Kingdom of Lesotho: Staff Report for the 2005 Article IV Consultation

The Kingdom of Lesotho’s 2005 Article IV Consultation reports that the government’s fiscal position and the external current account have improved markedly. The authorities are preparing an action plan, in collaboration with development partners, to improve the business climate. Critical measures aim to increase labor productivity through training, reduce domestic costs for the private sector by addressing infrastructure bottlenecks, remove regulatory and administrative impediments, improve access to financial services, and promote product and export market diversification.

Abstract

The Kingdom of Lesotho’s 2005 Article IV Consultation reports that the government’s fiscal position and the external current account have improved markedly. The authorities are preparing an action plan, in collaboration with development partners, to improve the business climate. Critical measures aim to increase labor productivity through training, reduce domestic costs for the private sector by addressing infrastructure bottlenecks, remove regulatory and administrative impediments, improve access to financial services, and promote product and export market diversification.

I. Introduction

1. Lesotho is a small, open, low-income economy with very close financial and commercial ties to South Africa. It is a member of the Southern African Customs Union (SACU) and the Common Monetary Area (CMA), and its currency—the loti—is pegged at par to the rand.1 There are no exchange controls between CMA countries. Trade among SACU countries is free of tariffs and duties. Trade with South Africa accounts for about two-thirds of Lesotho’s external trade, and foreign direct investment (stock) from South Africa is about one-fifth of Lesotho’s GDP. Lesotho’s banking system comprises four banks, three of them South African. Workers’ remittances from South Africa and receipts of Lesotho’s share of SACU revenue constitute a significant part of national income.

2. Lesotho enjoys a relatively stable political situation. Local government elections were held for the first time in April 2005, in which the ruling party won over three-fourths of the seats. It led to the establishment of 129 new councils to replace the Village Development Councils. The new councils function in accordance with the Local Government Act.

3. Lesotho has achieved moderate growth since the early 1990s. Growth was strongest during 1991–95, mainly reflecting the impact of substantial public investment in the Lesotho Highlands Water Project. During 1996–2000, growth weakened because of a political crisis and the adverse effects of exogenous shocks. Since 2000, garment exports to the United States, benefiting from preferences under the U.S. African Growth and Opportunity Act (AGOA), have become the main engine of growth. Nonetheless, overall real GDP growth has been driven primarily by factor accumulation (mainly of capital), with a minimal contribution from total factor productivity (TFP) growth. Per capita GDP in Lesotho was US$520 in 2004, and the HIV/AIDS prevalence rate was about 29 percent of the adult working population.

4. At the time of the recent ex-post assessment of Fund involvement in Lesotho and the previous Article IV consultation, Directors noted that Lesotho had made progress in achieving macroeconomic stability and implementing structural reforms during the last PRGF-supported program. The authorities reformed public expenditure management and the financial sector and privatized public enterprises. The introduction of the value-added tax (VAT) and the creation of the Lesotho Revenue Authority (LRA) helped to raise non-SACU revenue. In addition, Lesotho has participated in the Fund’s General Data Dissemination System (GDDS) since August 2003, and made progress in providing a broad range of statistics for program monitoring under the PRGF arrangement.

5. The authorities welcomed the Fund’s role in providing policy advice—through surveillance, program design, and technical assistance. However, they also stated that the policy advice would be more effective if the Fund were to focus more on identifying the beneficial linkages between macroeconomic policies and complementary microeconomic and structural reforms. The authorities requested that the Fund assist them in developing such an integrated policy package, through the timely provision of technical assistance and capacity building support.

II. Recent Economic Developments

6. Real GDP growth weakened to about 2 percent in 2004/05 from over 3 percent in the preceding two years, reflecting the adverse impact of external shocks on manufacturing and the ongoing drought on agricultural output (Text Table and Table 1). The slowdown in manufacturing reflected the appreciation of the real exchange rate since February 2002, uncertainty about Lesotho’s duty—free access to the U.S. market,2 and the elimination of textile quotas in January 2005. The effects of these shocks in the garment sector were particularly pronounced in the second half of 2004/05, resulting in factory closures and the loss of about 10,000 jobs (20 percent of jobs in the sector). Agricultural output has declined, as a result of a three-year drought and such long-standing structural weaknesses as poor farming techniques, soil erosion, lack of water in the lowlands, and a shortage of agro-financing. According to a 2005 government estimate, 500,000–741,000 people (about 23–34 percent of the population) need emergency food assistance.3

Text Table:

Sectoral breakdown of real GDP growth

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Source: Bureau of Statistics, Central Bank and Fund Staff estimates
Table 1.

