Loi M Bakani: Papua New Guinea's semi annual Monetary Policy
Statement (MPS)
Address by Mr Loi M Bakani, Governor of the Bank of Papua New Guinea, to the Port
Moresby Chamber of Commerce and Industry, Port Moresby, 31 March 2010.
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Mr. David Conn, CEO of Port Moresby Chamber of Commerce and Industry, members of the
Port Moresby Chamber of Commerce & Industry, distinguished guests ladies and gentlemen.
I'm most grateful and honored to be invited by the Port Moresby Chamber of Commerce and
Industry to make this presentation at today's breakfast, to coincide with the release of the
first Monetary Policy Statement (MPS) for 2010.
The Bank of Papua New Guinea was the first public institution that decided to subject itself to
transparency and openness by including in the Central Banking Act 2000, the requirement to
publish its semi annual MPS. The Act states in clause 10, and I quote: "The Governor shall
within one month of the coming into effect of this Act, and every six months thereafter, issue
a policy statement setting out the monetary policy of the Central Bank to achieve and
maintain price stability for the following six months" end of quote.
Monetary Policy is the central objective of the Bank of Papua New Guinea. The Central
Banking Act 2000 added the Regulation of the Financial System and the Promotion of an
Efficient National and International Payment Systems, as the second and third most
important objectives. These three main objectives and functions are fully vested and under
the control and responsibility of the Governor. The Act continues and states, I quote: "Subject
to the above, to promote macro-economic stability and economic growth" end of quote. This
implies that if the objectives of monetary policy, a prudently managed stable financial system
and low cost efficient payments system are achieved, and subject to other policies of
Government complementing these conditions, macroeconomic stability and sound economic
growth can be achieved. The outcome in the last five years is a testimony to the achievement
of these objectives.
I want to state that, we can be very pleased with the fact that our regulatory regime proved
itself to its full extent during the recent world wide financial meltdown. The credit goes first
and foremost to the boards and management of the banks and financial institutions that were
not carried away with the easy phantom profits the new instruments were presenting. I am
sure that they will agree that the Central Bank through the financial regulation and prudential
standards it issued and insisted on implementing has had its share in preventing the disaster.
I move now to this morning's breakfast presentation on the first MPS for 2010. While you can
read what's in the MPS in today's newspapers, my presentation will deal with two main
subjects:
1. What is defined as Price Stability by the Bank of Papua New Guinea; and
2. What effect might the Liquefied Natural Gas (LNG) project have on the economy in
general and on monetary developments in particular?
The Bank of Papua New Guinea defines Price Stability as a non volatile single digit or low
level of inflation supported by stable levels of interest and exchange rates. The term "non
volatile" is a very important part of the definition. The objective is, to create a conducive
environment for investment and growth in economic activity by the private sector. For the
private sector to plan ahead, it must have some certainty of what will be the price of inputs
during the period of investment and the selling price of the outputs. An entrepreneur knows
that there is risk involved in future flows from any investment. What Central Banks are trying
to achieve is a stable macro-economic environment that will reduce the risk of price volatility.
The risk of producing a salable product that has a market, at a competitive price rests with
the entrepreneur.
Based on this paradigm it is clear that we do not want a negative inflation. Expectation of
negative inflation will reduce investment, entrepreneurs will delay activity to benefit from the
lower future costs. Reduction in investment and activity and its multiplier effects will result in
a decline in economic activity and negative growth.
The most important decision the Governor has to take is what level of inflation will define
price stability. As you already understand it will depend on the level of expected economic
activity and growth. It is clear that there is a trade off between the two, i.e. inflation and
economic growth.
I want to clearly express to you my definition of price stability. At the level of average real
economic growth of 5.25% realized in the four years 2006-2009, the acceptable level of
inflation as defined by the Central Bank and even in Government budget documents is 5.0%
to 6.0%. The actual average inflation outcome for the same period was 5.265%. This is
within the range that I clearly define as a period of price stability. Looking at each year you
will see that the range of annual inflation rates varied from 2.4% in 2006 to 11.2% in 2008.
