Democratic Republic of the Congo
Selected Issues and Statistical Appendix
Author: International Monetary Fund
Publication Date:
25 Sep 2007
eISBN:
9781451808438
Language:
English
Keywords:
ISCR; CR; real GDP; central bank; public expenditure; DRC government; financial system; private sector
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This Selected Issues paper describes the three phases of IMF engagement in the Democratic Republic of Congo (DRC) with a view to drawing lessons that could prove useful in identifying objectives and policies for a medium-term program that could be supported through a successor Poverty Reduction and Growth Facility arrangement. The paper describes recent developments in the financial sector of the DRC and offers suggestions for fostering financial deepening. It addresses the agenda for structural fiscal reforms over the next five years. It also presents an overview of structural fiscal issues.

Abstract

This Selected Issues paper describes the three phases of IMF engagement in the Democratic Republic of Congo (DRC) with a view to drawing lessons that could prove useful in identifying objectives and policies for a medium-term program that could be supported through a successor Poverty Reduction and Growth Facility arrangement. The paper describes recent developments in the financial sector of the DRC and offers suggestions for fostering financial deepening. It addresses the agenda for structural fiscal reforms over the next five years. It also presents an overview of structural fiscal issues.

Democratic Republic of the Congo Basic Data, 2001–06

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Sources: Congolese authorities; World Bank; UNICEF; and IMF staff estimates.

Annual averages. Minus sign indicates depreciation.

Data for 2003 from UNICEF. Data prior to 2003 from World Bank.

UNICEF.

I. Assessment of Economic Development and Fund Involvement (2000-06)1

A. Introduction

1. In the early 2000s the economy of the Democratic Republic of Congo (DRC) was derelict after many years of mismanagement and poor governance, prolonged financial isolation, and a devastating civil war. The human toll of the conflict was staggering, with an estimated 3 million dead. A large part of DRC territory was under the control of foreign-backed rebel groups and the economy was trapped in a vicious cycle of hyperinflation, currency depreciation, increasing dollarization, financial disintermediation, lack of saving, falling output, and general impoverishment of the population.

2. Over the last five years the international community has supported reunification of the country and organization of the first democratic presidential and congressional elections. A power-sharing agreement was signed in 2002 and a transition government of national unity formed in June 2003 was charged with holding elections within two years. After extending the transition period by one year, the first democratic elections were successfully completed by the end of 2006. The new coalition government took office in late February 2007 after it was confirmed by the newly elected National Assembly.

3. The Fund’s postconflict engagement in the DRC has encompassed three phases. First, the Fund and the DRC ended many years of noncooperation by agreeing on a nine-month staff-monitored program (SMP).2 This laid the groundwork for deeper IMF involvement with the approval in July 2002 of a comprehensive program supported by PRGF arrangement. During this second phase, implementation of the program allowed the DRC to reach the decision point for the enhanced HIPC Initiative in 2003. The DRC, however, was unable to obtain full HIPC debt relief because large expenditure slippages in the run-up to the elections prevented completion of the last review of the arrangement before it expired in March 2006. In the third phase, starting in late 2005, Fund staff have helped the authorities design and monitor two SMPs. The intent was to strengthen implementation of economic policy and make it possible to draw up a credible medium-term program deserving of new PRGF financial support. Completion of the first review of such an arrangement would pave the way for the DRC to reach the HIPC completion point and receive full debt relief under the enhanced HIPC and the MDRI.

4. The present note describes the three phases of Fund engagement in the DRC with a view to drawing lessons that could prove useful in identifying objectives and policies for a medium-term program that could be supported through a successor PRGF arrangement.

B. The Program for June 2001-March 2002

Objectives and policies

5. Discussions on an economic program started in 2000 as the international community was making renewed efforts to resolve the conflict in the DRC and the related humanitarian and political crises. The government and the international community felt that lasting peace would be possible only if the political and security processes were accompanied by rapid stabilization of the economy. It was hoped that overcoming hyperinflation, returning to normal budgets, and resuming growth would help strengthen the political consensus to work toward peace and reunification and address economic governance issues. The SMP for June 2001-March 2002 took into account the DRC’s particularly difficult sociopolitical circumstances, including the fact that half of its territory was still controlled by rebel groups. This constraint demanded an appropriate level of security expenditure. The SMP also considered it important to allow public salaries to recover part of the erosion caused by years of hyperinflation. It was also recognized that the very low foreign reserves meant that debt service could not be paid in the short term, and arrears on external debt would have to continue to accumulate.

6. The SMP goals were to quickly break hyperinflation, stabilize the economy, and lay the foundations for reconstruction. The main quantitative objectives for 2001 were to:

  • halt the decline in real GDP that had occurred in each of the previous five years;

  • sharply reduce the inflation rate to below 100 percent (compared to 511 percent in 2000); and

  • maintain gross official reserves at a level equivalent to 2.4 weeks of imports of goods and services.

To ensure rapid rebuilding of the institutions responsible for managing the economy, the IMF conducted a mission to assess technical assistance (TA) needs and prepare a medium-term TA program. The World Bank also supported the program with a US$50 million pre-arrears-clearance grant for projects with rapid social and economic impact; other donors provided humanitarian aid.

7. Macroeconomic policies were therefore anchored on restrained fiscal and monetary policies, adoption of a floating exchange rate regime, restoration of basic budget procedures, and removal of the main price distortions. Fiscal policy was centered on strict adherence to a monthly plan to cut the treasury cash deficit from 3.9 percent of GDP in 2000 to near balance in 2001 so that the government need not have recourse to bank financing. New statutes were to be adopted for the Central Bank because its independence was essential to support a prudent monetary policy within a flexible exchange rate system. In the structural area, where the World Bank took the lead, reforms were directed to strengthening the banking system and improving economic security and governance, notably by setting minimum transparency rules for key sectors; and the diamond export monopoly was removed in 2001. The World Bank also facilitated reform of public enterprises by emphasizing audits and building domestic consensus on privatization and other reforms.

Performance on the program

8. The SMP quickly strengthened macroeconomic stability in 2001 (Figure I.1). Public finances were significantly strengthened by improved budgetary procedures; revenue and expenditure were centralized, and extrabudgetary channels reduced. For the first time in years, Parliament approved the budget. More important, the government strictly observed its monthly cash flow plan, thus ending monetization of the budget deficit, which had fueled the vicious circle of hyperinflation and currency depreciation in the past. With monetary policy effectively tightened, inflation fell sharply in the second half of 2001. With this the exchange rate was stabilized under the new floating exchange rate regime, and the difference between the official and the market exchange rate markedly narrowed. In addition, in 2001 the external current account was much better than expected; by year-end gross external reserves had increased to 4.7 weeks of imports, double the targeted minimum. While real GDP continued to fall instead of stabilizing as expected, some signs of recovery began to appear in the second half of the year.

Figure I.1.
Figure I.1.

Democratic Republic of the Congo: Selected Fiscal and Monetary Developments, 1998-2006

Citation: IMF Staff Country Reports 2007, 329; 10.5089/9781451808438.002.A001

Sources: Congolese authorites; and IMF staff estimates.

9. During the 2001-02 SMP prompt and far-reaching structural measures brought significant improvement in the business environment. All prices were liberalized except those for certain public utilities, though these were raised substantially to reflect changes in costs. The prices of petroleum products were increased by about 300 percent, to international levels, which eliminated not only heavy subsidies but also smuggling to neighboring countries. Together these measures significantly improved product delivery and transportation as a whole. Meanwhile, a new investment code and a law creating commercial courts were published and substantial progress was achieved in preparing for adoption of a new mining code. Administrative capacity was buttressed with the help of TA from the Fund, the World Bank, and other development partners. This made it possible to draw a clear road map for coordinated and targeted TA during the following PRGF arrangement.

C. The PRGF-Supported Program

Objectives and policies

10. Building on the success of the SMP, the PRGF-supported program aimed at entrenching macroeconomic stability and reviving economic growth so as to start reducing endemic poverty. Given the DRC’s dire starting conditions, the interim PRSP had stressed that it would not be feasible to achieve the Millennium Development Goal (MDG) of reducing poverty by half by 2015. Thus the PRGF-supported program defined realistic, though ambitious, macroeconomic targets for 2005, including (i) average real GDP growth rate of about 5 percent; (ii) a reduction of the annual inflation rate to 5 percent by year-end; and (iii) an increase in gross international reserves to US$320 million, close to 10 weeks of nonaid imports of goods and services.

