Cape Verde: Staff Report for the 2005 Article IV Consultation, Sixth Review Under the Poverty Reduction and Growth Facility, and Request for Waiver of Performance Criterion

The staff report for the 2005 Article IV Consultation for Cape Verde focuses on economic developments and fiscal policy. The fiscal deficit was lower than expected, and reserve accumulation exceeded the programmed level. Cape Verde appears well positioned to attract increasing external support, and there is also scope to mobilize greater domestic resources. In this regard, improvements in tax administration and rationalization of exemptions would enhance improvements to the revenue base that have come about with the new VAT.


The staff report for the 2005 Article IV Consultation for Cape Verde focuses on economic developments and fiscal policy. The fiscal deficit was lower than expected, and reserve accumulation exceeded the programmed level. Cape Verde appears well positioned to attract increasing external support, and there is also scope to mobilize greater domestic resources. In this regard, improvements in tax administration and rationalization of exemptions would enhance improvements to the revenue base that have come about with the new VAT.

I. Recent Economic Developments

1. Cape Verde faced severe macroeconomic imbalances in the wake of the 2000 parliamentary elections. The fiscal deficit including grants reached 20 percent of GDP in 2000 (and 27 percent of GDP excluding grants); the government had accumulated external and domestic arrears; international capital flows, including donor support, fell sharply; and international reserves declined to about one month of import coverage. While the exchange rate peg to the euro was maintained, despite this loss of reserves, the sustainability of the peg and of economic performance more generally was at risk.

2. After an initially inadequate response, macroeconomic policies have improved significantly from 2001 to the present. In particular, the marked strengthening of the fiscal position over this period has supported a buildup in international reserves together with reductions in external and domestic debt as a share of GDP. Since 2002, the current PRGF arrangement has added further support to the authorities’ efforts to pursue disciplined economic policies. In particular, program ownership and policymaking capacity have strengthened, as reflected in the timely and satisfactory completion of all program reviews so far. The lynchpin of the economic strategy under the PRGF arrangement has been the recognition that disorder of public finances and debt overhang fundamentally constrained policies and required a multiyear fiscal consolidation.1 This has been achieved principally by strengthening tax collection, including through the introduction of the VAT in 2004, and streamlining the externally financed public investment program (PIP). Monetary policy has focused on strengthening the sustainability of the exchange rate peg by building reserves and ensuring that inflation remained low, hence helping to foster an environment conducive to increased private investment, inflows of remittances, and accumulation of emigrant deposits.

3. In key areas, economic outcomes have been better than envisaged when the PRGF-supported program began. The discussion in subsequent sections covers the period from 2002 to 2004, with particular attention given to the most recent developments as part of this final review of the PRGF arrangement. In this regard, program performance remained strong in 2004: all end-year quantitative performance criteria were met with a substantial margin, as were most structural objectives (see Tables 9 and 10).

A. Growth and Inflation

4. Real GDP has grown at a robust pace over recent years (see Table A), supported by strong public and private investment. Reflecting this development and Cape Verde’s overall move toward middle income status, economic activity is dominated by secondary and tertiary activities. For example, the GDP shares of such sectors as energy, construction, commerce, and transport and communication have grown substantially since 2002. The primary sector, in contrast, accounts for only around 8 percent of GDP, although a much higher share of employment. Growth of GDP per capita in Cape Verde, around 3 percent on average over 1999–2002, is among the highest in the group of small island economies in Africa, the Pacific, and the Caribbean shown in Table B. As discussed in the recently released PRSP, this growth has supported poverty reduction and improvements in other human development indicators. In this regard, Cape Verde’s development indicators are generally comparable to and, in some cases, better than those of the other economies shown in Table B, and substantially stronger than the average for sub-Saharan Africa.

Table A.

Cape Verde: Selected Economic Indicators, 2000-04

(Annual percentage change unless indicated otherwise)

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Sources: Cape Verde authorities; and staff estimates.
Table B.

Human Development Indicators for Cape Verde and Comparator Countries, 1999–2002

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Sources: UN Human Development Report, 2004; and IMF.

Rank out of 177 countries

Percent ages 15 and above.

Combined gross enrollment ratio for primary, secondary, and tertiary schools (percent).

Antigua and Barbuda, Dominica, Grenada, St. Kitts and Nevis, St. Lucia, and St. Vincent and Grenadines.

5. In 2004, growth remained strong at an estimated 4.5 percent, although this was somewhat slower than in previous years. Activity was supported by the continuing strength of the construction sector, including private investment in tourism facilities and public investment in infrastructure. Agricultural production, however, was adversely affected by lower than average precipitation and a locust infestation in some areas. In addition, the implementation of public investment projects was somewhat lower than expected, a result in part of changes in budget administration (see below).

