Cape Verde: Joint World Bank–Fund Debt Sustainability Analysis
Author: International Monetary Fund
Publication Date:
16 Jan 2009
eISBN:
9781451809510
Language:
English
Keywords:
ISCR; CR; monetary management; fiscal policy; financial system regulation; monetary policy; debt-generating inflow; net FDI; nominal interest rate; creating flow; debt service-to-revenue; Debt sustainability; Depreciation; Global
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This paper presents key findings of the Fifth Review under the Policy Support Instrument for Cape Verde. All quantitative assessment criteria for end-June 2008 were met. GDP growth remains generally resilient, and inflation pressures have been contained. Progress on structural measures has been steady despite delays on many measures. The authorities have scope to manage the external shocks because over the last few years, they have made faster-than-planned progress in both increasing international reserves and reducing domestic debt.

Abstract

This paper presents key findings of the Fifth Review under the Policy Support Instrument for Cape Verde. All quantitative assessment criteria for end-June 2008 were met. GDP growth remains generally resilient, and inflation pressures have been contained. Progress on structural measures has been steady despite delays on many measures. The authorities have scope to manage the external shocks because over the last few years, they have made faster-than-planned progress in both increasing international reserves and reducing domestic debt.

The risk of debt distress in Cape Verde remains low. Nevertheless, medium-term fiscal policy will reverse the public debt decline of recent years. The total public debt-to-GDP ratio is projected to rise until 2012 and then decline thereafter—a path opposite that projected in the 2007 DSA. The temporary rise in external debt will be only partially offset by continued decline in domestic debt. Despite the rise, debt ratios remain manageable in all scenarios. Foreign direct investment (FDI) will finance most of the external current account deficit, which will narrow as Cape Verde transforms itself into a services exporter. The main risks to the debt outlook are currency exposure and contingent liabilities. The risk of debt distress remains low under the baseline as well as alternative scenarios that take those risks into consideration.

I. Background1

1. This DSA reviews the evolution of Cape Verde’s public debt since the 2007 DSA2 and analyzes the projected debt path for the period 2008–28. Using the Fund-World Bank debt sustainability framework (DSF), it projects the baseline economic scenario and performs stress tests to assess whether the risk of debt distress will stay low. The thresholds for public external debt distress are those for countries like Cape Verde that have sound policies and institutions (Table 1).3 The baseline scenario was updated based on discussions with the authorities during the fifth review of the Policy Support Instrument (PSI) (September–October 2008). The discussions centered on the 2009 budget and the medium-term fiscal framework the authorities submitted to Parliament in October 2008 along with the 2009 budget.

Table 1.

Cape Verde: Central Government External Debt Ratios

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Source: Ministry of Finance; and staff estimates.

Based on Cape Verde’s 2005-07 classification as a strong performer.

Excluding grants.

2. Since the last DSA Cape Verde has continued to reduce public debt as a percentage of GDP and to change its composition (Table 2). Total public debt (domestic plus external) was reduced by 10 percentage points of GDP in 2007. Net domestic debt was pushed down to the original PSI benchmark of 20 percent of GDP two years ahead of schedule; it is likely to reach 14 percent of GDP by year-end, thanks to expenditure restraint as well as buoyant revenues. The proportion of domestic debt in total debt was also reduced, reflecting efforts to reach out to development partners for concessional financing, making it possible to replace domestic with mostly concessional external borrowing. All external funds borrowed in 2007 were concessional. Cape Verde’s main external creditors are IDA and the African Development Fund (Table 2). While the credit crunch in Europe is making it hard to roll over the nonbank private external debt, this totaled only 8 percent of GDP as of the end of 2007 and is mainly long-term.

Table 2.

Cape Verde: Central Government Debt, 2004–08

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Source: Cape Verdean authorities, staff estimates and projections.

Net of deposits and obligations with the Trust Fund.

3. The depreciation of the dollar in 2007 and 2008 was favorable to Cape Verde, but it revealed open currency positions (Tables 2 and 5). The nominal external debt-to-GDP ratio declined by 5 percentage points despite the fact that the dollar value of the country’s nominal external debt grew by US$ 58 million in 2007 (4 percent of GDP). This is because the nominal GDP measured in dollars grew by 20 percent boosted by the appreciation of the escudo relative to the dollar. The open currency exposure to the dollar results from the fact that the external liabilities of the Treasury are denominated mainly in US$ and SDR (which contains dollars), and the net foreign assets of the central bank are mostly in euros. This raises questions about whether the authorities should swap part of their foreign reserves in euros for dollars to cover the outstanding open positions or should prefer that future loans be denominated in euros. The authorities have made commitments in the PSI and PRSC series to improve debt management, and the Fund and the Bank together will provide technical assistance (TA) on debt management in addition to the TA Cape Verde receives from Portugal.

II. Medium-Term Baseline Scenario

4. The long-term macroeconomic scenario is projected to revolve over the next 20 years around two axes: economic transformation toward a service-based economy, and accumulation of international reserves and government deposits at the BCV.

