## _wp0883

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---

### I. Introduction — scope and approach
- Exchange rate assessments for Botswana face heightened uncertainty due to poor data, frequent structural breaks, market imperfections, high macroeconomic volatility, and dependence on an exhaustible natural resource (diamonds).
- Assessment combines multiple methodologies:
  - Description of balance of payments trends, vulnerabilities, and evolution of several REER indices (CPI-based, productivity-based, internal terms of trade).
  - Econometric estimation of the equilibrium real effective exchange rate (EREER) via a reduced-form relationship between the real exchange rate and fundamentals.
  - Sustainability assessment of projected current account and net foreign assets (NFA) that explicitly accounts for exhaustibility of diamond receipts and compares projected current account path with medium-term fiscal sustainability.
  - Competitiveness assessment using non-price indicators: external outcomes, production costs, and business environment quality.
- Key summary findings:
  - Botswana’s REER is close to its medium-term equilibrium value, based on past trends in fundamental determinants.
  - A forward-looking assessment that accounts for the need to accumulate savings to sustain imports and consumption beyond diamond production suggests larger current account surpluses may be needed.
  - Structural competitiveness issues identified:
    - Declining labor productivity in tradables (except mining), particularly in manufacturing.
    - High utility prices and inadequate information technology and communication infrastructure.
    - Skills mismatch, difficulties hiring expatriate skilled labor, and labor market rigidities.
    - Difficult access to land and high cost of financing for small enterprises.

### II. External sector developments and vulnerabilities
- Diamond dependence and macro outcomes:
  - For 2006, diamond exports represented 74 percent of total goods exports and 32 percent of GDP.
- Historical current account patterns:
  - 1980s: average current account deficits of about 8 percent of GDP.
  - 1990s (1990–2006): current account surplus averaging about 8 percent of GDP.
- Volatility statistics:
  - Average annual standard deviation for the current account (1990-2006): 5 percent of GDP.
  - Average annual standard deviation for terms of trade: about 20 percentage points.
- Capital and financial account / balance sheet vulnerabilities:
  - No significant balance sheet vulnerabilities identified from capital and financial account.
  - 1980s: capital and financial account surplus averaged about 7½ percent of GDP; annual net FDI ≈ 4 percent of GDP.
  - 1990s: capital and financial account surplus ≈ 1 percent of GDP on average; FDI and other flows almost nonexistent.
  - Since 1999: account turned slightly negative due to offshore investments by growing pension funds.
- External debt and reserves (as presented):
  - External debt: "less than 3 percent of GDP."
  - Capital and financial account: projected to shift to net inflows of about 2 percent through 2015 owing to temporarily higher FDI associated with mining and energy projects.
  - Reserve stock at end-2006:
    - Total reserves: 75 percent of GDP.
    - Liquid reserves: 20 percent of GDP (about 6 months of imports).
    - Pula Fund: 55 percent of GDP (about 19 months of imports).
  - Reserve policy:
    - Central bank targets 6 months of import cover for liquid reserves.
    - Current liquid reserve coverage is sufficient to withstand a two-standard-deviation adverse current account shock for two years.
  - NFA dynamics:
    - Rate of growth of NFAs fell below that of nominal GDP in 1998; NFAs as percent of GDP started declining thereafter.
    - Government-funded privatization of pension funds lowered official reserve assets by about P13.5 billion between 2001 and 2005.
  - Financial sector exposure:
    - Banking sector vulnerabilities mostly credit risk from a global downturn reducing diamond revenues.

### III. Evolution of REER indices and contributing factors
- General movement (2000–2006):
  - Real appreciation between 2000-2004 was more than offset by devaluations in 2004 and 2005 and the subsequent switch to a crawling peg.
  - By end-2006:
    - Annual CPI-based REER: 5 percent below its average annual value for 1995-2000.
    - Productivity-based REER: 10 percent below its 1995-2000 average.
- CPI-based vs productivity-based dynamics:
  - Both moved together 1995–2000; real appreciation and subsequent depreciation were more pronounced in the productivity-based REER.
  - Gap between the two has recently been narrowing; bilateral real exchange rates of main trading partners (South Africa and United States) tended to move in opposite directions.
- Sources of real appreciation:
  - Largely caused by a trend increase in relative prices and accelerated nominal effective exchange rate appreciation around 2000.
  - Rapid productivity improvements in the diamond sector drove relative price increases.
  - Excluding mining, labor productivity in tradables versus nontradables has been declining relative to trading partners.
  - Mining wage increases may have transmitted to wage and price increases in nontradables (Dutch disease symptom).
- Nominal appreciation drivers and regime shift:
  - Possible role for removal of exchange controls in 1999 that might have induced rand-denominated capital inflows (no strong evidence).
  - Shift from fixed to crawling peg in 2005 increased REER stability:
    - CPI-based REER depreciated by 2 percent in the twelve months through August 2007 versus average annual appreciation of 5 percent from 1999-2004.
    - Net effect: REER roughly unchanged from mid-2005, with NEER depreciation offsetting relative price differentials.

