## DECOMPOSING THE PUBLIC-PRIVATE SECTOR WAGE DIFFERENTIAL IN LESOTHO

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---

### Introduction and context
- Lesotho’s public wage bill and employment share:
  - Sub-Saharan African countries (excluding SACU) spent on average [6] percent of GDP per year on general government payroll—equivalent to 28 percent of their total public expenditure.
  - Lesotho’s public wage bill averaged 17 percent of GDP (32 percent of total expenditure).
  - SACU average compensation of government employees is 13 percent of GDP (38 percent of total public expenditure).
- Public wage bill growth and SACU transfers:
  - Wage bill growth averaged 14 percent per year in years when SACU revenues exceeded the historical average of 22 percent of GDP.
  - Wage bill growth averaged 7 percent per year otherwise.
- Paper structure (excerpt):
  - Section B: overview of public sector employment and compensation.
  - Section C: estimation and decomposition of the public-private wage premium.
  - Section D: policy recommendations.

### The public sector wage bill: structure, dynamics, and distributional effects
- Public employment and role of state:
  - SSA (excluding SACU) public sectors account on average for 9.4 percent of total employment and nearly 5 percent of the working-age population (aged 15 and older).
  - In Lesotho, every eighth job is in the public sector.
  - Across SACU members, on average every sixth job is in the public sector.
- Civil service structure and contribution:
  - Civil service salary scale has 13 grades: six managerial, three operational, and four support roles.
  - Civil service accounts for over one-third of public sector wage bill and employment and contributed most to wage bill growth over the past five years.
  - Operational level staff (grades F and G) account for over half of civil service wage bill; support level staff account for close to 50 percent of civil service employment.
- Pay compression and grade differentials:
  - Compression ratio (highest salary to lowest) is 17 for the basic salary.
  - Comparative compression ratios: sub-Saharan Africa average 13; global average 7.
  - Wage differentials between adjacent grades:
    - Difference between basic salaries across grades at the support and operational levels is over 30 percent.
    - Jump to the next (lowest) managerial grade is a still significant 20 percentage points.
  - Allowances are relatively small, at about 1–2 percent of the basic salary, but tend to double or triple at the highest managerial grades (J and up).
- Automatic increases and inertia:
  - Automatic annual nonmerit pay increases (“notches”) and cost-of-living adjustments (COLA) generate upward drift tied to years of service rather than performance.
  - Administrative payroll panel (civil servants on payroll throughout 2017–22):
    - More than 90 percent experienced a positive adjustment almost every year, including FY19/20 and FY21/22 when there was no COLA.
    - Total wage bill for this panel increased by 4 percent in FY21/22 attributed solely to notches.
    - Median employee experienced around a 5 percent increase in basic salary in FY21/22.
- Distributional effects and fiscal crowding out:
  - Upward inertia in the public wage bill has been gradually crowding out other government spending.
  - Containment of the wage bill is essential for fiscal sustainability, income distribution, administrative efficiency, and private-sector competitiveness.
- Data coverage note:
  - Civil service salary scale table covers all civil servants with non-zero basic salary in FY21/22: 16,637 employees.
  - Those 16,637 account for close to 40 percent of all public employees with non-zero basic salaries (42,502).

### The public-sector wage premium: magnitude, methodology, and distributional patterns
- International and national magnitudes:
  - Average public wage premium in EMDEs is nearly 12 percent.
  - In Lesotho, average public wages can be twice as high as average private sector wages (and differentials would be even higher once allowances and nonwage benefits are included).
- Empirical approach:
  - Data: 2017 Household Budget Survey microdata.
  - Estimation: standard Mincerian wage regression:
    - ln(wage_ijt) = θ Public_i + β X_i + γ_j + δ_t + ε_ijt
  - Public sector definition: central and local government; private sector includes parastatals, private sector, private households, and self-employed in non-farm enterprises.
  - Controls: age, age squared, gender, marital status, urbanization, educational attainment (secondary, tertiary), number employed in household, industry and district fixed effects.
- Key distributional findings:
  - Public-sector wages are higher and more dispersed than private-sector wages.
  - More than 50 percent of the public sector wage distribution lies to the right of the private sector distribution.
  - Public sector distribution is more peaked and exhibits greater dispersion driven primarily by higher dispersion among women in the public sector.
- Estimated wage premium and quantile dynamics:
  - Baseline regression: employment in the public sector is associated with 36 percent higher wages.
  - Premium about the same when parastatals are included in the public sector.
  - Premium rises to 40 percent when self-employed in farm enterprises are included in the private sector.
  - Quantile regressions:
    - Public wage premium is over 60 percent at the lower end of the wage distribution, declining across the quantiles.
  - Public-private wage gap across percentiles:
    - Gap remains relatively flat at lower end, rises in middle (40th–60th percentiles), and declines at the top.
    - Gap higher among women than men except at the lower end; remains high until the 90th percentile for women.
    - Gap larger among workers with secondary education than those with tertiary education, particularly at the higher end.
    - From the 80th percentile onwards, the gap favors private sector workers with primary and tertiary education.
- Gender and education interactions:
  - Female workers are paid less than male counterparts on average by 37 percent (after controlling for individual characteristics).
  - Female wages are relatively higher in the public sector, particularly at the higher end of the distribution; at the 90th quantile, female public-sector wages are not much different from male wages.
  - Educational effects:
    - Workers with secondary education earn 27 percent more than those with primary or no education.
    - Workers with tertiary education earn 120 percent more than those with primary or no education.
    - Public sector employment boosts wages of workers with secondary and tertiary education by an additional 64 and 43 percent, respectively.
  - Public sector particularly rewards female workers at the higher end and workers with tertiary education at the lower end of the wage distribution.

