A. Economic Outlook

6. Near-term economic prospects are favorable. Real GDP growth is projected at about 5 percent in 2007 and could average nearly 5 ½ percent in the following years, propelled by continued expansion in mining, moderate growth of the garment industry (the recovery has taken place without new investments, and limited factory space is a bottleneck), and a pick-up in construction driven by high public investment. Agriculture is expected to make a negative contribution in 2007 due to the drought. The authorities project somewhat faster growth, especially in the garment sector. Growth will require diligent implementation of the investment projects included in the MCC compact. Staff agreed with the authorities that SACU revenues are likely to remain high at least through 2009/10 because of high economic activity in South Africa. Remittances are anticipated to rise in nominal terms—although diminishing as a ratio to GDP—as the increase in average pay should more than offset the decline in the number of workers resulting from structural changes in South African mines.

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Medium Term Outlook

Citation: IMF Staff Country Reports 2008, 136; 10.5089/9781451823882.002.A001

Source: IMF staff estimates and projections.

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7. The main risk to the real economy is the deterioration of the external environment. The evolution of the global regime for trade in textiles will affect Lesotho’s export sector. In particular, there is pressure to extend to non-African countries preferences similar to those established by AGOA, and Chinese exports to the U.S. and EU markets are expected to again be quota-free in 2008. The authorities are aware of these risks, and intend to strengthen infrastructure, notably electricity and water, to support productivity increases and vertical integration in the textile sector. Short run, the slowdown in the U.S. economy could affect orders for garment producers. A steeper downward trend in remittances from abroad would affect consumption.

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Basotho Migrant Workers in South African Mines

(Thousands)

Citation: IMF Staff Country Reports 2008, 136; 10.5089/9781451823882.002.A001

Sources: National authorities.

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8. A significant medium-term risk, especially for the budget, concerns the evolution of SACU revenues. SACU revenues could be affected by a slowdown in South Africa and trade liberalization. More fundamentally, South Africa has called for a review of SACU’s revenue-sharing arrangements, although it has not submitted a concrete proposal. In addition, the call for SADC to evolve into a customs union raises uncertainty about the durability of existing rules. The authorities believe that negotiations for a new revenue-sharing formula might be prolonged and it could take a long time to reach a consensus. Likewise, a SADC customs union would take time to materialize and the revenue implications for Lesotho would need to be taken into account.

9. Authorities and staff agreed also that unlicensed deposit-taking entities pose significant risk to the financial system (see paragraph 25 below). The growth of a weakly supervised credit cooperative sector is also worrisome.

B. Fiscal Policy and Reforms

10. After the fiscal surpluses of recent years, the 2007/08 budget raises some concerns. The high level of spending in the 2007/08 budget—an increase of 5 percentage points of GDP in current expenditure and a more than doubling of capital expenditure to 16 percent of GDP—could undermine fiscal sustainability and spending quality. Even if it is not expected that the budget will be fully executed, the amount of slack in the appropriations reduces the budget’s usefulness as a programming instrument. The authorities confirmed that, taking into account actual spending capacity (“outturn basis”), they project a significantly better balance in 2007/08 than the approved budget suggests, and stated that current budgeting procedures tend to generate excessively high appropriations.

Lesotho: Fiscal Framework, 2006/07-2010/11

Sources: Ministry of Finance; and Fund staff projection

Lesotho: Fiscal Framework, 2006/07-2010/11

			2006/07	2007/08		2008/09	2009/10	2010/11
			Est.	Budget	Proj.	Projections
			(Percent of GDP)
Total revenue and grants			62.3	57.1	56.4	59.1	56.8	54.7
	SACU revenue		37.9	31.8	33.0	31.7	29.7	27.9
	Domestic revenue		23.5	21.2	21.9	21.9	21.9	21.9
	Grants		0.9	4.1	1.5	5.5	5.2	4.9
Total expenditure			46.1	60.0	51.2	52.4	50.0	47.9
	Current expenditure		39.2	44.1	41.6	40.0	38.5	37.1
		Wages and salaries	13.8	14.5	14.5	14.2	13.8	13.6
	Capital expenditure		7.0	15.9	9.7	12.4	11.5	10.8
Overall balance, incl. grants			16.1	-2.9	5.2	6.6	6.8	6.8

