Port Moresby, Papua New Guinea
October 2, 2000

Mr. Horst Köhler
Managing Director
International Monetary Fund
Washington, D.C. 20431

Dear Mr. Köhler:

The attached Memorandum of Economic and Financial Policies supplements the understandings specified in our letter to Mr. Fischer and attached memorandum on March 20, 2000. It also describes the progress made to date in implementing the economic policies and attaining the economic objectives of the Government of Papua New Guinea, which are supported by the Stand-By arrangement approved by the Fund on March 29, 2000. As indicated in the Memorandum, we are committed to achieving a sustainable fiscal position, reducing inflation, strengthening international reserves, and implementing structural reforms.

In support of these policies, the Government of Papua New Guinea hereby requests completion of the first review and the second purchase under the arrangement. It also requests a waiver for the nonobservance of the end-June 2000 structural performance criterion on the preparation of a plan for a comprehensive public sector reform. This plan has now been prepared and endorsed by Cabinet (prior action for the completion of the first review). All other quantitative and structural performance criteria for end-June 2000 were met, and subsequent data suggest that the program remains on track to meet the performance criteria for end-September. To encourage the saving of any future revenue windfalls and safeguard the program against higher-than-expected domestic interest rates, the Government requests modification of the adjuster on the quantitative performance criterion at end-September 2000 on domestic financing of the government for excess non-MRSF (non-mineral and petroleum) revenue. It is proposed to broaden its coverage (including for newly-set performance criteria) to include nontax revenue and domestic interest expenditure.

During the remaining period of the arrangement, the Government of Papua New Guinea will stand ready to take any additional measures necessary to keep the program on track, and it will remain in close consultation with the Fund, in accordance with Fund policies. A second review will be carried out with the Fund before end-December 2000.

The Government of Papua New Guinea acknowledges the assistance provided by the Fund, including through the recent appointment of a resident representative, who is helping to improve program monitoring and policy implementation, and to maintain close communication between the Government and the Fund.

In the interest of solidifying private sector confidence through a commitment to transparency, the government requests that the Fund publish the attached Memorandum.

Attachment

MEMORANDUM ON ECONOMIC AND FINANCIAL POLICIES OF
THE GOVERNMENT OF PAPUA NEW GUINEA

I. Introduction

1. The Government’s economic program for January 2000-March 2001, which is supported by a Stand-by-Arrangement with the Fund, aims at strengthening confidence and laying the foundations for sustainable growth. It seeks to reduce inflation to 5 percent by end-year, and targets an increase in the gross international reserves of the central bank to US$408 million (4 months of nonmineral imports). In addition to the Fund arrangement, the Government’s program has received the backing of multilateral and bilateral donors, including through a US$90 million Structural Adjustment Loan (SAL) from the World Bank (approved on June 13, 2000) and sizeable financial packages from Australia and Japan.

II. Performance under the Program

2. The Government met or surpassed key macroeconomic targets for the first semester of 2000. All quantitative performance criteria (including on NIR and NDA of the central bank, and net domestic credit to government) were observed with margins at end-June. Quantitative fiscal benchmarks for end-June were also observed on tax revenue and government wages and salaries. However, the benchmark on central government recurrent expenditure was breached at end-June due to higher-than-anticipated interest obligations associated with tight monetary conditions, and a larger initial stock of domestic debt than originally estimated. Also, the benchmark on the clearance of pre-1999 domestic arrears was breached at end-June, but such payments are now back on schedule. Exceptional financing through end-June was somewhat lower than programmed due to realignment of disbursements under the SAL.

3. Most structural performance criteria and benchmarks were also observed, including completion of financial and performance audits of the two large pension funds (performance criterion for end-March 2000); passage by Parliament of the revised Central Bank Act and the Banks and Financial Institutions Act (performance criterion for end-April 2000); completion of the self-assessment questionnaire of the code on good fiscal practices; formulation of a plan for privatization; and action to prosecute administrators of the closed pyramid schemes. Also, steps were taken to improve efficiency, transparency and accountability in the operations of the Rural Development Program (RDP) prior to the approval of the arrangement by the Fund’s Executive Board. In view of the problems found by the audits of the two pension funds, plans to conduct actuarial reviews of the funds have been superseded by the Government’s decision to conduct a comprehensive review of the architecture of the pension industry to be completed by end-December 2000.

