Democratic Republic of São Tomé and Príncipe
2008 Article IV Consultation and Sixth Review Under the Three-Year Arrangement Under the Poverty Reduction and Growth Facility, and Request for Waivers of Performance Criteria-Staff Report; Staff Supplement; Public Information Notice and Press Release on the Executive Board Discussion; and Statement by the Executive Director for the Democratic Republic of São Tomé and Príncipe
Author: International Monetary Fund
Publication Date:
19 Sep 2008
eISBN:
9781451835182
Language:
English
Keywords:
ISCR; CR; PRGF loan; PRGF arrangement; São Tomé and Príncipe; expenditure overrun; NPV; external shock; MDRI debt relief; headline inflation; last quarter; São Tomé and Príncipe-assessment; Debt relief; Monetary base; International reserves; Africa
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The 2008 Article IV Consultation with the Democratic Republic of São Tomé and Príncipe and sixth review under the three-year arrangement under the Poverty Reduction and Growth Facility discusses policies and exchange rate arrangement. In recent years, public finances have been supported by large oil signature bonuses, but exploratory drilling for oil has not yet confirmed the existence of commercially extractable reserves. Executive Directors supported the authorities’ intention to reconsider São Tomé and Príncipe’s monetary and exchange arrangements.

Abstract

The 2008 Article IV Consultation with the Democratic Republic of São Tomé and Príncipe and sixth review under the three-year arrangement under the Poverty Reduction and Growth Facility discusses policies and exchange rate arrangement. In recent years, public finances have been supported by large oil signature bonuses, but exploratory drilling for oil has not yet confirmed the existence of commercially extractable reserves. Executive Directors supported the authorities’ intention to reconsider São Tomé and Príncipe’s monetary and exchange arrangements.

I. Background

1. São Tomé and Príncipe is a small, open, low-income economy, with a very narrow production and export base (Figure 1). The country’s main export commodity is cocoa but the once-dominant agriculture sector has declined over the last three decades. Tourism is relatively small and brings in little net foreign exchange receipts because it relies heavily on imported goods and services. In recent years, public finances have been supported by large oil signature bonuses, but exploratory drilling for oil has not yet confirmed the existence of commercially extractable reserves.

Figure 1.
Figure 1.

São Tomé and Príncipe: Income and Exports in a Regional Context

Citation: IMF Staff Country Reports 2008, 307; 10.5089/9781451835182.002.A001

Source: World Development Indicators, São Tome and Príncipe authorities, and IMF staff estimates.

2. The authorities have embarked on economic adjustment and reform supported by the Fund under the PRGF since August 2005. Growth has been robust and progress has been made in reducing fiscal imbalances and the pubic debt burden. The country reached the completion point under the enhanced HIPC Initiative in March 2007 and benefited from HIPC/MDRI debt relief. By September 2007, creditors representing over 80 percent of the country’s external debt at the completion point had agreed to deliver HIPC debt relief, enabling the Fund to disburse its share of topping-up assistance.

3. The cabinet has been reshuffled in late 2007 and early 2008. A coalition government took office in February 2008 but suffered recently a vote of no confidence in the National Assembly (NA). Under the constitutional arrangements, the current government remains in power until it is replaced democratically by a new government.

4. In the last Article IV consultation, Directors emphasized the importance of developing solid institutions to secure transparent management of oil revenue, strengthening macroeconomic policies and accelerating structural reforms to broaden the economy’s productive base. Progress has been made in strengthening the management of oil-related resources. The country is now a Candidate State of the Extractive Industries Transparency Initiative (EITI). However, broadening the country’s production and export base remains a challenge.

II. Recent Developments and Performance under the Program

5. Real GDP grew at an estimated 6 percent in 2007 (Figure 2 and Table 1). Growth was led by the construction and services sectors boosted by tourism-related foreign direct investment.1 However, spillover from foreign-funded tourism projects to local employment and income is still limited because of the high import content of these projects. Exports recovered slightly on the back of rising international price of cocoa.

Figure 2.
Figure 2.

São Tomé and Príncipe: Recent Macroeconomic Developments, 2003–2007

Citation: IMF Staff Country Reports 2008, 307; 10.5089/9781451835182.002.A001

Sources: São Tome and Príncipe authorities; and IMF staff estimates.1 There is a break in the GDP data series between 2003 and 2004.
Table 1.

São Tomé and Príncipe: Selected Economic Indicators, 2005–2013

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Sources: São Tomé and Príncipe authorities and IMF staff estimates and projections.

Production in the traditional export sector (such as cocoa) is projected to decline in 2012 and 2013 because production resources are expected to shift to the oil sector.

Central bank (BCSTP) buying rate.

Projected base money growth for 2008 reflects the high level of base money at the end of 2007, which was significantly reduced in subsequent months through the BCSTP’s foreign exchange sales.

Includes HIPC and MDRI debt relief.

