Cape Verde: 2006 Article IV Consultation and Request for a Three-Year Policy Support Instrument—Staff Report; Staff Statement; Public Information Notice and Press Release on the Executive Board Discussion; and Statement by the Executive Director for Cape Verde

Cape Verde’s economic and policy performance remains sound under the Poverty Reduction and Growth Facility (PRGF) arrangement supported by Policy Support Instrument (PSI). Executive Directors commended the prudent macroeconomic policies and structural reforms. They emphasized the need for strengthening economic management through building capacity in fiscal management and policy formulation. They advised that particular attention should be given to improving the public sector and regulatory reforms, and strengthening the regulatory framework for the energy and financial sectors.


Cape Verde’s economic and policy performance remains sound under the Poverty Reduction and Growth Facility (PRGF) arrangement supported by Policy Support Instrument (PSI). Executive Directors commended the prudent macroeconomic policies and structural reforms. They emphasized the need for strengthening economic management through building capacity in fiscal management and policy formulation. They advised that particular attention should be given to improving the public sector and regulatory reforms, and strengthening the regulatory framework for the energy and financial sectors.

I. Introduction

1. The cornerstones of Cape Verde’s economic strategy are sustained macroeconomic stability and structural reforms in support of private sector-led growth. Reforms pursued under the Poverty Reduction and Growth Facility (PRGF) arrangement that ended last year focused on fiscal consolidation. Public spending was restrained and revenue collection improved to correct the severe macroeconomic imbalances that had emerged in 2000–01. With the strengthening of the fiscal position since 2001, Cape Verde has built up its international reserves and grown in policy credibility. As a result, Cape Verde has experienced sizable inflows of external finance for investment and development, solid growth averaging around 5 percent since 2001, low inflation, and a reduction in poverty. Cape Verde was one of the first countries to receive support from the Millennium Challenge Account (MCA) in 2005 and is eligible for further MCA support under a new category created for lower middle income countries.1

2. To underpin and signal its commitment to sound economic policies, the government has requested a three-year Policy Support Instrument (PSI). The authorities note that macroeconomic stability has been achieved; IMF financial resources are not needed; but the government wants to stay in close dialogue with the Fund as it continues to strengthen the country’s economic and policy performance. The government also points out that Cape Verde continues to face large development challenges. Despite recent progress, unemployment and poverty are still high; and because the country consists of many small islands, improving infrastructure, public services, and other aspects of sustainable growth and poverty reduction is inherently slow and costly. To address these and other challenges, Cape Verde will continue to rely heavily on external support.

3. The program to be supported by the PSI would provide a coherent economic policy framework for the government’s medium-term development objectives. In particular—as outlined in the attached Memorandum of Economic and Financial Policies (MEFP)—the program is designed to enhance the sustainability of growth and development by maintaining a stable macroeconomic environment and moving forward with structural reforms. Specific attention is given to reducing fiscal risks and giving Cape Verde a margin of safety to protect the economy against exogenous shocks. The macroeconomic framework would also help prepare Cape Verde for the prospect that—as GDP per capita continues to rise—the country’s access to highly concessional external finance may fall.

II. Recent Developments

4. The Cape Verde economy continues to perform well, although it is now experiencing with a lag the impact of higher international oil prices. Growth is estimated to have picked up to nearly 6 percent in 2005, supported by increased private investment—mainly for tourism-related construction—and a higher execution rate of public investment. Prices fell for much of 2003–05 but have recently increased sharply: the CPI rose by 7.4 percent in the year to May 2006, mainly reflecting higher food prices—driven by temporary shortfalls in the supply of fish, fresh fruits and vegetables, and imported sugar—and increases in regulated petroleum prices. Excluding these factors, the CPI increased by only 0.6 percent (Figure 1). The CPI is expected to increase further after the June 2006 adjustment of electricity and water tariffs (see below). In the year to April 2006, the real effective exchange rate depreciated by 0.1 percent, primarily due to changes in the euro-dollar exchange rate (Figure 2).

Figure 1.
Figure 1.

Cape Verde: CPI Inflation Rates, 2003–06

(Percentage change from the same period of the previous year)

Citation: IMF Staff Country Reports 2006, 334; 10.5089/9781451809435.002.A001

Sources: Cape Verdean authorities, and staff estimates.
Figure 2.
Figure 2.

Cape Verde: Exchange Rates, 1999–2006

(Index, 2000 = 100)

Citation: IMF Staff Country Reports 2006, 334; 10.5089/9781451809435.002.A001

Sources: International Financial Statistics, and Information Notice System.

5. In a marked break from the past, the authorities maintained a prudent fiscal stance through the recent election cycle (Figure 3). Notwithstanding strong domestic revenues and prudent spending, however, the fiscal deficit reached 5.1 percent of GDP in 2005, mainly reflecting an increase in the provision of concessional external loans and a delay in the disbursement of budget grants. Still, sales of government financial and nonfinancial assets enabled net domestic borrowing, excluding for arrears clearance, to decline to −0.2 percent of GDP. As a result, domestic debt (including arrears, but net of deposits) fell slightly although, at around 33 percent of GDP at end-2005, it was still close to the level before the domestic debt reduction operation in the late 1990s. While exceptionally low interest rates have contained domestic interest payments, other spending components are beginning to create fiscal pressures. In particular, the government wage bill has continued to increase, recently because of promotions and hiring of security personnel and teachers toward the end of 2005.