11. Another major goal was to begin normalizing the DRC’s relations with its external creditors, including the Fund. As of March 2002 the DRC had accumulated about US$2 billion of arrears with international financial institutions (IFIs), including US$503 million with the Fund. To make it possible to approve the PRGF arrangement, arrears with the Fund and the World Bank were cleared through two bridge loans; arrears with other IFIs were consolidated, except for the arrears to the African Development Bank (AfDB), which were in part repaid by donors. In addition, the DRC had accumulated more than US$8.5 billion of arrears with bilateral creditors, including more than US$7.8 billion to countries participating in the Paris Club.

12. Medium-term projections showed that the country would need more favorable debt relief than under Naples terms (67 percent reduction of debt in net present value (NPV) terms). In fact, flow rescheduling on Naples terms was concluded with Paris Club creditors in September 2002, and then topped up to Cologne terms (80 percent reduction in NPV terms) in 2003 when the DRC reached the decision point under the enhanced HIPC initiative. At the time it was hoped that DRC could reach the HIPC completion point shortly after the end of the PRGF arrangement.

13. As in many other postconflict cases, the revival of the economy was predicated on a number of assumptions:

  • First, the signing of a comprehensive peace agreement in December 2002 followed by formation of an inclusive transitional government would stabilize security and the political situation and allow for gradual reunification of the country.

  • Second, strong security, political, technical, and financial support from the international community would allow the rebuilding of institutions.

  • Third, removal of major economic distortions and profound changes in regulation were expected to boost real GDP growth by improving resource allocation and supporting better functioning of production and trade activities.

  • Fourth, the passing of laws regulating telecommunication, forestry, and mining sectors, and restructuring of these sectors, were expected to boost growth.

  • Fifth, substantial increased investment in infrastructure, especially for key road connections and improved navigability of the Congo River, was to help relieve major supply bottlenecks, leading to broad-based economic expansion partly financed through direct foreign investment.

14. Achievement of the PRGF-supported program’s objectives would have to be based on sound financial policies. Building on the progress toward stabilizing the economy that was achieved under the SMP, programmed financial policies were anchored in continued improvements in public expenditure management, sustained determination to mobilize revenue, and a shift in the composition of expenditure toward the social sectors, which was monitored with quantitative targets. Strict adherence to monthly cash-flow plans continued to be essential to avoid recourse to bank financing that could undermine the ability of the Central Bank of Congo (BCC) to conduct the prudent monetary policy necessary to keep prices stable within a floating exchange rate system.

Performance under the PRGF-supported program

15. Macroeconomic performance improved markedly in the first three years of the PRGF-supported program, allowing completion of the first five reviews (Figures I.2 and I.3). Economic activity started to recover in 2002 and real GDP growth averaged more than 5 percent a year during 2002-04. Fiscal revenue increased from 6.5 percent of GDP in 2001 to 9.5 percent in 2004. The higher revenue, combined with a renewal of the DRC’s access to external financing, allowed the government to increase its spending, including for investment, while avoiding bank financing of the budget. This supported by prudent monetary policy, brought inflation down impressively, to 4 percent in 2004. The BCC also increased its ability to deal with external shocks by building its international reserves to US$236 million, or 5.2 weeks of imports, by the end of 2004.

Figure I.2.
Figure I.2.

Democratic Republic of the Congo: GDP Growth and Inflation, 1998-2007

(Annual percentage change)

Citation: IMF Staff Country Reports 2007, 329; 10.5089/9781451808438.002.A001

Sources: Congolese authorites; and IMF staff estimates.
Figure I.3.
Figure I.3.

Democratic Republic of the Congo: Developments during PRGF and SMP, 2002-06

Citation: IMF Staff Country Reports 2007, 329; 10.5089/9781451808438.002.A001

Sources: Congolese authorites; and IMF staff estimates.

16. But macroeconomic policy implementation started to weaken in 2005, as the authorities shifted their focus to the election. As a result, the last program review could not be completed, even after the PRGF arrangement was extended until March 2006. The circumvention of mechanisms to limit public expenditure to budget appropriations led to overruns in current spending in 2005. The resulting increase in bank financing of the budget rekindled inflation, which rose to 21.4 percent in 2005, while the Congo franc depreciated by close to 20 percent (annual average) and international reserves fell to US$131 million, 2.6 weeks of imports. However, real GDP growth held steady at 6.5 percent, sustained by a continued recovery in private sector activity.

17. Notable progress on structural reforms was made during the first three years of the program. Expenditure commitment and control procedures were streamlined and tightened. On the revenue side, administrative capacity to collect revenue was rebuilt and data collection and information management systems improved. A new large taxpayers’ unit was established, monitoring of exemptions was enhanced, and customs procedures were simplified. The BCC started to implement an action plan to strengthen accounting and better manage international reserves, internal audit procedures, and supervision of the banking system. In late 2002 the BCC also introduced central bank bills to absorb excess liquidity in the banking system. Six private and three public banks were liquidated, and the BCC approved restructuring plans for other banks. In addition, all public enterprises were audited, and restructuring plans for the most important ones prepared. Government arrears with the domestic private sector (US$840 million) were also audited.

18. Measures were also taken to improve governance, although the remaining agenda is large. A law on combating money laundering and the financing of terrorism and a law on anti-corruption were passed. A new forestry code consistent with long-term sustainability was adopted in 2002, and a large number of concessions were annulled. The code rationalizes taxation in the sector and introduces transparent market-based mechanisms to encourage high-value industrialization. A new mining code consistent with international best practices was adopted in 2002. The operations of the new Mining Registry (cadastre minier) were partly brought in line with the mining code. However, corruption remains a major issue in the management of public resources, especially natural resources.

19. From 2005 onward, the implementation of structural reforms also slowed. While a census of public employees was conducted in 2005, efforts to contain the size of the civil service and remove “ghost workers” from the public payroll yielded limited results, making it hard for the government to control its wage bill. Also, because many government agencies wanted to continue collecting fees, the decrees designating the customs office as the sole agency to operate the one-stop window for import valuation at DRC’s main port was only partially implemented. The pace of reform in the mining sector, forestry, and public enterprises was not sustained, and the BCC made little further progress in strengthening its operations and reducing its large structural deficit.

20. On social policies, under the PRGF-program progress was significant, though incomplete. The government adopted the Poverty Reduction Strategy Paper (PRSP) in July 2006. The PRSP provides a sobering poverty diagnosis: more than 70 percent of the population lives below the poverty line. The document outlines medium-term policies and measures to deal with issues identified after broad consultation in each province. The drafting of detailed medium-term strategies for education and health, prepared with the assistance of the World Bank and other donors, is well advanced. Domestic budget appropriations for education and health were increased from 2.0 percent of GDP in 2003 to 3.8 percent in 2006, financed largely with resources made available by interim assistance under the enhanced HIPC Initiative. However, actual spending fell short, mainly because of spending overruns for the elections, security, and political institutions (mainly the presidency, vice presidencies, and parliament).

21. Although poverty is still very high, anecdotal evidence suggests that improved security and sustained growth are helping to improve living standards. The pay of public employees has risen much faster than inflation; total wages rose from 1.7 percent of GDP in 2002 to 5 percent in 2006. The end of armed conflicts in most of the country also allowed the rural population to increase food production. Sustained growth, the liberalization of the economy, and improvement in transportation, especially on the Congo River, has led to a much greater supply of consumer goods and a decline in some prices. Nevertheless, progress toward the MDGs has been slow and income inequality is very high (the GINI index is estimated at 40 percent).

D. Macroeconomic Policy and Structural Reforms Since 2006

22. When the PRGF arrangement expired after the last review could not be completed, the government agreed to implement a program for April-December 2006 to be monitored by Fund staff. The main purpose was to offer the authorities a policy framework to keep the economy stable during the electoral period and finish implementing delayed structural reforms.

