Kina devaluation revisited

Written by David Lea

It seems the push to devalue the kina continues unabated. Following earlier arguments for devaluing the kina to be found in the Devpolicy Blog, most recently, the Devpolicy Blog offers a three part series by Martin Davies, a Visiting Fellow at the Development Policy Centre at The Australian National University.

Rather than addressing the varied points made throughout the three part series, I would like to narrow the focus to some of the claims made in the second blog. What is remarkable about this article is the level of certainty with which claims are made. For example, it is estimated that a 20% depreciation of the real exchange rate – a 20% devaluation of the kina requiring a 33% depreciation of the nominal exchange rate (kina relative to the US dollar) – will have some of the following consequences:

  • It will improve the trade balance by an amount exceeding USD250 million per annum, increasing forex inflows by the same amount.
  • It will increase real agricultural export income by over 30%.
  • It will stimulate economic activity in the export and import-competing sectors, providing much needed stimulus to non-resource sector economic activity.

These estimates soon become certainties with the author’s statement, “There is no alternative”.

One may well wonder how monetary policy and tinkering with the exchange rate is going to produce all these wonderful changes. The confidence that mathematical modelling offers a reliable prediction with regard to human behaviour ignores Weber’s argument that belief systems, cultural and political realities, which elude quantification, strongly influence economic activity.

Take the second claim above, that the required change in the exchange rate will increase real agricultural export income by over 30%. Today if you go into any of the major super markets in Port Moresby, you find that half the of the fresh vegetable produce, nearly all of the dairy products, and just about all of the canned goods and medicines, are imported. If the current producers cannot supply the domestic market, where would they find the surplus to satisfy the export market that will then increase export income by 30%?

It is true that for foreign investors exporting commodities a devalued currency will reduce labour costs and some of the value of the monies paid to landowners, but much of the latter, and government royalties, are priced at the market value of the commodity. At the same time political realities will continue to present obstacles to commodity exports; for example, the recent increase to a 55% export tax on the value of roundwood has led to a decrease in exports over the past year.

This projection also ignores the fact that post-independence agriculture declined with the decline of the plantations. Connell (1997) points out that economic nationalism significantly contributed to the decline in expatriate ownership and, accordingly, subsequent productivity of the agricultural sector. One might also underline that conscious political decisions have also contributed to this decline: in the 1970s the government began to grow less reliant on plantation production for income and balance of payments support, and began to rely on revenue from mining, particularly from the huge Bougainville copper mine and subsequently from energy extraction.

It is extremely doubtful that a modification of the exchange rate is going to conjure back into existence a thriving agricultural system based on plantations sufficiently extensive for the export market. It is true that smallholder coffee accounts for 27% of total agricultural export and 6% of GDP, translating to about K450 million, and there has been some expansion, but it is questionable whether devaluation alone will increase production given other factors such as lack of infrastructure.

At the same time Davies brushes over the harm that will be experienced in urban centres when households can no longer afford necessary imports, as a result of a devalued kina.

He writes:

It [a devaluation] will cause a redistribution of income from urban to rural households; however, some of the falls in urban income will be moderated by the increase in non-resource sector activity. This will increase the relative attractiveness of being located in a rural setting relative to an urban one, which could slow urban drift.

These statements fail to acknowledge the chaos that will follow as businesses fold and unemployment explodes in the urban centres, because people on fixed incomes can no longer afford imported necessities, such as medicines. Relocation to thriving non-existent agricultural sectors in rural PNG will not be a viable solution, though the final point would certainly be true – as with the fall of the Roman empire – when urban centres decline and disappear.

Moreover, as Adam Smith observed, the possibility of fostering specialisation, which can produce the surpluses that generate wealth, depends on the size of the market. Market size in turn depends on transportation and communication links that allow for contact between supply chains, as well as suppliers and consumers. In PNG, the road systems are woefully underdeveloped. Roads out of the capital only extend around a 100 kilometres east and 300 west. Most of the rural country can only be reached by airplane. This means that movement of agricultural produce is expensive and extremely inefficient while at the same time communication by internet is expensive, intermittent and often unreliable. This situation ensures that the agricultural market cannot grow and earn 30% more in export income until these issues are addressed – regardless of any supposed stimulus from tweaking the exchange rate.

Finally even if the forex situation improves – and, for example, the Honda and Toyota dealerships in Port Moresby and Lae can access sufficient foreign exchange to bring in more vehicles, which has been problematic lately – how will consumers afford them with their devalued kinas? It is not just luxuries, but also medicines, pharmaceuticals and the range of items necessary for a modern economy such as generators, components for vehicles, aircraft and machinery, that will increase in cost and make urban life and rural development increasingly unsustainable.

I have argued against devaluing the kina previously and I remain unpersuaded by Davies’ arguments.

