Kingdom of Lesotho: Selected Issues and Statistical Appendix

The challenge of achieving broad-based growth in Lesotho is discussed. Economic growth is inconsistent. Lesotho is highly dependent on trade with South Africa. The sources of growth in Lesotho using a social accounting matrix model and a growth-accounting framework are outlined. The main constraints to growth and private investment and current policy initiative to promote broad-based growth and private investment are analyzed. The various methods employed suggest that there is neither external stability nor significant evidence of exchange rate misalignment.

Abstract

The challenge of achieving broad-based growth in Lesotho is discussed. Economic growth is inconsistent. Lesotho is highly dependent on trade with South Africa. The sources of growth in Lesotho using a social accounting matrix model and a growth-accounting framework are outlined. The main constraints to growth and private investment and current policy initiative to promote broad-based growth and private investment are analyzed. The various methods employed suggest that there is neither external stability nor significant evidence of exchange rate misalignment.

II. Assessing Lesotho’S Real Exchange Rate and Competitiveness1

A. Introduction

1. There are several methods for assessing the real exchange rate, among them, the absolute purchasing power parity (PPP) approach, the macro-balance (MB) approach, the external sustainability approach (ES), and the Behavioral Equilibrium Exchange Rate (BEER) approach.2 In this chapter,

  • A number of approaches are used to compare Lesotho’s real exchange rate with its equilibrium exchange rate; and to quantify where possible any uncertainty about the estimated equilibrium exchange rate. We also discuss the problems that arise in applying these methods to Lesotho.

  • Recognizing the limitation of any model-based exchange rate assessment, alternative indicators are also used to assesses Lesotho’s competitiveness.

The main findings are that

  • Taking the PPP approach, Lesotho’s currency, the loti, would seem to be undervalued, but the undervaluation is not statistically significant. The MB approach produces a current account norm that is 1¾ points of GDP weaker than projected for 2007. The ES approach indicates that the current account balance that would stabilize the ratio of net foreign assets to GDP at the 2006 level would be 1 percent of GDP weaker than projected for 2011. These estimates should be taken with caution given their large margins of error.

  • The ES approach indicates that Lesotho is likely to see a strengthening of its net foreign asset position in the next several years. That is consistent with the results of the debt sustainability analysis (DSA), which in the baseline scenario shows continued accumulation of external assets over the medium term.3 This is a welcome prospect in view of the uncertainty around key external variables in the medium and long term.

  • Unit labor costs indices (adjusted for productivity) in Lesotho’s textile sector have been rising faster than in the manufacturing sectors of China and Kenya, two representative competitors; but Lesotho’s 2006 tax cuts and the depreciation of the rand against the U.S. dollar have helped restore some lost ground.

  • Survey-based indicators of competitiveness rank Lesotho low in many of the areas the government has already identified as weaknesses and which it is targeting in its structural reform agenda.

B. Background

2. Lesotho is a small, open economy highly dependent on trade with South Africa. It has a small population (1.8 million vs. 47.5 million for South Africa) living in an area that is roughly 2½ percent of South Africa’s area. Lesotho is landlocked and relies primarily on South Africa for its access to trade with the rest of the world. The volume of its trade amounts to 140 percent of GDP. About 80 percent of its imports come from South Africa, but 80 percent of its exports move outside Africa, primarily to the United States.

3. The Loti is pegged at par to the South African rand. This exchange rate regime is at the core of the Common Monetary Area (CMA), the other member of which are South Africa, Swaziland and Namibia. The CMA is not a monetary union—each CMA member has its own central bank and issues its own currency; there is no pooling of central bank reserves—but the rand is legal tender in all member countries. With free capital mobility within the CMA, the interest rate policy of the South African Reserve Bank (SARB), South Africa’s central bank, influences monetary conditions throughout the CMA. The target for central bank reserves in Lesotho (as well as in Namibia and Swaziland) is guided primarily by the commitment of each country to maintain the peg to the rand within the CMA arrangement.

