6.2.1 BCL Investment Boom 1971-72

Construction of the Bougainville Copper Mine brought the first major investment boom to the PNG economy. PNG experienced major foreign capital investment flow in the early 1970s from the Bougainville Copper Project amounting to approximately A$400 million. During the construction period of the Panguna mine of BCL, a massive capital inflow of K223 million in 1971 and K212 million in 1972 was recorded. During these two financial years, BCL accounted for nearly 72 per cent of all fixed capital formation in the country. Thus, 1971 marked the beginning of the BCL investment boom’ as investment in the construction sector grew at the rate of 62 per cent from the previous year’s level.

During the height of BCL construction, the growth rate of gross domestic investment was striking, increasing from 35 per cent of GDP in 1970 to about 47 per cent of GDP in 1971. Total (private and government) consumption increased from K410.0 million in 1968 to K614.5 million in 1972. Export value also increased at a rate of above 26 per cent of GDP in 1971. Imports increased substantially from the previous years and capital goods constituted the major share of imports.

Adjustment towards new economic activities in 1972 was influenced by a number of internal and external factors. Among them, a sharp increase in the world price for major export commodities and a substantial revenue flow from overseas sales of mineral ore by BCL, were the major factors altering the sectoral composition of the PNG economy during this period.

6.2.2 Mineral Boom: 1973-74

The growth rate of approximately 28 per cent in the monetised sector between 1972 and 1973 was wholly contributed by the increased production of mineral (copper and gold) ore from BCL. The mine came into full production at a time when the world prices for copper and gold were rising. The Bougainville mine contributed about 20 per cent of the monetised sector’s GDP in 1972,28 per cent in 1973 and 32 per cent in 1974 (Table 6.1). The increase in the export price index during 1973 outweighed the increase in the import price index and brought an average annual change in the TOT index of 25.6 per cent and 30.2 per cent in 1973 and 1974, respectively, and contributed significantly to export revenue earnings. Thus, 1973 can be marked as the first ‘mineral boom’ in PNG.

The share of exports to GDP increased significantly after the mine went into production in April 1972. The growth in total export revenue was four-fold over the first four financial years of the 1970s, increasing from K101.7 million in 1971 to K363.5 million in 1974. The BCL mine alone contributed about 50 per cent of total export revenue in 1973. The export value of minerals accounted for 63 per cent of total merchandise export receipts in 1973. The import share of consumer goods, fuels and petroleum also increased rapidly during 1973.

Table 6.1 Bougainville Copper Mine’s impact on monetised sector GDP, 1968–74 (kina million at 1968 constant prices)

6.2.3 Commodity Boom: 1976-77

Another major boom in PNG economy that began after the national independence, in September 1975 and monetary independence in January 1976, can be marked as the ‘agricultural commodity boom’. This boom originated from the increased supply of agricultural and other non-mineral exportable sectors which was supported by favourable world market prices for PNG’s primary commodities. The nature and impact of this boom was substantially different from the other major booms as the effects of this boom demonstrate dissimilar changes in relative prices, sectoral growth and income distribution patterns in PNG.

The pattern of income distribution between PNG nationals and expatriates changed during this boom. Papua New Guineans were the major beneficiaries of this boom as they became the direct recipients of an increasing share of income from cash crops exports. As the majority of the PNG population was involved with the agricultural sector for subsistence, most of cash crops which had been dominated by expatriates before independence were now produced under the ownership of local people. The amount of GDP directly accruing to PNG nationals grew at about 10 per cent per annum, in real terms, between 1973/74 and 1981 (Gamaut and Baxter, 1984, p. 66).

Excluding copper concentrate, the export price index for all commodities greatly increased between late 1976 and early 1978. Table 6.2 indicates that the TOT improved significantly by 20.6 per cent in 1976 and 22.2 per cent in 1977, from a negative 54.7 per cent in 1975. From the September quarter of 1976 the value of PNG’s exports grew strongly, largely attributable to buoyant prices for cash crops, particularly coffee and cocoa. The value of PNG’s exports continued to rise, mainly due to higher volume of coffee exports, together with increases in the volume of copper ore and concentrates and other agricultural export commodities.

During 1976, the export value of coffee increased dramatically to K132.62 million, almost a four-fold increase compared to K33.55 million in 1975. The large export receipts contributed by coffee exports were influenced by the high world market price (the export price index of coffee rose by 189 per cent during 1976) and the higher volume (about 35-per-cent increase from the 1975 level) of coffee exported during this year.

6.3.1 Fiscal Policy

The fiscal response to the ‘investment’ and ‘mineral’ booms in the early 1970s was expansionary. As seen from Table 6.3, government expenditure grew substantially. From 1971 to 1975, current expenditure to GDP increased by 30.3 per cent, dominated by wages and salaries (45 to 50 per cent of total) and purchase of goods and services (35 to 40 per cent of total). Capital expenditure shows a declining trend over the same period.

Total revenue increased from 74.2 million in 1971 to 136.7 in 1974 with a 49-per-cent increase in tax revenue and 235-per-cent increase in non-tax revenue (Appendix Table A6.1). The large increase in government revenue over these four years was contributed mainly by the big boost in income and profit, dividends, and royalties from the operation of the BCL mine. The contribution of personal income tax accounted for 30 per cent, while import duties accounted for 28 per cent of total revenue collection.

As predicted by the booming sector literature, government spending increased shaiply during the boom years. The phenomenal increase in government expenditure increased the demand and price for nontradables and reduced the price of tradables relative to nontradables bringing a real appreciation in PNG’s exchange rate.

