Cape Verde
Second Review Under the Policy Support Instrument: Staff Report; Press Release on the Executive Board Discussion; and Statement by the Executive Director for Cape Verde
Author: International Monetary Fund
Publication Date:
26 Jun 2007
eISBN:
9781451809459
Language:
English
Keywords:
ISCR; CR; cape Verdian authorities; government; net; government transfer; fiscal policy; net error; broad money; trust fund; financing flow; excess reserves; International reserves
Download PDF (1.3 MB)

The staff report for the Second Review under the Policy Support Instrument (PSI) of Cape Verde discusses the macroeconomic framework and recent developments. Cape Verde’s economic program under the PSI is designed to help the country prepare for the opportunities and challenges associated with its graduation from the United Nations least-developed-country (LDC) status in 2008. IMF staff recommended, and the authorities agreed, that a comprehensive medium-term investment plan be prepared, including for state-owned enterprises. This approach would support prioritization of public investment and the planning needed to secure concessional external financing.

Abstract

The staff report for the Second Review under the Policy Support Instrument (PSI) of Cape Verde discusses the macroeconomic framework and recent developments. Cape Verde’s economic program under the PSI is designed to help the country prepare for the opportunities and challenges associated with its graduation from the United Nations least-developed-country (LDC) status in 2008. IMF staff recommended, and the authorities agreed, that a comprehensive medium-term investment plan be prepared, including for state-owned enterprises. This approach would support prioritization of public investment and the planning needed to secure concessional external financing.

I. Introduction

1. Cape Verde’s economic program under the Policy Support Instrument (PSI) is designed to help the country prepare for the opportunities and challenges associated with its graduation from UN least-developed-country (LDC) status in 2008. The program emphasizes reducing macroeconomic risks, increasing the margin of protection against shocks, and preparing for a possible longer-term decline in access to concessional external financing. The main objectives are to increase foreign reserves, reduce domestic debt, and create fiscal space to meet spending priorities.

2. To further the macroeconomic agenda, discussions during the second review addressed structural measures the authorities are implementing or planning to reinforce:

  • Public sector management, especially by improving budget implementation and control, preventing arrears, strengthening debt management, and raising civil service productivity.

  • The monetary and financial system, particularly the operating framework for monetary policy and financial sector supervision and regulation, including in the offshore center.

  • Energy sector regulation, notably the mechanisms to set electricity and water tariffs and adjust retail petroleum prices.

II. Recent Developments and Performance Under the Psi

3. Cape Verde’s economic and policy performance is strong. Based on the strength of recent indicators—including consumption and investment demand, business confidence, and tourism exports—the GDP growth estimate for 2006 has been revised up from 5.8 to 6.5 percent. Unemployment fell to 18.3 percent in 2006, down 6.1 percentage points from 2005.

4. Though consumer inflation rose in late 2006 after a court ruling required a change in the way value–added tax (VAT) was applied to certain price–controlled products, it is now falling (Figure 1). The court declared unconstitutional government decrees that had altered the base upon which VAT was charged for electricity, water, transportation, and other services deemed essential. As a result, prices for some items rose significantly. The previous tax structure was largely restored in the 2007 Budget Law. These swings in headline inflation are reflected in the real effective exchange rate (Figure 2).

Figure 1.
Figure 1.

Cape Verde: CPI Inflation Rates, 2000–07

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

Citation: IMF Staff Country Reports 2007, 223; 10.5089/9781451809459.002.A001

Sources: Cape Verdean authorities, and IMF staff calculations.
Figure 2.
Figure 2.

Cape Verde: Exchange Rates, 1999–2006

(Index, 2000 = 100)

Citation: IMF Staff Country Reports 2007, 223; 10.5089/9781451809459.002.A001

Sources: International Financial Statistics, and Information Notice System.

