Economic Policy in PNG: 2010 - 2020 Institute of National Affairs - - PowerPoint PPT Presentation

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Economic Policy in PNG: 2010 - 2020 Institute of National Affairs - - PowerPoint PPT Presentation

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Economic Policy in PNG: 2010 - 2020 Institute of National Affairs 30 June 2016 Martin Davies Washington and Lee University and Development Policy Center, Crawford School of Public Policy, Australian National University Talk Outline

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SLIDE 1

Economic Policy in PNG: 2010 - 2020

Institute of National Affairs 30 June 2016 Martin Davies Washington and Lee University and Development Policy Center, Crawford School of Public Policy, Australian National University

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SLIDE 2

Talk Outline

  • Recent shocks and policy responses
  • Loan: Sovereign bond issue
  • Future policy: capital mobility increase and alteration to policy

responses

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SLIDE 3

PNG Economy

  • small open developing resource-rich economy (RRDC)
  • challenge of data collection, other information: rely on anecdotal evidence
  • Independent, inflation targeting central bank
  • setting interest rates to control inflation, then growth
  • exchange rate: adjustable peg vs managed float
  • capital mobility is low
  • inflows or outflows don’t respond to interest rate differentials (BPNG, IMF)
  • marginal propensity to import is high
  • government: 0.6 – 0.7
  • private consumers?
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SLIDE 4

PNG Economy: shocks

Demand Side

  • Investment boom (LNG) then contraction (2011-12 then 2013-14)
  • Fiscal expansion (2013-14)
  • offset ↓ I
  • spending ahead of LNG receipts
  • Exports boom (2014 - onwards)
  • Revaluation (and then subsequent stepwise devaluation) (mid 2014)
  • Terms of trade shock (oil/gas price fall) (late 2014)
  • Fiscal contraction (2015-16)

Supply side

  • Oil price fall (2014)
  • Increase in minimum wage (2014)
  • El niῆo (2015-16)
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SLIDE 5

Real exchange rate: 1990 - 2014

P eP* 1 e

Source: P. Flanagan, 18 June 2015

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SLIDE 6

Real exchange rate: 1990 - 2014

RER = eP* P e

Source: P. Flanagan, 18 June 2015

2014 2012

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

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SLIDE 7

RER =eP* P

Source IMF 2015

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SLIDE 8

Macro Policy in PNG

  • In an open economy, policy has two goals
  • internal balance: producing at full employment (Y = Yf )
  • over-employment (Y > Yf ): increase in inflation
  • underemployment (Y < Yf ): decrease in inflation
  • in a very open economy (large share of trade in GDP) Yf will vary with real exchange rate
  • external balance: current account is near zero: CA = 0
  • is large current account deficit: foreign investors question ability to repay debt. Is CA

deficit bad?

  • large current account surplus:
  • External balance can also mean balance of payments equilibrium (i.e. CA + FA = 0)
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SLIDE 9

External Balance

  • External balance: Balance of Trade or Current Account (CA = 0):

CA = Exports – Import = EX(θ) – IM(Y) = 0

  • real devaluation ↑θ → our goods cheaper to foreigners → ↑ exports (EX)

increasing the current account ↑ CA

  • To restore external balance: CA income (Y) → ↑ imports (IM) decreasing the

current account (↓CA)

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SLIDE 10

External balance

Y Real Exchange rate, θ External balance: CA =0 CA > 0 CA < 0

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Internal Balance

  • equilibrium employment determined by a bargain between workers and firms
  • equilibrium: real wage firms offer is equal to real wage that workers demand
  • lower real wage → workers offer less labor
  • Firms care about W/P

W = nominal wage P = domestic price

  • Workers care about W/Pcpi W = nominal wage

Pcpi = cpi

  • Pcpi depends on price of domestic and imported goods

Pcpi = (1-α).P + αe.P* α = import share in cpi

  • devaluation (↑e) → cost of imported goods (↑eP*) → ↑Pcpi → ↓ real wage

(W/Pcpi)