4. Lesotho’s CPI inflation rate closely tracks that of South Africa, which has an inflation targeting framework, because of both the peg to the rand and the large dependence on trade with that country. Recent econometric evidence suggests that South Africa’s inflation rate Granger causes Lesotho’s inflation rate there is not no evidence of reverse causality (Wang et al, 2007).

uA02fig01

Lesotho and South Africa: CPI Inflation

(Percent)

Citation: IMF Staff Country Reports 2008, 135; 10.5089/9781451823875.002.A002

5. Movements in the loti’s real exchange rate are largely exogenous to developments in Lesotho. The loti’s real effective exchange rate (REER) is dominated by movements in the rand-U.S. dollar exchange rate. As a small open economy, Lesotho simply cannot influence the relative price of the national currencies of its two major trading partners, the United States and South Africa.

uA02fig02

Exchange Rate: January 1996- July 2007

(2000=100)

Citation: IMF Staff Country Reports 2008, 135; 10.5089/9781451823875.002.A002

uA02fig03

Real Effective Exchange Rate: Annual data, 1996-2006

(2000=100)

Citation: IMF Staff Country Reports 2008, 135; 10.5089/9781451823875.002.A002

uA02fig04

Real Effective Exchange Rate, Monthly Data, January 1996-July 2007

(2000=100)

Citation: IMF Staff Country Reports 2008, 135; 10.5089/9781451823875.002.A002

6. The BEER approach and similar methods are, therefore, of little value in assessing Lesotho’s real exchange rate.4 Moreover, South Africa and Lesotho have different export structures: precious metals dominate South Africa’s exports and textiles dominate Lesotho’s. Commodity terms of trade, which is an important factor in BEER models, could therefore move in favor of or against Lesotho without affecting Lesotho’s conventionally estimated REER. Indeed, the correlation coefficient between South Africa’s terms of trade and Lesotho’s is not different from zero at the conventional statistical levels. Other explanatory variables used in BEER models, such as government consumption would also be of little value in assessing Lesotho’s REER since Lesotho’s government consumption, about 1 percent of South Africa’s, is too small to influence the value of the rand.

7. However, Lesotho’s absolute price level can differ from South Africa’s, due to being a landlocked country, which adds to transportation costs, prices of non-tradable goods and services, and other factors that affect the cost of doing business in the two countries. This is particularly relevant in the absolute version of the PPP approach.

8. The MB and ES approaches to exchange rate can be useful in assessing the sustainability of the current account balance, but not the exchange rate—although even in this limited role these approaches should be interpreted with caution. In most applications, the last step of both approaches is to calculate the change in the real exchange rate that is needed to close the gap between the underlying current account and the current account norm, given an estimate of the elasticity of the current account with respect to the real exchange rate. This crucial step assumes that a country’s saving-investment balance will be equilibrated over time through changes in its REER, but this is clearly not a realistic assumption for Lesotho. That is not to suggest that Lesotho cannot or should not try to influence its saving-investment balance for external stability purposes, given its commitments to the CMA and the peg; it merely means that such efforts will not have major repercussions on Lesotho’s measured REER. Moreover, Lesotho’s current account depends heavily on factors unrelated to its REER such as trade preferences under the African Growth and Opportunity Act (AGOA) that allows Lesotho to export textiles to the U.S. without tariffs and quotas.

9. However, adverse movements in Lesotho’s REER (perhaps brought about by movements in the rand-dollar exchange rate) could hurt the competitiveness of Lesotho’s textile exports. This could easily happen if Lesotho’s competitors in garments are better positioned in terms of their exchange rate against the U.S dollar; but it could also happen if Lesotho were less competitive in other areas, such as labor costs and factors related to costs of doing business, that operate independently of the exchange rate (see section D).

10. No model of exchange rate assessment is without shortcomings. Notwithstanding their problems, the MB and ES can be of interest. So is the PPP approach whose strengths and weaknesses are discussed next.

C. Exchange Rate Assessment

The Absolute PPP Approach

11. The international comparison of price levels is one way to assess the deviation of a country’s real exchange rate from its long-run equilibrium level. The theory of absolute PPP holds that prices of an identical consumption basket should be the same in all countries when expressed in a common currency.5 If the resulting exchange rate—the absolute PPP exchange rate—is the same as the market exchange rate, there is no misalignment. However, departures from absolute PPP are the norm rather than the exception. While the departures can be large and narrow only very gradually, they usually indicate the direction of future real exchange rate developments—toward the equilibrium long-run PPP level—if there are no other shocks. PPP can thus be a useful tool for assessing exchange rate misalignments.

