Avoiding the Dutch disease and directing funds towards long-term goals

On the cusp of a major resource windfall over the next decade, the government is establishing the means to manage such inflows in Papua New Guinea’s small and open economy. Like 58 other countries, PNG is in the process of establishing a sovereign wealth fund (SWF) just as liquefied natural gas (LNG) exports begin to flow from the PNG LNG project. Although state revenues from LNG will be lower during the cost-recovery period, both the Bank of PNG (BPNG) and the Treasury are eager to establish a resilient system to replace existing trust accounts. “We want to avoid the mistakes made in the past, including the depletion of the Mineral Resources Stabilisation Fund (MSRF) between 1990 and 2001 and the trust accounts in which the windfall revenues of the increase in resource prices in the last five years were parked,” Benny Popoitai, the deputy-governor of BPNG, told a Schroders seminar in Singapore in October 2013. In the medium term the country’s SWF will relieve pressure on the currency, act as a fiscal stabiliser and channel investments towards the country’s long-term development goals.

Legal Backing

An organic law passed in February 2012 creates the legal foundation for the SWF, although its exact administration and investment remit are still pending a revised organic law, drafted in conjunction with legal firm Allen Overy. Following the Santiago Principles, voluntary guidelines issues in 2008 by the IMF, the fund is set to follow the rules of transparency, strong governance and clear objectives. The aim is to provide macroeconomic stabilisation, improve economic oversight, enhance fiscal transparency by integrating all fund drawdowns into the budgetary process and enhance sovereign asset management and savings. By managing a share of the proceeds offshore, the SWF will also mitigate the risk of “Dutch Disease” where commodity exports cause significant currency appreciation, thereby crowding out non-mineral sectors. With assistance from the IMF, World Bank, Asian Development Bank and Australia’s Future Fund, the Treasury intends to structure the SWF in three sub-funds.

Fund Design

The first, a stabilisation fund, will offset any budget shortfalls to balance the books in an effort to insulate the budget from fluctuations in global commodity prices, similar to those since mid-2012, for instance. The stabilisation fund will only disburse funds on a needs basis, matching government spending with the domestic economy’s absorption capacity. The other development fund will be split between a sub-fund focusing on infrastructure development locally and another, larger, future savings fund that will channel investments offshore to offset upward pressure on the currency and manage assets for the benefit of future generations. While the stabilisation fund will derive funding from all government mining and petroleum revenues, the development funds will be capitalised with dividends from the government’s 16.8% stake in PNG LNG and equity in future projects. Sub-funds will be barred from investing in government securities, with drawdowns on the stabilisation fund expected to flow through the normal budgetary process.

Checks & Balances

Strong checks and balances are required to mark the SWF initiative apart from previous attempts to manage such windfall inflows. Indeed, PNG’s attempt at independence to establish a wealth management fund, the MRSF, is one the authorities wish to avoid repeating. The MRSF was established in 1974 to manage the proceeds from large projects like the Rio Tinto-backed Panguna Copper Mine in Bougainville and, later in the 1980s, BHP Billiton’s OK Tedi. Following a revision to the act in 1987, the government was given significantly more discretion in withdrawals. By 1999, when it was closed, the fund was exhausted through excessive withdrawals and misappropriations.

The new SWF plans for a more resilient governance structure aimed at fully accounting for withdrawals. An independent board will oversee all funds within the SWF, with regular audits from both international auditors and independent probity assessors.

The composition of the seven-member board will include the Treasury minister and six private sector representatives selected by an appointment committee comprising the prime minister, auditor general, BPNG governor, leader of the opposition and the head of the PNG Chamber of Commerce and Industry. Meanwhile, annual transfers from the stabilisation fund will not exceed the moving 15-year average of resource proceeds as a share of budgeted revenue.

Resource Proceeds

Although the PNG LNG project is expected to produce roughly 9trn cu feet of gas and some PGK75bn ($30.5bn) in income for the public purse over its 30-year lifetime, the fund is only expected to build up significant reserves from the start of the next decade. Given tax concessions, extended as incentives for the project’s backers to invest, and longer recoveries on the project’s $19bn costs (up from an originally estimated $15.3bn), the government projects tax income of PGK1.6bn ($650.4m) to PGK2bn ($813m) annually from the start of gas exports in 2014 to 2022, rising to PGK4.5bn ($1.8bn) a year thereafter. Most of the PGK52bn ($21.1bn) in annual LNG proceeds from 2015 will flow offshore. Royalty payments will be transferred to the affected landowner groups on top of their 2.8% equity stake in the project.

The government expects dividend payments of between PGK650m ($264.2m) and PGK800m ($325.2m) a year from its 16.8% equity stake, although the World Bank expected this income to be used initially to pay off the $1.6bn in debt associated with the financing of the equity stake in PNG LNG as well as state equity in future resource projects. In the first quarter of 2014 the Treasury contracted Swiss bank UBS to refinance a convertible bond issued to the International Petroleum Investment Company of Abu Dhabi using the government’s 14.7% stake in Oil Search as collateral (see analysis). Meanwhile, revenue projections for the fund are based on assumptions regarding Japanese LNG prices over the medium term, which could converge fall as North American export terminal come on-line.

Prospects

While the total of PGK75bn ($30.5bn) in government income over the LNG project’s lifetime would make PNG’s SWF the world’s 26th largest, according to the IMF, the fund will accrue reserves gradually. The Treasury notes in the 2013 budget that “over the next five years much of the this revenue will simply replace expected declines from other mines such as OK Tedi as well as declining production in the Kutubu oil fields”. The stabilisation fund is not expected to build up any reserves net of annual budgeted spending until 2024, while the development fund is set to receive PGK650m ($264.2m) annually, although significant amounts of funds will flow in and out in the interim.

As the details of the fund’s administration and investment remit are finalised, the IMF has warned about the potential for underfunding the SWF, stating in its 2013 Article IV consultation, “The mission encourages the government to revisit the withdrawal rules early on to ensure that sufficient resources are accumulated in the SWF for stabilisation and development purposes.”