Figure 3.
Figure 3.

Cape Verde: Selected Macroeconomic Indicators, 1995–2005

(Percent of GDP, unless otherwise indicated)

Citation: IMF Staff Country Reports 2006, 334; 10.5089/9781451809435.002.A001

Sources: Cape Verdean authorities, and staff calculations.1 Including domestic arrears and excluding government deposits.

6. The external current account deficit fell from over 14 percent of GDP in 2004 to 4.6 percent in 2005. Growth in exports and remittances was stronger, and a broader market base has allowed importers to draw on cheaper and more diversified sources of supplies. As a result, exports of goods and services grew by 20 percent from 2004 to 2005, while imports grew by only 0.5 percent in nominal terms. Reflecting the improvements in the current account, international reserves rose from 2.4 months of prospective imports in 2004 to 3.0 months in December 2005.

7. The excess reserves of commercial banks have increased significantly because of strong net foreign exchange inflows, a lower reserve requirement,2 and a slowdown in the growth of private sector credit in the first part of 2005 (Figure 4). Against this backdrop, Treasury bill rates declined sharply from 5.0 percent in April 2005 to 2.0 percent in April 2006; this is significantly below deposit rates. Actual lending rates have also markedly declined. Concerned about the potentially adverse effect on their deposit base, and emigrant deposits in particular, banks have only marginally lowered deposit rates. They have reacted to growth of excess liquidity by sharply increasing their holdings of foreign assets and pursuing domestic lending opportunities more aggressively, particularly consumer lending. The Bank of Cape Verde (BCV) has started to sell central bank securities to partially absorb excess liquidity.

8. Financial services have continued to develop. There has been rapid growth in the offshore financial sector, which now comprises five operating banks (several others are licensed but not yet operational). The payment system has been modernized with the creation of a network of automatic cash counters and expansion of international credit card services; and the Cape Verde stock exchange has been revitalized. Total banking sector assets have grown by 20 percent since end-2004 to reach over 90 percent of nominal GDP; growth is heavily concentrated in lending to the real estate and construction sectors. Emigrant deposits continue to play a critical role, accounting for over 40 percent of total deposits. Because of tightened interest spreads and excess liquidity, the profitability of domestic commercial banks suffered significantly in 2005, although prudential indicators remain sound (see Table 6).

9. Structural reforms are moving forward. The government has selected a new management team to restructure the national airline TACV in preparation for privatization; bidding is getting under way for privatizing the port operator, ENAPOR; and the remaining four companies on the government’s privatization agenda are expected to be either liquidated or sold later in 2006. Following the 2003 Country Financial Accountability Assessment (CFAA), the authorities have completed a detailed action plan to build capacity in public finance management, have established a civil servants database, and are preparing to reform the number, allocation, and remuneration of civil servants. They are also pursuing a wide range of measures related to Cape Verde’s accession to the WTO—expected to be voted on by WTO members in July 2006—including a proposal to further reduce external tariffs.

Figure 4.
Figure 4.

Cape Verde: Selected Monetary Indicators, 2000–06

(Millions of escudos, unless otherwise specified)

Citation: IMF Staff Country Reports 2006, 334; 10.5089/9781451809435.002.A001

Sources: Bank of Cape Verde, and staff calculations.

10. Steps have been taken to clear the backlog of government accounts. Draft accounts for 1998–2003 have been submitted to parliament for transmittal to the Court of Auditors (TdC), and provisional quarterly accounts for 2004 and 2005 have been submitted to parliament. Despite this progress, concerns remain about capacity constraints in the TdC and the Inspectorate General of Finance, and about large statistical discrepancies in the provisional quarterly accounts. Actions to address these concerns are part of the government’s new program.

11. An action plan has been prepared to settle public cross-debt. A recent study found total net central government debt to the municipalities, the social security fund (INPS), and public and parapublic enterprises of CVEsc 5.9 billion. The government has agreed to settle CVEsc 4.8 billion (equivalent to 5.5 percent of GDP) of this; the rest is disputed.

12. There has been progress in addressing the lingering conflict between the government and the majority private shareholders of Electra (see Box 1). After the government decided to eliminate fuel subsidies—including those for electricity and water generation (by desalinization)—starting June 1, 2006, water tariffs were increased by 13.3 percent and electricity tariffs by 25.4 percent at the end of May. The autonomous economic regulatory authority (ARE) has signaled its commitment to fully implement an automatic mechanism for adjusting these tariffs to ensure that electricity and water prices reflect input cost changes and provide incentives for efficiency improvements.

