Cape Verde
2008 Article IV Consultation and Fourth Review Under the Policy Support Instrument-Staff Report; Public Information Notice and Press Release on the Executive Board Discussion; and Statement by the Executive Director for Cape Verde

Over the last several years, Cape Verde has achieved a major economic transformation that is a tribute to its sound homegrown economic reform program. This 2008 Article IV Consultation highlights that real per capita GDP in Cape Verde has increased on average by more than 7 percent a year since 2001, faster than most small island economies and the average for sub-Saharan Africa. Policy implementation under the Policy Support Instrument (PSI) is also strong. All PSI quantitative assessment criteria for end-December 2007 were met with wide margins.

Abstract

Over the last several years, Cape Verde has achieved a major economic transformation that is a tribute to its sound homegrown economic reform program. This 2008 Article IV Consultation highlights that real per capita GDP in Cape Verde has increased on average by more than 7 percent a year since 2001, faster than most small island economies and the average for sub-Saharan Africa. Policy implementation under the Policy Support Instrument (PSI) is also strong. All PSI quantitative assessment criteria for end-December 2007 were met with wide margins.

I. A Success Story in Sub–Saharan Africa

1. Over the last several years, Cape Verde has achieved a major economic transformation. Real per capita GDP has increased on average by over 7 percent a year, faster than other small island economies and other countries in sub–Saharan Africa. The unemployment rate fell by more than 10 percentage points between 2001 and 2006.1 Cape Verde is also on track to achieve most of the MDGs by 2015, including halving the 1990 poverty level. This is remarkable for a small island economy with no natural resources. The transformation is reflected in an economy that is increasingly becoming service–based, led by tourism and commerce.

uA01fig01

Average GDP per Capita Growth (PPP), 1993-2007

Citation: IMF Staff Country Reports 2008, 248; 10.5089/9781451809503.002.A001

Source: World Economic Outlook and National authorities.1 Mauritius, Seychelles and Maldives.

2. Cape Verde also compares favorably with other mature stabilizers. Growth from 200 1–07 was about the average for countries that entered a PSI program, and inflation was the lowest. Although domestic debt reduction since 2001 was below the average for the PSI group, at its current rapid pace of reduction it should rival that average in a few years. The net present value of external central government debt has been reduced by 16 percent of GDP since 2001, despite the fact that, unlike most PSI countries, Cape Verde did not benefit from debt relief under the HIPC initiative and the MDRI.2 Since 2001, reserve accumulation by Cape Verde was higher than the PSI group average. In recognition of its strong performance and policy credibility, Cape Verde was accepted as a special partner of the European Union in November 2007, was invited to join the WTO in December 2007, and graduated from UN least–developed country (LDC) status in January 2008 (the second in sub–Saharan Africa after Botswana and the first graduation in more than a decade).

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Cross Country Comparison of PSI Program Countries, 2001‐07 Average 1

Citation: IMF Staff Country Reports 2008, 248; 10.5089/9781451809503.002.A001

Source: World Economics Outlook and IMF staff estimates.1 Includes Tanzania, Senegal, Mozambique, Nigeria and Uganda. Note: Domestic debt reduction is in percent of GDP and reserve accumulation is in months of imports

3. Cape Verde’s progress owes much to a homegrown reform program that has produced good policy outcomes:

  • Lower domestic debt: Tax reforms, notably the introduction of the value–added tax (VAT) in 2004, which improved revenue buoyancy, and tight restraint on recurrent spending, helped by civil service reform, have reduced domestic debt considerably.

  • A stronger external position: Good policies catalyzed high inflows of tourism–related foreign direct investment (FDI), which are breaking past dependence on aid and remittances. Thus, international reserves were rebuilt, which enhanced the credibility of the exchange rate peg.

  • Greater private sector participation: Structural reforms were undertaken to foster competition and enhance private sector’s role in the economy. Several state–owned enterprises were privatized; the government selected new management to prepare the national airline (TACV) for privatization; and the process of privatizing the ports operator (ENAPOR) is underway. Ahead of WTO accession, external tariffs were lowered. The Cape Verde Stock Exchange has been revitalized; its market capitalization is now 25 percent of GDP (from zero in 2005).

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Tourism and Remittances

(percent of GDP)

Citation: IMF Staff Country Reports 2008, 248; 10.5089/9781451809503.002.A001

Source: World Economic Outlook and National authorities.

These economic achievements were facilitated by Cape Verde’s political stability and enhanced governance.

4. The 2008 Article IV consultation discussions and 4th PSI review focused on policies to consolidate these gains on macroeconomic stability and deepen structural reforms to sustain growth over the medium term. Discussions centered on anchoring fiscal policy in a medium–term perspective, preserving financial stability, and enhancing the economy’s resilience to shocks.

II. Recent Performance and Outlook

A. What Is Happening in the Economy Now

5. Economic growth is strong with moderate inflation: The real GDP growth rate peaked at 10.8 percent in 2006, boosted by tourism, telecommunications, and construction. Based on information from the National Statistical Institute (INE), staff estimate that GDP grew about 7 percent in 2007 and, factoring in the effects of the global economic slowdown, growth should moderate only slightly to 6 ½ percent in 2008 as tourism and construction continue to expand. With the peg to the euro and the high openness allowing rapid import price pass–through, twelve–month inflation averaged about 3½ percent for December 2007–April 2008, broadly in line with inflation in the euro area.3 While food and energy prices have risen, this has not led to generalized inflation partly due to lack of a strong wage indexation.