Lesotho: Selected Economic and Financial Indicators, 2002/03–2009/10 1/

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Sources: Lesotho authorities; and Fund staff estimates and projections.

Fiscal year beginning in April.

In U.S. dollars.

Based on partner-country data, new trade weights from 2004. A minus sign indicates depreciation.

Change in percent of broad money at the beginning of the period.

Credit to the rest of the economy affected by a write-off of bad loans in 2002/03.

The average effective rate on three-month treasury bills.

The appreciation of the loti had a significant effect on the debt-to-GDP ratio in 2003/04.

In percent of exports of goods and services.

7. The loti has appreciated substantially since early 2002, contributing to a decline in consumer price inflation (CPI). Relative to the U.S. dollar, the loti’s nominal appreciation reached 40 percent over the three years to end-March 2005 (Appendix Figure 1). In the second quarter of 2005, however, the loti depreciated by about 7 percent, owing in part to the lowering of interest rates by the South African Reserve Bank. In real effective terms, the appreciation during the three-year period ending June 2005 amounted to 30 percent. In line with trends in South Africa, the CPI-based annual inflation rate declined from 7.7 percent at end-March 2003 to 3.7 percent ending March 2005, notwithstanding increases in oil import prices.

Appendix Figure 1.
Appendix Figure 1.

Lesotho: Macroeconomic Indicators

Citation: IMF Staff Country Reports 2005, 437; 10.5089/9781451823820.002.A001

Source: Lesotho authorities and Fund staff estimates.

8. Lesotho has a high unemployment rate (about 30 percent)4 partly because of downward wage rigidity and upward wage pressure. There is a minimum wage, and wage increases are determined through tripartite negotiations between the government (represented by the Ministry of Labor), the unions, and representatives of the private sector. In an environment of tense labor relations, productivity has remained low and wage costs have drifted up since the mid-1990s.

9. In the past two fiscal years, the overall fiscal balance (including grants) has turned from a deficit into a surplus (Table 2). The large fiscal surplus of 9.1 percent of GDP in 2004/05 reflected mainly temporary factors, particularly a 6.1 percentage points of GDP5 windfall increase in SACU receipts due to the revision of the 2002 import data6. Domestic (non-SACU) revenue collection has improved since the launch of the LRA, although outturns in the last fiscal year were affected by the slowdown in economic activity. Current expenditures, particularly salaries and wages, were lower than projected because the new local government administration did not take off during the fiscal year as envisaged.

Figure 1.
Figure 1.

Lesotho: Fiscal Balance and Revenues, 2000/01–2004/05

(In percent of GDP)

Citation: IMF Staff Country Reports 2005, 437; 10.5089/9781451823820.002.A001

Sources: Lesotho authorities and Fund staff estimates
Table 2.

Lesotho: Central Government Operations, 2002/03–2009/10 1/

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Sources: Ministry of Finance; and Fund staff estimates and projections.

Fiscal year from April to March.

In 2005/06, M430 million in one-off windfall revenue was added to the trend SACU revenue

The budget is on a cash basis. In 2004/05, net revenue was underrecorded in the authorities’ fiscal accounts by M470.1 million. The amount has been added to the overall balance to match Central Bank of Lesotho data (the domestic financing requirement)

Domestic balance excludes grants, foreign-financed capital spending, foreign interest payments, and exceptional factors.

10. Monetary developments in Lesotho have mirrored those in South Africa. The discount rate has held steady since August 2004; market yields on treasury bills have moved downward, influenced by the fall in the government borrowing equirement; and by end-March 2005 the interest rate spread relative South Africa had narrowed to less than 40 basis points. Banks’ financial soundness indicators remain strong (Table 4). Recently, two new banks started operations, one of which is the Post Bank set up by the government with a focus at this stage on mobilizing savings in rural areas. Draft anti-money-laundering legislation is expected to be presented to parliament by end-2005. The authorities have also begun implementing the recommendations of the stage-one safeguards assessment of 20017.

Figure 2.
Figure 2.