Update on Electra

The government and Electra’s private majority shareholders reached agreement in June 2005 on the tariff deficit that the government owed to Electra because electricity and water tariffs were not adjusted in 2000–02.1 The settlement of US$10 million is being paid to Electra in five equal annual installments starting in 2006. Additional outstanding government liabilities to Electra of about US$5 million comprise:

  • US$2.5 million for unpaid electricity and water bills of central government, parastatals, and other public entities

  • US$2.5 million for VAT refunds and revenue losses following the introduction of the VAT. Electra was required to pay VAT without any adjustment to the tariff structure.

The June 2005 agreement also addressed the recapitalization of Electra. The government has recently paid its share in this recapitalization, amounting to US$3 million.

Municipalities have built up considerable arrears with Electra for their consumption of electricity and water, a result of weaknesses in financial discipline and their small revenue base. Not including their share in the recapitalization of the company, which amounts to US$1 million, municipalities’ debt to Electra is believed to be around US$3 million. The central government is urging municipalities to clear their arrears and, as noted in the MEFP, is taking steps to ensure they remain current in electricity and water payments.


For further details, see the Staff Report for the Fifth Review of the PRGF Arrangement (, Box 1.

III. Accomplishments Under the PRGF Arrangement

13. When Cape Verde’s first PRGF-supported program was put in place, the country was facing severe macroeconomic imbalances in the wake of the 2001 elections. Since then, economic and policy performance has been strong. The overall results under the program were considerably better than anticipated and the country has been receptive to the Fund’s policy advice. Solid growth, supported by strong official and private capital inflows, has significantly alleviated poverty since the early 1990s. As a result, Cape Verde is about to graduate to middle-income status3 and is on target to reach most of the Millennium Development Goals (MDGs) before 2015—including the target of cutting poverty in half. Reaching the MDGs in areas such as health, education, and sanitation will, however, place major pressures on public spending to strengthen infrastructure and the volume and quality of services.

14. The lynchpin of the economic strategy under the PRGF arrangement was the recognition that disorder in public finances and debt overhang fundamentally constrained policies and required a multiyear fiscal consolidation. The strengthening of the fiscal position since 2001 has supported a substantial buildup in international reserves. Improved policy credibility has helped attract increased private investment, sizable inflows of official aid and remittances, and emigrant deposits.

15. Important progress has also been made with structural reforms. A major focus has been on regularizing the public sector’s relationship with large state-owned and public service enterprises to reduce fiscal risks and improve the efficiency of services. From forty a decade ago, only six enterprises remain on the government’s privatization agenda, which should be completed in 2006–07.

IV. Policy Discussions: Setting the Stage for the PSI

16. As backdrop for discussions on a PSI, the 2006 Article IV consultation considered the key challenges that will shape the economic and policy environment in the years ahead. These challenges include:

  • accelerating growth and reducing poverty, while consolidating macroeconomic stability;

  • safeguarding the exchange rate regime;

  • managing fiscal pressures and risks through, e.g., creation of fiscal space against future contingencies and reduction of central government debt; and

  • strengthening public sector management, notably by improving capacities for financial management and pushing ahead with comprehensive civil service reform.

The government’s strategy for tackling these challenges is set out in its Poverty Reduction Strategy Paper (PRSP) and the recent PRSP Progress Report.4 The main elements of this strategy are summarized below and then brought together in the discussion of the specific objectives and criteria of the PSI program.

IMF-World Bank Structural Conditionality

The IMF and World Bank cooperate closely on Cape Verde’s structural reform program. Program design and the conditionality of the Bank and Fund are fully consistent.

IMF Conditionality

Under the PRGF arrangement

  • Conditionality was aimed at deepening fiscal consolidation; strengthening monetary policy; improving the efficiency of tax and tariff structures; building external debt-management capacities; and improving the efficiency of the fiscal structure and the regulation of public services, through such means as a pricing mechanism for oil products and water and electricity tariffs.

  • Compliance was commendable; only two waivers were requested and granted throughout the arrangement.

Under the PSI

  • The PSI in the first year covers measures to reduce fiscal risks, strengthen policy formulation and control, streamline tax incentives, and improve budget prioritization; and measures to strengthen financial sector regulation.

World Bank Conditionality

  • Bank conditions are spelled out for annual Poverty Reduction Support Credits (about US$10 million for 2006) under the Country Assistance Strategy approved in February 2005; the goals are to ensure macroeconomic stability, support private-sector-led growth, and alleviate poverty.

  • The PRSCs are directed to reforms of public expenditure management, the civil service, and the judiciary; decentralization; human resource development; and improvements in the effectiveness and sustainability of the social protection system.

A. Accelerating Growth and Reducing Poverty

17. The new government’s economic strategy for 2006–11 aims at substantially increasing GDP growth over the medium to long term to support significant reductions in unemployment and poverty. Staff agreed that Cape Verde’s growth prospects seem favorable, despite higher oil prices and the country’s limited natural resources. Strong foreign interest and investment in tourism-related activities, coupled with continued public investment in infrastructure, provide a solid base for accelerating growth and reducing poverty. There was full agreement on the need to maintain stable and credible macroeconomic policies—as emphasized in the program to be supported under the PSI—to help ensure a continuing favorable environment for investment growth and, more generally, for economic and social development.

