1. The Zambian authorities remained steadfast in implementing prudent policies and deepening structural reforms, helped by favorable external environment, which contributed to strong economic performance over recent years. Macroeconomic stability strengthened and growth accelerated. While significant gains are being made in employment creation and poverty reduction, the proportion of people living in poverty remains very high, particularly in rural areas, with the economy still vulnerable to exogenous shocks. The authorities are committed to consolidating their positive economic achievements through a resolute implementation of the fifth national development plan (FNDP), with a view to reaching their development objectives set out in the Zambia Vision 2030. The authorities are in broad agreement with the analysis and policy recommendations in the well balanced staff report, and would appreciate the Board’s support of their request of a new three-year PRGF arrangement.
Recent Economic Developments
2. Zambia has continued to register commendable economic performance over the last years, supported by sustained economic reforms, favorable international copper prices, and broad-based growth including in agriculture, mining, manufacturing, construction, telecommunications and other services. Real GDP growth was estimated at 6 percent in 2007 and is expected to continue expanding by an annual average of 6–7 percent over the medium-term. Inflation had been contained at single digit since 2006 due to significant improvement in public finances and monetary policies. However, due to high oil and food prices, end-year annual inflation, which stood at 8.9 percent in 2007, has edged marginally above double digits since April 2008. Significant progress has been made in social indicators as reflected in increased enrolments in education and improved human development index. Poverty level was reduced by about 10 percent between 1998 and 2006, but remains unacceptably high and widespread.
3. The fiscal position in 2007 improved with the overall deficit excluding grants being 2.5 percent of GDP lower than planned, thanks to over-performance of revenue largely due to unexpected large income tax payments from the mining sector. In addition, expenditures were lower than planned due to shortfall in capital spending execution, resulting in accumulation of government deposits at the Bank of Zambia (BoZ).
4. Although there was a slowdown in monetary expansion, money growth exceeded the target on account of a reduction in cash reserve requirement in October 2007 and the difficulties faced by the BoZ to fully sterilize its net purchases of foreign exchange. This resulted in liquidity pressures and, subsequently, the authorities initiated appropriate corrective measures through its open market operations and auctions of government securities to slow down reserve money growth. Financial conditions and performance of the banking sector are broadly satisfactory. Capital and reserves were in compliance with the prudential requirements, and the banking sector was well capitalized, while the asset quality, earnings and liquidity ratios remained at sound levels.
5. The trade surplus narrowed despite higher copper export prices as flooding and electricity shortages adversely affected copper production. The current account deficit, excluding grants, deteriorated by 7 percent of GDP from 1 percent. Nevertheless, the increase in foreign direct investment to 8.6 percent of GDP contributed to an overall balance of payments surplus that resulted in a strengthened accumulation of international reserves and an appreciation in the exchange rate.
6. The exchange rate remained aligned with macroeconomic fundamentals, and domestic and financial policies are consistent with external stability.
Economic Challenges and Policy Framework
7. Zambia’s strong economic growth performance still falls short of the level required to substantially reduce poverty, and the authorities are still faced with the challenges of sustaining macroeconomic stability, increasing fiscal space for upgrading infrastructure, expanding the supply capacity in energy, improving human capital development, and diversifying the sources of growth and exports to lessen dependence on mining by improving conditions for private sector-led growth.
8. The authorities are aware of these challenges and are committed to making further progress in the implementation of prudent policies and their structural reform agenda, as set out in several multiyear programs, notably the Public Expenditure Management and Financial Accountability (PEMFA) program, Public Sector Management (PSM) reform program, Financial Sector Development Plan (FSDP), and Private Sector Development Initiative (PSDI). The key areas of focus include improving expenditure management and budget execution, making revenue collection more efficient and effective, strengthening monetary operations and deepening the financial sector, implementing debt management strategy, and strengthening policies in the energy sector.
9. The fiscal stance is expansionary in order to meet the authorities’ stated objectives, with revenues projected to increase from 18.7 percent in 2007 to 20.8 percent of GDP in 2008. The new fiscal regime for mining sector came into effect in April 2008 and mining revenue is estimated to increase by 2.8 percent of GDP in 2008. This is expected to substantially improve revenue collection to more than 21 percent in the medium-term. All mining revenue in excess of what should have been collected under the old regime (1.4 percent of GDP) would be saved in a separate Mining Resource Fund (MRF) to be used as a stabilization fund to even out expenditures and finance high priority projects in the FNDP. The new tax regime is considered by the authorities to be competitive, reasonable and balanced. The authorities do not anticipate mining companies’ profit to be less than what they had expected when the investment was made.
10. The authorities are appreciative of the formula advanced by staff of using a progressive profit-based variable tax but are skeptical of its appropriateness for countries like Zambia at the moment given their inherent structural rigidities and institutional weaknesses, particularly in that economic agents are prone to evade tax while most prefer to operate offshore accounts. The authorities feel that they should be given time to explore other alternative ways of broadening the tax base that may suit the country’s circumstances better.
Monetary and exchange rate policies
11. Monetary policy aims at reducing inflation to the target of 7 percent in 2008 and 5 percent in the medium-term. The authorities agree that the oil price increase and upward adjustment in electricity tariffs further amplifies the challenge they face. In this regard, BoZ will confine itself to smoothening wide fluctuations in the exchange rate while allowing a gradual build up of international reserves. The authorities are agreeable to making NDA a binding performance criterion and reserve money an indicative target. This arrangement had served them well thus far compared to targeting reserve money. In recent years, there does not appear to be a strong and clear empirical relationship between reserve money and inflation, since both the money multiplier and velocity are likely to have shifted.
Structural reforms and issues
12. The authorities are committed to implementing their ambitious structural reform program to complement their medium-term macroeconomic framework and support the successful implementation of the new program. Steady progress is being made to assist the modernization of the Zambia Revenue Authority. The authorities will also remain steadfast in implementing the PEMFA reform programs, including establishing a single treasury account system and completion of IFIMIS project. The second phase of the Financial Sector Development Plan reforms will be implemented in 2008 which aims at tightening financial regulations and supervision, as well as deepening the money and capital markets.
13. Executive Directors who visited Zambia in February this year can attest to the formidable infrastructure bottlenecks the country is experiencing, mainly in the energy and transportation sectors. Electricity supply shortages impose a serious threat to achieving the program objectives. The authorities will implement the necessary policies and strategies to address this problem. In this regard, the authorities are committed to support and ensure adequate availability of resources for the completion of ongoing rehabilitation projects and expansion of hydropower capacity. The authorities stand ready to support initiatives aimed at improving the regulatory framework required to enhance efficiency and cost effectiveness of their operations through the established channels.
14. The Zambian authorities consider their engagement with the Fund as crucial to help ease their developmental challenges. The new PRGF-supported program would enable them to continue enhancing a conducive environment for private sector investment, while sustaining macroeconomic stability, public sector efficiency and accountability, and creating the necessary fiscal space, and ensuring debt sustainability.