4. Significant work was undertaken in the first half of 2000 to set the stage for a comprehensive public sector reform. Preparations included reviews of several agencies, which helped establish the methodology for upcoming expenditure and functional reviews of key agencies that will be a major component of the proposed plan. The plan and timetable have now been prepared (complying with the missed end-June structural performance criterion), and endorsed by the National Executive Council (Cabinet) as a prior action for completing the first review. The plan clearly articulates the goals of the proposed reform, a sequencing of actions, the roles to be played by multilateral organizations and bilateral donors, and a description of the initiatives to be contained in the 2001 budget.

5. Strong implementation of the Government’s program and the support of the international community have greatly improved private sector confidence. In addition, higher export prices for petroleum and a recovery in the volume of gold exports have boosted export earnings in recent months, which also contributed to better MRSF tax revenue performance. Tight monetary policy has helped maintain significant interest rate differentials relative to rates in major financial centers. As a result of these factors, the net international reserves of the central bank have risen more rapidly than originally envisaged, and the Kina appreciated in the second quarter. So far in the third quarter however, there has been some reversal in exchange rate and international reserves trends, due in part to an acceleration in import demand.

III. Economic and Financial Policies, June 2000–March 2001

A. Overall Objectives and Macroeconomic Framework

6. The Government intends to build on the recent achievements to bring about a rapid decline in inflation during the remaining period of the program. The Government is committed to tighten financial policies if, at the time of the second review, the program objectives appear to be at risk. Economic growth in the range of 3–5 percent a year is expected over the medium term, as robust growth in nonpetroleum output will offset a secular decline in petroleum production related to the depletion of fields. To create a macroeconomic environment conducive to rising private saving and investment, the Government is determined to maintain sound macroeconomic policies and press ahead with the implementation of structural reforms.

B. Main Elements of the Program

Fiscal policy

7. Restoring a sustainable fiscal position is one of the cornerstones of the program. The fiscal deficit is projected to decline from 3.6 percent of GDP in 1999 to 1.9 percent in 2000, based on expenditure control and increases in selected taxes adopted in the second half of 1999 and early 2000. This is slightly higher than the original program target deficit of 1 1/2 percent of GDP. Although domestic interest payments will be somewhat higher, and nontax revenues lower than originally programmed, this will be mostly offset by stronger than expected tax revenues in both the mining and nonmining sectors. In addition, the Government is saving the mineral and petroleum tax revenue windfall stemming from the higher export prices to prevent overheating in the short term and hold core government expenditure in line with sustainable levels. This will result in a larger than originally envisaged reduction in net domestic government debt (K156 million compared to the original program target of K123 million).

8. Expenditure control will remain a key pillar of fiscal policy. An important development in this area has been the recent introduction of new procedures and management structures for the operation of the Rural Development Program, which will also help increase transparency, accountability, and efficiency. The Department of Finance and Treasury is closely monitoring the release of warrants and the utilization of appropriations to ensure that Departments adhere to spending limits. Particular attention is being given to departments that have a history of incurring arrears. Noninterest current expenditure will be contained at the level envisaged under the program, with public sector wage developments remaining supportive of the objective of lowering inflation and achieving a sustainable fiscal position. The total government wage bill will increase by no more than 10 percent in 2001, including allowances (which have not been adjusted in many years) and a deferred wage increase from 2000. To guard against overruns on the wage bill, the general hiring freeze imposed in November 1999 will remain in force until planned and ongoing departmental reviews are concluded.

9. A prudent fiscal policy in 2001 and the medium term will permit steady reductions in public debt in relation to GDP. This will facilitate an improvement in the quality of expenditure as the interest bill relative to GDP declines, government saving rises, and more resources can be allocated to development priorities, particularly infrastructure maintenance, education, health, law and order, primary industries, and revenue generation. The overall government deficit is expected to narrow to about ½ percent of GDP in 2001, enabling a further reduction in net domestic indebtedness and facilitating an expansion in credit to the private sector. Excluding the clearance of pre-1999 financial obligations arising in part from recent court rulings on disputed claims, the underlying fiscal position would be in balance.

