Port Moresby, Papua New Guinea
March 20, 2000

Mr. Stanley Fischer
Acting Managing Director
International Monetary Fund
Washington, D.C. 20431
U.S.A.

Dear Mr. Fischer:

The attached Memorandum of Economic and Financial Policies (the Memorandum) describes the economic program the Government of Papua New Guinea intends to pursue during 2000-01. As indicated in the Memorandum, we are working toward and committed to achieving a sustainable fiscal position in 2000, a reduction in inflation, an increase in international reserves, and significant structural reform, all of which will lead to sustainable real economic growth and external viability over the medium term.

In support of this program, we request on behalf of the Government a 14-month Stand-By Arrangement (SBA) in the amount of SDR 85.54 million (65 percent of quota).

The Government of Papua New Guinea believes that the policies and measures described in the attached Memorandum are adequate to achieve the objectives established under the requested SBA, but it stands ready to take any additional measures necessary to keep the program on track. The Government will remain in close consultation with the Fund in accordance with the Fund's policies on such consultations; and will provide the Fund with such information as the Fund requests in connection with Papua New Guinea's progress in implementing the economic and financial policies and achieving the objectives of the program.

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

Sincerely yours,

Attachment: Papua New Guinea: Memorandum of Economic and Financial Policies

12.  Total revenue and grants are projected to increase by 0.5 percentage point of GDP in 2000. Important steps to strengthen tax revenues were already taken in the 1999 supplementary budget. Indications are that the VAT, which was introduced in mid-1999, is proceeding satisfactorily and that the government's VAT estimate of 3.1 percent of GDP in 2000 is on track. Revenues flowing into the Mineral Resources Stabilization Fund (MRSF) are expected to increase with the rise in export prices. Contingency revenue measures, which could include increases in the cigarette excise and the corporate income tax, will be implemented if the program's budget targets are jeopardized. In light of the high public debt stock, the government recognizes the need to contain expenditures at budgeted levels. Should total non-MRSF tax revenues exceed program targets, the government intends to retire additional public debt. Also, should any privatization receipts materialize during the program period, these proceeds will be directed toward a further reduction in public debt. Quarterly targets for both non-MRSF and MRSF revenues are set out in Table 2.

13.  On the expenditure side, the government has identified the areas of health, primary industry, education, law and order, infrastructure maintenance, and fiscal management (including tax administration), as priorities. With appropriations for goods and services for other departments frozen in nominal terms, recurrent expenditures will decline by 1 percentage point of GDP in 2000. The Department of Finance and Treasury will closely monitor the release of warrants and expenditure commitments to ensure that sufficient resources are available to cover expenditures throughout the year. Particular attention will be given to departments that have a history of overspending. Quarterly limits on recurrent spending are set out in Table 2.

14.  The overall wage bill is budgeted at K 814.2 million (7.1 percent of GDP), and any wage increases or new hiring in 2000 will be fully accommodated within this envelope. Priority departments (as defined above) have received additional appropritions. To guard against overruns on the wage bill, the general hiring freeze imposed in November 1999 will remain in force until the planned public sector reform is implemented. Exceptions to the hiring freeze will be granted only to priority departments and only after consultation with Fund staff. Quarterly limits on the wage bill are set out in Table 2.

15.  Development expenditure is budgeted to increase by 0.8 percentage point of GDP in 2000, reflecting the shift in Australian aid flows from general budgetary support to project grants. In addition, the 2000 budget has identified and appropriated K101 mil-lion (less than half of total disbursements under the proposed World Bank Structural Adjustment Loan (SAL) to cover some of the one-time costs of structural adjustment associated with privatization, public sector reform (including the associated retrenchment payments), the conducting of the census, and strengthening the National Forests Authority, the Ombudsman's office and other government oversight agencies.

16.  Important steps are being taken, with assistance from the World Bank, to significantly enhance the transparency and accountability of development spending to ensure that it is effectively directed to priority areas. A key commitment in this regard has been the government's decision to fundamentally reform the Rural Development Program (RDP). The new RDP has been designed as a means for providing government services efficiently at the district level, consistent with the government's development priorities. In response to the government's request, the Bank has provided technical assistance to establish a mechanism that can be monitored and is transparent. No spending under the RDP will take place until the new system is in place and fully operational. Implementation of the new mechanism will be reviewed as part of the second program review with the Fund.

