Counterarguments to the devaluation of the PNG Kina

Papua New Guinea Kina
Papua New Guinea Kina
Written by David Lea

The proposed devaluation of the PNG Kina has recently been promoted by international donor agencies, specifically the IMF, and academics at The Australian National University (ANU). Stephen Howes, of the Crawford School of Public Policy within ANU, has been a strong academic voice arguing for devaluation. In a blog earlier this year, he argued that in recent years traditional business concerns such as security, skills shortages and infrastructure have been displaced by concerns around foreign exchange availability:

“The only real solution is a devaluation of the exchange rate. A devaluation would be neither painless nor a panacea, but there is simply no other way to resolve the foreign exchange crisis other than to try to wait it out. Again, the IMF has it right: “[We] recommend that the Kina be allowed to depreciate to eliminate the current over-valuation of the currency, end the FX shortage, and promote external competitiveness.””

Moreover, in the same article he continues to explain his position: “If businesses can’t import, they are not going to produce and employ. And if they can’t get their profits out, foreign investors are going to stay away… The IMF put it well in its December 2017 report on PNG: “The main impediment to private sector development is macroeconomic policies. The main obstacle to business activity and investment are difficulties in obtaining foreign exchange.”

If I understand Howes’ argument correctly, it appears he believes that essentially, businesses find it difficult to import because of the missing foreign exchange required to purchase imports. The high cost of the Kina means high operational costs within PNG. Lowering the cost of the Kina means lower operational costs, allowing for profits that will offset the cost of imports. As PNG thus creates a more profitable business environment, new investors will find it attractive, with a devalued Kina consequently increasing foreign investment – bringing in much-needed foreign exchange.

One might argue that a devalued Kina, which lowers the cost of investment for foreign investors, will not work if the prospective investor lacks confidence in the business environment. Howes claims, nevertheless, that business confidence is high and it is the lack of foreign exchange availability that is holding matters back.

But who are these investors that will rescue PNG from the foreign exchange crisis if the Kina is cheapened, allowing investors to “get their profits out”? PNG has a very limited resource-based economic market. As Adam Smith noted in the Wealth of nations (book one, chapter one), the division of labour is limited by the size of the market and the converse is true, limited specialisation is indicative of a limited market. Smith underlined that where there is little division of labour, each individual must assume a plurality of tasks as in a subsistence system, and a significant market cannot be generated. PNG approximates this assessment of the realities in a limited market, with one estimate that over 85% of the population engages in subsistence agriculture. This environment will fail to attract investors, regardless of Kina costs, unless factors are addressed which allow for market expansion.

Without proper transportation infrastructure which allows for market expansion, investment possibilities will remain extremely narrow. Outside Moresby, the road only reaches about 100 kilometres eastward to Kupiano, and a somewhat longer distance westward. In Lae, the Highlands Highway is in desperate need of repair, with holdups and road blocks frequently occurring as transportation has become a perilous undertaking.

The weakness of the central government is another factor. Law and order can be maintained to an extent in the urban centres, but beyond this the government’s ability to police relations diminishes.

Finally, skills shortages present further issues. Successive governments have failed to support a viable system of education. The national high school system that produced a core of elite well-prepared secondary school leavers has collapsed, while the universities have been starved of funds and cannot guarantee the quality of their graduates (see here and here). These are serious problems and cannot be simply resolved by tweaking monetary policy.

On the other hand, a devalued Kina would have a devastating effect on the urban markets, which are the only viable economies external to the subsistence economy. Significant economic activity, as it exists in PNG beyond the resource extraction industry, is centred in the urban areas, particularly Lae and Port Moresby. These markets depend heavily on the importation and trade of goods which are unobtainable locally. A devalued Kina will severely hinder the capacity to purchase and make these goods available on the local market. Because more Kina will be required to purchase the foreign exchange necessary to buy foreign products, foreign goods which do become available will exhibit a significant price increase in Kina. Inventories will go unpurchased and an inevitable economic downturn will follow. Staff will have to be laid off, and increasing unemployment will have a knock-on effect as demand shrinks along with growing unemployment. A devalued Kina would more than decimate retail trade in the urban centres.

