PNG monetary policy hinders coffee sector

Introduction

Coffee is a significant cash crop in Papua New Guinea (“PNG”), providing incomes for more than 2.43 million people that represent a large percentage of the country’s rural population (CIC, 2017; World Bank, 2019a). Many of the more than 37% of Papua New Guineans who live below the national poverty line (ADB, 2019) engage in subsistence farming and rely on coffee as a primary means of obtaining cash. Despite the importance of the crop, coffee yields in PNG are low relative to their potential (Hetzel & Sipani, 2018; World Bank, 2019a). Investments leading to improvements in coffee quality and productivity for these individuals will result in better food security, income generation, and poverty alleviation (FAO, 2019).

Despite several limitations faced by rural farmers, financial constraints may be the most significant and impactful to overcome (ADB, 2012; World Bank, 2019a). The purpose of this paper is to examine and discuss the macroeconomic conditions that led to a key financial barrier inhibiting development of PNG’s coffee sector in recent years: foreign exchange shortages resulting from overvalued currency.

Situation

Papua New Guinea’s economy has been threatened since 2014 by foreign exchange (“forex”) shortages resulting from an overvalued currency. Forex shortages restrict companies and individuals from making purchases overseas, which is important for a Pacific island nation dependent on imports. As a result, both GDP and economic development slowed dramatically from 2014-2018 (IMF, 2018).
The problem of undersupplied foreign exchange was recognized for three years straight as the most serious problem facing PNG business by the annual PNG 100 CEO survey (Howes, 2018). Although financial conditions have improved in 2019 (World Bank, 2019a), shortages continue, inhibiting investment in necessary supplies, machinery, and infrastructure (Business Advantage PNG, 2019). This has directly and indirectly impacted the nation’s coffee farming sector, which lags in international competitiveness and requires imported equipment and supplies for improvement (Hetzel & Sipani, 2018). Increasing financial hardship for rural coffee farmers, they earn lower nominal incomes when the kina (1) appreciates.

Background

The Bank of Papua New Guinea (“BPNG”) was established as the nation’s central bank by the Central Banking Act of 1973, the same year the country became self-governing (2). Its role at the time was defined as “promoting financial stability” for the benefit of PNG’s citizens (BPNG, 2019a). A new Central Banking Act passed in 2000 expanded and better-defined BPNG’s role as an entity independent of other government influence with full authority over monetary policy and a mandate of maintaining price stability of the kina (BPNG, 2019b). This changed BPNG’s objective to focus on favorable rates of exchange for the import-dependent nation rather than overall stability of the financial system. To carry out its mission, BPNG was given authority to regulate PNG’s currency, forex, and international reserves (BPNG, 2019c).

From 1995 until 2013, the value of the kina was set by a floating market rate regime (3), with exchange rates determined by supply and demand from interbank trade (Fox, 2016). Inflation was high in the early years immediately following the transition from a prior fixed-rate regime, eventually settling to a moderate 4-6% increase annually through 2017 (IMF, 2008; eglitis-media, 2019). Inflation during this period is thought to have been kept largely under control by strong economic growth resulting from higher export commodity prices and large capital investment projects, specifically the PNG LNG Project (Timothy, 2016).

PNG LNG and the Dutch Disease

Construction of the ExxonMobil PNG LNG liquified natural gas extraction and refinery project began in early 2010, pumping $19 billion in construction revenues into the underdeveloped nation, or approximately 40% of 2015 GDP (PNG LNG, 2019). The influx of construction capital combined with a commodity price boom through the Great Recession caused the rapid appreciation in the kina of 38% between June 2010 and October 2012 (4).

Although it may seem counterintuitive, coffee farmers do not directly benefit from strong national currency rates and may, in fact, be harmed, since most coffee traded is in US dollars. Although international competitiveness of PNG was not threatened (5) by the appreciation, an increase in real exchange rate (“RER”) has an inverse relationship to farm-gate price (6). Economist Paul Flanagan (2014) highlights an example of this principle at work during “a bad week” for PNG’s rural coffee farmers, where they received a farm-gate price of K6.00 per kg of coffee on June 2, 2014 but only K4.60 on June 10th. This was due to a 15% appreciation in the kina plus 5% slump in global coffee commodity price.

Although rural farmers may receive some incidental benefits from increased purchasing power for imported staple goods in the long term, like rice, most feel a more immediate negative impact on their livelihood by the reduction in pay (Flanagan, 2014).
The conditions experienced in PNG at this time may be described by an economic model called the “Dutch Disease,” (7) where a boom in one leading tradable sector (petroleum) has negative implications for a lagging sector (agriculture, other exports) as the result of decreased international competitiveness and higher domestic costs in the non-tradable sector (Fox & Schröder, 2017; C.W., 2014).