17.  The government is committed to not incurring any new domestic arrears and to settling any legitimate overdue claims speedily. To achieve this objective, all spending agencies have been required to submit monthly reports to the Department of Finance and Treasury identifying any unpaid obligations that have been outstanding for more than three months. The Department will prepare a quarterly report with information on arrears by department, long outstanding invoices, and judicial cases with potential budgetary liabilities. These reports will be submitted to the Minister for Finance and Treasury and the Auditor General. Cumulative quarterly targets for the clearance of arrears are set out in Table 2.

18.  Expenditure monitoring and control systems will be strictly enforced to achieve the intended budget outcomes. The Government will not make payments in excess of warrants issued which, in turn, will be determined by budget appropriations and up-to-date cash-flow projections. Any additional spending would have to be legislated in a supplementary budget. The system will be strengthened by: (i) requiring spending agencies to report all expenditure commitments; (ii) bringing the warrant issuance for the development budget (both cash and noncash expenditures) into the central warrant system; (iii) warranting in advance all debt-related payments; and (iv) enforcing the Public Finance Management Act. The Department of Finance and Treasury will support the efforts of spending agencies to stay within spending ceilings by issuing warrants in a timely manner and by communicating clearly on the timing of future warrants.

19.  Monitoring and control of the payroll will be strengthened. The government currently has procedures for tracking public sector employment and wage expenditures on a bi-weekly basis that are sufficient to monitor whether the spending ceilings on the wage bill are being met. This system will be further strengthened by integrating the separately executed payroll systems for education and civil aviation into the central payroll by end-March 2000, and defense by end-June 2000. The government is aware that budget management has been hampered in the past by a lack of a forward-looking centralized information system capable of linking information on approved positions and employees paid. The development and implementation of a system able to meet the needs of budget planning, execution and control, human resources management, and public service management will, therefore, have high priority in the government's public sector reform program.

20.  Monetary policy will be aimed at containing broad money growth to 8.8 percent in 2000, consistent with bringing inflation down to about 5 percent by the end of the year. To achieve this objective, the central bank expects to restrain the growth of reserve money through a substantial decline in its net credit to government. For the banking system as a whole, net domestic credit to government is projected to decline by 11½ percent. Credit to the private sector will grow at 9.2 percent, which would be sufficient to support the growth objective in the nonmineral sector.

21.  In January 2000, the government took steps to make interest rates more market-determined. Under the previous system, the government paid interest to the central bank at an administered rate on the entire stock of treasury bills. The central bank then paid interest at auction-determined rates to banks and other holders of the bills. Under the new system, all treasury bill holders are paid auction-determined interest rates on maturity. The central bank is still responsible for conducting auctions and for making over-the-counter sales of government securities, but it now acts primarily as the government's agent rather than its underwriter. The central bank also retains the registry function for government securities.

22.  To improve the efficiency of the money market, the central bank introduced a "Tap Facility" in 1998, which allows nonbank entities and individuals to purchase treasury bills over the counter from the central bank at the average interest rate obtained during the latest auction. Existence of the facility enhances competition for funds, thereby making deposits and lending rates more responsive to changes in treasury bill yields. The improved linkage between treasury bills and deposit and lending rates is expected to increase the efficiency of monetary policy and help facilitate a downward shift in the entire interest rate structure as inflation declines over the program period.

Structural reform policies

23.  Improving the transparency of fiscal practices is a key element of the government's reforms. To assess the need for improvements, the self-assessment questionnaire in the IMF's Code of Good Practices on Fiscal Transparency is being completed with the broad-based involvement of relevant departments and technical assistance from the Fund.

24.  In 2000 the government will review its budget planning process and establish clear guidelines that will translate government priorities into appropriations for spending agencies, while staying within the available macroeconomic resource constraint. The government will implement these rules in the preparation of the 2001 budget. To further enhance fiscal transparency, the government: (i) has enforced a cut-off date of end-January 2000 for the posting of expenditures to the 1999 general ledger; (ii) will produce an unaudited report on the annual fiscal outturn by end-March; (iii) will ensure that the Auditor General's reports are produced as prescribed by the law; (iv) will publish a midyear budget report, including estimates for the first half of the year and updated projections for the year; (v) will present an annual development budget report alongside the budget; and (vi) will continue to report on public trust accounts in the budget documents.

25.  A public expenditure review was initiated in March 2000 with assistance from the World Bank. It is intended to help: (i) prioritize government functions; (ii) evaluate human resource requirements; (iii) identify functions that can be contracted out to private enterprises; and (iv) determine adequate funding requirements for functions and agencies. Recommendations from the review will be issued by end-June 2000, endorsed by cabinet by end-August 2000, and incorporated into the 2001 budget.

