Papua New Guinea - Strategy for adjustment and growth

Repot No. S1 8-PNG Papua New Guinea Strategy for Adjustment and Growth April 30, 1990 Country Deparmnt V Asia Regional Office FOR OFFICIAL USE ONLY 'oum ofh Wo- Ban \~~~ . \ beds)e kot Wai B'k auwAzto. , s '1.' . \ > ' 0 1 2~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ .\~~~~~~~~~N* ; Oo - b*clwnn of te World Bank adzfn . . . . . .~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ * \ -~~~~~ .\~~~~~~~~~~~~~~~~~~~~~~~~~~~~N  CURRENCY EQUIVALENTS Annual Aver.... 1981 K 1.00 a US1 1.49 1962 K 1.00 a US 1.88 1983 K 1.00 a US8 1.20 1984 K 1.00 a US$ 1.12 1965 K 1.00 8 US$ 1.00 190 K 1.00 = US 1 1.08 1987 K 1.00 u JS 1.10 1989 K 1.00 a USI 1.16 1989 K 1.00 a US$ 1.16 February 28, 1990 K 1.00 v US11 1.08 FISCAL YEAR January 1 - DecOmber 81 A8BREVIATIONS AND ACRONYMS ABPNO - Agriculture lank of Papua New Guines ADB - Asian DOvelopment Bank AIDAB - Australian International Development As8lstance Bureau BCL - Bougainvillo Copper Limited CDA - Coffee Development Agency CSA - Commercial Statutory Authority DAL - Department of Agriculture and Livestock OVA - DDeprtment of Civil Aviation DEC - Department of Environment *nd Conservation 9FP - D p rtment of Finance and Planning OH - Department of Health -L - Department of Labor DLPP - Department of Land and Physical Planning DUE - Department of Minerals and Energy DPI - Dopertment of Primary Industries DTI - Department of Trade and Industry DI - Department of Works EEC - European Economic Community Elcom - Electricity Comission FIPA - Foreign Investment Promotion Agency IEP - Higher Education Plan _CO - International Coffee Organization IFAD - International Fund for Agricultural Development ISIC - International Standard Industrial Classification LUP - Land Mobilization Program MPWC - Mining and Petroleum Working ComittOo MROC - Mineral Resources Development Corporation URSF - Mineral Resources Stabilization Fund MUG - Minimum Unconditional Grant MWB - Minimum Wags board NEC - National Fxecutive Council NES - Nucleus Estate with Sm llholders NHS - National High School NIDA - National Investment and Development Authority NTP - National Training Policy NWSSB - National Water Supply and Sewerage Board CAM - Operations and Maintenance OPEC - Organization of Petroleum Exporting Countries OTUL - Ok Tedi Mining Company Limted PIP - Public Investment Program PEA - Public Employees Association TSC - Teachers' Services Commission UN - United Nations UNCTC - United Nations Center for Tranenational Corporetions UNDP - United Nations Development Program UNIDO - United Nations Industrial Development Organization UNDTCO - United Nattons Department of Techniael Cooperation for Development UPE - Universel Primary Education WHO - World Health Organization  FOR OMCIAL USE ONLY PAPUA NEW GUINEA STRATEGY FOR ADJUSTMENT AND GROWTH Table of Contents Page No. SUMMARY AND CONCLUSIONS .................................. .. i I. REVIEW OF RECENT DEVELOPMENTS A. Introduction ........................ .................... 1 B. Improvement in Economic Performance, 1985-88 ........... . 2 Growth, Employment and Investment ................... . 2 Macroeconomic Management ............................. 6 Progress on Structural Adjustment ................... . 10 C. Economic Shocks and Impact in 1989 ..... ................. 12 II. AGENDA FOR ADJUSTMENT AND GROWTH A. Introduction ....... ................................. . 14 B. The Short Term: Adjustment Policies for Stabilization and Economic Recovery ............... # ..... 15 Magnitude of Shocks and Need for Adjustment .......... 15 Main Elements of Adjustment Program ..... ............. 18 Macroeconomic Framework for Stabilization 8......... i Improvement of Public Resource Management ......... 19 Promotion of Nonmining Private Sector .. ........... 22 Alleviating Social Costs of Adjustment ............... 24 C. The Fedium Term: Strengthening Structural Reforms for Accelerated Growth ......... ................. 24 Maintaining a Stable Macroeconomic Environment ....... 25 Managing Mineral Resource Development ............... . 26 Promoting Growth of Nonmining Economy ..... *..* ....... 27 Supporting Broad-Based Development .................. 31 Ensuring Sustainability of Development ............... 31 This report was written by M. Zia Qureshi, with inputs from James Douglas, Swati Ghosh, Emmanuel James, Chita Jarvis, Peter Osei, Michael Porter, William Rees, Zmarak Shalizi, Michael Stevens, John Strongman and Toshiya Masuoka. It is based on the findings of an economic mission to Papua New Guinea in November 1989 and a structural adjustment loan appraisal mission in February 1990. A draft of the report was discussed with the Government in April 1990. IThis document has a estricted distribution and may be used by recipients only in the performance of their ofAci duties. Its contents may not otherwmi be disclosed without World Bank authodzation.  III. ECONOMIC OUTLOOK AND EXTERNAL FINANCING REQ IREMENTS Page No. A. Introduction ............................. .............. 33 B. Short-Term Prospects ....... ..... ............. .. ....... 33 C. Medium-Term Prospects ..... ......... ... .. *........ 34 Mineral Sector Prospects and Implications ............ 36 Growth and Development of Normining Economy .......... 38 Investment Effort and Savings ........................ 42 External Sector Outlook ........ . ............. ....... 47 D. External Financing Requirements and Sources ............. 52 Financing Requirements . ............................. . 52 Sources of Financing ... ***********.... .....*t ...... .. 54 Eg External Debt Management ......................... .. . . 58 F. Uncertainties and Risks in Prospects ...... o ............. 60 STATISTICAL APPENDIX ........****t***. **........... *...*.... 65 MAP  LIST OF TEXT TABLES Table No. Page No. Chanter I 1.1 Gross Domestic Product by Sector, 1980-89 .................... 3 1.2 Formal Sector Employment, 1980-89 .............. ....4.... 4 1.3 Fixed Investment by Sector, 1981-89 ........................ 5 1.4 National Government Fiscal Operations, 1981-90 ............. 7 1.5 Monetary and Price Developments, 1984-89 ............ 8 1.6 Balance of Payments, 1981-89 ............................... 9 1.7 Wage and Exchange Rate Developments, 1980-89 ...... ......... 11 Chapter II 2.1 Projected Impact of Adverse Economic Shocks, 1990-91 ....... 16 2.2 Projected Macroeconomic Adjustment Response, 1990-91 ... 17 Chapter III 3.1 Short-Term Economic Outlook, 1990-91: Selected Indicators 35 3.2 Mineral Sector Prospects, 1990-99 ............................ 37 3.2 Projected Growth and Composition of GDP, 1990-99 ........... 38 3.4 Projected Growth and Composition of National Income and Expenditure, 1990-99 ............. . .... . 41 3.5 Public Investment Program by Sector and Type of Expenditure, 1990-94 ........................ 43 3.6 Public Investment Program, 1990-94: Distribution by Sector and Agency ................ . 44 3.7 Projected Investment and Its Financing, 1990-99 .... ....... 46 3.8 Projected Growth in Merchandise Exports, 1990-99 ........... 48 3.9 Projected Growth in Merchandise Imports, 1990-99 ........... 49 3.10 Change in Merchandise Terms of Trade, 1981-99 ............. * 50 3.11 Projected Balance of Payments, 1990-99 ..... ................ 51 3.12 External Financing Requi.rements and Sources, 1990-95 ... 53 3.13 Requirements of Official Assistance by Type of Assistance, 1984-91 ......*********...***. *............ 55 3.14 Commitments of Official Assistance by Source, 1984-91 ...... 56 3.15 External Debt and Debt Service, 1984-99 ......59............... 59 3.16 External Financial Implications of a Prolonged Closure of Bougainville Mine, 1990-99 ........ ...................... 