Barker explains forex issues
Papua New Guinea is very unusual in that it has a very strong current account surplus and yet a shortage of foreign exchange and a weakening currency, says director of the Institute of National Affairs PAUL BARKER. The National’s business reporter DALE LUMA spoke to Barker about the state of foreign currency and how it can be restored.
Q: FOR the benefit of some of our readers, what is foreign exchange currency (forex)?
BARKER: Foreign exchange is technically a claim on a foreign country through the holding of some of its currency or bonds. In practice, it’s a store of foreign currencies held in our case by PNG, particularly US dollars as most of PNG’s exports are priced and marketed in US dollars. The currencies, held principally by the banks, the Central Bank (BPNG) and some other financial institutions in cash, but largely in electronic records, are used for trading, and notably to pay for imported goods and services, as well as to pay overseas debts and transactions, such as paying dividends to overseas shareholders. The foreign exchange market is by far the biggest financial market and is conducted across the world, particularly through the major financial centres like London, and transfers one currency into another to be able to effect payments for the goods and services being traded across international borders.
The exchange rate is the rate at which one currency is exchanged for another, and with most countries since the early 1970s shifting to a free or floating exchange rate, managed largely by the commercial banks, with the exchange rate largely set by the market, based upon a range of factors. Papua New Guinea used to have a managed exchange rate until 1996, determined upon the level of trade and the value of a basket of currencies of PNG’s main trading partners. In the mid-1990s, after several balance of payments shocks (leading to a shortfall of foreign exchange) the Kina was devalued and then floated, resulting in it depreciating or falling further in relation to the US dollar and other currencies. That, effectively, drove up the cost of imports, but resulted in higher returns for PNG’s exports, in kina terms, when converted from the US dollar. (It also safeguarded the viability and survival of major agricultural industries in the later 1990s). In practice, however, the PNG currency is not a freely traded currency, which could be described as having a partially managed or guided exchange rate, as transactions are undertaken through the Central Bank and through a managed mechanism that restricts the manner and composition of the trade.
This has restrained the level of market influence in determining the exchange rate, which is effectively set by the Central bank, albeit determined by, but in turn influencing the level of transactions being made, and the availability of foreign exchange to businesses, households and the government for their intended transactions. The current account surplus, means that the value of its exports, combined with what are called its invisible earnings (e.g. from tourism), far exceed its imports and invisible costs (interest, dividends, shipping etc).Indeed, PNG was reputed to have the second highest current account surplus in relation to GDP (Gross Domestic Product) during 2017, after Macau and ahead of Brunei, and yet suffered a major shortage of foreign exchange needed to cover the cost of imports, or planned imports and payments of services, interest and dividends. Normally one would expect, with a major surplus of exports (comprising LNG/oil, gold and other minerals and agricultural goods, forest and marine products), over imports, such as fuel, certain foods, industrial products, including spares, etc, that there’d be more than adequate earnings to cover these planned import costs, but that has not been the case.
It’s certainly true that prices of many of PNG’s main commodity exports fell from mid-2014, reducing the expected export earnings, which otherwise would have been markedly higher, and it’s true that Government entered the market in a big way with expenditure around major events, such as the Pacific Games in 2015 and hosting Apec in 2018, which required a lot of overseas payments for goods and services, but these were not the only determinants of the surprising shortage of foreign exchange. It’s been substantially determined by the major capital investment which occurred in the major resource projects in the late 2000s and early 2010s, and the nature of project agreements and concessional arrangements made with resource developers and financiers, that enabled export revenue to be retained in offshore accounts (such as in Singapore) to service and repay debt, rather than transferred initially into Kina, and concessional or advanced depreciation arrangements and in some cases 10 year plus tax holidays to be granted on certain resource projects.
In some cases, this should merely defer the day when the foreign exchange (and revenue) is eventually received onshore, although in some cases is likely also to restrain these transfers.
Q: How important is forex to businesses and the country as a whole?
BARKER:Availability of foreign exchange is necessary for almost all businesses (directly or indirectly), but particularly critical for businesses that are focused on importing, like wholesale/retail outlets, or having a high turnover of imported goods and services. Most businesses, require some foreign exchange, directly or indirectly, at times to be able to pay for imported inputs, equipment, spares and replacement parts, as services, whether software or overseas skills.
