Cape Verde
2010 Article IV Consultation and Request for a 15-Month 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

Cape Verde has demonstrated notable economic and policy resilience. The public investment program should be completed, but new external borrowing should be limited to restore fiscal buffers. The monetary policy framework could be improved in the medium term. The Bank of Cape Verde should step up efforts to safeguard the financial system and to develop the government securities market. Improving economic and financial statistics to facilitate better monitoring and analysis of developments to guide policy formulation is needed in Cape Verde.

Abstract

Cape Verde has demonstrated notable economic and policy resilience. The public investment program should be completed, but new external borrowing should be limited to restore fiscal buffers. The monetary policy framework could be improved in the medium term. The Bank of Cape Verde should step up efforts to safeguard the financial system and to develop the government securities market. Improving economic and financial statistics to facilitate better monitoring and analysis of developments to guide policy formulation is needed in Cape Verde.

I. Introduction

1. Performance under the 2006–10 Policy Support Instrument (PSI) was strong. International reserves grew to over four months of imports and net domestic debt declined to less than 20 percent of GDP. A prudent fiscal stance during the first years of the program allowed effective counter-cyclical policies in 2008–09 when the global crisis hit.

Successes of the Previous PSI

In 2006, after completion of a three-year PRGF arrangement, Cape Verde obtained a three-year PSI supported program, which was extended by one year in 2009. Under this previous PSI, covering the period 2006–10, policy measures enhanced macroeconomic performance in several areas, including: (i) reducing public debt, (ii) building international reserves, (iii) improving tax policies and public financial management, and (iv) strengthening regulatory capacity in the financial sector.

A key reason for the success of the previous PSI was the authorities’ ability to leverage its own reform agenda taking advantage of the technical discussions, structural benchmarks, and performance criteria associated with the program. PSI-supported policies helped to consolidate macroeconomic stability, which is at the center of the government’s poverty reduction strategy.

2. The authorities are requesting a new 15-month PSI. Legislative and presidential elections are scheduled for early 2011, and the authorities have requested a 15-month PSI supported program, which will allow the new government to assess the form of its future engagement with the Fund after elections in 2011. With only a notional budget for 2011, they consider the macroeconomic framework and conditionality of the PSI supported program as useful policy anchors.2 The new program would continue to focus on macroeconomic stability, and build on the successes of the previous program.

II. Recent Developments and Outlook

A. Recovering from the Global Slowdown

3. Economic growth in 2010 shows signs of a solid recovery. In recent months, both quantitative and qualitative economic indicators point to clear signs of recovery in economic activity. Leading economic indicators, such as the economic climate indicator and confidence indicators by economic sectors, reveal a favorable performance in the first half of 2010. Lower prices in the tourism industry have sustained growth in hotel nights and visiting guests. In the transportation sector, passenger arrivals and cargo activities have been robust. High growth in imports of consumer, intermediate, and capital goods herald strong domestic demand. Notably, rapid growth of cement imports portends a rise in construction activity and investment.

uA01fig01

Confidence Indicators

(Percent)

Citation: IMF Staff Country Reports 2010, 349; 10.5089/9781455212712.002.A001

Source: INE, and staff estimates.
uA01fig02

Tourism Indicators

Citation: IMF Staff Country Reports 2010, 349; 10.5089/9781455212712.002.A001

Source: INE, and IMF staff estimates.

4. Inflation edged up in recent months, but remains low and the real value of the escudo remains competitive. Inflation has increased to 3.0 percent in the 12 months to August 2010, mainly because of higher prices in service activities (i.e. restaurants and transportation sectors) and food. The implementation of the public investment program (PIP) should continue to have little effect on domestic inflation due to the high import content of investment in terms of inputs of goods, labor, and other services. The nominal effective exchange rate depreciated slightly in recent months due to the peg to the euro, which has depreciated relative to the dollar. The real effective exchange rate is broadly in line with fundamentals (Box 2).

uA01fig03

Inflation

(12-month rate)

Citation: IMF Staff Country Reports 2010, 349; 10.5089/9781455212712.002.A001

Sources: INE, and IMF staff projections.
uA01fig04

Effective Exchange Rates

(Index Jan 2003=100)

Citation: IMF Staff Country Reports 2010, 349; 10.5089/9781455212712.002.A001

Sources: IMF Information Notice System, and IMF staff estimates.

5. International trade and financial inflows are improving in the first half of 2010. Merchandise imports grew by approximately 5 percent when compared to the same period of the previous year. Service exports grew modestly, but hotel operators are reporting high advanced booking rates through the high season in the remainder of the year. Merchandise exports have achieved substantial growth (around 70 percent, although from a small base), mainly driven by fishery products. In the financial account, FDI has stabilized and strong pace of official disbursements should contribute to a positive overall balance of payments in 2010.

Assessment of the Exchange Rate

Cape Verde has a fixed exchange rate regime, with a peg to the euro. The competitiveness of the escudo was assessed using three alternative approaches based on the IMF’s methodology, adapted for Cape Verde’s specific circumstances, and using medium-term fundamentals (projections for 2014).3 Although the analysis has a high degree of uncertainty and is sensitive to methodological differences, the evidence shows that the escudo is broadly aligned with its fundamentals.

Results of CGER-type Analysis

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Source: IMF staff estimates and projections

The equilibrium real exchange rate approach (ERER) estimates a reduced-form relationship between the REER and macroeconomic fundamentals (e.g. relative productivity as proxied by GDP at a purchasing power parity exchange rate per unit of labor; terms of trade; government consumption to GDP; Net Foreign Asset (NFA); aid inflows; and remittances). The ERER suggests the exchange rate is undervalued by about 12.5 percent.