12. However, not all deviations from the absolute PPP should be seen as misalignment of the real exchange rate. They could simply reflect errors in measuring absolute prices in a given country or over time. More fundamentally, they could reflect economic factors that influence the long-run equilibrium exchange rate. Indeed, one factor that may account for the deviation of the exchange rate from absolute PPP is productivity differentials between the countries—commonly known as the Balassa-Samuelson effect.

13. The Balassa-Samuelson (B-S) effect refers to the idea that the long-run equilibrium exchange rate depends on relative productivity differentials. Countries with higher productivity growth in the tradable sector than the nontradable sector tend to experience a real appreciation. In essence, higher productivity in tradables pushes up wages in that sector, which leads to higher wages in the nontradable sector, and thus to higher prices for nontradables. Since tradable prices respond to international markets and not domestic market conditions, the price of nontradables relative to tradables rises. As the overall (consumer) price level is a weighted average of both tradable and nontradable prices, the higher price of nontradables pushes up overall prices. Moreover, assuming that relative per capita GDP differentials across countries are a reasonable proxy for relative productivity differentials, the B-S effect implies that as a country’s per capita income rises over time, its real exchange rate will appreciate. It also implies that countries with higher per capita income tend to have a higher national price level or a more appreciated real exchange rate.

14. The estimated B-S effect is remarkably strong. Using the Heston-Summers-Aten’s data set, which provides internationally comparable measures of absolute price level and real per capita GDP in PPP terms,6 the following regression is estimated for a cross-section of 172 countries in 2006:

ln(Pi/Pus)=0.09+0.33ln(Yi/Yus)+ȗiR2=0.43(1.40)(11.38)

where t-ratios are in parentheses, Pi and Pus refer to the price level for country i and the United States, respectively; Yi and Yus refer to real per capita GDP in PPP-adjusted U.S. dollars for country i and the United States. The ratio Pi / Pus is the measure of the real exchange rate, for country i versus the United States and ȗi, the residual of the regression, is the estimated deviation of country i’s real exchange rate from its absolute PPP exchange rate, adjusted for productivity differentials. The estimated regression conforms to the B-S effect. Countries with higher per capita income differential vis-à-vis the United States tend to have on average a higher national price level or a more appreciated real exchange rate.

15. The estimated elasticity of the B-S effect is close to those found in the literature (Rogoff, 1996; Bergin, Glick and Taylor, 2004; Frankel, 2005). Estimating the same specification individually for each year from 2000 to 2005 produces elasticities ranging from 0.33 to 0.38, with 0.34 representing the mode. Rogoff (1996) estimated an identical specification for 1990 for over 100 countries using an older version of the same data set, and produced a B-S elasticity of 0.37 and an R2 of 0.42.

16. According to the estimated regression, Lesotho’s real exchange rate against the U.S dollar may have been undervalued as of end-2006 (See Figure II.1). More precisely, Lesotho’s real exchange rate was undervalued by 24 ½ percent in logarithmic terms and 22 percent in levels as of end-2006. The first estimate is the value of ȗi from the B-S regression, expressed in percent; this is the vertical distance from the fitted line in the figure. The second estimate is simply [exp(ȗi)1]*100, where exp is the exponential function.

Figure II.1.
Figure II.1.

The B-S Effect and Deviation from the Absolute PPP

Citation: IMF Staff Country Reports 2008, 135; 10.5089/9781451823875.002.A002

17. Lesotho’s real effective exchange rate may be undervalued too, but by a smaller margin. More precisely, Lesotho’s REER was undervalued by some 17 percent and 19 percent in logarithmic terms and levels, respectively. These estimates are obtained by taking into account exchange rate “misalignments” (assessed against the same B-S regression) of Lesotho’s main trading partners, the United States and South Africa, which account for 90 percent of Lesotho’s trade. Lesotho’s REER shows smaller undervaluation than the real dollar-loti exchange rate due to the combined effect of a smaller real undervaluation of the rand vis-à-vis the US dollar, and South Africa’s large weight in Lesotho’s trade (¾ for South Africa and ¼ for the United States).