To deal with the downturn in the PNG mineral sector in 1973-74, the government established the Mineral Resources Stabilisation Fund (MRSF) in 1974 to smooth out the impact of large export revenue flows on the budget and the domestic price level.

Table 6.3 Central government revenues and expenditures, 1971–77 (percentage share of GDP)

Payments into the MRSF come only from large scale mining projects (until then, only BCL) revenues, with funds subsequently transferred into consolidated revenue to produce a steady flow into each year’s budget.

Between 1975/76 and 1980, the MRSF built up reserves in years of exceptionally large mining revenues (1974 and 1980) and ran them down again in years of exceptionally low revenues (1976 and 1978). In 1978, when mineral related receipts dropped by 60 per cent, the flow of funds out of the MRSF fell by less than half yet still contributed 12 per cent of domestic revenue. The MRSF, as a major policy tool of the PNG government, worked successfully to reduce the instability of the internal economic balance until the late 1980s.

Commodity Price Stabilisation Funds (CPSF) operated by the commodity board for three major export crops (copra, coffee and cocoa) also stabilised the prices along a moving long-term average price trend. At the end of 1980, these funds held K160 million and were preparing to pay bounties to producers to compensate for falling commodity prices.

During the agricultural boom, PNG pursued pragmatic economic policies. During 1976-77, the government implemented reductions in real expenditure. Central government expenditure fell 14 per cent as a share of GDP in 1977, from its 1975 level, as financial management focused on the requirements of stability and a deliberate reduction in Australian aid and budgetary grants. In 1977, capital expenditures rose about 41 per cent from the 1975 level, whereas current expenditures grew only 6 per cent between 1975 and 1977 (Appendix Table A6.1).

Over the 1975-77 period, real public consumption expenditure fell by more than 22 per cent and the total real public expenditure fell by slightly less than 9 per cent. A National Public Expenditure Plan (NPEP) was introduced in 1978 to facilitate careful allocation of increases in government expenditure in the light of national priorities. A target of a 3-per-cent increase in real expenditure for goods and services was implemented successfully during 1978-79. The NPEP was also successful in raising the share of capital expenditure in the budget to about 20 per cent before 1980. The Government’s fiscal revenue effort also increased significantly during the second half of the 1970s. Since independence, every budget had included new sources of revenues and steadily reduced the reliance on Australian budgetary support.

Another noticeable influence on economic stability was the steady reduction of Australian aid since 1976. In 1976, the two governments reached an agreement on a five-year aid package in which Australia undertook a policy to provide a minimum annual grant of A$180 million, with annual supplements to be determined on a year to year basis. This arrangement was a great improvement over the previous system which had sometimes resulted in serious disparities between expected and actual assistance. Between 1975 and 1977 Australian aid fell 17 per cent per annum in US dollar terms (Appendix Table A3.7). The 1976 agreement also opened the way for the development of the NPEP based on a steady growth of government spending. Since the level of aid was specified in Australian dollars, devaluation of the Australian dollar, and several revaluations by PNG, further reduced the value of aid to PNG over the period until 1980.

Overall, real government spending up to 1979 reflected macroeconomic prudence. The econometric investigation of RER determinants in Chapter 4 confirms that a reduction in foreign aid and government expenditure improves the competitiveness of an economy. It is clear that, during 1976-77, tight government budgets and reduced reliance on foreign aid helped maintain a stable domestic price level and prevented RER appreciation.

6.3.2 Monetary Policy

Policy instruments for maintaining a stable monetary system have been strengthened since independence, as the monetised sector expanded and the financial system became more developed.

Under the influence of a large balance of payments surplus, the money supply grew 49 per cent in 1976 and 54 per cent in 1977 from K186 million in 1975 to K428 million in 1977, contributed by increased income in the stabilisation funds for coffee, cocoa and copra growers. This large increase in the money supply in 1976 and 1977 also indicated the growing reliance in monetary policy.

The CPSF, which were set up to stabilise prices to producers, also helped dampen the effects of commodity price cycles on the domestic money supply, since the majority of their assets was held in the Central Bank. The CPSF reduced monetary instability as they developed substantial reserves between 1976 and 1979 when export prices were exceptionally high. About 60 per cent of these reserves were deposited in the Central Bank. The remaining 40 per cent deposited in the trading banks was available to support increased bank lending and thereby increased the money supply. The disbursements from the deposits held with the BPNG had reduced the monetary contraction associated with low export prices.

During 1976 to 1979, the stance of monetary policy was more or less passive. Domestic interest rates remained steady and were generally below international levels. From the early 1980s, there was a shift towards a more active and interventionist monetary policy.

6.3.3 Trade Policy

In the early years after Independence, PNG maintained a very open trade policy regime with primary reliance on market forces to promote industrialisation. During the 1970s, established firms experienced very little government interference in the form of quantitative trade restriction. Until the early 1980s, taxes on international transactions were low and generally comprised of a low and uniform import tax. No import bans or quotas were imposed although some interventions were made on an ad hoc basis to protect certain infant industries such as flour, poultry and animal feed (World Bank, 1981). Capital goods and raw materials were exempted from tariffs. Duties on manufacturing goods ranged between 10-18 per cent. A basic levy of 2.5 per cent was imposed on most imported goods, except for medicine and basic foods, and a tariff of up to 50 per cent was imposed on luxury goods. Given the lack of clear policy objectives, the impact of these ad hoc trade policy measures is not clear (World Bank, 1981).