6. Consumer inflation has been consistently below 2 percent a year since 2002, underpinned by the firm monetary policy and the exchange rate peg to the euro. Prices fell 1.9 percent in the year to December 2004, with lower food, beverage, and clothing prices helping to offset the impact of higher prices of oil imports. A key reason for the deflation in 2004 appears to have been the reductions in customs tariffs at the beginning of the year, which have allowed importers to draw on cheaper and more diversified sources of supplies. However, the current consumer price index (CPI), which uses a 1989 basket, may not provide a fully accurate representation of actual inflation. This problem should be rectified later this year with the expected release of the new CPI methodology, including an updated basket. Current indications are that, while the revised methodology would not lead to a major change in overall inflation trends, the extent of deflation in 2004 could be somewhat reduced because of the lower weight on food (whose prices have been falling) in the new basket.

B. Fiscal Policy

7. Substantial fiscal consolidation has been achieved over recent years. From a fiscal deficit (including grants) of 20 percent of GDP in 2000, the deficit was reduced to under 5 percent of GDP in 2001 and has averaged 2.5 percent of GDP over 2002-04. Progress in strengthening fiscal institutions has supported this consolidation effort, with the multiyear fiscal framework of the program under the PRGF arrangement helping to improve tax administration and expenditure planning. Tax revenue performance has improved significantly over this period, rising by over 2 percent of GDP since 2000 and backed by comprehensive tax reform. The new VAT was successfully implemented in January 2004, replacing a multiplicity of specific consumption taxes and thereby leading to a more efficient and broader-based tax regime. Recent reforms have also streamlined and rationalized taxes on imports, accompanied by a general reduction of customs duties and excises.

8. Public expenditure policy has concentrated on containing total expenditures as a share of GDP, along with improving the composition of spending. A key development has been the substantial reduction in transfers and subsidies since 2001 (see the text figure), notably subsidies to large public enterprises. This trend has allowed more resources to be committed to education, health, and other priority areas identified in the government’s poverty reduction strategy, as indicated by the rise in the public sector wage bill. Public capital spending has been sustained at around 10 to 12 percent of GDP over recent years, largely reflecting the availability of and drawings from foreign financing.

9. In 2004, the fiscal deficit including grants fell to 1.5 percent of GDP, much smaller than had been projected. There were two main reasons for the fall of expenditures as a share of GDP. The wage bill grew less than expected, mainly because of difficulties in hiring teachers in rural areas. The execution rate of public investment was also lower than anticipated, in part due to teething problems in the application of new administrative procedures to support the move of some donor assistance from project to budget support. In addition, public sector wages were firmly contained, as were expenditures on goods and services. As reflected in variations in the stock of arrears, the government has made progress, first, in acknowledging domestic arrears incurred in earlier years, and then in clearing these arrears. It also made a lump sum payment to Electra to cover outstanding obligations arising from public sector consumption of electricity and water.

10. The 2005 budget maintains a prudent fiscal stance, with the primary recurrent surplus expected to reach 3.7 percent of GDP. Domestic revenues (including domestic capital participation and net lending) are expected to stabilize at about 21.7 percent of GDP, with growth of VAT revenues reflecting efficiency gains in administration. Processing of VAT refunds is running behind schedule, however, mainly because of weaknesses in administration and control systems. The staff has taken a cautious approach in its revenue projections for 2005, partly due to uncertainties about how quickly revenues from the new VAT will grow. The projections also allow for the fact that some other consumption tax revenues collected in 2004 will not recur.3 Recurrent spending, notably the wage bill, continues to be restrained, although the budget provides for a small increase in transfers to those whose employment and incomes may be affected by the restructuring of public enterprises. With total expenditures projected to remain stable at the 2004 level, the fiscal deficit (including grants) would be around 2.8 percent of GDP. All external financing would be on concessional terms and recourse to domestic bank financing would be limited, in support of the monetary program targets and the accumulation of reserves.4 Furthermore, the budget incorporates the clearance of arrears to oil companies and to the social security fund.

C. Monetary and External Developments

11. Monetary policy has remained consistent with sustained low inflation and the accumulation of international reserves throughout the PRGF arrangement. Broad money and credit to the economy grew by around 11 to 12 percent on average over 2002-04, supporting the overall increase in economic activity. Responding to the strong balance of payments position and low inflation rate, the Bank of Cape Verde (BCV) lowered the required reserve ratio from 19 to 18 percent in December 2004, and reduced the standing lending facility rate from 8.5 to 7.5 percent in February 2005. Following these developments, and facing high levels of excess liquidity, commercial banks have reduced lending rates by 1 percent. Banks have also pushed ahead with efforts to differentiate lending rates across clients to better reflect credit risks.

12. The external current account deficit has narrowed substantially over recent years, falling from over 11 percent of GDP in 2002 to about 6 percent of GDP in 2004. While the latter outturn partly reflects the mild slowdown in growth in 2004, other factors—including improving revenues from tourism, sustained remittance flows, and the more diversified import sources noted earlier—have also supported the favorable external performance of the economy. International reserve accumulation of the BCV exceeded the program floor in 2004, with gross official reserves standing at Euro 102 million (2.6 months of imports) at the end of the year. The appreciation of the euro (and hence Cape Verde escudo) against the dollar does not appear to have damaged Cape Verde’s external competitiveness, reflecting the country’s relatively strong links to Europe with respect to trade, tourism, and remittance flows. The real effective exchange rate has been depreciating since early 2003, mainly on account of low domestic inflation.5 As discussed below, however, Cape Verde’s narrow export base continues to be a key source of vulnerability and, in their discussions with the authorities, the staff emphasized the need for further structural reforms to improve competitiveness and hence support export diversification.