### IV. Equilibrium REER estimation (BEER approach) — method and results
- Methodology and data:
  - BEER approach following Clark and MacDonald (1999), extending Iimi (2006).
  - Sample period: 1980-2006.
  - Pre-estimation diagnostics: REER and explanatory variables are I(1) (ADF tests).
  - Model: Vector error correction model (VECM) with Johansen methodology; preferred VAR lag-length: two lags.
  - Cointegration: one cointegrating vector retained in preferred specification.
- Variables and expected signs:
  - Terms of trade (ltot): positive movements tend to appreciate REER.
  - Capital flows (NFA of banking system relative to GDP): expected to appreciate REER (found not significant).
  - Relative productivity (lrelprod): Balassa-Samuelson effect — higher tradables productivity appreciates REER.
  - Government spending (lgc_gdp): interpreted as proxy for risk premium/fiscal stance; impact depends on tradables share in government spending.
  - Trade openness: more openness tends to depreciate REER (proxy found not significant).
- Preferred long-run cointegrating equation (estimates and t-statistics shown):
  - ln REER = 0.034(r-r*) + 0.042ltot + 0.338lgc_gdp + 0.052lrelprod + 2.946
    - [13.02] [1.42] [3.53] [4.11]
  - Statistical notes:
    - All coefficients statistically significant except the terms of trade.
    - Breakpoint Chow tests: coefficients stable over sub-periods.
    - Residual diagnostics: outliers noted but formal tests do not reject normality and show no autocorrelation.
    - Cointegration tests (Trace and Max-Eigen) indicate existence of one cointegrating relationship.
- Short-term dynamics (selected results):
  - Dln(REER) coefficient: -0.376 (t-statistic [-2.699]).
  - D(Real interest rate differential): 44.841 (t-statistic [6.932]).
  - Dln(productivity): 1.107 (t-statistic [5.364]).
  - R-squared: 0.367; Adj. R-squared: 0.156.
- Equilibrium REER path and valuation assessment:
  - EREER calculated using Hodrick-Prescott filters on fundamentals with 95 percent confidence interval.
  - Main result: REER was sharply overvalued prior to nominal devaluations in 2004 and 2005; subsequent real depreciation restored REER roughly toward equilibrium during 2006.
  - Over 1980-2006, REER movements closely followed changes in the real interest rate differential.
- Caveats:
  - Data quality issues, limited time series, sensitivity to sample period, variable selection, and smoothing method.
  - Equilibrium estimates may not be robust across estimation methods (single-country vs panel).

### V. External sustainability (CGER permanent-income adaptation) — calculations and scenarios
- Methodology:
  - Uses intertemporal budget constraint for the whole economy to compute current account balance-to-GDP ratio that stabilizes NFA at a benchmark b_s.
  - Permanent-income approach annualizes projected mineral revenue as an annuity; sustainable current account equals difference between mineral exports and annuitized projected mineral exports (plus non-mineral balances).
- Key assumptions for Botswana calculations:
  - Diamond resources assumed to begin to decline abruptly in 2021.
  - Annuity calculated between 2007 and 2050.
  - Baseline parameters (percent):
    - Interest rate to discount revenue flows: 9.3
    - Long-term inflation: 4.7
    - Long-term real growth: 4.4
    - Real rate of return: 4.4
  - Alternative parameters:
    - Interest rate to discount revenue flows: 7.8
    - Long-term inflation: 4.7
    - Long-term real growth: 4.4
    - Real rate of return: 3
  - Calculated annuity value of diamond receipts: about 9.2 percent of GDP.
- Baseline comparison for 2007–2015:
  - Average projected current account: about 10½ percent of GDP.
  - Sustainable current account (annuity approach): 14 percent of GDP.
  - Average gap: about 3½ percent of GDP (actual path below sustainable benchmark).
- Interpretations and sensitivity:
  - Implies a slightly overvalued exchange rate relative to external sustainability benchmark.
  - Projected lower surpluses for 2007-2013 are transitory, reflecting capital goods imports for mining and energy projects, largely financed by FDI.
  - If returns on these investments exceed returns from accumulating financial savings from diamond exports, such investment can be consistent with long-run sustainability.
  - Lower discount rate (alternative scenario) lowers annuity value, increasing required savings and widening the gap.
  - Higher diamond revenue (e.g., diamond exports stabilizing at 25 percent of GDP between 2010 and 2015) would allow higher annual savings and narrow the gap.
- NFA and reserve implications:
  - End-2006 NFAs: 75 percent of GDP (20 percent liquid reserves ≈ 6 months of imports; 55 percent in Pula Fund).
  - If Pula Fund is included as starting savings, annual required savings out of diamond receipts can be smaller or sustain imports longer.
  - Maintaining liquid reserves at about 6 months of imports while saving the annuity would rapidly draw down NFA stock even from end-2006 levels.
- Illustrative targets:
  - To stabilize NFAs at permanent consumption level (annuity 9.2 percent of GDP + average non-diamond exports ≈ 16 percent of GDP) current account surplus needed: about 20 percent of GDP.
  - To also maintain liquid reserve coverage of about 6 months of imports (about 10 percent of GDP), sustainable current account surplus would need to be about 37 percent of GDP.