18. Recognizing that there is not necessarily a direct link between tourism-related investment and stronger economic growth, the staff and authorities considered the policy priorities for ensuring that the benefits of tourism development spread into broad-based growth of domestic incomes and employment. It was agreed that improvements in domestic capacities were crucial, supported in many cases by stronger regulatory frameworks. Priorities (often inter-related) are to:

  • Improve the development and deployment of labor resources. As part of the general strategy for human capital development elaborated in Cape Verde’s PRSP, the authorities are working to enhance vocational training—including training targeted to tourism-related industries. While safeguarding working conditions, the government is also planning to amend the labor code to enhance the economy’s flexibility and capacity to create jobs.

  • Strengthen the business climate. One aspect of this is to support the development of small and medium-enterprises, including those that could provide ancillary services to the main tourism-related development. Besides its reforms in the labor market and financial sector, the government is reducing the administrative costs of doing business. “One-stop” facilities now being set up will make it possible to complete online all administrative procedures for registering and opening a business within 24 hours. Business development will also be supported by regulatory reforms the authorities are undertaking to liberalize the telecom market and develop transportation services.

  • Support financial sector development. The authorities are endeavoring to identify and remove obstacles to private sector credit growth and reduce the cost of capital. These efforts include amending the regulatory and legislative framework to protect lenders, strengthening banks’ capacity to provide project-based lending, and supporting access to credit for small and medium-sized enterprises. They also see development of the offshore financial sector as a means of expanding financial services and expertise. Noting, however, the risks that can arise in the offshore sector, the authorities agreed with staff on the need for regulatory reforms to ensure that this development takes place within a sound institutional framework that is in line with international best practice (see below).

  • Ensure adequate and reliable supplies of energy and water. Service quantity and quality has been uncertain, given the long-standing difficult relations between the government and Electra. The staff argued that improving the regulatory framework in the energy sector would help resolve these difficulties—through, for instance, full and transparent implementation of the automatic mechanism for adjusting electricity and water tariffs. In particular, application of this mechanism would help provide a more stable and predictable environment for much-needed investment to improve the volume and efficiency of energy supply. The staff supported the authorities’ strategy of promoting conservation and alternative energy sources to reduce Cape Verde’s dependence on oil imports.

B. Safeguarding the Exchange Rate Regime

19. The fixed exchange rate has served Cape Verde well as an anchor for economic stability. There are no indications of any misalignment of the exchange rate emerging: the real effective exchange rate has depreciated by more than 6 percent over the last three years, in line with changes in the terms of trade in goods (Figure 2); export growth in goods and tourism services is strong; and foreign direct investment is booming. To ensure that the country remains competitive despite natural cost disadvantages, the authorities view as essential the need to maintain macroeconomic stability and low inflation. They agreed with staff that wage growth, even with the temporarily higher “headline” inflation, needs to be kept in line with productivity growth and underlying inflation. They also agreed that competitiveness and growth need to be supported by increased labor flexibility and productivity, trade liberalization, and development of higher-priced niche products in tourism.

20. While the longer-term possibility of hardening the peg has been considered, the authorities saw no current need to move in this direction. In their view, the main benefit from hardening the peg would be to increase the pressure for further improvements in fiscal discipline, thereby enhancing investor confidence. However, current policies are already headed in this direction and are supporting further increases in foreign reserves.

21. Current foreign reserve coverage may be adequate to meet routine economic shocks and uncertainties, but the authorities would like to increase reserves further to better buffer against shocks. Supporting this objective, the staff noted that further liberalization of the capital account would also require an increase in reserves (see Box 3). The new government program envisages an increase in reserve coverage by 2011 to about 4 months of current-year imports of goods and services. Such an outcome would bring reserves closer to the level of the monetary base, which would in principle allow the monetary system to be converted into a currency board at any time.

Assessing the Adequacy of International Reserves

Assessing the adequacy of a country’s international reserves requires judgments based on multiple indicators and country specific factors. The main indicators to consider are:

  • Import coverage: Coverage of three or four months of prospective imports was in the past judged sufficient. It should be larger if official and private capital flows are large or volatile.

  • Short-term debt coverage: Reserves should cover at least the country’s one-year foreign liabilities (on a remaining maturity basis, and both domestic and foreign currency-denominated).

  • Base money coverage: Reserves at least as high as the monetary base would in principle allow the system to be converted into a currency board at any time.

Country-specific factors for Cape Verde that support the case for further buildup of reserves are:

  • The high dependence on capital inflows: official aid inflows are about 10–13 percent of GDP, remittances and other private transfers about 20 percent of GDP, and increases in emigrant deposits about 3–5 percent of GDP.

  • The large stock of emigrant deposits—around 30 percent of GDP and 40 percent of broad money—with unknown interest rate sensitivity.

  • A history of high volatility and periods of precariously low reserve coverage.