61  SUIGARY AND CONCLUSIONS Recent econamic Develoiments 1. Papua New Guinea's economic performance improved appreciably in the second half of the 19809. Overall economic growth revived sufficiently to allow some recovery in per capita income following several years of decline. The almost continuous fall in public investment occurring in the first half of the decade was halted and some ground regained. The improvement in performance was particularly notable in macroeconomic management. The economy's fiscal, balance of payments, external debt and inflation indicators all showed significant improvements. However, less progress was made in structural adjustment and institutional development needed to promote stronger growth in the nonmining economy, the source of income and employment to the bulk of the population, though efforts in these areas were stepped up toward the end of this period. The acceleration of economic growth that occurred was mainly due to increased mining sector activity. Growth in the nonmining economy picked up only modestly, and was insufficient to prevent unemployment from rising further. An important factor underlying this outcome was the limited progress made in improving the environment for private sector investment. Private nonmineral investment continued to decline in real terms for much of this period. In the absence of broad-based growth, regional income disparities appear to have increased, with areas lacking mineral resources or established treecrop cultivation lagging behind others. Moreover, with the increased exploitation of mineral and forestry resources, issues relating to the sustainability of development have acquired greater Importance. 2. Economic developments over the past year have been dominated by the closure of the Bougainville gold and copper mine since may 1989 because of strife on the island. With the mine contributing about 352 of export earnings, 152 of government revenues and 82 of GDP in recent years, its closure has had a major financial and economic impact. This has been compounded by a sharp deterioration of PNG's external terms of trade, about 152 in 1989 and an expected further 82 in 1990, and the disruption of genera' economic activity in North Solomons province resulting from the Bougainville crisis, especially cocoa production (the province produces 40-452 of the country's cocos). Through policy adjustments, and some offsetting favorable mineral sector developments, the Government was able to contain the macroeconomic imbalances arising from these adverse shocks in 1989. However, their full effect is likely to be felt in 1990, requiring much stronger adjustment policies. It is estimated that the combined effect of these shocks on the balance of payments, the fiscal position and national income could amount to as much as 12?, 4.5? and 11? of GDP respectively on average during 1990 and 1991 (assuming that the Bougainville mine remains closed throughout this period).  _ ii - Nalor Policy Challenges Ahead 3. Against this background, PUG faces four key policy challenges in the period aheads - to preserve internal and external financial stability in the face of the major shocks confronting the economy; - to accelerate the pace of growth by developing the nonmining economy in order to raise living standards and generate adequate and productive employment opportunities for the growing labor force; - to ensure broad participation in the process of growth and an equitable sharing of its benefits; and - to promote a sustainable pattern of development. 4. In the short run, the policy agenda will need to focus on the implementation of stabilization policies and on structural measures facilitating growth-oriented adjustment. This will pave the way for a more comprehensive program of structural reform and development over the medium term aimed at achieving stronger and broad-based growth on a sustainable basis. The short-term policy agenda summarized below represents the program of stabilization and structural adjustment that the Government intends to implement over the next two years or so. The medium-term policy agenda outlined in the following section is broadly consistent with the principles enunciated by the Government but the specific proposals are based on the views of Bank staff. the Short-Terms Adlustment Policies for Stabilitation and Economic Recovery 5. The Government was quick in recognizing that the shocks confronting the economy were of a magnitude that could easily destabilize it in the absence of prompt and strong adjustment measures. For instance, it is estimated that in the absence of any policy response, the overall balance of payments deficit could have risen to over US$350 million (10.52 of GDP) in 1990, and remained high at about US$300 million (82 of GDP) in 1991, which clearly signalled the need for adjustment to keep foreign reserves from falling below a minimum prudent level and avoid an excessive build-up of external debt. The Government also recognized that in addition to stabilization measures, the emerging difficulties underscored the need, as well as provided an opportunity, to undertake more fundamental structural adjustments to accelerate the development of the nonmining economy and diversify the productive base. Some key adjustment measures were announced early in 1990. To secure support for the stabilization and structural adjustment program that it had embarked upon, the Government approached the IMF for a stand-by arrangement and the World Bank for a structural adjustment loan. At the same time, arrangements were completed with the ADB for an agricultural sector program loan to support sector-related structural adjustments.  - iii - 6. In view of the magnitude of the financial losses resulting from the adverse shocks, a substantial reduction of domestic demand is unavoidable to maintain macroeconomic stability. But to ensure an early economic recovery, and to minimize the short-term costs of adjustment, the Government's adjustment program complements demand management measures with structural adjustments to protect priority public sector activities and promote private investment. In the formulation of the adjustment program, four major principles have been emphasized, namely: - to achieve the necessary reduction of domestic demand for stabilization purposes primarily by cutting public spending to minimize the impact of adjustment on private sector growth; - to concentrate the reduction of public spending on consumption expenditures, while protecting essential services, in order to maintain adequate funding of priority investments; to focus structural reform on two policy areas central to the development of the nonmining economy, i.e., public resource management and the environment for private investment; and - improve the competitiveness of the nonmining economy as the key means to promoting private investment and economic diversification. 7. The adjustment program under implementation, accordingly, is focused on three main policy areas: (a) macroeconomic framework for stabilization; (b) improvement of public resource management; and (c) promotion of the nonmimning private sector. 8. Macroeconomic Framework for Stabilization. The main elements of the program to maintain internal and external financial stability over the next two years include: (i) cuts in government spending and new revenue raising measures; (1) slower growth of domestic credit and increases in interest rates; (iii) wage moderation, which, in addition to complementing fiscal and monetary policy in achieving the stabilization objective, will contribute to improving the competitiveness of the economy; and (iv) limits on public external borrowing from commercial sources. The fiscal adjustment targeted under the program is substantial, with the Government aiming at a virtual balance in the overall budget in both 1990 and 1991 compared to deficits of about 41 and 3S of GDP that would likely have resulted in these years respectively without any adjustment measures. Strong fiscal adjustment will allow credit growth to support nonmining private sector activity to be maintained at an adequate level while still reducing growth in total domestic credit significantly. On January 9, 1990, the Government took the difficult step of devaluing the kina by 10. It subsequently reached agreement with public employees that will limit average annual wage increase in the public sector to about 4.51 over the next three years (wage awards in the private sector are likely to be similar). The average increase in public sector wages in 1990 will be well below this limit -- between 3-3.5Z. With inflation projected to rise to about 8.5 in 1990 because of the devaluation and tax measures, from a recent trend rate of around 5Z, this will result in an average fall in real wages of about 5 during the year.  - iv - 9. Improvement of Public Resource Management. The Government is implementing an agenda of actions that is designed to address three key structural aspects of public resource management in PNG. First, public resource mobilization is to be strengthened through measures tos (i) broaden the tax base as well as improve its structure, notably by more effective taxation of business incomes and the reorientation of indirect taxes toward broad-based taxation of consumption; (Ui) reform natural resource taxation, especially in forestry; (iii) strengthen tax collection; and (iv) improve cost recovery for key public services. Second, public expenditure management is to be improved through measures tos (i) restructure public expenditures by trimming the large administrative spending, especially the wage bill; (ii) improve the funding and management of operations and maintenance (O&M) expenditures in key sectors; (iii) direct resources available for public investment to priority projects and programs; and (iv) strengthen expenditure control and monitoring mechanisms to ensure that the planned expenditure cuts and reallocations are realized. To identify expenditure cuts under the program and determine reallocations, the Government carried out a comprehensive review of the original 1990 budget. Special attention was given in this review to protecting, and in some cases increasing, allocations for priority O&M expenditures and projects in the public investment program (PIP). To reduce administrative outlays and improve efficiency, the Government is initiating a major medium-term program of rationalizing the civil service which will involve significant staff redeployment and retrenchment and a streamlining of departmental functions and structures. Moreover, in order to reduce the burden on budgetary resources, and also to induce producers to become competitive at world prices, a phased reform of agricultural commodity stabilization funds has been started. Third, the enhancement of staff and Institutional capacities for the planning and implementation of development activities, especially the implementation of the PIP, is to be expedited through: (i) beginning the implementation of some key components of the National Training Policy (NTP) aimed at strengthening in-service training and of the Higher Education Plan (UEP) directed at improving the efficiency and relevance of higher-level pre-service training; (ii) completing the installation of a new project cycle system to streamline the preparation and implementation of PIP projects; (iii) establishing an effective mechanism for monitoring project preparation and monitoring; and (iv) simplifying procedures for procurement and the approval of loan agreements between the Government and external donors. 10. Promotion of Nonminina Private Sector. Reversing the declining trend in nonmineral private investment will be critical to the economy's growth prospects. A key element of the strategy in this regard will be to improve the international competitiveness of nonmineral productive activities. Policies to that end will include: limiting increases in nominal wages to achieve a significant reduction of real wages (which are currently high relative to productivity and wages in competing countries); reducing wage indexation to introduce greater flexibility in wage determination; and maintaining a responsive exchange rate policy. The recent decision to limlt the application of the wage indexation award of the Minimum Wages Board  strictly to minimum wages (unlike in the past when the award was applied practically across the board) introduces useful flexibility in the labor market. The next step in the systemic reform of wage determination should be the reduction of the extent of minimum wage indexation In the economy. Other measures forming part of the Government's adjustment program aimed at improving the environment and opportunities for private sector growth include: (i) a major reform of the institutional and regulatory framework governing foreign investment; (ii) acceleration of the Governmont's privatization and divestment programs (iII) reduction of import bans and rationalization of the tariff regime to improve incentives for efficiency and reduce distortions In resource allocation and disincentives against exports; and (iv) steps to strengthen the rural financial and credit system. 11. Alleviating Social Costs of Adiustment. While the implementation of the Government's adjustment program summarized above will facilitate an early economic recovery and should have an overall beneficial effect on income distribution, adjustments necessitated by the large financial losses from the adverse shocks will unavoidably have a short-term adverse effect on incomes, which is likely to fall more heavily on urban wage and salary earners. In order to mltigate these costs, the Government is taking several steps. First, in allocating expenditure cuts, basic services and programs aimed at disadvantaged groups and poorer areas have as far as possible been protected. Second. the Government will facilitate the reemployment in the private sector of those affected by civil service reform through retraining and improved placement mechanisms. Third, the Government has prepared a special program of interventions aimed specifically at offsetting the social costs of adjustment, which will include, for example, projects in housing, improvement of health facilities, and small industry development, and for which the Government Will be seeking urgent concessional assistance from the donor community at the May 1990 meeting of the PSG Consultative Group. The Medium-Termt Strensthening Structural Reforns for Accelerated Growth 12. Successful implementation of stabilization policies in response to the financial difficulties faced in the short term and progress made on the accompanying structural adjustment program will lay the basis for a strengthening of efforts to accelerate growth in the economy. Over the medium term, PNG's financial resource position is expected to improve substantially because of increasing exports of minerals as some major new projects come oan stream (para. 24). However, the mineral sector's real linkages with the rest of the economy are weak and its capacity to generate employment limited. Also, mineral resources are depletable. For a broad-based and sustained growth of incomes and employment, the development of the nonmining economy will remain the key. The role of the mineral sector, as the new projects begin to generate revenues, will be to provide substantially increased financial resources to the economy, and the challenge for development policy then will be to utilize those resources in investments that will strengthen the foundations for growth in the nonmining economy.  - vi - 13. The main elements of the policy agenda over the medium term to achieve the country's 6evelopment objectives will includes - maintaining a stable macroeconomic environment; - effectively managing mineral resource development; - promoting growth in the nonmining economy; - supporting broad-based development; and - ensuring the sustainability of development. 