Public Information Notice: IMF Concludes 2003 Article IV Consultation with Zambia and Discusses Ex Post Assessment of Performance Under Fund-Supported Programs

July 16, 2004


Public Information Notices (PINs) are issued, (i) at the request of a member country, following the conclusion of the Article IV consultation for countries seeking to make known the views of the IMF to the public. This action is intended to strengthen IMF surveillance over the economic policies of member countries by increasing the transparency of the IMF's assessment of these policies; and (ii) following policy discussions in the Executive Board at the decision of the Board.

On April 7, 2004, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Zambia.1

Background

Zambia's economic performance has improved significantly in the last four years. After more than two decades of economic decline and inflation averaging over 50 percent, growth has averaged about 4 percent per annum since 2000, and inflation has been sharply reduced. However, macroeconomic stability remains fragile, and faster sustained growth is essential to tackle pervasive poverty.

In 2002, real GDP grew by 3 percent despite difficulties in the mining sector and the impact of the severe drought on agricultural output. Drought-induced food shortages also pushed inflation to 26.7 percent in the 12 months to December 2002. The overall deficit of the central government narrowed to 6.3 percent of GDP from 8.1 percent in 2001. In the external sector, the current account deficit, after grants, narrowed to 6.5 percent of GDP from 10.8 percent in 2001, despite a sharp slowdown in the growth of copper exports. Gross international reserves at the Bank of Zambia rose to 2.2 months of imports in 2002 from 0.9 month at end-2001.

In 2003 fiscal policy implementation deteriorated sharply largely on account of large wage increases and new housing allowances introduced in April. Against this background, to facilitate the resolution of this issue and the transition to a new Poverty Reduction and Growth Facility (PRGF) arrangement, understandings were reached on a staff-monitored program (SMP) for the period July to December 2003 in which the macroeconomic framework was modified to accommodate part of the higher payments to government employees, while seeking to minimize inflationary pressures and protect priority expenditures on poverty reduction.

The overall fiscal deficit (after grants) and domestic financing are estimated to have exceeded the SMP targets by 1½ percent of GDP and 2 percent of GDP, respectively. This reflected large unbudgeted security-related spending and payment of retrenchment benefits and wage arrears of 0.8 percent of GDP to facilitate the sale in December of the Luanshya mine. Expenditures on poverty reducing projects again fell short of budgeted levels. To contain the wage bill, the government reached agreements with some unions to reduce housing allowances awarded earlier in the year by two-thirds. Domestic arrears continued to accumulate.

Despite the fiscal slippages, growth picked up and inflation declined in 2003, aided by a recovery in agricultural production. The increase in real GDP in 2003 is now estimated at 4.2 percent, while the 12-month inflation rate of 17.2 percent in December 2003 was the lowest since 1982.

Broad money increased by 23.4 percent during 2003, compared with a target of 17 percent in the SMP, largely because of the widening fiscal deficit. In late October, the Bank of Zambia eased monetary policy by lowering the cash legal reserve requirements from 17.5 percent to 14 percent with a view to provide banks with additional liquidity for lending to the agricultural sector and other production sectors. As a result, interest rates on treasury bills, which had remained in the range of 30-35 percent for most of the year, declined sharply to around 20 percent in December 2003.

The relatively stable trend in the real effective exchange rate since the mid-990s has continued in 2003 and supported the growth of nontraditional exports. The nominal effective exchange rate depreciated by 15 percent.

Reflecting a sharp increase in copper prices and further growth in nontraditional exports, the current account deficit (after grants) and overall balance of payments deficit are estimated to have narrowed to 5.9 percent and 7.6 percent of GDP respectively.

Progress in implementing structural reforms was mixed during 2003. A medium-term expenditure framework (MTEF) was discussed with stakeholders in preparation of the 2004 budget. The Bank of Zambia introduced an interbank foreign exchange market; completed a draft Financial Sector Development Plan (FSDP), and made some progress toward developing plans to deal with the insolvent nonbank financial institutions. However, effectiveness of the strengthened commitment control system was undermined by unanticipated spending decisions. Delays were also experienced in the procurement of hardware and software for an integrated financial management and information system (IFMIS) and the preparation of a multiyear plan for clearing domestic arrears. Negotiations were initiated with the preferred bidder, for the sale of 49 percent shares and management rights of the Zambia National Commercial Bank.

The Ex Post Assessment of Performance under Fund-supported programs pointed out that implementation under the ESAF arrangement, approved in 1995, was poor, but generally improved under the PRGF arrangement, approved in 1999. Zambia's mixed record of implementation has been indicative of incomplete program ownership, limited capacity and lapses in coordination.