### VI. Export performance, productivity, infrastructure, and business environment
- Export performance:
  - Share of total exports in GDP roughly constant since 1997.
  - Share of non-mining exports in non-mining GDP declined from 18 percent in 1997 to 8 percent in 2006 (a 10 percentage point drop).
  - Growth in volume of diamond and other exports has declined in recent years.
  - Botswana’s exports perform better than SACU members excluding South Africa (thanks to diamonds) but remain far behind South Africa; share of world trade stagnant.
  - Recent improvement in export profitability due to devaluation-driven higher export prices and modest productivity improvements mainly in mining.
- Productivity trends:
  - Declining labor productivity in tradables sectors other than mining; transport and manufacturing productivity declined since late 1990s with a modest uptick in the past two years.
  - In nontradables, only utilities show strong labor productivity improvement.
- Infrastructure and costs (late 1990s, U.S. dollars) — selected figures:
  - Airfreight to Europe (per kg): Botswana 1.84; South Africa 1.17.
  - Sea freight to Europe (per 20-foot container): Botswana 2.00; South Africa 1.00.
  - Electricity (per kwh): Botswana 0.10; South Africa 0.04.
  - Water (per m3): Botswana 1.02; South Africa 0.30.
  - Telecom to EU (per minute): Botswana 4.04; South Africa 2.21.
- Business environment and governance:
  - Competitiveness surveys: Botswana generally performs worse than key regional competitor South Africa, but better than Lesotho and Swaziland.
  - Perceived impediments: labor market functioning, inefficient government bureaucracy, inadequate and high-cost infrastructure, access to and cost of finance for smaller firms.
  - Labor market specifics: skills mismatch, simultaneous high unemployment and shortages of skilled labor, difficulties obtaining work/residence permits for expatriate skilled workers.
  - HIV/AIDS negatively affects workforce productivity.
  - Small and medium enterprises face difficulty or high cost in obtaining loans despite broader financial access.
  - 2004 FIAS report recommended regulatory and procedural improvements; government following up on company licensing, utility connections, foreign investment code, competition policy.
  - Some deterioration noted in regulatory quality, government effectiveness, and control of corruption, although governance indicators remain above historical trends and compare favorably with other upper-middle income countries.

### VII. Summary findings and policy implications
- Main macro and REER conclusions:
  - Botswana’s REER is broadly in line with fundamentals and with external sustainability when combining multiple approaches.
  - No immediate threat to external stability: current account volatility high due to diamond dependence, but reserve coverage adequate and no major balance sheet vulnerabilities from capital and financial accounts.
  - 2004-2005 devaluations and shift to a crawling peg have undone prior overvaluation and restored REER stability.
  - Equilibrium exchange rate estimation confirms that after earlier overvaluation the REER is broadly consistent with fundamentals (with caveats on sample limits).
  - Projected current account path through 2015 is consistent with external sustainability provided returns on mining and energy investments exceed returns from financial asset accumulation.
- Structural competitiveness priorities (policy recommendations from analysis and surveys):
  - Labor market and education reforms: ease access to work/residence permits for expatriate skilled workers; adapt education and vocational training to skill requirements.
  - Improve government efficiency and regulatory environment: streamline company licensing, reduce time to connect utilities, revise foreign investment code, implement competition policy.
  - Fiscal and monetary/exchange rate policy: adopt an appropriate mix to allow for lower real interest rates.
  - Financial sector reforms: streamline and/or privatize publicly-subsidized financial services to reduce cost of and improve access to financing for small and medium-sized enterprises.
  - Infrastructure and cost competitiveness: address high utility costs and ICT shortcomings to lower production costs and support diversification away from mining.

*Source: IMF staff analysis and Central Bank of Botswana data as presented in the provided content.*

### References..............................................................................................................

### _wp0883 - References..............................................................................................................

### I. INTRODUCTION
- Exchange rate assessments are central to Fund bilateral surveillance and involve considerable uncertainty.
- Estimation challenges are heightened in developing countries due to poor data, frequent structural breaks, market imperfections, and high macroeconomic volatility.
- Botswana’s dependence on diamond exports, an exhaustible natural resource, adds additional challenges:
  - Existing methodologies are ill-suited to assess implications for external stability and the exchange rate of the exhaustion of a natural resource within a predictable time-frame.
  - Current account volatility is particularly high in natural resource exporters because of commodity price fluctuations, making it difficult to separate underlying trends from temporary fluctuations.
  - In countries experiencing rapid growth, change, and high volatility, past values of fundamentals are poor guides of appropriate future values consistent with external stability and exchange rate equilibrium.
- Therefore, the paper combines various methodologies to assess the exchange rate in Botswana, explicitly taking into account dependence on diamond exports. The assessment is based on:
  - A description of balance of payments trends, vulnerabilities, and the evolution of a number of real effective exchange rate (REER) indices (CPI-based, productivity-based, and the internal terms of trade);
  - An econometric estimation of the equilibrium real effective exchange rate (EREER), involving direct estimation of a reduced-form relationship between the real exchange rate and its fundamental determinants;
  - An assessment of the sustainability of the projected current account and net foreign assets (NFA) position that explicitly takes into account the exhaustibility of diamond receipts and compares the projected current account path to a trajectory consistent with medium-term fiscal sustainability;
  - An assessment of competitiveness based on non-price indicators, such as external sector outcomes, production costs and the quality of the business environment.
- Key summary findings:
  - Botswana’s REER is close to its medium-term equilibrium value, based on past trends in fundamental determinants.
  - A forward-looking assessment that accounts for the need to accumulate savings to sustain imports and consumption beyond the horizon of diamond production suggests that larger current account surpluses may be needed.
  - Alternative REER indices and structural competitiveness indicators point to areas for government policy focus:
    - Declining labor productivity in tradables (except mining), particularly in manufacturing industries;
    - High utility prices and inadequate information technology and communication infrastructure;
    - A skills mismatch, compounded by difficulties in hiring expatriate skilled labor, and other labor market rigidities;
    - Other competitiveness obstacles such as difficult access to land and the high cost of financing for small enterprises.