  • Currently high excess reserves in the banking system.

Country-specific factors that mitigate the need for further reserve accumulation are:

  • A Portuguese exchange rate support credit line of 27.5 million euros, with extension up to 45 million euros if Cape Verde provides collateral.

  • The existence of capital account restrictions.

  • A likely high correlation between foreign exchange inflows and outflows (e.g., through aid-funded imports for infrastructure projects, imports for tourists, goods for processing, and imports of goods for procurement in ports).

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Sources: Bank of Cape Verde, and staff estimates.

C. Managing Fiscal Pressures and Risks

22. While the authorities have made substantial progress with fiscal consolidation in recent years, improving both expenditure prioritization and revenue collection, further efforts are needed to prepare for potential pressures on the budget. For example, fiscal pressures may arise from:

  • government liabilities to the public pension system as this develops and matures;

  • growth in demand for health, education, training, and other public services;

  • less access to highly concessional external support as Cape Verde moves into middle-income status; and

  • associated with the last point, the prospective need for increased domestic capital participation in public investment projects.

23. The authorities and staff agreed that medium-term fiscal policy should be oriented toward the creation of fiscal space to prepare for these and other contingencies. Such space (see below) would be generated in part by reducing government debt as a share of GDP, which would both lower interest expenditures and provide an additional buffer against economic shocks.

D. Strengthening Public Sector Management

24. The authorities are pursuing a number of structural reforms to strengthen the country’s fiscal position. These include measures to strengthen capacities and procedures for formulating, executing, monitoring, and auditing the budget. Implementing the Country Financial Accountability Assessment (CFAA) action plan and the medium-term expenditure framework (MTEF) will help. As mentioned, reforms are also under way to improve civil service capacities and productivity within the constraints of the wage bill. Departmental staffing levels are to be rationalized and wage structures reformed to ensure that government compensation is competitive without putting pressure on private sector wages.

V. Policy Discussions: The Medium-Term Policy Framework

25. Drawing on the discussion of medium-term prospects and challenges, the authorities and staff reached understanding ad referendum on a three-year policy framework that could be supported by the PSI. Details of the proposed program are set out in the attached MEFP. The economic and policy considerations underlying the program include:

  • projections for economic growth and inflation for 2006–09;

  • the rate of increase in foreign exchange coverage;

  • the relative role of fiscal and monetary policy in supporting the reserve buildup and, associated with this;

  • the formulation of the fiscal anchor and medium-term fiscal strategy;

  • the design of the monetary policy operational framework; and

  • structural measures to support fiscal objectives, reduce economic and financial risks, and enhance growth.

A. The Macroeconomic Framework

26. The government’s macroeconomic framework that would be supported under the PSI assumes a moderate pick-up in GDP growth after 2006, led by stronger investment. Growth is projected to be around 5.5 percent in 2006, mainly because of short-term influences: these include the negative impact on private sector purchasing power of recent increases in food and regulated prices, and delays in undertaking the 2006 public investment program. Growth is expected to increase thereafter, however, averaging 6–7 percent in 2007–09. Foreign direct investment (FDI) is expected to remain strong, although cautiously assumed to grow at a more measured pace over the medium term; budget grants and loan assumptions are based on identified donor commitments; and the current levels of project assistance (apart from MCA-related activity) and private remittances as a share of GDP are assumed to continue over the medium term before gradually tapering off as residents’ income level rises. There is also upside potential in the growth outlook—for example, if FDI continues to increase at the same rate as is projected for 2006 to 2007 (which is based on firm investment intentions).

Cape Verde: Key Projections, 2006–09

(Percent of GDP, unless otherwise specified)

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Sources: Cape Verdean authorities, and staff estimates.

Excluding for arrears clearance.

27. Consumer price inflation is projected to fall to close to zero in 2007–08 and stabilize at 2–3 percent thereafter. The staff emphasized that a rapid return to low inflation will be important for supporting the exchange rate peg and allowing budget limits, particularly with regard to the wage bill, to be respected. In the projected scenario, the 12-month inflation rate would fall sharply once the recent increases in regulated prices fall out of the base and food prices return to more normal levels, as was the case in past episodes of temporary shortfalls in supply of fish and fresh fruits and vegetables (Figure 5). Medium-to long-term inflation would then remain in line with inflation in the euro area. After declining in 2005, the current account deficit is projected to rise—largely reflecting higher imports of capital goods driven by MCA projects and private investment.

Figure 5.
Figure 5.

Cape Verde: CPI Inflation Rates

(Percentage changes from the same period of the previous year)

Citation: IMF Staff Country Reports 2006, 334; 10.5089/9781451809435.002.A001

Sources: Cape Verdean authorities, and staff projections.

28. The medium-term program aims to increase reserve coverage further, by 0.1 months of prospective imports per year (equivalent to about ½ percent of GDP). In the authorities’ view, which the staff shares, this goal should balance the need for strengthening reserve coverage against monetary and fiscal constraints, along with the desirability of keeping lending rates low to support credit expansion and private sector growth.