14. Maintaining a Stable Macroeconomic Environment. Assuming that the Government is successful in implementing a short-term program of stabilization and adjustment in response to the shortfall in mineral revenues resulting from the closure of the Bougainville mine, the main threat to macroeconomic stability over the medium term, ironically, will arise from the expected substantial increase in mineral revenues from new projects. This prospect carries the risk of inducing a relaxation of discipline in government expenditure policies. Any such tendency will need to be firmly resisted. There remain a number of uncertainties regarding the development of some of the new projects and their profitability (para. 28). At any rate, a major Increase In fiscal revenues from the mineral sector is not likely to occur before the middle of the 1990s. Accordingly, it would be inadvisable to shift to an expansionary fiscal policy, and resort to external commercial berrowing to finance it, in anticipation of a substantial easing of the fiscal constraint in the near Zuture. Even as larger mineral revenues begin to accrue later in the 1990s, the need for sound expenditure management will remain, to direct the new resources to priority uses and avoid waste. Moreover, to insulate government expenditures from the inherent instability of mineral revenues, the Mineral Resources Stabilization Fund will need to be maintained as an effective stabilizing mechanism. 15. Manating Mineral Resource Development. In order to ensure timely and effective exploitation of the considerable potential for mineral development and secure maximum benefits for the national economy, policy priorities fcr the sector will include: (i) preserving investor confidence by maintaining a stable and clear policy framework for the development of mineral projects and promoting harmonious comunity relations in project areas; (ii) satisfactorily resolving the issue of distribution of project benefits between the National Government, the Provincial Government and local landowners; (iii) judiciously fostering stronger real linkages between the mineral projects and the local and national economy, including developing a strategy for the domestic utilization of prospective petvnleum production; (iv) adopting and implementing a sound approach to government financial participation in the new projects, including ensuring that the Mineral Resources Development Corporation is adequately equipped for the task; and (v) strengthening the institutional capacity of the Department of Minerals and Energy In line with its responsibilities and the expanding project pipeline.  - vii - 16. Promoting Growth of Nonminin EcSonomy. The promotion of stronger and diversified growth in the nonmining economy vill require concerted efforts over the medium term on several fronts. First, in the productive sectors, the Government will need to pursue well-defined and integrated sector strate8ies for increased production. While the greatest potential for growth in the nonmining economy exists in agriculture, and the promotion of the sector through measures such as strengthening research and extension will remain a priofrity. the potential for growth in other sectors that so far have been relatively stagnant -- e.g., manufacturing, fisheries, services such as tourism -- wiLl also need to be tapped. This will be necessa y not only for economic diversification but also for generating adequate increases in employment as agriculture cannot be expected to continue to absorb almost six out of every seven new entrants into the labor force in the long run. The Government should use the inputs provided by some recent comprehensive sector studies, e.g., in fisheries and forestry, to formulate concrete agendas for action for these sectors over the medium term. 17. Second, the Government will need to continue to pursue a policy of actively supporting private sector development. A central element will remain the maintenance of competitive wages and exchange rate, a policy that will be particularly tested later in the 1990s by the upward pressures generated by the prospective strong growth in mineral revenues. The progress made during the present adjustment program should be followed up with a more basic reform of the wage-setting system. Other policies would includes effective implementation of the Government's Land Mobilization Program to facilitate availability of land for use in business activities; developing the institutional framework and programs for the promotion of small- to medium- size businesses; continuing efforts to improve the law and order situation; and strengthening basic infrastructure and education and training facilities In needed skills to reduce production costs and raise labor productivity. 18. Third, there will need to be a major build-up of Investment within the framework of the PIP for strengthening public infrastructure. While infrastructure development in general will command high priority in the PIP, an area for particular attention should be the development of rural infrastructure, especially roads to provide producers with better access to inputs, services and markets. This will require: an increased allocation of public resources to rural infrastructure development; drawing up a well- connected network of roads at the provincial and district levels on the basis of proper identification of project areas; assessing the requirements and planning the development of complementary infrastructure; and strengthening the capacity of the responsible agencies, especially in the provinces, to implement and operate rural infrastructure projects. The participation of the local construction industry and the use of labor-intensive methods should be encouraged in the development of these projects. 19. Fourth, to ease the shortage of skilled manpower, arguably the most Important single constraint to development in PNG, the high priority currently being accorded by the Government to accelerating human resource development will need to be maintained. The increased resources being committed to  - viii - education and training should be underpinned by a clearer definition of priorities within the sector, which should includes (i) giving strong support to primary education, focusing on improvements in quality while also expanding access as neisssary; (ii) accelerating the expansion of enrollments at the secondary level at rates allowed by the system's implementation capacity; (iii) linking the expansion of tertiary education more closely to priority skill needs, and reducing the high costs and fragmentation of education at this level (through effective implementation of the HEP); (iv) strengthening vocational training by establishing fewer but more viable institutions and making their programs more responsive to labor market needs, and providing greater incentives to private employers to offer employment-specific training; and (v) improving the institutional arrangements for policy formulation and coordination in the sector. 20. Fifth, the achievement of the desired growth in public investment and improvement of public services to more effectively support private sector initiatives will require considerable institution-building in the public sector. An approach comprising three main elements will be required. The first will be to continue and expand staff development programs, in particular the implementation of the NTP, and make an effective use of external technical assistance in filling critical skill gaps in major agencies. The second will be to continue efforts at strengthening and streamlining government operational systems, including making the new project cycle system fully operational and improving coordination among departments at both national and provincial levels. The third element will be to devise and implement specific program for individual key agencies based on a thorough institutional analysis of each agency. This will include completion of the medium-term civil service restructuring program being initiated by the Government (para. 9). 