26.  A review of the tax system will be conducted during 2000 aimed at: (i) enhancing fairness in the tax system by ensuring that all taxpayers are treated in an equitable fashion; (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, in order to incorporate its recommendations into the 2001 budget.

27.  Over the medium term (2000-05) the government will implement a comprehensive public sector reform program with assistance from the Asian Development Bank (AsDB), the World bank, and AusAID. The reform will aim at improving service delivery mechanisms and standards, strengthening financial and personnel management systems, and better tailoring government services to the particular needs of different regions. In addition, the optimal size of the civil service will be determined, and necessary adjustments in the composition and number of civil servants will be made on a timely basis. A Public Sector Reform Steering Committee, comprising heads of central agencies, was formed in November 1999 as the coordinating body to initiate and manage the reform process, the design of which will take into account the principles embodied in the Code of Good Practices on Fiscal Trans-parency. Implementation of the public sector reform program will be managed in an open and transparent manner, and in full consultation with affected groups and civil society.

28.  The government is taking other major steps to improve governance. Procedures for improving the policymaking process of the National Executive Council (NEC, Cabinet) were introduced at the beginning of 2000, including a streamlined system of committees to ensure that government agencies are consulted on policy matters relevant to their mandate. Also from the start of 2000, the National Planning Committee has been reestablished to ensure better coordination between the official and political decision-making levels, and to further screen and discuss submissions before they reach the NEC. All decisions taken by the NEC (except for those classified for security reasons) will be publicized. To fight corruption and mismanagement, the government is reviewing the functioning and procedures of the Central Supply and Tenders Board to make sure it carries out its function in the best interests of government in an open, transparent, and accountable manner. The review will commence by end-April and is expected to be completed by end-May. The government will also ensure that the independence and security of funding for the Auditor General and the Ombudsman Commission are fully maintained.

29.  Financial sector reforms are being implemented with technical assistance from the Fund, the World Bank, and the Reserve Bank of Australia to enhance central bank independence and improve the supervision and regulation of bank and nonbank financial institutions. Toward these ends, the government will enact major revisions to three key pieces of legislation.

30.  Under the new Central Bank Act (CBA), which will be passed by end-April 2000, the powers and independence of the central bank and its governor will be greatly enhanced to facilitate the achievement of price stability. The governor, who will be appointed on the advice of cabinet for a term of five to seven years, will have sole discretion over the hiring of all central bank staff and over the choice and use of monetary policy instruments. Aside from an operating overdraft of up to K100 million (which the government could draw at its discretion paying no less than the shortest maturity treasury bill yield), the central bank would be legally prohibited from lending to government for budgetary purposes. It may, however, buy, sell, and hold any quantity of government securities required for monetary management purposes. The government would continue to be able to borrow from commercial banks, and the central bank will continue to act as the government's agent in the auction of treasury bills. To increase transparency, the central bank will publish a semi-annual report in the form of a statement by the governor detailing monetary policy developments, policy stance, and prospects for the coming six months. The central bank is subject to an annual audit and, in addition, the Minister of Finance and Treasury may at any time call for an external managerial or financial audit of the central bank.

31.  A major overhaul of the Banks and Financial Institutions Act (BFIA) is being undertaken to strengthen powers of supervision, regulation, and licensing of bank and nonbank financial institutions and centralize these functions in the central bank. The revised Act will be submitted to Parliament by end-March 2000 and passed by end-April 2000.

32.  During 1999, a number of pyramid schemes began to operate in PNG. The schemes were tolerated and implicitly condoned by the previous government, which issued a number of exemptions from the licensing normally required to operate a deposit-taking institution. The government believes that elimination of these schemes and prevention of their reemergence is essential to the maintenance of confidence and integrity of the financial system and to avoid any potential fiscal cost. Accordingly, the government has taken the following steps: (i) a publicity campaign was launched to warn the public about the inherent unsustainability of the schemes; (ii) the exemptions from licensing requirements were revoked; (iii) a deadline was issued for the schemes' operators to submit full disclosure of their operations; and (iv) authority to prosecute the schemes' owners was delegated from the public prosecutor to lawyers appointed by the central bank. As a result, the two largest schemes have been placed under liquidation. In addition, by clearly defining deposit-taking and lending institutions the new BFIA will outlaw pyramid-type schemes. The government is also pursuing possible means of prosecution under the existing legal framework, including possible offences under the tax and criminal codes, the Companies Act, and the Securities Act. The government will not accept any financial responsibility for losses incurred under these schemes.