29. Fiscal restraint will be necessary to reach the reserve target, as there is only limited scope for monetary policy to effect a long-term, sustainable buildup in reserves. The fixed exchange rate regime implies that the domestic interest rate spread over the euro area must ultimately reflect the market risk premium and transaction costs. Moreover, containing domestically financed government expenditures would be the prime policy tool for achieving the reserve target. This arises because the overall fiscal deficit largely reflects the provision of external aid and its grant-loan distribution, and the demand for foreign exchange from imports induced by aid-financed expenditures is broadly matched by aid inflows.

30. Containing government domestic borrowing, moreover, will help the government reach its objective of lowering public debt. The program aims to lower the central government debt ratio to below 70 percent of GDP by 2009. This includes reducing government domestic debt to close to 20 percent of GDP by 2009, down from around 33 percent at end-2005. Anchored on this medium-term target for domestic debt, net domestic borrowing would be the operational target and assessment criterion under the PSI; borrowing would be measured exclusive of arrears clearance, to support the rapid elimination of arrears.5

31. The targeted debt reduction is consistent with further growth of capital spending and high-priority current spending. Moreover, the program would create significant fiscal space—growing to around 1.7 percent of GDP by 2009—for additional priority spending, tax cuts, or further debt reduction. This fiscal space is created through:

  • mobilizing domestic revenue as recent improvements in the tax system and tax administration take hold and efforts to streamline tax incentives and exemptions bear fruit;

  • improving expenditure prioritization in line with the PRSP;

  • moderately scaling back the wage bill as a share of GDP to its 2005 level;

  • ending petroleum subsidies, as announced in the 2006 budget; and

  • lowering interest costs as debt declines.

32. The program allows for a limited amount of well-targeted government or government-guaranteed external borrowing that does not meet the full 35 percent concessionality threshold, if fully concessional financing of essential projects is not available. The US$20 million cap on less concessional borrowing is in line with the PRGF arrangement, where this provision enabled the government to borrow on terms that fell short of the 35 percent threshold. This borrowing was used to finance important health, education, and infrastructure projects, including the new international airport in Praia. Cape Verde’s long-term debt sustainability (see Appendix II) would not be jeopardized if highly concessional loans are below the baseline assumptions and the resulting gap is covered by a limited amount of less concessional borrowing.6

33. As in the past, medium-term monetary policy will be geared to safeguarding the exchange rate peg with the euro as an anchor for low inflation. Consistent with this, the monetary policy framework has at times functioned similarly to a currency board: changes in the foreign reserves at the central bank have been the main source of variations in the money supply and, at least until recently, the BCV has been fairly passive in using the limited monetary policy instruments at its disposal to control liquidity. Fiscal dominance is absent; the government is required by law to settle any outstanding balance on its overdraft account in the BCV at the end of each year.

34. Nevertheless, periodic upsurges in excess liquidity in the banking system and the recent decline in Treasury bill rates have highlighted some uncertainties in the BCV’s monetary policy operating framework—including how the Bank should respond to such developments. Following recent technical assistance from the IMF, the authorities felt that there was a need for, and sufficient capital account frictions to allow, somewhat more active liquidity management to prevent destabilizing swings in liquidity and interest rates. Drawing on that technical assistance, the authorities intend to formulate a set of intermediate monetary indicators—including broad money, credit growth, excess liquidity, and the interest differential with the euro area—to guide liquidity management and other dimensions of policy conduct. In-house capacity for tracking large external capital flows will be built, in part to gauge the interest sensitivity of emigrant deposits and other private flows.

B. The Structural Reform Program

35. Enhanced structural reforms will be crucial to achieving the PSI’s objectives. Authorities and staff agreed that reform priorities are improving economic governance, fiscal management, and capacity to formulate policy; sheltering the budget from quasi-fiscal losses; and strengthening the financial sector. The reform agenda the MEFP details includes:

  • Clearance of the stock of outstanding central government arrears of CVEsc 5.3 billion by end 2009 (as scheduled in Appendix I, Table 1) and measures to prevent arrears from again accumulating.

  • Further efforts to reinforce revenue collection. The government intends to submit legislation to the National Assembly by mid-2007 that would reform the complex system of tax exemptions; in particular, exemptions will be granted only according to clearly defined economic criteria that correspond to the national development strategy, and will be regulated under a single law.

  • Measures to strengthen public sector management capacity, including implementation of the CFAA action plan and the MTEF and the new impetus to reforming civil service staffing and compensation arrangements.

  • Regulatory and institutional reforms to support production and distribution of electricity and water, including full application of the automatic tariff adjustment mechanism.

  • Reforms to ensure that the regulation and supervision of financial institutions, including in the offshore center, are in line with international best practice. These measures will draw on the conclusions of a task force organized by the BCV.

