Public Information Notice No. 08/38

Public Information Notice: IMF Executive Board Concludes 2007 Article IV Consultation with the Kingdom of Lesotho

March 20, 2008

On November 14, 2007, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Kingdom of Lesotho.¹

Background

Lesotho made further progress toward macroeconomic stability in 2006. After sluggish economic activity in recent years, real economic growth surged to about 7 percent, driven by booming diamond production, a recovery of the garment industry, and good performance in the agriculture and services sectors. Poverty has declined, but remains high, and Lesotho has a high prevalence of HIV/AIDS. The pace of structural reform has been slow.

Reflecting high transfers from the Southern African Customs Union (SACU) and exports of textiles and diamonds, the external current account balance registered a substantial surplus and international reserves rose to about six months of imports, even after significant external debt repayments. The recovery of the garment industry was helped by the extension of the US African Growth and Opportunity Act (AGOA), a depreciation of the rand, and a cut in corporate tax rates. Inflation has increased since the last quarter of 2006 owing to rising food and energy prices, broadly mirroring trends in South Africa. In July 2007 Lesotho and the US Millennium Challenge Corporation (MCC) signed a "compact" for US$363 million (23 percent of 2007 GDP) to be implemented over the next five years and covering the areas of water, health, and private sector development. A drought hit agriculture in 2007; the government has appealed to development partners for assistance.

The fiscal position and public debt sustainability indicators have improved although the 2007/08 budget envisages a high level of spending. The overall fiscal balance registered a record surplus in 2006/07, the third in a row. The surplus was the result of high SACU receipts, and the continuing sub-execution of capital expenditure projects. Most of the surplus in 2006 was saved at the Central Bank of Lesotho (CBL). The use of part of the SACU windfall to retire nonconcessional debt contributed to a decline in external debt-to-GDP ratio to 43 percent of GDP in 2006. The 2007/08 budget envisages a surge in current spending and a more than doubling of capita expenditure.

Broad money grew by 35½ percent in 2006, with net foreign assets of the banking system rising strongly. NFA growth largely reflected high SACU receipts and workers' remittances, as well as the relatively good performance of the textile industry.

The outlook is broadly positive, but subject to risks arising mostly from the external environment and emerging financial sector vulnerabilities.

Executive Board Assessment

Executive Directors commended the Lesotho authorities' commitment to prudent macroeconomic policies, which have contributed to the country's strong economic performance. In particular, Directors noted the marked acceleration in growth in 2006, the significant improvements in the fiscal and external balances, and the build up of international reserves-which have helped consolidate the country's exchange rate peg.

Nevertheless, Directors stressed that the country faces the considerable challenge of sustaining rapid and broad-based growth to reduce widespread poverty and make progress towards the MDGs, and to help tackle the high incidence of HIV/AIDS. Achievement of these objectives will call for an acceleration of the pace of structural reforms with a focus on promoting private sector development, while ensuring strong medium-term fiscal and external positions.

Directors considered that the medium-term outlook for Lesotho is positive but subject to several risks. These include a possible slowdown in markets for Lesotho's exports as well as uncertainty about the revenue-sharing regime of the Southern African Customs Union (SACU), prospects for global trade in textiles, and the outlook for remittances from workers in South Africa. While acknowledging that these factors are largely beyond Lesotho's control, Directors encouraged the authorities to prepare for possible adverse developments through strengthened fiscal policy and public financial management, and prudent reserves policies.

Directors welcomed Lesotho's prudent management of SACU windfalls so far, and urged the authorities to resist the surge in spending envisaged in the 2007/08 budget. Looking forward, they noted that containment of recurrent spending over the medium term would help keep fiscal policy sustainable while allowing the use of available fiscal space for increasing productive public investment. Directors also underscored the importance of approaching the upcoming salary review and the possible pension reform with caution, and more generally, of addressing existing weaknesses in the budget process and extending the Medium-Term Expenditure Framework to all ministries. Equally, Directors welcomed the authorities' intention to pursue prudent debt management policies.

Directors encouraged the authorities to continue to use grants as well as domestic resources to boost public investment, especially in infrastructure. They called for efforts to improve project execution and full utilization of external assistance, including the resources of the Millennium Challenge Corporation (MCC)-drawing on donor technical assistance. Directors welcomed the authorities' recognition that, while public-private partnerships have a role in public investment, they need to build the necessary capacity to manage them effectively.

Directors encouraged the authorities to accelerate the pace of structural reforms, and welcomed the preparation of a Growth Strategy Paper (GSP). They noted that envisaged programs-namely, the Public Sector Improvement and Reform Program, the Private Sector Development Component of the MCC compact, and the World Bank-supported Private Sector Competitiveness Program-would be key to relieving constraints on growth and enhancing productivity. In particular, these programs aim at strengthening institution building, establishing an appropriate legal and institutional framework, and improving the investment climate for domestic and foreign investors. Consistency between the GSP and Lesotho's Poverty Reduction Strategy would be important.

Directors agreed that Lesotho's monetary and exchange rate regime has been beneficial and should be preserved, along with the prudent policy mix that makes it viable. In particular, they underscored that membership in the Common Monetary Area and the peg of the loti to the rand have ensured stable and low inflation, and facilitated capital and commercial exchanges with South Africa. Fiscal restraint in the face of strong SACU revenues has ensured external stability by helping keep net international reserves at levels consistent with the sustainability of the peg. A few Directors advised that careful attention be paid to the risks associated with the volatility of the rand, and the inflation differential between Lesotho and South Africa.

Directors noted that, while the banking system appears solid, the limited access to its services by households and small businesses has fostered the growth of weakly supervised credit cooperatives. In this respect, Directors called on the authorities to step up their current efforts to improve the regulation and supervision of credit cooperatives and to increase access to banking services.

Directors expressed concern over the operation of unlicensed deposit-taking entities promising inordinately high rates of return. They observed that these vehicles have large and fast-growing liabilities, face constant rollover risks, and pose significant risk of failure. The continued operation of these entities would result in further growth in their liabilities and higher risk of social and financial repercussions. Accordingly, Directors urged the authorities to take prompt action to address this issue.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.