Supporting Inclusive Finance through the Development of Private Sector Banking (FAST Report PNG 51170) SECTOR OVERVIEW A. Economic Overview 1. Papua New Guinea (PNG) is rich with natural resources, yet sustainable exploitation has been hampered by the difficult terrain, land tenure issues, and the high cost of developing infrastructure. PNG’s economy is largely dependent on commodity exports, which represent a significant source of foreign exchange income. Mineral deposits, including copper, gold, and oil, account for nearly two-thirds of export earnings. Economic growth in PNG increased to 8.0% in 2014 as the country began its first exports of liquefied natural gas. In 2015, PNG recorded the fastest growth in the Pacific region at about 10.0%, which slowed down to 2.0% in 2016 and 3.0% in 2017 because of decreased foreign investment, soft global commodity prices, lower production from mining, and unfavorable weather conditions. Growth further slowed in 2018 to 0.2%, as an earthquake in February 2018 had a significant impact on the extractive sector. 2. The reconstruction of housing and infrastructure destroyed by the earthquake in 2018 will contribute to a mild pickup in gross fixed investment growth in 2019. Export volumes of mining and energy products will also recover following the disruption caused by the earthquake. As a result, real gross domestic product (GDP) growth is expected to increase to 3.7% in 2019. GDP growth will be supported by investment and construction in the natural resource sector following the signing of the largest gold mine and a new liquefied natural gas project in the country. Further, commodity prices, currently at historic lows, are expected to remain steady; there has been flight to quality, with gold prices on an upward trend since the beginning of the trade war between the People’s Republic of China and the United States (US). In the meantime, Government of PNG policies are expected to focus on building productive capacity in non-mining sectors such as agriculture, fisheries, and tourism. 3. Inflation eased to 4.5% in 2018 from 6.8% in 2016, as foreign exchange became more readily available. The average annual consumer price inflation is expected to ease from an estimated 4.5% in 2018 to 4.2% in 2019, as the impact of price increases that followed the February 2018 earthquake recedes. Nonetheless, consumer price inflation is expected to remain high during the forecast period (2019-2024), averaging 4.8% a year during 2019–2023 and then maintained at the Bank of Papua New Guinea (BPNG) targeted inflation reference rate of 5.0%. Higher global food prices and a depreciation of the kina (which will boost the local currency cost of imported products) can contribute to inflationary pressures. The BPNG has a reasonably strong track record in terms of inflation management. During 2007–2016, the average inflation rate in PNG was 5.5%, which is acceptable by frontier market standards. That said, official consumer price index figures may understate the pace of price increases in the economy. In addition, the government has set up a sovereign wealth fund that aims to curb appreciatory pressures on the kina and to address the potential for inflationary pressures should the country's trade account continue to surge; this should help keep inflationary expectations anchored. 4. Despite a large current account surplus, PNG continues to face a shortage of foreign exchange. PNG’s current account surplus for 2018 is estimated to be about 23.0% of GDP, as higher commodity prices offset the impact of the temporary cut in export volumes, while foreign exchange shortages continue to delay and compress imports. The current account surpluses have been almost entirely offset by capital and financial account outflows, mainly related to project debt repayments. PNG’s international reserves have remained stable, at about $1.7 billion, equivalent to 5 months of imports. Henceforth, some improvement in foreign exchange inflows is projected, associated with higher commodity prices, a second sovereign bond issue, and sovereign loans from multilateral institutions (footnote 1). The current account surplus is expected 2 to shrink somewhat as oil and gas prices fall below those of 2018. In 2020, imports should rise even more rapidly as construction begins on new projects, further shrinking the current account surplus. The new resource projects will attract significant inflows of foreign exchange, finally ending the era of foreign currency shortages. 5. An expansionary fiscal stance since 2012 prompted by generous fiscal conditions and a low debt-to-GDP ratio has depleted the fiscal and monetary reserves substantially. The 2019 budget targets a fiscal deficit equal to 2.1% of GDP, which aligns with the government’s fiscal consolidation strategy. Targets are to become progressively lower, with the 2022 deficit intended to equal 1.0% of GDP. The government’s expenditure strategy would reallocate spending from current to capital expenditure, which aligns with the government’s Medium-Term Development Plan 3, 2018–2022, which is to increase spending on infrastructure. The deficit will be financed by external borrowings, including budget support loans from multilateral institutions and proceeds from a new sovereign bond. PNG recorded total government debt equivalent to 36.90% of the country's GDP in 2018. 