Cape Verde: Contribution to Growth

(Annual percentage change)

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Net of financial intermediation charges indirectly measured.

Including housing rent, taxes on imports and all other sectors.

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Cape Verde: CPI Inflation Rates, Jan 2000–April 2008

(12 month percent change)1

Citation: IMF Staff Country Reports 2008, 248; 10.5089/9781451809503.002.A001

Sources: National authorities and staff calculations.1 New CPI basket in effect from Feburary 2006.

6. Fiscal policy continues to support the peg. Staff estimate that the prudent 2008 budget will ensure that domestic debt will be further reduced to 16 percent of GDP by end–2008. Tax revenues are exceeding budget forecasts, reflecting not just economic growth but also improvements in tax administration; also, asset sales have surpassed expectations. These factors, together with continued expenditure restraint, have reduced the domestic debt–to–GDP ratio.4 The authorities’ target for domestic debt, 20 percent of GDP, was reached in 2007, two years ahead of schedule (Figure 1).

Figure 1.
Figure 1.

Cape Verde: Fiscal Performance, 2004–08

(Percent of GDP)

Citation: IMF Staff Country Reports 2008, 248; 10.5089/9781451809503.002.A001

Source: National authorities and IMF staff estimates.1The capital expenditure budget is typically underexecuted owing to capacity and donors’ delays.

7. The Bank of Cape Verde (BCV) continues to conduct monetary management appropriately. Given the peg and a largely open capital account, passive monetary management by the BCV has been setting the official policy rate consistent with its endogenous equilibrium level, which smoothes and sterilizes short–term capital flows. Reserves continue to accumulate, and while FDI–related imports have led to and financed a higher current account deficit, there are no signs of a more general increase in imports that would jeopardize the targeted increase in reserves (Figure 2). Excess liquidity has been contained by sterilization, by the new investment opportunities on the Stock Exchange following rapid development of the domestic equity market, and by growth in private sector credit (Figure 3). The buildup of government deposits at the BCV is also helping to sterilize external inflows. Thus, monetary management and fiscal prudence are both supporting the exchange rate peg and promoting external stability.

Figure 2.
Figure 2.

Cape Verde: External Developments, 2004–2008

Citation: IMF Staff Country Reports 2008, 248; 10.5089/9781451809503.002.A001

Source: National authorities and IMF staff estimates.1.Growth in total exports in 2007 was dampened by a sharp decline in re‐exports of fuel because South African Airlines stopped refueling in Cape Verde.
Figure 3.
Figure 3.

Cape Verde: Monetary Developments, January 2004–December 2007

Citation: IMF Staff Country Reports 2008, 248; 10.5089/9781451809503.002.A001

Source: National authorities and IMF staff estimates.

B. Policy Implementation Under the PSI

8. All PSI quantitative assessment criteria for end–December 2007 were met with wide margins. The ceiling on net domestic borrowing was observed by a margin of 1.8 percent of GDP reflecting a much improved public financial management system, which also prevented the accumulation of arrears. International reserves exceeded the PSI floor by about 0.2 months of imports despite some moderation in the last quarter of 2007 as FDI slowed.

9. Despite capacity constraints, steady progress was made on implementing the structural assessment criteria: 5

  • The authorities reported that the base utility tariffs mechanism was finalized and approved by the Economic Regulatory Agency (ARE) on March 27, 2008 and posted on ARE’s website on the following day (LOI, ¶ 5). The goal of this structural assessment criterion in the program is to achieve full cost recovery to stop the accumulation of tariff deficits, a contingent liability. The adjustment of the final electricity price for consumers based on the new base tariffs will take into account the impact of the global food and oil price inflation on the poor and vulnerable segments of the population.6

  • On the fuel pricing side, however, the complex cost structures of the two oil companies, Shell and Enacol, posed technical difficulties that prevented implementation of the continuous assessment criterion on full application of the mechanism for setting and adjusting fuel prices.7To solve this problem, the Economic Regulatory Agency (ARE) took two main corrective actions: First, it adjusted fuel prices on March 25, 2008, clearing implicit subsidies owed to the oil suppliers that had accrued since the previous adjustment in October 2007.8Second, after some delay due to lack of funding, ARE hired a consultant to develop a new fuel pricing formula (a structural benchmark for March), which is expected to be finalized and published by end June 2008. The new simplified and more transparent formula, based on a unified cost structure of the upcoming joint venture between the oil companies, will ensure regular fuel price adjustments, stop accrual of fiscal liabilities, and encourage much–needed investment in the energy sector. On the basis of these remedial measures taken by the authorities, the staff recommends granting a waiver for the missed structural assessment criterion.

10. Important progress has also been made on implementing the structural benchmarks, despite some delays (text table).

Cape Verde. Selected Structural Benchmarks for 2007–08 1

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As in the Letter of Intent and Memorandum of Economic and Financial Policies of November 2007 for the 3rdPSI review (IMF Country Report 08/37).