Balance of Payments Shock and Forex Woes

In early 2014, construction of PNG LNG neared completion, halting inflows of foreign capital and causing a balance of payments shock. Large tax concessions made to its operators meant that few royalties would be received to offset the shortfall for several years to come (Westbrook & Barrett, 2019). This was compounded by dropping oil prices and a price collapse of other natural resource commodities, on which PNG is reliant for the vast majority of its export revenue (Hidalgo & Simoes, 2011; Sheppard, Raval, & Sanderson, 2015). The value of the kina declined sharply in a short period of time (Nguyen & Sum, 2019).

On June 4, 2014, BPNG intervened by introducing an series of measures that effectively fixed the kina to the United States dollar within a narrow band of trading (Westbrook, 2018; US State Dept, 2019). As a matter of economic principle, once a currency exchange rate is fixed, a monetary authority is forced to create an equilibrium nominal money supply (Floyd, 2019). The authority may then control either the domestic money supply or the country’s exchange rate, but not both (Floyd, 2019). To maintain a high rate of exchange, BPNG released most of its foreign currency reserves, taking domestic currency out of circulation and propping-up its value. Dollar reserves fell from $4 billion in 2012 to $1.7 billion at the end of 2017, or roughly the equivalent of only five months of imports. (IMF, 2018; Pryke, 2015)

Unable to float freely and depreciate to reach equilibrium, PNG’s RER became significantly overvalued (Schröder, Nema, Howes, & Fox, 2017). Forex rationing was put in place by BPNG to slow the inflow of foreign currency, leading to surplus demand (Oxford Business Group, 2019). By 2016, the currency shortage was estimated at up-to $1 billion, with businesses forced to wait three months or more (8) to make payments overseas (Westbrook, 2018; Schröder, Nema, Howes, & Fox, 2017). GDP growth slowed from an overheated 15.4% in 2014 to only .3% (9) in 2018 (World Bank, 2019a).

Discussion

Rural PNG is a difficult place to do business in the best of times (10). Farmers must overcome inadequate infrastructure, scarce electricity and clean water, unenforceable land tenure and general lawlessness. These issues are compounded by a smallholder agricultural labor force of millions that lacks organized cooperative support structures. PNG’s coffee industry is unproductive with low yields per hectare compared to other producing nations and average quality substandard (Hetzel & Sipani, 2018). The bulk of PNG’s coffee is discounted in international commodity trading due to quality inconsistencies (11). Although market demand exists for higher-value differentiated coffees from PNG, only a few skilled and organized small and medium enterprise (“SME”) or large multinational business operators are capable of meeting high international market standards (Hetzel & Sipani, 2018). Potential exists for the improvement of yield and quality that can increase incomes and improve rural livelihoods.

Maintaining or improving coffee yield requires active investment (Root Capital, 2016). Capital investments in PNG’s coffee agriculture sector are made by domestic SMEs and multinational exporters, as well as through direct investment by donor-sponsored projects like the World Bank Productive Partnerships in Agricultural Program (“PPAP”) (World Bank, 2019c; Hetzel & Sipani, 2018). Farm-level rehabilitation and productivity investments can raise yields by 300%; these require the purchase of tools and inputs (fertilizers, pesticides), plant breeding stock, vehicles, foreign expertise, materials and supplies (Technoserve, 2013). However, from 2014-2019 Foreign purchases of materials and services were delayed or canceled due to exchange shortages. This indirectly or directly contributing to lower sector performance (12).

Coffee quality and subsequent market value is also affected by capital investments made possible with foreign exchange. As identified by the PNG Coffee Market Study (2018) commissioned by the Pacific Horticultural and Agricultural Market Access Program, the distance between harvesting and processing areas in PNG is a significant contributor to poor coffee quality. Farmers sometimes need to travel one or more days (13) to reach processing centers, carrying perishable harvested coffee cherries that are susceptible to spoilage from fermentation, fungal infection and molds (ITC, 2011). The report recommends investment in community-level processing equipment and national infrastructure as a priority to improve quality and overall productivity. This equipment must also be purchased from abroad, as is any apparatus used in sorting, roasting, or quality control evaluation.

The forex backlog correlates positively with a drop in production during the affected years. From 2014-2019 (14), PNG produced an average of 842,926 60 kg bags of green coffee per annum. For the prior 5-year period, the average was 974,043 bags, representing a 13.46% drop in productivity (ICO, 2019). Although not proven to be a causal relationship, it is reasonable to consider this may be a contributing factor (15).

At the same time, hundreds of thousands of coffee farmers may have been pushed below the poverty line as the result of BPNG’s reluctance to allow the PGK to depreciate to RER equilibrium (Flanagan, 2014). International exchange rates for commodities flow through immediately to smallholder coffee farmers (and in other agricultural industries), lowering nominal value in the market for domestic products and services.