### Decomposition of the wage gap: price vs endowment effects
- Key empirical decomposition findings:
  - At the lower end of the wage distribution, the wage gap is largely due to the “price effect” rather than the “endowment effect.”
  - The public sector exhibits a wage premium, particularly at the bottom of the distribution, although inferior endowments among private sector workers also contribute.
  - The endowment effect increases starting from the 40th percentile and drives the increase in the wage gap between the 40th and 60th percentiles.
  - After the 80th percentile, returns to workers’ characteristics narrow the wage gap, as indicated by a strong negative “price effect.”
  - Overrepresentation of women in the public sector narrows the wage gap by 3–5 percentage points especially at the lower and higher ends of the wage distribution; however, at the 90th percentile this narrowing is outweighed by a corresponding positive “price effect,” so that gender contributes to widening the wage gap at the higher end.
  - Decomposition methodology: Oaxaca-Blinder (1973) type decompositions, based on Firpo et al. (2009) recentered influence function regressions.

### Policy implications and recommended reform principles
- Core policy messages:
  - Containing the wage bill is essential for fiscal sustainability and to improve income distribution and private-sector competitiveness.
  - Wage and hiring freezes can offer temporary relief but are not sufficient for durable adjustment.
  - Structural reforms are required to achieve a durable adjustment in the wage bill without jeopardizing service delivery:
    - Target sectors with excessive employment and salary levels.
    - Support reforms with strong institutions and legislation.
  - Reforms should aim to reduce public-private wage distortions that create a dual labor market and disincentivize private-sector employment.
- Principles for wage-bill reform:
  - Wage bill growth must not jeopardize fiscal sustainability.
  - Public sector employment should be consistent with targets for public service quality and delivery; the civil service should not function as the employer of last resort or a means of patronage.
  - Public sector compensation should be competitive, but not significantly higher than in the private sector.
  - The range of generous public sector allowances and benefits must be scaled back, as these compound the large size of the wage gap.

### Short-term and structural policy measures (toolbox)
- Short-term (quantity- and price-based):
  - Wage freezes, ceilings, or cuts.
  - Elimination of “notch” increases.
  - Hiring freezes; termination of off-payroll workers; early retirement; attrition.
- Structural (medium-term):
  - Unifying wage structures; rationalizing allowances.
  - Introducing comparisons of public and private sector compensation.
  - Tightening the link between pay and performance.
  - Public sector restructuring; enhancing payroll quality (e.g., payroll census).
  - Replacing career-based employment with position-based employment for some jobs.
  - Reviewing government programs to identify under- and/or overstaffing.

### Employment management and compensation containment recommendations
- Employment management:
  - Reduce and manage public sector employment using essential hiring, natural attrition, and staff redeployment.
  - Exploit consolidation of ministries, departments, and agencies (MDAs) to eliminate duplicate functions.
    - Scenario assumptions: number of ministries reduced from 27 to 15; eliminate 10 principal secretary positions in the merged ministries, reducing principal secretaries from 47 to 37; eliminate a fifth of positions at every grade level, except grade M.
  - Identify and terminate public sector employees hired outside of the establishment list and enforce hiring freezes for non-essential positions.
  - Abolish longstanding vacancies or reallocate existing staff from overstaffed areas.
- Compensation containment:
  - Eliminate non-merit increases and introduce performance-based remuneration.
  - Eliminate “notch” increases, consistent with the 2008 Public Service Regulations.
  - Tighten links between pay and performance metrics (e.g., attendance and performance efficiency).
  - Publish (online) comparisons of public and private sector compensation to highlight the public sector wage premium.

### Menu of reform scenarios and estimated fiscal impact (based on FY21/22 civil service payroll data)
- Eliminating duplicate functions at merged MDAs over a 3-year period: around 1 percentage point of GDP adjustment in the wage bill over the medium term.
- Capping COLA at 2.5 percent, while maintaining the notch increase of 5 percent and assuming new hires replace natural attrition (natural attrition assumed to be 2 percent): savings of 0.2 percent of GDP.
  - Note: If the notch were instead capped at 2.5 percent as in the FY23/24 budget, the savings would be much higher at 2 percent of GDP.
- Reducing the notch to 2.5 percent over a 3-year period (0.6 percentage point in the first two years and 0.7 percentage point in the third year): around 1.7 percentage points of GDP adjustment over the medium term.
- Completely eliminating the notch (gradually over a 5-year period, 1 percentage point each year): estimated savings of 2.8 percent of GDP.
- Context on historical wage dynamics:
  - Pre-pandemic wage increases of 6-10 percent each year were driven by a combination of “notch” increases and COLA, compared to pre-pandemic average inflation of 4.9 percent (over 5- and 10-year periods).
  - Recommendation: cap COLA at 2.5 percent over the next three years and subsequently set the cap just below the pre-pandemic average rate of inflation, around 4 percent.