Submitted to the Council of Ministers in May 2008.

C. Outlook, Risks and Challenges

11. The near–term outlook is broadly favorable but risks are tilted to the downside reflecting the continued high oil prices and more generally the global slowdown. Because the Cape Verde economy is predominantly service–based and depreciation of the US dollar is containing oil prices in escudos, the oil price impact is likely to be manageable.9Cape Verde also remains relatively unexposed to international capital markets as non–emigrant cross–border flows are relatively small. However, the global slowdown could have knock–on effects on Cape Verde’s external demand (including tourism) or FDI flows. Specifically, while none of Portugal’s banks that have dominant shares in Cape Verde banks have experienced difficulties so far, Cape Verde could be somewhat affected as the turmoil appears to have had some impact in the United Kingdom, Ireland and Spain which are important sources of FDI, remittances and tourism flows.

12. Staff expect strong economic performance over the medium term. Growth is projected to average about 6¾ percent through 2013, underpinned by tourism, FDI, and public investment. Cape Verde is expected to consolidate its position among the highly–tourism based economies (Box 1). The current account deficit will likely widen and be financed increasingly by the strong FDI flows (non–debt creating) unlike a decade ago, when debt and remittances financed the balance of payments. Emigrant remittances are expected to taper off as income in Cape Verde grows faster than in the countries where its emigrants reside and emigration declines. Staff’s empirical analysis also suggests that remittances are becoming more procyclical and thus less reliable as a shock absorber (Box 2). On concessional financing, in preparing for the transition from LDC status, the authorities reached out extensively, and most donors confirmed that graduation will not lead to an abrupt end to concessional aid. Continued fiscal restraint is envisaged over the medium term and the revenue losses of WTO accession and EU–economic partnership agreement will be limited and gradual. 10

uA01fig05

Balance of Payments Source of Financing, 1995–2007

Citation: IMF Staff Country Reports 2008, 248; 10.5089/9781451809503.002.A001

Source: National authorities

13. This said, Cape Verde faces old vulnerabilities and emerging challenges:

  • Infrastructure bottlenecks still constrain growth. Continued growth in the tourism sector will require large–scale investments in transportation and energy infrastructure. Making use of the fiscal space to increase capital expenditures, while maintaining debt sustainability, poses a challenge.

  • The financial sector still relies on nonresident deposits. These deposits constitute about 40 percent of total bank deposits making the banking system’s funding base significantly reliant on them. The annual growth rate of the stock of non–resident deposits (NRD), although still respectable at about 6 ¼ percent, has slowed in recent years. However, there are doubts about how interest–sensitive these deposits are. While banks have been pressured to launch new savings products to continue to attract NRDs in a context of declining rates,11the home bias and historical resilience of these remittance–based inflows significantly minimize the risks of a reversal. Thus, it remains unclear the extent to which the NRDs are a potential capital account–based source of vulnerability and hence warrant close monitoring

  • Cape Verde’s export base is narrow. The economy is vulnerable to a weakening of international demand for tourism, especially given the scarcity of natural resources as alternative exports. To date structural reforms have not been sufficiently broad–based to sustain high growth in the long term, and there are difficulties in adjusting to demand shocks given the ongoing specialization in tourism and the limited price and wage flexibility.12Limiting the vulnerability associated with this specialization, diversifying sources of growth, and increasing the economy’s flexibility to buffer against shocks pose a challenge.

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Contribution to Growth, 1990 ‐ 2006

Citation: IMF Staff Country Reports 2008, 248; 10.5089/9781451809503.002.A001

III. PolicyDiscussions:Sustaining theStrongPerformance

14. The discussions focused on the policies needed to maintain Cape Verde’s impressive macroeconomic performance and stability in the face of changing balance of payments flows.

  • Guided by external stability, the mission discussed a package of measures to respond to these challenges and minimize vulnerabilities to preserve macroeconomic stability. These include the use of a medium–term fiscal framework to accommodate the authorities’ plans to increase infrastructure and energy sector investment while keeping debt on an appropriate path; financial sector reforms to broaden the funding base of banks and reduce reliance on non–resident deposits, while further liberalizing the capital account; and structural reforms to diversify the economy and increase price flexibility in both goods and factor markets to enhance resilience to shocks.

  • The authorities concurred, in particular on the changing balance of payments, and welcomed the mission’s work on Cape Verde through cross–country analysis of highly–tourism–based economies. Nevertheless, they emphasized that in some areas capacity constraints may hamper policy implementation and in this context reiterated that they will continue to need technical assistance from the Fund in a range of areas. In the attached Letter of Intent (Appendix), the government affirms its commitment to the policy goals described in its recent Memorandum of Economic and Financial Policies (MEFP) (IMF Country Report 08/37) and updates its plans to meet those goals.

The Tourism Boom1

Cape Verde is the fastest–growing tourism market among the highly–tourism–based economies (HTBEs). It was recently discovered as a new frontier for European tourism. Travel exports have grown by more than 30 percent annually on average for more than a decade, far outpacing other HTBEs. The development of the tourism sector has been a success for Cape Verde with obvious growth benefits and poverty reduction potential.