Although Howes refers to the opinion of contacted CEOs, my anecdotal experience with numerous local businessmen, both expat and national, indicates a decidedly emphatic rejection of the notion of devaluation for the above reasons. I found that many already see the Kina as too low, attributing this to banking policies and the failure of resource developers to bring profits onshore. Many see the unavailability of foreign exchange as attributable to these realities, rather than the alleged overvalued Kina.

The counterargument holds that a degree of short-term pain is inevitable but that in the long-term the environment will be better off when investment picks up, bringing in much-needed foreign reserves and strengthening employment. This form of proposed austerity would be difficult to handle. Unemployment is already an issue in the urban centres, and risking an increase in unemployment will further worsen security and effective governance. This development would have the potential to make the local environment even more antithetical to investment.

The IMF report which Howes refers to argues for a devalued Kina that will “promote external competitiveness”. Again, competitiveness will depend upon the presence of plurality of investors, yet as argued, the market is not sufficiently large to attract this plurality. This is due to above the factors mentioned, and real competitiveness will not happen until these matters are actively addressed.

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David Lea

David Lea is a Professor and Head of Political Science at the University of Papua New Guinea.

4 Comments

  • Hi David, thanks for the contribution to this vital debate. Though I do respectfully disagree with your argument. At some level, when discussing exchange rate policy – you are trading off who gets to live in poverty – which is a nasty situation to be in. But anyway, here goes.

    I concur with Stephen’s comment – if we take the arguments outlined at face value then BPNG should make the exchange rate as high as possible. But given that no country on earth does this, and most intuitively know that this wouldn’t be a great idea.

    As such, the argument put forth seems to lack the acknowledgement of the trade off at play (where is the discussion about rural dwellers and exporters?) – which is the key factor in choosing actual value for the exchange rate – rather than just outlining an argument for “UP”, or “DOWN”.

    If the exchange rate shouldn’t be set as high as possible, then in the absence of quantitative analysis – the choice of rate has to ultimately be informed by individual experience, logical argument and/or anecdotes. Logic can’t tell you exactly what the exchange rate should be, – the argument in the blog is no doubt set out logically, but there is no figure suggested – nor could there be.

    That leaves individual experience and anecdotes – which while is valuable to an extent – is surely insufficient. It also makes sense that people living in Port Moresby would have much more contact with the anecdotes of urban dwellers, and less with those of rural dwellers.

    I also raise a query about the effect on employment. FX shortages don’t just happen now and then, they are directly a result of managing the exchange rate. Business says that FX shortages (caused by propping up the Kina) are the key impediment to business – if this is not behind the 5 year decline in employment, what is? There was an initial effect from the end of the LNG Project construction, however that finished in 2014, the decline in resource prices also occurred in 2014 and have stabilised or increased since then. Yet the argument seems to be that devaluation of the Kina would harm employment. Both these things can’t be the case.