### II. EXTERNAL SECTOR DEVELOPMENTS AND KEY VULNERABILITIES
- Current account developments and main vulnerabilities are closely linked to diamond exports.
  - For 2006, diamond exports represented 74 percent of total goods exports and 32 percent of GDP.
- Historical patterns:
  - 1980s: average current account deficits of about 8 percent of GDP, driven by large (though declining) imports and an early-1980s dip in diamond export receipts.
  - 1990s: more stable diamond exports and a comfortable current account surplus, averaging about 8 percent of GDP between 1990 and 2006.
  - Diamond and current account developments appear driven by terms of trade movements (reflecting mainly changes in diamond prices).
- Current account volatility:
  - The average annual standard deviation for the current account in the period 1990-2006 is 5 percent of GDP.
  - For terms of trade the average annual standard deviation is about 20 percentage points.
  - Such volatility complicates retrieval of an “underlying current account.”
  - Aside from an above-average peak in 2005-2007 linked to the 2004-05 devaluations and the switch to a crawling peg (and to higher diamond production and minerals prices), the current account trajectory is expected to remain within historical standard deviations.
- Capital and financial account / balance sheet vulnerabilities:
  - There seem to be no significant balance sheet vulnerabilities stemming from the capital and financial account.
  - 1980s: capital and financial account surplus averaged about 7½ percent of GDP; annual net foreign direct investment (FDI) flows accounted for about 4 percent of GDP and other capital inflows accounted for the rest.
  - 1990s: capital and financial account surplus declined to about 1 percent of GDP on average; FDI and other flows were almost nonexistent.
  - Starting in 1999 the account turned slightly negative, reflecting offshore investments by rapidly growing pension funds, particularly after the Public Officers Pension Fund was set up.

*Italic: Content derived from the provided pages of the source PDF.*

### 2001. External debt at less than 3

### 2001. External debt at less than 3 percent of GDP is extremely low, and direct foreign exchange exposures of the financial sector are limited, so that exchange rate and liquidity risks are well contained.

### Balance of payments, reserves, and vulnerability
- External debt: "less than 3 percent of GDP."
- Capital and financial account: "projected to shift to net inflows of about 2 percent through 2015, thanks to temporarily higher FDI flows associated with mining and energy projects."
- Reserve stock at end-2006:
  - "75 percent of GDP" total reserves.
  - "20 percent of GDP (about 6 months of imports)" are liquid reserves.
  - "55 percent (about 19 months of imports)" represent the Pula Fund.
- Reserve policy and adequacy:
  - Central bank explicitly targets "6 months of import cover for liquid reserves."
  - Specific triggers exist for accessing Pula Fund assets in case of simultaneous adverse shocks; first line of defense would be corrective macroeconomic policies or seeking external funding of development projects.
  - "The current liquid reserve coverage is sufficient to withstand a two-standard-deviation adverse current account shock for two years."
- Net foreign assets (NFAs) dynamics:
  - "The rate of growth of NFAs fell below that of nominal GDP in 1998, at which point NFAs as a percent of GDP started declining."
  - Note: "The government funded the privatization of pension funds through capital transfers, which lowered official reserve assets by about P13.5 billion between 2001 and 2005."
- Financial sector risk: "the banking sector could be mostly vulnerable to credit risk stemming from a global downturn that led to a fall in diamond revenues."

### Evolution of REER indices and contributing factors
- General REER movement (2000–2006):
  - "All REER measures indicate that the real appreciation between 2000-2004 was more than offset by devaluations in 2004 and 2005 and the subsequent switch to a crawling peg exchange rate regime."
  - By end-2006:
    - "the annual CPI-based REER was 5 percent below its average annual value for 1995-2000."
    - "the productivity-based REER was10 percent below."
- CPI-based vs productivity-based REER:
  - "Although both the CPI and the relative productivity-based REERs moved together between 1995 and 2000, the real appreciation and subsequent depreciation were more pronounced in the relative productivity-based REER."
  - "The gap between the two has recently been narrowing, the bilateral real exchange rates of the main import (South Africa) and export (United States) trading partners have tended to move in opposite directions."
- Sources of real appreciation:
  - "The appreciation was mainly caused by a trend increase in relative prices, while the nominal effective exchange rate started appreciating at a faster pace around 2000."
  - Productivity and sectoral composition:
    - "Relative price increase was linked to rapid productivity improvements in the diamond sector (which largely dominates tradables)."
    - "Excluding mining, labor productivity in tradables versus nontradables in Botswana has been declining compared to trading partners."
    - "Mining wage increases may have led to wage and price increases in the nontradables sectors (a classic symptom of Dutch disease)."
- Nominal appreciation drivers:
  - "May have been due to strong foreign exchange inflows in the wake of an increase in diamond export and large current account surplus in 2000."
  - Possible role of policy change: "need to determine whether or not the nominal exchange rate appreciation was induced to some extent by the removal of exchange controls in 1999" which "might have induced rand-denominated capital inflows that led to nominal effective exchange rate appreciation." (No strong evidence in financial account data.)
- Exchange rate regime shift effects:
  - "The shift from a fixed to a crawling peg in 2005 appears to have resulted in greater stability of the REER."
  - "The CPI-based REER depreciated by 2 percent in the twelve months through August 2007, compared with average annual appreciation of 5 percent from 1999-2004."
  - Net effect: "leaves the REER roughly unchanged from mid-2005, with the depreciation of the NEER offsetting the relative price differential in Botswana against its main trading partners."