Excluding oil revenue, grants, interest earned, scheduled interest payments, and foreign-financed scholarships and capital outlays.

In percent of exports of goods and nonfactor services. The difference between debt service before and after HIPC relief is larger than debt service saving in cash terms because this table is on an accrual basis.

Gross reserves exclude the National Oil Account and guarantee deposits placed at the BCSTP by financial institutions waiting for operating licenses.

Based on the assumption that dispute will be settled to allow disbursement of bonuses for Blocks 5 and 6 (US$ 26 million) in 2008.

6. After declining to 14 percent in the first half of the year, annual inflation rose to 28 percent by the end of 2007. This rebound was spurred by surging food and oil prices, upward adjustments of utility tariffs to cover the bulk of the costs, and depreciation of the dobra, particularly against the euro, the main invoicing currency for imports. Excluding food items, inflation was 10 percent (year-on-year) at the end of 2007, compared to 20 percent a year ago (Box 1). In real effective terms, the exchange rate changed little as appreciation in the second half of 2007 largely offset the depreciation early in the year.

7. The domestic primary deficit was larger than programmed in 2007, despite higher revenue (Table 2 and Table I.1). This was on account of a large increase in current spending, especially payments to EMAE, the state-owned utility company, to cover part of the costs to households arising from the utility tariff hike. High current spending also crowded out funding available for domestically financed capital expenditure. The domestic primary deficit, at 1.1 percent of GDP higher than the program target, was financed by a larger-than-projected drawdown of government deposits at the central bank (BCSTP), including from the National Oil Account (NOA).

Table 2.

São Tomé and Príncipe: Financial Operations of the Central Government, 2005–2008

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Sources: São Tomé and Príncipe authorities; and IMF staff estimates and projections.

For 2007, includes IDA and AfDB MDRI debt relief as a stock of debt reduction.

For 2007, includes the repayment of three $5 million loans disbursed by Nigeria in 2002–04 upon receipt of oil signature bonuses for Blocks 2–4 in the Joint Development Zone.

Excluding oil revenue, grants, interest earned, scheduled interest payments, foreign-financed scholarships, and foreign-financed capital outlays.

For 2006, refers to a temporary accumulation of technical arrears with bilateral creditors, pending reconciliation of debt records.

For 2008, the consistency and quality of debt data need to be improved.

For 2005, reflects impact of Paris Club rescheduling in the last quarter of 2005.

For 2007, assumes rescheduling agreement with non-Paris Club bilateral creditors for current maturities and stock of arrears.

Net of valuation changes. For 2007, includes IMF MDRI debt relief as a stock of debt reduction.

For 2007, data between monetary and fiscal accounts need to be reconciled on mission, owing to the difference in treatment of $2.3 million inflow into the National Oil Account.

Table 2.

São Tomé and Príncipe: Financial Operations of the Central Government, 2005–2013

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Sources: São Tomé and Príncipe authorities; and IMF staff estimates and projections.

Based on 2001 census and survey-based GDP series.

For 2007, includes IDA and AfDB MDRI debt relief as a stock of debt reduction.

For 2007, includes the repayment of three $5 million loans disbursed by Nigeria in 2002–04 upon receipt of oil signature bonuses for Blocks 2–4 in the Joint Development

Excluding oil revenue, grants, interest earned, scheduled interest payments, foreign-financed scholarships, and foreign-financed capital

For 2006, refers to a temporary accumulation of technical arrears with bilateral creditors, pending reconciliation of debt records.

For 2008 onwards, the consistency and quality of debt data need to be improved.

For 2005, reflects impact of Paris Club rescheduling in the last quarter of 2005.

For 2007, assumes rescheduling agreement with non-Paris Club bilateral creditors for current maturities and stock of arrears.

Net of valuation changes. For 2007, includes IMF MDRI debt relief as a stock of debt reduction.

For 2007, data between monetary and fiscal accounts need to be reconciled on mission, owing to the difference in treatment of $2.3 million inflow into the National Oil

Recent Rise in Inflation: Domestic Policies vs. External Shocks

Headline inflation went up sharply in the second half of 2007. During this period, a 30 percent general wage increase and faster-than-programmed liquidity growth resulted in a significant depreciation of the dobra against the euro and the U.S. dollar. In response to rising international prices, the authorities raised domestic prices of petroleum products (by 14–25 percent) and electricity and water tariffs (by 40–60 percent) in September 2007. Moreover, rising import prices for food items contributed to higher inflation.

uA01fig01

Food and Fuel Import Prices

(Index, 2003=100)

Citation: IMF Staff Country Reports 2008, 307; 10.5089/9781451835182.002.A001

Source: World Economic Outlook and staff estimates.1 Defined as the sum of all receipts in external current account deflated by an index of food (56 percent weight) and fuel (44 percent weight) prices.

Food consumption in São Tomé and Príncipe depends heavily on imports, and food items account for 72 percent of the CPI basket. Retail prices for food increased by 38 percent in 2007.

