Public Information Notice No. 05/135

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with the Democratic Republic of the Congo

September 29, 2005

On August 29, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the 2005 Article IV consultation with the Democratic Republic of the Congo.¹

Background

Since 2001, the DRC has experienced a significant turnaround. After the signing of a power-sharing agreement (Accord global et inclusif) in December 2002, a transition government of national unity was formed in June 2003, charged with holding elections after two years. The transition period was extended by six months in June 2005 to give the authorities more time to prepare for the first free and transparent elections in over 30 years. The transition government has made progress in reunifying the country and strengthening public institutions. A draft constitution was adopted by parliament in May 2005 and will be submitted to a referendum in November 2005. In addition, an integrated army and a police force are being created and the implementation of the Disarmament, Demobilization, and Reintegration (DDR) program is making progress.

Economic activity started to recover in 2002, after declining for 13 years, inflation declined from 511 percent at end-2000 to 4 percent at end-2003. However, by mid-2004 macroeconomic performance started to weaken due mainly to an increase in security-related government spending following rising tensions in the eastern provinces and outlays by political institutions. Overall, real GDP grew by 6.8 percent in 2004; 12-month inflation fell to less than 5 percent by mid-2004 before rising to over 9 percent by December 2004 and further to 26 percent by end-May 2005.

The external current account deficit, including official transfers, widened by 4 percentage points of GDP in 2004. Favorable terms of trade (due to an increase in the world market prices of commodities) and the return of private investors resulted in large increases in exports of cobalt, timber, crude oil, and copper. At the same time, imports of capital and consumer goods rose rapidly with the reconstruction of the economy and with rising income. The overall balance of payments improved when taking into account debt relief. International reserves more than doubled to 5.2 weeks of imports and are projected to rise further to 7.2 weeks in 2005. The country has benefited from a sharp improvement in competitiveness, with the terms of trade strengthening by more than 20 percent over the same period and the real effective exchange rate depreciating by 19 percent during 2002-04.

Fiscal developments were mixed in 2004, with government revenue higher and expenditure lower than programmed. Nevertheless, the composition of expenditure remained a major issue, with spending on social and poverty-reducing projects falling well short of projections when, at the same time, there was overspending for security and political institutions. In addition, the implementation of the fiscal reform agenda slowed down due to institutional rigidities, including the government's and the National Assembly's slow decision-making process. So, in spite of relatively high growth, progress toward reaching the Millennium Development Goals has been limited.

A higher-than-anticipated expansion in the monetary aggregates in 2004 led to the depreciation of the Congo franc and a surge in inflation in the second half of the year. To correct the slippages the Central Bank of the Congo (BCC) tightened monetary policy and eventually monetary stability was restored leading to the stabilization of consumer prices and the appreciation of the exchange rate by mid-June 2005.

In the area of governance, the authorities increased transparency in government spending and the tracking of poverty-related expenditure, which are key elements to monitor the use of resources generated by debt relief under the Heavily Indebted Poor Countries (HIPC) Initiative, and progress was made toward the MDGs. In addition a law to combat money laundering and the financing of terrorism was promulgated in 2005.

Important structural reforms have been implemented since 2002, but progress slowed in 2004 due to a large extent to rising insecurity and political tensions that made it difficult for the government to reach a broad consensus on reforms.

The soundness of the banking system is still fragile, although it has improved over the past year as its restructuring is ongoing. A plan to recapitalize the BCC has been elaborated which deals with the losses it incurred due to the revaluation of its foreign exchange accounts, high operating costs, and low earnings. As regards commercial banks, seven of them are being liquidated, the five remaining in operation are implementing restructuring plans and a new bank has started operations. Banks' profits are still low due to the narrow asset base and the volatility of earnings.

The DRC has made progress in obtaining debt relief. After reaching the decision point under the HIPC Initiative, the authorities signed bilateral agreements with most Paris Club creditors. The authorities have also continued their good faith efforts to reach collaborative agreements with commercial creditors with which they have signed 32 rescheduling agreements, and they intend to continue seeking agreements with all remaining creditors by end-2005.

In 2005, economic growth is expected to reach 6.6 percent and end-of-period inflation to rise to 22.6 percent. The authorities will seek to achieve an underlying fiscal surplus (which excludes all foreign-financed expenditure) equivalent to 1.1 percent of GDP, compared with a deficit of 0.9 percent of GDP in 2004. At the same time, spending for the political transition process and the restructuring of the economy, which is largely foreign financed, would cause the overall fiscal deficit, on a cash basis, to increase by 0.5 percentage points of GDP to 2.2 percent in 2005. The overall fiscal deficit is to be covered by external financing, including debt relief under the HIPC Initiative and budget support from the World Bank, the African Development Bank, and bilateral donors. The BCC will implement a prudent monetary policy in the context of the floating exchange rate regime, which has so far been appropriate for the country's circumstances with the restoration of price stability as the main objective.

The main risks for the rest of 2005 relate to security and social tensions, which could worsen in the case of further delays in the transition process. Bringing the political transition process to a successful conclusion is key and will require coordinated efforts to tackle simultaneously political, economic, and security challenges. Support of the international community will remain crucial in reaching the end of the transition process.