  • slower inflation at home than abroad (↑P < ↑P*) → ↓real wage (↑W by less

than ↑Pcpi)

  • Both effects: ↑ θ leads to lower employment and output (Y)
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SLIDE 12

Supply Side

Y Real Exchange rate, θ Internal Balance: π = π* Y > Yf : π > π* Y < Yf : π < π*

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Macroeconomic Goals: internal and external balance: 4 zones

Y Real Exchange rate, θ External balance: CA =0 I CA > 0 π > π* II CA < 0 π > π* Internal Balance: π = π* III CA < 0 π < π* IV CA > 0 π < π*

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SLIDE 14

Macroeconomic Goals: internal and external balance

Y Real Exchange rate, θ External balance: CA =0 Internal Balance: π = π* Y1 θ1

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Demand Side of Economy

  • Y = C + I + G + EX(θ) - IM

aggregate expenditure = full employment consumption (C) + investment (I) + gov’t spending (G) + exports (EX) – imports (IM) = Yf nominal exchange rate = e

real exchange rate = θ = eP*/P

foreign price level in Kina = eP*; PNG price level = P

Devaluation ↑e → our goods cheaper to foreigners → ↑ θ → ↑export (EX)

P rises slower than P* (PNG inflation is less than inflation in rest of world ) → ↑ θ → ↑ export (EX)

  • ↑ θ → ↑EX → ↑ AD → ↑ Y
  • why is AD steeper that internal balance: leakages due to savings and taxation
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Aggregate Demand (AD)

Y Real Exchange rate, θ AD Output

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SLIDE 17

Model

Y Real Exchange rate, θ External balance: CA =0 Internal Balance: π = π* Y1 θ1 AD

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Investment boom: 2010-2012

Y Real Exchange rate, θ AD1 CA =0 ERU AD2

.

B

.

CA < 0 current account deficit AD > y economy overheats BOP surplus (FDI increases financial account) → e ↓ nominal appreciation → ↓ θ π > π* → ↓ θ C

.

A

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SLIDE 19

RER =eP* P

Source IMF 2015

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SLIDE 20

Real exchange rate: 1990 - 2014

RER = eP* P e

Source: P. Flanagan, 18 June 2015

2014 2012

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

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SLIDE 21

Investment contraction, increase in Government spending

Y Real Exchange rate, θ AD1 CA =0 ERU AD2

.

B

.

C

.

A CA < 0 current account deficit remains BOP deficit (FDI inflows stop) → ↑ e nominal depreciation → ↑ θ (real depreciation) Then π > π* → ↓ θ (real appreciation) D

.

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SLIDE 22

Export boom, contraction in Government spending

Y Real Exchange rate, θ AD1 CA1 =0 ERU AD2

.

B

.

C

.

A CA > 0 current account surplus BOP deficit → ↑ e nominal depreciation → ↑ θ causes real depreciation Then π > π* → ↓ θ real appreciation D

.

CA2 =0

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SLIDE 23

RER =eP* P

Source IMF 2015

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SLIDE 24

Real exchange rate: 1990 - 2014

RER = P eP* 1 e

Source: P. Flanagan, 18 June 2015

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SLIDE 25

Export Supply Shock: fall in energy prices

Demand Side

  • Fall in Terms of Trade for PNG: shifts AD and BT curves inwards as net exports

fall

  • need to export more to buy same level of imports
  • ↓Poil/gas / Pfinal goods (fall in price of intermediates relative to final goods)

Supply Side

  • energy price fall (oil, gas)
  • big windfall for households
  • increase in real wage, θ constant, workers offer more labor →↑Y→ERU curve

right

  • offsetting: El Nino (reduces productivity), min wage increase
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SLIDE 26

Export Supply Shock: fall in energy prices

Y Real Exchange rate, θ AD2 CA2 =0 ERU2 AD1

.

B

.

CA < 0 current account deficit Y < Yf: π < π* e ↑ (depreciation C

.

A CA1 =0 ERU1

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SLIDE 27

Export Supply Shock + fiscal contraction

Y Real Exchange rate, θ AD2 CA2 =0 ERU2 AD1

.