23. However, political and security tension during the election period made it difficult for the government to implement tight macroeconomic policies. As large public spending overruns, primarily for security and campaign-related activities, continued to be monetized, the Congo franc depreciated by 15 percent against the US dollar, 12-month inflation rose to 18.2 percent (the target was 9.5 percent), and gross international reserves stood at US$150 million by the end of the year, far below the US$250 million target. In the second half of 2006 the government also did not service nonreschedulable debt to official bilateral creditors amounting to US$58 million. Meanwhile, real GDP growth slowed to 5.1 percent, owing to stagnating output in mining and manufacturing.

24. In view of the rapidly deteriorating macroeconomic situation, the government formed after the elections agreed on an economic program for April-December 2007 soon after taking office in February 2007. The program, which is monitored by Fund staff, offers the authorities an opportunity to demonstrate their commitment to macroeconomic stability and structural reform, and time to draw up a credible medium-term program that could be supported by the Fund through a successor PRGF arrangement. This objective requires better management of public finance to avoid government recourse to bank financing that inevitably translates into exchange rate and inflationary pressures. It is also essential that the authorities implement the structural reforms left pending from the last review of the PRGF arrangement and move to improve governance in the mining sector.

25. It appears that the new government has tightened fiscal policy. Strong revenue collection and lower than anticipated public spending reduced net bank credit to the government in the second quarter of 2007. This brought about declines in base money and commercial bank excess reserves, a 12 percent appreciation of the Congo franc, a decline in inflation to 12 percent, and some rebuilding of international reserves. However, the 2007 budget approved by Parliament and promulgated by the President calls for a very large and unrealistic increase in government revenue and concomitant higher spending, especially on wages. Execution of budgeted spending would likely yield a wide fiscal deficit, expand the monetary base, and push up inflation.

E. Program Conditionality and Compliance

26. Quantitative conditionality under the PRGF-supported program was primarily designed to curb inflationary pressures by avoiding monetization of fiscal deficits. Ceilings were set on net BCC domestic assets (NDA) and net bank credit to the government (NCG), and a floor on net BCC net foreign assets. Sub-ceilings were set for some categories of public expenditure; the DRC government was also not to accumulate external arrears and contract or guarantee external debt on nonconcessional terms.

27. Five of the six reviews of the PRGF arrangement were completed. In each case, observance of some quantitative performance criteria was waived because deviations were sufficiently minor for the authorities to take corrective action and keep the program on track. About three-fourths of the quantitative performance criteria set for the first five program reviews were observed. However, larger slippages relative to the performance criterion on NCG for the end of September 2005 and to the indicative targets for the end of December 2005 on NCG, NDA, and NFA precluded completion of the last review before the arrangement expired in March 2006 (Table I.1).

Table I.1.

Democratic Republic of the Congo: Observance of Performance Criteria during PRGF Arrangement, 2002-06

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Source: IMF documents.

End-September 2002 Ceiling on BCC’s NDA.

Implemented with delay.

End-March 2003 Floor on BCC’s NFA, ceilings on BCC’s NDA and NCG, and continuous PC prohibiting budgetary expenditure financed by the BCC without the prior authorization of the Ministry of Finance.

New expenditure procedures established with delay.

End-December 03 Floor on BCC’s NFA and ceilings on BCC’s NDA and NCG.

End-March 04 Floor on BCC’s NFA and ceilings on BCC’s NDA and NCG.

End-September 04 Floor on BCC’s NFA and ceilings on BCC’s NDA and NCG. End-December 04 indicators on BCC’s NFA and on BCC’s NDA and NCG were also missed.

External audit of MIBA done with three month delay.

End-September 2005 ceiling on NCG. End-December 2005 indicative targets for BCC’s NFA and NDA, and NCG were also missed.

28. The PRGF-supported program had substantial structural conditionality, focused on core areas of the Fund’s mandate (Table I.2). Of the 42 structural measures set as conditions, 18 were to strengthen public finances, 10 to address weaknesses of the central bank and the financial system, and the rest to reform public enterprises and governance. Fiscal structural measures aimed at putting in place appropriate budget processes, building revenue, and improving the quality of public spending.

Table I.2.

Democratic Republic of the Congo: Compliance with Structural Conditionality Under the PRGF Arrangement, 2002-06.

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Source: IMF documents.

March 04 SPI changed into PA for 4th review.

March 04 SPI changed into Sep04 SPC.

Originally schduled for May 2005. Moved to reflect delay in completion of 5th review and extension of arrangement until March 2006.

Superseeded by assistance provided by EU to strengthen conrols of military budget.

29. Structural conditionality was particularly heavy at the beginning of the PRGF arrangement. This is consistent with institutional weaknesses and the many deficiencies that greatly hampered economic policy-making after decades of mismanagement and civil conflict.

30. The structural conditions were substantially met during the first three years of the PRGF arrangement (Table I.3). More than 80 percent of the measures were implemented in the course of the PRGF arrangement, although half met with some delay. The slippages were found to be sufficiently limited or adequately remedied to allow for waivers. Compliance with structural conditionality, however, deteriorated markedly toward the end of the arrangement. During the final phase of the political transition, none of the four structural performance criteria for the sixth review and none of the structural indicators for the SMP were observed.

Table I.3.

Democratic Republic of the Congo: Compliance with Structural Conditionality under PRGF arrangement, 2002-06

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Source: IMF documents.

F. Performance Relative to Other Post Conflict Cases

31. The DRC’s macroeconomic performance was largely in line with comparable postconflict cases. Fund involvement in such cases is difficult to assess because each country’s circumstances are unique, including the timing and length of engagement relative to the conflict. The most suitable comparator for the DRC seems to be Sierra Leone, a country also rich in mineral resources that went through years of a vicious civil war. The DRC’s macroeconomic performance since 2000 compares relatively well with that of Sierra Leone except for international reserve adequacy, but it should be noted that the share of external grants in GDP is substantially less in the DRC than in Sierra Leone.

G. Main Lessons and Policy Challenges for the Medium Term

32. Stabilizing the economy was a vital element in helping the country move toward peace and security, and making it possible to hold the first successful democratic elections in more than 40 years. Donor-supported programs in the security, political, and economic areas were tightly coordinated and reinforced each other. This demonstrated a firm commitment from the international community to accompany the process by providing security as well as political, technical, and financial assistance. It encouraged all stakeholders, within and outside the government, to participate in the political and peace process. Since 2001, the IMF and the World Bank have been working to help the government stabilize the economy and secure sufficient technical and financial assistance from the international community to start rebuilding institutions and infrastructure and to finance the budget.

Table I.4.

Selected Economic Indicators for the Democratic Republic of the Congo and Sierra-Leone, 2000-07

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Source: IMF documents.

33. Rapid disinflation was crucial in restoring economic confidence. It encouraged private sector activity and foreign direct investment. This was made possible by the combination of tighter fiscal and monetary policies and high external financial support. The economy is now relatively open, major price distortions have been removed, and the private sector is driving growth. As a result, robust real GDP growth has been sustained for the past five years. However, progress in the social sector has been slow and improvement in social indicators limited.

34. The program outcome also demonstrates that the economic situation is still very fragile and maintaining momentum for economic stabilization and reforms is a challenge. Repeated pressures on the exchange rate and inflation demonstrate how rapidly progress can be overturned when macroeconomic policies are relaxed. This reflects (i) the difficulties of maintaining consensus on policies in a postconflict situation; (ii) weak institutions complicating the decision-making process and programming implementation; and (iii) an unsettled security situation in the eastern provinces, making it difficult to focus on economic and financial issues.

35. With the elections over, the question now is whether the new government will regain the momentum for reform. The challenges are enormous; determined leadership will be essential to move the process forward and prepare a coherent and focused medium-term program that would deserve the support of the IMF and the rest of the international community. Government institutions will need to be reinforced and decision-making made more open to ensure that the full government works toward observing the priorities and meeting the objectives set in the program. This implies that the political and technical committees responsible for design, implementation, and monitoring of programs be strengthened, streamlined, and given full support from the highest level of government.

36. Strengthening the management of macroeconomic policies is essential. Repeated cycles of policy tightening and relaxation have to cease for the private sector to gain confidence in government management of the economy and be willing to increase investment. Steady policies and improved confidence would greatly help the development of the domestic financial market, including the government bond market, which would greatly help treasury cash flow management. As a first step, the government needs to stop having recourse to bank credit to finance the fiscal deficit, the main source of economic instability. To achieve this, the government needs to strengthen public financial management along the lines indicated below in the chapter on the medium-term fiscal strategy.

