Kingdom of Lesotho: Selected Issues and Statistical Appendix

This Selected Issues paper on the Kingdom of Lesotho reviews the broad objectives and key institutional features of the Common Monetary Area (CMA) relating to currency arrangements. The CMA Agreement provides for the three small member countries to have access to South African capital and money markets, but only through prescribed investments or approved securities that can be held by financial institutions in South Africa. Lesotho’s exchange rate arrangement under the CMA shares certain characteristics of a currency board.

Abstract

This Selected Issues paper on the Kingdom of Lesotho reviews the broad objectives and key institutional features of the Common Monetary Area (CMA) relating to currency arrangements. The CMA Agreement provides for the three small member countries to have access to South African capital and money markets, but only through prescribed investments or approved securities that can be held by financial institutions in South Africa. Lesotho’s exchange rate arrangement under the CMA shares certain characteristics of a currency board.

II. Competitiveness and Export Performance in Lesotho9

A. Introduction and Background

1. This chapter assesses Lesotho’s external competitiveness. The country’s exports have risen spectacularly since the late 1990s, and, despite its small size, Lesotho has become Africa’s largest garment exporter. However, this achievement is at risk, and the present level of exports may not be sustainable. The next sections analyze four areas that are central to Lesotho’s competitiveness: (i) the trade preferences regime; (ii) exchange rate developments relative to main trading partners and competitors; (iii) wage costs and profitability; and (iv) non-wage costs and the investment climate compared with those of competitor countries. The chapter concludes with some recommendations for improving Lesotho’s competitiveness and its investment climate. In view of its importance (as well as data limitations), the chapter focuses on Lesotho’s garment industry, but its conclusions have a bearing on other sectors as well.

2. Lesotho’s export growth, driven mostly by garment exports to the United States, has been exceptional since the late 1990s (Figure II.1).10 Lesotho’s garment exports to the U.S. increased from US$100 million in 1998 to about US$450 million in 2004 (an average annual growth rate of more than 50 percent).11 Employment in the garment sector grew from 7,400 in 1991 to a peak of 50,000 in early 2004, and the garment industry became the largest employer in the country. This performance has been possible largely because of the duty- and quota-free access to the U.S. market that the African Growth and Opportunity Act (AGOA) has provided since 2000.

Figure II.1.
Figure II.1.

Evolution of Garment Exports to the United States, 1989–2005

Citation: IMF Staff Country Reports 2005, 438; 10.5089/9781451823837.002.A002

3. However, the current environment poses several challenges to Lesotho’s external competitiveness and, ultimately, to its ability to maintain or expand its exports. The loti has appreciated strongly since end-2001. External competitiveness has been compromised further by the erosion of trade preferences through the phasing out of textile quotas under the Uruguay Round Agreement on Textiles and Clothing (ATC) at the start of 2005, and approximately 10,000 workers have been laid off. At the structural level, Lesotho’s competitiveness is further compromised by the low labor productivity in the garment sector and an investment climate affected by serious bottlenecks in the provision of utilities and infrastructure, high security-related costs, and a relatively burdensome regulatory environment.

B. Trade Preferences

4. Trade preferences have constituted a key factor behind the development of Lesotho’s garment sector and strong export performance. Lesotho has maintained a garment sector since the early 1980s. But since 2000, sizable inward investments, in particular from Taiwan Province of China, have been reflected in large increases in production and exports. Lesotho’s garment exports have benefited, in particular, from AGOA’s “third party fabric provision” granted to least developed countries (LDCs). As an LDC, Lesotho is entitled to import inputs from nonmembers of AGO A without repercussions for its free access to the U.S. market. With relevant U.S. import tariffs at more than 15 percent, on average, and with foreign inputs accounting for at least 50 percent of total costs, value added in Lesotho is effectively protected at a rate of 30 percent or more.12

5. However, the erosion of Lesotho’s trade preferences poses a serious threat to the survival of its garment sector. Since textile quotas under the ATC ended at the beginning of 2005, exports by low-cost producers that are no longer quota-constrained, in particular China, have increased.13 Producers in Lesotho have reported a decline in garment prices of 10–15 percent. Indeed, in the first quarter of the year, unit values of U.S. garment imports from Lesotho fell by almost 12 percent in U.S. dollar terms. Further adverse shocks are likely over the coming years:

  • The “third party fabric provision” under AGOA is scheduled to be phased out in the fall of 2007. Maintaining tariff-free access to the U.S. market would then require sourcing fiber inputs from AGOA sources—which are generally more expensive than the current inputs, most of which originate in Asia.