Sources: Ministry of Finance; and Fund staff projection

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Lesotho: Fiscal Framework, 2006/07-2010/11

			2006/07	2007/08		2008/09	2009/10	2010/11
			Est.	Budget	Proj.	Projections
			(Percent of GDP)
Total revenue and grants			62.3	57.1	56.4	59.1	56.8	54.7
	SACU revenue		37.9	31.8	33.0	31.7	29.7	27.9
	Domestic revenue		23.5	21.2	21.9	21.9	21.9	21.9
	Grants		0.9	4.1	1.5	5.5	5.2	4.9
Total expenditure			46.1	60.0	51.2	52.4	50.0	47.9
	Current expenditure		39.2	44.1	41.6	40.0	38.5	37.1
		Wages and salaries	13.8	14.5	14.5	14.2	13.8	13.6
	Capital expenditure		7.0	15.9	9.7	12.4	11.5	10.8
Overall balance, incl. grants			16.1	-2.9	5.2	6.6	6.8	6.8

Sources: Ministry of Finance; and Fund staff projection

11. Staff supported the medium-term fiscal stance represented in the authorities’ projections on an outturn basis and under unchanged policies, while noting that implementing it will be challenging.⁵ Reflecting high SACU revenue, sustained non-SACU domestic revenue, and strict expenditure policies, the medium term fiscal framework (MTFF) projects fiscal surpluses (excluding grants) through 2010/11, even though government investment is substantially above its level of recent years. This projection implies a significant reduction in current expenditure as a ratio to GDP, which will be difficult to deliver; the projected revenue provides some margin of safety, but the risks to revenue itself advise against using up such margin.

12. Avoiding a generalized expenditure increase is key to preserve fiscal sustainability, but spending pressures are significant. Staff cautioned against using the SACU revenue windfall, temporary by definition, to raise recurrent spending. Specifically, staff recommended adopting a cautious approach to the introduction of the pension reform and the upcoming salary review, and limiting recruitment to priority areas. The authorities agreed in principle, but felt that pension reform will likely be costly and that Lesotho is losing qualified professionals such as nurses and teachers to South Africa and other countries, which suggests that increasing salaries for certain categories of civil servants may be justifiable.

13. The envisaged increase in public investment poses challenges. The underspending of the capital budget in past years reveals weaknesses in the programming and execution of projects. The government intends to increase flexibility in its procedures to release resources to those projects moving fast. It is essential that the government redouble its efforts to improve project execution, especially in view of the fact that the MCC funds will be lost if they are not used within five years. To speed up the execution of some domestically-financed investments, the authorities have started using public-private partnerships (PPPs).⁶ Staff agreed that PPPs could supplement government’s implementation capacity, but recommended that PPPs only be used when they deliver higher value for money than traditional government investment. Moreover, managing PPPs requires careful contract drafting and close monitoring. The authorities are aware of these challenges, and indicated their intention to seek technical assistance from relevant agencies.

14. Strengthening expenditure management will help ensure a good level and quality of spending. Staff welcomed progress made in this area in the context of the Public Sector Improvement and Reform Program (PSIRP), which includes the introduction of a medium-term expenditure framework, strengthening budget planning and execution, and public procurement reform. All line ministries are preparing budget framework papers for the 2008/09 budget that will cover a three year period. However, due to capacity limitations in line ministries, the full MTEF is being piloted in six ministries. Staff encouraged the authorities to extend the MTEF to all ministries as soon as feasible, following the recommendations of the PEMFAR assessment. Staff and authorities agreed that the use of the MTEF would help further align the budget with development priorities.