Staff estimates suggest that of the 3 percent increase in inflation in February 2008, about 1 percent can be attributable to base money growth and exchange rate depreciation, 1.5 percent to food and oil import prices, and the remaining 0.6 percent to other factors.1

uA01fig02

Base Money and Exchange Rate

(12-month change, percent)

Citation: IMF Staff Country Reports 2008, 307; 10.5089/9781451835182.002.A001

Sources: IFS and São Tome and Príncipe authorities.

As a result of higher import prices, the country’s external current receipts declined by an estimated 18 percent in real terms in 2007.

1 See the accompanying selected issues paper for more details.

8. Monetary policy implementation was complicated by volatile capital inflows and was not adequate in controlling base money growth (Table 3). The BCSTP’s sterilization of budgetary use of oil bonuses fell short of what was needed to mop up excess liquidity. As a result, net international reserves of the BCSTP were US$6 million above the program target at the end of 2007. The excess liquidity put downward pressure on the exchange rate and the spread between central bank and commercial bank exchange rates widened to over 2 percent.

Table 3.

São Tomé and Príncipe: Summary Accounts of the Central Bank, 2006–2008

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Sources: São Tomé and Príncipe authorities and IMF staff estimates and projections.

Includes guarantee deposits by prospective financial institutions waiting for operating licenses.

Oil signature bonuses for Blocks 5 and 6 in JDZ, totalling US$26.1 million are projected for 2008.

9. São Tomé and Príncipe has maintained an open trade regime. The tariff reform, which started in 2002, has lowered the simple average tariff rate to 11.7 percent and reduced non-tariff trade barriers. In late 2007, the authorities decided not to sign the European Union Economic Partnership Agreement (EPA), emphasizing the importance of first creating competitive export sectors, particularly in agriculture, and reducing reliance on trade taxes before joining the EPA.

10. Progress continued on structural reforms albeit slower than envisaged. The end-December 2007 structural performance criterion on upgrading the pilot system (SAFINHO) to strengthen budget execution and monitoring was implemented in early 2008 (Table I.2). The 2008 budget, prepared in line with the PRGF-supported program, was approved by the NA in mid-May 2008. The NA also started the process for final approval of the direct taxation reform package consisting of a new corporate income tax code, a personal income tax code, and an urban property tax code. On financial sector reform, the BCSTP issued in early 2008 the new prudential regulations on capital adequacy, internal control and auditing, bank financial reporting, and credit to employees. In late April 2008, the NA gave its final approval to the anti-money laundering (AML/CFT) law, paving the way for an operational AML/CFT regime in São Tomé and Príncipe.

11. Progress has been made in enhancing the transparency of managing current and prospective oil resources. The Oil Revenue Management Law (ORML) was enacted. The law ensures parliamentary authority and supervision over the use of signature bonuses and other oil-related receipts. Under the ORML, the Petroleum Oversight Committee and the Public Registration and Information Office were created, and the ORML Handbook was posted on the official website. The authorities formally declared their adherence to the principles of the EITI and set up a national committee and appointed a national coordinator for implementation. To lay the ground for launching licensing for the Exclusive Economic Zone (EEZ), the National Oil Agency prepared a Petroleum Sector Strategy and related laws, but their adoption has been delayed due to changes in government.

12. Some progress was made to improve the investment climate. In line with the recommendations of the 2005 Diagnostic Trade Integration Study, a new investment code was submitted to the NA, the labor code was revised, and customs procedures were simplified. Arbitration tribunals for business litigation were established in 2006. Legislation to reduce the cost and duration of starting a business were drafted in consultation with the private sector. The restructuring of the electricity sector and the airport and seaport authorities were initiated. Under a reform strategy for EMAE, the electricity and water company, utility tariffs were increased to cover production costs. EMAE also installed prepaid electricity meters to strengthen payment collection.

III. Policy Discussions

A. Lessons from the Past

13. As part of the Article IV consultation discussions, the authorities and staff exchanged views on the key lessons from the country’s recent adjustment experience. They agreed that the policy and reform agenda since 2005 was underpinned by a Poverty Reduction Strategy. While a large number of reforms have been introduced, notably in public resource management and banking supervision, financial policy implementation has not always been consistent. The resulting stop-go pattern of macroeconomic policies created pressures on inflation, compounding the country’s vulnerability to external shocks.

14. To improve macroeconomic management, staff and the authorities agreed on the following priorities:

  • Effective implementation of an appropriate policy mix to achieve a sustainable reduction in inflation. Staff analysis, taking into account relations between fiscal policy, money supply, the exchange rate, and import prices, suggests that a prudent fiscal policy needs to play a central role, supported by a proactive monetary policy. The former is particularly important because of São Tomé and Príncipe’s limited monetary policy instruments for liquidity management and the need to maintain adequate usable reserves (Box 2).