Executive Board Assessment

Directors welcomed the continued improvement in Zambia's economic performance in 2003. Real GDP is estimated to have increased for the fourth consecutive year, and inflation declined to its lowest level in two decades. However, Directors noted that this good performance reflected favorable exogenous developments, including the easing of drought conditions and a large increase in copper prices, which masked serious shortcomings in policy implementation. They expressed particular concern about the sharp deterioration in fiscal performance, which stemmed from overruns in the wage bill and ad hoc spending, and which resulted in nonobservance of the targets of the 2003 staff-monitored program by wide margins and a sharp increase in the domestic debt.

Directors noted that the Zambian economy remains fragile, economic growth is below potential, and macroeconomic stability is yet to be firmly entrenched. Against this background, Directors emphasized that determined implementation of prudent macroeconomic policies and structural reforms will be needed over the medium term to boost economic growth, reduce poverty, and achieve the Millennium Development Goals. Of particular importance will be fiscal adjustment to achieve fiscal sustainability, increase spending on poverty reduction, and free up resources to support private investment. Directors also encouraged the authorities to take steps to diversify the sources of economic growth and exports, with particular emphasis on agricultural development and exports. Directors urged the authorities to accelerate efforts to meet the HIPC Initiative completion point triggers, as this is essential for debt sustainability and poverty reduction.

Directors welcomed parliamentary approval of the authorities' 2004 budget, which aims to sharply reduce domestic borrowing in order to contain the domestic debt and interest payments. They agreed that expenditure restraint should be the main basis of fiscal adjustment, and urged the authorities to ensure that the wage bill was held to 8 percent of GDP as budgeted to provide more room for priority expenditure. However, Directors welcomed the emphasis on measures to broaden the base of the value added tax and simplify its administration, and to streamline exemptions.

Directors also welcomed the progress made in strengthening the expenditure commitment control system. To ensure further progress, Directors recommended that the system be backed by tight enforcement of procedures, including sanctions against officials responsible for overspending and unauthorized re-allocation of funds, and a firm commitment to avoid unbudgeted spending. They stressed that the Ministry of Finance and National Planning needs to receive full political backing for strict adherence to the budget and avoidance of ad hoc spending. In this regard, Directors welcomed the extensive consultations within the government that culminated in cabinet approval of the 2004 budget and the SMP, which will help strengthen ownership of policies.

Directors commended the recent development of a medium-term expenditure framework as an important step toward the preparation of more realistic budgets and the setting of expenditure priorities that are consistent with the goals of the PRSP. In this regard, they welcomed the intention to contain the government wage bill over the medium term. They considered that development of a medium-term strategy to "right-size" government operations and complete the pay reform will be essential to allow priority poverty-reducing expenditure to increase. Directors urged the authorities to continue working with the World Bank and bilateral donors on the design of these reforms.

Directors urged the authorities to monitor monetary developments closely, particularly in light of the recent reduction in interest rates, and to tighten monetary policy, if necessary based on a more ambitious inflation target. They observed that a sustained reduction in interest rates will require a durable reduction in government borrowing and inflation, as well as greater efficiency in the financial sector. They supported maintenance of the flexible exchange rate system to allow adjustment to changes in Zambia's external circumstances. They welcomed the introduction of the broad-based inter-bank foreign exchange market.

Directors noted that the financial system is generally sound. They considered the completion of the Financial Sector Development Plan to be a useful first step toward addressing the concerns identified in the 2002 Financial System Stability Assessment. They encouraged the authorities to prioritize the reforms to ensure that urgent issues, such as the insolvency of the nonbank financial institutions, are addressed in 2004. Directors considered privatization of the Zambia National Commercial Bank to be an important element of financial sector stability and fiscal sustainability.

Directors underscored the importance of improving the environment for private sector development and foreign investment in order to accelerate economic growth. In this regard, they urged the authorities to give serious consideration to private sector views when revising the Investment Act, labor legislation, and possibly land legislation. They encouraged completion of the process of finding a strategic investor in Konkola Copper Mines and commercialization of the electricity company to enhance efficiency and pre-empt potential strains on the budget. Directors welcomed the government's efforts to improve governance through the anti-corruption drive and the enhancement of transparency and accountability in government operations, including the commitment to adhere to budgetary procedures. They observed that this should enhance the climate for private sector activities.

Directors concurred with the conclusions of the ex-post assessment of Zambia's performance under past ESAF/PRGF supported programs. They agreed that another PRGF arrangement will help Zambia address challenges in macroeconomic management and structural reform. However, they noted that while Zambia has implemented significant reforms, the impact of these on poverty reduction has been limited. In addition, technical assistance to Zambia seemed to have limited impact in certain areas. Therefore, Directors stressed that an adequate track record of policy implementation would first need to be established. They also emphasized that the authorities will need to demonstrate greater ownership of the economic program and the PRSP process. In this context, Directors welcomed the generally satisfactory performance so far under the extended SMP for 2004, and stressed that continued good implementation will be crucial for Zambia to move as soon as possible to a PRGF arrangement to pave the way for the country to reach the completion point under the HIPC Initiative, as well as obtain increased external assistance.

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