Export taxes on primary products were set at 2.5 per cent. An export incentive scheme and tariff draw back system was also available during the 1970s for manufactured export industries. As a result of improved agricultural export prices, a 2.5-per-cent export tax for copra, tea and rubber was reintroduced from 1 January 1977. PNG also enjoyed duty free access for most of its primary exports to Australia, New Zealand and the EEC countries under the Lome Convention.

6.3.4 Exchange Rate Policy

In a period of rapid international inflation, the PNG government followed an exchange rate policy designed to help control imported inflation and achieved high level success in this regard as PNG’s rate of inflation has been one of the lowest in the world in 1975 (Goodman et al., 1985). Because of the very high import content of most consumer goods and intermediate goods. In the absence of trade restrictions in PNG, the relative prices of goods and services within the domestic economy were determined to a large extent by the corresponding relative prices set in international markets. Allowing these relative prices to determine an efficient allocation of resources, the government used the exchange rate to influence the absolute level of domestic prices. As shown in Table 6.4, there have been a number of exchange rate changes since monetary independence. The exchange rate of the kina appreciated against most currencies except the German Mark and the Japanese Yen. Currency appreciations relative to its major trading partners, combined with measures to

Table 6.4 The foreign exchange value of kina, 1975–80 (IK = units of foreign currency)

prevent a real increase in wages, resulted in a rate of inflation lower than that experienced by PNG’s major trading partners during the second half of the 1970s.

6.4.1 Effects on Key Macroeconomic Variables

The effects of a resources boom on the key macroeconomic variables are examined by analysing the changes on the aggregate demand side of the economy. Both private and government consumption increased during 1972-74 but export growth was much larger than the growth in consumption. The fall in private consumption by expatriates in 1972 was compensated by increased consumption by locals, with final private consumption remaining at around K357 million over 1971-72 (Table 6.5). Government consumption was about 0.9 per cent higher in 1973 than the 1970 level.

Private foreign investment in the construction sector increased from A$96.9 million (K107 million) to A$414.8 million (K454 million) in 1972 at current prices. Investment spending on the BCL mine fell to A$20 million in 1972 from an average ofA$ 100 million in the previous years (World Bank, 1976). Other private investment was much the same in money terms as in previous years. The large volume of copper production and exports by the BCL mine, contributed to a large surplus in PNG’s balance of payments (BOP) in 1973.

In 1973, the trade account exhibited a surplus of K15.5 million from a deficit of K160 million in 1972. Most of this improvement was offset by the distribution of income and dividends payable to overseas shareholders plus the payment of interest and debt repayments. Nevertheless, the balance of payments on the current account improved from a deficit of K140 million in 1972 to a surplus of K42.5 million in 1973. The current and capital account surplus over 1973-74 brought a balance of payments surplus of K29.2 million in 1973 and K153.2 million 1974. The non-market primary and subsistence sector, which then accounted for 40 per cent of the economy, grew by more than 4 per cent with an output of K132 million in 1973 from K126.5 million in 1971.

Data on consumption expenditure show a declining trend in the real growth of

Table 6.5 Gross domestic expenditure, 1968–74 (at constant 1969 prices, kina million)

both private and public consumption spending over the period of 1976-77 (Table 6.6). Real private consumption increased moderately but public consumption fell 22 per cent in 1977. Most private consumption expenditures were on food, beverages, cigarettes, beer and motor vehicles. During 1976/77, gross fixed capital formation grew by 23 per cent in real terms, to K113.0 million in 1977 compared with K87.5 million in 1975, mostly contributed by the private sector.

Gross domestic investment increased by 26 per cent in 1977 from its previous year’s level and contributed 13 per cent to total GDP. Private investment also showed an increasing trend over the same period. Expenditure on plant, equipment and buildings increased with a very significant increase indicated for plant and equipment in the Highlands in 1976, during the December quarter. Inventory investment for raw materials and intermediate inputs and stock of finished goods also showed an increasing trend in this quarter.

By industry classification, investment in primary production, building and construction, motor vehicle and machinery distribution reported strong growth. Both gross domestic savings and investment increased substantially with gross domestic investment increased from 15 per cent in 1973 to more than 22 per cent in 1978 which indicates that the boom was perceived by households as a temporary one. As a result, the agricultural boom in 1976-77 induced a subseqcent construction boom, indicated by increased production in the construction and building sector, and reduced inflationary pressure on the nontradable goods market. Between 1975/76 and in 1980, the public sector’s real investment doubled which was very conducive to long-term steady growth. This outcome is predicted by the theoretical propositions of a construction boom where the private sector correctly perceived the nature of a resources boom and increases investment in nontradable capitals due to imperfection in the under-developed capital market. This outcome is also verified by the econometric results of Chapter 5.

In 1977, the total value of exports increased relative to the total value of imports and brought a large current account surplus. The strong current and capital account balance during 1976-77 brought an overall balance of payments surplus of K34.6 million in 1976 followed by a huge K110.3 million in 1977. This substantially reduced PNG’s net foreign indebtedness over the first four years of monetary independence.

6.4.2 Relative Price Effect

The indices of most important price series have been shown in Tables 6.7 and 6.8, indicating the relative price movements over 1970-80. The CPI shows a sharp increase in 1973. The CPI rose 5.6 per cent in 1971 followed by 3.5 per cent in 1972.