37. Tighter fiscal policy should also be accompanied by a prudent monetary policy and a deepening of financial intermediation. This will require the central bank to improve its operations and capacity to conduct monetary policy and supervise the financial sector (see also the section below on the financial sector). In particular, fiscal and monetary policies should be better coordinated to reduce volatility in base money.

38. Fighting vested interests and widespread corruption is essential to promote private sector development and achieve high growth. The main reason for failing to implement structural measures has often been the inability to overcome opposition from powerful vested interests. To succeed now, the government must build broad coalitions with civil society and other groups outside government, as was the case early in the initial PRGF-supported program. In turn, this will imply government willingness to operate in a more open and transparent way and better communicate the purpose and objectives of the program. This will require that the government make management of natural resources-especially mining and forestry and public finance much more transparent.

39. Social policies should receive greater attention. Improved and less costly delivery of services in health and education would help the population support strong economic policies. While significant progress was made to improve salaries in those sectors, the quality of services remains low, and fees paid by hospital patients and parents of students remain high. So, it would seem essential for the government, together with donors, to assess the utilization of public resources in those sectors, and complete medium-term strategies for their developments (which are also conditions for reaching the HIPC completion point).

40. The international community must continue its support of the reform process. The international committee (CIAT) set up to accompany the political transition was disbanded at the end of the transition. While development partners continue an active dialogue on sectoral policies with the government, a new forum would improve coordination on issues, especially those with significant political, security, and economic elements. It is also essential that the international community increase its technical and financial assistance, given the country’s limited absorptive capacity and huge reconstruction and social needs. Because the DRC’s debt burden is unsustainable, it is essential that financial assistance be in the form of grants.

41. The DRC has substantial macroeconomic imbalances and structural problems in core areas of IMF expertise, warranting continued close involvement. One key area is for the IMF to agree with the government on strong economic policies and medium-term program. This is vital since satisfactory implementation of a PRGF-supported program is a condition for the DRC to reach the HIPC completion point and obtain debt relief that will bring the external debt to a sustainable level. The DRC could also greatly benefit from Fund technical assistance to strengthen capacity, particularly in the fiscal area and at the central bank. Current efforts to improve the DRC’s record of economic policy implementation and governance must be strongly encouraged in order to buttress donor support and avoid jeopardizing the progress achieved since 2001.

II. The DRC Financial Sector 3

A. Overview

42. This chapter describes recent developments in the financial sector of the DRC and offers suggestions for fostering financial deepening. Because of the civil war and cycles of high inflation and depreciation of the local currency, the financial sector is barely functioning. Although there has been progress in stabilizing the economy, confidence in the financial sector has yet to recover, further slowing its development.

43. Reconstructing the DRC financial system is a precondition for successful and broad-based economic recovery. A reliable financial system promotes growth by (i) efficiently mobilizing and pooling savings; (ii) channeling investments toward activities with high returns; (iii) making it possible to monitor the use of funds; (iv) facilitating risk management by allowing for risk diversification; and (v) easing the exchange of goods and services. Deep financial markets also render monetary policy more efficient. Finally, access to finance can increase welfare and promote alleviation of poverty and the emergence of an economically active middle class.

44. If growth is to be sustained, the financial sector must be strengthened to ensure its stability, encourage growth in private sector credit, and increase competition by facilitating market entry subject to “fit and proper” tests according to international best practices. This calls for reforming the BCC, reinforcing prudential supervision, and restructuring insolvent financial institutions. Building a sound microfinance sector would also be a vital step toward increasing deposits from, and credit to, the private sector, especially medium and small enterprises.

45. Meeting such challenges is more difficult in postconflict countries like the DRC. Information asymmetries between borrower and lender are aggravated by the loss of financial records. This results in credit rationing and crowding out of most of potential borrowers except for a few large players. A weak judicial system, pervasive corruption, and ill-defined property rights also constrain access to credit. Reinvigorating the banking system must therefore be carefully sequenced with reform of the legal system, creating mechanism for banks to share credit information, and strengthening financial sector assessment of credit risk. This will help reduce the risk premium and enhance access to credit.

B. Size and Structure of the Banking Sector

46. Commercial banks—the dominant institutions in the financial sector—are small (Table II.1). Their assets accounted for about 10 percent of total GDP and 75 percent of total financial sector assets in 2006.4 The state holds minority shares in two banks and the other nine are totally or majority foreign-owned.5 In addition, 10 insolvent banks are being restructured or liquidated.

Table II.1.

Democratic Republic of the Congo: Financial System Structure, 2006

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Source: Central Bank of the Congo (BCC), Directory of Bank Supervision.

47. Bank networks have limited coverage. Since the state-owned banks with large networks were liquidated, only 60 bank branches cover a country the size of Western Europe. The number of bank accounts is estimated at 100,000. With one branch per million inhabitants, the DRC has one of the lowest bank penetration rates in the world. Furthermore, banks are concentrated in the capital, Kinshasa, though a few branches were recently opened in economically important cities like Lubumbashi (capital of the mineral-rich Katanga province), Kisangani, Mbuji-Mayi, Kananga, Goma, Bukavu, and Matadi.

48. Concentration in the banking sector is relatively moderate. The Herfindahl-Hirshman Index (H) indicates medium concentration of total bank assets (Table II.2).6 At the end of 2006, the market was still dominated by one bank that accounted for about 25 percent of deposits, though this is down from 33 percent in 2005. This trend reflects the arrival of new banks since 2002, a sign of economic recovery and growth potential.

Table II.2.

Democratic Republic of the Congo: Herfindahl Index (H), 2006

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Sources: Central Bank of the Congo (BCC), Directory of Bank Supervision, and IMF staff estimates.

C. Banking System Operations

49. The depth of the banking sector and the extent of its financial intermediation are minimal. While the ratio of broad money to GDP doubled in the past five years, it still amounted to only 11 percent in 2006, one-third the average for SSA (Table II.3).7 Similarly, relative to GDP total banking sector assets rose from 4.1 percent in 2001 to 10 percent by the end of 2006, much below the 25 percent average for low-income SSA countries. The DRC also lags other SSA countries in respect to private sector credit. The very limited interbank activity (3 percent of GDP in 2006) reflects a lack of confidence among banks and collaterals.

Table II.3.

Democratic Republic of the Congo: Banking Sector Development, 2001-06

(Percent of GDP)

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Sources: Central Bank of the Congo (BCC), Directory of Bank Supervision, and IMF staff estimates.

50. The banking sector is highly dollarized (Table II.4). Most bank loans (75 percent) and deposits (87 percent) are denominated in foreign currency (mostly U.S. dollars). In light of past inflation, businesses prefer using foreign currencies for settling large transactions and as a vehicle for savings. This preference is accentuated by the absence of high-denomination Congolese banknotes. Payment systems other than cash are virtually nonexistent.

Table II.4.

Democratic Republic of the Congo: Trend of Dollarization, 2001-06

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Sources: Central Bank of the Congo (BCC), Directory of Bank Supervision, and IMF staff estimates.

51. Banks face difficulties in mobilizing deposits. High dollarization and a large informal sector partly explain why the ratio of total bank sight deposits to currency in circulation was only 17 percent at the end of 2006. Deposits represented 60 percent of the banking system balance sheet, and 89 percent were short term. Local currency time deposits were less than 1 percent of total deposits, mostly because of the country’s past experience with hyperinflation but also because banks generally have very restrictive requirements for opening an account, including high minimum balances and fees.8

52. Banks focus on large corporate customers. Their client base mainly consists of international and top-tier local companies, especially in mining and trade, the public sector, and wealthy individuals. This reflects limited investment opportunity, imperfect competition, and banks that are highly risk-averse, given the difficult sociopolitical situation. However, this has started to change. One bank that started operations in August 2005 concentrates on supporting small and medium-sized enterprises. Others are also beginning to show an interest in the retail clientele, offering deposit accounts with lower minimum balances.

53. Banks extend very little credit to the private sector. In 2006, less than 3 percent of GDP was loaned to the private sector, compared with 12.3 percent for low-income countries in SSA. About 87 percent of the loans are short-term, mirroring the maturity structure of bank deposits, the main source of bank funding. Most loans are either for working capital, overdrafts, and letters of credit. Moreover, a large share of loans is made to a small number of clients, resulting in a high loan concentration. Banks’ exposure to government lending is also limited.