Lesotho: Interest Rate Spread with South Africa, 2000/01 - 2004/05

(In percent)

Citation: IMF Staff Country Reports 2005, 437; 10.5089/9781451823820.002.A001

Sources: Lesotho authorities and Fund staff estimates
Table 3.

Lesotho: Monetary Survey, 2002 - 2006

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Sources: Central Bank of Lesotho; and Fund staff estimates and projections.
Table 4.

Lesotho: Commercial Banks’ Quarterly Performance Ratios, 2004 - 2005

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Source: Central Bank of Lesotho.

In 2005, affected by the operations of two new banks.

11. Lesotho’s external current account deficit has narrowed significantly and net international reserves increased during 2003/04 and 2004/05 (Table 5). Exports were boosted by strong volume growth in the garment sector, especially during the first half of the year, as a foreign-funded denim mill started operations, and by the mid-2004 reopening of a diamond mine. SACU receipts rose sharply in 2004/05, while remittances from South Africa also grew strongly despite ongoing layoffs8, owing to increases in the wages of miners working there. These positive effects more than offset the adverse impact of a worsening of the terms of trade, which, since 2001, has been exacerbated by the real appreciation of the rand vis-à-vis the U.S. dollar.9

Figure 3.
Figure 3.

Lesotho: Foreign Trade and Grants (in millions of US dollars), 2000/01 - 2004/05

Citation: IMF Staff Country Reports 2005, 437; 10.5089/9781451823820.002.A001

Sources: Lesotho authorities and Fund staff estimates
Table 5.

Lesotho: Balance of Payments, 2002/03 - 2009/10 1/

(In millions of U.S. dollars)

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Sources: Central Bank of Lesotho (CBL); and Fund staff estimates and projections.

Financial year is April-March.

Lesotho Highlands Water Project.

Direct investment has been revised downwards owing to reclassification of some flows in the financial account.

3/ Lesotho Highlands Development Authority.

Transaction based data, a minus sign indicates an increase in reserves.

12. Lesotho’s debt indicators have improved markedly over the past two years (Table 1). With the strengthening of the country’s fiscal position, the government reduced its domestic debt and the stock of treasury bills fell from 17 percent of GDP in 2002/03 to 8 percent in 2004/05. Lesotho’s external public debt as a share of GDP declined from 83 percent of GDP at end-March 2003 to 53 percent in 2005, largely because of the exchange rate appreciation. In net present value terms, the stock has fallen below 40 percent of GDP.

13. The authorities have strengthened their efforts to tackle poverty and HIV/AIDS They have prepared a poverty reduction strategy, which identifies reforms that are important if Lesotho is to make progress toward the MDGs. The government has begun aligning its budget with the strategy, paying particular attention to strengthening institutional and implementation capacity, so that it can avail itself more quickly of funding, including from donors, in the fight against poverty and the HIV/AIDS pandemic10.

14. To promote private sector development, the authorities, with support from the World Bank, organized a private sector development forum in April 2005. In line with plans under preparation, several laws and business procedures will be reviewed and simplified, products and markets will be diversified, physical infrastructure will be developed, and workers’ skills will be strengthened.

III. Policy Discussions

A. Outlook, Future Challenges, and Strategy

15. Lesotho is vulnerable to a range of potentially permanent adverse developments over the medium term: the eventual elimination of the new restraints on textile imports in the United States and other industrialized countries, the expected removal of the AGOA provision allowing the use of third-country fabrics in 2007, the forecast decline in SACU tariff revenues as a result of trade liberalization, and the likelihood of further decreases in inward remittances as Basotho workers continue to be retrenched from South Africa’s mining sector. Even more worrisome is the likely impact of HIV/AIDS. The high infection rate could, over time, contribute to higher mortality rates, a loss of productivity and real income, mounting fiscal pressures, and deeper social and humanitarian distress.

16. The near-term economic outlook has also been affected by the cumulative impact of several shocks, including the erosion of trade preferences and the real effective appreciation of the exchange rate. Despite the recent weakening of the loti vis-à-vis the U.S. dollar, garment exporters expected their export earnings to stagnate or decline as export prices came under downward pressure from low-cost producers in Asia. In the agricultural sector, although drought conditions have recently eased somewhat in the highlands, the authorities expected farm output to remain depressed because of the structural weaknesses noted earlier. On the upside, diamond exports are projected to rise further with the opening of two more mines, supported by foreign investment. On balance, GDP is forecast to decline in 2005/06 by about ¾ of 1 percent, the average annual inflation is expected to be somewhat higher, and the external current account deficit is projected to widen.