5. The growth forecast is designed to test the robustness of the conclusions of this DSA. Because of the financial and commodity price shocks in 2008, short-term growth was revised downward and inflation upward compared to the previous DSA (Table 3). For the outer years, the previous assumptions are maintained: real GDP is expected to grow by 5 percent in the long term (5 to 20 years), which is a prudent 2 percentage points below the historical average (1 standard deviation). Growth will be driven by the transformation into a service-exporting economy, financed mostly by FDI. Moreover, the projections do not consider the growth-promoting effect of public investment in infrastructure.

Table 3.

Cape Verde: Macroeconomic Baseline Assumptions, 2008–28

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Source: National authorities, staff estimates and projections.

Current account plus foreign direct investment.

6. The economic transformation is marked by an increase in imports and service exports and by a decrease in reliance on remittances and other current transfers. Cape Verde is expected to break its past dependence on aid and remittances as it continues to transform itself into a self-propelled economy. While the fuel and food shock increased the import bill in 2008, the restraint in recurrent expenditures created fiscal space that has enabled the government to expand social transfers to protect the vulnerable without putting pressure on the balance of payments. As a result, foreign reserves will stay above 3 months of imports and continue to grow through the forecast horizon. FDI will drive and finance the current account deficit and keep debt-generating flows close to balance. The debt-generating inflows needed to finance the current account deficit are likely to be largely unaffected if FDI is below baseline projections owing to the self stabilizing dynamics of the current account relative to FDI (imports would decline in tandem with FDI thanks to its high import content). Despite a possible deceleration caused by global financial turmoil, the prospects for FDI inflows in the medium term continue to be bright. New commitments approved by the Investment Promoting Agency support the expectation that the private investments will materialize.

uA03fig01

Balance of Payments Source of Financing, 1995-2007

Citation: IMF Staff Country Reports 2009, 014; 10.5089/9781451809510.002.A003

Source: National authorities
uA03fig02

The transformation of the Cape Verdean economy

Citation: IMF Staff Country Reports 2009, 014; 10.5089/9781451809510.002.A003

7. The baseline scenario projects that international reserves will continue to accumulate, as will government deposits at the BCV. The prudent fiscal policy implemented in the PSI is assumed to continue through the forecast horizon, with foreign reserves building up. This assumption is based on two facts:

  • a. In October 2008 the authorities submitted to Parliament a medium-term fiscal framework for 2009–2011 that indicates a prudent fiscal policy. Although the policy reverses the recent decline in public debt, it preserves a stable debt path that allows for public investments in infrastructure and social transfers.

  • b. The authorities announced in the Letter of Intent for the 5th PSI review that they intend to continue with a PSI for at least four more years, until 2013 (a 1-year extension of the current PSI followed by a request for a new 3-year PSI).

Based on these facts, net domestic borrowing is projected to be contained in the next 20 years, allowing net domestic debt4 to land softly at about 11 percent of GDP. This fiscal restraint is needed to accomplish the authorities’ goal of increasing reserve coverage by 0.1 month of prospective imports each year, reaching 5.7 months by 2028 (equivalent to 41 percent of GDP). Financing the reserve accumulation requires that the Treasury make annual deposits of about 1.2 percent of GDP at the BCV. Using the balance sheet approach, this result assumes that the authorities’ efforts to develop the domestic securities market will allow the domestic private sector to absorb about 19 percent of GDP in Treasury securities by 2028 (Table 4).

Table 4.

Balance Sheet Approach: Intersectoral Positions with the Treasury, Selected Items

(in percentage of GDP)

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Source: IMF and IDA staffs’ projections.

Excludes TCMF.

uA03fig03

The accumulation of net foreign assets (NFA) and Treasury deposits

Citation: IMF Staff Country Reports 2009, 014; 10.5089/9781451809510.002.A003

8. The baseline scenario assumes a faster rise than the previous DSA in the share of nonconcessional external borrowing. While Cape Verde will continue to have access to concessional loans from IDA and others,5 this DSA assumes that Cape Verde will increasingly take out nonconcessional loans to finance growth-enhancing public investments. It is assumed that the average grant element of all external borrowing will decline to less than 10 percent by 2028. This assumption is justified by the recent graduation of Cape Verde from the U.N.’s least-developed country category and nonconcessional loans envisaged with the European Investment Bank (EIB), the IBRD, and the OPEC Fund. This assumption is useful for probing the resilience of the debt path to less favorable borrowing terms.6 To further test resilience in stress scenarios, the grant element of marginal debt7 is negative because it is assumed that under stress conditions the country would be charged a risk premium of 100 basis points above the market rate.8

III. External Debt Sustainability

A. Baseline Scenario

9. Although the recent decline in external debt will be temporarily reversed because borrowing to finance public investments will accelerate, it will remain below the threshold. In the previous DSA, external debt was expected to decline continuously. The reason for the difference is the new funds Cape Verde recently secured for public investments, especially from the EIB and the IBRD. The finding that this temporary rise in external borrowing will not jeopardize debt sustainability repeats the finding of the 2007 DSA that a 5-year scaling-up of nonconcessional borrowing is consistent with debt sustainability. The average grant element of the new borrowing will be especially low during 2009–2011 when the EIB loan will be disbursed. The debt service ratios will rise gently but stay below the stress thresholds. This rise in debt service indicators results from the decline in concessional financing and the assumed shortening of amortization periods. Because in this DSA the grant element of new borrowing is projected to decline faster than in the previous one, the rise in debt service ratios will be frontloaded rather than backloaded, as it was in the previous DSA.