54. Most banks are highly liquid; 83 percent of bank assets consist of cash, deposits at the central bank, and investments in central bank treasury bills. This is due to a high liquidity ratio requirement, limited access to domestic financial instruments such as bonds, and an inefficient payments system. Currently the use of checks and credit cards is minimal. Settlements between provinces can take 30 days and may be executed only in Congo franc, even though the banking system is highly dollarized. The holding of liquid assets is also encouraged by an interbank market that lacks depth (Table II.5).

Table II.5.

Democratic Republic of the Congo: Interbank Market, 2001-06

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Sources: Central Bank of the Congo (BCC), Directory of Bank Supervision, and IMF staff estimates.

55. The profitability of banks has recently improved. Return on assets averaged about 3 percent and return on equity 52 percent in 2006; the latter largely reflects the low capital base of the banking system. With credit activity limited, noninterest income (such as fees on international transfers, foreign exchange transactions, and letters of credit) constitutes a large share of total income.

D. Banking System Soundness and Vulnerability

56. The BCC is responsible for supervising the financial system. Under the Central Bank Law of 2002, the BCC issues bank licenses, publishes regulations, and supervises banks both off- and on-site. The BCC also issued regulations for microfinance institutions (MFIs) in 2003. Regulation of the financial system has improved substantially since 2002, but many areas need improvement.

Banking system soundness

57. The solvency of banks has somewhat improved but remains fragile (see Table II.6). At the end of 2006 the capital-risk-weighted adequacy ratio averaged 10.5 percent—the first time the 10 percent requirement was met since 2002. However, four banks did not meet this requirement.

Table II.6.

Democratic Republic of the Congo: Financial Soundness Indicators, 2003-06

(Percent)

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Source: Central Bank of the Congo (BCC), Directory of Bank Supervision.

58. Nonperforming loans (NPLs) are reported to be low. However, the accuracy of the reporting system is uncertain, not least because the BCC does not have sufficient inspection capacity to verify the information and if necessary require adjustments. Loan classification is in line with international norms (see Table II.7).

Table II.7.

Democratic Republic of the Congo: Loan Provisioning Rules for Nonperforming Loans

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Sources: Central Bank of the Congo (BCC), Directory of Bank Supervision, and IMF staff estimates.

Banking system risks

59. Though financial soundness and performance indicators have improved in the last two years, risks remain high. Volatile macroeconomic policy can lead to a rapid change in the liquidity of the banking sector. For instance, a fiscal and monetary tightening in early 2007 sharply reduced banks excess reserves; so by end-March 2007, 8 out of 10 banks did not observe the liquidity ratio.9 Furthermore, because the ratio is based on overall liquidity, it is uncertain whether it captures the liquidity risk in individual currencies.

60. No bank respected the ratio on net foreign exchange position. This is a source of concern considering how volatile the Congo franc is and the difficulties banks may have in covering short-term position.

61. No bank respected the credit risk ratio (25 percent of equity on a single signature), partly because banks concentrate their activities on a few large enterprises and because they have a narrow capital base. In addition, the risk for the banking system of enterprises borrowing in foreign currency is uncertain; there is little information on how much of which currencies are in the company revenue streams.

62. Interest rate risk is small. There is little maturity mismatch between assets and liabilities due to the predominance of short-term assets. Loans are overwhelmingly short-term (87 percent), as are liabilities (demand deposits account for 89 percent of total deposits), and the interest rate spreads are large.

E. Microfinance

63. The microfinance sector, though embryonic, is growing fast. The BCC has granted licenses, most of them since 2000, to 11 microfinance institutions and 46 cooperatives. Two commercial banks also provide micro credits.

64. Microfinance institutions help deepen financial intermediation. Reports from 28 institutions show their total deposits and loans increasing in 2005 by 50 percent, to US$9.3 million in deposits and US$6.8 million in loans. Most loans were for trade-related activities; 97 percent were granted in urban areas and 61 percent to women. The potential for rapid growth is demonstrated by ProCredit Bank, which opened in August 2005 and had 22,000 accounts by March 2007. It opens 100 new accounts every day and processes about 400 loan applications every month; the average loan, often denominated in U.S. dollars, amounts to US$2,750.

65. Regulation of the sector needs to be tightened. MFIs are regulated by an instruction from the BCC issued in 2003 and updated in 2005.10 The BCC is building an exhaustive database on MFIs and establishing a reporting system with assistance from the U.N. Development Program (UNDP) and the U.N. Capital Development Fund (UNCDF). Currently, information on microfinance is limited and unreliable because institutions do not report financial statements to the BCC, as required.

F. Nonbank Financial Institutions

66. The nonbank sector is in dire straits. Financial information is scarce because nonbank institutions do not produce audited accounts, do not follow international accounting standards, and are not well supervised. Several have stopped allowing customers to draw on their deposits, seriously damaging confidence in the sector.

Savings banks

67. The state-owned Caisse d’epargne du Congo (CADECO) has ceased to function. It has accumulated large losses and a high volume of nonperforming loans. The BCC excluded CADECO from its clearing house and dispatched a team to take over its management in July 2006. Financial and organizational audits of the CADECO are urgently needed to decide its future.

68. The postal savings network is almost bankrupt and no longer operates as a financial institution. Though 69 offices are still open, small depositors are unable to withdraw funds because available resources are used to cover operating expenses.

Insurance

69. The state-owned Société nationale d’assurances (SONAS), which has a monopoly on the insurance market, faces serious financial difficulties. Its restructuring and opening the sector to competition are essential to improve the availability of insurance products at a reasonable cost.

Pension funds

70. The Institut National de Sécurité Sociale (INSS) also faces serious difficulties. The INSS is not able to collect the premiums it needs to pay claims because of the large size of the informal sector and the number of public enterprises in financial distress. Moreover, much of its infrastructure has been mismanaged. But it still employs 1,650 agents and has 36 branches throughout the country.

Specialized financial institutions

71. The Société Financière de Développement (SOFIDE) and Fonds de Promotion de l’Industrie (FPI) are specialized institutions that have accumulated heavy losses. SOFIDE is a development bank that finances medium and long-term projects for small and medium-sized enterprises. Its loan portfolio has dropped sharply and is mostly non-performing, it has been accumulating losses for years, and it has a negative net worth. To promote the development of manufacturing enterprises, the FPI is funded by a tax on industry, the taxe de promotion de l’industrie (TPI). It provides subsidized loans to enterprises, but defaults are reportedly high.11

G. Addressing the Challenges Facing the Financial Sector

72. Despite recent progress, financial intermediation is still very limited. A strengthened central bank and a conducive business environment. This together with prudent macroeconomic policies is essential to develop financial markets and deepen financial intermediation.

Strengthening the central bank

73. The BCC’s current program of reforms needs to be accelerated. This is essential to (i) improve BCC financial and technical capacity; (ii) enhance its management of monetary policy; (iii) reduce operating losses by streamlining its operations to gain financial autonomy; (iv) strengthen bank supervision; and (v) modernize the payment system.

74. Procedures for licensing and closing banks should be reinforced. Minimum capital should be raised from the current US$1.5 million to probably at least US$5 million, given the level of risk faced by banks in the DRC and their rapidly growing balance sheet. Transparent application of licensing requirements is also essential to ensure that the reference shareholder satisfies criteria for reputation, experience, and financial standing and that new banks are prudent. In addition, banks in difficulties should be either restructured or liquidated without delay. The process, however, must ensure that depositors’ claims are protected.12

75. Aligning prudential regulation and bank supervision with international standards is crucial. As recommended by the South African Development Community (SADC) committee on bank supervision, the BCC is to complete an assessment of its compliance with the 25 Basel Core Principles by the end of 2007. This will form the basis for an action plan for remedying deficiencies and introducing new banking regulations. Over the long term regulations should be upgraded to international standards (Basel 1 and 2). Bank supervision will also be strengthened with the Bank Supervision Application13 software, which is to become operational in early 2008. Ultimately, however, the supervision of banks will improve only to the extent that the department of the BCC in charge of it is able to monitor and enforce the observance of prudential ratios, including by imposing sanctions when necessary.

