Public Information Notice No. 01/51

Public Information Notice: IMF Concludes Article IV Consultation with Lesotho

May 21, 2001

On March 9, 2001, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Lesotho.¹

Background

Lesotho continues to face considerable economic challenges since the sharp downturn in growth in 1998/99 aggravated by political riots. Real GDP growth has recovered to above 2 percent, helped by a recovery in manufacturing. Still, growth remains constrained by structural changes such as the winding down of Phase I of the Lesotho Highlands Water Project and the decline in mining employment in South Africa. Unemployment, estimated at over 40 percent, and poverty are widespread and there is a serious HIV/AIDS problem. The fiscal and balance of payments situations have also deteriorated. However, inflation is relatively low and the external debt remains sustainable.

Declining revenue-to-GDP and one-off expenditures associated with the restructuring of a public enterprise and state banks caused the budget deficit in 1999/2000 to rise to 16 percent of GDP. The budget deficit should narrow in 2000/01, though unexpected expenditures such as the settlement of a tax dispute with South Africa continue to highlight fiscal pressures. While the current account deficit has narrowed, it remains large and inflows of official grants and foreign direct investment have become insufficient to finance it, leading to a fall in international reserves since 1999/2000.

Lesotho's one-to-one exchange rate peg between the loti and the rand has helped maintain monetary stability and relatively low inflation at 6 percent. The authorities have committed to maintain gross international reserves at six months of imports and contain the current account deficit. The exchange rate regime also limits monetary policy and so raises the importance of a healthy fiscal policy. The government has agreed to pursue a path of fiscal consolidation through increases in tax revenue, cuts in current expenditure, and public sector reforms. The central bank will also enhance its capacity to control liquidity through the establishment of a treasury bill market.

Lesotho has made good progress in implementing structural reforms. These include the start of a major tax reform aiming at introducing value-added tax and a National Revenue Authority, and a public sector reform project. Restructuring of the electricity company is underway with plans for privatization in 2002. Financial sector reform has also made significant advancement with the restructuring and privatization of the two state banks and major improvements in bank supervision.

The government aims to raise growth and boost employment through attracting foreign direct investment and enhancing export competitiveness, while continued privatization will fuel private sector development. Structural reforms to be implemented cover the areas of tax reform and tax administration, expenditure control and rationalization, public sector reform, financial sector reform, privatization and statistics strengthening.

Executive Board Assessment

Executive Directors noted that Lesotho is facing a downturn of economic growth, high unemployment and poverty, and fiscal and balance of payments pressures as a result of long-term structural changes affecting the economy. Correction of these problems will require bold and sustained action by the authorities over the medium term. Directors therefore commended the authorities for adopting a growth-oriented adjustment program in the context of a three-year PRGF arrangement aimed at restoring the economy to a path of high and sustained growth. In view of Lesotho's limited capacity to implement wide-ranging reforms, Directors welcomed the program's focus on a number of key areas in which progress is most needed. They also welcomed that the authorities have secured technical assistance from bilateral and multilateral agencies, including from the Fund, in undertaking the reforms in these areas.

Given recent budgetary pressures, Directors underlined the importance of the authorities' commitment to fiscal consolidation, to be achieved through a compression in current expenditure and an increase in noncustoms tax revenue. Directors drew attention to the need to lower and rationalize government expenditure over the medium term, taking note in particular of the need to contain growth in the wage bill, while preserving priority social and capital investment expenditures. They encouraged the authorities to complete the public expenditure review as early as possible and to speed up the public sector reform project. They saw these measures as supporting the budgeting process and improving the efficiency and transparency of government operations. Tax administration also needed to be strengthened.

Directors agreed that the current monetary regime with South Africa has served Lesotho well, and has helped keep inflation relatively low, but observed that the fixed exchange rate needed to be backed by financial discipline. Thus they welcomed the central bank's efforts to refine its policy instruments in the area of open market operations. Directors also supported the authorities' efforts to address the structural weaknesses that affect Lesotho's financial sector and contribute to the lack of savings mobilization and financial intermediation. They noted that, following closure of the two loss-making state-owned banks, the banking system is now in better health. They stressed the importance of reinforcing bank supervision and of continued efforts to ensure the enforcement of loan contracts, and welcomed recent steps to increase the competitiveness of the financial system.

Directors observed that, given its size and geographical location, emphasis on outward-looking policies supported by private-sector development is the best option for Lesotho. They, therefore, welcomed the authorities' efforts to privatize state-owned enterprises. Directors also supported the stress on small and micro enterprise development, such as small-holder agriculture, to broaden the base of growth and maximize employment generation.

Directors stressed that Lesotho would need to take maximum advantage of the opportunities afforded by its close economic ties with South Africa and by regional trading arrangements, to attract foreign investment and diversify its production base. This would require appropriate policies to enhance external competitiveness and improve the business environment. In this context, Directors encouraged the authorities to eliminate the remaining non-tariff barriers.

Directors mentioned that, although the statistical database was adequate for purposes of the Article IV consultation, it still contains major weaknesses, especially in national accounts and the balance of payments. They, therefore, urged the authorities to improve the quality, timeliness and frequency of reporting of key statistical data.