Public Information Notice No. 05/111

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with Cape Verde

August 11, 2005

On May 25, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Cape Verde together with the sixth review of Cape Verde's arrangement with the IMF under the Poverty Reduction and Growth Facility (PRGF) (see Press Release No. 05/124).¹

Background

Macroeconomic policies in Cape Verde have strengthened significantly over recent years, enabling the country to correct the severe macroeconomic imbalances that emerged in 2000 in the run-up to parliamentary and presidential elections. In particular, the fiscal position is now markedly stronger than in 2000; external and domestic public debt have declined as a share of GDP; and international reserves have been built up, supporting the credibility of the exchange rate peg to the euro. Important progress has also been made on a range of structural reforms to increase efficiency, improve the business climate, and support investment. Underpinned by this sound policy environment, GDP growth has been robust—averaging nearly 6 percent since 2000—and inflation has remained low.

Following a Fund staff-monitored program in the second half of 2001, the authorities' economic program has been supported by an arrangement with the IMF under the PRGF. This arrangement was approved in April 2002 and ended in July 2005. The government's medium-term development strategy is set out in the Poverty Reduction Strategy Paper (PRSP), which focuses on combating poverty and promoting private-sector-led growth by strengthening education, training, and health care, developing economic infrastructure, and improving governance. The PRSP was discussed by the Boards of the IMF and World Bank in January 2005.

Considering recent developments, GDP growth is estimated to have been 4.5 percent in 2004, held down in part by short-term difficulties in the agricultural sector, and is projected to reach around 6 percent in 2005. The construction sector continues to provide key support to economic activity, notably through private investment in tourism facilities and public investment in infrastructure. These trends have been backed by increasing foreign direct investment and concessional assistance from Cape Verde's bilateral and multilateral partners.

The fiscal deficit (including grants) fell to 1.5 percent of GDP in 2004, a stronger performance than expected. Revenues from the new value-added tax—introduced in January 2004—exceeded expectations and, within effective restraints on overall public spending, more resources were directed toward education, health, and other priority areas. The fiscal deficit in 2005 is projected to be 2.8 percent of GDP, fully financed through higher external assistance.

International reserves increased at a faster pace than anticipated in 2004, reaching 2.6 months of imports of goods and services at the end of the year—up from 1.9 months at end-2003. Further accumulation of reserves is expected in 2005. In view of continuing low inflation, the strong balance of payments position, and stable money and credit growth, the Bank of Cape Verde was able to lower the required reserve ratio in December 2004 and the standing lending facility rate in February 2005. These moves have been followed by a reduction in commercial banks' lending rates.

The remaining enterprises on the government's privatization agenda are being prepared for sale, tender under concession contracts, or liquidation. While progress in some areas is behind schedule, the program is expected to be largely completed over 2005-06. With the help of an independent mediator, negotiations are underway between the government and the majority shareholders of Electra, the electricity and water company, to reach agreement on the amount of the "tariff deficit" owed to this company. This deficit stems from the non-adjustment of electricity and water tariffs during 2000-02. Following some delays, the authorities are finalizing an automatic mechanism to adjust electricity and water tariffs in response to changes in import prices of oil products.

Executive Board Assessment

They commended the Cape Verde authorities' strong record in implementing their economic program, particularly the progress that has been made with fiscal consolidation, strengthening the credibility of the exchange rate peg, and structural reform. This has contributed to strong economic performance in recent years. The macroeconomic imbalances that emerged during the pre-election period in 2000 have disappeared. Real GDP growth has been robust, supported by private and public investment in tourism and infrastructure; inflation has been consistently low; international reserves have increased; and the external debt is relatively small. These achievements have supported poverty reduction and paved the way for Cape Verde's graduation to middle-income status in the near future.

While the public debt profile of Cape Verde at end-2004 appears sustainable under long term scenarios, Directors observed that the economy remains vulnerable to external shocks, due to the heavy dependence on external concessional financing and the narrow export base. Directors therefore urged the authorities to maintain prudent macroeconomic policies and a cautious approach to borrowing, and to sustain the reform momentum. Domestic resource mobilization, to reduce the reliance on external financing, and export diversification should remain high priorities.

Directors welcomed the decline in the fiscal deficit in 2004, which reflected the strong performance of the new value added tax and restraint on overall public spending, but also delayed wage and capital expenditures. They stressed the importance of continuing a prudent fiscal policy, especially in the run-up to elections in early 2006. They saw scope for further improvement in revenue performance, including through measures to strengthen tax administration and rationalize tax exemptions. They welcomed the authorities' commitment to keep expenditures within budgeted levels, and underscored the importance of prioritizing spending according to the objectives set out in the Poverty Reduction Strategy Paper.

Directors noted the key role monetary policy has played in supporting overall macroeconomic stability and growth, particularly by ensuring sustained low inflation and the credibility of the exchange rate peg. They supported the recent easing of the monetary policy stance, which has led to a much-needed reduction in commercial banks' lending rates. Directors considered that the current exchange rate regime remains appropriate for Cape Verde. They welcomed the further sizeable accumulation of international reserves in 2004, and noted the important role that remittances have played in strengthening the balance of payments.

Directors considered that the banking system is generally sound, but highly concentrated. They urged the authorities to push ahead with reforms to improve competition and efficiency in financial services, including through the introduction of new indirect monetary policy instruments to promote financial deepening. It was also noted that continued improvements in financial sector supervision will contribute to macroeconomic stability and private sector development. Directors welcomed the intention to adopt international financial reporting standards with technical assistance from the Fund.

Directors encouraged the authorities to continue with structural reforms focused on improving the conditions for private-sector-led growth. They welcomed the commitment to complete the restructuring and privatization of the remaining companies on the reform agenda during 2005 and 2006, but stressed the importance of parallel measures to strengthen the underlying regulatory framework. They considered that implementation of the automatic mechanism to adjust electricity and water tariffs in response to changes in input costs is important to reduce fiscal risks, restore the electricity and water company to financial health, and ensure a more efficient supply of utility services. Directors welcomed Cape Verde's move toward a more liberal trade regime, and called for faster progress in WTO membership negotiations. They encouraged efforts to enhance labour market flexibility and improve the business environment.

Directors welcomed the efforts being made to tackle poverty and achieve the Millennium Development Goals. They supported the creation of the National Council for Poverty Reduction, and commended the authorities for approving a PRSP after consultation with key stakeholders.

Directors observed that, while Cape Verde's statistical systems are generally adequate for program monitoring, there is substantial scope for improvement in this area. They urged the authorities to make full use of available technical assistance to strengthen national accounts data, implement the improved methodology for measuring consumer prices, and undertake labour market surveys.