Should the Kina be devalued in the current environment?

The value of the Kina is a long ongoing debate. The IMF has recently indicated that the overvaluation is in the order of 11% to 18% and therefore the economy would benefit from a devaluation.

The Bank of PNG, on the other hand, has consistently taken the position that a devaluation of the Kina is not a panacea for the economy. They argue that there are other fundamental and structural changes required, ahead of devaluing the Kina.

In simple terms, the basis for a devaluation stems from the general premise that a lower value Kina would strongly benefit PNG’s export industry, while incentivising local industry to filling domestic demand caused by higher costs of imported products.

However, in the context of COVID-19, our view is that devaluing the Kina is unlikely to result in an immediate increase in exports and local production due to uncertainties in the current environment. And as such, we recommend policy makers to take a measured approach prior to introducing any change, and prioritise policies that could drive the long-term growth of the PNG economy.

A long held view for managing the exchange rate is that the Kina is a commodity currency. This means that the movements in the value of the Kina fluctuates with changes in commodity prices, both from the mineral and non-mineral sectors. This exposure to price volatility is also not ideal for domestic business, and we understand the objectives of the Bank of PNG’s intervention is primarily to maintain price stability, and in some respects manage inflation.

Without intervention by the Bank of PNG, there is the risk that any commodity shocks, and now the shocks arising from a global pandemic, could introduce even greater volatility, uncertainty and instability into an already fragile and low confidence environment. Of course, the flip side is that foreign reserves are at risk if these interventions are not supported by foreign currency inflows, including inflows from development partners.

In theory, a devaluation is generally recommended to address the current currency situation.  However, without the structural changes that the Bank of PNG highlights, will this be sustainable in a PNG context, where we are facing tremendous economic risks arising from the global economic outlook, a weaker economic and fiscal position domestically, and the uncertainties of COVID-19? Brazil is one economy that highlights that the devaluation of its currency wasn’t enough to offset problems with commodity price volatility. Similarly, for PNG, with these dynamics at play, we recommend a carefully measured approach to any proposed change.

For these reasons, we believe that devaluing the Kina could create more challenges in the near term. It is unlikely that we would see in the near term, sufficient improvements in export volumes and large-scale import substitution to offset the significant adverse impact on cost of inputs, labour costs and therefore cost of business. Government and business behaviours will need to change significantly to see real benefits from a devaluation and whether this is achievable in the short term is arguable.

We recommend policy makers to (1) take a measured approach to understanding the full socioeconomic impact of any proposed devaluation; and (2) accelerate attention to more fundamental measures and levers to strengthen the PNG economy, as a way of improving the equilibrium in the Kina and supporting a more flexible currency in the future.

Such measures should be centered around policies that:

• Create large scale employment opportunities to stimulate the domestic market, including accelerating large-scale projects
• Respond to domestic demand by encouraging investment in local industry. This is best achieved, not by protectionist measures, but by removing impediments and creating opportunities for local producers to step up and fill the import gap
• Support economic diversification to de-risk dependency on the mineral sector
• Enhance our productivity to improve cost of living outcomes and international competitiveness
• Continue to enhance the environment for competition to flourish.

Giving credence to these priorities are the results of the many surveys we have conducted, indicating that investors, both local and international, as well as established businesses are far more concerned with these fundamental issues, than the value of the Kina, to drive their investment decisions, setting aside the currency backlog as a separate issue.