76. To modernize the national payment system, the BCC should press ahead with the implementation of the SADC Payment System Project. The law related to the payment system also needs to be amended to recognize new technologies. ATMs, point-of-sale machines, and electronic bank cards would lower the costs of financial services. Considering the size of the country and the lack of roads and land lines, linking the financial infrastructure to cell phone technology could also be a useful shortcut.

Improving the business environment

77. Building the financial sector requires improving the business environment. The main reasons for high lending costs and limited access to credit are lack of competition and the risks associated with the high cost of doing business in the DRC. The World Bank’s Doing Business survey ranks Congo last among 175 economies in terms of ease of doing business (Table II.8). On measures of the scope, access, and quality of credit information available through public registries or private bureaus, the DRC scores zero on a scale of zero to six. Financial institutions find it difficult to assess creditworthiness because information from the Centrale des Risques is limited and unreliable, standards for accounting and auditing practices are poor, collateral and property registries are not generally available, and contracts are difficult to enforce.

Table II.8.

Democratic Republic of the Congo: Doing Business Rankings, 2005-06

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Source: World Bank Doing Business 2006 database.

78. In the short term, adopting the following measures should be a priority: (i) granting tax exemptions for provisions for disputed debt and foreign-exchange losses; (ii) promulgating the new accounting plan for lending institutions; and (iii) amending the current corporate law to allow for creation of limited liability companies, the legal structure required for banks.

79. Other crucial legal reforms are ratification and implementation of OHADA. DRC membership in the Organization for the Harmonization of African Business Law (OHADA) became effective in February 2006 but has yet to be ratified by Parliament. Over the medium term new laws governing contracts are needed and judicial administration must be made more efficient. Setting up a pledge registry and a credit bureau would also help deepen financial intermediation. Finally, new charts of accounts for financial institutions should be disseminated promptly to facilitate audit and publication of bank financial statements.

Developing microfinance institutions

80. Given the size of the country, MFIs could compensate for the limited outreach of the traditional banking system. They already have as many accounts as banks and serve clients that the banks find costly to reach, such as poor and rural households, nonsalaried workers, and small entrepreneurs operating in the informal sector. To achieve long-term sustainable outreach and avoid the boom-bust cycles that some countries faced when the sector grew rapidly, MFI soundness should be carefully monitored to ensure that they achieve and sustain profitability.

81. Supervision of MFIs must be improved. Completion of the BCC database and analysis of the sector will be a precondition for effective regulation. A draft law for regulating the sector is to be presented to the National Assembly by May 2008. The BCC should also draft regulations and supervision procedures for other deposit-taking institutions. This must all be done carefully to avoid further burdening the limited supervisory capacity of the BCC.

Increasing donor support

82. Given the challenges in the financial sector, the assistance of development partners is very important. For the last few years the IMF and the World Bank staffs have helped address weaknesses in the BCC and the banking sector. Microfinance is receiving considerable attention from development partners, and efforts are under way, with the help of the Consultative Group to Assist the Poor (CGAP), to improve coordination and ensure that best international practices are applied. More should be done, however, to address the serious financial difficulties of the state-owned insurance company and the social security system.

83. Although the BCC has its own strategic plan, there is no comprehensive strategy for the financial sector. DRC participation in the IMF and World Bank Financial Sector Assessment Program (FSAP) would make possible a comprehensive evaluation of the financial system and give the authorities a basis for designing a strategy to reduce sector vulnerabilities and improve access to financial services.

References

  • Addison, Tony, Alemayehu Geda, Philippe Le Billon and S. Mansoob Murshed, 2001, “Financial Reconstruction in Conflict and ‘Post-Conflict’ Economies,” Wider Discussion Paper No. 2001/90 (Helsinki: United Nations University).

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  • Addison, Tony, Alemayehu Geda, Philippe Le Billon and S. Mansoob Murshed, 2005, “Reconstructing and Reforming the Financial System in Conflict and ‘Post-Conflict’ Economies,” Journal of Development Studies, Vol. 41 (4), pp. 703- 18.

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  • Gulde, Anne-Marie, Catherine Pattillo, and Jakob Christensen, 2006, Sub-Saharan Africa: Financial Sector Challenges (Washington, DC: International Monetary Fund).

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  • Levine, Ross, Norman Loayza, and Thorsten Beck, 2000, “Financial Intermediation and Growth: Causality and Causes,” Journal of Monetary Economics, Vol. 46 (1), pp. 31- 77.

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III. The DRC’s Medium-Term Agenda For Structural Fiscal Reforms14

A. Introduction

84. Progress in rebuilding DRC revenue collection and budget execution capacities has been remarkable. After a long period of civil and military strife, which left several parts of the country without functioning government structures, the transition government implemented reforms in both revenue administration and budget preparation and execution. More efficient collection, in addition to the rebound of economic growth, helped increase the share of total revenue (excluding oil revenue and grants) in GDP from 6.3 percent in 2002 to 9.9 percent in 2006. Monthly reporting on budget execution from commitments to payments is now available on the basis of a computerized expenditure chain, and important progress has been made in preparing three-month rolling spending commitment and cash-flow plans.

85. Despite these important achievements, the agenda of structural fiscal reforms is still vast. Low government revenue, combined with a massive need to step up reconstruction and social spending, leaves the DRC’s fiscal position heavily dependent on external financing. At the same time, the need to consolidate progress in macroeconomic stabilization precludes monetization of fiscal deficits, which has been the main cause of inflation—most notably through the immediate impact on the exchange rate under conditions of high dollarization and very limited sterilization capacity of the central bank. Reconciling fiscal consolidation with the need for a large increase in infrastructure and social expenditure will require accelerating reforms to overcome the fragmentation of revenue collection agencies, address corruption, and strengthen public financial management (PFM).

86. This chapter addresses the agenda for structural fiscal reforms over the next five years. To create fiscal space for the urgently needed increase in infrastructure and social expenditures,15 the medium-term fiscal strategy should aim to (i) streamline the tax system and broaden the tax base; (ii) improve tax collection; (iii) strengthen PFM; (iv) enhance the quality and efficiency of government spending; and (v) manage fiscal risks emanating from decentralization. The remainder of this chapter presents an overview of structural fiscal issues (section B) and discusses fiscal reform priorities (section C). Section D concludes.

B. Structural Fiscal Issues

87. Tax administration and budget preparation and execution have significantly improved since 2001, but critical weaknesses remain:

  • Weak revenue mobilization. In 2006 revenues (excluding grants) amounted to 13.2 percent of GDP and covered only 60 percent of total spending. Low government revenue, combined with large need for rebuilding infrastructure, leaves the DRC heavily dependent on external financing (including direct budgetary support) and limits pro-poor spending.

  • A complex tax system impedes transparency and engenders graft. A plethora of taxes, and the pervasive fees and duties collected by a variety of public agencies, results in unwieldy tax administration and revenue leakage.

  • Despite progress over the last few years, weaknesses remain in tax and customs administration. Fragmentation of collection agencies, the prevalence of corruption, frequent changes in management and a costly and nontransparent incentive system have hindered reform. In the eastern provinces, major investments, including in human capital, are essential to ensure basic collection functions. The presence of multiple agencies collecting fees and duties at the border hinders the work of customs.

  • The weaknesses of revenue mobilization are particularly pronounced in the mining sector. Widespread corruption, lack of controls, and tax exemptions lead to large revenue losses. A sustained approach to managing joint venture contracts would improve government revenue from mining (less than ½ percent of GDP in 2005) and improve transparency. Noncompliance in paying mining fees should result in penalties and, where breach is continuous, cancellation of contracts. Ad hoc exemptions have further narrowed the tax base.

  • Budget management is fragmented between several ministries with little coordination among them, leading to overruns and payment arrears. Budget preparation and execution is split between the ministries of finance, budget, and planning, resulting in a de-linking of commitment management from cash flow management and the emergence of arrears to domestic suppliers (0.8 percent of GDP in 2006). Circumvention of budgetary expenditure chain through the use of ad hoc spending procedures (“mises à disposition de fonds”) is widespread, significantly weakening budgetary discipline. These ad hoc procedures also give the budget ministry broad leeway to allocate resources irrespective of budget ceilings, often at the expense of pro-poor spending.

