Papua New Guinea’s evolving exchange rate regime

PNG interbank mid-rate and mid-market exchange rates
Written by Rohan Fox

Papua New Guinea has neither a purely floating currency, nor does it have a purely fixed currency. However, the institution of trading bands in June 2014 has led to less flexibility in the foreign exchange market. The graph below shows PNG’s transition from more a flexible regime to a less flexible one.

PNG interbank mid-rate and mid-market exchange rates

Sources: Interbank midrate: BPNG (data missing for the mid-rate from Jan 1 2009 – Dec 31 2009); Mid-market rate: Ozforex

The interbank mid-rate, the red line shown in the graph, is the average rate at which banks (including BPNG) trade foreign exchange with each other. The ‘mid-market rate’, the blue line shown in the graph, is the average of the rates at which banks are willing to buy and sell (in this case) US dollars for Kina with the broader market.

I conducted an econometric ‘Granger causality’ test to examine whether the movement of the market rate could be said to follow the movement of the interbank rate, or visa-versa, both after the trading bands were instituted, and before. According to the test, both before the interbank rate stopped moving in October 2013, and after the institution of trading bands, the market rate follows the movement of the central bank mid-rate, and not the other way around.

This is an interesting finding because it suggests continuity pre- and post-June 2014 (clearly between October 2013 and June 2014 the interbank rate lost its influence). What then is the nature of the change in the exchange rate regime before and after June 2014 when the trading bands were introduced?

One possibility is that before October 2013 the interbank rate was set by trades between PNG’s banks, including the central bank, whereas after October 2013 it has been set by fiat, by the Central Bank. This is consistent with the reduction in volatility in the interbank rate post October 2013. It is also consistent with the build-up over the last couple of years of excess demand for foreign exchange reserves. The backlog in foreign exchange orders is now said to total K3 billion.

This excess demand is an indicator that the interbank rate cannot be market-determined. That is why the trading bands are important. Given the trading bands, the market rate cannot now deviate from the interbank rate.

If the interbank rate is now set by the Central Bank, this would make PNG’s exchange rate regime a crawling peg, which is what the IMF most recently classified PNG’s exchange regime as. A crawling peg regime is defined by the IMF to exist when an exchange rate remains within a margin of 2 per cent relative to a trend for six months or more. It is not considered to be a floating regime. Based on an analysis I conducted of the official exchange rate after the institution of trading bands, a linear trend line, which reduces the exchange rate by 0.014 cents per day, explains 99 per cent of the movement in the exchange rate, i.e., it is within a margin of less than 2 per cent relative to the trend. Hence the IMF classification.

We can speculate on the reasons for this change from a managed float to a crawling peg. Perhaps as per the official reason, it was trying to reduce bank profits on foreign exchange trading. Additionally, the central bank could also have been trying to smooth what it saw as a temporary decline in the value of the Kina. With large resource projects like the Wafi Golpu gold mine, Total LNG and Frieda River copper mine looking to begin construction, this seems credible.

Whatever the reason, once global commodity prices fell, the game changed entirely. It was at this point that the inflexibility of the interbank rate resulted in greater problems for access to foreign exchange.

It will not be possible to quickly reverse the change back from a crawling peg to a managed float. There are some who say that a floating exchange rate will not clear the backlog of outstanding exchange orders. I agree. However, a significantly lower exchange rate would have the effect of improving access to foreign exchange, through higher supply and lower demand for foreign exchange. How much further does the exchange rate have to fall? International experience is a useful guide, as the next post in this two-part series will show.

Rohan Fox is the Partnership Coordinator for the Crawford ANU – SBPP UPNG partnership, which is funded by the Australian aid program under the Pacific Leadership and Governance PrecinctThis is the first post in a two-part series; find the second post here.

Rohan Fox

Rohan Fox is a Research Officer at the Development Policy Centre. He has a Masters in International & Development Economics from the ANU and is currently working on research on the development impact of roads infrastructure in Papua New Guinea in partnership with the National Research Institute and Development Policy Centre. His interests include behavioural economics and development impacts of infrastructure projects.

1 Comment

  • Hi Rohan
    Thanks for this important analysis. The exchange rate, and the related foreign currency shortage, is now regarded as the greatest impediment to business in PNG. Although exchange rate policy is often seen as a boring and technical issue, it is a priority for development analysis.
    Four comments. First, PNG probably would not be in the current problems if 4 June 2014 didn’t exist. That is the date for the introduction of the exchange bands and the big upward spike in the blue line to join the red line. If the blue line just kept going down from where it was on 3 June 2014, possibly at a slightly faster rate, then PNG would be much closer to a market clearing rate (so no foreign currency crisis).
    Second, the graph is in US dollars. This is appropriate as the crawling peg policy has been based on the Kina/USD exchange rate. However, this hides a major story given the strength of the US dollar over the last two years. The Kina exchange rate has stayed much flatter relative to many of its trading partners, including Australia and Asian countries. Economically, this means that the exchange rate has not been as large a policy shock absorber as suggested by this graph. If PNG continues with a crawling peg system, this should be based around the Trade Weighted Index (TWI).
    Third, it is a matter of choice whether the vertical axis for the graph shows USD/Kina, or Kina/USD. Technically, both show exactly the same ratio. My preference is for Kina/USD which inverts the graph. This would show the tail end of the graph going up rather than down. This would reflect increases in competitiveness for the PNG economy. This small technical change can move the policy narrative from concern about a “weak” Kina going down, to one of a Kina becoming more competitive and going up. If you are a poor rural coffee or cocoa exporting household in PNG, you’d prefer the latter approach. If you are in an urban area on a formal sector wage relying on food imports, you’d probably prefer the former.
    Finally, PNG is currently seeking to release a USD 1 billion sovereign bond. There are K2 billion worth of reasons for making any needed exchange rate adjustment before issuing the bond (covered in this blog).
    There are significant distributional issues in making changes and I look forward to the next post on international experiences of adjustment.
    Cheers
    Paul

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