FIRST some basics. The Papua New Guinea kina ‘floats’ relative to a weighted basket of currencies, called a trade weighted index.
It is a managed float in the sense that the Bank of PNG (BPNG) intervenes on a daily and weekly basis to smooth out shorter term volatility and allows the kina’s price to move to reflect longer term trends.
Determining these trends requires some guess work, and in addition BPNG may have other policy objectives. For example by depreciating the trade weighted index it can make PNG’s exports more competitive.
In recent weeks it appears that BPNG has altered the weighting to 100% US dollars and is pegging the exchange rate and limiting purchases of foreign currency.
While there is the whiff of a first generation currency crisis about the situation (loose fiscal policy with the deficit partially funded by the central bank), this is likely only a short term stop-gap while the kina remains under pressure. Normal practice will resume at some point the future.
If the exchange rate floated freely then the overall balance of payments, which is the sum of the balance of payments on the current account and the balance of payments on the financial account, would be zero (ignoring the capital account for simplicity).
What do these terms mean? They are simply the summations of different parts of the demand of and supply for foreign exchange.
The current account is made up of net exports (exports less imports), net factor income (earnings on foreign investments less payments to foreigners who own domestic assets) and net income transfers.
The largest and most interesting components of the current account are exports and imports so let’s restrict our attention to them.
The financial account reflects net capital inflows, which is the difference between foreigners’ purchases of our assets and our purchases of foreign assets.
This may all sound a bit confusing but it is not when you think about it this way. Exports and foreigners’ purchases of our assets reflect a demand by foreigners for our goods and assets, and are thus a supply of foreign currency for PNG.
On the other hand imports and our purchases of foreign assets reflect a demand for by Papua New Guineans for foreign goods and assets, and are a demand for foreign currency.
Adding the current account and the financial account together is adding the demand and supply for foreign currency together.
When they equal zero, the demand and supply for foreign currency are equal, or equivalently the balance of payments is in equilibrium, and the kina will be at its equilibrium price.
So where is PNG currently? In 2013 the current account was in deficit because imports exceeded exports, and the financial account was in surplus (foreign purchases of PNG assets exceeded PNG’s purchases of foreign assets).
This situation is forecast to continue in 2014 with the current account at about minus K7.2 billion and the financial account at K6.1 billion leading to a balance of payments deficit of K1.1 billion.
This means there is an excess supply of kina, or an excess demand for foreign currency, and to keep the kina from depreciating the BPNG must buy kina and sell foreign exchange, which will deplete foreign currency reserves.
And this is what is happening. From the beginning to the end of 2014, foreign currency reserves are projected to fall from $US2.855 billion to $US2.785 billion, although the recent outflow limits are a hint that it may be larger than this.
So what is the outlook for the kina?
This is where things get interesting. Big (and as yet unanswered) questions are asked.
From 2015 onwards BPNG is predicting large current account surpluses as exports jump due to the LNG project activity. The current account in both 2015 and 2016 is projected to be around K11.2 billion, up from minus K7.2 billion in 2014.
At the same BPNG is forecasting that the financial account will offset this, becoming immediately negative and falling to about minus 10.8 billion in both 2015 and 2016.
These forecasts mean that there will be small balance of payment surpluses in both years. However, there is no reason or mechanism to ensure that the financial account will comply in such a convenient way.
Certainly it will fall as LNG investment tails off, but there is no reason to forecast that it will become so strongly negative.
A far more reasonable and likely forecast is one in which PNG runs a large balance of payments surplus with underlying current account and financial account surpluses in 2015, 2016 and beyond while the economy adjusts to the export boom.
The financial account may become more neutral, and its behaviour will depend largely on foreign investment elsewhere in PNG.
This would mean an excess demand for kina, and pressure for the kina to appreciate, which it would if it were freely floating.
There might be resistance to this because of ‘Dutch Disease’ concerns, as it will make PNG’s exports less competitive as they become more expensive to foreign buyers.
If BPNG was to resist this pressure for the kina to appreciate it would need to sell kina on the foreign exchange market and buy foreign currency, which would increase foreign currency reserves.
However, this action increases the amount of kina in circulation and ultimately the broad money supply will grow more quickly which will push up inflation, which also has the effect of making PNG exports more expensive to foreigners. It is difficult to escape the ‘Dutch Disease’!
In 2015 and 2016 the broad money supply growth rate forecast is at below the five year trend. This forecast highly questionable given the assumptions about the financial account in those years, and it is perhaps the reason for them.
There are other options open to BPNG. For example, if it did resist the pressure on the kina to appreciate, it could sell bonds at the same rate that it sells kina to minimise the impact of its foreign currency operations on the domestic money supply.
To summarise, the big question is ‘how is the Bank of PNG going to deal with the arrival of a large balance of payments surplus’?
Will it allow the kina to appreciate, will it moderate the kina’s rise and allow growth in the monetary base, or will it use some instrument to sterilise the monetary consequences of kina intervention?
A smaller and corollary question is ‘are the BPNG forecasts arranged to avoid, or to avoid revealing their, thinking about the big question’?
* The name of the author, who requested anonymity, is known to the editor