Kingdom of Lesotho: Staff Concluding Statement of the 2022 Article IV Mission

March 30, 2022

A Concluding Statement describes the preliminary findings of IMF staff at the end of an official staff visit (or ‘mission’), in most cases to a member country. Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, or as part of other staff monitoring of economic developments.

The authorities have consented to the publication of this statement. The views expressed in this statement are those of the IMF staff and do not necessarily represent the views of the IMF’s Executive Board. Based on the preliminary findings of this mission, staff will prepare a report that, subject to management approval, will be presented to the IMF Executive Board for discussion and decision.

Washington, DC: An International Monetary Fund (IMF) team led by Mr. Aqib Aslam held virtual meetings with the authorities and other counterparts from the public and private sectors from March 7 to 28, 2022, as part of the 2022 Article IV consultation.

Lesotho has been hit simultaneously by the pandemic, declining Southern African Customs Union (SACU) transfers, and climate shocks since 2020. The government’s swift response to the pandemic—through containment, social, and economic mitigation measures, and vaccination—has been notable. Nevertheless, the resulting fiscal and external pressures have once again exposed the fragility of the current economic model and underlined the urgent need to diversify the economy and consolidate public finances to preserve fiscal and debt sustainability. Alongside this, broad-ranging structural reforms will be vital to support a durable, resilient post-pandemic recovery built on green, job-rich, sustainable, and inclusive private sector-led growth. In the run-up to the general election, the government should continue to initiate policies and institutional reforms that are less constrained by the political economy.

Context and Outlook

The pandemic caused widespread social and economic disruption during 2020 and continued to drag on activity through 2021. The government’s vaccination response has gathered pace and allowed restrictions to be gradually lifted. Over half of the adult population are fully vaccinated—more than twice the regional average—helping to contain the pandemic.

However, Lesotho has been facing significant structural challenges and capacity constraints even before the COVID-19 pandemic . The economy has stagnated since 2016 and estimated to have contracted by almost 10 percent. The government-driven growth model remains a challenge for sustainable and inclusive growth, displacing resources from the private sector. Fiscal policy is constrained by gaps in public financial management and a reliance on large and volatile transfers from the Southern African Customs Union. The latter have contributed to persistently high public expenditures. Private-sector development and job creation have also been hampered by limitations in access to finance, financial intermediation, human capital, governance and control of corruption, and the overall business environment. The largely foreign-owned banking sector is well capitalized and liquid but plays a limited role in intermediating credit, particularly to micro-, small-, and medium-sized enterprises. Government arrears also create liquidity shortages. With legislation pending to improve the business environment, high credit and setup costs, skills mismatches, and gaps in legal and dispute resolution frameworks, insolvency resolution, and property rights continue to inhibit business development.

Political instability and governance issues have continued to hamper fiscal adjustment and hold up overdue reforms. Expenditure pressures in the run-up to the 2022 general election are driving up financing needs, and recent fraud cases have highlighted vulnerabilities in public financial management. Spending is being supported through growing domestic and external loans, arrears, and a drawdown of government deposits. Political economy constraints have also created a backlog of reform Bills in Parliament.

The growth outlook remains subdued and contingent on fiscal consolidation, structural reforms, the path of the pandemic, and external developments. The secular decline of key sectors and continued limited access to finance weigh on the post-pandemic recovery. The war in Ukraine has raised commodity prices, which will likely benefit certain sectors such as diamond mining but hurt the vulnerable as inflation increases. Beyond the pandemic, growth remains largely dependent on uneven foreign investment in infrastructure mega-projects and developments in South Africa. The fiscal outlook remains challenging and must balance upfront consolidation with recovery, to prevent the external position from deteriorating further.