33.  By August 2000, a new Insurance and Superannuation Act will be submitted to parliament to address the question of how to regulate and supervise the pension and insurance industries.

34.  In December 1999, the Minister for Finance and Treasury directed the Mineral Resources Stabilization Fund (MRSF) Board to utilize the remaining balance of the fund specifically to reduce the government debt held at the central bank. During 2000 all inflows to the MRSF will be drawn down into the consolidated revenue account for supporting the budget.

35.  The two major pension funds--the Public Officers' Superannuation Fund (POSF) and the National Provident Fund (NPF)--help mobilize long-term savings, foster private sector investment, and provide an important social safety net. The operations of these funds, however, have been subject to extensive political influence, resulting in an underperformance of their investments. Over the medium term, a framework for allowing competition will be developed in which private sector pension funds could compete for contributions. More immediately, to stem further deterioration in the performance, governance, and accountability of these funds, the government will ensure that the funds are audited annually by a recognized accounting firm and that the annual reports, prepared by the external auditor, are certified by the Auditor General and published, as prescribed, no more than three months after the end of the financial year. By end-March 2000, financial and managerial audits will be completed, and the government will prepare an action plan, in consultation with the Fund and Bank staff. Actuarial reviews of these two funds will also be carried out, beginning no later than end-April 2000.

36.  Privatization of the larger public enterprises will be initiated over the course of the program period. The government has already established the Privatization Commission, with a Managing Director and commissioners, and an International Advisory Group, comprising internationally recognized experts in the privatization field. Funding for the Privatization Commission is expected to be provided under the World Bank structural adjustment loan. Actions by the Commission will include, by end-March 2000, the formal identification of state enterprises to be privatized and the formulation of a detailed schedule for: (i) the conduct of appropriate legal and financial due diligence; (ii) auditing; and (iii) the decision on the method of divestiture, including liquidation or sale by international tender. It is expected that parliamentary approval of the amendments to the Privatization Commission Act necessary to enhance accountability will be obtained by end-April. To pave the way for privatization and halt the drain on public finances, the government adjusted tariff rates for the electricity utility in 1999 and the telecommuni-cations utilities in early 2000. The government will keep utility tariffs under close review and will be receiving technical assistance from the World Bank and other donors on tariffs, community service obligations, and other regulatory issues that arise in the context of privatizing of utilities.

37.  While the institutional framework for privatization is being established, the government has taken steps to ensure that privatization of at least one large state enterprise begins immediately. In January 2000, the Prime Minister convened a meeting of the Privatization Commission, the International Advisory Group, and other experts from the Australian Asset Management Office, New Zealand, and the World Bank Group to make recommendations on the modalities for bringing Finance Pacific (a holding company that owns the Papua New Guinea Banking Corporation) to the point of sale by end-2000. The approved privatization process, which has been adopted under the parameters of the Privatization Act and the Public Finance Management Act will proceed in two stages: a trade sale of controlling interest will be brought to financial closure by end-March 2001; and a public offering of the balance of the shares within 12-18 months of the closing of the trade sale. The proceeds of this and future sales will be used for a further reduction of net government debt beyond what is in the baseline program.

38.  The external current account is expected to register a small deficit in 2000, reflecting mainly significantly increased investment associated with the nickel and gas projects. Taking into account purchases from the Fund under the proposed SBA, exceptional financing from donors, the government's foreign exchange earnings and payments, and planned net market purchases of foreign exchange by the central bank (US$12 million), the level of gross official reserves would increase to $379 million (equivalent to 3.6 months of nonmining imports) by end-2000. These projections are consistent with commitments expressed at the Consultative Group meeting held in Port Moresby on November 8-9, 1999, in which donors and international organizations indicated support for fully funding the overall program on a timely basis. Quarterly targets for exceptional financing inflows are set out in Table 2.

39.  The government intends to maintain prudent fiscal, monetary, and exchange rate policies, with the central bank intervening in the foreign exchange market primarily for short-term smoothing purposes.

40.  A prudent external debt policy will be pursued in 2000-01. To contain the growth of debt-service obligations, the government will refrain from commercial borrowing. To this end, the government will limit the contracting or guaranteeing of new nonconcessional external debt with an original maturity of more than one year by the public sector. Cumulative limits on such debt have been established (Table 1). In addition, the public sector will not contract or guarantee debt with an original maturity of one year or less (excluding normal import-related credits).