  • The decentralization agenda enshrined in the new constitution poses serious fiscal risks. The constitution grants provinces 40 percent of government revenue collected in their territory and full responsibility for their budgets, but the transfer of spending responsibilities is less clearly defined. Such measures, particularly if implemented rapidly, could lead to loss of control over government spending, fiscal imbalances between provinces, and macroeconomic instability.

C. Fiscal Reform Priorities

Tax policy

88. Efforts to streamline the tax system need to continue so as to expand the tax base without increasing the burden on the formal economy. This can be achieved by (i) reassessing tax policy for the mining sector, which until now has been ineffective in ensuring that the sector makes an adequate contribution to government revenue; (ii) limiting tax exemptions to those complying with the investment, mining, and forestry codes; (iii) refraining from granting ad-hoc exemptions; (iv) simplifying taxes, including by reforming the turnover tax and corporate taxes; and (v) eliminating nuisance taxes.16 A drastic reduction in the number of taxes and fees (about 800) is also a necessary condition for increasing tax administration efficiency.

89. Preparations for introducing the VAT should be accelerated. The authorities have for several years planned to replace the current turnover tax system with a broad-based value-added tax and a draft VAT law was finalized in the second quarter of 2006. However, the draft was not submitted to Parliament, implying that a VAT introduction will not be feasible before January 2010. To meet this deadline, the draft VAT law should be submitted to Parliament as soon as possible and sufficient budgetary resources be provided for necessary investments by the revenue collection agencies. In particular, this will require setting up ten tax centers for medium-sized enterprises (Centres des Impôts, or CDIs) in the provinces (only one is fully operational so far and another two may be established by end-2007). Moreover, the revenue collection agencies will need to step up training of their staff.17

Tax administration

90. Tax administration reform remains the main short-term instrument for increasing the tax take. The DRC is highly dependent on donor support, which is volatile—partially reflecting changes in the perception of the authorities’ willingness to vigorously address governance issues—and uncertain over the medium term. Fiscal sustainability, therefore, requires far-reaching changes in the management and institutional structure of the three revenue agencies. However, reforms in this area have proceeded only slowly despite considerable technical assistance from the IMF and other donors. Reform continues to be hampered by vested interests, resulting in inefficient procedures, poor governance, and insufficient investment in information technology, human capital, and the provincial CDIs.

91. Further strengthening the tax administration capacity is a short-term priority. In the short term, tax administration reform should focus on (i) strengthening the large taxpayers’ unit (LTU) and extending its scope to cover another 111 large enterprises; (ii) establishing CDIs in all provinces; (iii) improving taxpayer registration by enforcing the use of the new single taxpayer identification number for commercial, financial, and fiscal operations; (iv) strengthening and refocusing the work of the audit unit; and (v) improving cooperation with customs.

92. The merger of the tax and nontax collection agencies is a key medium-term reform to overcome the fragmentation of the revenue administration. The timing of this reform will crucially hinge on (i) the pace of tax reform, in particular a sharp reduction in the number of taxes and fees; and (ii) progress in streamlining management and regulations within the two organizations, most notably by reinforcing the LTU.

93. Further efforts are necessary to modernize the customs organization and procedures. These should focus on strengthening the customs offices at the port of Matadi, in Kinshasa, and at other ports of entries in Katanga and the eastern provinces. Strengthening customs administration also urgently requires stopping interference by the Congolese Office of Control (OCC) by merging its customs department with the main customs administration, OFIDA.18 This would render the one-stop window at the main port of entry fully operational and help establish similar structures at other points of entry. This will need to be complemented by stepped-up efforts to modernize the computer system, implement a new manual of procedures, enforce the regulations requiring pre-inspection of imports, and enhance operational capacity to fight fraud and contraband. Ensuring uniform application of the tax and tariff rates across the country is another priority.

94. There is a need to reform the intransparent and costly incentive system for the tax collection agencies. At present, these agencies receive 5 percent of non-oil revenue to cover operating expenses and grant salary bonuses to employees. This system, which implies a strong bias against efficiency-enhancing capital spending, should be replaced by appropriations in the government budget for the operating expenses and investment of collection agencies, coupled with a more moderate bonus system.

Tax administration in the mining sector

95. Increasing the tax take from the mining sector will be essential to reducing high aid dependence.19 The key role of the mining sector in earlier decades and information about new mining projects coming on-stream suggest considerable potential for broadening the domestic revenue base. Reinforcing the capacities and procedures of the revenue agencies is critical for improving the management of mining revenue and ultimately increasing collections.20 However, this can only be done if the authorities address the serious governance issues in this area, in particular the resistance of vested interests to creating more effective tax administrations structures, widespread corruption, and lack of enforcement of legislation and regulations, including the tolerance of pervasive smuggling.

96. The current fragmentation of revenue administration is preventing realization of the mining sector’s revenue potential. According to the current division of responsibilities, the nontax agency DGRAD, an institution with very limited capacity and infrastructure, is in charge of collecting mining sector royalties, while DGI is in charge of corporate income taxes. In assessing tax obligations, both agencies depend on information from the customs administration on the nature and value of mining sector exports. However, owing to the absence of export taxes for this sector,21 customs lacks incentives to control exports. This deprives DGRAD and DGI of the means to assess whether mining company self-assessment of export values is appropriate. Difficulties in accessing independent laboratories further complicate their task.

97. Transferring mining sector collection functions—at least for large companies—from DGRAD to a specialized unit under the DGI’s LTU could resolve this problem. Such a move would anticipate the eventual merger of DGRAD with DGI over the medium term. However, the transfer of current DGRAD collection responsibilities for large mining companies to the DGI requires an immediate push to build up DGI’s administrative and technical capacity in this area. The most promising approach would be to establish a unit within the LTU that is responsible for assessment, audit, and collection of all taxes, fees, and royalties of large mining companies, with full access to information from other ministries and agencies22 based on information-sharing agreements between the LTU and those agencies. Strong capacity building efforts will be needed to develop the LTU unit’s core competences, perhaps through agreements with specialized audit firms or international consultancies capable of providing training. While core tax administration functions, such as tax audits, should not be outsourced, tax audit experts might be contracted to work with LTU staff (e.g., external auditors could participate in audits together with LTU auditors).

98. These measures will need to be complemented with efforts to strengthen OFIDA’s capacity to control mining sector exports. The modern specialized customs office recently built in Kasumbalesa should be made fully operational and specialize in managing Katanga mining sector trade. The primary task of the office should be to provide comprehensive data on trade by taxpayer (including values of exports and imported inputs) to the LTU unit. Measures needed to achieve this include training and assignment of specialized staff, computerization, access to verification tools (independent laboratories, databases, and weighing bridges), anti-smuggling capability, and introduction of a system for monitoring customs performance that is not based on collected revenue. This should be the first step toward broader compliance and enforcement strategies to be prepared by OFIDA to control mining sector exports (including illegal flows from the Eastern provinces).

Public financial management

99. PFM reform needs to be accelerated. Some PFM progress has been registered in recent years in the DRC, but key weaknesses remain, including a lack of a framework for institutional and operational budgetary discipline. Now that the political transition period is ended, it is time to conduct an in-depth assessment of progress made in strengthening PFM over the past three years and to reach consensus on a new medium-term strategy. This strategy should seek to (i) eliminate or reduce the fragmentation of the budget management responsibilities or significantly ameliorate the coordination among responsible ministries; (ii) prepare and execute realistic budgets; and (iii) eliminate ad hoc expenditure execution procedures. Other key actions are to:

  • Adopt double-entry treasury accounting.

  • Reorganize the cashier relationship between the Finance Ministry and the BCC.

  • Strengthen the capacity of line ministries to prepare and manage their budgets and to report accurately on budget execution.

  • Implement a new payroll system, reflecting the results of the civil service and military censuses.

  • Design a medium-term fiscal framework in close cooperation with line ministries.

100. Donor coordination in the area of PFM reforms needs to be strengthened. Given the large and increasing number of bilateral and multilateral donors that are providing technical assistance to strengthen PFM, much greater coordination to avoid overlap, inconsistent advice, and inefficient use of scarce TA resources is needed:

  • The World Bank is providing TA in procurement and will focus its public expenditure review on fiscal management, including at the provincial level.