6. Managing the foreign exchange imbalance has been a challenge for the government, which fears that significant inflation could result if the market determined the exchange rate. The foreign currency environment improved in 2018; while there was only minimal kina depreciation in 2017. In 2018, the kina depreciated about 4.0% against the US dollar, which helped improve the foreign exchange imbalance. Since July 2018, the BPNG has undertaken several interventions to increase foreign exchange supply, averaging about $50 million per month, and has also overseen a gradual downward adjustment in the exchange rate against the US dollar of about 0.3% per month. Clearing the backlog of foreign exchange orders will withdraw substantial liquidity from the system.1 B. Financial Sector a. Commercial Banks 7. As of April 2018, four commercial banks accounted for 90% of the total assets in the PNG financial sector.2 The remaining assets are held by 12 licensed finance companies (including 5 microfinance institutions); 22 savings and loan societies (although few are fully operational); other institutions like the state-owned National Development Bank, which lends to the rural sector; and unregulated semiformal and informal microfinance providers. 8. In order of market share, the four commercial banks operating in PNG are the locally owned Bank of South Pacific (BSP), Australia and New Zealand Banking Group Limited (ANZ), Westpac Banking Corporation, and Kina Bank. BSP, which serves small and medium-sized enterprises (SMEs) and middle- to lower-income borrowers, has a market share of slightly more than 60% in terms of total of banking sector loans outstanding. The two foreign banks, ANZ and Westpac, focus on foreign corporates; ANZ had a 21% market share and Westpac had a 13% market share as of April 2018 (footnote 2). Kina Bank’s market share is 5.8% in terms of lending assets and 4.8% in terms of deposits. However, with the acquisition of ANZ’s retail and SME banking business by Kina Bank in September 2019, Kina Bank’s market share will increase to 8.8% in terms of lending assets and 9.9% in terms of deposits, reducing ANZ’s share. ANZ and 1 International Monetary Fund (IMF). 2018. Papua New Guinea: 2018 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Papua New Guinea. Washington, DC. 2 BPNG. 2018. Fortnightly Statistics Update for 25 May,2018. PNG. Market share is based on total banking sector loans at the end of April 2018. Data after April 2018 is not available. 3 Westpac have been gradually withdrawing from the retail and SME business in all Pacific countries (including PNG) to focus on larger corporate business. 9. The four commercial banks in PNG had total assets of $8.9 billion and a total loan portfolio of $4.1 billion as of December 2018. Overall, the loan portfolio grew at a compound annual growth rate (CAGR) of 12% during 2010–2018. Deposits grew at a CAGR of 6% during the same period, although there was a fall in deposits in 2017–2018 because of uncertainty around the general election outcome and the enactment of the Public Money Management Regularization Act 2017, which led to the transfer of statutory authority funds from BSP to government coffers. 10. Over the next five years, it is expected that the overall commercial bank loan book will continue to grow at a CAGR of 12% due to: (i) increased investment and construction in the natural resource sector; (ii) capacity building in non-mining sectors; and (iii) increased household debt for consumption.3 Also, because of a limited number of saving alternatives, deposits are expected to continue to grow at the historical rate of 10.0% (CAGR from 2010 to 2016) over the next five years.4 This should provide adequate liquidity in the PNG banking system, offsetting risks posed by the banking system's limited access to offshore or wholesale funding markets. The commercial banks are expected to garner deposits from corporates and attract new household deposits. Corporate deposits will continue to grow as a percentage of total system deposits as economic growth resumes and corporates regain confidence. Overall, it is expected that deposits will stabilize because of more household savings as banking penetration increases. 11. The banking system is sound, profitable, and adequately capitalized. Banks have abundant liquidity, as they hold only about half of their assets as loans. The other half is held in short-term securities and cash, because of structural constraints related to: (i) the foreign exchange shortage, which has contributed to a buildup of liquidity as bank deposits have been bolstered by funds intended for repatriation abroad while credit growth has weakened; and (ii) the lack of a properly functioning interbank market (due to lack of trust among banks, which makes monetary policy instruments such as the policy rate ineffective).