B. Alternative and Stress Scenarios

10. The risk of external debt distress is low even with depreciation and an abrupt worsening of borrowing terms. The debt ratios remain far below their thresholds in all alternative and stress scenarios, including the scenario where all new borrowing is 200 basis points above the baseline rates (Figure 1 and Table 6 alternative scenario A2). This finding reinforces the conclusion that nonconcessional borrowing is unlikely to jeopardize debt sustainability. The extreme scenario is a currency depreciation, which highlights the need to hedge open currency positions to support the peg. This result is a corollary to the cautionary note about the country’s currency exposure (¶ 3).9 In the historical scenario, the external debt ratio rises for a longer period of time because FDI is less than in the baseline, but it also declines faster in the outer years because the historical scenario implies faster growth and a smaller external deficit. The historical scenario should be interpreted with caution because it does not take into account that in a highly open economy like Cape Verde the current account self-stabilizes to some extent to fluctuations of FDI and growth.

Figure 1.
Figure 1.

Cape Verde: Indicators of Public and Publicly Guaranteed External Debt under Alternatives Scenarios, 2007-2028 1/

Citation: IMF Staff Country Reports 2009, 014; 10.5089/9781451809510.002.A003

Source: Staff projections and simulations.1/ The most extreme stress test is the test that yields the highest ratio in 2018. In figure b. it corresponds to a depreciation shock; in c. to a borrowing cost shock; in d. to a depreciation shock; in e. to a export shock; and in picture f. to a depreciation shock.
Figure 2.
Figure 2.

Cape Verde: Indicators of Public Debt Under Alternative Scenarios, 2007-2028 1/

Citation: IMF Staff Country Reports 2009, 014; 10.5089/9781451809510.002.A003

Sources: Country authorities; and staff estimates and projections.1/ The most extreme stress test is the test that yields the highest ratio in 2018.2/ Revenues are defined inclusive of grants.
Table 5.

Cape Verde: External Debt Sustainability Framework, Baseline Scenario, 2005-2028 1/

(In percent of GDP, unless otherwise indicated)

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Source: Staff simulations.

Includes both public and private sector external debt.

Derived as [r - g - r(1+g)]/(1+g+r+gr) times previous period debt ratio, with r = nominal interest rate; g = real GDP growth rate, and r = growth rate of GDP deflator in U.S. dollar terms.

Includes exceptional financing (i.e., changes in arrears and debt relief); changes in gross foreign assets; and valuation adjustments. For projections also includes contribution from price and exchange rate changes.

Assumes that PV of private sector debt is equivalent to its face value.

Current-year interest payments divided by previous period debt stock.

Historical averages and standard deviations are generally derived over the past 10 years, subject to data availability.

Defined as grants, concessional loans, and debt relief.

Grant-equivalent financing includes grants provided directly to the government and through new borrowing (difference between the face value and the PV of new debt).

Numbers not comparable with the 2007 DSA, which mistakenly excluded grants.

Table 6.

Cape Verde: Sensitivity Analysis for Key Indicators of Public and Publicly Guaranteed External Debt, 2008-2028

(In percent)

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Source: Staff projections and simulations.

Variables include real GDP growth, growth of GDP deflator (in U.S. dollar terms), non-interest current account in percent of GDP, and non-debt

Assumes that the interest rate on new borrowing is by 2 percentage points higher than in the baseline., while grace and maturity periods are the

Exports values are assumed to remain permanently at the lower level, but the current account as a share of GDP is assumed to return to its baseline level after the shock (implicitly assuming an offsetting adjustment in import levels.)

Includes official and private transfers and FDI.

Depreciation is defined as percentage decline in dollar/local currency rate, such that it never exceeds 100 percent.

Negative numbers indicate interest rates higher the market rates. Applies to all stress scenarios except for A2 (less favorable financing) in which the terms on all new financing are as specified in footnote 2.

Table 7.

Cape Verde: Public Sector Debt Sustainability Framework, Baseline Scenario, 2005-2028

(In percent of GDP, unless otherwise indicated)

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Sources: Country authorities; and staff estimates and projections.

Central government. Debt figures are net of deposits at central bank.

Gross financing need is defined as the primary deficit plus debt service plus the stock of short-term debt at the end of the last period.

Revenues excluding grants.

Debt service is defined as the sum of interest and amortization of medium and long-term debt.

Historical averages and standard deviations are generally derived over the past 10 years, subject to data availability.

The difference with Tables 2 and 5 is caused by different exchange rates (average or end-of-period).

Table 8.

Cape Verde: Sensitivity Analysis for Key Indicators of Public Debt 2008-2028

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Sources: Country authorities; and staffestimates and projections.

Assumes that real GDP growth is at baseline minus one standard deviation divided by the length of the projection period.

Revenues are defined inclusive of grants.