D. Financial Sector Developments

13. The highly concentrated banking sector continues to dominate financial intermediation. Although there are four commercial banks, the two largest banks shared 89 percent of total assets and total deposits at end-2004, with the larger of these two (Banco Comercial de Atlântico) having a share of over 65 percent of assets and deposits. One of the small commercial banks (Banco Totta de Cabo Verde), which has had a high share of nonperforming loans in total loans and a negative return on equity for a number of years, has recently been acquired by a group of private domestic investors, becoming the first domestically owned private bank.

14. While financial markets remain shallow, financial soundness indicators suggest that the banking system is strengthening. As discussed in the accompanying Selected Issues Paper on the Cape Verde financial system, these improvements have been supported by stronger banking regulation and supervision, and by the stable macroeconomic environment. In aggregate, banks are highly profitable and liquid, with the ratio of nonperforming loans to total loans (7.2 percent at end-2004) gradually decreasing. Commercial banks fully comply with prudential regulations. However, potential concerns of the BCV include the high concentration of credit, the duopolistic behavior of the two largest banks in setting interest rates, and weak risk assessment capacity in the commercial banking sector. As discussed below, the authorities have emphasized the need to develop alternative sources of financing, including through leasing companies, and are considering policy measures that could support such development.6

Table C.

Cape Verde: Financial Soundness Indicators, 2001-04

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Source: Bank of Cape Verde.

Provisional data.

E. Structural Developments

15. Important progress has been made with structural reforms in the course of the PRGF arrangement (see Box 1). In addition to measures to strengthen the implementation of fiscal and monetary policies, a major focus of structural reform has been to regularize the public sector’s relationship with large state-owned and/or public service enterprises. Key steps have included:

  • Eliminating direct budget subsidies to TACV (the national airline) and Electra.

  • Preparing the remaining enterprises on the government’s privatization agenda for sale, for tender under concession contracts, or for liquidation (see Box 2). While there have been delays in some areas, this program is moving ahead and is expected to be largely completed over 2005-06.

  • Implementation of an automatic mechanism to adjust fuel prices in response to changes in import prices of oil products, and development of a price adjustment mechanism for electricity and water. The former is now operational, but an end-December 2004 performance criterion for published the latter mechanism was missed. The authorities have requested a waiver for noncompliance with this performance criterion (see Appendix II), which the staff supports. In their request, the authorities note that the process of developing the mechanism is well advanced: the underlying economic and financial model of Electra is now completed, and a consultant is to translate this model into the desired price adjustment mechanism. The economic regulatory agency expects to publish the mechanism by end-June, 2005.

16. The long-standing difficulties between the government and Electra still appear some way from settlement, however.7 In particular, Electra’s private shareholders and the government still need to reach agreement on the amount of the so-called “tariff deficit” to the company, which stems from the nonadjustment of electricity and water tariffs during 2000-02. An encouraging step toward settlement is a recent agreement, reached with World Bank support, to appoint an independent mediator to help resolve the wide differences between the parties concerned. Resolving this dispute is vital to reduce fiscal risks arising in this area, to support Electra’s recapitalization, and to enable the company to expand its electricity and water capacities to meet growth of demand. Urgent action is required, as electricity blackouts and water cutoffs are increasing in areas where supply capacities have not kept pace with the growth of demand. A further concern is that some municipalities are running significant arrears to Electra, a problem compounded by the fact that most municipalities, while autonomous, do not appear to have budget resources to meet their growing consumption. Also important is the implementation of the price adjustment mechanism for electricity and water noted above, which would help prevent a recurrence of the current difficulties and put Electra on a more sustainable financial footing.

Overview of Structural Conditionality Under the PRGF

Structural conditionality set out when the PRGF arrangement was requested in March 2002 aimed at deepening fiscal consolidation, strengthening monetary policy, improving the efficiency of the tax and tariff structures, building external debt-management capacities, and implementing a pricing mechanism for oil products.

During the course of the arrangement, additional conditionality was introduced—mainly aimed at improving the efficiency of the fiscal structure and the regulation of public services. It included (i) setting up the regulatory framework and creation of associated agencies; (ii) eliminating budgetary subsidies to the national airline (TACV) and water and electricity company (Electra); (iii) approving an automatic and transparent mechanism for adjusting electricity and water tariffs; (iv) calculating the government’s liabilities to Electra; (v) assessing the cost of tax exemptions and incentives, with some reduction in these included in the 2005 budget; and (vi) strengthening VAT collection.