15. Debt and financial management needs to be reinforced. Staff welcomed the decision to use part of the surplus to pay off expensive nonconcessional debt. Nevertheless, the payment of substantial amounts (totaling nearly 5 percent of GDP in the last two years) to retire debts accumulated outside the conventional budgetary framework underscores the need for tight control of government’s obligations.⁷ The authorities expect their financial management reforms to help prevent similar problems in the future.

16. An updated DSA shows Lesotho’s external and public debts to be sustainable, although there is a moderate risk of debt distress (see supplement 2). In the baseline scenario debt should continue to decline over the medium term. However, in some adverse scenarios some debt indicators might rise above levels that are considered sustainable for low-income countries. The authorities generally agreed with this assessment.

C. Achieving Broad-based and Sustainable Economic Growth

17. The authorities underlined their intention to continue to focus on pro-growth policies to achieve poverty reduction. While the output growth observed in 2006 was strong, it reflected in part the performance of sectors with limited linkages to the rest of the economy and a favorable external environment. Reducing poverty, improving living standards, and more generally making progress towards the MDGs depend on achieving sustainable and broadly based growth. In this context, staff recommended looking beyond the lapse of AGOA in 2015 and giving due priority to the challenges of the rural economy. Authorities and staff agreed that attaining sustainable growth will require a major effort to improve the quality of Lesotho’s institutions.

18. The mission provided feedback on the authorities’ draft Growth Strategy Paper (GSP). The GSP seeks to identify binding constraints on growth and to collate prior development programs to derive policy recommendations, emphasizing the improvement of the investment climate, especially in key sectors, and the enhancement of infrastructure and skills. To be most useful, the GSP should be congruent with the Poverty Reduction Strategy (PRS), provide a strategic approach to the challenges and opportunities arising from the proximity to South Africa, and outline a multi-year implementation agenda that may be reflected in the MTEF. The authorities indicated that these are elements they intend to incorporate in their growth strategy.

19. Staff welcomed the inclusion of a Private Sector Development Component in the compact signed with the MCC. Effective implementation of this program and of the ongoing Private Sector Competitiveness Program should relieve some constraints on growth, notably inadequate infrastructure and low access to credit. In this regard, to improve the business environment and reduce “red tape,” the authorities have launched a one-stop trade facilitation center for foreign investors, which is part of their private sector development agenda (Box 2).

D. External Stability

20. Economic policies have been consistent with external stability.

Staff shared the authorities’ view that the current exchange rate system should be maintained. It promotes price stability in Lesotho and facilitates capital and current transactions with South Africa, Lesotho’s most important economic partner. Prudent fiscal policies have underpinned the continued viability of this arrangement.

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Exchange Rate

Citation: IMF Staff Country Reports 2008, 136; 10.5089/9781451823882.002.A001

Sources: National authorities and IMF staff estimates.

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21. Standard assessments of the real exchange rate and the current account suggest no immediate threat to external stability (Box 3 and Selected Issues Paper). While the appreciation of the rand between 2002 and 2005 reduced some measures of cost competitiveness in Lesotho, its depreciation in 2006 and so far in 2007 and recent adjustments in corporate tax rates seem to have stemmed that trend. The projections for the current account over the next few years are consistent with an improvement in Lesotho’s NFA position. To the extent that it may be financed by capital transfers (such as some MCC grants) and FDI, a reduction in the current account balance would not raise significant concerns. Nevertheless, Lesotho’s external stability is subject to uncertainty in the medium term (see paragraphs 7-8), which raises the margin of error of the methodologies used.

Box 3.

Assessing the Real Exchange Rate

Lesotho pegs its currency to that of South Africa, from where most of its imports and inflation come, and sends most of its exports outside SACU. Thus, Lesotho’s REER is essentially a smoothed version of South Africa’s, and largely independent of its fundamentals. Conversely, Lesotho’s current account and growth depend heavily on factors unrelated to its REER and outside the country’s control, such as AGOA and SACU transfers. These factors are surrounded by a degree of uncertainty, especially in the outer years of the medium term projections. This suggests taking the estimates of current account norms shown below with caution. With these caveats, the various approaches used yielded no consistent evidence of misalignment.