  • The French Cooperation is financing the implementation of a new payroll system and intends to conduct a study on the existing accounting framework.

  • The EU plans to conduct a PEFA in the second half of 2007.

  • The Belgian authorities are helping with the reorganization of the Ministry of Budget.

  • Other donors are working on strengthening budget preparation and execution for specific sectors.

Expenditure policy

101. The composition of spending needs to be aligned with the government’s priorities of increased propoor spending and investment in infrastructure. This will require:

  • Developing an institutional framework for expenditure prioritization. While the authorities have not yet developed a medium-term fiscal framework,23 the surge in infrastructure and social spending envisaged in the PRSP and the government program implies the need for an institutional framework for selecting public investment projects and spending programs with the highest social rate of return.

  • Better coordination of investment projects financed from foreign grants and loans as part of a medium-term Public Investment Program (PIP). At present, responsibilities for contracting, executing, and monitoring foreign-financed investment projects are de facto scattered, despite the pro forma coordination role of the Ministry of Planning. In this context, the authorities will also need to develop institutional capacity for reflecting the annual PIP in the budget and estimating medium- and long-term recurrent expenditure implications (e.g., maintenance, wages).

  • A gatekeeper role for the Budget Ministry. The Budget Ministry should be put in charge of (i) undertaking cost-benefit analyses of investment projects and expenditure programs submitted by line ministries; and (ii) assessing the availability of budgetary resources for the projects.

  • Ring-fencing of priority spending. Despite the priority attached to health and education spending, these sectors have periodically suffered from underinvestment and lack of maintenance, reflecting both short-term shifts in government priorities to election-related and military spending, and the volatility of foreign financing. To establish some certainty for key expenditure programs, contingent expenditure savings in non-key areas will need to be identified.

  • Civil service reform and an adequate budgetary sector wage policy. Updating the civil service roster based on the results of the military and civil service censuses, the retirement program, and a new payroll system are high priorities considering the very low wages, the size of the civil service, the lack of control over the number of civil servants, and the large number of ghost workers and civil servants above retirement age.

  • Containing expenditures of political institutions. While the establishment of the new institutions requires additional spending for government functions at the provincial and local level, the tendency of parliamentarians to grant themselves hefty wage increases, and of ministers to employ generously paid staff in their cabinets runs counter to the declared objective of stepping up pro-poor spending.

Decentralization

102. While the new constitution established a far-reaching decentralization agenda, key parameters, including the revenue sharing mechanism, are only vaguely defined. The 2005 constitution, which became effective on February 1, 2006, establishes three levels of government: central government, provinces, and subprovincial (Entités Territoriales Décentralisées), and defines the responsibilities that are (i) exclusively assigned to the central government; (ii) shared between the central government and the provinces; or (iii) exclusively assigned to provinces (e.g., primary education and health care). It also determines that 40 percent of “national revenues” collected in each province will be devolved to that province, and 10 percent will be assigned to an equalization fund (Caisse Nationale de Péréquation). However, the constitution does not clarify which government level is responsible for collecting revenues, the distribution of “shared responsibilities,” or what will be the tax base used to calculate the 40 and 10 percent shares of revenue.

103. Pressures for rapid decentralization are increasing. While the government is currently preparing 11 laws that are required to implement decentralization, elected provincial assemblies and governors are demanding that the constitution’s revenue transfer rule be applied as of this year. There is a high risk that the fiscal aspect of the reform will be decided with a view to appeasing provincial governments and holding together the fragile government coalition rather than ensuring fiscal sustainability over the medium term.

104. Full and immediate implementation of the 40 percent rule would involve significant risks for macroeconomic stability and the quality of spending:

  • It would lead to a sizeable resource transfer to largely unprepared provincial and local authorities, implying high risks of poor-quality spending and large-scale misappropriation of funds. The creation of excessive provincial administrations and the granting of high salaries for provincial politicians are prominent risks.

  • The transfer of 40 percent of the revenues collected in each province would unavoidably create a major vertical imbalance because health and primary education together account for only 18½ percent of total expenditures, leaving the central government with sizeable unfunded spending responsibilities.

  • It would also create substantial inequity among provinces, as the share of several provinces in total revenue collection is below 1 percent, which would prevent them providing even the most basic public services.

  • At the same time, the Caisse Nationale de Péréquation as currently designed would not mitigate these horizontal imbalances because it is limited to investment financing (while poorer provinces would be unable to cover current expenditures).

105. These risks argue for a gradual approach. Revenue transfers to the provinces should be increased only gradually and revenue devolution should be in line with the devolution of expenditure responsibilities. The latter, in turn, crucially hinges on progress in building provincial capacity. Institutional capacity for expenditure execution is often only rudimentary—most obvious in, but not limited to the reunified eastern provinces. This reflects, inter alia, the nascent state of provincial public administration, a pronounced shortage of qualified staff, and the absence of harmonized treasury management, accounting, and computer systems.

106. A gradual approach to expenditure devolution requires a strategy for building subnational administrative capacity. Each line ministry should elaborate medium-term sectoral transfer plans that are credible, feasible, and negotiated among the interested parties. These transfer plans should be accompanied by performance indicators that would trigger moving to the next stage. It may be necessary for the central government to reach a consensus with provincial governments not only on performance criteria but also on procedures for costing expenditure responsibilities. In any case, the status of PFM reforms should be a key criterion for determining the pace and scope of expenditure devolution. This process usually takes years (e.g., decentralization in Belgium and Spain lasted several decades; Peru and Mexico have also taken a gradual approach to devolving expenditure mandates based on capacity).

107. To contain the risk of vertical imbalances, the base for deriving the 40 percent to be transferred to provinces should be narrowly defined. A narrow definition would help reduce the gap between the supplementary revenue transferred to provinces and the expenditure devolution that can realistically be expected (given the assignment of expenditure responsibilities in the constitution and the presumably slow pace of building provincial capacity). This could be achieved by excluding custom duties, oil sector revenues, and LTU revenues, which are difficult to assign to specific provinces.

108. Adequate control mechanisms need to ensure that approved provincial budgets are balanced and consistent with the overall macroframework. The central government will need to keep control over provincial spending by enforcing budget monitoring and reporting mechanisms, including expenditure procedures to be used at the sub-national levels, particularly in respect of internal and external financial control.24 This will require giving the Ministry of Finance (MOF) an explicit role in regulating, coordinating, and supervising local government finances and their link with national fiscal policies. The MOF should also review and preapprove the budget and borrowing authorizations of subnational governments. Moreover, the central government should remain in control of major taxes and customs and oversee provincial borrowing. At the same time, the administration of all national domestic taxes (both direct and indirect taxes) as well as customs duties should remain the responsibility of the central tax administration. In the medium term, it will be crucial to build local government ability to collect the taxes for which they are responsible and to reinforce budget preparation and execution, as well as treasury management and the accounting framework.

109. The revenue transfer to provinces should be complemented by an equalization component. The equalization formula should be based on transparent and objective criteria, e.g., the number of inhabitants and the surface, and aim to ensure at least a minimum level of public services. While revenue equalization may be opposed by the provinces with the highest share in total revenue, the planned division of the current 11 provinces into 26 new provinces may help break this resistance; several new provinces emanating from currently “rich” provinces would receive only a very small share of total revenue.

D. Conclusion

110. The medium-term fiscal strategy has to reconcile fiscal consolidation with the need for a large increase in infrastructure and social expenditure. Structural fiscal reforms need to be accelerated to create fiscal space for rebuilding infrastructure after the civil war and increase social spending, particularly on education and health. A tangible and sustained increase in the revenue-to-GDP ratio and an improved structure of public expenditures in line with the PRSP can only be achieved if there is a comprehensive strategy to address the structural fiscal issues discussed in this chapter. Moreover, reforms will need to be implemented much more vigorously than in the recent past. In particular, the authorities will need to (i) confront the vested interest that have so far been successful in preserving the fragmentation and inefficiencies of the revenue collection agencies; (ii) speed up the fight against corruption; and (iii) enforce the rule of law, especially in the mining sector.

STATISTICAL APPENDIX

Table 1.

Democratic Republic of the Congo: GDP by Sector at Market Prices, 2001-06

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Sources: Congolese authorities; and IMF staff estimates.

Including processing of minerals.