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November 10, 2010

Fiscal Policy in the Tropics—Hitting a Moving Target

Posted by Jason Harris[1]

Papua New Guinea is a developing, resource-dependent economy located on the Pacific Rim, east of Indonesia and north of Australia.  While not well known or much visited, it is a reasonably large country, with an incredibly varied population of around 6 million people and 800+ different languages. It has also been home to some interesting fiscal policy innovations over recent years.  In particular, it is one of only a few countries to formally adopt a non-mineral budget balance target to deal with the recent commodity boom.[2]

Since emerging from its recent economic nadir in the early 2000s, the PNG economy has enjoyed a robust turnaround.  Real GDP growth has averaged 4.3 percent since 2002, compared to average growth of less than 1 per cent in the previous 7 years, and growth has been broad based, with non-mining growth outpacing overall GDP growth. While only a small proportion of the population is involved in the formal sector, and poverty is still widespread, employment growth has been strong, averaging 5.1 percent a year since 2002, compared to the previous decade where employment growth had stagnated at 0.6 percent a year. The budget position has improved significantly over this period, with large budget surpluses, a halving of government debt to less than 30 percent of GDP, and a large accumulation of public resources. 

This turnaround has been due to three main factors: an unprecedented terms of trade boom; sound macroeconomic policy settings, which have successfully adjusted to changing circumstances; and some surprisingly effective micro-reforms, which have encouraged growth in the non-mining sector (particularly in the telecom sector). This post looks at how fiscal policy in PNG has adjusted to meet the challenges associated with the terms of trade boom. The strategies that were adopted have been successful in stabilizing public finances and avoiding the boom-bust cycle of past commodity booms in PNG.  However, they have also resulted in a great deal of pressure being applied to an already overstretched public financial management system, creating new challenges and opportunities for leakages.

The initial turn-around was successful

In the early 2000s, the PNG economy was in considerable trouble. The economy had been contracting for a number of years and the exchange rate had collapsed, bringing with it inflation in excess of 10 percent. The government was running persistent deficits, yet the private sector was reluctant to finance these deficits, leading to central bank financing of the budget in 2001. In response to this dire situation, the PNG government took some tough steps to improve the situation. A medium-term fiscal strategy was adopted that mapped out a path to return the budget to surplus over the next 5 years and expenditures were brought under control. At the same time political stability was restored.

The government successfully met the fiscal targets laid out in the fiscal strategy for a number of years.  By 2004, the budget had returned to surplus, off the back of expenditure restraint and a merging terms of trade boom. The prices of PNG’s key exports: oil, copper and gold, had begun to rise, and rise fast.

But the commodity boom brought new challenges…

As the commodity boom progressed, and commodity prices continued to increase, it became clear that a fiscal strategy simply targeting budget balance was less than what was needed for prudent fiscal management. The surge in commodity prices resulted in a surge in tax revenues.  Between 2004 and 2007, mineral revenues more than tripled, and total revenue increased by 80 percent in nominal terms. If this was to all pass through into government expenditure (as allowable under a budget balance rule), the result would have been a sharp increase in inflation—as the economy struggled to absorb a massive increase in expenditure—and a great deal of waste, as the bureaucracy struggled to absorb and spend the increased expenditure effectively.

Instead, the government began saving a portion of the windfall revenue, using it for debt repayment, repaying of state superannuation liabilities, and putting funds aside in trust accounts to pay for future investments. Unlike a predictable surge in revenue from a new project, which provides long lead times to prepare for, the increase in commodity prices was large and sudden, requiring a rapid response from policy makers, which meant that systems were not necessarily in place to meet the new demands, particularly around the use of trust accounts.

...which necessitated a change to the strategy

In 2007, the IMF was asked to help design a new fiscal strategy that was more suited to the boom conditions and volatile commodity prices. In particular, the government wanted to avoid locking in ongoing spending based on varying, volatile, and highly uncertain amounts of revenues from PNG’s commodity exports.

After considerable work and consultation, the PNG government adopted a new medium-term fiscal strategy, based on the idea that “ongoing spending” (effectively current expenditure) should be kept in line with “normal revenues”—that is, the amount of revenue that could be expected in the absence of a commodity boom. Or in IMF parlance, the new fiscal strategy was to target a non-mineral ongoing budget deficit of 4 percent of GDP. This would ensure that if the commodity boom was to suddenly end, and prices reverted to “normal” levels, there would not need to be any disruptive adjustment to government expenditure, as had occurred in the past.

The additional mineral revenue—those mineral revenues in excess of 4 percent of GDP—were to be used to pre-fund public investment projects and repay debt and other liabilities, using a 70:30 split (i.e., 70 percent for pre-funding of public investment, and 30 percent for debt and liability repayment). Given the volatility of the mineral revenues, it was important to allocate these funds in ways that could be adjusted with minimum disruption if the amounts received varied from forecasts and fluctuated from year to year.

