Loi M Bakani: Commodity and food prices, inflation and monetary policy
in Papua New Guinea
Presentation by Mr Loi M Bakani, Governor of the Bank of Papua New Guinea, to the
National Research Institute Food Security Policy Conference on "High food prices in Papua
New Guinea", Port Moresby, 6 September 2011.
* * *
I wish to express my gratitude to the National Research Institute for arranging this
conference on food prices in Papua New Guinea and for inviting me here today to make a
presentation. I would also like to thank other policy makers and specialists working in this
crucial field. Today I will be discussing global commodity and food prices, how this has
affected inflation in Papua New Guinea, and how the Bank of Papua New Guinea has
responded to these issues.
International commodity price boom
Since 2004, global commodity prices have increased substantially, largely due to increased
demand in resource-intensive emerging economies such as China, which has outstripped
global supply. Other factors have supported this boom, including low interest rates, a weaker
US dollar, and arguably some speculation. International food prices increased at a slower
pace during this period until they surged in 2007 and again in 2010, largely due to supply
constraints.
Prices Indices of Food and PNG's Exports (USD)
400
International Food Price
350
PNG Mineral Export Price
PNG Non-mineral Export Price
300
250
200
150
100
50
2004Q1 2004Q3 2005Q1 2005Q3 2006Q1 2006Q3 2007Q1 2007Q3 2008Q1 2008Q3 2009Q1 2009Q3 2010Q1 2010Q3 2011Q1
Source: Food and Agriculture Organization, Bank of PNG.
The commodity price boom has had numerous positive benefits for the PNG economy. First,
due to increased mining and petroleum export revenues, the Government has been able to
reduce its external debt, allowing for more stable financing of the Budget and external
position. Moreover, with stable government financing, there has been no central bank
financing of the government's budget, which historically has led to high inflation and
exchange rate depreciation. Additionally, the increased export prices have contributed to
high GDP growth, while higher non-mineral export prices have increased incomes and
employment. Because of these factors, the Bank of PNG has been able to increase its
international reserves, while the kina exchange rate has appreciated mildly and been broadly
stable.
Impact on inflation in PNG
These factors have changed the nature of inflation in PNG in recent years. Historically,
inflation was relatively stable up through 1994, when PNG maintained a "hard kina" policy.
During this period from independence through 1994, inflation averaged 5.9 percent.
However in 1994, following years of Government deficits and the deterioration of foreign
exchange reserves, the Government was forced to float the kina, reducing its value
substantially and leading to higher prices of imported items. Between 1995 and 2003,
exchange rate depreciations caused by government deficits and monetization, international
crises, a drought, and consequently low foreign exchange reserves led to high inflation,
averaging 12.6 percent.
Since 2004, however, strong and increasing export prices led to stable government
revenues, a build-up in reserves, and a stable exchange rate, leading to the lowest inflation
in PNG's history between 2004 and 2007, when inflation averaged 1.8 percent.
Annual Headline Inflation Since 1976
25
Headline Inflation
20
Period Average
15
10
5
0
-5
Dec-76 Dec-78 Dec-80 Dec-82 Dec-84 Dec-86 Dec-88 Dec-90 Dec-92 Dec-94 Dec-96 Dec-98 Dec-00 Dec-02 Dec-04 Dec-06 Dec-08 Dec-10
Source: National Statistics Office, Bank of PNG staff calculations.
But when the commodity price boom extended to surging international food and oil prices in
2007 and again in 2010, it began to negatively affect the people of PNG through higher
prices for many imported items. Since 2008, inflation has averaged 8.1 percent. For the first
time in twenty years, higher inflation was not mostly due to exchange rate depreciation, but
was largely due to external forces that have affected most countries.
Rising food and fuel prices have affected inflation throughout the world. With food comprising
a large portion of the consumption basket in developing economies - 40.9 percent in PNG -
higher prices have significantly increased inflation in both 2008 and again in 2010 and 2011.
Headline inflation in PNG has trended slightly above developing countries as a whole, while
PNG's trimmed mean inflation, which excludes the most volatile components such as
betelnut, has trended very closely to other developing economies over the last 2 years.