  • Revenue mobilization. São Tomé and Príncipe’s domestic revenue is smaller than its current expenditure. To meet rising demand for developmental and poverty reduction expenditures and to avoid putting undue pressure on limited official reserves, in addition to mobilizing external support, domestic revenue must be increased through a combination of tax policy reform and improvement in tax administration, based on an expanded economy.

  • Developing the supply side of the economy. While real GDP has recently grown at 6-7 percent a year, recorded output growth has not yet translated into broad gains in income and employment. Indeed, the traditional agriculture sector has been shrinking, the emerging tourism sector remains small, and the government has become the largest employer in recent years. Reforms to attract investment therefore will have to be accompanied by public sector reform to make room for private sector development. Better use of available resources, including oil bonuses and donor funding, to boost the country’s growth potential, notably in tourism and agriculture, would help raise living standards and reduce poverty.

B. Medium-Term Outlook and Challenges

15. São Tomé and Príncipe’s medium-term outlook depends critically on the prospects for oil export earnings and revenue. Available information suggests that the outlook for further inflows of oil signature bonuses from Blocks 5 and 6 of the Joint Development Zone (JDZ) and from the EEZ remains uncertain at this time.2 In Blocks 1-4 of the JDZ, where investors have paid their signature bonuses, oil exploration is ongoing but discovering commercially extractable reserves continues to be an uncertain process (Box 3).

Policy Mix, Sustainable Disinflation, and Revenue Mobilization 1

Appropriate policy mix. The two recent inflation spikes (mid-2006 and end-2007) were heavily influenced by domestic policies but also affected by external factors. Staff analysis suggests that the increase in excess liquidity during the two episodes can be largely explained by larger-than-projected withdrawals from the government’s deposits at the central bank to finance public spending and by inadequate central bank sterilization.

Although sterilization can be an effective tool to contain liquidity in the short term, continuous selling of foreign exchange to mop up liquidity may not be sustainable. The level of usable net international reserves is rather modest when excluding commercial bank and government deposits at the central bank.

uA01fig03

Central Bank Reserves and Useable NIR

(months of imports)

Citation: IMF Staff Country Reports 2008, 307; 10.5089/9781451835182.002.A001

1/ In months of imports of goods and services excluding oil project-related imports in a subsequent year.

To achieve a sustainable reduction in inflation, fiscal policy therefore will need to play a central role, not only in directly reducing domestic demand pressures on prices but also reducing the need for foreign exchange sales by the central bank for sterilization. A prudent fiscal policy, together with a proactive monetary policy, is essential to contain liquidity growth and anchor inflation and depreciation expectations. Fiscal and monetary anchors are important for sustainable disinflation.

Domestic Revenue Mobilization. São Tomé and Príncipe’s small and undiversified economy leaves it with a narrow tax base to depend on. At the same time, its revenue performance has increasingly depended on trade taxes, both custom tariffs and excise duties.

Compared to neighboring countries in sub-Saharan Africa and other island economies around the world, São Tomé and Príncipe’s tax revenue-to-GDP ratio, at 16.3 percent in 2007 is rather low, suggesting room for increasing revenue. Pressing ahead with the direct taxation reform, improving tax and customs administration, and, in due course, introducing the reform of indirect taxation will help broaden the tax base and increase revenue buoyancy to meet the country’s rising expenditure needs.

uA01fig04

Domestic Revenue and Expenditure

(average 2001–2006, in percent of GDP)

Citation: IMF Staff Country Reports 2008, 307; 10.5089/9781451835182.002.A001

1 See the accompanying selected issues papers.

São Tomé and Príncipe: Status of Oil Exploration

For oil exploration purposes, São Tomé and Príncipe’s territory can be divided into three distinctive geographical zones:

The off-shore Joint Development Zone operated jointly with Nigeria. Oil exploration in the JDZ has started but, as of April 2008, has not yet confirmed the existence of commercially extractable reserves.

The off-shore Exclusive Economic Zone. Preparatory work is under way for launching licensing for oil exploration in the EEZ, which is located in areas with deeper water than the JDZ.

On-shore area includes the island of São Tomé and that of Príncipe. The potential for hydrocarbon discoveries on-shore is considered low and, to date, the authorities have no plans for promoting exploration in this area.

Joint Development Zone: Status of Exploration

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Sources: National Oil Agency of São Tomé and Príncipe (www.anp-stp.gov.st)

16. To illustrate the down side risks and their implications for macroeconomic policies, staff discussed with the authorities two medium-term scenarios. The baseline scenario assumes that oil signature bonuses for Blocks 5 and 6 are received in 2008 and oil production starts in 2014, as previously projected. Under a worse-case scenario where oil bonuses for Blocks 5 and 6 are delayed indefinitely and there is no oil production, the NOA could be depleted quickly (Figure 3). Moreover, external budgetary support is expected to be limited in the next few years. Under the worse-case scenario, large expenditure compression would be unavoidable, and depletion of official reserves, high inflation, and currency depreciation are also likely.