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Travel exports from Cape Verde are the fastest growing among HTBEs.

Citation: IMF Staff Country Reports 2008, 248; 10.5089/9781451809503.002.A001

Source: IMF, Balance of Payments Statistics Yearbook

Country–specific factors explain the comparative advantage in tourism: convenient location, good position to harness the overflow of Mediterranean tourism, a favorable sociopolitical situation, macroeconomic stability, and good governance.

However, specialization in tourism and increasing openness will bring high volatility. Dependence on a single export means that shocks to demand for that export will propagate throughout the entire economy. The tourism sector in Cape Verde is not an enclave and is becoming a conduit for external shocks and the business cycle is becoming synchronized with tourism originator countries. Cross country analysis shows that output volatility tends to increase as economies become more HTBE. HTBE also have business cycles with higher amplitude and longer duration, so large buffers are needed to smooth consumption during longer and deeper contraction phases. However, countercyclical policies are not available to Cape Verde because it has a passive monetary policy under a peg, and the small fiscal multipliers with the high import leakage. Thus, as it becomes more and more an HTBE, Cape Verde would need buffers through higher reserves and fiscal space.

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Cape Verde has been less volatile than HTBEs.

Citation: IMF Staff Country Reports 2008, 248; 10.5089/9781451809503.002.A001

Source: IMF staff estimates.
1 Selected Issues, Chapter 1.

A. Maintaining Fiscal Prudence

Staff and the authorities agreed on the need to articulate a medium–term fiscal strategy. This would provide room for the authorities’ planned increase in infrastructure spending to sustain the tourism boom and ensure that the upcoming tax reforms are broadly revenue–neutral.

15. The mission and the authorities agreed on the need to orient fiscal policy in a medium–term perspective.

  • Staff noted that the reserves target should anchor medium term fiscal policy. By constraining domestic demand to build up foreign reserves, fiscal policy contributes directly to the credibility of the peg. The use of the reserves target to anchor medium–term fiscal policy is also consistent with keeping public debt along an appropriate path. The recent decline in the country risk premium largely reflects better fiscal fundamentals and the associated rise in official reserves. Staff’s cross-country analysis shows that while growth has been higher than average and inflation lower, Cape Verde’s public debt–to–GDP ratio is one of the highest among highly–tourism–based economies, and its reserves are below average (Figure 4). Thus, Cape Verde needs larger buffers in the form of higher international reserves and fiscal space (Box 1), especially in the context of declining reliability of remittances to smooth consumption and hedge against macroeconomic shocks (Box 2).

  • The authorities concurred and stated that their objective is to increase reserves by about 0.1 month of prospective imports annually reaching over 4 months by 2013. This is appropriate as it is equivalent to about 6 months expunging FDI–related imports, and 172 percent of short–term debt, supported by continued fiscal restraint.

Figure 4.
Figure 4.

Cape Verde in Cross–Country Perspective, Based on Highly Tourism Based Economies

(Average for 2000–061)

Citation: IMF Staff Country Reports 2008, 248; 10.5089/9781451809503.002.A001

Source:World Economic Outlookand International Financial Statistics.1A&B: Antigua and Barbuda; T&T: Trinidad and Tobago.

Adequacy of Central Bank’s Reserves (average)

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Source: National Authorities, staff estimates and projections.

Short term debt based on remaining maturity.

Permanent imports equal imports minus one‐half of FDI and of tourism exports.

16. Staff and the authorities reached understandings on the operational aspects of medium–term fiscal policy. Thus, the authorities agreed to include a new structural measure in the PSI program on submitting a simplified medium–term fiscal framework (MTFF) to the Council of Ministers along with the 2009 budget proposal and publishing it on the Ministry of Finance website (LOI, ¶8).13Implementing this MTFF would require accelerating public financial management (PFM) reforms to enhance implementation capacity and thereby improve the quality of public investment. Given the fiscal space created by the larger–than–expected reduction in domestic debt in 2007, the envisaged medium–term baseline scenario projects that the fiscal deficit will average about 5 percent of GDP through 2013, bringing the total nominal debt–to–GDP ratio from 67 percent at the end of 2007 to 49 percent by 2013.14This scenario assumes that, since the authorities have already reached their domestic debt target of 20 percent of GDP, they will keep the ratio below that over the medium term to buy “policy insurance” against shocks and to support the peg. To provide room for the authorities’ planned increases in infrastructure expenditures to sustain the tourism boom and reduce poverty, an alternative scenario was developed in which capital expenditures on infrastructure increase by further 2 percent of GDP annually for five years. The results show that even under this scenario, the risk of debt distress remains low (Figure 5).15Furthermore, the authorities’ envisaged reserve buildup is preserved (¶ 15).16Moreover, recent steps taken by the authorities to improve the energy pricing mechanism coupled with their broader energy sector reform plan (LOI, ¶ 12), will also help reduce fiscal risks over the medium term and potentially contribute fiscal space toward infrastructure development. The MTFF will also be a tool to ensure that the upcoming tax reforms and the rationalization of tax exemptions are implemented in a broadly revenue neutral fashion. The authorities also noted that operationalizing the MTFF will enhance the implementation of the new Poverty Reduction Strategy (PRSP–2), which was finalized in May 2008.