Compliance with structural conditionality has been commendable, with only two waivers requested throughout the arrangement. The first covered the pricing mechanism for oil products, which was successfully introduced after the first review with only a few months delay. The second waiver, requested in this review, involves the approval of an automatic and transparent pricing mechanism for electricity and water. As the arrangement comes to an end, only two structural benchmarks are yet to be concluded: the introduction of new rules for tax collections through commercial banks, which is significantly advanced; and the conclusion of an assessment of the government’s financial liabilities to Electra. As noted in the main text, this issue is still some way from resolution although, with the support of the World Bank, progress is expected through the appointment of an independent mediator.

Structural Areas covered by World Bank lending and conditionality

Other structural areas, notably including the privatization agenda and the completion of a public expenditure review, have been mostly pursued as part of World Bank lending facilities operating under successive Country Assistance Strategies (CAS). Assistance was also provided in such areas as macroeconomic management and debt reduction, private sector development, human resource development, and poverty reduction. Most projects have been rated satisfactory or better; during 2004, however, projects in the areas of Privatization and Regulatory Capacity Building, Energy and Water, and Social Sector Development were rated unsatisfactory. Except for the Energy and Water Project, which was extended for two additional years, the other areas demonstrated significant turnaround through the end of 2004, and were expected to finally meet their goals. The current CAS, approved in February 2005, is aligned with the PRSP and is based on three pillars: ensuring macroeconomic stability, supporting private-sector-led growth, and alleviating poverty.

The Privatization Agenda

A cornerstone of the authorities’ economic strategy to support private-sector-led growth and diversification has been to improve efficiency in the provision of key services. This goal has helped motivate the privatization program, which has seen large numbers of state-owned enterprises either liquidated or sold since the early 1990s—driving the number down from approximately 40 to just 6 by end-2004 (plus minority shareholdings in a few other enterprises). Results have not always been as successful as had been hoped, largely due to inadequate regulatory frameworks at the time of privatization. With a gradual strengthening of the regulatory environment now under way, however, the government is pushing forward with the remaining agenda. This covers the following companies.

  • Arca Verde, the interisland maritime transport company, is in the process of being liquidated, with final decisions regarding disposal of remaining vessels, including sales and leases, expected within 2005.

  • TACV, the freight and passenger air service, is to be restructured and then privatized. This process is behind schedule, however. The appointment of new management charged with restructuring the company has been held up due to procurement issues raised by the World Bank in the awarding of the management contract. Solving this problem could take up to a year, with privatization to take place afterwards.

  • CABNAVE, the shipyard is technically bankrupt. Options are being explored to avoid liquidation.

  • Interbase, the fishing storage company, is expected to be transferred to a consortium of Spanish and Cape Verdean interests during the first semester of the year. The contract would include investment undertakings to meet health standards for exporting to the European Union.

  • ENAPOR, the port authority, would see concession contracts covering operations of port facilities transferred to the private sector. A technical study on privatization options is almost finished, and the privatization process is expected to be concluded by early 2006.

  • EMPROFAC, in charge of imports and distribution of pharmaceuticals, has already started the privatization process. The government will decide on the privatization strategy when a technical report on transfer options is completed, and the process is expected to conclude within 2005.

II. Report on the Discussions

17. In addition to assessing recent economic developments as part of the final review of the PRGF arrangement, the staff held discussions with the authorities on a range of economic and policy issues in the context of the Article IV consultations. The focus was on medium-term economic prospects, including potential vulnerabilities surrounding the outlook, and the accompanying stance of fiscal, monetary, external, and structural policies to reduce risks and support ongoing growth and development. Attention was also given to the authorities’ views on the overall results of the PRGF arrangement which is about to end, including lessons that could be applied to a successor arrangement. Finally, the staff assessed the quality of statistics and prospects for improvements in this area.

A. Economic Outlook

18. The staff shares the authorities’ view that the medium-term outlook for Cape Verde is promising and that GDP growth of 6 to 7 percent over 2005-08, as envisaged in the PRSP, appears achievable. Underpinning this baseline scenario would be continued pursuit of sound macroeconomic policies—directed in particular at expenditure restraint, debt reduction, and exchange rate stability—and ongoing implementation of structural reforms. Growth is projected to be led by private investment in the tourism sector and, in support of this development, public investment in infrastructure. While the former would increase the capacity of the country to absorb the expected increase in tourist numbers, the latter would allow for improved and cheaper communications by land, sea, and air. In addition to supporting tourism growth, this public investment would also facilitate the diversification of the economy and development of other export-oriented activities. For example, the anticipated improvements in international air links and expansion of port capacities, combined with the strategic geographic location of the islands, point to the potential for Cape Verde to increase its service exports in the shipping and airline sectors.

Table D.

Cape Verde: Key Projections, 2005-08

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Sources: Cape Verde authorities; and staff estimates.

Excluding official transfers.

Including grants.

19. Supporting this favorable outlook for growth, Cape Verde’s relatively strong policy record and high institutional quality have enabled it to continue attracting substantial inflows of private investment and official grants and loans. Significant support, starting in 2005, is expected from the Millennium Challenge Account, and commitments from other bilateral donors, including the European Union and Portugal, have also increased. As discussed in one of the Selected Issues papers, inflows of remittances and deposits from the Cape Verde diaspora also appear robust.