Monetary and exchange rate policies

10. The Government remains committed to achieving a reduction in inflation to 5 percent and an increase in gross official international reserves to 4 months of import cover by end-2000. Broad money is projected to grow by 9 percent in 2000 and reserve money to contract by nearly 7 percent, reflecting the unwinding of the overhang of liquidity that developed during 1999 as a result of lax monetary policy in the first half of the year and the need to allow for possible Y2K-related risks at the end of the year. In view of the recent favorable external and fiscal developments, the end-year target for NIR has been increased, and the end-year NDA target correspondingly lowered, as specified in Table 1. Thus, the net domestic assets of the Central Bank would decline by K451 million, reflecting net repayments of Central Bank credit to Government and open market sales of treasury securities. For the banking system as a whole, the reduction in net domestic credit to Government would permit an expansion of bank credit to the private sector of 9 percent by end-2000. Nominal interest rates are expected to decline gradually as inflation trends down. On an operational aspect of monetary policy, the Central Bank recently lowered the rate on treasury bills sold through the tap facility to one percentage point below the average rate obtained in the auction, and discontinued access by licensed nonbank financial institutions to this facility in order to prevent moral hazard and strengthen competition in the auction.

11. The Central Bank will maintain its flexible exchange rate policy, limiting its intervention in the foreign exchange market to the smoothing of short-term volatility, and the achievement of international reserve targets.

Structural reform policies

12. The Government remains fully committed to implementing an ambitious structural reform agenda. The program for the remainder of 2000 focuses on public sector reform initiatives, including: (i)  preparations for pension reform; (ii) preparations for privatization; (iii) departmental reviews to define core functions and appropriate staffing levels, and efforts to improve financial management, strengthen human resource management, and improve expenditure monitoring and control; and (iv) implementation of the recommendations of the Tax Review Committee, continued implementation of the current tariff reform program and intensifying efforts to improve tax administration. The program also focuses on strengthening the framework for supervision of the financial system.

13. The Government will take strong and timely action to address the problems of the National Provident Fund (NPF) and to strengthen the regulatory framework for the pension industry. The Government recently appointed new members of the board of the NPF, in compliance with the NPF Act, and instituted an independent commission of inquiry. The commission is conducting an investigation of management decisions, ascertaining responsibilities for any past improprieties, and preparing recommendations. Implementation of a plan to write down member balances to reflect audit results has been halted by a court challenge. In the meantime, the Government has decided to shelter new members’ contributions by avoiding commingling of such funds with the rest of NPF assets. To deal with severe cashflow difficulties, the new NPF board will suspend benefit payments while a comprehensive resolution of the capital deficiency is formulated. In this regard, the Government is committed to ensure that any Government payment to attenuate the impact of the write down (or contribute to a possible recapitalization of the NPF) will be limited, fully reflected in the budget, and preceded by a comprehensive restructuring of the pension industry. The Government recently requested bids for a contract to prepare a comprehensive plan for pension reform. In line with the program, the Government intends to submit to Parliament a new Life Insurance Bill and a new Superannuation Bill that will provide a comprehensive framework for the regulation and supervision of these industries by mid-November.

14. The Government is making considerable progress in the area of privatization. It sold its shares in PNG Halla Cement in July and is committed to take Finance Pacific to the point of sale by end-2000 (structural performance criterion). At the time of the discussions for the second review, the Government will identify and agree with the Fund staff on the timetable for the privatization of another major public enterprise. In the first semester of 2000, the Government identified enterprises to be privatized and formulated detailed guidelines for: (i) conducting of legal and financial due diligence; (ii) auditing state companies; and (iii) determining the method of divestiture, including liquidation or sale by international tender. At the same time, Parliament approved amendments to the Privatization Commission Act necessary to enhance accountability. Assistance in the design of the privatization strategy and in its operational aspects is being provided by the World Bank and an International Advisory Group. With this support, an audit of Finance Pacific is underway and those of other public enterprises will soon be initiated. Audited accounts of selected enterprises will be submitted to Parliament before investment bankers are given the task of preparing their sale. The contract for carrying out due diligence in the case of Finance Pacific has been awarded to a major international accounting firm. Also, to facilitate the sale of key utilities, the Government will award a contract through international tender for the review of the regulatory frameworks for utilities.