5. Monetary policy in 2006 was consistent with the program goal of building up foreign exchange reserves to support the exchange rate peg. Reserve accumulation reached 3.0 months of prospective imports at the end of 2006 (Figure 3)—above the program target. Cape Verde has continued to attract inflows of official assistance, and tourism exports and foreign direct investment (FDI) have picked up strongly. Net inflows of remittances and emigrant deposits also continued, even though the spread of the emigrant deposit rate against the euro area rate has narrowed substantially in recent years (Figure 4).1 Excess reserves of commercial banks declined toward the end of 2006 as the BCV’s sterilization efforts and continued growth in private sector credit gradually drained excess liquidity (Figure 5). The largest share of the credit growth went to highly collateralized lending for real estate and a domestic bank’s purchase of a Portuguese bank’s claim of €71 million on Electra (the electricity and water company);2 the latter transaction also lowered the record–high net foreign assets of commercial banks—a reflection of the excess liquidity.

Figure 3.
Figure 3.

Cape Verde: Selected Macroeconomic Indicators, 1995–2006

(Percent of GDP, unless otherwise indicated)

Citation: IMF Staff Country Reports 2007, 223; 10.5089/9781451809459.002.A001

Sources: Cape Verdean authorities, and IMF staff calculations.1 Including domestic arrears and excluding government deposits.
Figure 4.
Figure 4.

Cape Verde: Emigrant Deposits, 2000–07

Citation: IMF Staff Country Reports 2007, 223; 10.5089/9781451809459.002.A001

Sources: Bank of Cape Verde, and IMF staff calculations.
Figure 5.
Figure 5.

Cape Verde: Selected Monetary Indicators, 2000–07

(Millions of escudos, unless otherwise specified)

Citation: IMF Staff Country Reports 2007, 223; 10.5089/9781451809459.002.A001

Sources: Bank of Cape Verde, and IMF staff calculations.1. Excluding a domestic bank’s purchase of a Portuguese credit to Electra.

6. Fiscal policy in 2006 was largely consistent with program goals. Tax revenues were higher than projected and recurrent public spending was firmly restrained. A record high execution rate of the public investment program was reported. Toward the end of the year, domestic borrowing increased unexpectedly because of delayed proceeds from land sales and privatization and unexpectedly low profit transfers from public enterprises. As a result, the program ceiling on net domestic borrowing was exceeded by 0.8 percent of GDP (after adjustors were applied). Nevertheless, helped by unexpectedly high growth in nominal GDP, the net domestic debt–to–GDP–ratio was reduced sharply—from 33.5 percent of GDP at the end of 2005 to 28.7 percent at the end of 2006 (close to the initial program target; (Figure 3).

7. The Ministry of Finance is making progress in tackling domestic arrears. The stock of arrears is being cleared more rapidly than initially targeted. The government is also implementing measures agreed during the first program review to avoid accumulating new arrears. In particular, the Ministry is:

  • more carefully monitoring the payment arrears of central government entities, including semi–autonomous agencies;

  • working with these entities to strengthen their budget execution and payment practices; and

  • putting in place procedures to make the required payments on behalf of these entities if they continue to incur arrears and deduct those amounts from government transfers to them.

In addition:

  • Municipalities have signed a memorandum of understanding accepting their responsibility to pay electricity bills on time and have begun to comply with this agreement; and

  • The government plans to introduce a tax on consumer electricity bills to meet the costs of public lighting, which has been a persistent area of dispute between municipalities and Electra.

In November–December 2006, however, while these new procedures were being implemented, hospitals again incurred arrears to the state–owned pharmaceutical company. Also, arrears to Electra that accumulated earlier in 2006 were not fully unwound by the end of the year.

8. There has also been notable progress with other structural reforms:

  • The automatic adjustment mechanism for electricity and water tariffs was published in January 2007 and is being applied.

  • A draft public employment law will soon be submitted to the National Assembly. It will provide the legal base for new salary plans and career and mobility rules for public administration.

  • A Large Taxpayers Unit has been established in the Ministry of Finance and will be fully operational by mid–2007.

  • A new law concerning the Court of Auditors (TdC) has been submitted to the National Assembly, and the Inspectorate General of Finance has been reinforced with additional staff and brought within a new organic law.