18. However, the statistical evidence shows that the loti is not misaligned. The visual inspection of See Figure II.1 shows that the loti’s real exchange rate in 2006 was “close” to the fitted line, with the South African rand even closer. The equilibrium real exchange rate for the loti in logarithmic terms is -1.03 whereas the actual real exchange rate is -1.28. The estimated 90 percent confidence interval for the equilibrium real exchange rate, (-1.78,-0.29), includes the actual real exchange rate. In other words, the null hypothesis of zero misalignment cannot be rejected at the 10 percent level.

The MB and ES Approaches

19. The MB approach compares the current account balance projected over the medium term with an estimated equilibrium current account (CA) balance or “CA norm” driven by some fundamental factors. Estimates of the CA norm for Lesotho over 2007-11 were obtained each year by applying the coefficients from the MB regression of the Consultative Group on Exchange Rate Issues (CGER) (IMF, 2006, Table 1, p. 10, column 1) to values of Lesotho’s fundamentals over the same period. These fundamentals are: the fiscal balance (which incorporates a projected reduction in SACU transfers as a ratio to GDP), the old-age dependency ratio, population growth, oil balance and relative income.

20. The application of the MB approach to Lesotho using parameters from the GCER regressions has important problems, which requires taking its results with caution. The CGER parameters were estimated for a sample of high- and middle- income countries, and comparable parameters have not been convincingly estimated for African countries.7 This means that the result from this method for Lesotho will be subject to especially large margins of error. However, the use of this approach may still be of interest, as some relationships between the current account balance and key fundamentals, such as the fiscal balance, should be qualitatively similar in most countries. The signs of those relationships are correctly identified by CGER regressions.

21. The MB approach produces a current account norm that is weaker than projected for Lesotho. A comparison of the 2007 current account—a surplus of 1 ½ percent of GDP—with the CA norm in 2011 suggests that current account should deteriorate by about 1 ¾ percent of GDP to close the gap. A comparison of the current account projection averaged over the 2007-11 period with the average CA norm over same period shows a smaller gap (½ percent of GDP).

22. The ES approach also produces a current account norm that is weaker than projected. Under the ES approach, the current account norm that stabilizes the ratio of net foreign assets to GDP at end-2006 level is a deficit of 2.2 percent of GDP, against a projected CA deficit of 1 percent of GDP in 2011 (with surpluses projected in the intervening years).8 Therefore, in the baseline scenario projected by staff, Lesotho should be able to strengthen its net foreign asset position over the next several years, a welcome prospect in view of longterm uncertainties. This finding indicates that such a scenario does not contain immediate threats to external stability. These results are consistent with those of the Debt Sustainability Analysis carried out as part of the 2007 Article IV consultation.

uA02fig05

Lesotho: Current Account And Its Norms

(In percent of GDP)

Citation: IMF Staff Country Reports 2008, 135; 10.5089/9781451823875.002.A002

D. Alternative Measures of Competitiveness

23. The standard estimate of the REER has serious shortcomings in the case of Lesotho, some of which have already been discussed. This suggests that it might be useful to look at other indicators as well. A useful indicator for analyzing competitiveness, according to IMF (2005), is the manufacturing wage in dollar terms. Below we construct a related unit labor cost measure for Lesotho and two comparator countries, Kenya and China. Survey-based indicators such as the World Bank’s Doing Business index and the World Economic Forum’s Global Competitiveness index also provide a useful snapshot.

24. In 2006, Lesotho’s labor cost competitiveness was supported by the depreciation of the rand against the U.S. dollar, and tax cuts for exporters. The evolution of the dollar wage in Lesotho’s manufacturing sector reflects the combined effect of a trend increase in loti wages (though slower than the increase in the price level in Lesotho) and major swings in the dollar-rand exchange rate. These trends pushed dollar labor costs in 2006 up about 40 percent higher than in 2000, after adjusting for changes in worker productivity. In 2006, to offset the impact on exporters of the stronger rand, the government reduced the profit tax rate for firms exporting outside SACU—a measure that, on average, provides a benefit roughly equivalent to a reduction of 17 percent in labor costs.9 Figure II.2 shows both the labor cost index and a version of the index adjusted for the labor-cost equivalent of the benefit to exporters from the tax reform. For comparison, similar unit labor cost indices were estimated for the manufacturing sectors of China, a major beneficiary of the end of the Multi-Fiber Agreement (MFA) and thus a competitor of Lesotho, and Kenya, another country taking advantage of AGOA. The figure demonstrates that the gap in labor costs that had opened (relative to the position of these countries in 2000) as a result of appreciation of the rand seems to have been reduced recently, and to have been largely offset by the 2006 tax cut.