Figure 5.
Figure 5.

Cape Verde: Indicators of Public Debt Under Alternative Scenarios, 2007-27

Citation: IMF Staff Country Reports 2008, 248; 10.5089/9781451809503.002.A001

Source: Staff projections and simulations.1/ See 2007 DSA (IMF Country Report 08/3 7)2/ Revenue including grants.

Remittances: A Less Reliable Hedge against Macroeconomic Shocks 1

The changing financing structure of the balance of payments calls for a closer look at the volatility of worker remittances and their role as a shock absorber. Historically, remittances from the Cape Verdean diaspora have constituted a large share of external financing. Staff’s previous analysis (WP/06/132) found that remittances from Europe were largely driven by altruistic motives and thus acted countercyclically in smoothing consumption, while flows from the United States may have partly been motivated by investment in Cape Verde.

Indeed, remittances have been less volatile than foreign direct investment (FDI) and exports, and only slightly more volatile than official development assistance (ODA) . Compared to other inflows, remittances remain an important source of foreign currency even as they decline in importance: remittances as a share of total foreign financing fell from 46 percent in 1995 to 18 percent in 2007.

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Volatility of Inflows, 1980 - 2006

Citation: IMF Staff Country Reports 2008, 248; 10.5089/9781451809503.002.A001

More recent econometric evidence suggests that remittances are becoming increasingly procyclical, thus reducing their role as a shock absorber. Disaggregated data from Portugal, France, and the USA suggest that remittances are positively associated with business cycles in Cape Verde: a 1 percent increase in real GDP growth in Cape Verde raises remittances by approximately 2.5 percent. Detrended by the Hodrick–Prescott filter, remittances and GDP show a relatively high correlation of 70 percent from 1980 through 2006. Overall, the relationship between remittances and GDP based on a battery of empirical analysis suggest that remittances have been increasingly motivated by investment considerations rather than altruistic considerations or for consumption smoothing.

uA01fig10

Cyclicality of Inflows, 1981 - 2006

(billions of US dollars)

Citation: IMF Staff Country Reports 2008, 248; 10.5089/9781451809503.002.A001

1 Selected Issues, Chapter 2.

B. Preserving Financial Stability

Staff and the authorities agreed on the challenges posed by the continued deceleration of the growth of nonresidents deposits in the banking system. The slowdown poses both liquidity risk for banks and a potential capital account based source of vulnerability.

17. The mission called for enhanced monitoring of nonresident deposits in the banking system and more generally the funding base for banks. Banks noted that the slowdown in non–resident deposit flows into the banking system was due to new investment opportunities in the Cape Verde Stock Exchange. Some nonresidents are reportedly diversifying their portfolios away from bank deposits in a search for higher yields in equities. Better monitoring of the sources and direction of these deposits is important for promptly detecting potentially destabilizing capital flows to gauge the appropriateness of the official policy interest rate. The slowdown of these deposits can be better managed on two fronts:

  • Continue BCV’s cautious approach of conducting monetary management consistent with the peg. The mission noted that the BCV should continue to carefully set its short–run official policy interest rate consistent with its endogenous equilibrium level—the level that smoothes inflows or outflows of short–term capital.17

  • Strengthen the banking system. Strong oversight of banking system soundness would help attract more diverse sources of financing as a way to grow out of dependence on nonresident deposits. Recent measures taken to strengthen the financial system (LOI ¶ 5) will go toward meeting this goal. The BCV should also follow up on the recommendations of the recent MCM technical assistance for an enhanced macro–prudential surveillance framework to be built around an expanded set of financial soundness indicators.

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Source: National authorities and staff estimates.

18. The authorities stated that the financial system is broadly sound and banks have ample liquid assets. The BCV noted that they view the continued decline in the growth of nonresident deposits from the perspective of a changing balance of payments rather than the impact on bank liquidity, as resident deposits are gradually becoming a dominant source of funding for banks. 18To better measure how interest–sensitive non–resident deposits are, the BCV will closely monitor external flows (including these nonresident flows), an action that will be supported under the PSI as a structural benchmark (LOI, ¶ 11). They also noted that their plans to liberalize financial flows will also support the diversification of the financial system. The authorities noted, and staff concurred, that removing bureaucratic burdens on certain types of financial flows should not pose any near–term risk; it would largely validate the current de facto situation, remove formal restrictions hampering resident participation in tourism projects, and further develop Cape Verde as an international financial center.19

19. The mission recommended strengthening the framework for analyzing the real–financial sector linkages. While the current macro–prudential surveillance framework, which is focused mostly on banks, shows a sector that seems to be generally sound, available financial soundness indicators (FSIs) are limited in scope and coverage.20

  • Cape Verde’s FSIs compare well with international benchmarks and are better than the average for sub–Saharan Africa. Banks generally comply with the prudential requirements, thanks to BCV enforcement efforts. New regulations for both on–and off–shore banks on capital ratios, provisioning and loan classification, credit risk assessment, and credit concentration were published in November 2007.