15. Also in the second half of 2000, the Government will move forward with efforts to raise the efficiency of public administration. In particular, it will conclude departmental reviews to define core functions and appropriate staffing in the Defense, Foreign Affairs, and Treasury Departments, and in the Central Supply and Tenders Board. These reviews, which are being conducted in place of a Public Expenditure Review, will result in the shedding of redundant staff and in other economies, as well as in the improvement in the delivery of services. Separations have already been effected in the Defense Department and a decision will be taken shortly on the rationalization of diplomatic representations abroad. Reviews of the Departments of Planning and Monitoring, Personnel Management, Health, Education, Agriculture and Livestock and the National Fisheries Authority will be initiated in the months ahead. To increase transparency and accountability in financial management, the Government has closed all major revenue-retaining trust accounts, with control over these proceeds transferred to the Treasury. To close the Mineral Resources Stabilization Fund, the Government will repeal the Fund’s Act in the context of the legislative process of the 2001 budget. In addition, external consultants are assisting in the strengthening of the accounting, management, and debt-recording systems at the Department of Finance and Treasury.

16. Headway is being made in improving human resource management. By end-December 2000, the Central Agencies Coordinating Committee, headed by the Chief Secretary, will finalize a blueprint for reform involving a redefinition of the role of the Department of Personnel Management and the Public Service Commission; improved recruitment, evaluation and promotion procedures; and a new compensation system linking compensation more closely with performance.

17. With the assistance of the World Bank, the Government is improving the operations of the Rural Development Program. It has recently strengthened the Office of Rural Development (ORD) and put in place new procedures to improve the efficiency, transparency and fairness of the Rural Development Program. Under these procedures, funds for rural development will be administered by the ORD based on project proposals submitted by the Joint District Planning and Budget Priorities Committees. The ORD will disburse funds upon completion of the projects directly to contractors. Contracts will be publicly tendered and a private managing agent will monitor spending.

18. A comprehensive taxation review is underway. The review will be aimed at: (i) enhancing fairness by ensuring that all taxpayers are treated equitably; (ii) improving the competitiveness and efficiency of the tax system; and (iii) simplifying and enhancing the transparency of the tax system to reduce the cost of compliance. The taxation review will be presented to Cabinet by end-September 2000 (structural benchmark), in order to incorporate its recommendations into the 2001 budget.

19. The Government is determined to allocate sufficient resources to support revenue collection. In particular, resources will be made available to strengthen the administration of the VAT and to increase the number of tax audits. The Government intends to redeploy staff to support tax and nontax collection.

20. Recent passage of the revised Central Bank Act (CBA) and the Banks and Financial Institutions Act (BFIA) has improved the framework for monetary policy and supervision of financial institutions. The CBA places strict limits on lending to Government; mandates the payment of market-determined interest rates by the Government on Central Bank holdings of treasury bills; and grants the Central Bank wide discretion in the choice of monetary policy tools to meet its objectives. In compliance with requirements under the new Act, the Central Bank published its first semi-annual Monetary Policy Statement on July 14, 2000. This practice will help improve public understanding of how the bank intends to achieve price stability and will increase the accountability of monetary policy makers. The BFIA, which became operational on July 18, 2000, enhances the supervisory and regulatory powers of the Central Bank, enabling it to prevent the operation of pyramid schemes.

IV. Prior Actions and Program Monitoring, June 2000–March 2001

21.As a prior action for the completion of the review, the plan and timetable for the public sector reform program have been endorsed by Cabinet (paragraph 4).

22. Quantitative performance criteria for end-December 2000 and revised indicative targets for end-March 2001 have been set as follows: (i) a ceiling on net domestic assets of the Central Bank; (ii) a ceiling on net domestic financing of the Government; (iii) a floor for the net international reserves of the BPNG; (iv) ceilings on new short-term and medium- and long-term external nonconcessional debt, including loan guarantees; and (v) the continuing prohibition on the accumulation of external payments arrears. The budget for 2001 will be finalized during the second review.