Risks are tilted to the downside but there are upsides for growth if well-managed. Fresh waves of the pandemic and other large external shocks would further delay large infrastructure projects and dent investor confidence. Further disruptions to activity, growing unemployment, and income losses could drive social instability. Political tensions, expenditure pressures, and stalled governance reforms could also increase ahead of elections. Ongoing delays to fiscal adjustment have increased debt sustainability risks since 2020, as the space to absorb shocks has narrowed. Furthermore, should public debt continue to increase at the current rate, private-sector credit risks being crowded out. Commercialization of agriculture, supported by investments in infrastructure and irrigation, presents an avenue for export growth, self-sufficiency, and food security.

Aligning Expenditure with Available Resources to Ensure Sustainability and Preserve Stability

Fiscal consolidation is crucial to reduce imbalances and rebuild much-needed fiscal space to protect the vulnerable, finance the recovery, and mitigate external shocks. Rising expenditure in recent years has not contributed to higher growth, likely owing to inefficiencies. Fiscal consolidation through scaling back less-productive expenditure while focusing on more efficient, well-targeted spending, growth-friendly investment, and revenue administration could mitigate risks to growth. At the same time, strong social safety nets remain important to protect the vulnerable and secure livelihoods. The development, implementation, and commitment to a set of fiscal rules and the development of a fiscal risk management framework will help embed much-needed discipline.

Given the limited scope for nominal exchange rate adjustment, fiscal and structural policies must drive external adjustment. And given the already-high revenue ratio—the highest among SACU countries—the adjustment will need to be largely expenditure based. The authorities can find ways to contain current spending, scale back unproductive capital spending, and improve efficiency to ensure fiscal sustainability and preserve macroeconomic stability. A combination of short-term containment measures—on wage growth, hiring, and perquisites—and long-term structural reforms would help to tackle the large public sector wage bill. Social spending can also be rationalized and reprioritized. Plans to reduce costs and improve the targeting of the tertiary education loan bursary scheme by introducing means-testing and pursuing loan recovery will release much-needed funds to increase coverage of other social assistance programs that better target the most vulnerable, such as the child grants programme.

Public investment should finance areas where it will have the maximum growth impact, crowding in private sector investment, and reducing poverty. The capital budget has so far produced a capital stock that is relatively high as a share of GDP but of a quality that is lagging peers. Streamlining the budget by identifying and minimizing stalled projects and misclassified current spending—as well as improving accountability, contract design, investment appraisal, and execution—will help ensure that capital spending is more efficient and better targeted to achieve development priorities and maximize growth.

Domestic revenue mobilization can still help support the adjustment . Despite strong (non-SACU non-grants) domestic revenue performance—driven by stable personal income tax revenues, VAT, and water royalties—all available opportunities to broaden the tax base, improve tax administration, and increase compliance must be exploited to help maximize resources and mitigate volatility from SACU transfers. It is also vital to maintain the integrity of existing taxes, notably the VAT, strengthen the tax system to guard against international tax avoidance, and develop a reform plan for improved revenue administration.

Enhancing Governance and Institutional Capacity and Improving Policy Coordination

Underpinning fiscal consolidation with robust public financial management would help ensure oversight and accountability and avoid corruption. Improving budget processes, procurement, and treasury operations in the Ministry of Finance are critical to strengthening fiscal governance. Tight fiscal space makes sound budget and financial management essential but challenging. Capacity development has helped core public financial management functions, which remain however to be embedded. Robust expenditure control, a transparent and well-coordinated budget process, strong monitoring of state-owned enterprises, and centralized government accounts can help avoid instances of fraud, minimize fiscal risks, and limit spending overruns and arrears. Digitalization of government payments can help improve public financial management over the medium term, including revenue mobilization and expenditure management.

Given policy constraints imposed by the exchange rate peg, coordination between the Ministry of Finance and Central Bank of Lesotho is paramount for macroeconomic and financial stability. As a small open economy with a large foreign-owned banking sector and pegged exchange rate, macroeconomic policy objectives should be well-articulated and aligned to ensure that fiscal and exchange rate policies do not come into conflict. It is important for government expenditures and cash management plans to be consistent with an adequate level of international reserves to support the peg.