When Lesotho’s medium-term fundamentals are used, the macroeconomic balance approach, based on the regression estimates of CGER (http://www.imf.org/external/np/pp/eng/2006/110806.pdf, Table 1), produces a current account norm that is 1¾ points of GDP weaker than projected for 2007. The fundamentals used in this analysis are the medium term values of 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.

The external sustainability 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 (also including the decline in SACU transfers mentioned above).

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Garment Sector Monthly Wages¹

Citation: IMF Staff Country Reports 2008, 136; 10.5089/9781451823882.002.A001

Sources: National authorities and IMF staff estimates.¹ Minimum wage for unskilled workers. For 2007, as of October with inflation assumed to be 8.6 percent.

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The absolute version of the purchasing power parity (PPP) approach estimates the deviation of the loti’s REER from its “long-run level” based on an international comparison of price levels adjusted for productivity differentials. Under this approach, the loti was undervalued by 19 percent in 2006, but the margin of error (at a 90 percent confidence level) is larger than this.

On the other hand, Lesotho’s dollar wage in the garment industry remains relatively high by the standard of the last decade, although below its 2005 peak.

22. Staff supported further gradual accumulation of international reserves. The CBL’s net international reserves (NIR) target seeks to ensure the viability of the exchange rate peg of the loti to the rand, and should be considered a floor. Currently, reserves exceed the target, reflecting the saving of recent SACU revenue windfalls. The continuation of Lesotho’s prudent fiscal stance should result in further accumulation of foreign assets in the near to medium term, provided that SACU transfers remain elevated. This is to be welcomed, in view of uncertainties that loom ahead. The authorities indicated that it might not be optimal to accumulate international reserves at the CBL indefinitely. Staff agreed that other options for managing the future accumulation of external assets should be considered as long as they held to high standards of governance and transparency.

E. Financial Sector Issues

23. The banking system is solid, but access to banking services for households and SMEs remains limited. The banking system, dominated by three South African banks, is profitable, well-capitalized, and liquid; nonperforming loans (NPLs) are moderate and well provisioned. Possible vulnerabilities might result from a relatively high and increasing concentration on the asset side of the banks’ balance sheets. A challenge going forward is to increase the role, so far limited, of the banking system in financing domestic firms and households. The authorities indicated that the ongoing strengthening of Lesotho Postbank together with an ordered development of microfinance would increase population access to financial services. It is also expected that efforts to formalize land titling, build the credit bureau, and reform commercial courts will increase the availability and quality of bank credit to the economy.

Lesotho: Commercial Banks’ Quarterly Performance Ratios, 2005-07

Source: Central Bank of Lesotho.

¹ Since 2005, affected by the operations of two new banks.

Lesotho: Commercial Banks’ Quarterly Performance Ratios, 2005-07

			2005	2006				2007
			Dec.	Mar.	Jun.	Sep.	Dec.	Mar.
Performance ratios			(Percent)
	Capital adequacy
		Basel capital ratio	22	25	23	19	19	20
		Nonperforming loans to total capital	3	2	2	6	6	9
		Top 20 exposures to total capital	100	84	63	98	117	116
Asset quality
		Loans to deposits ratio	29	30	17	30	26	26
		Earning assets to total assets	93	94	95	94	95	95
		Nonperforming loans to total loans	2	1	2	2	2	3
		Reserve for losses to total loans	3	2	3	2	3	3
		Reserve for losses to nonperforming loans	167	242	161	112	125	93
Liquidity Ratios
		Liquid assets to total deposits	120	112	132	88	100	98
		Available reserves to total deposits	8	6	6	5	4	5
		Liquid assets to total assets	77	75	83	75	78	78
		Current assets to total current liabilities	86	85	95	83	85	84
Profitability ratios1
		Net income to average total assets (return on assets)	2	1	1	2	2	1
		Net income to average total equity (return on equity)	15	7	8	20	27	8
		Total expenses to total income	73	75	73	68	70	74
Solvency ratios
		Total debt ratio	10	12	12	10	7	8

Source: Central Bank of Lesotho.