Present situation

As of May 2019, the forex backlog situation has improved but significant shortages still exist. Only 5% of PNG business leaders currently report timely access to needed foreign exchange (Business Advantage PNG, 2019). An earlier March 2019 monetary policy statement issued by BPNG Governor Loi Bakani estimated that a shortage of about $133 million USD remained, down from over $500 million in December 2017. The reduction is credited to cash inflows from higher oil prices, external financing from the World Bank and Asian Development Bank, the successful issuance of the country’s first $500 million USD sovereign 10-year bond in September 2018, and softening of the kina, which was allowed to depreciate approximately 4% (Business Advantage PNG, 2019; Oxford Business Group, 2019).

The mid-term outlook for improvement is positive but forex issues are not expected to be resolved in 2019 (Oxford Business Group, 2019). Furthermore, GDP growth is highly contingent on the valuation of global commodities (specifically metals, minerals, and petroleum), and royalties received from large extraction projects (World Bank, 2019a). A sudden downturn in the value of global commodities may result in delayed recovery.

Conclusion

Maintaining a fixed exchange rate is a risky monetary policy strategy in a commodity-rich economy prone to sudden balance of payment and supply shocks (Nguyen & Sum, 2019). By not allowing the kina to depreciate to natural RER equilibrium at the end of PNG LNG construction, BPNG controlled inflation at the risk of other severe externalities that developed in future years. PNG businesses and its poorest rural farmers were hardest hit by consequential foreign exchange shortages and the impact of lower nominal income from domestic currency overvaluation.

BPNG leaders are collaborating with international monetary authorities to make a gradual move towards greater exchange rate flexibility, which is expected to eliminate overvaluation of the kina. The government of PNG adopted a new five-year medium-term development plan in late 2018, which focuses effort outside of the resource sector (World Bank, 2019a). The move is intended to lessen Papua New Guinea’s reliance on natural resource extraction, leading to better financial stability through commodity market fluctuations. Coffee, however, remains an important cash crop for the majority of the country’s rural population and is positioned to achieve dramatic improvements from new investment, benefitting the Papua New Guineans who need it most.

[1] PNG’s national currency, the kina or symbol PGK

[2] Papua New Guinea was a territory seized from Germany (then German New Guinea) by Australia during WWI and administered by authority of the League of Nations until 1975, when it gained independence as a sovereign nation.

[3] Inflation reached over 17% in 1995 as the currency adjusted to RER equilibrium (eglitis-media, 2019)

[4] Exchange rate data obtained from XE.com, PGK to USD chart, June 29, 2010 to October 29, 2012

[5] With the exception of higher costs for ground transportation, licenses, and other domestic services necessary to export coffee

[6] Value of coffee or other agricultural products after leaving the farm or place of harvest, less marketing costs – most often a processing mill or intermediary cherry (unprocessed coffee) trader in the case of PNG

[7] Term coined by The Economist magazine in 1977, referring to the negative impact of the Netherlands discovering a natural gas field in the North Sea in 1959. This sudden wealth caused the Dutch guilder to rise sharply, making exports of non-oil products less competitive and causing other sectors to fall (Chen, 2019)

[8] BPNG prioritized transactions for food, medicine, aviation, and fuel during the shortage, meaning that lower priority expenditures may be delayed significantly longer or not completed at all (Westbrook, 2018)

[9] A 7.5 earthquake in February 2018 in the highlands region near LNG processing facilities, killing 100 people and doing significant damage to regional infrastructure. Production was disrupted temporarily, leading to net .3% GDP growth for 2018, compared to a 2.5% pre-earthquake projection (World Bank, 2019a)

[10] Papua New Guinea ranks 108^th out of 190 countries for overall ease of doing business, surveyed by the World Bank in its “Doing Business” report, which focuses on urban business (World Bank, 2019b)

[11] The FOB price of PNG coffee averaged 12.7% below baseline commodity coffee value between 2012-2017 (CIC, 2017)

[12] Information obtained by the author from in-person stakeholder interviews with SME, NGO organizations and multinational coffee export representatives in May 2018. List of participants available upon request

[13] It is recommended that pulping, the first stage of coffee processing be done within 24 hours to avoid spoilage. Furthermore, storage in boxes or plastic bags, as PNG farmers may use to transport coffee, may lead to premature fermentation and inferior quality (Easton Smith & Bittenbender, 2008)

[14] 2014/15 through 2018/19 crop season, harvesting May-October

[15] Coffee productivity may be affected by numerous other factors, including global coffee commodity prices, weather (crop productivity and infrastructure condition), natural disasters, biannual crop cycles, availability of labor, political stability, and other issues not reviewed by this report.