### Equilibrium real exchange rate estimation (BEER approach)
- Method and data:
  - Approach: Behavioral equilibrium exchange rate (BEER) following Clark and MacDonald (1999) and extending Iimi (2006).
  - Sample period: "1980-2006."
  - Pre-estimation diagnostics: REER and explanatory variables are integrated of order one (ADF tests).
  - Model: Vector error correction model (VECM) with Johansen methodology; preferred VAR lag-length is two lags.
  - Cointegration: "two are found in the initial set," but preferred specification chosen to yield "just one cointegrating vector."
- Variables considered and economic interpretation:
  - Terms of trade (ltot): positive movements tend to appreciate the REER via nominal appreciation or wealth effects.
  - Capital flows (proxied by NFA of the banking system relative to GDP): increases would tend to appreciate REER (but later found not significant).
  - Relative productivity (lrelprod): captures Balassa-Samuelson effect; productivity improvements in tradables lead to REER appreciation.
  - Government spending (lgc_gdp): impact depends on tradables share in government spending; here used as a proxy for a risk premium/fiscal stance.
  - Trade openness: more openness tends to depreciate REER (proxy used but found not significant).
- Estimation results:
  - Preferred specification includes: real interest rate differential (r-r*), terms of trade (ltot), government consumption (lgc_gdp), and relative productivity (lrelprod).
  - "NFA and the indicator of trade openness were not significant determinants of the REER."
  - Cointegration test: "one cointegrating vector in the estimated system at the 95 percent level of confidence."
  - Long-run equilibrium equation (with t-statistics):
    - ln REER = 0.034(r-r*) + 0.042ltot + 0.338lgc_gdp + 0.052lrelprod + 2.946
      - [13.02] [1.42] [3.53] [4.11]
  - Statistical diagnostics:
    - "All of the coefficients in this specification were determined to be statistically significant with the exception of the terms of trade."
    - Breakpoint Chow tests: "coefficients are stable over all sub-periods."
    - Residual diagnostics: some outliers noted, but "formal tests do not reject normality and no autocorrelation."
- Equilibrium REER path and valuation assessment:
  - Estimated equilibrium REER calculated using Hodrick-Prescott filters on fundamentals, with a 95 percent confidence interval.
  - Main result: "the real exchange rate was sharply overvalued prior to nominal devaluations in 2004 and 2005, and that the resulting real depreciation restored the REER roughly toward its equilibrium value during 2006."
  - Historical pattern: "While the actual REER remained relatively close to the EREER for most of the 1990s, it started to diverge in about 2000-2001 as it appreciated faster than the EREER; by 2003 the estimated overvaluation was" (text cuts off at this point).

*Source: IMF staff analysis and Central Bank of Botswana data as presented in the provided document excerpt.*

### 10.8 percent. This broadly corresponds with the assessment in Iimi (2006), which concluded

### _wp0883 - 10.8 percent. This broadly corresponds with the assessment in Iimi (2006), which concluded

### EREER and REER assessment
- The real exchange rate overvaluation during 2000-2003 "appeared to have been corrected by the subsequent devaluations."
- Figure 4 suggests part of the real appreciation between 2000 and 2004 reflected an appreciation of the EREER, which "appears to have stabilized around its 2006 value."
- Equilibrium appreciation possibly captured:
  - an improvement in the terms of trade; and
  - tight monetary policy, reflected in higher relative real interest rates compared to trading partners.
- The most significant factors in the REER’s movement back toward equilibrium:
  - narrowing of the real interest rate differential since 2003; and
  - downward trend in government spending over the same period.
- Over the sample period 1980-2006, movements in the REER "appear to have closely followed changes in the real interest rate differential."
- Caveats on EREER estimation:
  - issues of data quality, limited time series, sensitivity to sample period, choice of variables, and smoothing method;
  - equilibrium exchange rate estimation may not be robust to the choice of estimation method─single country versus panel.
- The results are "consistent with Iimi’s findings": coefficients on common variables similar in magnitude and the coefficient on the productivity variable "is more plausible."

### External sustainability approach (CGER methodology and permanent-income adaptation)
- Methodology:
  - Relies on the intertemporal budget constraint for the whole economy.
  - Calculates the current account balance-to-GDP ratio that would stabilize the NFA position at a benchmark value b_s.
  - Formula (assuming no capital gains, zero errors and omissions and no capital transfers) given by: ss b g g ca ⋅ ++ + = )1)(1(π π  (where g is GDP growth rate and π is inflation rate).
- Benchmark selection:
  - CGER uses a backward-looking benchmark (latest actual value) for cross-country comparison.
  - For exporters of exhaustible natural resources, NFA benchmark can be forward-looking and normative, consistent with medium-term fiscal sustainability.
- Permanent-income/fiscal sustainability linkage:
  - Sustainable overall fiscal balance defined as difference between total revenue (mineral and non-mineral) and permanent income (non-mineral revenue + annuity from projected stream of mineral revenue).
  - In external sustainability, sustainable current account position can be calculated as the difference between mineral exports and the annualized discounted value of the projected stream of mineral exports (the annuity).
- Limitations:
  - Does not take into account different savings and investment preferences nor feedback effects on medium-term growth.
  - Medium-term growth, inflation, and interest and discount rates are exogenously given.
  - Permanent income framework may be less accurate for developing countries with substantial investment needs.
  - Decisions on saving versus spending of mineral revenue have monetary and exchange rate implications and affect the REER.