Executive Board Assessment

Executive Directors commended the authorities for the progress made in stabilizing the economy and pursuing reforms in recent years, despite the difficult security and political situation. GDP growth has been higher than anticipated, inflationary pressures have eased, and the exchange rate remained broadly stable. In addition, important reforms were introduced, and advances made toward national reunification.

Directors noted that economic performance was mixed during the second half of 2004 and the first quarter of 2005. They regretted the policy slippages, which contributed to renewed inflationary pressures, a shift away from pro-poor spending, and slow implementation of structural reforms during this period. They were encouraged, however, by the tightening of fiscal and monetary policies early this year, which has helped stabilize the macroeconomic situation.

Directors noted that developments since mid-2004 underscored the fragility of the economic situation and that confidence in government policy remained tenuous. While recognizing the daunting challenges associated with the political and security situation, Directors encouraged the authorities to accelerate the economic reform process, including in the area of governance, which is essential for rebuilding the economy, achieving high and sustainable growth, and reducing poverty. They also emphasized the importance of bringing the political transition process to a successful conclusion and of improving security by completing reforms of the army and the police.

Directors concurred with the authorities' medium-term economic framework, which they found ambitious for a country that is still at an early stage of post-conflict recovery. They supported the fiscal strategy that aims at keeping the deficit at a level compatible with macroeconomic stability and debt sustainability. While noting the steps taken to increase revenue, Directors recommended that this effort be intensified in order to generate the resources required to develop the economy and reduce poverty. To enhance tax collection, they noted that emphasis should be placed on modernizing the tax administration, broadening the tax base, and fighting smuggling, fraud, and corruption. Directors urged, in particular, that the government take steps to ensure that the mining sector contributes an appropriate share of government revenue.

Directors urged the authorities to contain overall government expenditure, since money-financed outlays were the main cause of the recent surge in inflation. They emphasized the importance of improving the composition of spending by ensuring that resources for poverty reduction are effectively utilized in order to contribute to the achievement of the Millennium Development Goals, and that outlay for security and political institutions are contained. Directors strongly supported the strengthening of public expenditure management, which is essential for improving transparency and enhancing the efficiency of fiscal spending. They also welcomed the actions taken to enhance the efficiency of the civil service, and in particular, the undertaking of the military and civilian personnel census, which is an essential step toward improving control over the payroll, and creating room to increase wages. Directors noted the provisions in the draft Constitution to decentralize fiscal resources and key responsibilities to the provinces. To safeguard fiscal discipline, they urged that the pace of decentralization take into account the institutional capacity in the provinces, and saw a role for Fund technical assistance in this area.

Directors commended the authorities on their commitment to a prudent monetary policy in the context of the floating exchange rate regime, with the restoration of price stability as the main objective. They encouraged the authorities to implement the Fund's technical assistance recommendations regarding monetary management, including by developing the market for central bank paper as an efficient tool to address excess liquidity. Effective liquidity management might also require sales of foreign exchange. Directors were of the view that intervention in the foreign exchange market should be limited to achieving the target for international reserves and smoothing out short-term volatility in the exchange rate.

Directors urged the BCC to accelerate the implementation of its action plan aimed at strengthening its financial position, its institutional and management capacity, and the transparency of its operations. Actions in this area should take into account the recommendations of the safeguards assessment report, and Directors recommended that increased independence of the central bank would also be helpful in this regard. Directors welcomed the BCC's commitment to enhance supervision of the commercial banks and to strengthen the soundness of the banking system. They were of the view that commercial banks' restructuring was essential to improve their financial situation and enhance financial intermediation.

Directors emphasized the crucial importance of further actions aimed at improving governance and reducing corruption. Such actions are a key element of the strategy for improving the business climate and investor confidence and for enhancing donor support. In this context, Directors urged the authorities to take all necessary steps to implement recently adopted legislation to intensify the fight against corruption, money laundering, and the financing of terrorism. In addition, they looked forward to the authorities' implementation of plans to establish a financial intelligence unit and to participate in the Extractive Industries Transparency Initiative.

Directors encouraged the authorities to complete the Poverty Reduction Strategy Paper through a broad participatory process. They welcomed the draft PRSP that was circulated to civil society and development partners, and looked forward to the final version in the fourth quarter of this year. They urged the authorities to implement all actions necessary for the Democratic Republic of the Congo to reach the completion point under the enhanced HIPC Initiative by end-2006.

Directors noted progress made in finalizing negotiations on debt relief and encouraged the authorities to reach agreement with all remaining creditors. In light of the downside risks to exports and the terms of trade, they emphasized the need to continue to follow a prudent external debt management policy, and to secure highly concessional foreign assistance, while strengthening the authorities' debt-management capacity.

Directors agreed that macroeconomic statistics still need to be improved significantly, especially in the areas of the national accounts, price and production data, and the balance of payments. They urged the authorities to continue their efforts to enhance the coverage and quality of key statistics in the context of the General Data Dissemination System project.