20. Notwithstanding this bright outlook, Cape Verde faces a number of challenges in the way of sustaining a strong pace of economic growth over the longer term. As a small island economy with a relatively narrow export base, Cape Verde is vulnerable to a range of external and domestic shocks. For example, growth prospects appear to hinge on further development of tourism services—a sector that is susceptible to changes in the global security situation, to economic conditions in Europe, and to international oil prices. In addition, this sector faces a relatively high cost structure compared with other tourism destinations, reflecting in part Cape Verde’s high import requirements for food and energy, and high internal and external transportation costs. Cape Verde also remains heavily dependent on foreign support from loans, grants, and remittances to support domestic investment and the balance of payments position.

21. The staff noted that, while some sources of vulnerability would be unavoidable, maintaining sound macroeconomic policies and pushing ahead with market-oriented structural reforms would offer Cape Verde the best prospect for securing ongoing growth and development. Economic and regulatory policies that supported improvements in the flexibility and competitiveness of the economy would enhance its capacity to adjust to shocks. The staff also pointed out that the authorities should maintain their efforts to attract increased foreign private investment and improve the mobilization of domestic resources (see below). In addition, external vulnerabilities would be reduced through ongoing efforts directed at trade liberalization and export diversification. In this regard, the staff emphasized to the authorities the importance of moving rapidly toward complying with the requirements for WTO membership within Cape Verde’s current opportunity for accession as a low-income country.

B. Fiscal Policy

22. In assessing the medium-term fiscal outlook, the staff urged the authorities to maintain the prudent policy stance that has been in place over recent years. The staff noted in particular the substantial increase in commitments of external grants and debt financing covering the next few years and, associated with that, the strong outlook for public investment spending. In addition, implementation of the PRSP may lead to increased pressures on current spending. The mission emphasized the need for expenditure growth to remain consistent with macroeconomic stability and with debt sustainability. In this context, the staff‘s current medium-term fiscal framework maintains a clear surplus in the primary recurrent domestic balance and a small deficit (around 1 percent of GDP or less) in the overall primary balance including grants. With the support of measures to increase domestic revenues (see below), the staff believes that this fiscal stance would allow a modest increase in spending on PRSP priorities, while helping ensure that aggregate demand and public debt remain at manageable levels. The debt sustainability analysis discussed below and in Appendix I elaborates these points and also takes into account the possibility that Cape Verde’s access to highly concessional financing may at some point diminish as the country’s income level rises.

23. The projected growth of real GDP should generate substantial increases in direct and indirect tax revenues, and there is also scope for mobilizing domestic resources by improving tax administration and reining in tax exemptions. Recent technical assistance from the Fiscal Affairs Department (FAD) has recommended some urgent measures to improve VAT administration, including in the checking and timeliness of data entries, together with broader measures to strengthen the monitoring and collection of tax payments. Furthermore, the mission strongly supported the objectives recently set out by the Minister of Finance to rationalize tax exemptions through a number of constitutional and legislative reforms (see Box 3).8

Fiscal Incentives and Exemptions

While recent reforms has strengthened Cape Verde’s tax system, a key challenge ahead is to revise the outdated system of incentives and exemptions. 1/ Tax incentives in Cape Verde are complex, pervasive, and generous. In particular:

  • they are covered by scattered and outdated legislation;

  • multiple agencies and departments are involved in their administration;

  • they have a high cost in terms of revenue loss. Revenue forgone from import duties and income taxes alone is estimated at 27 percent of total tax revenue between 1997 and 2003 (see the table);

  • revenue losses are volatile and difficult to predict, given the absence of an upper limit on the value of benefits.

The authorities are committed to rationalizing tax incentives, emphasizing the principles of exceptionality, stability, predictability, and moderation. As a first step, they have indicated their support for a single law on exemptions. Furthermore, with an amendment to the constitution, granting incentives and exemptions would be brought under the same legislative process as used to reform taxes, rather than taking effect through use of decrees. They have also indicated their intention to rationalize exemptions to import duties, eliminating exemptions on consumption goods and keeping only those on capital goods.

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1/A technical assistance mission from the Fiscal Affairs Department visited Praia in November 2004 to evaluate the fiscal cost of incentives and advise authorities on their rationalization.

24. On the expenditure side, the staff recognized that implementation of the PRSP would continue to put upward pressure on some areas of personnel spending—including increased hiring in education, health care, and security. To contain spending growth, including on the public wage bill, and ensure that the recurrent domestic balance remained in surplus, the staff urged the authorities to strengthen prioritization of PRSP-related spending and to continue to restrain nonpriority spending.

