Public Information Notice No. 01/105

Public Information Notice: IMF Concludes 2001 Article IV Consultation with Cape Verde

October 3, 2001

On June 15, 2001, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Cape Verde.¹

Background

Since 1992, Cape Verde has pursued an economic reform program aimed at transforming its command economy into one organized on the principle of free markets and private ownership. Until 1997, however, as the liberalization of the economy had been conducted with insufficiently restrained fiscal policies, large macroeconomic imbalances emerged that resulted in the accumulation of substantial domestic public debt and the virtual depletion of foreign exchange reserves. Initial attempts at fiscal consolidation were frustrated by the domestic debt burden, and exchange controls were introduced to protect reserves.

In 1998, the authorities adopted an economic and financial program aimed at restoring financial stability. The program, which was supported by a Stand-By Arrangement with the Fund, included the implementation of a large domestic debt-reduction operation, supported by the donor community.

Under this program, Cape Verde made good progress in 1998-99, despite occasional backsliding. Structural reforms created an environment conducive to private sector activity. Progress was made in the comprehensive privatization program, a key element of the domestic debt-reduction operation. During 1998-99, real GDP growth accelerated from 4¼ percent during 1996-97 to 8 percent on average, driven by the development of tourism, significant foreign investment in the export-oriented manufacturing sector, and sustained inflows of workers' remittances, which stimulated construction activities. Inflation was halved to an average level of 4.4 percent in both years, compared with 1997.

However, partly as a result of extraordinary public expenditures aimed at cushioning the social impact of a serious drought that had destroyed much of the 1998/99 harvest, fiscal slippages occurred in the second half of 1999, leading to pressures in the balance of payments.

In 2000, Cape Verde's fiscal situation deteriorated considerably and economic activity slowed down. Real GDP grew by about 7 percent, compared with 8½ percent in 1999, while average consumer prices declined by 2½ percent, owing to significant energy price subsidies, a good 199/2000 harvest and the fixed exchange rate peg. The deterioration in the fiscal stance that started in the second half of 1999 worsened, undoing much of the progress made in previous years. The overall fiscal deficit, including grants, widened to 19 percent of GDP―compared with 11 percent in 1999—and was largely monetized, while domestic and external arrears were accumulated. The sizable recourse to bank credit increased the stock of domestic debt, largely reversing the impact of the domestic debt-reduction operation launched in 1998.

Given the fixed exchange rate regime, the fiscally induced expansion of net domestic assets of the banking system resulted in a decline of official reserves from the equivalent of 2.2 months of imports at end-1999 to 1.3 months at end-2000. The central bank raised the discount rate by 100 basis points. However, unlike in 1999, the central bank did not use the foreign exchange queue as an instrument to control the outflow of foreign exchange.

Executive Board Assessment

Executive Directors agreed with the thrust of the staff appraisal. They regretted that the progress made in macroeconomic stabilization in recent years was partly undermined by fiscal slippages in 2000 and that structural reforms have mostly stalled. In this connection, they expressed concern at the interruptions in the flow of information to the Fund, and the postponement of regular surveillance dialogue in 2000. Directors noted the continued strong growth and the emergence of a more dynamic private sector and a more diversified export base, but stressed the need for early action to restore macroeconomic stability. They, therefore, welcomed the development of a preliminary medium-term macroeconomic policy framework with emphasis on fiscal consolidation and the willingness expressed by some donors to support the authorities' reform efforts.

Directors underscored the importance of supporting the fixed exchange rate with prudent macroeconomic policies to bolster the official reserves, and of tackling the unsustainable debt burden of the public sector. They welcomed the authorities` commitment to the current exchange system and urged them to implement a strong fiscal adjustment, the necessary structural reforms in the public enterprise sector, and a tight monetary policy.

In this regard, Directors welcomed the authorities' commitment to reduce fiscal imbalances. They commended the decision to increase domestic petroleum prices without delay, and recommended the early implementation of an automatic and transparent petroleum pricing mechanism. They urged the authorities to prepare a realistic budget, including both revenue-enhancing and expenditure-restraining measures. In particular, they supported the implementation of quick-yielding revenue measures, the containment of the wage bill, and the elimination of off-budget transactions. They also stressed the importance of the new budget management and monitoring system being prepared for effective control of expenditure. Directors encouraged the authorities to resume preparations for introducing the VAT and the new tariff schedule in the 2002 budget.

Directors stressed that a reduction in the domestic debt remains the key to achieving medium-term fiscal sustainability. They urged the authorities to push forward with the privatization of the remaining public enterprises and to work with the principal donors to ensure that the debt conversion process can be completed as soon as possible.

Directors observed that the independence of the central bank is crucial to curb inflation and protect the exchange rate peg. They welcomed the authorities' intention to amend the central bank law and the constitution in order to assure the central bank's statutory independence and limit central bank financing of the budget. Directors also commended the monetary authorities for not rationing foreign exchange to stem the loss of reserves and for having instead raised the discount rate twice in the last four months.

Noting that data weaknesses limit the government's financial management capacity, Directors urged the authorities to take steps to improve the quality and timeliness of economic and financial statistics.