Figure 3.
Figure 3.

Medium-term Fiscal Scenarios 1

(percent of GDP)

Citation: IMF Staff Country Reports 2008, 307; 10.5089/9781451835182.002.A001

Source: National authorities, and IMF staff estimates.1 Baseline scenario assumes oil signature bonuses for Blocks 5 and 6 are received in 2008. Worse case scenario assumes oil bonuses are delayed indefinitely.

17. São Tomé and Príncipe is vulnerable to adverse external developments and has a high risk of debt distress, despite HIPC and MDRI debt relief. The government has not contracted any new debt since reaching the completion point under the HIPC Initiative. However, as indicated in the Debt Sustainability Analysis which has been jointly updated with the World Bank staff (Supplement I), in the event of a large output loss or terms-of-trade deterioration, key debt ratios could exceed the relevant indicative thresholds. Moreover, the risk of debt distress would increase significantly should oil prospects diminish further. Under these circumstances, the authorities agreed that they should rely primarily on non-debt-creating external financing, attracting foreign direct investment and donor grants. They stood ready to reassess their external financing strategies after further oil exploration drillings.

18. There was a consensus that the key challenges facing the authorities include maintaining fiscal sustainability and developing the domestic production and export base. In view of the uncertain oil revenue outlook, staff argued for continued reduction of fiscal imbalances, bringing recurrent outlays, particularly on budgetary personnel costs, in line with available domestic revenue and donor budgetary support. Improving the composition of public expenditure and increasing the efficiency of public investment are also important not only for fiscal sustainability but also for increasing the growth orientation of the budget.

19. The authorities pointed out that the country’s productive base must be developed and broadened to sustain growth and reduce external vulnerability. They noted that São Tomé and Principe has a low saving rate and a very small domestic market. To unlock the country’s growth potential, it is imperative that the investment climate be significantly improved by removing the regulatory impediments to private sector development, upgrading infrastructure, improving access to financing, and developing agriculture and other sectors based on the country’s comparative advantages.

C. Macroeconomic Policies for the Remainder of the Program

20. Against the backdrop of an external shock stemming from rising food and fuel prices, the authorities emphasized their commitment to strengthen policy implementation and restore financial stability. The discussions centered on actions to correct the policy slippages that occurred in the second half of 2007, particularly in expenditure control, liquidity management, and structural reforms. With an additional grant from the World Bank, the discussions also covered the need to support the vulnerable segments of the population.

Fiscal Policy

21. The 2008 budget envisages a reduction of the domestic primary fiscal deficit to 5.2 percent of GDP, from 8.1 percent of GDP in 2007 (MEFP ¶11). The domestic primary deficit for 2008 is higher than the 4.8 percent of GDP originally programmed, to mitigate the impact of high import prices for food and petroleum products. This will be financed by an additional budgetary support grant from the World Bank, part of which will be saved for future use.3 The fiscal program is fully financed by the use of the World Bank grant of $4.5 million (2.8 percent of GDP), a drawdown from the NOA of $3 million (1.9 percent of GDP), and other external budget support of 0.6 percent of GDP.

Financing of the Domestic Primary Deficit

(Percent of GDP)

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Sources: São Tomé and Príncipe authorities; and IMF staff estimates and projections.

Excludes receipts of oil signature bonuses.

Includes goods and services, non-essential current spending, domestically financed capital expenditure, and HIPC-related spending.

For 2007, $15 million of the oil bonus was used to pay back a Nigeria loan.

Includes the World Bank Public and Natural Resource Management Development Policy Grant.

For 2007, includes debt relief of about US $1.0 million.

22. Fiscal consolidation under the 2008 budget would come mainly from expenditure reform (Figure 4). The full-year effect of the 2007 general wage increase will be felt in 2008. In addition to measures to strengthen expenditure control, the authorities are committed to initiating wage reform, as a first step toward a broader civil service reform strategy, to help contain recurrent spending within the budget envelope (MEFP ¶13). A comprehensive wage study to rationalize the public service salary structure and integrate fringe benefits into the wage bill will be launched with the support of the World Bank.

Figure 4.
Figure 4.

São Tomé and Príncipe: 2008 Fiscal Program

Citation: IMF Staff Country Reports 2008, 307; 10.5089/9781451835182.002.A001

Sources: São Tome and Príncipe authorities; and IMF staff estimates and projections.

23. To prevent the recurrence of an expenditure overrun, the authorities agreed to tighten control on non-wage current expenditure. Key measures include:

  • Strictly limiting nonessential current spending, particularly on goods and services and transfers not funded by donors (see text table below).

  • Reassessing transfers to the Joint Development Authority to take into account oil revenue prospects and budget constraints.