41.  The government is committed to a liberal trade and exchange system. In 1999, it began implementing its seven-year Tariff Reform Program, under which the average nominal tariff rate will be reduced to 6.4 percent (or an average trade-weighted rate of 4.7 percent), with a schedule containing four main rates (0, 15, 25, and 45 percent) by 2006. The previous average nominal rate was 21.9 percent (average trade-weighted rate of 14.3 percent) with a schedule of five main rates (0, 15, 11, 40, and 55 percent) and prohibitive rates ranging from 75 to 175 percent. The government has decided to accelerate the implementation of tariff reform in order to achieve its objectives over a period of five years. The government will also limit the scope for arbitrary exemptions and will continue its dialogue with the World Trade Organization to identify further trade liberalization measures.

42.  During the period of the proposed SBA, the government will not impose or intensify restrictions on payments and transfers for current international transactions; will not introduce any multiple currency practices; will not conclude bilateral payments agreements that are inconsistent with Article VIII of the Fund's Articles of Agreement; and will not impose or intensify import restrictions for balance of payments reasons.

43.  Prior to IMF Executive Board consideration of the government's request for an SBA, the following actions will have been taken: (i) a monitoring and control system that provides accountability and transparency to the process of allocating Rural Development Program spending, acceptable to the IMF and World Bank, will have been designed and approved by Cabinet (paragraph 16); (ii) a full and transparent accounting of the existing stock of domestic arrears and a time-bound schedule for their progressive elimination by end-2000 will have been adopted (paragraph 17); (iii) an expenditure monitoring and control system will have been established which, among other things, brings the development budget under the warrant system and ensures that no new arrears are accumulated (paragraph 18); (iv) the final form of the CBA will have been agreed with the Fund staff (paragraph 30); and (v) the processes and timetable for bringing Finance Pacific to the point of sale before end-2000 will be developed (paragraph 37).

44.  Quantitative performance criteria for end-June 2000 and end-September 2000, and indicative targets for end-March 2000, end-December 2000, and end-March 2001 will be set initially on the following variables: (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 short-term and medium- and long-term external debt; and (v) the nonaccumulation of external payments arrears. Performance criteria for these variables for end-December 2000 will be set at the time of the first review; performance criteria for end-March will be set at the time of the second review. Purchases under the Stand-By Arrangement will be subject to four reviews, expected to be completed by mid-August 2000, mid-November 2000, mid-February 2001 and mid-May 2001. The outline of the 2001 budget will be discussed with the Fund during the first review and finalized during the second review.

45.  The following structural performance criteria will be observed: (i) by end-March 2000, the financial and managerial audits of NPF and POSF will be completed (paragraph 35); (ii) by end-April 2000, the new Central Bank Act will be passed by Parliament (paragraph 30); (iii) by end-April 2000, the Banks and Financial Institutions Act, in a form that makes pyramid-type schemes illegal, will have been introduced and approved by parliament (paragraph 31); (iv) by end-June 2000, the design and timetable for the public sector reform program will be completed and submitted to Cabinet (paragraph 27); and (v) by end-December 2000, Finance Pacific will be brought to the point of sale (paragraph 37).

46.  Structural benchmarks are to be observed as follows: (i) by end-March 2000, the self-assessment questionnaire on good fiscal practices will be completed and submitted to the Fund (paragraph 23); (ii) by end-March 2000, the Privatization Commission will have identified candidates for privatization and will have formulated a detailed schedule of the timing of actions with respect to privatization and the methodology to be employed (paragraph 36); (iii) by end-April 2000, actuarial reviews of the NPF and POSF will have begun (paragraph 35); (iv) by end-August 2000, recommendations of the public expenditure review will be endorsed by Cabinet (paragraph 25); (v) by end-August 2000 the public sector reform program will be approved by Cabinet (paragraph 27); (vi) by end-September, a report on the tax review will be approved by Cabinet (paragraph 26); and (vii) the government will continue to pursue all available means to close down pyramid-type schemes (paragraph 32).

47.  Quantitative benchmarks will be set: (i) floor on Mineral Resources Stabiliza-tion Fund receipts (paragraph 12); (ii) floor on non-MRSF tax revenue (paragraph 12); (iii) limit on central government recurrent expenditure (paragraph 13); (iv) limit on central government wages and salaries (paragraph 14); (v) floor on domestic arrears reductions (paragraph 17); and (vi) floor on exceptional financing flows (paragraph 38).

48.  The government is aware that there are many weaknesses in the economic statistics of Papua New Guinea, especially in national accounts, price statistics, government finance and balance of payments statistics. The government is seeking to address these, in part through assistance from external sources, including from the Fund.

49.  To facilitate program monitoring and communications with the IMF, the government has requested that the Fund appoint a Resident Representative.