They may need to pay directly or through an intermediary, which secures the forex. With the shortage of foreign exchange, suppliers no longer provide extended credit even to long established and trusted business partners in PNG, and instead require payment up-front, so the costs are pushed well up and there can be long delays, which can leave plant and equipment idle and losing money for the business. Even exporters and manufacturers require imported goods and services to function, and without them lose production, sales, including export earnings in turn. Some businesses have been able to develop a form of barter trade to be able to function, but this is legally problematic and hard to manage.
The Bank of PNG’s data shows that pressure on foreign exchange reduced over the past three years, thanks partly to improved resource revenue flows from the second half of 2018 and international financing in late 2018 (including the Sovereign Bond, World Bank and ADB), with an increase in the months of cover.
They report that outstanding sell kina orders have fallen to K1.9 billion in August 2018 to K1.2 billion in August 2019, a significant improvement, but still a major backlog. However, the increased import cover has been the case largely because forex hasn’t been made available and therefore demand has been constrained forcibly, with some of that demand simply deferred, but in other cases forfeited entirely, undermining overall business turnover and therefore jeopardizing jobs, profitability and tax revenue, in turn. One positive aspect of foreign exchange not flowing into the country has been that it’s imposed downward pressure on the kina, which has provided some stimulus to exporters, for example of agricultural products suffering from low commodity prices, and tourist operators trading in US dollars, by shoring up kina incomes.
However, many economists and some businesses would argue in favour of the kina being more freely convertible and the market setting the exchange rate. They argue that the reduced kina exchange rate would further raise kina prices for export products and import substitution products, including staple foods, fruit and vegetables, providing a greater production stimulus and extra local jobs.
The Central Bank has tended to resist this faster slide of the kina, to discourage perceived inflationary effects, limit increased living costs on low income earners, and suggesting that the production response by farmers in PNG, and in other industries, is too slow and inadequate to justify these hazards, with the Treasury also concerned at the higher cost of servicing foreign debt with a weaker kina. Some modelling by economists, including at the Central Bank, however, suggests that these concerns, of inflationary impacts and low production responses to a weaker kina, are exaggerated, and that the economy would benefit from letting the market find the suitable exchange rate, rather than BPNG continuing to intervene in the market and filter the level of trading. This would enable the market to level out quicker and help restore confidence and constrain unhelpful speculation.
Of course, market confidence is also dependent upon a range of other factors, which influence the readiness of businesses to bring money into the economy and invest, both in major projects, and diverse smaller business activities. Policy stability, political priorities and consistency, including really tackling corruption and other crime, and addressing other key constraints, from basic infrstrucre to business-friendly fiscal conditions are all key components.
Q: The country has been having forex problems as of late, how bad is it?
BARKER:The Forex constraint has been troubling the business community for several years now. Foreign exchange availability was not a problem through most of the 2000s, and with improved commodity prices in the later 2000s, foreign exchange reserves were building up, along with tax revenue to the State.
With the construction phase of PNG LNG, capital was brought into the country; however, once the production phase commenced (in 2014), to the surprise of many in government and the business community, rather than rising, along with GDP, foreign exchange availability diminished, coinciding with the lower commodity prices, major reinvestment and reduced production at Lihir, and reduced activity at some of the other major resource projects, including during the 2015/16 El Nino drought years, and following the 2018 Hela/SHP earthquake. This was combined, as stated, with the relatively concessionary resource project conditions, which allowed company foreign exchange receipts to be retained offshore and limited early revenue flows to be received following capital investment or prior to declared profitability.
Q: How can the country recover and make a turnaround to resolving its forex problems?
BARKER: As stated, in due course, if commodity prices increase, and as project international debts, and advanced investment depreciation arrangements on resource projects mature, by mid-next decade, foreign exchange inflows should increase substantially (along with revenue); major new resource projects and/or extensive SME investment, in the face of improved investor confidence, bringing new foreign direct investment into the country would restore forex reserves and availability. New international borrowings by the Government for balance of payments, fiscal and project purposes, stimulates forex, but would also impose added debt servicing costs and impose issues of sustainability, unless part of a credible debt management plan; failure to plan and manage the growing debt levels would undermine the country’s credit rating and raise the cost of international capital and undermine investor confidence. If and when major increased foreign exchange inflows do eventually occur, the challenges will change, notably with the need to restrain any substantial appreciation of the kina, which would jeopardise the viability of critical industries, which provide much of the country’s economic activity, and particularly employment and prospects.
This requires various policy measures and instruments being in place, operational and managed accountably and transparently, including the long planned SWF, intended to provide revenue and exchange rate stability, as well as funds for investment and future savings.