B

.

CA < 0 current account deficit Y < Yf: π < π* e ↑ (depreciation) C

.

A CA1 =0 ERU1 AD3 D

.

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SLIDE 28

Sovereign bond issue: borrow USD 1 billion

  • borrowing in foreign currency: original sin; assets in Kina, liabilities in foreign

currency

  • exposes borrower to foreign currency risk
  • cost of borrowing in kina = foreign interest rate + expected depreciation of kina

r = r* + Δe/e

25% = 10% + 15%

  • K depreciating at 15% p.a. => cost of loan 25% p.a. (assuming r*=10%)
  • BPNG has perfectly elastic supply of K
  • can covert USD to K at any e-rate; choose long term (5 year equilibrium)
  • increase of e=3.33 convert at e = 5
  • monetary consequences: converting USD to K increases money supply
  • sterilization: sell gov’t bonds to offset monetary expansiion
  • excess liquidity anyway
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SLIDE 29

Capital Mobility: change in policy paradigm

  • capital mobility very low: financial flows between PNG and the rest of the

world are insensitive to the relative rates of return (BPNG, IMF)

  • forex flows are primarily exports, imports, fdi (intl remittances also)
  • BPNG set interest rate (r) and exchange rate (e) (intervene heavily – crawling peg)
  • sovereign bond encourage intl investors into t-bill market and local stock

market: increase capital mobility (flows hot compared to FDI)

  • Impossible Trinity: monetary consequences: set interest rate or exchange rate – not

both

  • fiscal consequences:
  • currently fiscal expansion causes to bop deficit – pressure to depreciate (↓ CA)
  • ↑G → ↑Y → ↑IM → ↓CA → ↓BOP= CA + FA
  • new paradigm: fiscal expansion leads to bop surplus
  • higher interest rates attract foreign investment (↑ FA)
  • ↑G → ↑r → ↑capital inflows→ ↑ Financial account → ↑ BOP = CA + FA
  • fiscal response depends on e-rate regime
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SLIDE 30

The Impossible Trinity

Free Capital Mobility Monetary Policy Autonomy Fixed exchange rate Bretton Woods system ERM, Asian pegs, Within eurozone USA, Japan, Eurozone, UK

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Fiscal Policy under zero and perfect capital mobility

r Y LM IS1(G1) Y0 r* IS2(G2) BP: Zero Capital Mobility BOP: Perfect Capital Mobility BOP = Current Account (EX-IM) + Financial Account (net capital inflows)

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SLIDE 32

PNG: Market for Foreign Exchange

e Foreign Currency (USD) DFC SFC Exports + Capital Inflows Imports + Capital Outflows e* = 1 = 3.33 0.3 S* D* Balance of payments deficit = Excess demand for forex / Excess supply of Kina (K607 mn)

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Capital Mobility: Risks

  • Current international paradigm
  • inflation targeting central bank: set r (monetary autonomy)
  • BPNG
  • allow e to float
  • risks: excess volatility in e
  • alternatively: fix e, give up control of M
  • import monetary policy of country you peg to (uncorrelated shocks)
  • risk of currency crisis: UK (1992), Mexico (1994), Asia (1997), China (20XX?)
  • before free float need to build domestic financial sector capacity to deal

with exchange risk

  • hedging, forward rates
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SLIDE 34

Brexit

  • Brexit: global uncertainty shock – that will last for a long time
  • lower growth
  • uncertain how big - could be quite large
  • if it causes a cascade of EU departures then very large
  • effects on PNG; lower global growth, low commodities prices
  • banks safe – SMEs can continue to borrow; large enterprise may be affected
  • may effect sovereign bond issue (market reluctant to risk)
  • possible vulnerabilities:
  • China
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SLIDE 35

Export boom, Fiscal expansion (small or big)

Mundell-Fleming model

rbig Y BP1 LM IS1(G1) Y1 r1 IS2(Gsmall) rsmall Ysmall Ybig IS3(Gbig)