Figure II.2.
Figure II.2.

U.S. Dollar Labor Costs in Lesotho and Comparator Countries

Citation: IMF Staff Country Reports 2008, 135; 10.5089/9781451823875.002.A002

Source: Lesotho Authorities; ComMark; National Bureau of Statistics of China; Republic of Kenya Economic Survey, 2007; WEO; Kim and Kuijs, “Price and Wage Pressures and Profitability in China’s Industry” (forthcoming World Bank working paper); and Fund staff estimates.

25. Survey-based indicators of competitiveness reveal the difficulties of engaging in private business in Lesotho, which ranks 126th out of 178 countries in the 2007 Doing Business index, and 115th out of 128 countries in the 2007 Global Competitiveness index.

  • According to the Doing Business indicators, Lesotho ranks relatively well in the areas of paying taxes and employing workers, but ranks poorly in starting a business, registering property protecting investors, and dealing with licenses. Notably, Lesotho also ranks poorly on trading across borders (Table II.1).

  • Lesotho ranks especially high in the macroeconomic pillar of the Global Competitiveness Index; in the institutions pillar it also ranks better than might be expected given its overall ranking. Lesotho’s worse rankings are in business sophistication, infrastructure, market efficiency and skills. Survey respondents cited low access to credit, government inefficiency and inadequate infrastructure as the main impediments to doing business, in each case with more than 10 percent of respondents (Table II.1).

  • In terms of competitiveness with other SADC countries, Lesotho scores better than some (e.g., Mozambique and Angola), but needs to improve significantly to catch up with Mauritius, South Africa, Namibia and Botswana; see Table II.2.

Table II.1.

Lesotho: Survey Based Indicators of Competitiveness

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Source: World Bank, 2007 and WEF, 2007
Table II.2.

SADC: Competitiveness, 2007

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Source: www.doingbusiness.org and the World Economic Forum.

26. The government is targeting many of the areas flagged by these surveys in its structural reform agenda. The Private Sector Competitiveness Program, the Public Sector Improvement Program, and the private sector development component of the compact with the Millennium Challenge Corporation specify promising measures in all of these areas (see Chapter I of this paper).

E. Conclusion

27. The various methods employed suggest that there is no threat to external stability nor significant evidence of exchange rate misalignment. In fact, confirming the findings of the DSA, there is a likelihood that Lesotho’s net external position will strengthen in the next few years. Conventional methods must be applied with caution to Lesotho, given its characteristics as a small open economy participating in the Common Monetary Area of the rand. Indicators of competitiveness rank Lesotho relatively low in some key areas targeted for improvement in government programs. The challenge now is for Lesotho to embark vigorously on the implementation of its agenda.

Data Appendix

Price level and real PPP per capita GDP

The data used in the B-S regression in the main text of the chapter are taken from the Heston-Summers-Aten’s data set, of which version 6.2 is the latest available (the ICP project with the World Bank). The data on price levels in the S-H-A data set are the price level of Gross Domestic Product (p in the S-H notation) and chain weight per capita PPP GDP in 2000 international dollar prices (rgdpch in the S-H-A notation). However, data on p and rgdpch in the data set end in 2004. Data for later years on p and rgdpch for each country were obtained by applying the growth rate of the implicit GDP price deflator and real GDP in local currency to the level of the indicator (p and rgdpch) from the S-H-A data set, respectively.