### Related macro framework and implications for policy (MVF and Macroeconomic Model of Lesotho)
- Potential output and business cycle:
  - Model-consistent estimation uses a multivariate filter (MVF) to locate Lesotho’s position in its business cycle.
  - Lesotho’s business cycle is strongly linked to that of South Africa, but with greater volatility.
  - The MVF shows potential growth has been decelerating over the recent decade and that at 2 percent, the current estimate of potential growth is below the rate needed to close the income gap with other CMA members.
  - Despite some rebound in growth, a negative output gap persists since the pandemic started.
- Modeling framework highlights:
  - Semi-structural New Keynesian model with IS curve, Phillips curve, uncovered interest parity, and monetary policy reaction function.
  - Two-module layered approach: (i) Lesotho module; (ii) South Africa module.
  - Model is quarterly and uses “gap” terms; foreign exchange reserves are directly impacted by fiscal policy and interest rate deviations from SARB’s policy rate.
- Calibration and fiscal multiplier:
  - Fiscal impulse coefficient in the output gap equation ranges from 0.25 to 0.35, with the mean close to a prior value of 0.3—indicating a relatively lower fiscal multiplier in Lesotho.
  - Reference for desired reserves calibration: Assessing reserves adequacy for Credit-Constrained Economies (ARA for CCEs) as March-2023 is 4.7 month of import coverage.
- Selected impulse responses (selected simulations):
  - SARB one percentage point unanticipated rate increase (with immediate CBL response):
    - NEER and REER appreciate by 0.6 and 0.9 of a percentage point, respectively.
    - Output gap widens by 0.6 of a percentage point relative to trend.
  - Delayed (2-quarter) CBL reaction to SARB rate hike:
    - Declining international reserves; rising currency risk premium; higher lending rates; wider output gap.
  - Government spending shock: a one percentage point of GDP increase in fiscal deficit:
    - Output gap on impact increases by 0.3 of a percentage point of GDP.
    - International reserves fall by 0.5 of a month of import coverage before recovering.
    - Currency risk premium rises by almost 0.5 of a percentage point.
- Policy-relevant composite scenario:
  - Composite shock simulated: South Africa output gap widens by 1 percentage point; U.S. Fed funds rate is higher by 0.5 of a percentage point for two quarters.
  - If SARB raises rates: trade-offs between growth and inflation emerge; nominal exchange rate depreciates with muted REER impact.
  - If SARB lowers rates: exchange rate adjusts to lower demand; inflation pressures could limit easing; fiscal adjustment (e.g., limiting wage growth below inflation) advisable to restore competitiveness.
- Policy takeaways:
  - The peg insulates monetary policy but amplifies transmission of South African shocks.
  - Fiscal policy affects output gap directly and indirectly (via reserves → currency risk premium → lending rates).
  - Fiscal multiplier is weak; spending inefficiencies and import leakages reduce fiscal stimulus impact.
  - Precautionary reserve buffers enhance fiscal policy autonomy.

### SOEs, private sector development, and sectoral opportunities (selected excerpts)
- SOE governance and fiscal impact:
  - Assessment: "SOEs do not deliver value for taxpayers’ money and are not fulfilling their economic and social policy mandates, as well as operating inefficiently and burdening the budget."
  - Recommended actions: redefine SOE mandates and staff incentives; increase transparency of SOE activities.
- Private sector potential and sectoral opportunities:
  - Agriculture:
    - Opportunities: commercial horticulture, livestock, poultry, dairy, freshwater fishery, medical cannabis.
    - MCC second compact includes US$118 million investment in horticulture.
    - Constraint: "More than 80 percent of fresh fruits and vegetables sold in supermarkets are imported (World Bank 2020)."
    - Regulatory barrier: licensing fee LSL500,000 charged by the Ministry of Health identified as a barrier.
  - Tourism:
    - Assets: diverse cultural heritage and unique topography; potential for skiing, hiking, adventure tourism.
    - Constraint: lack of transportation and accommodation facilities.
  - Textiles:
    - Issues: lack of productivity improvements; need to diversify export destinations and products.
    - Note: expiration of AGOA insight requires diversification to European and regional markets.
  - Mining:
    - Sector importance: diamond mining remains important.
    - Examples: Letšeng attempts to capture value-added; Mothae expanded processing capacity by 45 percent in 2021.
    - Risk: power shortages in South Africa threaten mining activity and margins.
- MSMEs and inclusive growth:
  - Most businesses are MSMEs and in services; they are the largest private employers.
  - Priority actions: integrate MSMEs into value chains; improve access to finance.
- Institutional and financial constraints:
  - Public sector averaged 30 percent of GDP (2007–22).
  - Civil service employed about 14 percent of the labor force in 2017/18.
  - Financial access: 41 percent of adults owning a bank account; only 4 percent borrowing from banks.
  - Bank loans to the private sector as a share of GDP: Lesotho 20 percent; South Africa and Namibia 60 percent on average.
  - Just over 6 percent of Basotho report receiving loans from formal sources.
  - Sector concentration of business loans (2021–22): construction and real estate around 40 percent; wholesale and retail trade 21 percent; mining 17 percent.
- Policy implications for private-sector development:
  - Reduce crowding-out of business credit by reorienting credit supply from salaried consumption/mortgages toward MSMEs.
  - Address high spreads and borrowing costs to improve competitiveness with South African credit conditions.
  - Reform SOE mandates and strengthen effectiveness of institutions (BEDCO, LNDC, LTDC).
  - Improve basic infrastructure (water, transport, electricity) and trade logistics.
  - Enhance governance, legal protections, and a level playing field to attract private and foreign investment.

*Source: DECOMPOSING THE PUBLIC-PRIVATE SECTOR WAGE DIFFERENTIAL IN LESOTHO (excerpt from IMF chapter).*

### References _______________________________________________________________________________ 14

### DECOMPOSING THE PUBLIC-PRIVATE SECTOR WAGE DIFFERENTIAL IN LESOTHO

### Introduction
- Lesotho’s public wage bill is markedly higher than comparators:
  - Sub-Saharan African countries (excluding SACU) spent on average [6] percent of GDP per year on general government payroll—equivalent to 28 percent of their total public expenditure.
  - Lesotho’s public wage bill averaged 17 percent of GDP (32 percent of total expenditure).
  - SACU average compensation of government employees is 13 percent of GDP (38 percent of total public expenditure).
- Public wage bill growth varies with SACU transfers:
  - Wage bill growth averaged 14 percent per year in years when SACU revenues exceeded the historical average of 22 percent of GDP.
  - Wage bill growth averaged 7 percent per year otherwise.
- Paper structure:
  - Section B: overview of public sector employment and compensation.
  - Section C: estimation and decomposition of the public-private wage premium.
  - Section D: policy recommendations.