### Sustainable current account calculations for Botswana
- Assumptions and specifics:
  - Diamond resources assumed to begin to decline abruptly in 2021.
  - Annuity calculated between 2007 and 2050.
  - Assumptions summarized in Table 1 (Percent):
    - Baseline: Interest rate to discount revenue flows 9.3; Long-term inflation 4.7; Long-term real growth 4.4; Real rate of return 4.4.
    - Alternative: Interest rate to discount revenue flows 7.8; Long-term inflation 4.7; Long-term real growth 4.4; Real rate of return 3.
  - Calculated annuity value of diamond receipts: about 9.2 percent of GDP.
- Baseline comparison (2007–2015):
  - Average projected current account: about 10½ percent of GDP.
  - Sustainable current account: 14 percent of GDP.
  - Average gap: about 3½ percent of GDP (actual path stays below sustainable benchmark).
- Interpretation:
  - Implies a slightly overvalued exchange rate relative to external sustainability benchmark.
  - Projected lower surpluses for 2007-2013 are transitory, reflecting imports of capital goods linked to large mining and energy projects largely financed by FDI.
  - If returns on these investments exceed returns from accumulating financial savings from diamond exports, such investment is consistent with long-run current account sustainability.
- Sensitivity analysis highlights:
  - Lower discount rate (alternative scenario) lowers the annuity value, increasing the need for higher savings and widening the gap between actual and sustainable current account.
  - Higher diamond revenue (diamond exports stabilize at 25 percent of GDP between 2010 and 2015 instead of declining) would allow for higher annual savings and narrow the gap.
- NFA and reserves considerations:
  - At year-end 2006, NFAs amounted to 75 percent of GDP, including liquid reserves of about 6 months of imports (about 20 percent of GDP) and longer-term savings in the Pula Fund (another 55 percent of GDP).
  - If the Pula Fund (or some portion) is included as starting savings, annual savings out of diamond export receipts can be smaller or sustain imports for longer.
  - Maintaining liquid reserves at about 6 months of imports, in addition to saving the annuity, would rapidly draw down the NFA stock even from end-2006 position.
  - Evolution of FDI and portfolio flows may differ depending on project financing.
- Illustrative calculations:
  - To stabilize NFAs at the permanent consumption level (annuity 9.2 percent of GDP + average non-diamond exports about 16 percent of GDP) the current account surplus would need to be about 20 percent of GDP.
  - To also maintain liquid reserve coverage of about 6 months of imports (about 10 percent of GDP), the sustainable current account surplus would have to be about 37 percent of GDP.

### Export performance and nonprice competitiveness indicators
- Export outcomes:
  - Share of total exports in GDP roughly constant since 1997.
  - Share of non-mining exports in non-mining GDP declined by 10 percentage points between 1997 and 2006 (from 18 to 8 percent).
  - Growth in the volume of both diamond and other exports has declined in recent years.
  - Botswana’s exports perform better than other SACU members (excluding South Africa) thanks to diamonds, but remain far behind South Africa.
  - Botswana’s share of world trade has been stagnant.
  - Recent improvement in export profitability due to higher export prices following devaluation and modest productivity improvements mostly in mining.
- Productivity trends:
  - Worrying decline in labor productivity in tradables sectors other than mining.
  - Productivity in transport and manufacturing declining since the late 1990s, with an uptick in the past two years.
  - In nontradables, only utilities show a strong improvement in labor productivity.
- Infrastructure costs (late 1990s, U.S. dollars):
  - Airfreight to Europe (per kg): Botswana 1.84; Kenya 1.70; Mauritius 2.57; Mozambique 2.18; Namibia 2.33; South Africa 1.17; Zimbabwe 2.22.
  - Sea freight to Europe (per 20-foot container): Botswana 2.00; Kenya 1.40; Mauritius 1.80; Mozambique 1.50; Namibia 1.08; South Africa 1.00; Zimbabwe 2.00.
  - Electricity (per kwh): Botswana 0.10; Namibia 0.08; South Africa 0.04; Zimbabwe 0.04; Mozambique 0.06; (table shows gaps in some entries).
  - Water (per m3): Botswana 1.02; Kenya 0.35; Mauritius 0.52; Mozambique 0.35; Namibia 0.67; South Africa 0.30; Zimbabwe 0.34.
  - Telecom to EU (per minute): Botswana 4.04; Kenya 4.00; Mauritius 1.65; Mozambique 3.60; Namibia 1.23; South Africa 2.21; Zimbabwe 2.58.
  - Source: Namibian Investors (1998-99), reproduced in UNCTAD (2003).
- Survey-based competitiveness and business environment:
  - Competitiveness survey results mixed; Botswana generally performs worse than key regional competitors, notably South Africa, but better than Lesotho and Swaziland.
  - Perceived impediments: labor force and labor market functioning, inefficient government bureaucracy, inadequate and high-cost infrastructure, access to and cost of finance (especially for smaller firms).
  - Labor market issues include skills mismatch, high unemployment alongside shortages of skilled labor, and difficulties obtaining work/residence permits for expatriate skilled workers.
  - HIV/AIDS epidemic negatively affects workforce productivity.
  - Small and medium-sized businesses face difficulty or high cost obtaining loans despite broader financial access.
  - 2004 FIAS report highlighted need to improve regulatory environment and remove administrative barriers; government following up on recommendations (company licensing, reducing time to connect utilities, revising foreign investment code, setting up a new competition policy).
- Governance indicators:
  - Some deterioration in regulatory quality, government effectiveness, and control of corruption, though indicators remain above historical trends.
  - Botswana’s governance performance continues to compare favorably to other upper-middle income countries.