You will all agree that once it was realized that inflation is on the rise during 2007 and 2008,
the Bank of Papua New Guinea took steps to contain it and it declined to 5.7% in 2009.
The next question I want to answer is what if economic growth accelerates and inflation rate
rise to two digit levels, as was the case in China and India prior to the last Depression in
World economic activity. Some of you might be asking was it a recession or a depression. If
we go by the standard definition of two quarters negative growth that defines a recession,
and any period of negative growths longer than that defines a depression, then to the best of
my judgment the world is just coming out of a depression.
My response is that we should accept the fact that the economic environment will be different
and inflationary pressures will be substantial. At higher levels of economic growth, we should
accept a higher range of inflation rates. We will have to live with a high inflation environment.
But the policy challenge is not to allow the rate of inflation to spiral out of control and become
entrenched in double digit figures. We should do all we can to keep it within ranges of single
digit mark. But at an average annual economic growth rate of around 9.0% and above, the
range of price stability has to be redefined. In a country like Papua New Guinea, in which
domestic supplies in all areas are very scarce and those available are in very short supply;
just look at professional, skilled and semi skilled labor, housing, building materials,
manufactured goods, etc... the high annual economic growth rates will exhaust domestic
supplies and exert inflationary pressures to unprecedented levels. In such a case the
questions the Governor will face are:
(1) Do we dampen demand by implementing a very tight monetary policy of high
interest rates; or
(2) Set a higher range of inflation rates for price stability.
Based on the experience of other countries, in such a case, my intention is to define price
stability at inflation rates around the 8.0% mark. But I will be quiet reluctant to have a double
digit level of inflation, for the main reason that I want to be sure inflation is not going out of
control. Even this higher mark is achievable only if the Government and the Central Bank will
cooperate and coordinate all their activities, to ensure that fiscal operations are not imposing
any further pressures on the scarce domestic resources and monetary policy management
does not become difficult and expensive as experienced in 2008 and 2009.
Some examples of cooperation and coordination relate to maintaining a balanced budget
inclusive of draw downs from trust accounts. Historical experience in the 1980's and 1990's
and early 2000's show that Government deficits have a very immediate impact on inflation.
Depositing all trust accounts with the Central Bank, creating the Sovereign Wealth Fund that
should act as Stabilization and a Future Generation Fund will insulate large foreign currency
inflows in offshore managed accounts. These should prevent those flows from impacting on
the domestic liquidity, which have been a source for monetary inflation that the Central Bank
had to defuse at a very high cost to the public purse by selling Central Bank Bills (CBB's). I
would like to commend the Government for deciding to establish a Stabilization Fund, Future
Fund and Infrastructure Fund from the windfall revenue comprising taxes and dividends that
will come from the LNG project. A joint working group has been set up comprising Treasury
and BPNG staff and will submit its recommendation on an appropriate model or framework
for these Funds to the National Executive Council (NEC) at the end of June 2010.
During the construction phase of the LNG project, there is a need for Government to review
all development projects and budget and implement only the most immediately needed ones,
to ensure that no further pressures are placed on the very limited domestic resources. The
Government has to be conscious not to crowd out the private sector, which will implement
vey large infrastructure and development projects in the next four years, during which the
LNG project is constructed. In 2010, we have allowed for broad money to grow by 21%,
which we consider sufficient to meet the borrowing needs of the private sector to support
economic growth. If the Government will receive any windfall revenue from high mineral
taxes and dividends as a result of increasing commodity export prices, it should allow the
Central Bank to insulate them by keeping the funds in offshore foreign currency accounts,
instead of depositing them in trust accounts domestically. This would reduce the impact of
these funds on domestic liquidity, the exchange rate and inflation.
On the second question of how the LNG project will impact on the Papua New Guinea
economy this issue has been continuously discussed in many forums, and only one or two
studies have been undertaken on it. I will only touch on some of the areas of the project's
impact, mainly those that influence the areas the Bank of Papua New Guinea is responsible
for.
