A. Background

1. In the mid-1980s, Mozambique’s economy was in collapse as a result of civil war, weak economic policies, and excessive government intervention in the economy. In 1986, Mozambique’s macroeconomic imbalances were severe: the inflation rate was 41 percent; real GDP growth was -2.3 percent; the fiscal deficit before grants was 24 percent of GDP; the external current account before grants was more than three times the exports of goods and nonfactor services; and the exchange rate in the parallel market exceeded the official exchange rate by about 25–40 times.

2. In 1987, the government launched an Economic Rehabilitation Program (ERP), supported by the Fund, the World Bank, and the donor community. The program involved a fundamental shift to market-based economic policies and structural reforms. Major economic reforms undertaken to date include the unification of the exchange rate; the liberalization of trade; the reform of the import tariff structure and of the regime of exemptions; the elimination of most price controls; the privatization, liquidation, or leasing to the private sector of over 900 public enterprises; and reforms in the financial sector, including the liberalization of interest rates.

3. In the period 1987–97, the economy has made impressive gains: real GDP and exports grew on average by 6.8 percent and 15.6 percent, respectively, and the ratio of investment to GDP rose from 36.1 percent in 1987 to 45.2 percent in 1997. Inflation sharply increased in 1987 as a result of the devaluation of the metical and price decontrols; it remained high in the following years, driven mainly by monetary expansion. However, in the two years ended December 1996, the 12-month inflation rate fell dramatically from 70.1 percent to 16.6 percent, primarily because of a tightening of monetary policy made possible by the privatization of the BCM, a large state-owned bank.

B. Economic Developments in 1997

4. Real GDP growth in 1997 was estimated at 7.9 percent. Growth was vigorous in all the major sectors. Transportation, industry, and services showed particularly encouraging increases of 11.3 percent, 9.1 percent, and 8.4 percent, respectively. Agriculture, one of the pillars of the economy, grew by 5.9 percent as a decline in cashew production was offset by strong increases in cotton (43 percent) and foodstuffs (22 percent) production. The pickup in activity was accounted for by good weather, high levels of foreign assistance, privatization, and low inflation.

5. Inflation continued its steady decline in 1997, reaching 5.8 percent by year’s end. This outcome reflected greater monetary control, exchange rate stability, and a strong supply response in the economy.

6. Broad money increased by 25.4 percent in 1997, even though the Bank of Mozambique took measures to curtail the growth of reserve money to 16.3 percent. Two factors explain the increase in broad money: the growth in money demand, spurred by a more dynamic economy, greater confidence, and high real deposit rates; and an increase in the money multiplier resulting from a decline in the currency-to-deposits ratio and a shift toward time deposits.¹ The Bank of Mozambique accommodated the higher money demand by allowing credit to the economy to increase by 47.6 percent and accumulating net foreign assets in excess of its December targets. These actions had no discernible impact on prices and helped sustain real growth.

7. The nominal exchange rate was stable in 1997. The metical depreciated by less than 2 percent in 1997, following a 5 percent depreciation in 1996. This outcome reflected price stability, capital inflows (direct investment and foreign aid), and growing confidence. In real effective terms, the metical has depreciated by 32 percent since 1995, mostly from late 1995 to early 1996 when prices rose sharply because of floods. The spread between the market and the parallel exchange rates narrowed to less than 2 percent in 1997 from 5 percent in 1996. The interbank foreign exchange market is now cleared twice daily, instead of weekly.

8. The overall deficit before grants increased from 17.0 percent of GDP in 1996 to 20.1 percent in 1997, as foreign aid (grants and concessional loans) expanded. Total revenue increased from 18.0 percent in 1996 to 20.4 percent in 1997, owing mainly to a rise in tax revenue from 16.5 percent of GDP in 1996 to 18.9 percent in 1997. The increase in tax revenue stemmed from a strengthening of tax and customs administration, as well as from the quarterly adjustment of the petroleum tax rates. Total expenditure and net lending grew by 5.5 percentage points of GDP from 1996 to 1997, with current expenditure increasing from 15.9 percent of GDP to 18.9 percent, and capital expenditure rising from 18.9 percent of GDP to 21.5 percent. Current expenditure in health, and education increased in real terms, while the growth in capital expenditure reflected primarily higher spending in the transportation and water sectors.