21. Supporting Broad-Based Development. An important aspect of the development challenge in PNG is the wide disparity of incomes that exists among its different regions. To ensure broad participation in the process of growth and the distribution of its benefits, the development strategy will need to take into account the significant differences in productive potential and the state of development present among regions. In areas with known crop growing potential and a good infrastructure base, an emphasis on investment in agriculture will vield significant and early returns in production and employment. On the other hand, in areas where potential for agricultural production exists but its realization is constrained by lack of transport links, it is investment in infrastructure that has priority. While leading to stronger agricultural growth over the medium term, such investment will also in the meantime create useful employment opportunities in the construction of infrastructure projects. Still in other areas where agroclicatic conditions do not allow scope for crop production, which are the least developed areas of the country, the emphasis will need to be on exploring and developing other possible activities, e.g., forestry, fisheries, small industry, small-scale mining, etc. These efforts vill need to be complemented by further reduction of regional disparities in access to social services, education and health.  - ix - 22. Ensuring Sustainability of Development. Even though PNG's sizable mineral resources are at a relatively early stage of exploitation, they are exhaustible. The judicious management of these resources and the channelling of revenues derived from them into investments that will contribute to income growth on a sustainable basis deserve emphasis in policymaking. Mineral development also has potentially major environmental implications, which underline the importance of effective observance and monitoring of the guidelines and standards that have been established. Ensuring sustainable exploitation of resources and protecting the environment have emerged as particularly urgent concerns in forestry, because of the lack of effective control over logging operations in the past. In response, the Government has announced some major initiatives aimed at improved and sustainable management of forest resources at a recently held Tropical Forestry Action Plan round table. These include: reserving ecologically valuable areas (including the possibility of large World Heritage declarations); assessing the level and growth rate of the forest resource and determining and monitoring logging levels consistent with sustainable yield management; and restructuring sector administration to enhance its effectiveness. Significant external financial and technical assistance will be needed to implement the envisaged action plan. To ensure the sustainability of development, the Government will also need to develop and implement a strategy and related family planning programs to reduce the current rapid growth of population. Economic Prospects 23. Short-Term Prospects. Provided the stabilization and structural adjustment program outlined above is firmly implemented, and the required additional external assistance is obtained, the prospects are good for PNG to overcome its lmuediate financial difficulties and achieve an early recovery of growth. The adjustment measures should allow the balance of payments deficit to be reduced to a level that can be financed from official support likely to be available and is consistent with the economy's capacity to carry additional debt, with the use of foreign reserves limited to keeping them around four months of nonmineral imports that is considered necessary to ensure maintenance of private investor confidence. It is estimated that this would require reducing the balance of payments deficit by about US$130 million (3.8Z of GDP) in 1990, and US$175 million (4.6Z of GDP) in 1991 if the Bougainville mine remained closed in that year, from what it would have been without any adjustment measures, which would constitute a substantial adjustment effort. Economic growth is expected to be negligible in 1990 but, despite the magnitude of adjustment, could recover in 1991 to 2? in the nonmining economy, close to its recent trend growth rate, and a much higher rate of just under 61 overall because of increased activity in the mining sector. 24. Medium-Term Prospects. Despite the recent setbacks, PNG's medium- term economic prospects remain favorable. If the current prospects for development in the mineral sector are realized, and with successful adjustment in the short term, PNG's financial position will improve substantially as some major new mineral projects (which are expected to include four medium- to large-size gold mines and an oil field) come on stream over the next three  to five years. Initially, the effect of the increasing mineral export earnings on the balance of payments is likely to be moderated by rising service payments on the large funds borrowed to finance the new projects. However, by the mid-1990s, the overall balance of payments is expected to show a strong improvement, and could begin to record significant surpluses. Because of accelerated depreciation provisions affecting taxable profits, the effect of the rising mineral export earnings on the fiscal position will be more lagged than on the balance of payments, with the major increase in government mineral revenues likely not occurring until after 1995. The expected substantial improvement in the balance of payments position toward the mid-1990s will also be reflected in the debt service position. After averaging a relatively high 272 in the early 19909, reflecting a bunching of government amortization payments and substantial service payments by the mineral sector on its new debt, the debt service ratio is expected to fall sharply, reaching about 122 by the end of the decade. 25. Provided the agenda for structural reform and development is vigorously implemented, the economy's growth performance -- and employment generation -- should also improve appreciably. On this basis, growth in the nonmining economy is projected to rise to 3.22 p.a. during 1992-95 and to accelerate further to an average of 4.51 p.a. in the latter half of the decade. Because of the expected rapid growth in the mineral sector in the early- to mid-1990s, overall GDP growth during 1992-95 could rise to close to 71 p.a. However, with all of the currently planned mineral projects expected to have been developed and have reached full capacity by the end of that period, the mineral sector growth rate would fall sharply thereafter (unless new projects are identified and developed). This could cause a fall in the overall GDP growth rate to about 2Z p.a. early in the latter half of the 1990s, before it recovers, supported by the projected acceleration of growth in the nonmining economy, to over 32 p.a. by the end of the decade. This underscores the importance of developing the potential of the nonmineral sectors as the basis for sustained growth in the long run. xzternal Pimancing Requirements 26. PNG's external financing requirements are expected to be sharply higher over the next few years. The principal reason for this is the planned development of some major mineral projects, which will be financed primarily from private capital inflows. Part of the increase in the requirements is due to the significant official balance of payments financing that will be needed to support the Government's adjustment program. Official project-related financing will also need to increase to support the expansion of public investment within the framework of the PIP, but the increase will be at a relatively moderate pace determined by the rate of growth of the requisite institutional capacities. Total external financing requirements will start to fall toward the mid-1990s as the new mineral projects are completed and begin to generate export earnings. The need for official balance of payments financing will decline with successful adjustment and increase in mineral exports from recently or about to be completed projects. It could disappear altogether in 1992 if the Bougainville mine returns to full production early in that year.  - ~~~~~~~~~~~- xi - 27. The total external financing requirement in 1990 is estimated at about US$1.3 billion. Of this, about US$600 million (or 472) will need to be met from official sources. This will consist of four types of assistance. First, to ensure adequate funding of the government recurrent budget (and also to support the balance of payments), Australian budgetary grants are being maintained in nominal terms, which will amount to roughly US$215 million. Second, technical assistance requirements to support institution-building and particularly the capacities for project preparation and implementation are estimated at about US$25 million. Third, to finance planned investments under the PIP, and the projects in the special program to alleviate the social costs of adjustment (para. 11), disbursements of project-related assistance (loans and grants) of about US$165 million will be needed. To generate the required level of disbursements of such assistance in 1990 and subsequent years, it is estimated that new commitments of about US$225 million will be needed in 1990. Fourth, the requirement for special balance of payments financing in support of the adjustment program is estimated at US$190 million in 1990. It is envisaged that this financing will be obtained wholly from official sources as the Government prudently intends to refrain from external commercial borrowing for general-purpose financing. Multilateral sources (ADB, IMF and the World Bsank) are expected to provide US$150 million of this amount in 1990, with the rest likely to come from bilateral sources. Uncertainties and Risks in Prospects 28. The medium-term prospects discussed in this report and summarized above are subject to several uncertainties and downside risks that need to be kept clearly in view. Two are particularly important. First, the improved growth performance of the nonmining economy projected in the report is predicated on a vigorous implementation of the envisaged agenda for structural reform and development. Significant slippages in the implementation of that policy agenda would jeopardize the attainment of the projected outcome. Second, mineral sector prospects, which dominate the financial outlook of the economy, remain subject to several uncertainties. A major source of uncertainty is the outlook for the Bougainville mine. The report's medium- term projections assume that the mine will return to full production in early 1992. It is quite possible that the mine remains closed for a still longer period. The major policy implication of this scenario is that the stabilization program will have to be continued for about two more years beyond 1990-91, and so will the provision of supportive balance of payments financing, though on a diminishing scale. By 1994, increasing export earnings from the new mineral projects should offset the shortfall resulting from the closure of the Bougainville mine. Beyond that, the external financial position should begin to improve appreciably as earnings from the new projects rise further, even if the mine continued to remain closed. However, it is possible that some of the new projects get delayed, in which case the improvement in the external financial position will be further delayed. Besides the timing of development, there are also cost, price and other uncertainties that bear on the expected financial contribution of the new projects. An implication of these uncertainties is that even beyond the period of immediate financial difficulties stemming from the closure of the Bougainville mine, it would be advisable to maintain a cautious stance in macroeconomic management. The various uncertainties associated with mineral development prospects also reinforce the case for a strong, multiyear program of structural adjustment to develop the nonmining economy.  CUAPTER I REVITW OF RECENT DEVEORPENTS A. Introduction 1.1 Papua New Guinea's economic performance was on an improving trend in the second half of the 1980s. Thanks to major improvements in macroeconomic management, financial stability was reestablished, following a period marked by large financial imbalances. The turnaround in the macroeconomic situation was clearly reflected in the substantial gains made in all domestic and external financial indicators during 1985-88. The economy's growth performance remained relatively weak, but some signs of a pick up were beginning to emerge as the Government stepped up efforts to address the underlying structural constraints to faster growth toward the end of this period. These promising developments, however, were interrupted in 1989 by some severe shocks. Civil disturbances in North Solomons Province caused the closure of the Bougain-ille copper and gold mine, a major contributor of foreign exchange earnings and fiscal revenues. The effects of this shock were compounded by a sharp deterioration in the external terms of trade. These developments posed a fresh challenge to financial stability. At the same time, they underscored the need to strengthen structural reforms to promote the growth of the nonmining economy and broaden the productive base. The G'vernment has responded promptly to these challenges by embarking on a major adjustment program. Issues relating to the twin challenges of adjustment for stabilization and growth, that the economy is currently facing, are the main theme of this report. 1.2 The report is structured as follows: recent economic developments are'. reviewed in this chapter, with Section B assessing the areas of relative strength and weakness during 1985-88 when the economy's overall performance improved and Section C evaluating the impact of, and the response to, the economic shocks occurring in 1989; the policy agenda, both for stabilization and recovery in the short term and for stronger and broad-based growth over the medium-term, is discussed in Chapter II; and, finally, the economy's growth and financial prospects, based on the implementation of this policy agenda, are evaluated in Chapter III, including a review of the external financing requirements, with the chapter concluding with an assessment of the uncertainties and risks that attend these prospects.  B. Imrovement in Economic Performanee. 1985-88 1.3 Considerable improvements were seen in PNG's economic performance during 1985-88. Overall economic growth revived sufficiently to allow some recovery in per capita income and employment. The sharp drop in public investment that took place during the early 1980s was halted and some ground regained. At the same time, major improvements were seen in macroeconomic management. Both the fiscal and balance of payments deficits were reduced significantly, and inflation was curbed to an average of below 52 p.a. However, less progress was made in structural adjustment and institutional development needed to promote stronger and broad-based growth in the nonmining economy, though efforts in these areas were stepped up toward the end of this period. Most of the acceleration of growth that occurred was in the mining sector. The nonmining economy, which involves the bulk of the population, grew much more slowly, although somewhat faster than in the first half of the decade. Since the mining sector is highly capital intensive, it offers limited employment opportunities. As a result, despite the higher overall growth, employment growth was inadequate. The goal of diversifying the economy also remained largely unfulfilled as sectors such as nontraditional agriculture, fisheries, manufacturing and services showed only very modest growth. A major factor underlying this outcome was the limited progress made in improving the environment for private sector development. Growth., mployment and Investment 1.4 Economic Growth. Following a period of very low growth during 1980-84, when the adverse effects of a global recession and low comnodity prices, reinforced by domestic structural weaknesses, had kept the average growth rate to about 1.3? p.a., the economy picked up in 1985. From 1985 to 1988, growth averaged around 3.7? p.a. (Table 1.1). With the population officially estimated to be growing at about 2.3? p.a., the acceleration of growth provided a welcome recovery in per capita income. However, because of- the losses occurring in the preceding period, per capita income at the end of 1988 was probably no higher in real terms than at the beginning of the decade. Furthermore, the main impetus to growth during this period was provided by the coming into production of the country second major gold and copper mine at Ok Tedi, the first being the Bougainville mine. Because of the mining sector's limited linkages with the rest of the economy, and the nature of its production process, the potential to generate broad-based growth in incomes and employment lies mainly in the nonmining economy. Nommineral growth also picked up, but only modestly, increasing from an average of 1.9? p.a. during 1980-84 to 2.3? during 1985-88. 