  • The safeguards imposed by the United States in May 2005 on garment imports from China (renewable on an annual basis) will expire by mid-2008. These safeguards limit the annual growth of garment imports from China to 7.5 percent.

  • Multilateral tariff reduction of nonagricultural products under the Doha round is likely to gradually erode the significance of tariff-free market access.

C. Exchange Rate Developments

6. Lesotho’s external competitiveness is strongly influenced by its currency peg to the South African rand. In the context of the Common Monetary Area (CMA),14 the loti is pegged to the rand at par.

  • On the one hand, the monetary arrangement has precluded any exchange rate movement against Lesotho’s main trading partner, South Africa. Conditioned by this regime, domestic price movements in Lesotho have been largely similar to those in South Africa.

  • On the other hand, between end-2001 and end-2004, the strength of the rand combined with the general depreciation of the U.S. dollar, has led to a sizable appreciation of the loti relative to the dollar, by 51 percent in nominal terms and 57 percent in real terms (Figure II.2). Considered over a longer horizon, this appreciation has merely restored the exchange rate level that existed in 2000. During the first half of 2005, the loti weakened against the U.S.dollar by about 10 percent.

Figure II.2:
Figure II.2:

Exchange Rate (U.S dollar-loti), 1995–2005

(Index: 2000=100)

Citation: IMF Staff Country Reports 2005, 438; 10.5089/9781451823837.002.A002

Source: International Financial Statistics

7. The loti’s sharp rise vis-a-vis the U.S. dollar resulted in a 23 percent real effective appreciation from end-2001 to mid-2005. Indicators of nominal and real effective exchange rates provide a widely used initial snapshot of overall competitiveness.15 The evolution of the effective exchange rates is illustrated in Figure II.3, and is based on 2002 data on partner country weights that reflect each country’s relative share in Lesotho’s trade (imports plus exports).

Figure II.3:
Figure II.3:

Effective Exchange Rate, 1995–2005

(Index: 2000=100)

Citation: IMF Staff Country Reports 2005, 438; 10.5089/9781451823837.002.A002

8. However, Lesotho’s effective appreciation essentially stems from developments on the export side. In the case of Lesotho, adding up imports and exports creates a picture of effective exchange rates that is hard to interpret, given that the trade patterns on the import and export sides are very different. In 2002—the base year—74 percent of imports stemmed from South Africa and 21 percent from Asia (including inputs for the garment sector). Almost 77 percent of exports were destined for the U.S. market (virtually all garments) and 23 percent for South Africa. Therefore, a more meaningful analysis distinguishes between effective exchange rates (nominal and real) for the import side and for the export side (Figures II.4 and II.5).16 Although the effective exchange rates on the import side have remained relatively stable, those on the export side have mirrored the fluctuations in the loti-dollar rate.

Figure II.4:
Figure II.4:

Nominal Effective Exchange Rates, 1995–2005;

(Index: 2000=100)

Citation: IMF Staff Country Reports 2005, 438; 10.5089/9781451823837.002.A002

Source: International Financial Statistics
Figure II.5:
Figure II.5:

Real Effective Exchange Rates, 1995–2005;

(Index: 2000=100)

Citation: IMF Staff Country Reports 2005, 438; 10.5089/9781451823837.002.A002

9. Exchange rate appreciation has also been strong relative to other garment exporters to the U.S. During 2001-04, the Indian rupee appreciated by 7 percent in nominal terms, and the Kenya shilling depreciated by 2 percent (Figure II.6). During this period, the Chinese yuan was pegged to the U.S. dollar.

Figure II.6.
Figure II.6.