  • The public sale of most of the government’s remaining shares in Enacol, a petroleum distribution company, has been initiated through the Cape Verde Stock Exchange—the biggest financial operation ever in Cape Verde.

III. Report on the Discussions

9. In its Letter of Intent (LOI; Appendix I), the government reaffirms its commitment to the macroeconomic and structural objectives of the PSI program. Policy discussions focused on updating the macroeconomic framework and on structural measures to improve fiscal and monetary management, and energy and financial sector regulation.

A. Macroeconomic Framework

10. The macroeconomic framework is largely unchanged since the first review:

  • Growth: The projection for 2007 was revised up to 6.9 percent, reflecting significant increases in FDI that are in the pipeline. Medium–term growth is expected to average above 7 percent, driven primarily by the FDI–led expansion of the tourism industry.

  • Inflation: The 12–month rate is expected to return to low single digits during 2007 as fresh food prices continue declining toward trend levels (Figure 6).3 The current growth in private sector credit is expected to have limited impact on inflation. Since most of the consumer basket comprises imported products, and the small domestic component is dominated by fresh food, inflation in Cape Verde seems to be predominantly a supply-side phenomenon; demand growth leads mainly to increased imports.

  • International reserves: The target of increasing reserves by at least another 0.1 month of prospective imports in 2007 was retained.

  • Domestic debt repayment: Using the delayed proceeds from privatization and land sales, now expected to arrive in 2007, this year’s repayment target was raised by CVEsc 800 million to unwind the higher–than–expected borrowing in 2006. The domestic–debt–to–GDP ratio is expected to decline to 22.5 percent by year–end.

Figure 6.
Figure 6.

Cape Verde: CPI Inflation Rates 2005–08

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

Citation: IMF Staff Country Reports 2007, 223; 10.5089/9781451809459.002.A001

Sources: Cape Verdean authorities, and IMF staff projections.

B. Monetary Conditions and Prospects

11. The BCV is more actively managing liquidity. Since December 2006 it has aimed to fully sterilize the liquidity impact of reserve accumulation by issuing 14–day and 6–month central bank bills. The BCV is continuing to explore a formal operating framework based on closer monitoring and targeting of external interest rate differentials. In an attempt to create an official policy rate, the BCV has been offering 14–day bills at a fixed interest rate, currently set at a margin below the Euribor rate. Through this approach, the BCV has aimed to reduce commercial bank incentives for placing excess liquidity abroad while recognizing the transactions costs of these overseas placements.4 The BCV is seeking further technical assistance to support their efforts to strengthen monetary operations.

12. Following discussions with the BCV and commercial banks, the staff agreed that excess liquidity in the banking system has eased in recent months, mainly because of increased sterilization efforts and continued rapid growth in private sector credit. These developments have also reduced the downward pressure on emigrant deposit rates. Banks are seeing both requests for withdrawals from some emigrants and increased domestic competition for these deposits.5 Furthermore, increased private sector access to international capital markets and to the offshore financial institutions has exacerbated the interest rate pressures and market distortions caused by the high reserve requirement. Responding to these concerns, the BCV lowered the reserve requirement from 15 to 14 percent in late March 2007 and intends, if necessary, to fully sterilize the liquidity increase.

C. Structural Fiscal Issues

13. In the LOI the government commits to improving public sector financial management; it plans to

  • Submit to the National Assembly legislation to support streamlining of tax exemptions, a revised General Tax Code, a new Code on Judicial Processes, and bills on individual and corporate income taxes. While the tax exemption reforms are slightly delayed from end–June to end–December 2007, the government is determined to implement measures to rationalize exemptions, in coordination with its other tax reform initiatives.

  • Reform the structure and functions of the Tax Directorate in the Ministry of Finance.

  • Set up a new customs audit court and modernize the Inspectorate General of Finance.

  • Improve budget management—e.g., by better forecasting revenue and financing flows, broadening coverage of the medium–term expenditure framework, and expanding the online, real–time system (SIGOF) for budget execution and monitoring.

