Public Information Notice No. 05/134

Corrected -- Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with Lesotho

September 29, 2005

On September 19, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Lesotho.¹

Background

Real GDP growth weakened to about 2 percent in 2004/05, from over 3 percent in the preceding two years, mainly due to the impact of adverse shocks affecting manufacturing and agriculture. The slowdown in manufacturing reflected the appreciation of the real exchange rate (by 30 percent) since February 2002, uncertainty regarding Lesotho's duty free access to the U.S. market under the U.S. African Growth and Opportunity Act, and the elimination of textile quotas in January 2005. Agricultural output declined due to a prolonged drought in the past three years, as well as structural weaknesses, such as poor farming techniques, soil erosion, lack of water in the lowlands, and lack of agro-financing. Over one quarter of the population is estimated to be in need of emergency food assistance.

In line with trends in South Africa, the CPI-based annual inflation rate declined from 7.7 percent at end-March 2003 to 3.7 percent at end-March 2005, notwithstanding increases in oil import prices. The unemployment rate is estimated at 30 percent, and the HIV/AIDS prevalence rate has remained high (at about 29 percent of the adult population).

The overall fiscal balance (including grants) has turned from a deficit to an increasing surplus in the last two fiscal years. The large fiscal surplus of 9.1 percent of GDP in 2004/05 reflected mainly the temporary rise in receipts from the South African Customs Union. Domestic revenue collection has improved since the launching of the Lesotho Revenue Authority. On the expenditure side, current outlays particularly salaries and wages, were lower than projected, as the new local government administration did not take off during the fiscal year as earlier envisaged.

Monetary developments have reflected those in South Africa. The discount rate has held steady since August 2004, market yields on Treasury-bills have moved downward, influenced by the fall in the government borrowing requirement, and spreads relative to South Africa have narrowed to less than 40 basis points as of end-March 2005.

During 2003/04 and 2004/05, the external current account deficit narrowed from 11 percent of GDP to less than 3 percent, mainly owing to considerable export growth and a sharp rise in South African Customs Union (SACU) receipts in 2004/05. Remittances from South Africa also increased. These developments have led to an increase in the central bank's foreign reserves, which reached 4.5 months of imports of goods and services by end-March 2005.

Lesotho's debt indicators have improved markedly. With the strengthening of its fiscal position, the government reduced the stock of outstanding Treasury bills from 17 percent of GDP in 2002/03 to 8 percent in 2004/05. Lesotho's external public debt as a share of GDP has declined from 83 percent of GDP at end-March 2003 to 53 percent two years later, largely due to exchange rate appreciation. In net present value terms, the stock has fallen below 40 percent of GDP.

The authorities have strengthened their efforts to address poverty and HIV/AIDS. They have prepared a Poverty Reduction Strategy (PRS) through a highly participatory process involving the private sector, civil society and the donor community. The PRS identifies key areas that are important for making progress toward the Millennium Development Goals. Particular attention has recently been paid to strengthening institutional and implementation capacity to speed up the use of government and donor funding for the fight against the HIV/AIDS pandemic.

Executive Board Assessment

Executive Directors welcomed the marked improvement in the economic performance of Lesotho over the past two fiscal years, with a lower fiscal deficit, a stronger external current account position, a further decline in inflation, and an increase in net international reserves. The authorities' prudent policies had helped to contain government debt at manageable levels. However, persistent drought conditions, weakened external competitiveness, a continued worsening of the terms of trade, and job losses from the phasing out of textile quotas by industrial countries had caused real GDP growth to slow in 2004/5. Against this background, Directors considered that finding the basis for consistent high growth over the medium term, to help address widespread poverty, achieve the Millennium Development Goals, and confront the high incidence of HIV/AIDS, will be the primary challenge for the authorities in the period ahead.

Directors observed that the further loss of trade preferences, declining revenues from the South African Customs Union SACU, and contraction of inward remittances from migrant workers were likely to be durable economic shocks. They considered that faster economic growth in the future is therefore likely to depend on raising efficiency and broadening the production and export base. In that light, Directors urged the authorities to implement ambitious structural reforms aimed at restoring competitiveness and fostering private sector development.

Directors observed that, as Lesotho's membership in the Common Monetary Area constrains the use of the monetary policy lever, an appropriate fiscal policy will be the key to preserving financial viability. They recommended limiting future fiscal deficits to levels that can be financed largely by foreign grants and concessional loans. Also, the government's net creditor position vis-à-vis the banking system should be maintained, and the official net international reserve position protected. Directors noted that a continued prudent fiscal stance will provide room to expand credit to the private sector without pushing domestic interest rates higher than those prevailing in South Africa.

Given the decline in receipts from SACU, Directors called for a strengthening of revenues through a broadening of the tax base and improved tax administration. They encouraged the authorities to proceed with their plans to upgrade the hardware and provide training to the staff of the Lesotho Revenue Authority, to implement the planned Automated System for Customs Data project, and ensure that government entities comply with VAT payment and refund procedures.

Directors welcomed the authorities' efforts to strengthen the execution, monitoring and evaluation of public expenditure programs, which will support the alignment of expenditures with poverty reduction strategy priorities and the phase-out of nonpriority outlays. They emphasized the importance of ensuring that planned increases in outlays for poverty reduction are consistent with medium-term fiscal sustainability and the absorptive capacity, and take into account the recurrent cost implications of such spending. Directors encouraged the authorities to expedite implementation of the Public Sector Reform and Improvement Program so as to contain the public sector wage bill and improve public services.

Directors welcomed the progress made in strengthening the institutional framework to address the incidence of HIV/AIDS, especially the steps taken to improve the management and coordination of HIV/AIDS-related programs and to set up monitoring and evaluation systems. They encouraged the authorities to accelerate similar efforts in the other priority areas related to poverty reduction.

Directors stressed that, in order to promote private sector-led growth, a comprehensive structural reform agenda needs to be formulated and implemented without delay. Key reforms should aim to enhance labor productivity through training and skill-enhancing programs, address bottlenecks in infrastructure and public service delivery, eliminate the legal and administrative impediments to investment, and promote financial intermediation through the removal of legal obstacles to bank lending.

Directors supported the authorities' objective of strengthening regional trade and investment links, especially with South Africa, through structural reforms and sectoral strategies, which could help to diversify Lesotho's export products and markets. In this context, they advised the authorities to avoid creating subsidies for certain sectors that could distort incentives, entail large fiscal costs, or weaken fiscal transparency and accountability.