Nominal Exchange Rate, 2000-05

(Index: 2000=100, U.S dollar / national currency)

Citation: IMF Staff Country Reports 2005, 438; 10.5089/9781451823837.002.A002

Source: International Financial Statistics

D. Wage Costs and Firm Profitability

10. Given Lesotho’s dependence on garment sector exports, a closer look at export competitiveness should take into account developments in this sector concerning wages, prices and the relative costs of key competitors. The calculation of the effective exchange rate implicitly assumes that the partner countries’ overall price and exchange rate levels are the relevant standard for measuring Lesotho’s export competitiveness. However, a more in-depth assessment of Lesotho’s attractiveness as a location for—largely footloose—garment producers should also take account of other factors, which will be explored in some detail in this section:

  • First, the profitability of garment production in Lesotho depends on the domestic costs of production and on garment prices in Lesotho’s core market, the United States, rather than on CPI-based indicators.17 Lesotho’s fixed exchange rate heightens the importance of domestic cost control for maintaining competitiveness. In particular, wage costs are conditioned by countrywide minimum wages, which are set for each sector based on tripartite negotiations involving unions, enterprise representatives, and the government.

  • Second, with the recent elimination of import quotas, international competition in garments has increased. Accordingly, the comparative costs of production of Lesotho and its key competitors are crucial.

  • Finally, given that Lesotho depends on only a few very large U.S. importers, their sourcing strategy is of great importance. Indeed, given the market power of the U.S. buyers, Lesotho’s competitiveness in the garment sector may not be reflected clearly in its profitability, because lower costs or other advantages are captured in large part by the buyers—in the form of lower prices. The introduction of AGO A illustrates this phenomenon: the tariff preferences were barely reflected in higher fob export sales prices (see below); instead, the U.S. buyers largely captured the tariff rents in the form of lower cif import prices.18 However, the implied small increase in profitability supported the expansion of production capacity in Lesotho, and demand increased as U.S. buyers turned to the country.19

11. Garment sector wages have usually been found to be lower in Lesotho than in most competitor countries (Table 1). Wages in the garment sector, based on 2002 data, are below those in China and other major African garment exporters such as South Africa and Mauritius, and in line with most other Asian competitors.

Table II.1:

Garment sector wages for selected countries, 2002

article image
Source: USITC (2004); Cadot and Nasir (2001), USAID (2004).

Midrange of monthly wages as reported in USITC (US$ 80-US$ 100) and a 50-hour week as reported in USITC.

Estimated based on a US$155 monthly wage reported in USAID and a 45-hour work week.

Data for 2001 computed in Cadot and Nasir (2001).

Midrange between US$ 0.68-US$ 088 as reported in USITC.

12. Although labor costs are relatively low in Lesotho, so is labor productivity. The situation is particularly critical in the garment sector where very low productivity levels cause unit labor costs to be higher than in most competitor countries. Labor productivity in Lesotho’s manufacturing sector is more than 50 percent lower than in Kenya, India and China.20 These findings regarding labor productivity appear consistent with other studies that have used different methodologies. For instance, a value-chain analysis of a large T-shirt factory in Lesotho found that the average worker produced about 16 T-shirts a day, compared with between 20 and 25 in Kenya.21 As a result, garment manufacturers in Lesotho have reported unit-labor costs, defined as the share of wages in value added, as high as 75 percent, against 50 percent in Kenya and less than 30 percent in both India and China (Figure 7).

Figure II.7:
Figure II.7:

Unit-Labor Costs of Selected Garment Exporters, 2002

Citation: IMF Staff Country Reports 2005, 438; 10.5089/9781451823837.002.A002

Source: World Bank (2005)

13. Moreover, Lesotho’s wage competitiveness has been eroded with the appreciation of the loti. Wage costs, while declining in real terms, have increased in terms of U.S. dollars. Actual wages in the garment sector are reported to be very close to the applicable minimum wage. The minimum wage for trained employees has risen by more than 50 percent in local currency terms between 1998 and 2004, implying an 8 percent decline in real terms (Figure II.8). The annual increase appears to have been largely independent of the changes in the exchange rate. However, given the loti’s appreciation relative to the U.S. dollar, minimum wages have increased sharply in dollar terms since end-2001, and, by 2004 were about 30 percent above the 1998 level.

Figure II.8.
Figure II.8.

Monthly Wages, 1998–2004 1/

Citation: IMF Staff Country Reports 2005, 438; 10.5089/9781451823837.002.A002

Source: Lesotho authorities and Fund staff estimates.1/ Minimum wage for a trained weaver (1998–2003) or a trained manufacturing worker (2004).