  • Putting in place a functioning computerized public financial management system to effectively manage expenditure commitments. In addition to upgrading information technology hardware, the authorities intend to make progress in training users at the level of spending entities, and take other steps to elevate SAFINHO to a fully-fledged e SAFE system.

  • Strictly complying with the provisions of the ORML on withdrawals from the National Oil Account.

São Tomé and Príncipe - Indicative Targets

(billion dobra, unless indicated otherwise)

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Preliminary data suggest that dobra base money growth was below the indicative path and NIR was above the indicative floor for April 2008.

24. In response to the rising import prices for food and fuel, the fiscal program was modified to provide extra room (about 0.4 percent of GDP) for temporary, targeted assistance to the poor and the most vulnerable (MEFP ¶13). Staff pointed out that implicit general subsidies, such as those made through EMAE in the last quarter of 2007, are neither efficient nor effective in delivering assistance to the most needy. Staff encouraged the authorities to work closely with the World Bank to put in place a scheme, based on income or other criteria, to provide targeted support to the poor. This extra spending, together with the HIPC/MDRI debt relief-supported expenditure programs and efforts to align budgetary allocations with the Priority Action Plan of the Poverty Reduction Strategy Paper (PRSP), is expected to help mitigate the impact of the recent external shocks on the population.

25. On the revenue side, timely implementation of the direct taxation reform package after NA approval is crucial for the 2008 program. Although the reform is expected to be revenue neutral for the first few years of implementation, it will help broaden the tax base, reduce tax distortions, and over time reduce the country’s heavy reliance on taxation on foreign trade (MEFP ¶14). To ensure that revenue collections are improved, the authorities have intensified their effort to strengthen tax and customs administration. In this regard, they are being assisted by the U.S. Millennium Challenge Corporation (MCC) under its Threshold Program, including in auditing tax returns, keeping track of large tax payers, and collecting tax arrears.

Monetary and Exchange Rate Policies

26. The BCSTP is committed to use foreign exchange auctions more actively to reduce base money growth, in the context of a flexible exchange regime (MEFP ¶17). Since extensive use of foreign currencies and weak financial intermediation severely limit the effectiveness of interest rates and other monetary policy instruments, the authorities have to rely on fiscal restraints and foreign exchange sales to control liquidity. Accordingly, the BCSTP held more frequent foreign exchange auctions in March 2008, while maintaining net international reserves (NIR) above the program target. As a result, annual base money growth slowed down from 50 percent at the end of 2007 to 27 percent by the end of March 2008. Depreciation of the dobra also slowed from 6.5 percent against the U.S. dollar in the last quarter of 2007 to 2.6 percent in the first quarter of 2008.

27. To increase the effectiveness of liquidity control, the fiscal and monetary authorities agreed to improve their coordination to ensure timely sterilization of budgetary use of oil bonuses and donor funding (MEFP ¶18). Aside from information-sharing among staff of the Treasury and the BCSTP, the Finance Minister and the BCSTP Governor also intend to meet regularly on the government’s cash outlays and the BCSTP’s liquidity forecast. To enhance the accuracy of liquidity management, the BCSTP has started monitoring the weekly average commercial bank minimum reserve requirement, instead of the monthly average. These steps are expected to strengthen implementation of the monetary program for the remainder of the year, which aims to bring inflation on a downward path, while preserving NIR equivalent to about 4 months of imports.

28. The authorities remain committed to deepening foreign exchange market reform (MEFP ¶19). The recent external shock has complicated the implementation of the reform by worsening supply-demand imbalances in the foreign exchange market. The authorities reiterated their intention, in due time, to remove all multiple currency practices and restrictions (see Informational Annex I), de facto or de jure, and on that basis, to accept the obligations under Article VIII, Sections 2(a), 3, and 4 of the Fund’s Articles of Agreement. In the near term, they will focus on expediting approval by the NA of the new investment code, which contains provisions aiming to remove the exchange restrictions on transferring dividends abroad. The BCSTP will also revise the mechanism for setting the daily central bank exchange rate, after a review of domestic market conditions in 2008, to ensure that the spread between the official and commercial bank exchange rates does not exceed 2 percent.

Structural Reforms

29. For the remainder of the program, the authorities intend to make progress in several areas where significant preparatory work has already been done. These include: (i) putting in place new modules to implement the public accounting system and preparing regulations for the organic budget law (SAFE), as part of the effort to upgrade public financial management; (ii) completing the revision of the commercial code, an important regulatory reform to reduce the cost of doing business in the country (MEFP, ¶21); (iii) adopting the Petroleum Sector Strategy and the related laws before launching the licensing round for the EEZ (MEFP, ¶22).

30. Financial sector reform will continue to focus on strengthening the regulatory framework and the BCSTP’s implementation capacity (MEFP ¶23). There are five banks in São Tomé and Príncipe. Recently, the BCSTP has received a new bank application and two more foreign banks have expressed interest in entering the market. To reduce the risk of money laundering and bank distress, the authorities have given top priority to making the AML/CFT regime operational through issuing and implementing the enabling regulations that the BCSTP already prepared. Moreover, they plan to strengthen the requirements for issuing bank licenses by raising the minimum capital requirement and improving the standards for feasibility studies, among other conditions.