VI. Program for 2006–07

36. The government’s program for 2006–07 as spelled out in the MEFP is in line with the medium-term strategy discussed above. By frontloading implementation of key measures, the 2006 budget takes important steps toward supporting the government’s medium-term macroeconomic strategy. Some highlights of the short-term fiscal strategy:

  • The fiscal position will be strengthened, supported by privatization and land sale receipts (3.7 percent of GDP). To continue to reduce domestic debt, government net domestic borrowing—except for clearance of arrears and late payments—will be limited to −1.9 percent of GDP in 2006 and −0.2 percent in 2007. As a result, domestic debt, net of deposits but including arrears, is projected to decline to 25 percent of GDP at end-2007.

  • Arrears clearance of 1.7 percent of GDP is budgeted for 2006 (one-third of the end-2005 stock of arrears) and significant further arrears clearance is anticipated in 2007.

  • Petroleum subsidies were eliminated starting June 1, 2006, and full provision has been made in the 2006 budget for oil subsidies accrued in 2005 and the first part of 2006 (in the past, these subsidies were paid with a one-year lag).

37. The program will be monitored using the assessment criteria and structural benchmarks set out in the tables and in the Technical Memorandum of Understanding attached to the MEFP (see also paragraph 29 of the MEFP). Program implementation and the economic results associated with the program will be subject to two reviews per annum. The program initially establishes quantitative and structural assessment criteria and benchmarks for end-September 2006 and end-December 2006, and indicative targets for 2007.7 The first review mission, scheduled for November 2006, would reach understandings on assessment criteria and structural benchmarks for 2007.

VII. Risks to the Program

38. As a small open economy with a narrow export base, Cape Verde is susceptible to external and domestic shocks. For example, a deterioration in international security could reduce tourism flows or investments; and increases in refugee inflows, as have occurred recently, could put pressure on social services and the fiscal situation. Specific risks that are related more directly to program assumptions include:

  • Higher than expected inflation: this could occur, for example, if wage growth in 2006–07 exceeds underlying inflation and productivity growth. An encouraging sign that economy-wide wage movements will be moderate despite increases in food and regulated prices is the recently announced 3.5 percent increase in civil service wages.

  • Continued increases in the government wage bill: failure to scale back the wage bill to its 2005 level (as a share of GDP) would cut the 2007 fiscal space in half, while a continuation of the wage bill growth experienced over the last five years would eliminate the projected fiscal space entirely and leave a residual financing gap of 1 percent of GDP by 2009.

  • Quasi fiscal risks and service disruptions among public service enterprises: such concerns could arise if there was failure to reach agreement on the investment plan for Electra, or if economic or political obstacles did not allow TACV to operate on fully commercial terms.

  • Outflows of emigrant deposits: there is still substantial uncertainty about what motivates emigrant deposits, which comprise around 40 percent of M2. In particular, it is unclear how sensitive these deposits would be to further reductions in the interest rate differential between Cape Verde and more advanced economies (particularly the European Union and the United States) where most of the Cape Verde diaspora resides. Gross international reserves would be reduced to less than 2 months of imports if only 20 percent of the emigrant deposits were withdrawn, and completely depleted with a withdrawal of less than 60 percent.

  • Fluctuations in external concessional support: Cape Verde’s ability to reduce domestic debt as projected under the program would be impaired if there were temporary shortfalls in external grants or highly concessional loans (or if this support fell away more rapidly than expected with the country’s move to middle-income status), and if resulting financing gaps were met using domestic resources.

VIII. Statistical Issues and Technical Assistance Needs

39. The quality and timeliness of Cape Verde’s economic and financial data are generally adequate for surveillance and program monitoring, although some areas need substantial improvement (see Appendix III). The staff expressed concerns about the monitoring of some aspects of fiscal performance and debt (especially external debt), weaknesses in the national accounts and CPI, and tracking of large external flows. The authorities are working to strengthen statistics. A comprehensive master plan directed by the National Statistical Institute (INE) outlines the steps needed for improving all areas of statistics. Cape Verde’s development partners have already committed a substantial part of the estimated US$15 million required to implement the plan through 2010. The authorities are also making progress in revising the national accounts and a new CPI index is scheduled to be released in 2006. Staff stressed the importance of adequately funding full implementation of these improvements.

40. The authorities are seeking continued technical assistance, not only for strengthening the statistical system but also for improving debt management, producing summary fiscal information from the online budget monitoring system, and strengthening regulation of the financial sector.

IX. Staff Appraisal

41. The authorities are firmly committed to macroeconomic stability and structural reforms. Their policies are strengthening the foundations for sustained growth and poverty reduction. Cape Verde’s strong economic performance under its first PRGF-supported program, supported by official and private capital inflows, has significantly alleviated poverty and led to Cape Verde’s “graduation” (effective in 2008) to middle-income status. Growth reached close to 6 percent in 2005, and the fiscal stance was prudent through the recent election cycle—contributing to a further build-up of international reserves, a decline in domestic debt, and enhanced policy credibility.