But the index rose by 31 per cent during 1973, with food components (including alcohol, tobacco and betel nuts) dominating the index. Following the sharp increase during 1973, the rate of price level increase slackened markedly from the first quarter of 1974 and the inflation rate stood at 7.5 per cent over the year. Imported inflation

Table 6.7 Changes in key price indices, 1970–80 (1970=100)

Table 6.8 Changes in key price indices of export and import–competing industries, 1970–80 (1970=100)

impacted on PNG’s inflation rate during 1975. Table 6.7 also indicates an increasing trend for the prices of tradables. The average trade-weighted nominal exchange rate (RER1) appreciated 1.2 per cent against major trading partners’ currencies over 1971—74. The increase in domestic CPI was much higher than the increase in the price of tradables, bringing a significant reduction in the relative price of tradables to the domestic CPI during 1973. While the trade-weighted real exchange rate (RER1) appreciated 18 per cent in 1973 from the previous year’s level, the real exchange rate for exports and the import-competing sector depreciated by 50 and 16 per cent, respectively, in 1973, due to increases in world price for PNG’s export commodities (Table 6.8).

Table 6.8 indicates that the real exchange rate for export- and import-competing industries depreciated as the export and import price indices rose more rapidly than the domestic price of nontradables (weighted average of nontradable components of CPI) over the 1972-74 period. It can therefore be concluded from the empirical analysis and the econometric investigation that the appreciation of the trade-weighted real exchange rate in 1973 might have been overestimated due to a sharp increase in the CPI which itself contains a considerable amount of tradable items.

During the commodity boom of 1976-77, the kina value price of tradables continued to rise, while domestic inflation began to decline in 1976. Increased tradable prices, and an inflation rate of 0.4 per cent in 1977, increased the prices of tradables relative to the domestic CPI (Table 6.7). This change in relative prices brought about a 5-per-cent depreciation of the trade-weighted real exchange rate which was a significant improvement over a 4-per-cent appreciation of the real exchange rate in the previous year.

Real exchange rates for the export and import competing sectors also indicate a substantial depreciation. In 1977, the export price index increased by 25 per cent and the import price index increased about 6 per cent compared with a 2-per-cent increase in the domestic price of nontradables (Table 6.8). It is interesting to note the real exchange rates depreciated significantly in terms of all alternative measures at the height of the agricultural boom in 1977, which can be attributable to prudent policy choices during the 1976-77 period.

Note: RER1= trade-weighted real exchange rate

Source: Equation 4.1

Figure 6.1 Actual and estimated real exchange rates in PNG,1972-94

Figure 6.1 indicates that the actual real appreciation of the trade-weighted exchange rate was greater than estimated real appreciation due to the very high inflation induced by the dramatic increase in nominal wages and government spending in the nontradable sector during the mineral booms of 1973. But during the 1976-77 commodity boom, the actual real depreciation was much higher than what is predicted by the estimated model. It seems to reflect the impact of income and wage restraint policies, as well as reduced aid and grants flow from Australia. The proposition that the open trade regime of the 1970s also reduced appreciation of the real exchange rate over the period, is supported by the econometric results in Chapter 4.

6.4.3 Effects on Employment and Wages

This section attempts to analyse the changes in employment and real wages in PNG during the resources booms of the 1970s. As discussed in the theoretical framework, a resources boom shifts labour from the non-booming traded sector to the nontradable sector as the price of traded goods falls relative to nontradables. This shift of labour is likely to have enormous ramifications for wages and overall distribution of income.

Available data on employment in monetised activities suggest there was an increase in total formal employment during the boom years. Total formal employment increased from the 1968 level by about 11 per cent in 1973 with a substantial increase in public and mining sector employment, although private non-mining employment shows a declining trend (Appendix Table A3.6). This outcome confirms the booming sector theoretical proposition that labour shifts from the non-booming private sector to the more profitable booming mining and nontradable public sectors. Available limited data on wage rates in Table 6.9 indicate that both real and nominal wage increased rapidly during the early 1970s, with employment in the non-mining sector failing to keep pace with the wage rise.

The declining trend for private non-mining employment growth appears to have been closely related to the increase in real wages. The rise in domestic CPI was 13 per cent on average whereas the nominal weekly wage rose 56 per cent for urban workers and 13 per cent for rural workers over the 1972-75 period.

As a result, rural and urban real wages increased on average by 0.5 per cent and 30 per cent, respectively (Table 6.9). The higher cost of labour due to this substantial increase in money wages and salaries added upward pressure to domestic prices, exacerbated inequality between rural and urban incomes, and adversely affected employment. It is evident from the wage and price data that the increase in real wages during the high inflationary period was clearly influenced by the deliberate implementation of a wage policy which raised the urban nominal wage faster than domestic price level changes.

It is noticeable that during the BCL investment and mineral boom in 1971-74, a large share of the wages bill went to pay skilled expatriate labourers. As a result, the enclave nature of these booms did not have much spill-over effect on the vast non-mining sector’s employment and spending behaviour. The mobility of labour across national boundaries reduced the spending effects of the resources boom which might have helped to keep the domestic price level relatively stable, as discussed in the extension of ‘Dutch disease’ theory under the openness of the labour market in Chapter 2.

Table 6.9 Changes in real and nominal weekly wages, 1967–85

It has been the policy of the PNG government, since independence, to maintain a steady trend in real wages. The wage structure that was determined between 1972 and 1975 posed a number of problems. The wages study by Gamaut and Baxter (1984, p. 99) suggested that employment growth was very slow when urban minimum wages were rising 50 per cent during 1972-76, and indicated that the high level of wages was one of the major factors responsible for depressing the level of employment and the pace of employment generation in PNG.