Program Monitoring

31. Indicative targets for selected fiscal and monetary variables are set to facilitate program implementation prior to the expiration of the PRGF arrangement in August 2008 (MEPF, ¶28). These include indicative ceilings on primary nonwage current spending and 12-month dobra base money growth, as well as floors for the BCSTP’s net international reserves for end-March and end-June 2008 (Table I.1). Two structural benchmarks are added to help monitor progress in fiscal structural reform (Table I.2).

IV. Exchange Rate Arrangement and Other Issues

A. Exchange Rate Arrangement and External Stability

32. The exchange rate regime is currently classified as a de facto managed float. The BCSTP has mostly been the sole seller in the official foreign exchange market for the last two years while seldom buying foreign exchange from market participants. Empirical evidence, while limited by the weak database, does not suggest a significant misalignment of the real exchange rate from its equilibrium level. The authorities are making efforts to remove the remaining exchange restrictions.4 In view of the uncertain timeframe of implementation, staff does not recommend Fund approval for maintaining these restrictions. Staff assessment based on the updated DSA (¶16–17) also indicates that sustainability of the country’s external position depends critically on finding commercially extractable oil reserves. If oil prospects do not materialize, i.e., there would be no oil exports and revenue, maintaining external stability will require further economic adjustment, including that of the real exchange rate (Box 4).

33. The authorities expressed interest in reassessing the country’s monetary and exchange rate arrangements. They have commissioned experts from the European Union to conduct a study on this issue. After a seminar held by the mission in October 2007, the authorities noted that São Tomé and Príncipe could benefit from a strongly anchored currency arrangement, including possible membership in a monetary union or an agreement to allow for parity between the dobra and a strong currency. Staff analyzed the pros and cons of various exchange systems, putting together the monetary history of São Tomé and Príncipe and relevant international experience.5 The analysis highlights the benefits under certain conditions of a firmly anchored currency arrangement for a small, open, low-income country, emphasizing that prudent fiscal and debt policies are preconditions for a sustainable regime.

B. Debt Management

34. The authorities are conscious of the need to maintain debt sustainability. They are committed to refraining from new external borrowing, especially on non-concessional terms. To strengthen their debt management and analysis capacity, they have installed the Commonwealth Secretariat debt management system (DS-DRMS) and plan to utilize the system to obtain a debt payment schedule and other information to analyze the country’s debt sustainability.

35. The authorities are seeking full delivery of HIPC relief from the remaining creditors. Having initiated the negotiations, they have concentrated their efforts to conclude debt relief agreements with Angola and Portugal, the two largest remaining creditors.

The Equilibrium Exchange Rate and External Competitiveness

A simple empirical approach was used to assess exchange rate developments against equilibrium levels. Due to data weaknesses and lack of high frequency statistics, the model used real per capita GDP and government consumption to assess developments in the REER.

The results show that the REER moved from overvaluation to slight undervaluation in 2000-2001 and the gap between actual REER and its equilibrium level has narrowed in recent years. These developments do not seem to have had an adverse effect on the competitiveness of exports, since export volumes of cocoa—the main export commodity—are small, targeted to niche markets in Europe, and are mostly affected by weather conditions. Tourism is a high value-added sector that attracts relatively wealthy eco-tourists and mainly depends on large FDI inflows. Foreign reserves (excluding the National Oil Account) grew from 4.1 months of imports in 2005 to 4.5 months in 2007.

uA01fig05

São Tomé and Príncipe-Assessment of REER, 1986-2007

Citation: IMF Staff Country Reports 2008, 307; 10.5089/9781451835182.002.A001

Source: IMF staff estimates

Institutional indicators suggest a modest improvement in the business environment and competitiveness, although significant weaknesses remain. Cumbersome regulations for opening businesses and rigid rules on hiring and firing employees are the main obstacles to doing business in the country. Moreover, inadequate energy, water, and transport infrastructure continues to hamper São Tomé and Príncipe’s competitiveness.

Ranking on the ease of doing business

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Source: World bank’s Doing Business database.

A positive change means an improvement in the rank.

Maintaining external stability will require prudent macroeconomic management, continued donor support and private inflows, including FDI, and a significant improvement in export earnings. The large external current account deficit, at about 50 percent of GDP before official transfers, is projected to persist over the medium term. Given the limited external assets, the country’s production and export base must be developed and broadened. If oil prospects do not materialize, maintaining external sustainability will require further economic adjustment, including that of the real exchange rate.