1.5 Within the nonmining economy, there was an encouraging acceleration of growth in the key agricultural sector, which constitutes the main source of livelihood for about 80 of the population and accounts for about one-third of GDP and most of nonmineral exports. Growth in agriculture rose to an average of around 3.8Z p.a. as the Government's efforts to promote this sector through improved availability of services and inputs, particularly through the introduction of higher-yield crop varieties, started to bear fruit. Growth in the sector continued to be led by the export treecrop subsector, which is  - 3 - Table 1.1, GROSS DOH8STIC PRODUCT BY SECTOR, 1980-89 (2 annual change at 1981 prices) Shares 1980-84 1985-88 1989 in GDP Est. (1989) Agriculture la 1.6 3.8 2.1 31.0 Mining -7.6 15.4 -4.6 14.0 Mabnfacturing 1.5 1.0 1.0 11.3 Construction & Utilities 5.9 2.6 6.9 7.4 Rest of the Economy 1.8 1.3 1.7 36.3 (mainly services) Gross Domestic Product 1.3 3.7 1.4 100.0 memo Item: Nonmining GDP 1.9 2.3 2.1 86.0 l Includes forestry and fisheries Sourcet Data provided by PNG authorities and staff estimates. dominated by coffee, cocoa, oil palm and coconut, which together account for about three-quarters of all cash-crop agriculture in PNG and 90 2 of agricultural exports. In response to higher prices and aided by favorable weather conditions, coffee output rose particularly strongly in 1987 and 1988, despite the threat to the industry posed by the outbreak of leaf rust. The strong extension and rehabilitation efforts mounted by the Coffee Development Agency (CDA) helped in containing the spread of the disease. 1.6 The performance of most other nonmining sectors, however, was much weaker. Growth in manufacturing and services remained modest, and indeed was slower than in the first half of the decade. The slowdown in growth in the services sector partly reflected smaller contribution of government services, which account for roughly one-third of the overall services sector, as the Government tightened its expenditure policies. Activity in the construction sector, which was brisk during 1980-84, suffered a slowdown with the completion of major development works at the Ok Tedi mine at the end of 1984. Overall, weak growth in the nonmining economy as a whole during 1985-88 reflected the continuation of the major underlying constraints, in particular the lack of skilled manpower, both at the entrepreneurial and workforce levels, and high labor costs, limited public sector institutional capacities, and the weak infrastructure base (especially inadequate transport links which, inter alia, have the effect of fragmenting an already small domestic market). These constraints need to be addressed through a program of structural reform and development in a medium-term framework, as discussed in Chapter II.  -4- 1.7 Employment. It is estimated that only about 132 of the latour force in PSG is in formal wage employment, roughly a third of whom are in the public sector. Informal commercial activities account for another 35? (comprising mainly self-employed _allholders producing some cash crops), and the remaining 52? are mostly engaged in subsistence activities but also include a significant number who are unemployed. Since the subsistence sector is large in PNG, and as unemployment in this sector is more likely to translate into underemployment than overt unemployment, data on formal unemployment are likely to underestimate the true extent of the problem. Based on the 1980 census data, it was estimated that unemployment then was probably as high as 172, and still higher at 25? in urban areas. 1.8 Formal sector employment fell appreciably during the first half of the 1980s (Table 1.2). It picked up during 1985-88, increasing at an estimated 2.0X p.a. over the period, with higher growth of 6.42 p.a. in agriculture. The increase in employment, however, was probably insufficient to keep unemployment from rising. An increase in unemployment is also Indicated by the reported worsening of the law and order situation in recent years. With an estimated 50,000 entrants into the labor market each year, total employment needs to increase by about 2.6S p.a. just to prevent a rise in unemployment. The relatively large backlog of unemployment and underemployment, combined with the rapidly growing labour force, underlines the urgency of policies and programs to promote stronger growth in the nonmining economy, not only in agriculture but in manufacturing and services Table 1.2: PORMAL SECTOR DHPLOYMENT, 1980-89 (change in percent p.a.) 1980-84 1985-88 1989 Share in Total /a Est. (Z) Private Sector -4.2 2.6 4.4 64.5 Agriculture, Forestry -4.2 5.2 4.6 22.5 & Fisheries Of which Agriculture 2.9 6.4 2.9 15.8 Mining 6.0 -0.1 -16.6 2.4 :4anufacturing -4.2 2.2 5.7 8.1 Rest of the Economy lb -5.1 2.4 11.9 31.5 Public Sector /c 1.7 0.9 - 35.5 Total -2.1 2.0 2.9 100.0 L In 1984, the last year for which comprehensive formal sector employment data are available. L Construction, transport and services; does not include domestic servants. fc Estimate; comprises Government employees, including education and health workers, employees of public utilities, as well as Government daily paid workers. Sources Data provided by PNG authorities and staff estimates.  - 5 - as well. A major factor constraining employment growth is the relatively high wages, underpinned by a centralized wage indexation system. These have checked employment growth by reducing the profitability of, and hence discouraging, private investment, and by biasing production techniques toward greater capital intensity. Furthermore, a high differential between urban and rural wages has contributed to the more acute unemployment problem in urban areas. A reform of wage policy, therefore, would be a key element of a strategy to promote employment growth in PNG. 1.9 Investment. The steady decline in private nonmineral investment over the 19809 (Table 1.3) has been a major reason for the low growth rates of the nonmining economy. Some of the key factors which have discouraged private investment have already been mentioned above in explaining the weak growth performance of the nonmining economy, namely, poor competitiveness of many activities because of high wages, paucity of managerial and tecbnical skills, and inadequ4cy of supportive infrastructure. Others have been the difficulty of acquiring land to establish businesses, cumbersome regulations governing foreign investment, the generally weak public sector institutional support, and the law and order problem. Perhaps the least satisfactory aspect of economic performance during 1985-88 was the continued decline in real private nonmineral investment. Reversing this trend will be critical to the economy's future growth prospects. 1.10 Public investment also fell substantially in real terms during the first half of the 1980s, as investment bore the brunt of the Government's efforts to contain public spending to reduce the high fiscal deficit (para. 1.12). However, recognizing the need to protect public investment, the Government began to tighten controls on current expenditures in 1985, allowing Table 1.3S FIXED IWBSTMZ1TS BY SZCTOR, 1981-89 (percent of GDP) 1981 1983 1985 1987 1988 1989 Est. Total Fixed Investment 26.8 29.7 18.6 20.3 20.1 24.9 Public Investment 8.7 5.0 4.3 5.3 5.5 5.9 Government 6.4 3.0 2.3 3.7 3.8 4.0 Public Enterprises 2.3 2.0 1.9 1.6 1.7 1.9 Private Investment 18.1 24.7 14.3 15.0 14.6 19.0 Mining 4.8 14.0 3.6 7.0 6.8 10.5 Nonmining 13.4 10.7 10.7 8.0 7.8 8.5 Agriculture, Forestry & Fisheries 4.3 2.9 2.6 2.6 2.5 Manufacturing 2.0 1.3 1.0 0.8 0.7 Construction 1.6 1.2 1.5 1.2 1.2 Others la 5.4 5.2 5.6 3.4 3.3 la Include commerce; transport, storage and comuunications; financial and business services; and social and community services. Sourcet Data provided by PUG authorities and staff estimates.  - 6 - some recovery in public investment levels during the 1985-88 period. Efforts to raise public investment received a further boost in 1988 with the introduction of the country's first public investment program which aimed at a major increase In public investment in a medium-term framework, emphasizing in particular investment in productive and infrastructure sectors that would support private sector initiatives. By virtue of these endeavors, public investment recovered from 4.32 to 5.52 of GDP during 1985-88. Notwithstanding this recovery, public investment in real terms was lower at the end of this period than at the start of the decade because of the large decline occurring in previous years. 1.11 Movements in aggregate investment in PNG for the past several years have been dominated by investment activities in the mineral sector due to the lumpiness of mineral projects. The sharp drop in aggregate investment in 1985 (Table 1.3) was mainly due to the completion of major construction activity at the Ok Tedi mine. Similarly, much of the rise in aggregate investment later during 1985-88 was due to the start of construction at Misima, and some further development work at Ok Tedi and Bougainville mines. Macroeconomic Management 1.12 Fiscal Policy. An area where the improvement in performance during 1985-88 was particularly noteworthy was fiscal management. Because of expansionary expenditure policies and weak revenue mobilization, large fiscal deficits had developed in the early 1980s, averaging about 5.5 2 of GDP during 1981-83 (Table 1.4). Toward the mid 19808, the Government began to tighten its control over expenditures. However, most of the cuts in expenditures initially fell on investment, resulting in a sharp drop in capital expenditures. By 1985, the overall National Government fiscal deficit had been lowered to about 2S of GDP but capital expenditures had also dropped to only 2.4S of GDP and 7.52 of total expenditures in National Government budget. Realizing that investment levels had fallen to levels that endangered future growth, the Government undertook an important policy shift, moving away from purely short-term stabilization to more growth-oriented fiscal adjustment. Expenditure restraint was extended to current expenditures, to release more resources for investment, and measures were also taken to improve revenue mobilization, including tax adjustments and improvements in the collection of both tax and nontax revenues. This not only led to a further narrowing of the fiscal deficit to around 12 of GDP in 1987-88, but also an improvement in the composition of expenditures. As a reflection of this, government dissavings (excess of current expenditures over domestic revenues) fell from 9.02 of GDP in 1985 (10.22 in 1983) to 3.72 in 1988, which represents substantial fiscal adjustment. 1.13 Another aspect of the improvement in fiscal performance was the increased fiscal self-reliance as reflected in a reduced dependence on Australian budgetary grants. The share of these grants in total government current revenues fell from 322 in 1984 to 212 in 1988. Also, the Government adopted a more prudent approach to external borrowing, strictly limiting recourse to borrowing from commercial sources for budgetary financing (in contrast to substantial such borrowing in the first half of the 19809) and strengthening efforts to mobilize greater assistance from official concessional sources.  - 7 - TabI. 1.4: NATIOML wiNOf FISCAL 8PUATIU, 18100 1991 1i88 1985 1987 1988 1989 1989 1990 Budget E.t. Budget Rev. (In millions of kina) Current Receipt 557 629 718 829 88 979 1,007 1,005 Domestic Revenue 874 410 407 644 603 778 819 792 Tax Revenue 821 837 416 601 5BB 641 099 646 DirPet Texas 206 192 287 271 826 840 890 Indirect Texes 115 145 179 280 240 801 299 Non-Tax Revenue 58 79 91 144 127 187? 1O 147 Budgetary Grant. 183 213 216 184 190 201 188 218 Current Expenditure 587 617 712 766 809 881 908 874 Capital Expenditure 122 98 B8 97 109 158 129 l88 Total Expenditure 659 718 77 8U6 918 1,034 1,087 1,012 OveraIl B lanco -102 -84 -58 -36 -85 -66 -80 -7 External Finnneing (net) aS 111 2 e1 -18 34 -7 is Of which: Official 26 49 4 108 /L 60 102 62 164fr Commrclal 6o 62 -2 -42 -78 - -68 .9 -88 Dometic Financing (net) 17 -25 s6 -25 Ss 21 87 -n 1emo0 ite Domestic Revenue l"s Current Expenditure -168 -201 -216 -124 -116 -108 -89 -82 (Government Savings) (In percent of GOP) Current Receipte $3.1 29.8 29.7 29.8 28.0 81.4 32.8 81.1 Do"metic Revenue 22.2 19.4 2C.7 22.8 22.0 25.0 28.8 24.5 Tax Revenue 19.1 15.7 17.8 17.7 18.0 20.6 22.1 20.0 Direct Texes 12.8 8.9 9.9 9.6 10.3 10.9 12.5 Indirect Taxe" 6.8 6.0 7.4 8.1 7.6 9.7 9.6 Non-Tax Revenue 3.2 3.7 3.4 5.1 4.0 4.4 4.2 4.5 Budgetary Grant. 10.9 9.9 9.0 6.6 6.0 6.5 8.0 6.6 Current Expenditure 31.9 28.8 29.6 27.2 25.6 28.8 29.1 27.1 Capital Expenditure 7.3 4.6 2.4 3.4 8.6 4.9 4.1 4.3 Total Expenditure 39.2 38.2 32.1 80.6 29.1 83.2 83.8 31.3 Ovorall Balance -6.1 -8.9 -2.4 -1.8 -1.1 -1.6 -1.0 -0.2 Government Savin" -9.7 -9.4 -9.0 -4.4 -3.? -8.8 -2.8 -2.6 / Includes the rectipt of K 47 million from STABEX In 1987. Includes dditional officiel Inflow to support the balance of paymnts, excluding the ugs of w resource. Source: Data provided by PUG authorities and staff estimtes. 1.14 Monetary Policy. Fiscal restraint, by limiting government recourse to the banking system, facilitated the task of monetary policy in keeping the increase in money supply consistent with the requirements of noninflationary growth and a sound balance of payments position while meeting the credit needs of the private sector. Growth in total liquidity averaged about 7Z p.a. during 1985-88, decelerating to an average of less than 32 p.a. during 1987-88 (Table 1.5). This contributed to reducing domestic inflation from over 72 p.a. in the first half of the 19809 to an average of 4.52 p.a. during 1985 -88. Interest rates were mostly market determined, and were generally significantly positive in real terms.  - 8 - 1.15 While the Sank of Papua New Guinea (BPNG) was able to achieve its broad monetary policy goals during the period under review, there continued to be some volatility in credit growth from year to year, as indicated in Table 1.5. This in part reflects the limited instruments available to BPNG to ensure attainment of its annual credit targets. The Bank relies primarily on the use of the minimum liquid asset ratio and discount facilities. The use of open market operations, a potentially more effective control instrument, is constrained by the small market for government securities. A factor hampering the development of the securities market has been the Government's policy of meeting its domestic financing needs mostly through advances from BPNG rather than the issuance of securities. A change in this policy would not only allow the Government to tap nonbank sources for meeting some of its domestic financing requirements but would also facilitate more effective monetary management. Table 1.5t KONST.AY AND PRUCR DEVELOMNBIS 1984-89 (Annual percentage change) 1984 1985 1986 1987 1988 1989 Total Liquidity 14.2 8.7 14.1 1.5 4.4 5.9 Broad Money (M3*) La 17.0 8.8 16.0 9.5 16.9 7.0 Domestic Credit 20.1 21.6 16.7 3.6 20.5 11.6 Of whicht Public Lb -1.1 2.0 3.0 -5.6 7.0 2.6 Private /b 21.2 19.6 13.7 9.2 13.5 9.0 Consumer Price Index /c 7.5 3.7 5.5 3.3 5.4 4.5 a Equals total liquidity (M3) less deposits of stabilization funds and of BCL. lb Change expressed in percent of total domestic credit outstanding at the beginning of the period. jc Period averages. Source: Data provided by PN