Except for the mining sector, urban wage employment growth was relatively stronger from 1976 because of the direct spending effects of the agricultural boom. The growth in rural wages shows this effect. The growth in urban wages is also quite significant, given that they were already artificially high as a result of the MWB ruling in 1972/73. The government’s institution of a temporary wage freeze in 1976, was successful as an initiative to reduce the inflationary wage spiral. After that, until 1992 wages were indexed at, or slightly below, the growth rate of the urban based consumer price index. Minimum Wage Boards had accepted the argument that wage determination should be restrained to encourage the growth of income earning opportunities and to allow the government to increase the share of new development spending in the budget. Although rural wages rose slightly, the result was a reduction of 2 to 6 per cent in the real value of urban minimum wages for unskilled labourers between 1976 and 1980.

Over the period 1977-79, total wage employment increased by 1.7 per cent annually, with an increase of 2 per cent in private sector employment, while employment in the mining and public sector remained steady (Appendix Table A3.6). Rural nominal wages increased on average by 9.7 per cent, but urban wages rose by only 3.5 per cent in 1978, from the 1975 level. Costs and prices increased due to continued increases in the cost of materials and supplies, but labour costs increased only marginally. In 1978, real rural wages rose by 3.4 per cent, but real urban wages fell by 1.9 per cent as a result of temporary wage freeze in 1976.

6.6.1 Resources Boom: 1992-93

The rapid economic growth in the early years of the 1990s came largely from growth in minerals and petroleum production along with spin off activities in other non-mining sectors. Oil production from the Kutubu oil project accounted for 10 per cent of GDP in 1992. Oil exports earned K301 million in 1992 increasing up to an estimated K848 million in 1993. Production of petroleum from the Kutubu project alone provided 37 per cent of total exports in 1993 from nothing in 1991.The combined share of the minerals and petroleum sector in GDP improved from 15 per cent in 1990 to about 30 per cent in 1993, and provided 30 per cent of government revenue. Non-mining GDP also increased by 5 per cent in 1991 but then came down to 1.1 per cent in 1993.

Between 1991 and 1994, the value of total exports increased enormously. Mineral exports increased from K758 million, or 32 per cent of GDP, in 1990 to K1768, or 53 per cent of GDP, in 1993. From K205 million in 1990, agricultural exports increased to K270 million in 1993 and K375 million in 1994. Revenues from log exports increased more than six fold from K80 million in 1990 to K494 million in 1994.

6.7.1 Fiscal Policy

The PNG government’s undisciplined fiscal policy was a major issue of concern during 1990-94. The fiscal deficit widened in 1990 with the closure of the Panguna mine at Bougainville. Government internal revenue and grants fell from K1014 million in 1989 to K998 million in 1990 while total government spending increased from K1049 million in 1989 to K1089 million in 1990. In 1991, government revenue recovered to 1989 levels and grew rapidly over 1992 to 1994, owing to increased revenue flows from the boom in the minerals and petroleum sector.

In 1991 central government expenditure increased by K99 million with large increases on education, defence, transport, public debt servicing and transfers to local and provincial governments.

The economy absorbed the mineral windfalls through current consumption as the boom was perceived as lasting a longer period. This is evident from the shaip rise in government expenditure over the years 1991 and 1993, which contributed to a fiscal deficit of 5.6 per cent in 1992 and 5.9 per cent in 1993.

Table 6.11 Key economic indicators, 1989–94

The 1994 budget was expansionary at the beginning of the year but later changed to a more restrictive policy stance owing to the sharp increase in the fiscal deficit. By early 1994, the price support programme announced in 1992 was creating significant pressure on government expenditure, and the budget deficit had grown to 11 per cent of GDP by the middle of the year. The government announced another mini budget to reduce the deteriorating fiscal situation largely due to an unexpected but shaip decline in oil prices. As prices rose in mid-1994, the subsidy for coffee became redundant. By the end of the year, the adoption of an expenditure restraint policy had reduced total government expenditure to K1570 million. Higher than expected mining revenues, as well as cuts in crop price support and transport costs, increased total revenue and grants of K1446 million, reducing the budget deficit to 2.3 per cent (AusAID, 1996).

A positive balance in the MRSF over this period gave a misleading conception of the government as a net saver. Over this period, continuous fiscal deficits simply indicated that the government effectively borrowed from the private sector to augment the MRSF. Between 1990 and 1994, public sector debt increased to K2.9 billion, or 48 per cent of GDP, and the debt servicing requirement increased to K86 million. To finance these continuous budget deficits, foreign debt rose to US$4.2 billion with debt servicing costs rocketing to over 30 per cent of export earnings (AusAID, 1995).

6.7.2 Monetary Policy

In mid-1991, the BPNG changed monetary policy from a liquid asset requirement to a base money management approach, adopting open market operations as the principal policy instrument. This monetary approach was reasonably successful in keeping liquidity growth under control. As fiscal deficits grew, and interest rates remained above those in Australia the BPNG faced enormous pressure to keep interest rates under control. However, at the end of 1992 and in mid-1993, lending rates were lowered, narrowing the spread somewhat (Table 3.9).

During 1992 and 1993, private sector credit growth was above 4 per cent but liquidity had fallen due to a substantial decline in foreign assets. Total money showed an increasing trend over the period. The growth rate of money supply increased from 4.2 per cent in 1990 to 17.7 per cent in 1991 and then eased back to 12.5 per cent in 1992 whereas real GDP grew at a slower rate than money supply by 9.5 per cent in 1991 and 11.8 per cent in 1992.