42. Cape Verde’s medium-term outlook is favorable despite the impact of higher international oil prices on current economic activity. After slowing in 2006, growth is expected to increase in the years ahead. The recent sharp increase in inflation is expected to subside in 2007, but vigilance is required to ensure that one-off price adjustments do not spread into more generalized inflation. Economic prospects are still largely driven by tourism. A narrow economic base, capacity constraints, and the natural cost disadvantages of a small country spread across many islands keep Cape Verde susceptible to such external and domestic shocks as a deterioration in international security or the investment environment or, on the domestic front, quasi-fiscal risks and service disruptions in public service enterprises.

43. The fixed exchange rate has served Cape Verde well as an anchor for economic stability. The peg to the euro should continue to play the central role in the macroeconomic policy framework. There is no current need to harden the peg further, although this could be considered as a longer-term policy option.

44. The government’s medium-term program provides a sound basis for macroeconomic stability, economic development, and poverty reduction. The program gives particular attention to reducing fiscal risks and allowing Cape Verde a margin of safety to help protect the economy against shocks. The structural reform program appropriately centers on strengthening economic management through building capacity in fiscal management and policy formulation; sheltering the budget from quasi-fiscal losses; and strengthening the financial sector.

45. To provide a firmer buffer against economic shocks, the government’s medium-term macroeconomic framework is geared toward a further increase in international reserves and a reduction in the government debt-to-GDP ratio. The staff fully agrees with these program anchors. Containing domestic borrowing should help achieve both objectives: the overall fiscal deficit largely reflects the provision of external aid and its grant/loan distribution, and there is only limited scope for monetary policy to effect a long-term, sustainable buildup in reserves. Fiscal restraint is also needed for creating space to meet potential future pressures on the budget, including from the public pension system and possible declines in highly concessional external support.

46. The targeted rate of reserve build-up and debt reduction appropriately balances monetary and fiscal considerations. In particular, the macroeconomic framework provides adequate room for lower interest rates, increased credit to the private sector, and further growth of government capital spending and high-priority current spending.

47. The government’s program for 2006–07 is in line with the medium-term strategy and frontloads key measures. The fiscal position will be substantially strengthened through a sizable reduction in the domestic debt ratio; clearance of arrears and steps to prevent their recurrence; and full provision in the budget for past oil subsidies together with elimination of future petroleum subsidies, which will remove a key source of fiscal risk. However, debt reduction in 2006 is largely due to one-off privatization and land sale receipts, which cannot be relied on as financing sources in the future.

48. The restructuring and privatization of the national airline TACV and the port operator ENAPOR should help reduce fiscal risks, improve economic efficiency, and enhance growth prospects.

49. Despite recent progress, ensuring adequate and reliable supplies of electricity and water remains a significant concern. A key for overcoming current difficulties is to strengthen the regulatory framework so that tariff levels provide adequate incentives for investment. In particular, full and transparent application of the automatic tariff adjustment mechanism for electricity and water would help provide a more stable environment for much needed investment to improve the volume and efficiency of energy supply, and prevent the re-emergence of a tariff deficit.

50. The rapidly developing offshore financial center needs to be carefully monitored. While this sector may provide gains in employment, expertise, and financial services to the economy, there are also inherent risks. Regulatory reforms are necessary to ensure that financial development takes place within a sound institutional framework that is in line with international best practice.

51. Cape Verde’s economic and financial data are generally adequate for surveillance and program monitoring, but weaknesses remain. Efforts currently under way to address these weaknesses are welcome, and the staff urges the authorities to provide adequate budgetary resources to ensure full implementation of the statistical master plan.

52. Given the authorities’ clear and demonstrated commitment to sound economic management, the staff recommends Executive Board approval of the request for a three-year PSI.

53. It is recommended that the next Article IV consultation with Cape Verde take place within 24 months subject to the provisions of the decision on consultation cycles in program countries.

Table 1.

Cape Verde: Selected Economic and Financial Indicators, 2002–09

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

Net of central government deposits; including verified stock of domestic and external arrears.

Measured in domestic currency. The increase in the ratio from 2004 to 2005 is due to the appreciation of the dollar in 2005.

Excluding the claims on the offshore Trust Fund.

Table 2.

Cape Verde: Annual Fiscal Operations of the Central Government, 2005–09

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Sources: Ministry of Finance and Public Administration, Bank of Cape Verde, and staff estimates and projections.

Differ from the budget column in that budget grants firmly committed by the donors have been added, and the budgeted clearance of old arrears shown separately.

Overall balance (including grants)- total expenditure + domestic and external interest payments.

Domestic revenue - recurrent expenditure.

External grants + net foreign financing.

Table 3.

Cape Verde: Annual Fiscal Operations of the Central Government, 2005–09

(Percent of GDP)

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Sources: Ministry of Finance and Public Administration, Bank of Cape Verde, and staff estimates and projections.

Differ from the budget column in that budget grants firmly committed by the donors have been added, and the budgeted clearance of old arrears shown separately.

Overall balance (including grants) - total expenditure + domestic and external interest payments.

Domestic revenue - recurrent expenditure.

External grants + net foreign financing.

Table 4.

Cape Verde: Monetary Survey, 2005–09

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Sources: Bank of Cape Verde, and staff estimates and projections.