Papua New Guinea Ratings Affirmed At #B+/B#; Outlook Remains Negative

Stocks and Financial Services Press Releases Friday April 29, 2016 17:13
Standard & Poor's--29 Apr--Standard & Poor's

On April 29, 2016, Standard & Poor's Ratings Services affirmed its foreign and local currency long-term rating on Papua New Guinea (PNG) at 'B+', and the respective short-term rating at 'B'. The outlook on the long-term rating remains negative. The Transfer and Convertibility (T&C) assessment remains 'BB'.

RATIONALE

The sovereign ratings on PNG reflect structural constraints inherent in a lower middle-income economy dependent on extractive industries and served by weak institutions. In addition, the economy faces external and fiscal imbalances linked to the recent completion of a US$19 billion (118% of 2014 GDP) liquefied natural gas (LNG) project. With the LNG project now operational, we expect it to contribute to both export receipts and government revenues, enabling the unwinding of PNG's related imbalances in the next few years. But risks have risen that these external and fiscal imbalances may be very slow to unwind, mainly due to the current weakness in global energy prices, underpinning our negative rating outlook on PNG.

Papua New Guinea faces pressing development needs. It had a per capita GDP of US$2,100 in 2015 and is ranked 158 out of 188 countries on the United Nations Development Programme's Human Development Index. Moreover, the prevalence of urban crime in the country deters investment in our view, while governmental institutions are a weakness. In addition, economic data inconsistency is another credit weakness. While there have been some recent improvements, there remain gaps and lags in economic and external data as well as a lack of transparency in public-sector fiscal affairs.

PNG's economy has been undergoing a transformation in recent years, with the construction and, since 2014, operation of a new LNG plant, operated by ExxonMobil PNG Ltd., a subsidiary of ExxonMobil Corp. Economic growth is set to slow sharply this year, after being boosted in recent years by the LNG plant's construction, then a surge in government spending and, most recently, the LNG plant's ramp up to full production. We expect growth to be about 3% in 2016, down from about 9% in 2015, due to a combination of lower commodity prices and associated cost-cutting in the resources sector; drought conditions hurting agricultural production and leading to the temporary shutdown of Ok Tedi (a large copper and gold mine); and sharp cuts in government spending.

The medium-term economic outlook hinges on whether further large foreign-financed projects, such as the touted additional LNG projects, go ahead. Despite the weakness in global energy prices, the Papua LNG project and expansion of the existing ExxonMobil project still appear to have the support of their proponents, although final investment decisions are still some way off. Should these projects proceed, they would boost growth sharply relative to our current forecasts, probably from 2018.

In the meantime, the government is dealing with a collapse in resources-related revenues, with global energy prices plunging just as the ExxonMobil LNG project came online. Fiscal imbalances had already grown significantly, with the government running large fiscal deficits to address development priorities and to support economic growth until LNG production reached full capacity. Importantly, the current rating assumes that these fiscal imbalances would narrow quickly after LNG revenues started to flow to the government from 2015.

The government has responded forcefully to the collapse in revenues. Total revenues in 2015 were more than 20% below what the government projected in its 2015 budget, but the government managed to cut spending by 17% relative to its budget, and by 7% compared to the previous year. The result was that the budget deficit still narrowed significantly, from 7.2% of GDP in 2014 to 5.6% of GDP in 2015.

We expect the government to achieve further fiscal consolidation in 2016, with a deficit of 4.6% of GDP, with further falls in its deficit in following years, such that debt broadly stabilizes as a share of GDP. On our measure, net general government debt is about 30% of GDP. Should the government fail to continue to restrain spending adequately, or should growth in the nominal economy come under even further downward pressure, net general government debt could rise materially above this level. However, prospects for continuing political stability in the near term will continue to provide PNG with a supportive environment to address fiscal pressures. Prime Minister Peter O'Neill's People's National Congress Party and his coalition partners currently control a strong majority in the parliament. Prospects for stability beyond the 2017 election are less clear.

PNG's interest burden is elevated, with its average interest rate rising over the past couple of years as it stretches the domestic market's ability and willingness to finance widening fiscal deficits. (Banks already hold a large share of their assets in government debt.) The government previously announced that it plans to issue an international sovereign bond, which would lessen its reliance on short-term domestic borrowing. It would, though, further expose the government's debt stock to exchange rate risk, which we already view as material.

A sovereign bond may also alleviate the current shortage of foreign currency in PNG, as might a possible U.S.-dollar loan to PNG's commercial banks currently being considered by the International Finance Corp. The current shortage of U.S. dollars within PNG is symptomatic of a currency that is above the market-clearing exchange rate, while the International Monetary Fund (IMF) assesses PNG's exchange rate to be a crawl-like arrangement. Although the PNG kina has depreciated substantially against the U.S. dollar over the past few years (notwithstanding a sharp spike in early 2014 when the central bank's trading band policy was put in place), dollar shortages remain, and the currency also remains high against those of major trading partners.

A shortage of foreign currency available for debt repayment may be contributing to a slower wind down of PNG's high level of external debt than we had previously expected, although lower resource-sector profitability is likely the major factor. External debt has ballooned in recent years, with very large current account deficits—financed by a combination of external debt and foreign direct investment—that averaged more than 30% of GDP between 2010 and 2013 during the LNG project's construction phase. PNG's net external liabilities had risen to nearly 480% of current account receipts in 2013 from 45% of current account receipts in 2008. We estimate that this ratio began to decline in 2014 with the commencement of LNG production, and expect it to steadily decline over future years, although the pace of decline will be tempered by weak global commodity prices. On that front, we anticipate that the long-term volatility in PNG's terms of trade will ease a little, after the tumbles in prices over the past decade, providing a little more stability to PNG's external profile. On the other hand, potential future LNG projects would lead to further external imbalances arising during their construction phases.

Further weighing on the rating is our view of the Bank of PNG's weak monetary policy flexibility. This weakness mainly reflects the very limited transmission of monetary policy settings to the interest rates faced by borrowers—largely because of the high level of liquidity in the banking system, which remains on an upward trajectory.

PNG's banking system stability benefits from limited competition and a high reliance on deposit funding, which is supported by high levels of liquidity. It also has an external net asset position and limited linkages to global markets. That said, hampering system stability are the country's low income levels and credit risk concentrations that weigh on credit risks. Legal infrastructure and judicial system delays also pose challenges to enforcing creditor rights. Our Banking Industry Credit Risk Assessment for PNG is '9' (with '1' being the highest assessment and '10' being the lowest).

OUTLOOK

The negative outlook reflects our view of a one-in-three chance that we may lower the rating within the next 12 months. This is due to the possibility that the government is unable to constrain its debt levels, and that large fiscal and external imbalances are slow to unwind in an environment of weaker export revenues and modest medium-term economic growth.

The outlook could revert to stable if we become more confident that the government will successfully narrow fiscal deficits further and stabilize its debt level (relative to GDP), and that it remains likely that PNG's external position will improve significantly over the next few years, supported by solid economic growth and export receipts.


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