  • I think David has well encapsulated the challenge of economists convincing business people why there should be a devaluation in PNG. A devaluation has many vocal losers and silent winners – a common challenge for better public policy. For an exchange rate is simply a price, and any movement of a price has winners and losers.
    I expect that many of the people that David mixes with will stand to lose significantly from a devaluation, and this will lead to actual divestment and loss of jobs for those firms. In particular, businesses primarily involved in importing foreign goods (or simple transformation of imported goods) will be clear losers (assuming they’ve been able to get around current foreign exchange shortages). So David has covered the situation facing many hard-working businesses reliant on imports, and sets out reasons for why many doubt there are business opportunities for more PNG-based production. Other losers, and this was a particular political challenge for the Kina devaluation in the early 2000s, are the urban poor who will face higher prices on items such as imported rice. Losers will also be expat employees paid in foreign currencies, and politicians who want to move their Kina overseas to buy a house in Cairns or Singapore.
    However, there will also be significant winners – such as rural women bringing coffee and cocoa to the factory gate for export. Indeed, with over 2 million people in households with 40-60 per cent of their cash income coming from coffee, they would stand to immediately have an increase in their Kina incomes. A 25% devaluation means the Kina income from their bag of coffee immediately increases by 25%. Indeed, a 25% devaluation is equivalent to a 25% export subsidy for all local PNG production. This would be expected to have incentive effects for more exports – and studies indicate farmers are responsive to higher prices. If PNG had maintained its agriculture production per capita as at the time of Independence, then agriculture exports would be over K3 billion higher than currently.
    In addition, the farmers of Central Province would be more likely able to sell their locally grown produce relative to imported agricultural products in the supermarkets of Port Moresby as a devaluation is actually equivalent to a very effective, non-discriminatory tariff on all imports.
    Tuna manufacturers would immediately have a reduction in their costs relative to producers in the Philippines. Indeed, a 25% devaluation immediately removes 25% of the cost disadvantages faced by firms in PNG due to the higher costs of security, energy, telecommunication, transport and labour.
    Overall, businesses reliant mainly on PNG goods, services and labour will be winners from devaluation. Businesses mainly reliant on imports will be losers. In general, the rural population will benefit as they are cash crop exporters as well as subsistence providers. Many in urban areas will not stand to gain increased export income but will face higher costs of food and imported consumer items.
    Getting the balance right between winners and losers is a real challenge, as is the best way to make the adjustment. This may require some direct compensation measures for the losers – such as a temporary rice subsidy or price controls. However, all indications are that the exchange rate is not at the right price. In 2014, the foreign exchange shortages were predicted by myself and others once the central bank moved the exchange rate away from market fundamentals with an extraordinary 15% appreciation in early July 2014 despite declining commodity prices. This prediction also covered the likely impact of such over-valuation in pushing over 100,000 Papua New Guineans into poverty. The only long-term solution for foreign exchange shortages is to get the price right. Even the ANZ Bank says so – so its not just the IMF and academics and all the international credit ratings agencies.
    The risks to even importing businesses also should not be over-stated as businesspeople in PNG are resourceful and resilient. After allowing for inflation differences between countries (so the Real Effective Exchange Rate), even a 25% devaluation will move the exchange rate back to levels equivalent to the levels of 2004 to 2007. These were times when many businesses were finding new investment opportunities, formal sector employment was growing, and the non-resource sector had a growth rate of around 5%. So even a 25% devaluation would simply be returning to a level when times were much better for importing businesses than current conditions!
    Congratulations to Stephen for publishing David’s counterarguments. This reflects healthy debate and discussion which unfortunately is in decline in PNG.

  • Hear, hear! So happy to read the alternate view put succinctly at last. The arguments for devaluation are filled with theoretical maybes, somewhere down the track, that might benefit the big end of town and might trickle down. As David points out, environmental factors in PNG from security to transport to available skills, land etc. make those outcomes less assured than in more developed economies. To say the least.

    What is guaranteed, though, is that immediately the cost of many, many, things will increase substantially. The cost to build houses – or anything. The cost to feed your urban family. Transport costs. Equipment, spare parts, fertilizer etc.

    One small positive of the FX issue is that local companies should be able to sell more of their product. Supermarket shelves seem to have more local products that before. For obvious reasons.

    If only the billions of current export income could be bought onshore for a while.

  • David,

    I appreciate your contribution. This is definitely a debate PNG needs to have. But I have to ask you: By your argument why stop at not devaluing the Kina? Why, if a strong Kina is such a good thing, not appreciate it and go for parity with the US dollar? This is the logical implication of your argument, and it shows its weakness.

    I won’t repeat all the arguments for a devaluation here. Suffice it to say that the real exchange rate in PNG today is the same rate that prevailed about five years ago at the height of the economic and resource boom. This makes no sense. The economy is paying the price for the government’s refusal to allow the exchange rate to adjust.

    Finally, I don’t think I said business confidence is high. Business confidence has been undermined by the management of the the excess demand for Kina by a complex, expensive, and confidence-sapping system of rationing – a system needed because of a refusal to allow a real depreciation.

    Regards,

    Stephen

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