In 1993, money supply of about 27 per cent was much higher than 16.6 per cent growth of real GDP (Table 3.9, Table 6.11 and Table 6.12). The econometric results in Chapter 4 indicate an excessive growth rate of money supply (growth of money exceeds GDP growth) had an adverse impact on the real exchange rate of PNG. The RER appreciated by 5 per cent in 1993 (Table 6.15).

Although the growth rate of money supply fell dramatically to 2.3 per cent in 1994, the burden on the banking system of financing the entire budget deficit domestically, resulted in tighter credit conditions in the private sector and foreign assets, putting further upward pressure on interest rates.

The introduction of a floating exchange rate system in October 1994 impacted substantially on how monetary policy was conducted. Since the BPNG has no obligation under the floating system to sell or buy foreign currencies at a particular exchange rate, it could set the level of the money supply independently, and the weighted average of commercial bank lending rates increased substantially from 10 per cent in December 1994 to 15.4 per cent by December 1995. Private sector demand for credit was affected by adverse fiscal and monetary conditions in 1994, the subseqcent high interest rates in 1995 and the uncertain investment climate.

Table 6.12 Major economic indicators before and during the 1991–93 boom

6.7.3 Trade Policy

Until the early 1980s, PNG followed an open trade regime, with taxes on imports and exports quite low and relatively uniform. From the mid-1980s, an increasing number of trade interventions were introduced to achieve an assortment of revenue, protection and distributional objectives. Tariff policy has been seen as an instrument of industry policy to promote the interest of a particular sector or industry. The protective policy introduced in PNG produced widely differing rates of effective protection and served the interest of producers focussed on the domestic market. Import bans and very high duties on selected products created an incentive structure with high levels of effective protection for a limited range of activities and a strong bias against exports and the agricultural sector. Table 6.13 shows that currently 68 per cent of 5,366 total tariff items are taxed at rates of 11 per cent or below. The remaining 31 per cent items are protected at rates of 40 per cent or higher. In the early 1980s, the tariff rate for a smaller number of import competing industries was 10 per cent which was increased to 17.5 per cent in the mid-1980s, and sharply increased in the early 1990s to 30 per cent for all goods where there was domestic production (Fallon et al., 1995). The rise in import protection has been accompanied by bans on certain food items, import quotas, and special privileges given to cement, canned meat and sugar industries.

As shown in Table 6.13, currently 2 per cent of imports are duty-free. Basic food items such as rice as well as medical supply and equipment, books and kerosene are exempted from duty, while a 5 per cent tariff is imposed on 22 per cent of tariff items classified as basic inputs to production.

The basic tariff rate of 11 per cent is imposed on the largest category which

includes many foodstuff items, textiles, production inputs and raw materials. The current rate of 40 per cent is on the category of goods that are produced or potentially can be produced in PNG. A 55-per-cent restrictive tariff is imposed on 504 tariff items, including fish, some toiletries, photographic Aim, wood boards, carpets, pearls and precious stones, steel netting and fencing, double cab vehicles and motor cycles, arms and ammunition and furniture. Another 2 per cent of importable items are subject to a prohibitive tariff rate of 75 to 175 per cent. The specific import duty rates are imposed K3.50 per kg of poultry and K0.05 per box of matches. When these special rates are converted into ad valorem form, they provide very high levels of protection. The ad valorem rates include many vegetables and fruits (75%), vehicles (75%), sugar (85%), tinned mackerel (99%), beer (125%), cigarette and cigars (125%), veneer and plywood (100%), and door frames (100%).

Table 6.14 indicates currently in PNG the average nominal tariff rate is 21.9 per cent and the trade-weighted tariff rate is 14.3. At a broader industry classification level, the highest level of nominal protection is given to fisheries (53.9%), agriculture (46.3%) and food processing (46.1%). Both the nominal and trade-weighted tariff is on manufactured articles imposed at about 30 per cent.

Although PNG’s nominal rate of tariff is not exceptionally high, some of the tariff barriers, especially on fish and fish products, food processing, leather, rubber and footwear and other manufactured articles have been imposing significant costs on the most efficient import-competing and export-oriented sectors as well as on consumers.

The limitations of this trade policy have been recognised by successive governments, and several unsuccessful attempts have been made in recent years to reform the system.

In the 1990s, promotion of export oriented manufacturing was regarded as a longer term goal. Under this programme the PNG government decided to remove all import bans and introduce tariffs where protection was required to continue. The result was high tariffs on several items, such as poultry, but a decision to remove the remaining bans was postponed (AIDAB, 1993, p. 19). In 1992, the PNG government took further initiatives to reform trade policy by replacing quantitative restrictions with more uniform and simple import duties (at around 10 per cent). This reform was also directed at removing export taxes, except for logs and unprocessed shells (AusAID, 1995, p. 142). Tariffs on a number of commercial inputs, including fuels, spare parts and transport equipment were subsequently reduced in the 1993 budget, but the general import levy was also increased, from 8 per cent to 10 per cent, and again to 11 per cent in 1994 with its coverage extended to a range of goods including some agricultural and manufacturing inputs that had previously been exempted.

The 1993 budget also proposed highly restrictive tariff protection on some chosen goods and individual manufacturers and projects and continued a ban on sugar imports which was overtly inconsistent with underlying trade reform principles. This budget increased further restrictive protection for the Lea Mackerel Cannery and the Halla Cement Factory. From September 1993, a nominal monopoly was given to the sole domestic producer of cement, where users could import cement only with a special licence. As a result, the prices of cement increased more than 50 per cent. The 1994 budget again imposed a protective rate of duty of another 11 per cent on basic consumer goods used by the low income consumer while reducing duties on luxury items. The Supply Bill of November 1994 raised the protective rate of duty to 40 per cent.