### Summary and policy implications
- Main findings:
  - Botswana’s REER is broadly in line with economic fundamentals and consistent with external sustainability using a combination of approaches.
  - Balance of payments and REER developments indicate no immediate threat to external stability: current account volatility is high due to diamond dependence, but reserve coverage is adequate and no significant balance sheet vulnerabilities from the capital and financial account are evident.
  - 2004-2005 devaluations and switch to a crawling peg regime have undone previous overvaluation and restored REER stability.
  - Equilibrium exchange rate estimation confirms that after a period of overvaluation, Botswana’s REER is broadly consistent with fundamentals (small sample limits reliability).
  - Based on current policies, the projected current account path through 2015 is consistent with external sustainability provided returns on mining and energy investments exceed returns from accumulating financial assets.
- Structural competitiveness obstacles and priorities:
  - Natural constraints: small, landlocked, partly arid country limiting non-mineral diversification and attractiveness to large foreign investors outside mining.
  - Higher utilities costs than neighboring countries increase production costs.
  - Worrisome trends: fall in nondiamond export volume growth and declining labor productivity in non-mining tradables.
  - Authorities have prioritized productivity enhancements and export diversification.
- Priority policy areas recommended by competitiveness surveys:
  - Labor market and education reforms to ease access to work/residence permits for expatriate skilled workers, and adapt education and vocational training to skill requirements.
  - Continue improving government efficiency and the regulatory environment (company licensing, utility connections, foreign investment code, competition policy).
  - Implement an appropriate mix of fiscal and monetary/exchange rate policy to allow for lower real interest rates, and streamline and/or privatize publicly-subsidized financial services to reduce cost of and enhance access to financing for small and medium-sized enterprises.

*Source: IMF staff analysis and calculations as presented in the provided content.*

### References

### _wp0883 - References

### References
- Balassone, F., Takizawa, H., and H. Zebregs, 2006, “Managing Russia’s Oil Wealth: An Assessment of Sustainable Expenditure Paths”, in Russian Federation: Selected Issues, IMF Country Report No 06/430 (Washington: International Monetary Fund).  
- Botswana National Productivity Centre, 2006, Productivity Insights (Gaborone: National Productivity Centre).  
- Botswana National Productivity Centre, 2006, Botswana National Productivity Statistics: Update 2006 (Gaborone: National Productivity Centre).  
- Chudik, A., and J. Mongardini, 2006, “In Search of Equilibrium: Estimating Equilibrium Real Exchange Rates in Low-Income African Countries,” IMF Working Paper No. 07/90 (Washington: International Monetary Fund).  
- Clark, P.B., and MacDonald, R., 1999, “Exchange Rates and Economic Fundamentals: a Methodological Comparison of BEERS and FEERS,” in Equilibrium Real Exchange Rates, ed. by R. MacDonald and J.L. Stein (Massachusetts: Kluwer Academic Publishers), pp. 209-40.  
- Clausen, Jens R., 2008, "The Non-mineral Balance as a Benchmark for Fiscal Policy in a Mineral Rich Country - The Case of Botswana", IMF Working Paper, forthcoming (Washington: International Monetary Fund).  
- Botswana Institute for Development Policy Analysis and World Bank, 2005, Diversifying Botswana’s Exports, An Overview.  
- Di Bella, G., M. Lewis, and A. Martin  “Assessing Competitiveness and Real Exchange Rate Misalignments in Low-Income Countries,” IMF Working Paper No. 07/201 (Washington: International Monetary Fund).  
- Financial International Advisory Service, 2004, Botswana: Further Improving the Regulatory and Procedural Framework for Encouraging Private Investment (Washington: International Finance Corporation and World Bank).  
- Gutierrez, E., 2007, “Export Performance and External Competitiveness in the Former Yugoslav Republic of Macedonia,” South-Eastern Europe Journal of Economics, Vol.2, pp. 83-104.  
- Iimi, Atsushi, 2006, “Exchange Rate Misalignment: An Application of the Behavioral Equilibrium Exchange Rate (BEER) to Botswana”, IMF Working Paper No.  06/140 (Washington: International Monetary Fund).  
- International Monetary Fund, 2006, Methodology for CGER Assessments (Washington: International Monetary Fund).  
- Johansen, S., 1995, Likelihood-based Inference in Cointegrated Vector Autoregressive Models (United Kingdom: Oxford University Press).  
- Murgasova, Z., 2004, “Assessing Competitiveness,” in Republic of Poland: Selected Issues, IMF Country Report No. 04/197 (Washington: International Monetary Fund).  
- Olters, J.-P., 2007, “Old Curses, New Approaches? Fiscal Benchmarks for Oil-Producing Countries in Sub-Saharan Africa”, IMF Working Paper No. 07/107, (Washington: International Monetary Fund).  
- Ramirez G. and C. Tsangarides, 2007, “Competitiveness in the CFA Franc Zone”, IMF Working Paper No. 07/212 (Washington: International Monetary Fund).  
- Roudet, S., Saxegaard, M. and C. Tsangarides, 2007, “Estimation of Equilibrium Exchange Rates in the WAEMU: a Robustness Approach”, IMF Working Paper No. 07/192 (Washington: International Monetary Fund).  
- UNCTAD, 2003, Investment Policy Review of Botswana (Geneva: United Nations).  
- World Bank, Doing Business Project, (Washington: World Bank) http://rru.worldbank.org/DoingBusiness/.  
- World Bank, Worldwide Governance Indicators (Washington: World Bank), various years. www.worldbank.org/wbi/governance/govdata/  
- World Economic Forum, Global Competitiveness Reports, various years, www.weforum.org.