### The Public Sector Wage Bill
- Public employment and role of state:
  - SSA (excluding SACU) public sectors account on average for 9.4 percent of total employment and nearly 5 percent of the working-age population (aged 15 and older).
  - In Lesotho, every eighth job is in the public sector.
  - Across SACU members, on average every sixth job is in the public sector.
- Civil service structure and contribution:
  - Civil service salary scale has 13 grades: six managerial, three operational, and four support roles.
  - Civil service accounts for over one-third of public sector wage bill and employment and contributed most to wage bill growth over the past five years.
  - Operational level staff (grades F and G) account for over half of civil service wage bill; support level staff account for close to 50 percent of civil service employment.
- Pay compression and grade differentials:
  - Compression ratio (highest salary to lowest) is 17 for the basic salary.
  - Comparative compression ratios: sub-Saharan Africa average 13; global average 7.
  - Wage differentials between adjacent grades are large:
    - Difference between basic salaries across grades at the support and operational levels is over 30 percent.
    - Jump to the next (lowest) managerial grade is a still significant 20 percentage points.
  - Allowances are relatively small, at about 1–2 percent of the basic salary, but tend to double or triple at the highest managerial grades (J and up).
- Automatic increases and inertia:
  - Automatic annual nonmerit pay increases (“notches”) and cost-of-living adjustments (COLA) generate upward drift tied to years of service rather than performance.
  - Administrative payroll panel (civil servants on payroll throughout 2017–22):
    - More than 90 percent experienced a positive adjustment almost every year, including FY19/20 and FY21/22 when there was no COLA.
    - Total wage bill for this panel increased by 4 percent in FY21/22 attributed solely to notches.
    - Median employee experienced around a 5 percent increase in basic salary in FY21/22.
- Distributional effects and fiscal crowding out:
  - Upward inertia in the public wage bill has been gradually crowding out other government spending.
  - Containment of the wage bill is essential for fiscal sustainability, income distribution, administrative efficiency, and private-sector competitiveness.
- Data coverage note:
  - Civil service salary scale table covers all civil servants with non-zero basic salary in FY21/22: 16,637 employees.
  - Those 16,637 account for close to 40 percent of all public employees with non-zero basic salaries (42,502).

### The Public Sector Wage Premium
- Magnitude and international context:
  - Average public wage premium in EMDEs is nearly 12 percent.
  - In Lesotho, average public wages can be twice as high as average private sector wages (and differentials would be even higher once allowances and nonwage benefits are included).
  - Such differentials incentivize low-skilled workers to favor public employment.
- Methodology:
  - Uses 2017 Household Budget Survey microdata and a standard Mincerian wage regression:
    - ln(wage_ijt) = θ Public_i + β X_i + γ_j + δ_t + ε_ijt
    - Public sector defined as central and local government; private sector includes parastatals, private sector, private households, and self-employed in non-farm enterprises.
    - Controls include age, age squared, gender, marital status, urbanization, educational attainment (secondary, tertiary), number employed in household, industry and district fixed effects.
- Distributional patterns:
  - Public-sector wages are higher and more dispersed than private-sector wages.
  - More than 50 percent of the public sector wage distribution lies to the right of the private sector distribution.
  - Public sector distribution is more peaked and exhibits greater dispersion driven primarily by higher dispersion among women in the public sector.
- Estimated wage premium and quantile dynamics:
  - Baseline regression: employment in the public sector is associated with 36 percent higher wages.
  - Premium about the same when parastatals are included in the public sector.
  - Premium rises to 40 percent when self-employed in farm enterprises are included in the private sector.
  - Quantile regressions:
    - Public wage premium is over 60 percent at the lower end of the wage distribution, declining across the quantiles.
  - Public-private wage gap across percentiles:
    - Gap remains relatively flat at lower end, rises in middle (40th–60th percentiles), and declines at the top.
    - Gap higher among women than men except at the lower end; remains high until the 90th percentile for women.
    - Gap larger among workers with secondary education than those with tertiary education, particularly at the higher end.
    - From the 80th percentile onwards, the gap favors private sector workers with primary and tertiary education.
- Gender and education interactions:
  - Female workers are paid less than male counterparts on average by 37 percent (after controlling for individual characteristics).
  - However, female wages are relatively higher in the public sector, particularly at the higher end of the distribution; at the 90th quantile, female public-sector wages are not much different from male wages.
  - Educational effects:
    - Workers with secondary education earn 27 percent more than those with primary or no education.
    - Workers with tertiary education earn 120 percent more than those with primary or no education.
    - Public sector employment boosts wages of workers with secondary and tertiary education by an additional 64 and 43 percent, respectively.
  - Public sector particularly rewards female workers at the higher end and workers with tertiary education at the lower end of the wage distribution.

### Policy Implications and Recommendations
- Key policy messages:
  - Containing the wage bill is essential for fiscal sustainability and to improve income distribution and private-sector competitiveness.
  - Wage and hiring freezes can offer temporary relief but are not sufficient for durable adjustment.
  - Structural reforms are required to achieve a durable adjustment in the wage bill without jeopardizing service delivery:
    - Target sectors with excessive employment and salary levels.
    - Support reforms with strong institutions and legislation.
  - Reforms should aim to reduce public-private wage distortions that create a dual labor market and disincentivize private-sector employment.