25. The staff‘s assessment of public financing conditions and prospects has been supported by a full debt sustainability analysis (DSA) on external and total public debt (see Appendix I). The staff’s simulations suggest that under long-term economic scenarios that are in line with or more cautious than recent historical averages, Cape Verde’s debt would appear to be sustainable. Nevertheless, the staff emphasizes that, in view of its vulnerabilities to shocks as noted above, Cape Verde should maintain a prudent approach to borrowing together with consolidation of fiscal reforms to improve domestic resource mobilization. The staff also supports the authorities’ request for technical assistance from the Fund to improve the management of external public debt.

C. Monetary and Exchange Rate Policies

26. Key support for macroeconomic stability has come from the maintenance of sound monetary and exchange rate policies. The staff agreed with the authorities that, in the context of the fixed exchange rate peg to the euro, monetary policy should continue to be directed toward price stability and the accumulation of international reserves. With the latter, the staff concurred that the benchmark of around 3 months of import cover would be an appropriate medium-term objective, and noted that, given the country’s vulnerabilities, increases beyond that level could be sought over the longer term. Furthermore, the staff supported the authorities’ assessment that there was no compelling need to consider a change the current exchange rate regime. The peg has served Cape Verde well, anchoring the overall macroeconomic framework and contributing to a stable economic environment for inflows of remittances and emigrant deposits. In view of the economic and policy progress that has been made under the current exchange rate arrangement, moving to a more flexible regime would not appear warranted. The alternative of hardening the peg—for example, though a currency board or euroization—could well be kept under consideration as a longer-term policy option. However, moving in this direction would require the financial and technical support of Cape Verde’s international partners, and would best be considered in the context of broader growth of economic integration with the euro area. The staff also noted that, to reduce risks arising under the fixed exchange rate, attention would need to be paid to improving productivity and competitiveness in the economy, including through real wage restraint.

27. The staff observed that financial intermediation remained relatively shallow, making it difficult for the BCV to manage banking system liquidity. With a view to improving monetary management, the staff supported the authorities’ intentions to explore means of deepening financial markets through introducing new indirect monetary policy instruments and through the revival of secondary markets and the stock exchange. These improvements would help to reduce the costs of financing, supporting further increases in credit to the economy. The staff also agreed with the authorities that there is a growing need to develop the nonbanking financial sector—such as credit institutions and leasing companies—to promote competition in financial services, lower lending rates, and foster credit growth to the private sector.

28. The BCV has made progress in building its capacities for management and supervision. In particular, the mission supported the BCV’s ongoing plans to improve liquidity and reserve management,9 and to strengthen banking and financial sector supervision. In addition, the mission welcomed the BCV’s commitment to adopt international Financial Reporting Standards and supported its request for technical assistance from the Fund for this reform.

D. External Sector Policies

29. Cape Verde has a liberal trade regime, recently enhanced by the introduction of simplified and lower customs tariffs in early 2004.10 Tariffs are still above international standards, however, and the government has indicated it would consider further reforms over the next few years. Cape Verde does not have substantial nontariff barriers to trade. Recent trade policies have focused on diversification of exports to developed countries through improving the quality of export-oriented production. This would allow Cape Verde to make use of existing initiatives with the EU and the US (under AGO A). As noted earlier, however, there have been some slippages in current negotiations for WTO membership, and the staff emphasized the need for clear progress on this front. The authorities’ efforts to provide a supportive climate for tourism growth and trade diversification should be boosted by the plans to open international airports in at least three islands, which would decrease transportation costs and ease capacity constraints in inter-island connections.

E. Structural Policies and PRSP Implementation

30. Discussions on structural policies focused on measures to improve conditions for private-sector-led growth and to reduce poverty. The staff supported the authorities’ efforts to complete their privatization agenda; as discussed earlier, this should see a number of large and strategically important public enterprises, including the national airline and the port operator, transferred to private ownership or management over the next two years. While acknowledging the complexities of the Electra issue, the staff emphasized that a full and equitable settlement of the dispute between the government and the majority shareholders was essential to restore Electra to sustainable financial health and enable it to invest in additional capacity to meet demand growth.

31. As illustrated by the difficulties that have followed Electra’s privatization, such reforms need to be backed by an adequate regulatory framework. The recent creation of several new regulatory agencies should strengthen capacities in this regard. The main tasks of the regulatory agencies are monitoring privatization contracts and the associated provision of public services. The staff emphasized the need to ensure that the legal framework for these agencies guarantees the regulators’ financial and legal autonomy. The staff also noted that some remaining functional overlaps among these agencies’ responsibilities had to be addressed, specialized human capital developed, and the overall regulatory culture strengthened.

32. Following approval of the PRSP in September 2004, the authorities have focused on developing the institutions needed to implement, monitor, and evaluate the strategy. In accordance with the institutional framework envisaged in the PRSP, the authorities have drafted a bill to create the National Council for Poverty Reduction and the Technical Secretariat. The bill is expected to be approved in the first half of 2005. The strong mobilization of external resources projected for 2005 and subsequent years will also support implementation of the strategy.