17. The authorities agreed that the principal challenge facing Lesotho is to generate more rapid and broad-based economic growth. To this end, policies need to (i) address the immediate trade shocks, (ii) consolidate the gains in macroeconomic stability achieved so far, and (iii) promote private sector development and foreign investment. Given Lesotho’s narrow export base, characterized by heavy dependence on a few textile products, the authorities shared the staff’s view that a strong export diversification strategy could be helpful in both generating higher growth and reducing the country’s vulnerability to exogenous shocks.

18. While recognizing the urgent need to restore external competitiveness, the authorities plan to maintain the exchange rate parity, given the benefits of the CMA and Lesotho’s close trade and financial ties to South Africa.11 They noted that the currency peg and the circulation of the rand as legal tender facilitated commercial ties with neighboring countries. For these reasons, they plan to rely on structural reforms to strengthen competitiveness. In view of this, and as a backdrop to the policy discussions, the staff explored two alternative medium-term scenarios with the authorities. The first one illustrated the shortcomings of a policy package with no acceleration of structural reforms and a weakening of the fiscal balance (baseline scenario); the second one showed the benefits of policies that aimed to improve competitiveness and the business climate through accelerated structural reforms and consolidation of macroeconomic stability.

19. Under the baseline scenario for 2005/06–2007/8, real GDP growth remains weak because the dampening effect of the trade shock on growth is only partially offset by increases in nongarment manufacturing and diamond mining (Table 6). With the implementation of the PRSP, this scenario assumes that public investment and implementation capacity improve beginning in 2005/06 and that private investment remains at about 24 percent of GDP. Taking into account the impact of HIV/AIDS, and assuming some improvement in the marginal output-capital ratio, annual real GDP growth is projected to pick up to about 2 percent a year over the medium term. The fiscal surplus (including grants) is projected to decline in 2005/06 and switch to a deficit in subsequent years. The fiscal weakening reflects both a downward trend in revenues (after 2005/06) and a sharp rise in total expenditures in 2005/06 followed by gradual reductions (relative to GDP) in subsequent years. The revenue decline is due to the anticipated drop in SACU receipts precipitated by trade liberalization, which lowers import duties. The expenditure pressures stem mainly from increases in current outlays on goods and services and transfers and subsidies, and in domestically funded capital outlays in 2005/06. Reflecting these developments and the adverse impact of the shocks mentioned above, the external current account deficit (excluding official transfers) is expected to widen sharply in 2005/06 and deteriorate further in subsequent years. Reserve coverage is projected to fall from 4.5 months of imports in 2004/05 to 3.1 months by 2010.

Figure 4.
Figure 4.

Medium-Term Scenarios, 2004/05 - 2009/10

Citation: IMF Staff Country Reports 2005, 437; 10.5089/9781451823820.002.A001

Sources: Lesotho authorities and Fund staff estimates
Table 6.

Lesotho Medium-Term Scenarios, 2004/05–2009/10

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Sources: Lesotho authorities; and Fund staff estimates and projections.

The budget is on a cash basis. In 2004/05, net revenue was underrecorded in the authorities’ fiscal accounts by M 470.1 million. The amount has been added to the overall balance to match Central Bank of Lesotho data (the domestic financing requirement)

Domestic balance excludes grants, foreign-financed capital spending, foreign interest payments, and exceptional factors.

The reform scenario assumes the implementation of structural reform policies.

20. Given the importance of continuing prudent debt management, the staff prepared, jointly with the World Bank staff, a Debt Sustainability Analysis (DSA) and discussed its implications with the authorities. The baseline assumptions include an annual net external borrowing equivalent to about 2 percent of GDP, and a gradual pick-up in the real growth rate (reaching 4.5 percent after 2012/13).12 Under this scenario, Lesotho’s external debt drops well below the debt-burden thresholds applicable to low-income countries with a policy and institutional environment of median quality, as measured by the World Bank’s CPIA rating (Appendix IV). It thus appears to be sustainable, although severe adverse shocks to the garment sector could alter this assessment. A reversal of the large exchange rate appreciation of the past few years could also substantially raise the debt-to-GDP ratio.

Figure 5.