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David Lea

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

6 Comments

  • Thank you for your response to the recent blog series David, also Songo, Moses, Nik for your comments.

    Firstly, I would recommend to each of you, and particularly David, that you read the document on which the blog series is based, The Path to Kina Convertibility: a study of the foreign exchange market of Papua New Guinea (http://inapng.com/wp-content/uploads/2021/02/The-Path-to-Kina-Convertibility-Study-of-the-Foreign-Exchange-Market-of-Papua-New-Guinea-21-February-2021.pdf). There is a thorough explanation of each of the points made in the blog series, and more, here.

    Briefly, the estimates for the calculation of increases in agriculture income are in section 11.6 and are based on estimates for agricultural export supply elasticities from Nakatani 2017. These estimates are based on recent data and so incorporate the current state of agriculture in PNG, and do not ignore the post-Independence decline in agriculture, as David claims. They are also consistent with other studies. Just the depreciation alone, without any supply response, confers a significant increase in income for this group. The at least USD 250 million p.a. improvement in the trade balance, and commensurate increase in forex reserves, is also based on Nakatani’s analysis.

    For Songo’s point about the effect of depreciation on foreign held debt, see section 11.7. On your comments about a gold standard and a return to it see section 10.4.

    In terms of the effects on inflation, pass-through in PNG is about 40% (perhaps a bit less at the moment) and is complete after about one year (section 11.3). Under current monetary policy arrangements, a depreciation will not cause hyperinflation, so that possibility can be ruled out.

    For Moses’ point about foreign investment, current conditions discourage it with difficulty for businesses in remitting profits and dividends due to queues for forex and the expectation of a large depreciation.

    As for the complex set of “usual” arrangements around how exchange rates are set to which Nik alludes, it is difficult to evaluate such claims without any evidence so no further comment is warranted. It should be noted that BPNG has adjusted the exchange rate over the past 6 years, with slow depreciation to offset the inflation differential with PNG’s trading partners to keep the real exchange rate constant (section 12.3). See also point 12 on p. 79 on possible reasons for reluctance to allow adjustment in the nominal exchange rate.

    The key points to remember are there is a structural imbalance in the forex market and that forex rationing has led to large queues for forex and import compression. This market dysfunction has hurt growth in PNG, and continues to do so, through a reduction in investment which diminishes productive capacity, also reducing current and future exports. It also reduces the availability of imported goods.

    With any relative price change, there are winners and losers and redistribution between them. For a depreciation, there are a large group of losers, mainly from urban areas (to avoid repetition see Paul Flanagan’s response to David’s last blog on this same topic). On the other hand, there are also a countering large group of winners (also elaborated on in the same response). There is a meaningful political economy between these two groups. As for the claim about brushing over the impact of a depreciation, I again refer the reader to the report (see section 11.2 and others).

    It is important to note that a 20% depreciation is like an ongoing 20% subsidy for all producers in the tradables sectors (at no cost to the government), that is, those who produce exportable and importable goods (goods which compete with imports). This provides a significant ongoing stimulus to this group and will spur growth in the non-resource sector, which is currently low (see section 11.1).

    In term of alternatives to a depreciation, wage restraint so that PNG’s inflation rate falls below that of its trading partners is an option but a painful and difficult one and so is not feasible. Fiscal restraint will assist with the structural imbalance in the forex market but that alone is not sufficient. A big increase in the government take is a viable alternative (see recent paper by Davies and Schroder), however given LNG tax concessions that possibility is a number of years away. Finally, a new commodities supercycle, which would improve PNG’s terms of trade, would also help.

  • I agree Prof. David Lea, but strongly disagree with Prof. Martin Davies.

    Depreciating the kina exchange rate by 20% will only increase the cost of imported goods as it will require more kina to buy imported goods. Businesses are driven by profit-motive and if they pay a higher price for imported goods, then they will charge higher price to the consumers to make profit. The prices of basic necessities like imported rice, fuel, medicines, etc. will skyrocket because of imported price inflation. School fees for colleges and universities will also increase, leading to massive withdrawals from low-income earners, depriving them of their basic right to higher education. Generally, the cost of living will become very expensive because of a mere tweaking of monetary policy on the exchange rate. PNG is one of those countries with a very high cost of living, and devaluing the PNG Kina by 20% as proposed by Prof. Martin Davies will only worsen the socio-economic status of most ordinary Papua New Guineans, systematically pushing them into poverty and below poverty line. Hyper-inflation would be the most likely effect.