33. A draft new labor code is in its final stages of preparation, following extensive discussions at the level of government, employers, and employees. After some delays in 2004, a proposal is to be submitted to the National Assembly in the second quarter of 2005. The code would unify and update the dispersed labor legislation currently in place and provide a stronger framework for enforcing labor regulations. This would represent an important step forward, especially given the apparently high degree of informality in labor contracts at present, and reported tensions between some groups of workers on formal contracts and some on informal contracts.

F. Perspectives on the Current PRGF Arrangement and on a Successor Arrangement

34. The Cape Verde authorities assessed positively the cooperation with the Fund under the current PRGF arrangement. They emphasized that the country’s performance under the program was substantially better than they anticipated in 2002. For example, GDP growth, the reduction of external debt, and the buildup of international reserves have all been much stronger than expected.11 They commented favorably on the following:

  • The authorities have found the policy dialogue with the Fund to be useful and productive. In particular, close cooperation with the Fund has helped them to view macroeconomic policies within a consistent framework and promoted associated discussions among key policymakers.

  • The Fund’s role in building policymaking and technical capacities has also been important, including through technical assistance from FAD and other departments.

  • Program conditionality has provided an important discipline on policy direction and incentive for reform efforts. For example, the program ceiling on nonconcessional debt has supported the authorities’ efforts to prioritize capital spending.

35. The authorities recognized that a challenging structural reform agenda remains in front of them to support growth and development. Drawing on the positive results from the first PRGF arrangement, the authorities have requested the staff to commence negotiations on a successor program under the PRGF; it would be a low-access arrangement. The staff agrees that such an arrangement would appear appropriate: while Cape Verde does not face a large balance of payments need, as a small island economy it will continue to be exposed to the range of vulnerabilities noted earlier. In this context, close engagement with the Fund would provide guidance for policy implementation, help address potential risks, and signal to donors and creditors the authorities’ intentions to maintain policies directed at macroeconomic stability and structural reforms.

G. Statistical Issues

36. Cape Verde’s statistical system remains weak, although significant improvements are underway. The mission urged the National Statistics Institute (INE) to push forward with revamping the national accounts statistics in order to implement the 1993 System of National Accounts (SNA), with technical assistance from AFRISTAT. The Statistics Department is also supporting this reform, which would include a substantial improvement in source data collection programs, and has scheduled technical assistance [for 2005]. A significant commitment will be required of INE to coordinate this assistance and implement the resulting recommendations. INE is expected to release final GDP numbers for 2002-03 in May 2005. With assistance from the National Statistics Institute of Portugal, INE is now completing a new consumer price index, based on an updated commodity basket, and this is to become operational by end-2005. Fund technical assistance is also scheduled on this matter. Finally, in collaboration with the Employment Institute, labor market surveys would be undertaken twice a year, starting from the second half of 2005. The staff recommended that INE receive the funding necessary to ensure that it collects the relevant information and generates accurate and reliable data in a timely manner.

37. These weaknesses and reform plans notwithstanding, there have been improvements in the compilation and dissemination of statistics. The authorities are committed to use the GDSS as a framework for the development of statistical system. Furthermore, the BCV publishes a wide variety of monetary, external, real sector, and fiscal data on the worldwide web, and has strengthened its balance of payments statistics with technical assistance from the Fund.

III. Staff Appraisal

38. Cape Verde’s economic and policy performance remains strong. Economic growth has been robust over recent years, contributing to a decline in absolute poverty. Moreover, with the backing of continued prudent macroeconomic policies and further structural reforms, the medium-term economic outlook is positive. Key driving forces for growth are coming from private investment in tourism facilities and public investment in infrastructure, financed through increasing levels of external support. Inflation has recently been negative, a result in part of tariff reforms in early 2004. With the support of the fixed exchange rate peg, inflation is expected to remain low in the years ahead.

39. Economic policymaking has strengthened under the current three-year PRGF arrangement. As reflected in the decline in public debt, fiscal performance and debt sustainability has improved substantially. Key reforms have occurred in the tax system, notably the introduction of the VAT. To draw the full potential from these reforms, the authorities need to maintain their efforts to strengthen tax administration and push forward with plans to rationalize tax incentives. Pressures to grant additional exemptions, including from import tariffs, should be resisted. Expenditure performance and administration have strengthened, with recurrent spending contained and increasingly focused on social priorities set out in the PRSP. These improvements will receive further backing from the planned introduction of a full medium-term expenditure framework.

40. A further key element behind Cape Verde’s macroeconomic stability has been the firm monetary policy of the Bank of Cape Verde (BCV). In particular, the credibility and robustness of the exchange rate peg has grown, both supported by and contributing to sustained price stability and accumulation of international reserves. The fixed exchange rate regime remains appropriate, providing a major anchor for macroeconomic policies and contributing to a stable environment for inflows of remittances and emigrant deposits.

41. Financial soundness indicators do not indicate any imminent banking sector vulnerabilities. Nevertheless, the BCV must be prepared to act quickly should pressures emerge. Important steps to help ward off such pressures include the further strengthening of banking supervision, introduction of new indirect monetary policy instruments, and improvements in the effectiveness of banking and other financial intermediation services.