14. Export prices in dollar terms (on a fob basis) have remained fairly constant since the mid-1990s (Figure II.9). The large U.S. importers set prices in terms of U.S. dollars. Accordingly, exchange rate changes are reflected in loti prices. Dollar-denominated unit values of Lesotho’s garment exports to the United States have not increased with domestic U.S. prices, did not go up with the introduction of AGOA in 2000, and fell by 2 percent in real terms between 1998 and 2004 (based on the U.S. CPI). This decline can be attributed largely to gradual trade liberalization (and, in fact, testifies to the benefits of liberalization for the United States).

Figure II.9.
Figure II.9.

Unit value of U.S. Garment Imports, 1995–2005

(Index, 2000 = 100)

Citation: IMF Staff Country Reports 2005, 438; 10.5089/9781451823837.002.A002

Source: U.S. Department of Commerce and Fund staff estimates

15. Reflecting these developments in garment prices, exchange rates, and wages, the profitability of garment production in Lesotho appears to have decreased significantly. Indicators of the profit of garment production in Lesotho are presented in Figure II.10. For the companies that were established shortly after the start of AGOA, profit margins, proxied by the ratio between unit prices and unit-labor costs, have declined continuously by more than 60 percent since 2002.

Figure II.10.
Figure II.10.

Garment Sector Estimated Profitability Developments, 1998–2004

Citation: IMF Staff Country Reports 2005, 438; 10.5089/9781451823837.002.A002

Source: Lesotho authorites, U.S. Department of Commerce and Fund staff estimates.1/ In U.S. dollars per square meter (Index: 2000=100).2/ Nominal Wages in U.S. dollars / Real value-added per worker in constant 2000 U.S. dollars (Index: 2000=100)3/ Unit Prices/Unit-Labor Costs (Index: 2000=100)

16. The above analysis of price and cost developments confirms that the Lesotho garment sector is at risk. A favorable exchange rate and the introduction of AGOA greatly improved the attractiveness of Lesotho as a location for garment production for the U.S. market after 2000. Although most of the tariff rents were captured by US importers, production remained sufficiently profitable. However, since 2002 profit margins have been eroded by the combined development of wage increases and—especially—exchange rate appreciation. The sectoral boom continued nonetheless, probably reflecting the lagged response to the strong demand by U.S. firms for Lesotho’s garments. Moreover, with the elimination of the import quota regime at the start of 2005, Lesotho’s low productivity in comparison with other producers has become a serious handicap.

E. Nonwage Costs and Investment Climate

17. Lesotho’s relatively low nominal wages seem to indicate that increased labor productivity and lower nonwage costs will have to be the main sources of improvements in competitiveness. This section compares Lesotho with other countries in sub-Saharan Africa and key competitors in Asia, based on preliminary results obtained in a recent World Bank Investment Climate Assessment (ICA) as well as reports from the authorities and representatives of garment companies obtained during the last two Article IV consultation missions.22,23 The focus will be on four areas identified as most problematic: (i) provision of utilities; (ii) transportation; (iii) security; and (iv) regulation and governance.

Utilities (energy, water)

18. Cost augmentations stemming from the poor delivery of utilities, rather than from the direct costs of the utilities, have been identified as one of the crucial factors undermining the competitiveness of Lesotho’s firms.

19. Although the cost of power is not high by international standards, output losses caused by power outages are higher than in most sub-Saharan countries. The median firm in Lesotho reported that energy and fuel costs were equal to about 2.5 percent of sales in 2002—lower than in any of the comparators in sub-Saharan Africa, except South Africa, but slightly higher than in India and considerably higher than in China (Table II.2). On the other hand, Lesotho has more frequent power outages than China and South Africa, with the resulting losses (as a percentage of sales) even higher than those observed in African countries with more frequent power outages, such as Senegal.

Table II.2.

Electricity Costs and Reliability

article image
Source: World Bank (2005).

20. Water supply is also considered inadequate. It represents a major capacity constraint for the garment sector and a critical element in investor decisions to deepen the local supply chain by introducing a knitted-fabric mill.24 The frequency of shortages has been a major source of concern of the garment sector. On top of that, it is estimated that between 30–40 percent of the water supply is lost through leakage.25 Lesotho’s prolonged drought has amplified the problem.