¹ Since 2005, affected by the operations of two new banks.

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Lesotho: Commercial Banks’ Quarterly Performance Ratios, 2005-07

			2005	2006				2007
			Dec.	Mar.	Jun.	Sep.	Dec.	Mar.
Performance ratios			(Percent)
	Capital adequacy
		Basel capital ratio	22	25	23	19	19	20
		Nonperforming loans to total capital	3	2	2	6	6	9
		Top 20 exposures to total capital	100	84	63	98	117	116
Asset quality
		Loans to deposits ratio	29	30	17	30	26	26
		Earning assets to total assets	93	94	95	94	95	95
		Nonperforming loans to total loans	2	1	2	2	2	3
		Reserve for losses to total loans	3	2	3	2	3	3
		Reserve for losses to nonperforming loans	167	242	161	112	125	93
Liquidity Ratios
		Liquid assets to total deposits	120	112	132	88	100	98
		Available reserves to total deposits	8	6	6	5	4	5
		Liquid assets to total assets	77	75	83	75	78	78
		Current assets to total current liabilities	86	85	95	83	85	84
Profitability ratios1
		Net income to average total assets (return on assets)	2	1	1	2	2	1
		Net income to average total equity (return on equity)	15	7	8	20	27	8
		Total expenses to total income	73	75	73	68	70	74
Solvency ratios
		Total debt ratio	10	12	12	10	7	8

Source: Central Bank of Lesotho.

¹ Since 2005, affected by the operations of two new banks.

24. The rapid growth of the credit cooperative sector calls for better regulation and supervision. Credit cooperatives have grown in response to the low access to bank credit. Taking advantage of loopholes in regulations, they often engage in financial intermediation with nonmembers without adequate supervision. The extent of the operations of these cooperatives is not well known, and the quality of supervision is limited at present. The authorities concurred with this assessment and stated that technical assistance is expected from the International Fund for Agriculture Development (IFAD). The measures currently contemplated include the revision of the regulation and supervision framework and a strengthening of the role of the CBL, which at present has no jurisdiction in this area.

25. The operation in Lesotho of unlicensed deposit-taking entities poses significant risks to depositors and potentially to social stability. These vehicles have attracted sizable deposits from the public by offering inordinately high rates of return (60 percent a year in one case), accumulating large and fast-growing liabilities that will be exceptionally difficult to meet. These vehicles face significant rollover risks, implying a high probability of failure with possible social and macroeconomic repercussions, as many thousands of savers could lose their investments. Their operation may create opportunities for money laundering and could undermine deposit-taking activities of the banks, although an eventual failure of those entities should not pose significant credit risk to banks. Staff noted that the liabilities of the largest vehicles had become quite large (about 8 percent of GDP) and that their unwinding might cause social tension. Staff encouraged the authorities to seek the support of regulatory agencies in partner countries with relevant expertise and take early action, and reiterated that the Fund is ready to help within the limits of its mandate and expertise. The authorities said they intend to address this issue and would approach some of their development partners for input should the need arise.

F. PRS Process

26. The authorities are preparing a final report on the implementation of the PRS 2003/04–2006/07. Staff noted that efforts made during that period were significant, but capacity limitations prevented the full implementation of the actions envisioned in the PRS. Staff observed that timely progress reports might have signaled implementation difficulties, and encouraged the authorities to improve the collection of economic and social statistics in support of monitoring the results of the PRS. The authorities intend to prepare a new PRS that will include some of the elements still pending and reflect the growth strategy under preparation and the results of the 2002 household budget survey. This PRS should be finalized by April, 2008; meanwhile, the PRS 2003/04–2006/07 remains operative.

27. HIV/AIDS is highlighted as a cross-cutting challenge in the PRS. Its impact on society and the economy is high, but difficult to quantify. Donor and budget resources are used to provide treatment and promote prevention, but implementation capacity is insufficient.