    Also, most of the state-owned-enterprises foreign debt and the government’s foreign debt are held in US Dollars. Depreciating the kina exchange rate by 20% devaluation will require more kina to offset foreign debts. The USD value of our foreign debt will remain status quo, but the kina value will increase because of currency devaluation. Therefore, most of the SOEs will face difficulties to offset foreign debts because their revenues will be diverted toward debt-service repayments. Thus, loss-making will be inevitable. That was the case after October 1994 when the kina was floated and then devalued by 10-12% by Sir Julius Chan’s government. The SOEs will not make profit but continue to make losses. A particular case is the Air Niu Gini where imported aviation fuel will cause flight fares to go up to make profits but because of price controls mechanisms, it will continue to make losses instead of profits. Government revenues from this important SOE will shrink bigtime which can contribute to our continuous fiscal deficits scenario.

    Given the fact that the former US President Richard Nixon has suspended the convertibility of the US Dollars into gold, there is no guarantee for price stability on the global market. On 15 August 1971, 35 US Dollars is worth an ounce of gold. After the abolishment of its convertibility into gold, now an ounce of gold is worth $1,790 US Dollars. PNG Kina is pegged to the US Dollar, and it uses the USD to measure its value. With a depreciating US Dollars overtime, the PNG Kina is also depreciating fast. On the same note, currency devaluation by 20% will remove the kina’s purchasing power bigtime.

    Lastly, the government continuous fiscal deficits and perpetual foreign exchange shortages did not improve with the kina devaluation of 10-12% in 1994 and then by 40% kina devaluation in 1998 as argued by IMF, World Bank, and other international donors.

    I think it is time we should ‘think out of the box’ as to how we address the problem of continuous foreign exchange shortages and fiscal deficits in Papua New Guinea. And the first step is for the US to revert back to the Gold Exchange Standard to help other countries
    which are using the US Dollar as an anchor currency to maintain price stability. Secondly, the International Monetary Fund must not impose restrictions on its 186 member countries in regard to the setting of exchange rate arrangements, even if it means for countries to choose to peg their currencies to gold. Finally, PNG is facing a chronic shortage of foreign exchange for more than a double decade (1995-2020) and the government must innovate to new exchange rate arrangements to deal with their foreign exchange shortages and fiscal deficits.

  • Very true. The key elements to help appreciate the Kina value is trapped in the production sector. We continue to import more and export far below. Government need to allow more foreign investment and set up more factories of the goods to begin with the most frequently imported products.

  • Hi Prof, what would be your solution then? Obviously, something needs to give. At the moment, we are not going anywhere.

    The agriculture sector will not pick up anytime soon. Road, electricity, internet etc. remain underdeveloped and expensive. The currency remains pegged higher than its market value. And we are caught between two theories.

  • While David Lea’s argument about the shallowness of the devaluation proponents’ claims is strong, I have to take issue with one proposition he makes. Lea claims: `This projection also ignores the fact that post-independence agriculture declined with the decline of the plantations’. This claim is as mono-causal as the argument Lea attacks. To repeat points I have made for almost 40 years: plantations were never the drivers of the major post-war increase in agricultural exports. Well before Independence and in the case of coffee, by 1959, smallholder acreage exceeded that on large holdings. By Independence, coffee output by households was already 70% of the total. While the smallholder ascendancy occurred at a different rate for cocoa and copra, by Independence the days of plantations producing more than smallholders were over. (Copra and cocoa figures should always be treated with great caution as a quantity of what figures in largeholding output was actually grown by smallholders and taken to the nearby plantations for processing, then sold and calculated as plantation output.)

    Plantation production was in decline by the mid-60s for reasons which would take more space than is available here. (I have offered a seminar to the Development Policy Centre on the subject of the coffee industry in PNG: in lieu Prof Lea and others might care to read my Securing Village Life and two Discussion Papers published by the Dept of Pacific Affairs at ANU.)

    What has happened to smallholder production, which in the case of coffee is still over 80% of the national total, has nothing to do with the decline in plantations since these played little to no part in the previous expansion. (That the expatriate largeholdings were very important for the explosion of smallholder growing from the 1950s onwards is pure `white man’s myth’ about a plantation era.) Instead the near total disappearance of agricultural extension services, the decay of rural infrastructure and other services, as well as the near-stagnation even decline of international prices for agricultural crops have been the major drivers of what has occurred on smallholdings.

  • This is an important article. There is certainly a critical need for a more sanguine understanding of this issue. The exchange rate of PNG is a result of a complex set of “unusual” arrangements between the central bank and the financial sector and is not the result of direct price fixing as assumed by many economists. Hence to understand the nature of the problem it is important to understand the political and economic drivers behind these arrangements and how and why the came into being in the first place.
    All economic studies absolutely fail in this regard and hence you end up with the debate of inflation versus “market efficiency” whereas the reality on the ground is far more complex. More critically, the economic perspective cannot, by implication, provide any useful remedy for a solution or a way forward as they do not contain any useful information on the actual mechanics of how forex works in PNG.

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