*Source: DECOMPOSING THE PUBLIC-PRIVATE SECTOR WAGE DIFFERENTIAL IN LESOTHO (excerpt from IMF chapter).*

### 15.      The public-private sector wage gap is largely driven by higher public wage premium

### 15.      The public-private sector wage gap is largely driven by higher public wage premium

### Key empirical findings
- At the lower end of the wage distribution, the wage gap is largely due to the “price effect” rather than the “endowment effect.”
- The public sector exhibits a wage premium, particularly at the bottom of the distribution, although inferior endowments among private sector workers also contribute.
- The endowment effect increases starting from the 40th percentile and drives the increase in the wage gap between the 40th and 60th percentiles.
- After the 80th percentile, returns to workers’ characteristics narrow the wage gap, as indicated by a strong negative “price effect.”
- Overrepresentation of women in the public sector narrows the wage gap by 3–5 percentage points especially at the lower and higher ends of the wage distribution; however, at the 90th percentile this narrowing is outweighed by a corresponding positive “price effect,” so that gender contributes to widening the wage gap at the higher end.
- Decomposition methodology: Oaxaca-Blinder (1973) type decompositions, based on Firpo et al. (2009) recentered influence function regressions, are used to decompose public-private sector wage gap (Annex Table 3).

### Policy implications (three key messages)
- First: Total public-private sector wage gap in Lesotho is relatively high for both the bottom and middle of the wage distribution.
- Second: The gap at the bottom end is largely explained by a higher wage premium, but also by differences in observed characteristics. This suggests the public sector both attracts and rewards workers with inferior endowments at the lower end.
- Third: The high public wage bill is driven by a generous salary scale, large wage differentials between adjacent grades, and automatic annual salary increases, which are not merit-based.

### Principles for wage-bill reform
- Wage bill growth must not jeopardize fiscal sustainability.
- Public sector employment should be consistent with targets for public service quality and delivery; the civil service should not function as the employer of last resort or a means of patronage.
- Public sector compensation should be competitive, but not significantly higher than in the private sector.
- The range of generous public sector allowances and benefits must be scaled back, as these compound the large size of the wage gap.

### Short-term and structural policy measures (toolbox)
- Short-term (quantity- and price-based): Wage freezes, ceilings, or cuts; elimination of “notch” increases; hiring freezes; termination of off-payroll workers; early retirement; attrition.
- Structural (medium-term): Unifying wage structures; rationalizing allowances; introducing comparisons of public and private sector compensation; tightening the link between pay and performance; public sector restructuring; enhancing payroll quality (e.g., payroll census); replacing career-based employment with position-based employment for some jobs; reviewing government programs to identify under- and/or overstaffing.

### Employment management recommendations
- Reduce and manage public sector employment using essential hiring, natural attrition, and staff redeployment.
- Exploit consolidation of ministries, departments, and agencies (MDAs) to eliminate duplicate functions.
  - Scenario assumptions: number of ministries reduced from 27 to 15; eliminate 10 principal secretary positions in the merged ministries, reducing principal secretaries from 47 to 37; eliminate a fifth of positions at every grade level, except grade M.
- Identify and terminate public sector employees hired outside of the establishment list and enforce hiring freezes for non-essential positions.
- Abolish longstanding vacancies or reallocate existing staff from overstaffed areas.

### Compensation containment recommendations
- Eliminate non-merit increases and introduce performance-based remuneration.
- Eliminate “notch” increases, consistent with the 2008 Public Service Regulations.
- Tighten links between pay and performance metrics (e.g., attendance and performance efficiency).
- Publish (online) comparisons of public and private sector compensation to highlight the public sector wage premium.

### Menu of reform scenarios and estimated fiscal impact (based on FY21/22 civil service payroll data)
- Eliminating duplicate functions at merged MDAs over a 3-year period: around 1 percentage point of GDP adjustment in the wage bill over the medium term.
- Capping COLA at 2.5 percent, while maintaining the notch increase of 5 percent and assuming new hires replace natural attrition (natural attrition assumed to be 2 percent): savings of 0.2 percent of GDP.
  - Note: If the notch were instead capped at 2.5 percent as in the FY23/24 budget, the savings would be much higher at 2 percent of GDP.
- Reducing the notch to 2.5 percent over a 3-year period (0.6 percentage point in the first two years and 0.7 percentage point in the third year): around 1.7 percentage points of GDP adjustment over the medium term.
- Completely eliminating the notch (gradually over a 5-year period, 1 percentage point each year): estimated savings of 2.8 percent of GDP.
- Context on historical wage dynamics: Pre-pandemic wage increases of 6-10 percent each year were driven by a combination of “notch” increases and COLA, compared to pre-pandemic average inflation of 4.9 percent (over 5- and 10-year periods). Recommendation: cap COLA at 2.5 percent over the next three years and subsequently set the cap just below the pre-pandemic average rate of inflation, around 4 percent.

*Sources: 2017 Household Budget Survey and IMF staff calculations.*

### 10.      Potential output in Lesotho is estimated using a multivariate filter (MVF), to help

### 10.      Potential output in Lesotho is estimated using a multivariate filter (MVF), to help

### Potential output and business cycle
- Model-consistent estimation of historical trend real GDP uses a multivariate filter (MVF) to locate Lesotho’s position in its business cycle.
- Lesotho’s business cycle is strongly linked to that of South Africa, but with greater volatility.
- Potential growth combines South Africa-specific (common) factors and Lesotho-specific factors, with Lesotho-specific factors captured in lower total factor productivity growth due to governance, fiscal management, and public service delivery weaknesses.
- The MVF shows that potential growth has been decelerating over the recent decade and that at 2 percent, the current estimate of potential growth is below the rate needed to close the income gap with other CMA members.
- Despite some rebound in growth, a negative output gap persists since the pandemic started.