Papua New Guinea has a history of investments in mineral and petroleum projects. I went
back to study what can be deduced about the impact they have had on economic growth,
inflation, foreign exchange flows and employment. In the decade 1981 to 1991 five major
projects were constructed, Ok Tedi, Misima, Hides Gas, Porgera and Kutubu, all at a total
cost of US$ 6.0 billion. They commenced production in the years 1984 to 1992. The
information about their impact was distorted by the second oil crisis in the early 80's, and the
Bougainville uprising in 1989. In spite of those events the lesson we can draw is that
economic activity as measured by GDP increased from around 4% to 5% before reaching
11% to 12% during the period of construction of the mining projects, and to 17% when the
Kutubu petroleum project was constructed.
The construction of these projects has had a very moderate impact on inflation, if at all. It
increased to 11.7% in 1980 mainly as a result of the second oil crisis. For the period of
construction of these projects, inflation rate averaged 5.5% with some outliers in 1982 and
1983 at 6.9% and 8.5% and in early 1990's by around 7.0%, respectively. Most of the
projects in the 80's and 90's were in remote areas in the Star Mountains, Misima Island,
Southern Highlands, and Enga and these areas are not measured in the Urban Based CPI
we are using. The lessons learnt are limited.
The LNG project is two and a half times larger at around US$15 billion to be spent in four
years. But what is expected is that PNG will experience a period of heightened economic
activity with GDP growth increasing, combined with inflation rate moving up to a new level.
This is expected to occur during the construction phase of the LNG project. The MPS makes
mention of some of these impact based on a study we carried out jointly with the Monash
University. The project is important but we have to be careful not to exaggerate its benefits.
The GDP may increase significantly (expected to be around 50%) but what matters most are
the expenditures on domestic factors of production for the construction and set-up phase.
Upon the production phase, the main means through which to spread the benefits of the
project throughout PNG over time is the Government's fiscal policy. The best fiscal strategy
is to save some of the windfall revenue gain in a SWF for the future while consuming only a
part of it. Under this strategy the effects of the Dutch Disease can be minimized. This fiscal
strategy will also make it easier for the management of monetary policy in addressing
inflationary concerns. This is in contrast to spending more than it receives or spending all
that it gets where the effects of the Dutch Disease will be exacerbated. Some sectors such
as building and construction, transportation, manufacturing and services will benefit from the
project, especially in the short run during the construction phase. While others will not,
particularly the traditional agricultural exports sector as it will be adversely affected by the
Dutch Disease effect (due to appreciation of kina exchange rate). Let me emphasize that
these findings are based on preliminary information and data, and they can be updated once
all the information and the data will be provided by the project developers.
So the Bank of Papua New Guinea will have to assess the developments and take the
necessary steps to ensure that inflation is not getting out of control.
The system used to fund projects will assist in containing some of the inflationary pressures.
The major developers or Engineering, Procurement and Construction (EPC) contractors use
off-shore finance to fund the project. We expect most of these financing transactions to be
undertaken between offshore accounts as allowed for under the 2008 Exemption Regulation,
where they are exempted from seeking approval from BPNG for opening of foreign currency
accounts offshore. But other sub-contractors will still be required under the Central Banking
(Gold & Foreign Exchange) Act to submit their requirements to the Bank of Papua New
Guinea to determine their eligibility under the 2008 Exemption Regulation. Some of the labor,
materials and supplies will be purchased in the domestic markets. To purchase them the
developer or contractor has to exchange foreign currency for Kina. The result is that the
supply of foreign exchange increases which has a revaluation effect on the exchange rate.
As a result imported inflation declines. This will mitigate some of the unprecedented very
high demand pressures on domestic resources, and inflation. This together with prudent
management of the budget and trust accounts can minimize the effect of Dutch disease in
PNG.
The analysis leads me to the conclusion that the Bank of Papua New Guinea is going to face
untested turbulent times. Once all the information will become available, we will design the
policy framework for ensuring that price stability is maintained.
The challenges faced by the Government and the Bank of Papua New Guinea are huge. I
am sure that we can live up to them and secure a stable macro economic environment
conducive to a country wide long term economic growth.
Thank you all for listening and have fun on a Fools Day.