Net Foreign Assets

Though this indicator shows up in the MB and ES approaches, at present there is no official information Lesotho’s international investment position which is the ideal measure of net foreign assets for both approaches. As a proxy, we use net foreign asset of the central bank plus NFA of the rest of the banking system minus public external debt minus stock of foreign direct investment liabilities (from the United Nations’ World Investment Report). The NFA for future years is generated by adding the current account for the current year to the NFA of the previous year.

References

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Statistical Appendix Tables

Table 1.

Lesotho: Gross Domestic Product by Sector, Constant (1995) Prices, 2000-06

(Millions of Maloti)

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Source: Lesotho Bureau of Statistics
Table 2.

Lesotho: GDP by Sector, Current Prices, 2000-06

(Millions of Maloti)

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Source: Lesotho Bureau of Statistics
Table 3.

Lesotho: Gross Domestic Product by Expenditure, 2000-06

(Millions of Maloti)

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Sources: Lesotho Bureau of Statistics; and Fund staff estimates.

Calendar year

GNP plus unrequited transfers.

Gross national disposable income less consumption.

Government revenues plus grants less government current expenditures (excluding interest payments).

Estimated as a residual.

Lesotho Highlands Water Project.

Equivalent to the external current account balance.

Table 4.

Lesotho: Consumer Price Indices, 2000 - 06 1

(Dec 1997= 100, unless otherwise indicated)

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Sources: Lesotho Bureau of Statistics

Covers all households in eight lowland towns, including Maseru.

Based on 2000 Household Survey. Weights applied from 2002.

Start of new series based on revised classification system.

Since January 1994, rent has been excluded from CPI data because of data collection problems.

Table 5.

Lesotho: Monthly Minimum Wages, 2000-2007

(Maloti)1

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Table 5.

(concluded). Lesotho: Monthly Minimum Wages, 2000-2006

(Maloti) 1

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Source: Ministry of Labor.

Based on legal notices. The schedule of minimum wages by was revised in September 2004.

All other sectors.

Table 6.

Lesotho: Public Service Employment, 2000/01-2006/071

(Units)

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Source: Ministry of Public Service.

Fiscal year is April-March.

The established civil service posts exclude teachers, members of the armed forces, and workers paid daily, but include chiefs parliamentarians, senators, and statutory workers.

Table 7.

Lesotho: Central Government Operations, 2000/01-2006/07 1

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Sources: Ministry of Finance; and Fund staff estimates.

Fiscal year is April-March.

including arrears payment in 2006/07

Table 8.

Lesotho: Government Revenue and Grants, 2000/01-2006/07 1

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Sources: Ministry of Finance; and staff estimates.

Fiscal year is April-March.

Table 9.

Lesotho: Southern African Customs Union (SACU) Operations, 2000/01-2006/07

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Sources: Department of Customs and Excise; and Fund staff estimates.

Fiscal year (April-March) in which indicated revenue payments are received.

Fiscal year of data on which calculations are based (rates and dutiable base).

Customs and excise revenues as percent of dutiable base (imports and excisable production, and duties) for Southern African Customs Union as a whole (data year).

Basic rate multiplied by 1.42, as initial compensation for disadvantages to smaller members.

One-half of difference between 20 percent and revenue (compensation) rate.

Revenue (compensation) rate plus stabilization factor.

At least 17 percent and no more than 23percent; the calculated stabilized rate applies if it falls between 17 percent and 23percent. In recent years, the lower limit of 17 percent has been the operative rate applied to the dutiable base.

Lesotho’s imports (c.i.f.).

Stabilized rate (actual) times dutiable base. Referred to as “accrued receipts” of data year.

Stabilized rate (actual) times increase in dutiable base from two years earlier (as allowance for growth in dutiable base to revenue year).

Minor adjustments made to account for revisions in base data, usually of previous data year. Calculated here as a residual.

As reported in government revenue data.

Basic rate times dutiable base. Referred to as “accrued receipts based on basic rate only.”

Based on share of intra-SACU trade in the previous period.

Based on share of intra-SACU GDP.

Distributed inversely to GDP per capita.

Adjustment payments for deviation of actual import duty and excise receipts from previous year estimate.

Table 10.

Economic Classification of Government Expenditure, 2000/01-2006/07 1

(Millions of Maloti)

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Sources: Ministry of Finance; and staff estimates.

Fiscal year is April-March.