### The modeling framework (Macroeconomic Model of Lesotho)
- Framework: a semi-structural New Keynesian model with an IS curve, a Phillips curve, an uncovered interest parity condition, and a monetary policy reaction function.
- Two-module layered approach:
  - (i) Lesotho module
  - (ii) South Africa module (which incorporates the rest of the world)
- The model captures Lesotho–South Africa linkages and allows scenarios that model SARB policy choices’ impact on Lesotho.
- The model is quarterly and expresses all variables in “gap” terms (percentage deviations from trend), with trends estimated jointly in the model.
- Foreign exchange reserves are directly impacted by fiscal policy (through import leakages) and by interest rate deviations from SARB’s policy rate; risk premium depends on deviations of reserves from desired level and influences lending rates.

### Core equations and country-specific features
- Aggregate demand (IS curve) links the output gap to:
  - Lagged and lead output gap terms,
  - Monetary conditions (interest rate gap 푟̂ and real effective exchange rate gap 푧̂),
  - ZAF output gap (푦ො ZAF) to capture trade and remittances,
  - Government spending shock (퐺̂).
- Aggregate supply (modified Phillips Curve) links headline inflation (휋 Lesotho) to:
  - South Africa inflation (휋 ZAF) adjusted for CPI weight differences,
  - Output gap and a long-lived persistent shock (휀 2) (e.g., energy price shocks).
- Monetary policy reaction function reduces to tracking SARB’s policy rate given the objective to maintain exchange rate parity.
  - CBL policy rate (푖 Lesotho) assumed equal to SARB policy rate (푖 ZAF) plus a small currency risk premium wedge (푝푟푒푚).
- Foreign exchange reserves (in months of import coverage, 푟푒푠̂) deviation dynamics:
  - Lagged reserves with coefficient 훿 (close to one but less than 1 for stationarity),
  - Linked to government spending and real effective exchange rate pressures,
  - Desired reserve level follows an autoregressive process converging to steady-state (푟푒푠̂^ss).
- Currency risk premium (푝푟푒푚̂) depends negatively on the deviation of reserves from desired levels and feeds into market lending rates.

### Calibration, estimation, and parameter inference
- Parameters largely calibrated due to limited time series and structural changes; calibration informed by impulse response analysis, the Kalman filter, and other QPM models.
- Some parameters estimated using Bayesian methods; posterior modes for most parameters are close to priors, confirming calibration values.
- Fiscal impulse coefficient in the output gap equation ranges from 0.25 to 0.35, with the mean close to a prior value of 0.3—indicating a relatively lower fiscal multiplier in Lesotho.
- Reference for desired reserves calibration: Assessing reserves adequacy for Credit-Constrained Economies (ARA for CCEs) as March-2023 is 4.7 month of import coverage.

### Impulse response findings (selected simulations)
- SARB one percentage point unanticipated rate increase (with immediate CBL response):
  - Real market lending rate increases; inflation expectations fall.
  - NEER and REER appreciate by 0.6 and 0.9 of a percentage point, respectively.
  - Output gap widens by 0.6 of a percentage point relative to trend; downward pressure on inflation and expectations.
- Delayed (2-quarter) CBL reaction to SARB rate hike:
  - Declining international reserves amid mounting exchange rate pressures.
  - Falling reserves increase currency risk premium, raising long-term interest and lending rates.
  - Output gap widens as growth falls and risk to the peg increases.
  - Highlights the need for CBL to follow SARB policy rate to maintain the hard peg.
- Government spending shock: a one percentage point of GDP increase in fiscal deficit:
  - Output gap on impact increases by 0.3 of a percentage point of GDP due to large import share.
  - International reserves fall by 0.5 of a month of import coverage before recovering.
  - Currency risk premium rises by almost 0.5 of a percentage point, increasing market interest rates and offsetting fiscal stimulus.
  - Following initial increase, output gap falls below zero—implying muted long-term effects of government spending due to import leakages and spending inefficiencies.
  - Higher reserve buffers would insulate fiscal policy from affecting currency risk premium and the real economy.

### Policy-relevant composite scenario
- Composite shock simulated:
  - South Africa output gap widens by 1 percentage point.
  - U.S. Fed funds rate is higher by 0.5 of a percentage point for two quarters.
- Scenario implications:
  - If SARB raises rates: SARB tightens to counter FX-driven inflation pressures; nominal exchange rate depreciates with muted REER impact; trade-offs between growth and inflation emerge.
  - If SARB lowers rates: exchange rate adjusts to lower demand; inflation pressures (from oil/food prices, unanchored expectations, or power outages) could limit easing and make the external demand shock more severe for Lesotho; fiscal adjustment (e.g., limiting wage growth below inflation) advisable to restore competitiveness.
  - Fiscal space to stimulate depends on reserve levels and spending efficiency; optimal response may require both fiscal adjustment and structural reforms.

