External Stability Assessment1
After severe balance of payments pressures in 2012 and 2013, due to a decline in the international price of cashew, Guinea-Bissau’s main export product, combined with political uncertainty after the 2012 coup, exports have recovered and support by international partners has returned. While imports have also been strong, a significant increase in current transfers moderated the current account deficit in 2014, and the balance of payments recorded an overall surplus. In the medium-term, financing needs would increase significantly as terms-of-trade are projected to deteriorate and import demand to remain strong due to continued robust growth and large—mainly officially funded—infrastructure investment needs. The real effective exchange rate appears broadly in line with fundamentals in the short-term. The economy remains vulnerable to shocks due to high export concentration and the country’s fragile status. The business environment remains difficult. To safeguard external stability in the medium term, policies targeting the diversification of the economy combined with improvement in non-price competitiveness will be critical.
A. Recent Economic Developments and Outlook
1. Pressures on Guinea-Bissau’s balance of payments moderated significantly in 2014 (Figure 1). After severe external pressures due to the decline of cashew nut prices by more than 40 percent between 2011 and 2013, Guinea-Bissau’s terms of trade improved by more than 30 percent in 2014, and exports recovered. Imports also grew substantially (by almost 31 percent in real terms), driven by a more favorable growth outcome and substantial demand for fuel. As a result, the trade deficit widened from 7.7 percent of GDP in 2013 to 9.7 percent in 2014. Current transfers more than doubled in nominal terms compared to their 2013 level and reached 7 percent of GDP due to a strong increase in budget grants and continued robust private transfers. Consequently, the current account deficit including grants is estimated to have declined to 1.2 percent of GDP in 2014, down from 4.4 percent in 2013. The balance of payments recorded a significant surplus.
Figure 1.Guinea-Bissau: Recent External Developments
2. Financing needs are expected to increase in the medium term, driven by a scaling up of public investment and a weakening in the terms of trade (Figure 2). Large public investments, financed through project grants and concessional borrowing, and a further increase of real growth to around 5 percent would boost imports in the medium-term. Exports values, while projected to rise significantly due to a favorable outlook for cashew prices in 2015, would stay relatively flat in the medium term. The current account deficit would expand to an average of more than 5 percent of GDP per year during 2015–19. The current account deficit would be driven on average mainly by a public savings-investments gap, while the private savings-investments gap would decline as well.
Figure 2.Guinea-Bissau: External Outlook
3. Guinea-Bissau’s external position remains vulnerable to a range of risks. A stable political and security situation is the necessary condition for a sustainable external position. From the macroeconomic perspective, Guinea-Bissau’s very high export concentration in cashew nuts (85 to 99 percent of exports) poses the main risk to external stability as it leaves the country vulnerable to international price fluctuations. An increase in currently favorable oil prices could exert pressure on the current account as the economy is highly dependent on the import of petroleum products. In the medium term, continued flows of grants and access to concessional loans will be necessary to finance huge infrastructure development needs which in turn constitute the precondition for developing Guinea-Bissau’s export base.
B. External Sustainability Assessment
Based on the external balance assessment for developing and emerging markets (EBA-lite), Guinea-Bissau’s real effective exchange rate (REER) appears to be broadly in line with the country’s fundamentals.
4. To assess the stance of the current account for Guinea-Bissau, this note uses the “EBA-lite” methodology (Figure 3). The fitted values resulting from this exercise capture the current account deficit dynamics well, but there are substantial differences between the actual current account in percent of GDP compared to the levels implied by the regression. In the more recent years, the implied levels exceed the actual levels, implying that countries with similar characteristics, such as demographics, institutions and size of private and public transfers and fiscal stance, openness to trade and terms of trade movements, have, on average, experienced somewhat lower current account deficits.
Figure 3.Guinea-Bissau: External Stability Assessment
5. Based on the EBA-lite approach, Guinea-Bissau’s current account stance in 2015 can be decomposed as follows:
in which CA Gap is the current account misalignment, Fitted CA is the predicted value from the regression above and Policy Gap relates a country’s actual policies not only to its optimal policies, but also to the average policy misalignment in the rest of the world.
