Warning on Dutch Disease

 PAPUA NEW Guinea is potentially suffering from Dutch Disease before its liquefied natural gas starts flowing in late 2014, a World Bank economic briefing 2013 says.

The report said ‘Dutch Disease’ referred to the unintended negative impact of a resource boom on a country’s non-resource tradable sector (agriculture, manufacturing, and tradable services such as tourism). 

It was first used to describe the unexpected negative impact of the discovery of the North Sea gas fields on the Netherlands economy in the 1960s. 

The large inflows of foreign exchange following a resource boom lead to an appreciation of the exchange rate. 

The inflows are spent in the domestic economy, which results in a rise in the price of non-tradable goods. Together this implies an increase in a country’s real exchange rate, which in turn harms the tradable (exports and import-competing) sectors. 

For PNG, these pressures mean lower production and incomes for rural cash crop exporters. It reduces the amount of cash available for the majority of PNG’s population living in rural areas in the short-term. 

It undermines incentives to maintain and invest in plantations, and processing and transport infrastructure in the longer-term. It slows the diversification of PNG’s economy and broadening of the range of job opportunities and revenue sources, by making it more difficult for local manufacturers and tourist operators to compete and expand. 

In most economies these pressures follow the start of resource production or a boom in prices. 

In PNG, the volume of resource production has declined since 2003 – although those resources now receive much higher prices with the increase in international commodity prices. 

Rather, in PNG in recent years, the source of any Dutch Disease has been the large capital inflows associated with the construction of the PNG-LNG project with investments in future resource production – unlike Holland, PNG is potentially suffering from Dutch Disease before its gas starts flowing. 

The five broad indicators of Dutch Disease emerge from the economic literature and these indicators do seem to be moving in the direction suggested by the Dutch Disease hypotheses:

• A real appreciation in the currency: The kina real effective exchange rate (ie, against a basket of PNG’s trading partners’ currencies and adjusting for differences in inflation) was 52 per cent stronger in November 2012 than January 2005;  
• A rise in government spending: In 2013 the central government budgets to spend nearly 90 per cent more than it did in 2005, in real terms. As a share of GDP, domestically-financed central government spending rises from 21.7 per cent in 2005 to 28.1 per cent in 2013;  
• A rise in non-traded goods prices: Lack of data makes this difficult to assess. The urban consumer price index in Q3 2012 was 50 per cent higher than in Q1 2005. But this tells us little about non-tradable prices, as over half of the NSO’s current (1976) CPI basket are tradable items, and the prices of many items are likely to suffer from significant mis-measurement, especially non-tradable prices such as housing and services. 

Anecdotal evidence points to steep growth in non-tradables prices, such as very large increases in residential and commercial property prices and rents, and in wages and other employment costs for skilled and semi-skilled workers (with few anecdotes suggesting gains in productivity have matched labour costs); 

• A resultant shift of resources out of non-commodity traded goods: The share of PNG’s aggregate GDP of agricultural and manufacturing output (PNG’s core non-resource tradable sectors) declined from almost 40 per cent in 2005 to 35 per cent in 2012. However this was in a context of rapid economic growth across the economy – output from these sectors still expanded by approximately 30 per cent between 2005 and 2012, but this was well out-paced by output of non-tradable services, which rose by 130 per cent. 

But lack of data on production inputs makes this difficult to assess fully. 

No sectoral investment information are available, bank lending data likely to relate to a fraction of investments, and BPNG’s employment survey has suffered from poor coverage of emerging firms that have generated many of PNG’s new jobs, which suggests little difference in employment growth between resource, non-resource tradable and non-tradable industries between 2005 and 2012; 

• A current account deficit:  PNG’s current account deficit has been around one-third of GDP in recent years. 

However this deficit has been due to the large amount of imports of equipment and workers, especially for the PNG-LNG project, and has been funded by foreign direct investment (FDI). Issues with data quality, especially given that many of these imports have not been transacted through kina and so may be poorly covered in BPNG’s balance of payments data, makes it difficult to assess PNG’s underlying current account position. 

Especially as the FDI inflows slow and imports for project developments complete, and the emergent Dutch Disease pressures slow production from PNG’s non-resource exports. 

This is an area to be especially watchful. 

However, the briefing said the policy makers could reduce the Dutch Disease impacts by improving the competitiveness and lowering the costs of non-resource tradable producers and through implementing the Sovereign Wealth Fund. 

The PNG Sovereign Wealth Fund will reduce the pressure on the kina by investing the proceeds from mineral revenues offshore. 

Indications that the pass-through from exchange rate movements into consumer prices suggest that BPNG may have greater scope to allow the kina to depreciate without the inflationary impact that would have been expected in the past, while still supporting farmers’ kina incomes and production decisions. 

In the longer-term, most effective can be efforts by the government to address other impediments to PNG businesses’ competitiveness, including reducing the impact of crime on business costs, cutting the cost of complying with regulations, and addressing market restrictions that raise the price of inputs, and improving the quality of infrastructure services.