  • Prevent arrears by fully implementing the measures agreed in 2006 (see ¶7). Indications from the authorities are that these measures are now taking hold.

LEG is providing technical assistance on tax legislation, and the authorities have requested further technical assistance from FAD to help them formulate criteria for granting tax exemptions.

D. Financial Sector

14. The BCV is moving ahead with plans for strengthening regulation of the financial sector, including the growing offshore financial center. A consultant has completed a report assessing the legal and institutional framework and, after discussions with stakeholders, the BCV expects to finalize legislative proposals by December 2007. Discussions are well advanced on information–sharing agreements with home country supervisors of institutions operating in Cape Verde, although formal agreements have not yet been signed. An AML/CFT assessment mission from the IMF is planned for the second quarter of 2007. To safeguard Cape Verde’s good reputation, staff reiterated the need for caution in granting offshore licenses until the regulatory environment is consistent with international standards.

E. Public Investment and Financing

15. Staff recommended, and the authorities agreed, that a comprehensive medium term investment plan be prepared, including for state-owned enterprises. This approach would support prioritization of public investment and the planning needed to secure concessional external financing. It would also help identify the possible financing gap to be met by fiscal measures or, if debt sustainability considerations allow, through less concessional government and government–guaranteed external borrowing. This approach should also enable the program ceiling on external nonconcessional borrowing to be set on a more systematic basis.6

F. Automatic Price Adjustment Mechanisms

16. The government is improving the regulatory framework for the energy sector. With the automatic adjustment mechanism for electricity and water tariffs now in place, the Economic Regulatory Agency (ARE) expects to finalize a mechanism for setting base tariffs by mid–2007. ARE also intends to apply the current adjustment mechanism for retail petroleum prices soon after each incoming shipment of petroleum products, as originally envisaged. Further, the government has embarked on a comprehensive review of the structure, operation, and regulation of the energy sector. The staff emphasized that automatic and transparent updates of utility tariffs and petroleum prices would depoliticize price setting, safeguard the budget, and give companies incentives for investment and efficiency gains.

IV. Program Monitoring

17. Assessment criteria, benchmarks, and indicative targets for the next two reviews are in Tables A1 and A2 of the LOI. The review schedule is in Table 8.

Table 1.

Cape Verde: Selected Economic and Financial Indicators, 2005–09

article image
Sources: Cape Verdean authorities, and IMF staff estimates and projections.

Excluding a December 2006 purchase of a Portuguese credit to Electra.

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

Excluding the claims on the offshore Trust Fund.

The 2005 domestic debt stock has been revised up by 1,160 million escudos compared with the data reported in CR/06/334. To ensure comparability, 2006 program projections have been revised up by the same amount.

Table 2.

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

(Millions of Cape Verde escudos, unless otherwise indicated)

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

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

Domestic revenue – recurrent expenditure.

External grants + net foreign financing.

The 2005 domestic debt stock has been revised up by 1,206 million escudos compared with the data reported in CR/06/334. To ensure comparability, 2006 program projections have been revised up by the same amount.

Table 3.

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

(Percent of GDP)

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

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

Domestic revenue – recurrent expenditure.

External grants + net foreign financing.

4 The 2005 domestic debt stock has been revised up by 1,160 million escudos compared with the data reported in CR/06/334; to ensure comparability, 2006 program projections have been revised up by the same amount.
Table 4.

Cape Verde: Balance of Payments, 2005–09

(Millions of Cape Verde escudos, unless otherwise indicated)

article image
Sources: Bank of Cape Verde; and IMF staff estimates and projections.
Table 5.

Cape Verde: Monetary Survey, 2005–09

article image
Sources: Bank of Cape Verde; and IMF staff estimates and projections.
Table 6.

Cape Verde: Central Bank Survey, 2005–09

article image
Sources: Bank of Cape Verde; and IMF staff estimates and projections.
Table 7.

Cape Verde: Deposit Money Bank Survey, 2005–09

article image
Sources: Bank of Cape Verde; and IMF staff estimates and projections.