  • However, the lack of a broader macro–prudential surveillance leaves considerable uncertainty about current and emerging macro–critical risks and vulnerabilities. Better understanding the links between the tourism boom and the real estate market, and the financial system is urgent. Anecdotal evidence suggests a significant price rise in the luxury end of the real estate market boosted by non–residents’ demand for second homes. Although banks exposure to the residential real estate is mainly with residents and largely backed by collateral (with a loan–to–value ratio of 80 percent), some banks are now also venturing into large real estate projects to non–residents without a comprehensive credit risk assessment—at commercial banks themselves, and at the macro–prudential level at the BCV. While non–residents purchasing second homes are more loyal to sustain tourist arrivals, shocks to tourism could propagate to the real estate market and may affect banks. Furthermore, continued slowdown of non–resident deposits may subject the banking system to liquidity risk. The forthcoming FSAP should help to strengthen the authorities’ hands on these issues.

C. Maintaining Competitiveness and Fostering Private Sector Development

Both staff and authorities view the exchange rate as broadly in line with macroeconomic fundamentals, and the peg remains appropriate and supported by domestic policies. The authorities agreed with staff on the need for broader export diversification, and increased price flexibility consistent with the peg, and to foster private sector development.

20. The mission called on the authorities to use the window of opportunity provided by the tourism boom to diversify the economy and improve price flexibility to enhance resilience to shocks. Structural reforms to make the economy more flexible will be key to competitiveness and to sustaining high growth in the long term. The authorities’ efforts to address both infrastructure gaps and labor market rigidities bode well for enhancing growth, as do Cape Verde’s recent accession to the WTO and its commitment to liberalize trade. Sustained productivity growth is essential to maintain competitiveness.

Cape Verde: Selected Economic Integration and Openness Indicators

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source: National authorities
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Effective Exchange Rate Developments, Jan 2000 - Jan 2008

Citation: IMF Staff Country Reports 2008, 248; 10.5089/9781451809503.002.A001

Source: IMF, Information Notice System.

21. Cape Verde’s balance of payments position is consistent with external stability and the tourism boom does not raise undue concerns. Staff and the authorities agreed that the recent increase in the current account deficit is no reason for concern because it is largely linked to FDI–related imports, and there is an automatic stabilizer (imports will decelerate if tourism and FDI flows decelerate). Although tourism inflows also affect the determination of the real effective exchange rate (REER), the REER is broadly in line with fundamentals (Box 3). While the rate generally appreciated during 2005–07 reversing the depreciation of 2003–04, the REER has fluctuated around a constant for the last several years in response to supply–side–driven inflation differentials. This said, the staff noted the significant appreciation of the euro against the US dollar warrants close monitoring.

22. With both monetary management and fiscal policy promoting external stability, staff and the authorities agreed that exchange rate peg has served Cape Verde well as an anchor for financial stability and remains the appropriate regime. The peg has also helped to achieve lower inflation at little apparent cost in terms of lost growth.21The existence of a large dominant trading partner—the European Union—whose business cycles are highly synchronized with Cape Verde, provides an obvious standard of reference for the peg. This said, staff and authorities agreed that there would be no discernible gains from hardening the peg given entrenched fiscal discipline, much enhanced policy credibility, and greater investor confidence. On the contrary, alternatives for hardening the peg would necessarily entail additional fiscal costs and the monetary and reserve management could be complicated during the transition to such arrangements.

Assessment of External Stability

The current account and fundamental misalignment: Directly estimating Cape Verde’s current account norm through the macroeconomic balance approach of the Consultative Group on Exchange Rates is complicated by data limitations and frequent structural breaks resulting from rapid structural changes. The exchange rate will thus be assessed by (i) analyzing the reduced–form relationship between the real effective exchange rate (REER) and certain macroeconomic fundamentals; (ii) assessing the exchange rate regime; and (iii) assessing the sustainability of domestic policies.

  • The current and equilibrium REER: Cape Verde’s balance of payments is consistent with external stability, and there is no strong evidence of fundamental exchange rate misalignment. The results of the equilibrium real exchange rate approach show that the REER was significantly overvalued from 1992 through 1999, but after adoption of the peg in late 1998 the REER depreciated, and in recent years it has remained close to equilibrium despite large FDI inflows. Other indicators also suggest that Cape Verde’s competitiveness is broadly improving (see table). Possible Balassa–Samuelson (B–S) effects coming from large tourism inflows are likely to be limited: while the actual REER will rise, given the tourism boom so will the equilibrium REER. In any case, with an unemployment rate of about 20 percent, any B–S effect on the nontradable sector is likely to be moot. In addition, there is no strong wage indexation in Cape Verde. Assessment: The current exchange rate is broadly in line with macroeconomic fundamentals.

  • Exchange rate regime: The exchange rate peg is supported by domestic policies, has contributed to external stability, and has not pushed the REER out of line with fundamentals. Overall, the exchange rate regime has served Cape Verde well as an anchor for financial stability (see ¶ 22 and Figure 6).Assessment: The peg has promoted external stability and remains appropriate.