42. Helped by the tariff reforms in early 2004, Cape Verde has a liberal trade regime. There have been some slippages, however, in the current negotiations for WTO membership, and rapid progress is needed on this front within the current window of opportunity for accession.

43. The momentum of structural reforms needs to be maintained. A key goal for 2005-06 should be to complete the restructuring and privatization of the remaining enterprises on the government’s reform agenda. These efforts need to be backed by the ongoing development of a sound and efficient regulatory framework, including through the authorities’ plans to create specialized regulatory agencies. Also essential is settlement of the long-standing dispute between the government and the majority shareholders of Electra. In addition to reducing fiscal risks, such a settlement is urgently required to restore Electra to financial health and enable it to meet growing demands for electricity and water.

44. While Cape Verde’s data quality has been generally adequate for program monitoring, statistical systems remain weak. The staff urges the authorities to make full use of the technical assistance that is underway or planned, in order to strengthen national accounts data and implement the new methodology for measuring consumer prices.

45. The staff agrees with the authorities that the results achieved under the current PRGF arrangement, which ends in July, have exceeded initial expectations. Noting the government’s interest in a successor arrangement with the Fund, the staff shares the authorities’ assessment that the arrangement best suited to their needs would be a low-access PRGF. A mission to negotiate a new program under this arrangement is scheduled for June 2005.

46. The staff recommends completion of the sixth review under the PRGF arrangement. The staff also supports the authorities’ request for a waiver for nonobservance of an end-December 2004 structural performance criterion relating to the publication of an automatic mechanism to adjust electricity and water tariffs. Preparation of this mechanism has taken longer than the staff and the authorities originally envisaged, mainly as a result of capacity constraints faced by the newly established economic regulatory agency. However, the authorities have taken corrective actions to address these constraints—notably the appointment of consultants to complete the underlying economic model and to translate this into the tariff adjustment mechanism by the new target date of end-June, 2005. It is recommended that the next Article IV consultation with Cape Verde be held in accordance with the July 2002 decision on consultation cycles. The authorities have consented to publish this Article IV staff report and related documents.

Figure 1.
Figure 1.

Cape Verde: Selected Economic Indicators, 1995–2004

Citation: IMF Staff Country Reports 2005, 320; 10.5089/9781451956153.002.A001

Sources: Cape Verdean authorities; and Fund staff estimates and projections.
Figure 2.
Figure 2.

Cape Verde: Real and Nominal Effective Exchange Rates, January 1995-December 2004

(Index, July 1998 = 100, unless otherwise indicated)

Citation: IMF Staff Country Reports 2005, 320; 10.5089/9781451956153.002.A001

Source: International Monetary Fund, Information Notice System (INS).1/ Prior to January 1999, based on the Portuguese escudo multiplied by the December 1998 euro-escudo conversion rate.
Figure 3.
Figure 3.

Cape Verde: Monetary Indicators, January 2000-November 2004

(In percent, unless otherwise indicated)

Citation: IMF Staff Country Reports 2005, 320; 10.5089/9781451956153.002.A001

Sources: Bank of Cape Verde; IMF, International Financial Statistics; and Fund staff estimates.
Table 1.

Cape Verde: Selected Economic and Financial Indicators, 2002-08

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Sources: Cape Verdean authorities; and staff estimates and projections.

As contained in the January 14, 2005 staff report (IMF Country Report No. 05/46).

Exports and imports of goods and nonfactor services.

Including verified stock of domestic and external arrears.

Projection numbers include financing gap.

Excluding the claims on the offshore Trust Fund.

Table 2.

Cape Verde: Annual Fiscal Operations of the Central Government, 2002-05

(In billions of escudos)

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Sources: Ministry of Finance and Planning; Bank of Cape Verde; and staff estimates and projections.

As contained in the January 14, 2005 staff report (IMF Country Report No. 05/46). Pensions in the program are classified as transfers, while in the budget and projections are classified as wages.

2003 includes exceptional revenues of CVEsc 455 million from old tax debt that were used to clear arrears of the same amount with a domestic oil company.

“Overall balance, including grants” = revenue including grants - total expenditure.

“Domestic expenditure” = total expenditure - external interest - foreign financed capital expenditure - capital expenditure financed by domestic capital participatio

“Domestic balance” = domestic revenue - domestic expenditure.

“Primary domestic balance”= domestic revenue - domestic expenditure + domestic interest payments.

“Primary recurrent domestic balance”= domestic revenue - primary current expenditure.

“Overall balance, excluding grants” = revenue excluding grants - total expenditure.

Excluding external interest payments, and including financing gap.

2005 includes tax and nontax arrears to the BCA and construction companies.

Table 3.

Cape Verde: Monetary Survey, 2002-05

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Sources: Bank of Cape Verde; and staff estimates and projections.
Table 4.

Cape Verde: Balance of Payments, 2002-05

(In millions of Cape Verde escudos, unless otherwise indicated)

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As contained in the January 14, 2005 staff report (IMF Country Report No. 05/46).

In percent of GDP.