The Papua New Guinea economy is on the edge of a ‘slippery slope’, if the Bank of PNG finances government debt and continues to fix the exchange rate at too high a rate. Former Australian Treasury advisor Paul Flanagan argues rising inflation, falling foreign exchange reserves and declining private sector credit growth are compounding the problem.

Former Australian Treasury adviser, Paul Flanagan

The Bank has agreed to purchase any government bills and stocks that aren’t picked up by the private market, saying it will then sell them to small investors.

In theory, this sounds great. In reality, it is disastrous.

Deficit funding

Small investors are not buying the new central bank bills (in the last week of September, less than K1 million were purchased). So, the central bank is now providing almost unlimited financing for any deficit. Once started, this near printing of money can be a very addictive habit for any government.

Of course, a central bank can have a role in dealing with a short-term liquidity problem for a government, but this was already in place in PNG through the equivalent of a small overdraft facility.

Gross international reserves are expected to drop from K8.42 billion in 2012 to K6.49 billion in 2014 and then down to K4.95 billion in 2015, before recovering in 2016. The major issue here is that PNG LNG receipts are not expected to flow through strongly in 2015, yet major repayments are expected on the commercial loan of $US1.3 billion which paid for the government’s Oil Search shares.

Quantitative easing

Some may argue that this process, also known as a form of ‘quantitative easing’ or ‘unconventional monetary policy’, is being used in the US and Japan, and possibly Europe, to try and stimulate the economy after the Global Financial Crisis.

However, inflation is not an issue in the US, Europe and Japan, whereas PNG inflation is now expected to rise to eight per cent.

The US, Japan and Europe also have one key safeguard to help minimise the damage to macro-economic stability from this ‘quantitative easing’ or printing money. That safeguard is a market-based currency, but this is no longer the case in PNG.

‘The central bank itself should revert to a floating exchange rate, and stop financing the government deficit.’

Knowing that setting the Kina exchange rate and printing money are only temporary measures will provide some reassurance, but there is no indication when or if the exchange rate will revert to a true floating regime.

The moves towards effectively printing money to finance the deficit and moving away from a market determined exchange rate are very disturbing. They put the central bank, and ultimately PNG itself, on a tempting but potentially disastrous slippery slope.

A smaller deficit in 2015 will help reduce the need for deficit financing, and put less downward pressure on the exchange rate. But the central bank itself should revert to a floating exchange rate, and stop financing the government deficit.

‘But there are a number of unique and positive aspects about how the PNG economy is being managed. Firstly, the Bank of PNG’s regular economic updates provide a positive pattern of transparency. Some countries don’t do this at a cost to their credibility.’

Otherwise, PNG will be increasingly exposed to risks of high inflation and exchange rate rationing, its macroeconomic credentials will be damaged, and the benefits of its long period of un-interrupted growth potentially thrown away.

Positive aspects

But there are a number of unique and positive aspects about how the PNG economy is being managed.

Firstly, the Bank of PNG’s regular economic updates provide a positive pattern of transparency. Some countries don’t do this at a cost to their credibility.

Secondly, the move to the electronic payment of such things as remittances to villagers lowers costs for people and businesses.

Thirdly, the Bank can and does express its concerns. For example, its latest report expresses concern about unbudgeted expenditures, it calls for spending constraint, and it is justifiably concerned about the lack of progress on the proposed Sovereign Wealth Fund.

Fourthly, the balance of payments is expected to record a deficit of only K196 million in 2014, down considerably from the estimated deficit of K1,143 million only six months ago.

Paul Flanagan recently left his position as Chief Advisor, Foreign Investment and Trade Policy Division, at the Australian Treasury. This is an edited version of an article originally published on the DevPolicy blog.