9. The external current account deficit (before grants) declined from US$642 million in 1996 to US$615 million in 1997. The trade deficit decreased from US$557 million in 1996 to US$541 million in 1997, as merchandise exports rose by 3.7 percent and imports fell by 1 percent. Merchandise exports other than cashews increased by over 14 percent as a result of the substantial expansion in exports of prawns and nontraditional products, including apparel. The decline in imports stemmed from import substitution, spurred in part by privatization and better border controls, and lower import prices. The services deficit narrowed by 13 percent in 1997, mainly because of higher receipts related to travel and tourism.

10. The capital account surplus declined from US$239 million in 1996 to US$163 million in 1997, owing to lower public sector external borrowing and private investment.² Despite the smaller capital account surplus, the substantial reduction of the current account deficit (including grants) allowed the net foreign assets of the banking system to increase by almost US$137 million. Gross reserves of the Bank of Mozambique rose by over US$176 million, reaching a level equivalent to 6.4 months of imports of goods and nonfactor services.

C. Organization of the Report

11. The remainder of the report comprises a series of background studies prepared by the Fund staff in the context of the Article IV consultation discussions. Chapter II analyzes the behavior of inflation in Mozambique, showing that the marked tightening of monetary policy since 1995 was the fundamental reason for the recent decline of inflation. The control of monetary expansion also impacted directly on the balance of payments, thus helping to stabilize the metical and contributing twice to the containment of inflation. The results indicate that Mozambique has experienced a change in the “fundamental” inflation trend that may have long-lasting effects.

12. Chapter III studies the relationship between growth and investment. Mozambique’s growth performance although strong was less impressive than that of other sub-Saharan countries like Botswana and Uganda. While its investment-to-GDP ratio was much higher, Mozambique’s productivity of investment was lower, a result that highlights the need for setting investment priorities.

13. Chapter IV discusses the evolution of wages in Mozambique. Real wages rose sharply at the beginning of the stabilization program (1987–89) as inflation decelerated, then declined as inflation picked up in 1990–95. It is important to note, however, that the decline in real wages was never an objective of economic policy, but resulted instead from the failure to bring inflation down to the program targets, which, in turn, usually resulted from slippages in monetary or fiscal policies. The decline in real wages was more significant for agricultural workers than for industrial workers. In 1996, as inflationary pressure started to subside, an upward turn in real wages was observed.

14. Chapter V reviews the evolution of Mozambique’s external competitiveness in the last decade. The analysis shows that Mozambique’s competitiveness deteriorated sharply from 1980 to 1986, followed by a strong recovery through 1995. The main factors that accounted for this recovery were the liberalization of the exchange rate, the behavior of real wages, and the increased productivity, particularly in 1995, following the privatization process. The evidence on competitiveness in 1996 is mixed. Several factors accounted for this mixed picture, including the sharp devaluation of the South African rand, the stabilization of the metical, and a strong increase in exports.

15. Chapter VI evaluates present social conditions, analyses the evolution of budget expenditures on the social sectors, and describes the existing social safety nets. Available evidence indicates that gradual progress is being achieved in reducing poverty in Mozambique. However, the proportion of households living in absolute poverty could still be as high as 58 percent and social indicators remain substantially below averages for sub-Saharan Africa. The real per capita current budget expenditure on the social sectors has increased by 45 percent since 1987, broadly in line with real per capita GDP growth. This was achieved mainly through an increase in the share of social sector expenditures in the budget. Apart from emergency relief, the only government-financed social safety net of importance has been a cash transfer scheme for destitute urban households. A recent review of this social safety net indicates that, while this scheme has contributed significantly to alleviating the poverty of the households it reached, its targeting needs to be improved, and its administration strengthened, to avoid possible misappropriation of resources.