  • Domestic policies: These have generally promoted both domestic and external stability (Figure 6). Cape Verde’s success in attracting more FDI than neighboring economies despite having no natural resource advantage reflects the strength of its domestic policies and reforms. The fiscal position is solid and sustainable. The recent debt sustainability analysis shows that the risk of debt distress remains low even under alternative stress scenarios (Country Report 08/37). Continued fiscal consolidation has significantly reduced domestic debt and helped to create fiscal space for a modest increase in capital expenditure to ease infrastructure bottlenecks. Monetary management is appropriately adjusting the interest differential with the euro area and has avoided destabilizing short–term capital flows. Assessment: Fiscal and monetary policies are consistent with domestic stability and internal balance.

  • The capital and financial accounts and external stability:Private capital flows are related primarily to non–debt creating FDI flows in the tourism sector. Cape Verde remains largely unexposed to movements in international capital markets and cross–border non–emigrant flows. The BCV is closely monitoring vulnerability from the recent slowdown in emigrant deposits. Assessment: The capital and financial account does not pose major concerns for external instability.

uA01fig13

Deviation from the long run equilibrium REER

1980 ‐ 2006 (in natural logarithms)

Citation: IMF Staff Country Reports 2008, 248; 10.5089/9781451809503.002.A001

Source: IMF staff estimates.

Cape Verde: Indicators of Competitiveness

article image
Sources: IMF, Information Notice System, national authorities, and staff estimates.Notes:Unless noted otherwise, an increase (decrease) in indicators implies a improvement in (deterioration of) competitiveness.

Ghana exports to selected countries as percent of those countries’ total imports.

Imports of goods and services as percent of domestic demand. An increase (decrease) in the indicator implies a deterioration of (improvement in) competitiveness.

Ratio of export price index (2000=100) to tetriary GDP deflator (2000=100).

Figure 6.
Figure 6.

Cape Verde Escudo Peg to the Euro Performance

Citation: IMF Staff Country Reports 2008, 248; 10.5089/9781451809503.002.A001

Source: IMF World Economic Outlook, IMF International Financial Statistics, and National authorities.

23. The mission urged the authorities to facilitate the diversification of the export base and enhance the economy’s resilience to shocks. Actions to improve conditions for the private–sector–led development could be implemented in two areas:

  • Promote economic diversification to ensure that growth is sustainable for the long term: The mission urged the authorities to implement an export diversification strategy that could draw on the conclusions of the Diagnostic Trade Integration Study (DTIS) being conducted through the Integrated Framework agency consortium.22

  • Improve wage and price flexibility: Given the peg, greater flexibility in both labor market and energy prices is needed to facilitate adjustment to shocks. The mission welcomed the recent opening of the Citizen House, which will strengthen the business environment by, for instance, reducing the time to start a business from 52 days to 1 (something not yet reflected in the 2008 investment climate indicators); facilitate entrepreneurship; and ensure sustainable growth. However, staff emphasized that the authorities should address other issues related to the cost of doing business. While Cape Verde ranks above average on some indicators, it fares poorly on such labor market indicators as cost of hiring and firing.

Selected Investment Climate Indicators, 2008

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Source: World Bank, Doing Business Report (2008).

Average of St. Luica, Antigua and Barbuda, Malvides, Seychelles, St. Kitts and Nevis, St. Vincent and Grenadines, Vanuatu, Dominica, Samoa, Jamica, Fiji, Mauritius, Grenada, Dominican Republic, Tonga, Trinidad and Tobago, and Paua New Guinea.

A smaller index means an improvement in the rank.

24. The authorities noted that they are moving ahead with their strategy for diversifying exports and making prices more flexible:

  • They are developing several sectors: offshore financial center, which will be enhanced by the new prudential regulation and the new AML/CFT law; the fishing and fish–processing industry, marine and transshipment services; and information technology (IT) which has already begun with a recent agreement between NOSi and Microsoft to facilitate government e–commerce and data processing across Cape Verde. They also pointed out that even within tourism there is room for diversification.

  • The authorities recognize the need to make the labor market more flexible and agreed that the recent new labor code will not do much to accomplish that. They plan to upgrade human capital, retrain labor, attract skilled workers, and improve the mechanism for addressing arbitration and labor disputes. With recent steps taken on energy pricing, a rapid pass–through of energy prices will facilitate faster adjustment to terms of trade swings.

IV. StatisticsIssues

25. The macroeconomic data are broadly adequate for surveillance and program monitoring. The mission welcomed recent improvements in data release. INE recently released a new CPI index and a new web portal, both of which go toward strengthening data collection and improving disclosure. The authorities also now publish most of their data on the Internet.23In line with STA’s recommendation, the mission stressed the increased importance of unambiguously indicating data links in the official websites and regularly updating the metadata for General Data Dissemination Standards (GDDS).

26. However, capacity constraints are severe, and further improvements in data are needed. Specifically:

  • GDP/national accounts: The lack of reliable demand–side GDP data constrains policy formulation, although the BCV does project demand–side GDP.

  • Labor market statistics: Data on unemployment are compiled with long delays, and wage data are nonexistent.

  • Tourism statistics: Better data on tourism arrivals and prices would allow the authorities to gauge the economy’s competitiveness, given the specialization in tourism. INE noted that it plans to compile Tourism Satellite Account statistics.