### Appendix — Data Sources
- REER: The REER is the multilateral CPI-based exchange rate of the pula, as calculated by the IMF Effective Exchange Rate Facility.  
- real interest rate differential (r-r*): The Botswana real interest rate refers to the CPI-deflated prime lending rate; data on both CPI and the prime lending rate are taken from the IMF, International Financial Statistics (IFS). The foreign real interest rate is defined as the weighted average of long-term government bond yields, deflated by the CPI, for trading partner countries; data are taken from the IFS.  
- terms of trade (ltot): The terms of trade, defined as the relative price of exports to imports, are constructed based on trade data from the Central Statistics Office and the Bank of Botswana, and commodities prices from the IMF World Economic Outlook database.  
- government consumption (lgc_gdp): Defined as the ratio of government expenditure to GDP; based on data from the Ministry of Finance and Development Planning, the Central Statistics Office and the IFS.  
- relative productivity (lrelprod): Defined as relative labor productivity in tradable/non-tradable goods (excluding mining) in Botswana against the weighted average of labor productivity in tradable/non-tradable goods for trading partner countries. Data for Botswana are taken from the Botswana National Productivity Centre, Botswana Productivity Statistics Update 2006. Data for trading partner countries are taken from the IMF Research Department (CGER Database).

### Appendix Tables — Key Results and Tests
- Appendix Table 1. Unit Root Tests (Augmented Dickey-Fuller): Note: The augmented Dickey-Fuller statistic (ADF) tests the null hypothesis of a unit root in the series against the alternative of stationarity. The p-values indicate the significance of the statistic, and the last column shows the conclusion, with I(1) indicating that the null hypothesis of a unit root in the series in levels cannot be rejected.
- Appendix Table 2. Test for Model Reduction.
- Appendix Table 3. Cointegration Tests: Trace Test and Maximum Eigenvalue
  - Number of Hypothesized Cointegrating Equations
    - None * Trace Statistic 92.300 P-value .005 Max-Eigen Statistic 56.520 P-value .00
    - At most 1 Trace Statistic 35.780 P-value .41 Max-Eigen Statistic 17.420 P-value .54
    - At most 2 Trace Statistic 18.360 P-value .54 Max-Eigen Statistic 11.280 P-value .62
    - At most 3 Trace Statistic 7.080 P-value .57 Max-Eigen Statistic 6.630 P-value .53
    - At most 4 Trace Statistic 0.450 P-value .50 Max-Eigen Statistic 0.450 P-value .50
  - Note: Both the trace and maximum eigenvalue statistics indicate the existence of one cointegrating relationship.
- Appendix Table 3 — ADF test and conclusion for variables:
  - ln(REER) ADF Statistic -3.16 P-Value 0.037 Conclusion I(1)
  - (r-r*) ADF Statistic -3.43 P-Value 0.019 Conclusion I(1)
  - ln(tot) ADF Statistic -5.50 P-Value 0.000 Conclusion I(1)
  - ln(gc_gdp) ADF Statistic -3.91 P-Value 0.007 Conclusion I(1)
  - ln(relprod) ADF Statistic -7.75 P-Value 0.000 Conclusion I(1)
- Appendix Table 2 — VAR lag reduction test:
  - Conclusion VAR(2) to VAR(1) F(25,38) 2.53 P-value 0.005
  - Note: The F statistic test the null hypothesis that it is appropriate to reduce the model by one lag.
- Appendix Table 4. Results of Cointegration Estimation: Variables in first differences. Standard errors below coefficient estimates, and t-statistics between brackets.
- Appendix Table 5. Residuals Tests:
  - Vector AR 1-1 test: F(25,20) = 1.230 [0.321]
  - Vector Normality test: Chi^2(10)= 6.0206 [0.814]
  - Note: the statistics test the null hypothesis of autocorrelation in the residuals, and of no normality, respectively.
- Estimates of the cointegrating relationship (coefficients, standard errors, t-statistics):
  - Real interest rate differential -0.034  -0.003  [-13.024]
  - ln(terms of trade) -0.042  -0.029  [-1.427]
  - ln(government consumption) -0.338  -0.096  [-3.532]
  - ln(productivity) -0.052  -0.013  [-4.110]
  - Constant -2.946
- Estimates of the short term coefficients (coefficients, standard errors, t-statistics):
  - Dln(REER) -0.376  -0.139  [-2.699]
  - D(Real interest rate differential) 44.841  -6.469  [ 6.932]
  - Dln(terms of trade) -0.065  -0.526  [-0.124]
  - Dln(government consumption) 0.172  -0.234  [ 0.733]
  - Dln(productivity) 1.107  -0.206  [ 5.364]
  - R-squared 0.367
  - Adj. R-squared 0.156
- Note: Probability (in percent) that the coefficient on the indicated variable is stable. Values below 1 significant at the 1 percent level.

### Appendix Figures — Notes and Captions
- Appendix Figure 1. Breakpoint Chow Tests: Panels and labels include years 2000 2005 and series labels Ndn REER_LN, Ndn TOT_LN, Ndn REALIRDIFF, Ndn GCGDP _LN, Ndn NMRELPROD_LN, Ndn CHOWs, and corresponding Nup series (e.g., Nup REER_LN). Chart axes include markers 0.25, 0.50, 0.75, 1.00 and 0.5, 1.0 with significance level 1%.
- Appendix Figure 2. Equilibrium REER Estimation: Cointegration Residuals: Charts show REER and individual variable panels over 1985 1990 1995 2000 2005 for:
  - REER (scale from -.12 to .08)
  - Real Interest Rate Differential (scale from -4 to 6)
  - Terms of Trade (scale from -.3 to .4)
  - Government Expenditure (scale from -.15 to .15)
  - Relative Productivity (scale from -.10 to .15)

*Source: _wp0883 - References (PDF).*

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