Annual Inflation
PNG headline PNG trimmed mean Developing countries headline
16
14
12
10
8
6
4
2
0
-2
-4
Jun-06 Jun-07 Jun-08 Jun-09 Jun-10 Jun-11
Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11
Dec-05 Sep-06 Dec-06 Sep-07 Dec-07 Sep-08 Dec-08 Sep-09 Dec-09 Sep-10 Dec-10
Source: National Statistics Office, Bank of PNG staff calculations, World Bank.
Other factors affecting inflation in PNG
While food prices contributed to 60 percent of PNG's inflation between March 2008 and June
2009, over the last year, they have only contributed about 35 percent. Therefore,
increasingly, additional pressures are contributing to inflation. After years of strong revenues,
Government spending has increased dramatically, contributing to strong domestic demand.
Additionally, PNG's macroeconomic stability of recent years has led to increased business
activity and foreign investment, most notably the PNG Liquefied Natural Gas project which is
currently under construction.
Moreover, due to the length of this boom in business activity, domestic demand pressures
have consistently exceeded the ability of domestic supply to increase, and inflation
expectations have increasingly become a factor in price setting and wage negotiations. With
data collected from our Business Liaison Surveys, we can see that wage expectations
increased with the food and fuel price surge in 2008. But starting at the end of 2009 - even
before the current food price surge began - we have seen wage expectations increase to
their highest sustained levels since our survey began. When expectations of higher inflation
are built into business costs, higher inflation can become entrenched, and monetary policy
must then also decrease these expectations to reduce inflation.
Expected Average Employee Wage Change Over
the Next Year (percent)
9
8
7
6
5
Trimmed Mean (50%)
4
Survey Response
3
2003 2004 2004 2005 2005 2006 2006 2007 2007 2008 2008 2009 2009 2010 2010
Q4 Q2 Q4 Q2 Q4 Q2 Q4 Q2 Q4 Q2 Q4 Q2 Q4 Q2 Q4
Thus, since 2007, inflation in PNG has been affected mainly by these factors: 1) external
food and fuel prices; 2) increased domestic demand due to high government spending,
business activity, and LNG project construction; and, increasingly, 3) inflation expectations.
Role of monetary policy
The Bank of PNG has some tools to affect these inflation developments, but when it comes
to externally driven factors such as food prices, PNG is a price taker, and the main challenge
is for the Bank to limit these prices passing on to other prices. Moreover, with much of the
current business boom driven by the LNG project, the Bank of PNG can only have a limited
effect on demand conditions.
In this scenario, tightening monetary policy through increasing interest rates could potentially
lower current consumption and demand to some extent; however, this does little to affect
imported food price inflation, government spending, and LNG construction, although it could
have a slight effect on expectations. Moreover, a severe monetary tightening could increase
the effects of Dutch Disease by reducing the ability of the rest of the private sector to expand.
In fact, private sector credit growth has already slowed. Although it was high up through early
2009, since then, it has decreased to a relatively low level of around 10 percent annual growth.
Otherwise, there is some potential for the kina exchange rate to appreciate further. This
would lower the cost of imported prices, which would benefit urban consumers, while also
dampening export revenue due to lower export prices in kina terms, which would negatively
affect rural exporters and government revenues. Between the first quarter of 2010 and the
second quarter of 2011, food prices increased by about 34 percent in US dollar terms, while
the kina appreciated against the US dollar by around 13 percent, thereby containing the price
of imported food. However, kina appreciation would not be able to fully offset international
food prices, or if it were, it would introduce volatility and require an unsustainable sell-off of
international reserves.
USD and Kina Food Price Indices
250
USD Food Price
225
Kina Food Price
200
175
150
125
100
75
50
2004Q1 2004Q3 2005Q1 2005Q3 2006Q1 2006Q3 2007Q1 2007Q3 2008Q1 2008Q3 2009Q1 2009Q3 2010Q1 2010Q3 2011Q1
Source: Food and Agriculture Organization, Bank of PNG staff calculations.