### Policy implications and recommendations
- The framework enables modeling of external shocks and their impact on reserves and the domestic output gap—informing monetary and fiscal policy trade-offs.
- Key insights:
  - The peg insulates monetary policy from political interference and supports price stability credibility but amplifies transmission of external (South African) shocks.
  - Fiscal policy affects the output gap directly (aggregate demand) and indirectly (reserve pressure → currency risk premium → lending rates).
  - Fiscal multiplier is weak in Lesotho; spending inefficiencies and import leakages reduce fiscal stimulus impact.
  - Precautionary reserve buffers enhance fiscal policy autonomy to stabilize output.
  - In environments with stretched reserves and no independent monetary policy, domestic shocks are prolonged and severe.
- Policy guidance:
  - Effective coordination of fiscal and monetary policies under the peg requires forward-looking analysis and macroeconomic forecasts.
  - Fiscal responses to shocks should consider lags and be conditioned on reserve targets.
  - Setting an optimal target for international reserves should be guided by fiscal policy and shock scenarios.

*Source: IMF staff summary from the Lesotho model section in the provided content.*

### References

### 1lsoea2023002 - References

### Public sector dominance and financial development
- Public sector averaged 30 percent of GDP (2007–22).
- Civil service employed about 14 percent of the labor force in 2017/18.
- Financial access: 41 percent of adults owning a bank account; only 4 percent borrowing from banks.
- Bank loans to the private sector as a share of GDP: Lesotho 20 percent; South Africa and Namibia 60 percent on average.
- Overall credit to the private sector averaged 28.5 percent of total bank credit during 2019–22.
- Key observations:
  - Government holds significant stakes in multiple large businesses and SOEs, exerting control over key sectors.
  - Financial depth indicators (e.g., broad money as share of GDP) show Lesotho lags other SACU members.
  - Credit growth volatility: sharp decline during FY20/21, partial rebound as economy reopened, then deceleration in 2022.

### Distortions in the provision of private sector credit
- Distribution of household loan access:
  - Just over 6 percent of Basotho report receiving loans from formal sources.
  - Over 20 percent of professionals, legislators, senior officials, and managers reported receiving bank loans.
  - 3.3 percent reported among those that are self-employed.
- Loan usage:
  - Almost 98 percent of bank loans received by households went to personal use, not business.
  - Resulting risks: growing household indebtedness and exposure of financial sector to household balance sheets (risk of NPLs in downturns).
- Regression findings (Logistic model; Household Budget Survey 2017/18; 4,251 observations):
  - Salaried Employees: Logit 0.56***; Marginal Effects (Probability) 0.02***.
  - Professionals (relative to self-employed): Logit 1.84***; Marginal Effects (Probability) 0.18***.
  - Legislators, senior officials, and managers: Logit 1.49***; Marginal Effects (Probability) 0.13**.
  - Service workers: Logit 0.95***; Marginal Effects (Probability) 0.06***.
  - Plant and machine operators: Logit 0.74***; Marginal Effects (Probability) 0.04**.
  - Constant reported as -7.76*** and -7.26*** in different specifications.
- Sector concentration of business loans (2021–22):
  - Construction and real estate: around 40 percent.
  - Wholesale and retail trade: 21 percent.
  - Mining: 17 percent.
- Cost of borrowing:
  - Spreads between deposit and borrowing rates in Lesotho are the highest among SACU members (but below SSA average).
  - Deposit rates much lower than lending rates; lending rates decreased in 2020–21 (likely due to low demand during the pandemic).

### Other constraints to private sector development and growth
- Enterprise survey (World Bank, 2016; 150 enterprises: manufacturing and services) identified key barriers:
  - Access to finance, high taxes, informality, crime and theft, limited infrastructure, and trade logistics challenges.
- Specific findings:
  - One in five enterprises identified high taxes as a significant obstacle (higher proportion than in other SACU countries).
  - Corporate tax statutory rate noted as lower than other SACU members; standard VAT rate is 15 percent.
  - Investment financing by firm size:
    - Medium-sized enterprises (20–99 workers): 24 percent financed investments through loans.
    - Small businesses (<20 employees): 20 percent financed investments through loans.
    - Large businesses (>100 employees): 12 percent financed investments via domestic banking system.
  - Infrastructure deficits: insufficient water (reported by more than 40 percent of firms), weak internal transportation network, unreliable electricity.
  - Trade logistics: higher difficulty arranging international shipping competitively; delays at Durban port; anecdotal nontariff barriers (ad hoc inspections in transit through South Africa); high transport costs sometimes forcing use of air freight.

- SOE performance and support institutions:
  - BEDCO:
    - Maintains estates for business rent, but access is not based on business viability.
    - In FY22/23, 500 jobs created at a cost of LSL14 million.
  - LNDC:
    - Four key interventions (PCGS, PPF, QEF, TFI) have been ineffective to date.
    - PCGS guaranteed projects totaling LSL50 million; lenders see little value in government guarantee.
    - Project pipeline stalled; new industrial zones yet to be completed.
  - Overlapping mandates between LNDC and BEDCO create inefficiencies and uncertainty.
  - LTDC has made limited progress developing tourism; coordination setbacks with LHDA have halted development at sites associated with the Lesotho Highlands Water Project.
  - Tourism potential underutilized due to weak infrastructure and lack of a clear supporting strategy.

### Policy implications and recommendations
- Core obstacles to private investment:
  - Lack of good governance, including rampant corruption.
  - Gaps in the legal framework and weak protection of property rights.
  - Differential treatment of domestic and foreign investors.
  - Dominance of the public sector in the economy.
- Policy measures and observations:
  - Government has introduced e-licensing and e-registration platforms and streamlined import and export procedures.
  - Rollout challenge: e-licensing requiring payment of licensing fees at the Central Bank of Lesotho met resistance and dissatisfaction from businesses, potentially discouraging formalization.
  - Recent measures to protect local entrepreneurs from foreign competition in some sectors could discourage foreign-owned MSMEs.
- Implicit policy directions from analysis:
  - Reduce crowding-out of business credit by reorienting credit supply from salaried consumption/mortgages toward MSMEs.
  - Address high spreads and borrowing costs to improve competitiveness with South African credit conditions.
  - Reform SOE mandates and strengthen effectiveness of institutions (BEDCO, LNDC, LTDC) to better support MSME development and sectoral investment.
  - Improve basic infrastructure (water, transport, electricity) and trade logistics to lower costs and delays for exporters.
  - Enhance governance, legal protections, and a level playing field to attract private and foreign investment.