  • Fiscal data: The new chart of public accounts (PNCP) will not be ready until 2009.

V. StaffAppraisal

27. Cape Verde’s impressive economic performance in recent years is a tribute to its sound homegrown economic reform program. The authorities are to be commended for their prudent macroeconomic management. Good policies have catalyzed investments and export growth, especially in tourism, breaking past dependence on aid and remittances. Economic growth is strong, inflation is moderate, and the unemployment and poverty rates have been gradually falling.

28. Staff view the exchange rate as broadly in line with macroeconomic fundamentals, and the peg remains appropriate. Fiscal policy and monetary management are promoting external stability. The peg has served Cape Verde well and helped to achieve low inflation. Staff sees no discernible gains from hardening the peg given entrenched fiscal discipline, much enhanced policy credibility, and greater investor confidence.

29. Sustaining this strong performance requires tackling three challenges. First, building tourism will require investments in transportation and energy. The challenge will be to use the fiscal space to increase capital expenditures while keeping debt sustainable. Second, the financial sector still relies on nonresident deposits, and their decelerating growth rate should be monitored as it is a potential capital account–based source of vulnerability. Moreover, Cape Verde’s export base is narrow with increasing specialization in tourism. The challenge here is to limit the vulnerability associated with this specialization, diversify sources of growth, and increase the economy’s flexibility to enhance resilience to shocks.

30. Continuing prudence in fiscal policy is essential. This is needed to buy policy insurance against shocks and support the peg. A medium–term fiscal strategy is needed to anchor the authorities’ expenditure and tax reform plans. Given the larger–than–expected domestic debt reduction in 2007, even with current plans to increase capital spending to ease infrastructure bottlenecks, the risk of debt distress remains low and the envisaged reserve buildup is preserved. These plans would also need to be implemented within the medium term fiscal framework (MTFF) and take into account implementation capacity. Staff urges the authorities to move ahead with their plans toward publishing the MTFF as part of the 2009 budget cycle. The authorities should also pursue their plans to enhance the capacity of their debt management office including through seeking technical assistance.

31. Strengthening the financial system further is important. Staff welcomes the recently published regulation that broadly aligned prudential requirements for both on–and offshore banks, which should help preserve Cape Verde’s good reputation. Nonetheless, there is a need to broaden the source of funds for banks so they will continue to grow out of dependence on non–resident deposits. Staff recommends improving the monitoring of these nonresident deposits to gauge better the appropriateness of BCV’s policy interest rate by promptly detecting potentially destabilizing capital flows. Banks exposure to the real estate market also warrants close monitoring. Staff welcomes the BCV plans to establish an enhanced financial sector macro–prudential surveillance; this will provide a good basis for comprehensive assessment of credit risk. The forthcoming FSAP should help to strengthen the authorities’ hands on these issues, including on the real–financial sector linkages.

32. Structural reforms are necessary to maintain external competitiveness and sustain high growth over the long term. Staff calls on the authorities to implement their strategy for export diversification. Given the peg, greater flexibility in labor markets and energy prices is also needed to facilitate adjustment to shocks. To remove labor market rigidities, the authorities should address the high cost of hiring and firing. The authorities’ plans to upgrade human capital, retrain labor, and attract skilled workers are important. On energy prices, regular application of the new utilities base tariffs and fuel pricing formula is essential for fast adjustment to terms of trade changes. Staff urges the authorities to accelerate the implementation of their broader energy sector reforms to further reduce fiscal risk and unleash Cape Verde’s growth and poverty reduction potential.

33. Staff recommends completion of the fourth review of the PSI program. Based on the strength of the authorities’ policies and the corrective measures taken, the staff supports granting a waiver for the missed structural assessment criterion.

34. The next Article IV Consultation will be held in accordance with the decision on consultation cycles approved on July 15, 2002.

Table 1.

Cape Verde: Selected Indicators, 2006–13

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

For 2008, the government finance indicators refer to budget figures.

Excluding a December 2006 purchase of a Portuguese credit to Electra and subsequent offloading on the domestic securities market.

Velocity is nominal GDP devided by average end period broad money. Velocity declines gradually because of financial deepening.

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

Excluding claims on the offshore Trust Fund.

Capital expenditures decelerate in 2011 as the execution of the MCC grant is completed.

Table 2.

Cape Verde: Fiscal Operations of the Central Government, 2006–10

(Millions of Cape Verde escudos, unless otherwise indicated)

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

The energy subsidies recorded in 2007 were incurred in previous periods.

The capital expenditure budget is typically underexecuted.

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

Domestic revenue–recurrent expenditure.

External grants + net foreign financing.

Reflects borrowing from the pension fund and scheduling of payments to energy companies.

Table 3.

Cape Verde: Fiscal Operations of the Central Government, 2006–10

(Percent of GDP)

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

The energy subsidies recorded in 2007 were incurred in previous periods.

The capital expenditure budget is typically underexecuted.

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

Domestic revenue–recurrent expenditure.

External grants + net foreign financing.

Reflects borrowing from the pension fund and scheduling of payments to energy companies.

Table 4.

Cape Verde: Balance of Payments, 2006–13

(Millions of Cape Verde escudos, unless otherwise indicated)

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