6. For most policies, staff expects no policy gap for Guinea-Bissau in 2015. On the national level, this note assumes that the projected cyclically adjusted fiscal stance, the degree of capital controls and the accumulation of official net foreign assets is in line with staff’s recommendations, so that any policy gaps incorporated into the approach would stem from differences in policies compared to the rest of the world. For the level of credit to the private sector to GDP, however, a benchmark level of 22 percent is set as the optimal “policy” variable, in line with its benchmark level obtained Section III on financial stability, depth and inclusion, and which is substantially above the projected level of private sector credit to GDP of 11 percent of GDP in 2015.
7. The EBA-lite approach suggests that Guinea-Bissau’s REER would be broadly in line with its fundamentals in 2015. The current account benchmark implied by the EBA-lite approach is -2.7 percent of GDP, of which -1.5 percent of GDP are driven by the policy gap and another -1.2 percent by Guinea-Bissau’s macroeconomic fundamentals. The actual current account deficit is projected to rise to 3.6 percent of GDP in 2015. The implied misalignment of the current account is therefore -0.9 percent of GDP, implying a statistically insignificant 6.5 percent over-valuation of the REER.2 Such an over-valuation is considered to be within the margin of error, and the REER thus appears to be broadly in line with the Guinea-Bissau’s fundamentals.
8. As Guinea-Bissau’s is part of a monetary union, its exchange rate should also be seen in the context of the external stability of the WAEMU as whole (IMF, 2015b). As a member of a currency union, and being the smallest player in it, Guinea-Bissau’s external position also depends on the other WAEMU members’ performance. An assessment of the WAEMU as a whole suggests that the external position remains sustainable but vulnerabilities have increased. The region’s exchange rate appears broadly in line with fundamentals, but its external buffers have been shrinking: the BCEAO’s gross international reserves (GIR) coverage decreased from 6.6 months of imports in 2010 to 4.6 months of imports in 2014; commercial banks’ net foreign exchange position has declined significantly in 2014 and turned negative. The level of GIR is below optimal based on standard metrics (5 to 12 months of imports).3 However, GIR are still significantly higher than the floor that acts as a warning signal under the zone’s monetary arrangement with France (84 percent of narrow money compared with 20 percent).
C. Non-Price Competitiveness
9. The business climate in Guinea-Bissau remains difficult (Figure 4 and 5). Guinea-Bissau’s relative rating in the Doing Business ranking has deteriorated compared to the last assessment; only 10 out of 189 countries evaluated are currently ranked worse.4 Getting access to electricity, starting a business and enforcing contracts are particularly challenging areas compared to other WAEMU countries and a benchmark group of fast growing African economies.5 Guinea-Bissau’s institutions and policies are also consistently ranked weaker than in other WAEMU countries in the Country Policy and Institutional Assessment. Considering that Guinea-Bissau cannot devalue its currency as it is part of a monetary union, improvements in these areas will be even more critical for the private sector’s development and economic diversification which are the necessary conditions to make Guinea-Bissau an economy which is more resilient to shocks (Section IV).
Figure 4.Guinea-Bissau: Doing Business and Access to Communication Infrastructure Figure 5.Guinea-Bissau: Country Policy and Institutional Assessment
10. The REER appears broadly in line with fundamentals, improvements in non-price competitiveness will be necessary to safeguard stability in the medium term. Based on the external balance assessment for developing and emerging markets (EBA-lite), Guinea-Bissau’s real effective exchange rate (REER) appears to be broadly in line with the country’s fundamentals. However, the economy remains exposed to shocks due to high export concentration and the country’s fragile status, and the business environment remains difficult. To safeguard external stability in the medium term, policies targeting the diversification of the economy combined with improvement in non-price competitiveness will therefore be critical.
Prepared by Monique Newiak.
-3.6 - (-2.7) = -0.9. The assumed elasticity of the current account to movements in the real exchange rate is -0.13.
Given the commitment of France to back the convertibility of the CFA franc this metric does not fully apply for the WAEMU. For details on the metric, see Dabla-Norris, Kim and Shorono (2011): “Optimal Precautionary Reserves for Low-Income Countries: A Cost-Benefit Analysis,” International Monetary Fund, Working Paper WP/11/249.
Doing Business indicators should be interpreted with caution because of the limited number of respondents, a limited geographical coverage, and standardized assumptions on business constraints and information availability.
These benchmarks include Ghana, Kenya, Lesotho, Rwanda, Tanzania, Uganda, and Zambia.