting bought by banks.’
Fox says this has affected the way the Bank of Papua New Guinea has offered Treasury Bills to the market, increasing the costs.
‘To gain access to further credit from domestic banks, they have to make the terms more amenable.
A sovereign bond is likely to have a lower interest rate than debt raised in PNG.
‘One way to do this is to reduce the terms of the bills. This makes them a different type of risk for domestic banks to be exposed to. But it is more costly administratively for government.’
Interest rates
There may be a further reason for the PNG authorities to look internationally. Global interest rates are at historic lows, especially in the developed world.
Fox says a sovereign bond is likely to have a lower interest rate than debt raised in PNG. ‘The interest cost of their five year US 500 million bond was 10.9 per cent per annum, which is cheaper than the latest costs of PNG borrowing domestically for five years which were 11.8 per cent per annum.’
‘I don’t envy the decisions the PNG authorities have to make.’
‘But it does have extra costs in terms of commission to banks that organise the bond (likely to be in the range of 2-4 per cent).’
Decisions
Fox acknowledges that there are no easy solutions. ‘There is no doubt that it is very tricky, and I don’t envy the decisions the PNG authorities have to make.
‘The decisions that may be the best economically down the track, are not the same as the ones that are the best politically in the short-term.
‘A more competitive exchange rate would be one policy that I believe would be positive overall. There is recent empirical evidence which says that resource exporting countries with flexible exchange rates have better outcomes and faster recovery in terms of GDP growth and government expenditure, than countries with less flexible regimes.’
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Yes, I too agree with Loi Bakani. A more competitive kina would not solve PNG’s foreign exchange shortages. However, I do believe a more competitive kina would reduce the demand and increase the supply of foreign exchange, which would reduce (though not fix entirely) the forex shortage problem.
Governor Loi Bakani is indeed correct to question claims that moving towards a more market-orientated rate will fix PNG’s severe foreign exchange problems. Evidence is needed. PNG’s economy is not as “flexible” as some other countries such as Australia. (Of course, there are policies that could make the economy more flexible and better for businesses, especially small businesses and start-ups – the World Bank’s “Doing Business” indicators provide some options for action). However, an interesting example of another Pacific country that did lower its exchange rate and did substantially improve its foreign exchange position is Fiji in April 2009. The 20 per cent improvement in competitiveness from lowering the exchange rate was judged by the central bank as having contributed to a narrowing in the trade deficit by 24% and the current account deficit by 73% in 2009. The details are in the Reserve Bank of Fiji’s paper “The Impact of Exchange Rate Movements on Trade” released on 14 May 2016. This is in addition to evidence that Fox provides on other resource-rich countries.
paul, you say evidence is needed but would you agree the the 20% appreciation in June 2014 create the FX problems of the past 24 months and would you agree that on that basis a devaluation may alleviate it?
Hi Eric. I agree with your implication that there is some pretty clear evidence based on PNG’s recent experience. My economic blogs since September 2014 have warned that the June 2014 exchange rate decision was a poor policy choice for PNG. Unfortunately, predictions on its adverse impact on foreign exchange shortages, falling international reserves and adverse distributional implications have been prescient. BPNG will argue that the Kina/USD exchange rate has now fallen below the rate at the start of June 2014. However, that arguments ignores the international strength of the US dollar since 2014. A better indicator is the real effective exchange rate, and on this benchmark, the Kina hasn’t returned to its former competitive position. Rohen in his excellent article makes the additional argument that moving to a more competitive currency can be an important “shock absorber” to deal with the drop in commodity prices. Other resource-rich countries have used this as an important safety valve. Of course, the PNG government initially denied that the dramatic fall in oil prices in late 2014 would have any effect on budget revenue or the balance of payments. My pointing to Fiji’s experience in 2009 was aimed at adding to the Pacific evidence base that a more competitive exchange rate can improve the balance of payments and foreign exchange receipts. Earlier economic literature on PNG (some of it written by excellent economists within BPNG) does raise questions about how flexible the PNG economy is to changing prices, and of course highlights the imported inflationary risks. Economic policy is usually about trade-offs, and as you imply, more recent experience highlights the adverse effects of moving so far away from the likely market rate. Cheers. Paul.