The institutional independence of the central bank needs to be preserved within a cohesive, well-coordinated, and commonly agreed macroeconomic policy framework. At the operational level, policy consultation and coordination can be embedded through regular cross-institutional high-level meetings and technical working groups. An independent central bank with robust functions will lend credibility to both monetary and financial sector policies and limit political interference.

Maintaining Price and Financial Stability and Enhancing Access to Financial Services

Unlocking much-needed access to finance, notably for micro-, small-, and medium-sized enterprises, remains one of the key enabling factors for economic development and private sector growth. To overcome these barriers, the authorities should continue to improve the credit infrastructure and support the development of local capital markets. The recent pricing directives to alleviate financial transaction costs are an important step in this direction. Fostering digital financial services will also broaden financial access and inclusion and increase financial literacy.

Important progress has been made with bank supervision; however, the nonbank financial sector requires further attention. On banking, the authorities have implemented measures in line with past recommendations on the Basel ll Capital Adequacy Framework, the risk-based approach to anti-money laundering/combating the financing of terrorism (AML/CFT) supervision, and on payments systems. However, due to the pandemic, Basel II.5 implementation was postponed. Nonbank financial supervision is still in early stages and must be strengthened to help address troubled financial cooperatives and improve supervisory effectiveness.

Progress has also been made in AML/CFT and it is important to build on this progress, strengthening resources and capacity in line with best international practice, including the effective migration to a risk-based approach. The Central Bank of Lesotho recently revamped its regulatory framework and is currently building capacity at the Financial Intelligence Unit. AML/CFT standards for banks are being implemented with external support, and a Financial Action Task Force (FATF) evaluation will help identify priorities for nonbank financial institutions. Progress has also been made in the management of risks associated with Politically Exposed Persons and the collection and retention of beneficial ownership information. Plans to establish a national registry of bank and mobile network operator accounts will provide information to support these efforts.

Catalyzing Inclusive, Sustainable, Private Sector-led Growth

Given the need for fiscal consolidation, broader structural reforms will be vital to help reenergize growth in the economy. The government continues with its efforts to secure support and explore measures to diversify and revitalize the private sector.

  • A stable and well-regulated business environment is an essential foundation for sustainable private sector-led growth. Reforms to improve the business environment are needed, including establishing commercial standards, developing an investment law that provides for open and competitive foreign and domestic investment, implementing digital verification systems for businesses, increasing private-sector participation in state-owned enterprise, and strengthening the rule of law.
  • As a small open economy in which growth is predominantly dependent on a few sectors with preferential market access, the need to improve competitiveness and diversify is clear. Robust policies focusing on governance, education, infrastructure, and removing barriers to trade can support competitiveness and industrial diversification. These include supporting human capital development to close the skills gap, moving businesses up the value chain, and investing in infrastructure to enhance connectivity with the region.

Lesotho’s vulnerability to climate shocks underscores the importance of building climate-resilient infrastructure. Measures to improve irrigation systems, halt soil degradation, and regulatory reforms to promote climate-smart agricultural practices could help strengthen resilience in agriculture.

Despite positive strides, significant structural gender inequalities persist in Lesotho, the removal of which can boost growth . While gender parity has been achieved at most levels of education, female labor remains concentrated in informal, low-skilled, and contact-intensive sectors, which were among the hardest hit during the pandemic. Furthermore, discriminatory gender norms persist due to the dual civil and customary legal system, limiting women’s access to finance, land, and employment. Better paid parental leave policies, measures to reduce female school drop-out rates, and improved female health outcomes, particularly in maternal health and HIV, can help redress current imbalances. Introducing components of gender responsive budgeting will also help prioritize gender-focused spending priorities and enhance growth prospects.

The IMF team thanks the Basotho authorities and other counterparts for the candid and productive discussions.

IMF Communications Department

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