Transportation

21. Lesotho’s cost-competitiveness is also affected by bottlenecks in the Maseru railhead that connects Lesotho’s capital with the South African railroad system. The railhead has a single station that lacks adequate storage facilities and is operating at full capacity with only a single track suitable for loading and unloading. It takes up to 30 days to transport containers from the nearest sea port to Maseru and vice versa. Many firms opt for road transportation, which costs 75 percent more but takes only one day for the same journey.26 Improvements await an agreement between the South Africa rail service and Lesotho’s government.

Security

22. In the ICA, security was ranked as the most serious obstacle to enterprise operations and growth, with about 85 percent of manufacturing firms reporting security-related losses in 2004. Overall, such losses are estimated at about 4 percent of sales. These figures are much higher than in most comparator countries (Figure II.11).

Figure II.11.
Figure II.11.

Median Firm Losses due to Crime and Security Costs, 2004

(in percent of sales)

Citation: IMF Staff Country Reports 2005, 438; 10.5089/9781451823837.002.A002

Source: World Bank (2005).

Governance and regulation

23. Lesotho performed better than average for sub-Saharan Africa in most of the governance indicators27, and was particularly well ranked on corruption.28 Corruption and other governance drawbacks are usually perceived to be a direct outcome of a highly restrictive regulatory environment. On the basis of this favorable governance environment, Lesotho’s regulatory burden should thus be expected to be relatively modest, but cross-country comparisons of business surveys convey a different message. Managers reported spending about 22 percent of their time dealing with regulations and inspections, compared with less than 15 percent in Tanzania, Kenya, Senegal, South Africa, India, or Mozambique (see Figure II.12). Entry restrictions were also reported to be relatively higher in Lesotho resulting in a longer and costlier process to set up businesses.29

Figure II.12.
Figure II.12.

Regulatory Burden, 2004

(in percent of management time spent dealing with government regulation)

Citation: IMF Staff Country Reports 2005, 438; 10.5089/9781451823837.002.A002

Source: World Bank (2005).

24. Problems of land ownership and customs clearance are additional deterrents to investment. The Land Act of 1979 restricts foreign ownership of land. In lieu of ownership, foreign investors may lease land for a period of 30 years from the Lesotho National Development Corporation (LNDC). Given that the return on investment may require more than 30 years, the regulation creates a disincentive for investment (Public Private Infrastructure Advisory Facility, 2004).

25. Finally, enterprises that rely on expatriate staff and are heavily dependent on imported inputs, like the garment sector, face additional regulatory burdens. Obtaining a visa to enter Lesotho is relatively expensive and time consuming. Because it does not have extensive diplomatic missions, foreigners may need to travel to third countries to obtain a visa, as visas are not granted at ports of entry in Lesotho. The issuance of work permits is equally burdensome. Finally, import document clearance procedures are cumbersome, taking between 7 and 30 days.30

F. Conclusions

26. As the combined positive effects of a depreciated exchange rate and favorable trade preferences come to an end, and because the remaining trade preferences are likely to erode further over the coming years, Lesotho’s garment sector is at risk. Although the appreciation of the loti since 2001 seems to have played an important role in the sharp increase in wage costs and in the decline of firm profitability, Lesotho’s export performance has recently started to weaken, with the removal of ATC quotas.

27. To maintain a competitive garment sector, Lesotho needs to implement wide-ranging reforms to reduce unit labor costs and improve the country’s investment climate. Its main priorities should be to:

  • Train workers to help address the very low labor productivity.

  • Introduce wage flexibility, by taking into account productivity and terms of trade movements in the wage-setting process, and to restrain public sector wages to avoid spillover effects.

  • Improve the quality and reliability of utilities and infrastructure. These reforms, in turn, would also be essential for attracting a knitted-fabric mill, which would allow Lesotho garment producers to source inputs within the country, and thereby maintain tariff free access to the U.S. market after 2007.

  • Implementation of an action plan to improve the investment climate, with efforts to reduce the high security-related costs and streamline the relatively burdensome regulatory regime.