This appreciation has come at the cost of exports, with the 13 percent kina appreciation
against the US dollar moderating the export prices for both mineral and non-mineral exports,
which rose by about 50 percent and 60 percent, respectively, in US dollar terms. However,
even in kina terms, with mineral and non-mineral export prices much higher than one year
ago, there may have been room for more appreciation of the kina.
USD and Kina Export Price Indices
450
USD Mineral Export Price
400
Kina Mineral Export Price
USD Non-mineral Export Price
350
Kina Non-mineral Export Price
300
250
200
150
100
50
2004Q1 2004Q3 2005Q1 2005Q3 2006Q1 2006Q3 2007Q1 2007Q3 2008Q1 2008Q3 2009Q1 2009Q3 2010Q1 2010Q3 2011Q1
Source: Bank of PNG staff calculations.
Fiscal and monetary policy coordination
The strong Government revenues in recent years have led to a rapid expansion in
Government expenditure. Although there are certainly development needs for the
Government to spend on, during a period of high demand pressures, the government should
prioritize spending on non-competing sectors and only gradually increase expenditure to
improve the quality of spending. In doing so, the government should invest education and
workforce training, health, and law and order, while avoiding large construction projects.
Moreover, investing in agriculture to help make the industry more competitive will help
mitigate the effects of Dutch Disease.
Furthermore, the strong Government revenues in recent years have led to the accumulation
of Government deposits. This affects monetary policy because the Government has placed
the majority of the deposits, currently around 2.5 billion kina, at commercial banks, which the
Bank of PNG has then sterilized through Central Bank Bill issuance. This poor coordination
may cost the Bank of PNG, and ultimately the Government, around K70 million per year in
interest costs.
Location of Government Deposits (K million)
3,000
Government Deposits
at Commercial Banks
2,500
Government Deposits
at BPNG
2,000
1,500
1,000
500
0
Jul-06 Jul-07 Jul-08 Jul-09 Jul-10
Jan-06 Apr-06 Jan-07 Apr-07 Jan-08 Apr-08 Jan-09 Apr-09 Jan-10 Apr-10 Jan-11 Apr-11
Oct-06 Oct-07 Oct-08 Oct-09 Oct-10
Moreover, when these deposits are drawn down, they will contribute to domestic demand
and imports. The Bank of PNG holds foreign currency reserves to offset this future exchange
rate pressure, but a rapid drawdown of these deposits would still be disruptive and would
likely result in wasteful spending.
Outlook
Demand pressures associated with LNG construction and high growth will continue to affect
inflation in the coming years. Although international commodity and food prices have
stabilized in recent months, it is still expected that they will remain high in the near future.
This will continue to present challenges to Papua New Guinea and we can expect that
imported food and fuel prices will continue to contribute to inflationary pressures in PNG.
This calls for close and effective monitoring of food prices by the ICCC.
This will raise the cost of imported food, but it also presents an opportunity to increase local
food production which would reduce dependence on imports in urban areas. Although
estimates have shown that only 20 percent of the food consumed in PNG is imported, it may
be as high as 50 percent in urban areas.1 There is, therefore, a clear market for increased
local production and distribution.
Also, while the government may continue to benefit from high revenues, the management of
these revenues is increasingly an issue for both fiscal and monetary policy. Therefore, the
Bank of PNG continues to call for the Government to allow it to establish an overseas
account to manage windfall mineral tax revenue prior to the establishment of a Sovereign
Wealth Fund for the LNG Project. This would also assist the Government in smoothing out
expenditure which would reduce domestic demand and inflationary pressures while also
increasing the quality of spending.
Furthermore, there is still the potential for commodity prices to drop, of a weather or
conflictrelated crisis causing a reduction in exports, or of some slowdown in the construction of the
LNG project. The Government should plan for these possibilities by saving appropriately
during the boom so that it can continue expenditure during any revenue shortfalls. It should
not increase expenditure in expectation of higher future revenue when there are already
issues with spending quality.
Thank you.