C. Statistics, Capacity Building, and Other Issues

36. Data provision is generally adequate for surveillance purposes, although there are still weaknesses in national accounts, government financial operations statistics, and balance of payments data. The National Institute of Statistics has made significant progress in updating GDP statistics, but the lack of reliable data still hampers analysis in areas such as private sector development and progress toward the Millennium Development Goals. To further improve data quality, staff recommended that within the tight budget constraint, the government provide funding for a new household expenditure survey in order to improve compilation of the consumer price index.

37. On capacity building, the authorities have showed willingness to follow Fund technical advice but their ability to implement remains weak. Noting that São Tomé and Príncipe is not a member of AFRITAC and, therefore, cannot benefit from its technical assistance, the authorities hoped that the extension of AFRITAC currently under consideration will cover the country. The BCSTP welcomed a Fund assessment of their future technical assistance needs, particularly in banking supervision and development.

38. The authorities have submitted to the Fund and the World Bank the second Annual Progress Report of the PRSP. In the Joint Staff Advisory Note (JSAN), the staffs noted that the authorities need to enhance monitoring and evaluation to ensure effective implementation of the PRSP. Moreover, the staffs believe that an update of the PRSP would be warranted when oil prospects are updated in late 2008-early 2009.

V. Staff Appraisal

39. São Tomé and Príncipe’s economic performance under the PRGF-supported program has been mixed. While economic activity remains robust, inflation accelerated in the second half of 2007. The higher inflation reflected surging international prices for food and fuel which represented a severe shock to São Tomé and Príncipe’s external current receipts. However, an expenditure overrun and the lack of effective control of base money growth also fueled inflation and currency depreciation.

40. To lower inflation and restore financial stability, it is important that the authorities significantly strengthen fiscal discipline and liquidity management. In this regard, staff supports the 2008 budget that aims to reduce the domestic primary deficit. The authorities are committed to tightening expenditure control. As the 2008 fiscal program has been modified to provide funding to mitigate the impact of the recent external shock, staff encourages the authorities to refrain from generalized price subsidies and work closely with the World Bank staff to implement direct, targeted assistance to the poor.

41. Timely implementation of the direct taxation reform package is crucial for the 2008 program. The tax reform would help broaden the tax base and reduce tax distortions. Staff encourages the authorities to promptly begin implementation, following approval by the National Assembly, along with continued effort to improve tax and customs administration.

42. Recent progress by the BCSTP in curbing liquidity growth is encouraging. Although base money is an indicative target, it serves as the anchor for the program, playing a central role in restoring price stability. The central bank therefore needs to continue using foreign exchange auctions more actively to bring dobra base money growth to a downward path while observing the NIR floor. In addition, monetary policy needs to be supported by fiscal restraint. In the event that the program’s NIR target is at risk, the government will have to support monetary tightening by further curtailing non-essential domestic primary spending.

43. The main challenges facing the authorities over the medium term are to maintain fiscal sustainability and to develop the economy’s production and export base. In view of the uncertain outlook for oil revenue, fiscal consolidation needs to continue beyond 2008 by increasing growth orientation of the budget and bringing recurrent spending, particularly on personnel costs, in line with domestic revenue and available donor budgetary support. In this regard, the country’s adjustment experience since 2005 provides valuable lessons, particularly in avoiding stop-go patterns of policy implementation. Staff also recommends that the authorities strengthen debt management and rely primarily on concessional financing.

44. Accelerated structural reforms are needed to achieve sustained, private sector-led growth. The authorities are to be commended for obtaining the National Assembly’s final approval of the anti-money laundering legislation. Staff encourages the BCSTP to take other steps to advance financial sector reform, including tightening the requirements for issuing new bank licenses. High priority should be attached to improving the investment climate. The authorities should press ahead with regulatory reform to reduce the cost of investing and doing business and attract foreign investment and donor support to upgrade infrastructure and the key economic sectors, particularly tourism and agriculture. Staff encourages the authorities to make further progress under the EITI to increase the transparency and accountability of oil-related resource management.

45. Staff encourages the authorities to maintain an open exchange system. Efforts need to be made to remove all remaining restrictions in order for the authorities to accept the obligations under Article VIII of the Fund’s Articles of Agreement. Staff welcomes the authorities’ interest in reconsidering the country’s monetary and exchange arrangements. Fiscal discipline and prudent debt management are the main prerequisites for a sustainable exchange rate regime.

46. Staff recommends completion of the sixth review based on the country’s performance and policy commitments. Staff supports the authorities’ request for waivers for the nonobservance of the end-December 2007 quantitative performance criteria related to the domestic primary deficit and net credit to the government and the structural performance criterion on public financial management reform, based on remedial measures (summarized in ¶ 23 and 26) and policy commitments for the remainder of the program.

47. It is proposed that the next Article IV consultation be held in accordance with the decision on consultation cycles approved on July 15, 2002.

Table 4.

São Tomé and Príncipe: Monetary Survey, 2006–2008

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Sources: São Tomé and Príncipe authorities and IMF staff estimates and projections.