6.7.4 Exchange Rate Policy

Since monetary independence, under the influence of the ‘hard kina’ policy, PNG maintained a convertible currency and until 1980 was successful in maintaining low inflation, relative to world inflation. Domestic inflation increased sharply in 1981-82 and remained relatively high up until 1984 (Appendix Table A3.2). From June 1978 to October 1994 the kina was pegged to a basket of currencies of its major trading partners. The kina was devalued by 10 per cent in early 1990 and in 1993 appreciated by 1.7 per cent against the Australian dollar, 0.9 per cent against the US dollar, and 10.3 per cent against the German Deutschemark but depreciated by 9.4 per cent against the Japanese yen. On 12 September 1994, the kina was devalued by 12 per cent against the US dollar. The PNG government decided to float the kina in the face of a worsening foreign exchange crisis on 4 October 1994. By mid-1995 the kina had declined by more than 40 per cent in nominal terms from the level 12 months earlier.

6.8.1 Effects on Key Macroeconomic Variables

During 1991-93, both private and public consumption growth were moderate. The share of private consumption to GDP fell from 60 per cent in 1991 to 51 per cent in 1993. Overall government demand remained at about 28 per cent of total GDP with a public consumption demand of 20 per cent of total GDP in 1993 compared with 22 per cent in 1991. Total private demand (consumption and investment) declined significantly from around 88 per cent of GDP in the early 1980s to around 68 per cent of GDP in 1993 (AIDAB, 1994). This relative decline in private spending reflected diminished optimism in private consumption and private investment. The construction of the Porgera and Kutubu projects contributed to a sharp increase in private fixed investment which accounted for more than 23 per cent of GDP in 1991. Gross domestic investment increased to 27.4 per cent of GDP in 1991 and then declined to 20.3 per cent of GDP in 1993.

The value of merchandise imports grew by 26.5 per cent from 1990 to 1991 due to K250 million in capital imports associated with the construction of the Kutubu oil project. General imports also increased by 25 per cent indicating a general recovery in the economy. However, a continuous rise in export revenue and a substantial reduction in capital imports more than offset the increased imports of consumer goods between 1992 and 1994. The value of merchandise imports declined by 4.6 per cent in 1992 as a result of reductions in mining, petroleum and general imports. A further decline of 14.9 per cent in merchandise imports in 1993 was due to a lower level of imports by the mining and petroleum sectors. As a result, the trade surplus grew rapidly to K1437 million in 1993 from K75 million in 1991. The balance on die current account changed from a deficit of K144 million in 1991 to a surplus of K632 million in 1993 despite a large increase in services payments and net transfers associated with the mining sector.

Despite a large current account surplus, and a 10-per-cent devaluation of the kina in 1990, the overall balance of payments continued to weaken over the period 1991— 93 with an overall deficit of K68 million in 1992 and K96 million in 1993. This large deficit in 1993 was mainly brought about by the large capital account deficit of K701 million. The capital account deficit was mainly attributed to substantial increases in the private capital outflow, reflecting deterioration in private sectors’ confidence in a volatile investment climate. The outflows were also facilitated by the liberalisation of foreign exchange controls in 1992. As a consequence, international reserves fell to K112 million in 1993 from K309 million in 1991. In 1994, the value of merchandise imports increased by 16.9 per cent due to increased capital imports by the Porgera mine. However, the surplus in the trade account increased to K1346 million and the deficit in the capital account was K605 million. The overall balance of payments situation improved substantially in this year. The lower balance of payments deficit of K26 million was the result of higher merchandise exports, lower service payments and lower outflows of private capital.

6.8.2 Relative Price Effect

The inflation rate was 6 per cent in 1990 and 5 per cent in 1991 easing back to 4 per cent in 1992. This relative decline in the price level was mainly influenced by lower inflation in Australia, the major source of PNG’s imports, as well as by the appreciation of the kina against the Australian dollar. The CPI index rose to 7.2 per cent in 1993 but slowed down to a lower rate of 4.6 per cent during 1994. The kina value of tradables increased more than 17 per cent in 1990 which brought a 10.5-percent depreciation of the trade-weighted real exchange rate.

Over 1991-93 period, price of tradables increased less than one per cent (0.76 per cent) on average whereas domestic CPI rose by 5.6 per cent. The increase in the domestic price level relative to PNG’s major trading partners resulted from increased government spending, which appreciated the trade-weighted real exchange rate by 4.4 per cent. As the price of tradables increased substantially with a fall in the domestic price level to 4.5 per cent and a depreciation of the nominal exchange rate by 34 per cent, the trade-weighted real exchange rate depreciated more than 28 per cent in 1994 (Table 6.15).

Until 1992, the growth in the export price index was slower than the domestic price of nontradables but the index increased sharply during 1993-94 due to improved world market prices for PNG’s mineral and agricultural products. Real exchange rate for export sector depreciated by 8.5 per cent in 1993 and 15.4 per cent in 1994. In both years this was the outcome of greater increase in export prices compared to an increase in domestic price of nontradables.

The real exchange rate for import competing industries appreciated over 1991-93 before depreciating slightly at about 0.6 per cent in 1994 (Table 6.16). The movement of real exchange rates suggests that the relative price of tradables to nontradables declined over the 1991-93 period.