*Source: References and accompanying chapter excerpts, 1lsoea2023002 (International Monetary Fund).*

### 17.      Revamping the governance of SOEs and their role in private sector development. At

### Revamping the governance of SOEs and their role in private sector development

### SOE governance and fiscal impact
- Current assessment: "SOEs do not deliver value for taxpayers’ money and are not fulfilling their economic and social policy mandates, as well as operating inefficiently and burdening the budget."
- Cross-country evidence: "larger state ownership is not the way to achieve faster growth and convergence (IMF 2019)."
- Recommended government stance: "avoid allocating scarce public resources in areas where intervention has been proven ineffective."
- Governance actions needed:
  - "SOE mandates and staff incentives need to be redefined."
  - "Transparency of SOE activities is also critical to bolster accountability (IMF 2020)."

### Private sector potential and sectoral opportunities
- Overall: "the country has an enormous potential for strong private sector participation in a broad range of sectors."
- Source reference: "The 2020 World Bank report on unlocking the private sector's potential has identified key areas for new investments, as well as existing industries that are vulnerable and would need strengthening."

- Agriculture
  - Opportunities: "commercial horticulture such as fruit and vegetable farming" could "provide additional income and employment opportunities in rural areas and reduce import costs."
  - Supporting investment: "The Millennium Challenge Corporation’s (MCC) second compact, which includes a large investment in horticulture (US$118 million) with a focus on high-value crop production, would facilitate leveraging the sector’s potential."
  - Other promising areas: "livestock herding, including sheep and goat, poultry, dairy, and freshwater fishery."
  - Specific assets: "the huge water reservoirs created in the Lesotho Highlands Water Project (LHWP) dams provide added opportunity for commercial fishery."
  - Emerging industry: "A growing medical cannabis industry has enormous potential to attract direct investment (FDI) and generate revenue."
  - Constraints to address:
    - "boosting the use of modern inputs"
    - "identifying readily available suitable land for agrobusinesses"
    - "creating a productive link between investors and host farming communities"
    - "supporting integration into the global value chains through better logistics"
  - Noted statistic: "More than 80 percent of fresh fruits and vegetables sold in supermarkets are imported (World Bank 2020)."
  - Regulatory barrier: "A prohibitively high licensing fee (LSL500,000) charged by the Ministry of Health has been identified as a barrier by businesses."

- Tourism
  - Comparative assets: "diverse cultural heritage and unique topography makes it attractive for inimitable touristic activities, including skiing, hiking, adventure tourism, and cultural sightseeing."
  - Potential benefits: "Tourism that supports local economic activities and benefits the host destinations could have enormous benefits, beyond just garnering tourism receipts."
  - Key constraints: "addressing infrastructure challenges, including lack of transportation and accommodation facilities, is crucial for the sector’s growth in the face of large, attractive tourist destinations in neighboring South Africa."

- Textiles
  - Current issues: "Lack of productivity improvements is harming competitiveness."
  - Strategic needs: "the sector needs to diversify its export destinations and products."
  - Labor characteristics: "the industry remains a large employer of informal labor."
  - Trade environment note: "With expiration of the African Growth and Opportunity Act (AGOA) insight, diversification to European and regional markets is crucial."
  - Diversification opportunities: "Expanding to related activities, e.g., car seats production, could help create new opportunities."
  - Policy continuity: "The specific policy recommendations outlined in the 2020 World Bank report are still relevant."

- Mining
  - Sector role: "The diamond mining sector remains an important part of the country’s economy."
  - Fiscal design objective: "The mining fiscal regime should also be designed in a way to ensure long-term generation of revenue for public use."
  - Dual requirement: "both a favorable environment for investment in mineral exploration and extraction, to broaden the revenue base, and fiscal terms that secure a competitive share of the returns from individual mines for the public treasury."
  - Value chain focus: "to maximize returns to the sector—for both the business and the public—opportunities to move up the value chain or design mechanisms to tap value further along the chain will need to be identified, particularly given the low-grade and high-cost structure of operations."
  - Case examples:
    - Letšeng: "recent attempts to capture value-added further down the chain through supply and partnership agreements that guarantee a share of the sales of polished diamonds are an innovative step in the right direction."
    - Mothae mine: "expanded its processing capacity by 45 percent in 2021 and continuing its cutting and polishing partnerships."
  - External risk: "power shortages in South Africa are a serious threat to mining activity and could potentially disrupt activity and increase costs, reducing margins further in the sector."
  - Policy implication: "Energy security is, therefore, an important consideration for this sector, as well as the broader economy."

### MSMEs and inclusive growth
- Rationale: "Policy emphasis should also be placed on MSMEs to support job-rich private sector-led growth."
- Labor market role: "Most businesses in Lesotho are MSMEs and in the service sector and, taken together, they are the largest private employers and hence central to job creation (Bureau of Statistics 2016)."
- Priority actions:
  - "Integrating MSMEs into value chains"
  - "improving their access to finance"
- Goal: "key for inclusive growth."

*Source: KINGDOM OF LESOTHO — INTERNATIONAL MONETARY FUND (excerpt).*

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_Source: https://www.imf.org/-/media/files/publications/cr/2023/english/1lsoea2023002.pdf_