28. Effective implementation of the above measures would also improve the competitiveness of other sectors and lay a firm foundation for product and market diversification, which would reduce Lesotho’s vulnerability to external shocks. Although the rapid growth of the garment sector has brought Lesotho large benefits in the form of higher employment and income, the economy has become overly dependent on a footloose industry that is facing increasing global competition. Key to diversification will be efforts to strengthen the focus on regional markets (in particular, South Africa) and to promote agriculture and agroprocessing, diamond and sandstone mining, and tourism. In addition, diversification should also involve the garment sector itself, with a move toward higher-quality products and new markets.

References

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  • Kauffman, Daniel, Aart Kraay, and Massimo Mastruzzi, 2003, “Governance Matters III: Governance Indicators for 1996–2002,” World Bank Policy Research Report No. 3106 (Washington D.C., World Bank).

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  • World Bank, Africa Private Sector Group, 2005, “Lesotho: An Assessment of the Investment Climate,” (Washington D.C.: World Bank).

9

Prepared by Victor Lledo, Jan Kees Martijn and Jacob Gons.

10

Garment exports, of which more than 90 percent destined for the United States, constituted about 80 percent of total exports in 2003 and 2004.

11

Since 2002, nongarment manufacturing exports have actually declined.

12

Thus, for given foreign input costs, the cost of finishing garment products (the “cut, make, and trim” phase) could be at least 30 percent higher in Lesotho than in a country not receiving these preferences, at the same after-tariff import costs.

13

Under the ATC, which superseded the Multifiber Arrangement (MFA), these bilateral quotas were to be eliminated in four phases over the period 1995–2005 (1995–98; 1998–2002; 2002-04; and the beginning of 2005). The last ATC phase was expected to have the largest impact because it applied to products that were highly quota-constrained and that account for the bulk of Lesotho’s exports such as trousers and T-shirts. These are products in which China and other low-cost producer countries are expected to increase their market share following the quota removal.

14

See Chapter I, The Institutional Arrangement of the Common Monetary Area and Policy Implications for Lesotho.

15

The real effective exchange rates were calculated on the basis of Lesotho’s consumer price index (CPI). An alternative and more appropriate methodology, given the focus on cost competitiveness, would have been to use unit labor costs, but data limitations prevented this.

16

In theory, imports of garment sector inputs could be included as a negative item in the calculation of export weights (rather than as a positive item in the calculation of import weights) in order to derive an indicator of the effective exchange rate for net exports—as opposed to the current one, which relates to gross exports. However, data limitations precluded such a calculation.

17

Profitability per unit can be expressed as: π = (p$ - α * pi$) - E$/M * [w * (L/Q) + Cnw], where p$ and pi$ are the dollar-denominated output and input prices, α is the input coefficient (of imported fabric), E$/M is the U.S. dollar-loti exchange rate, w is the wage rate, L/Q represents the labor input share, and Cnw stands for the per unit nonwage costs. Because of data limitations, the analysis focuses mainly on output prices and wage costs.

18

For further analysis, see Olarreaga and Ozden (2005). Across Africa the average price increase for products benefiting from AGOA preferences was 6 percent, with U.S. buyers capturing the remaining 14 percent (given a 20 percent average tariff). The price increase was smaller for smaller countries (like Lesotho) and those with higher importer concentration.

19

Lesotho’s largest buyer, GAP, recently announced that it would continue sourcing from Lesotho, even if China were cheaper, in the context of the company’s membership in the Ethical Trading Initiative (The Independent (United Kingdom), May 18, 2005).

22

See World Bank (2005). Some of this report’s data may still be revised due its preliminary nature.

23

For a more detailed analysis of the performance and constraints of the garment sector, see Hossain (2004).

24

Without access to water, the dyeing, bleaching and washing cycles, which constitute the core of textile production, cannot be completed.

28

Evidence from business surveys conveys a similar message. Relative to China and most countries in the region, firms in Lesotho are less likely to report that bribes are needed to “get things done”, and that bribes are lower when they are needed (World Bank 2005).

29

It takes about 92 days and US$ 500 to set up a business in Lesotho. This is longer than observed in most comparator countries (India, China, Kenya, South Africa).

30

Export regulations are substantially less cumbersome. Generally, the private sector does not find the processing of export documentation, which takes less than a week, to be problematic.

Kingdom of Lesotho: Selected Issues and Statistical Appendix
Author: International Monetary Fund