While debt repayment is the obvious choice for additional revenues—particularly in a high debt environment—the appetite for it amongst decision makers (and voters) is finite. And in a country with significant development needs, there is an argument that it may not always be the most appropriate choice. Thus the majority of the windfall revenues were to go towards prefunding investment projects that would benefit future generations, with the pre-funding to be saved in trust accounts. This provided flexibility in case additional revenues did not materialize

The spending of funds from the trust accounts in capital projects was to be made while considering the impact on domestic and import demand, prevent inflationary or balance of payment issues, and be compared to and assessed against all other potential investment projects in order to identify the projects with the highest public returns. The strategy also placed a limit of 4 percent of GDP on the amount of the additional revenues that could be spent in any year.  This amount was assessed as drawing a balance between allowing the government to proceed with its investment program, and the need to manage and smooth aggregate demand fluctuations in the economy caused by large swings in government spending.

Taken together, the 4 percent of GDP non-mineral ongoing budget deficit, and the 4 per cent of GDP limit on capital expenditure out of trust funds implied a total non-mineral deficit limit of 8 per cent of GDP.

Increased transparency

The strategy was also accompanied by a substantial improvement in the quality and transparency of reporting around the Budget. A new Fiscal Responsibility Act was adopted in 2006, requiring in addition to the annual budget, the publication of a mid-year economic and fiscal update, a final budget outcome within 3 months of the end of the financial year, and a budget strategy paper outlining the approach of the upcoming budget.

On top of the standard budget reporting, these documents provided detailed reporting on the status and use of the funds held in trust—an important reform with such a large amount of money at stake.  This included line by line reporting of each withdrawal from a trust fund.  It was hoped that by increasing the transparency of reporting, sunlight would be the best disinfectant.

How has the Strategy held up?

In the three budgets since the design of the strategy (while formally adopted in mid 2008, it was also used to formulate the 2008 Budget), the government has largely stuck to the first element of the new fiscal strategy. Current expenditures remained in line with normal revenues, and additional revenues have been used to reduce debt, which is now less than 30 percent of GDP, down from a peak of 70 percent, and pre-funded public investments, resulting in the balance held in trust accounts, increasing to 17 percent of GDP.

The strategy ensured that the PNG economy rode out the global financial crisis. While the PNG economy was not overly exposed to the direct consequences of the crisis, it was hit hard by the drop in commodity prices.  Oil and copper prices fell from peaks of US$145 per barrel and $8,900 per ton in July 2008, to $30 per barrel and $2800 per ton in December 2008.  And this all happened in the midst of the formulation of the 2009 Budget—an extremely difficult time for policymaking.

By keeping ongoing expenditure in line with an estimate of normal revenues during the boom years, the budget was able to absorb a very large shock to revenues without any need for a disruptive cut to current expenditure. The adjustment was all taken through reductions in additional expenditure, which by design was completely flexible. So despite a sharp drop in mineral revenues, the 2009 Budget remained in balance—a stark contrast to previous episodes in PNG.[3]

However, the strategy has struggled in containing the amount and quality of investment expenditure coming out of the trust accounts. The speed limit of 4 percent of GDP a year worth of additional investments has been far exceeded in 2009, with trust account draw downs worth around 8 per cent of GDP. This was largely due to the relaxation of controls around the trust accounts, which saw funds leaking out faster than allowed. This has been accompanied by a reduction in the quality of the spending, which is starting to move away from the principles outlined in the MTFS, towards lower quality consumption expenditure, which has not gone through any cost benefit analysis.

Lessons

PNG’s experience provides a lesson for fiscal policy in developing countries. While adopting a macro fiscal strategy is important in setting a fiscal anchor, it is also heavily reliant on effective public financial management. This is particularly the case when the fiscal strategy entails the accumulation of large amounts of savings—be it in trust accounts, in a stabilization fund or a sovereign wealth fund. If there are not sufficient controls in place, no matter how sound the macro or fiscal strategy is, the leakages from those savings can create problems.  In this case, where there were concerns over the structural integrity of the trust accounts from the beginning, it was hoped the increased transparency requirements, combined with strengthened controls around releasing funds from trust would be effective. 

Unfortunately, a quick glance at the 2010 Budget would reveal the line “No financial or project reporting has been provided by the Implementing Agency” repeated over and over again in the section reporting on expenditures from trust funds.  And the fact that spending is being released faster than allowed under the strategy, and for lower quality spending is a sign that the controls around release of the funds are not sufficient to withstand the political desire to spend the money. The large increase in spending from trusts is now exerting demand pressure on an economy already running up against capacity constraints, risking higher inflation, interest rates and imports, and increasing the challenges for other arms of policy. 

PNG is presently looking to set up a sovereign wealth fund, in order to help manage the resource revenue coming from a new LNG project, which is expected to deliver a large increase in resource revenues. While it is possible that such a fund will provide a more effective vehicle for saving windfall revenue than the trust accounts, the lessons around the need for stronger public financial management of the trust accounts, and the previous experience with a stabilization fund should be heeded.



[1] Jason Harris is a technical assistance adviser in the Fiscal Affairs Department of the IMF.  He spent 2½ years working as an economic and fiscal adviser in the PNG Treasury, riding out the commodity boom.  He also enjoyed a front row seat of the boom from Australia.

[2] Other examples include Norway and Azerbaijan.

[3] According to the PNG method of reporting, which for a variety of reasons treats the transfer of funds into trust as expenditure, rather than when the funds are spent from trust. Using the IMF definition, the budget fell into deficit due to the large increase in trust account expenditure.

Note: The posts on the IMF PFM Blog should not be reported as representing the views of the IMF. The views expressed are those of the authors and do not necessarily represent those of the IMF or IMF policy.

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