Table 6.15 Changes in relative price indices, 1988–94 (1990=100)

Table 6.16 Changes in relative price indices of export and import-competing sectors, 1990–94 (1990=100)

Appreciation of the real exchange rate was driven by a rapid fall in the inflation rates of PNG’s major trading partners. Increased domestic inflation was also aggravated by persistent expansionary fiscal policy and an increasingly restrictive trade regime. From the late 1980s until 1993, the increase in the domestic price level was higher than the price of tradables, which greatly reduced competitiveness of the economy and appreciated the real exchange rate substantially. This outcome is supported by the econometric results in Chapter 4, which indicates increased government spending significantly appreciates the real exchange rate, at least on a year to year basis. From 1994, PNG began to regain some competitiveness for its export commodities.

6.8.3 Effects on Employment and Wages

In 1990-91 employment in the private non-mining sector declined by about 4 per cent on average. Mining sector employment was also in a declining trend because of this sector’s capital intensive nature. The employment situation recovered in 1992 due to increased spin off activities in the non-mining sector, especially in agriculture. Employment in the formal sector declined by 3 per cent in 1993. The BPNG’s 1994 employment survey recorded a 10-per-cent decline in private formal sector employment. Both rural and urban nominal wages rose about 11 per cent in 1992 from 1990 levels whereas the real wage remained constant at about K25 weekly for urban and K9.4 weekly for rural workers over the 1990-92 period at 1977 prices (Table 6.17).

Introducing a land mark wage policy in 1992, the Minimum Wages Board Determination (MWBD) lowered urban minimum wages for new entrants and abolished wage indexation. Since 1992, private sector wages have been determined by market forces, subject to a national minimum wage set by the MWBD. The MWBD decision changed the focus of wage negotiation from an income based approach to a productivity based approach. It unified the dual system of urban and rural minimum wages at the much lower rural wage level and introduced a new national youth wage set at 75 per cent of the new national minimum. This

Table 6.17 Real and nominal weekly wages, 1988–93

policy opened the way for achieving a reduction in the real exchange rate through a nominal exchange rate devaluation. A decline of 61 per cent in the nominal urban wage in 1993 brought a 63 per cent reduction in real urban wages compared with the 1992 level. A 3.5-per-cent growth in the nominal wage in 1994 resulted in a less than expected 2.1-per-cent decline in the minimum real wages.³

6.10.1 Contribution of Savings and Investment

Given the constraints on the mobilisation of foreign direct investment and other kinds of foreign resources, a sustainable rate of investment can only be achieved by a raising of the domestic savings rate. Investment is therefore crucially dependent on the overall economic condition that is conducive to mobilising both private and public savings and the ability to attract foreign savings and direct foreign investment.

From the late 1960s, investment policies of the PNG government have addressed these two key issues, as well as providing incentives to influence investment in specific key sectors. Private sector contribution to gross domestic savings and investment played a crucial role in the development of the economy as it had a positive and direct influence on the long-term growth of PNG.

During the 1970s, PNG’s investment and savings performances were high enough to build a foundation for long-term growth. Between 1970 to 1972, the contribution of gross domestic investment to GDP was 40 per cent, funded mainly by foreign savings and direct foreign investment. During 1973-76, the contribution of gross domestic investment to GDP declined sharply with the completion of the BCL mine and the lack of new foreign investment projects.

The share of gross domestic savings to GDP began to rise from 1972 and accounted for 28 per cent of GDP on average over 1973-76. Gross national savings

Table 6.18 Investment and savings, 1970–94 (percentage share of GDP)

also rose to 19 per cent of GDP on average over this period and resulted in a positive resources gap which accounted for 10 per cent of GDP (Table 6.18).

Between 1977-80, the share of investment to GDP increased compared with the previous period and both national and domestic savings remained at comfortably high levels.

These figures indicate the PNG government was wise to utilise its windfall gain from the first two major resources booms of the 1970s and to save a large portion of its windfall, facilitating economic development in later years. During the 1980s, PNG’s share of investment to GDP was comparable with other lower middle income countries of the world. Between 1981-85, gross domestic investment averaged around 27 per cent of GDP and a large share of this was in the form of direct foreign investment. Over the first half of the 1980s, both domestic and national savings declined due to unfavourable economic conditions but regained a satisfactory level during the second half of the 1980s.

In 1991, gross domestic investment reached a peak of 28 per cent of GDP and declined over the next three years due to a reduction in mining investment. Among other factors, instability in government policy relating to resource development was the major factor in explaining this declining trend of gross domestic investment over the period.

During 1991-94, private sector investment averaged about 17 per cent of GDP, but public sector investment fell to about 5 per cent over the period (Table 6.19). Until 1992, domestic investment was funded mainly by private and foreign savings. From 1992, major investment projects were solely funded by domestic private savings as foreign and public savings continued to decline. The share of private savings to GDP declined substantially in 1993, as the private sector was called on to finance

large budget deficits and to make up the shortfall in foreign financing of government transactions. Despite the large capital flight during 1992–93, and significant public and foreign dis-saving since 1992 as a result of large debt repayments by the government and diminished confidence by investors in the mining sector, private saving’s contribution averaged 30 per cent of GDP over 1991–93. Thus, private sector savings have played an important role in building up the necessary capital stock conducive to the long-term growth of the country.

Private sector savings behaviour clearly indicates the consumption smoothing behaviour which supports the central theme of the theory of ‘construction boom’ by the private sector. The econometric results in Chapter 5 confirmed that there is a significant positive effect of real GDP growth (contributed mainly by the increased windfall income) on the private and total savings of the nation. These empirical and econometric findings indicate the farsightedness of private sector savings decisions.