The macro-balance approach (MB) estimates an equilibrium current account balance (i.e. norm) as function of macroeconomic fundamentals (e.g. relative old age dependency; relative population growth; relative income; relative income growth; relative fiscal balance; oil trade balance; initial NFA; aid inflows; and remittances) and estimates the change in the exchange rate necessary to adjust the underlying current account to the norm. This approach suggests a small gap of -2.4 percent of GDP between the current account norm and the underlying current account in 2014, implying an exchange rate overvaluation of 9 percent. Large negative current account norm is due to low level of NFA and relatively young population, which reduce national savings and hence current account balance.

The external sustainability approach (ES) computes the current account needed to stabilize the net foreign position at a benchmark level, and then estimates the exchange rate change required to adjust the underlying current account to this norm. Based on the medium-term average projections for real growth, the ES suggests a small gap of -1.6 percent of GDP, implying an exchange rate overvaluation of 6.2 percent.

An appropriate assessment of Cape Verde’s external competitiveness also needs to take into account the country’s main export industry: tourism. During the depths of the global financial crisis, the tourist industry demonstrated its considerable price flexibility as hotels slashed prices to adjust to the demand shock and, in doing so, maintained solid growth in number of hotel nights. Cape Verde’s export growth potential in the tourist sector hinges on alleviating bottlenecks in supporting infrastructure, particularly ports, airports, electricity, and water.

B. Risks to the Outlook

6. Risks to the outlook are broadly balanced. Growth is projected to pick up in 2010 and gather momentum over the medium term as global conditions improve. Private capital inflows, particularly FDI, are expected to improve, but the current account balance will likely decline significantly in 2010–11 due to the high import content of the PIP. The PIP should nonetheless support medium-term growth, with a significant upside potential for crowding in private sector investment, especially in the tourist industry. However, Cape Verde has strong links to Europe through official lending, tourism, FDI, and remittances. Thus, the deterioration of European conditions in recent months has amplified downside risks, and austerity measures in donor countries could have some negative effects on tourism as well as disbursements and approval of new projects.

III. Policy Discussions: Rebuilding Buffers and Developing Markets

A. Improving Infrastructure While Maintaining Fiscal Sustainability

Accelerating the public investment program

7. Large fiscal and current account deficits over 2009–12 reflect a temporary acceleration of the public investment program as counter-cyclical stimulus. The authorities have taken advantage of a transitional window for concessional external financing following graduation to middle-income status and the need for countercyclical stimulus to accelerate their PIP.4 The PIP aims to alleviate infrastructure bottlenecks, including those that hinder development of the tourism sector, and to support progress on social policies. The IMF has supported this strategy, which is contributing to a temporary deterioration of fiscal balances relative to those planned before the crisis (e.g., the fifth PSI review in 2008).5 Likewise, the large temporary current account deficits reflect higher imports associated with public investment. Despite this temporary deterioration of fiscal and external balances, Cape Verde’s macroeconomic fundamentals are broadly stable and sustainable, and meet the PSI requirements: (i) the large fiscal and current account deficits are financed by one-off concessional resources; (ii) absent any capital spending financed externally (through loans and grants), Cape Verde would realize fiscal surpluses and small current account deficits, in line with PSI requirements, and would compare favorably with other PSI cases; (iii) the feasibility study show that the projects should bring significant value added and revenues in the medium term.

8. The authorities are confident of a high rate of project implementation in 2010. Preliminary data suggest an execution rate of public investment of 46 percent at end-August. The authorities expect the implementation rate to accelerate through the remainder of the year and they project capital spending at 22.6 percent of GDP for 2010.

uA01fig05

Fiscal and external current account balances

(percent of GDP)

Citation: IMF Staff Country Reports 2010, 349; 10.5089/9781455212712.002.A001

1/ All foreign financing (grants and loans) related to the public investment is taken out over the entire period. This highlights the weight of externally-financed investment on the fiscal and external balances.

9. The public investment program aims to achieve national development objectives for increasing growth, diversifying the economy, and protecting vulnerable groups. The authorities have completed cost-benefit assessments for all projects, most often in partnership with donors or lenders. Staff supports the objectives of the investment program, noting that many of the projects should enhance competitiveness by relieving infrastructure bottlenecks that act as a cost to business. Staff nonetheless underscores the need for judicious selection and transparent implementation of projects. Thus, staff advised the authorities to exercise caution in agreeing to foreign loans with procurement requirements tied to the donor in order to minimize costs and to crowd in domestic provision from the private sector.

Maintaining external debt sustainability

10. The authorities are cognizant of the need to manage external debt well and safeguard debt sustainability (MEFP ¶ 5). They are committed to taking advantage of their window of opportunity for obtaining concessional financing for the public investment program. Indeed, with low interest rates and long grace periods and maturities, debt service ratios remain very low, minimizing liquidity and solvency risks. The rapid implementation of the PIP during 2009–12 would attenuate the impact of the global slowdown and would provide the foundation for sustained medium-term growth, which should enhance repayment capability. Nonetheless, given the prospect of a gradual move to non-concessional financing in the medium run, the authorities wish to make debt management a key element of the new PSI supported program. Staff concurs, but also emphasizes the need to rebuild fiscal policy buffers following the rise in debt stocks relative to before the crisis. Thus, to provide fiscal space for adjusting to future shocks, staff stressed that the authorities should avoid incurring any new foreign borrowing beyond that already planned and included in the current debt sustainability analysis (see DSA supplement). Scaling back spending in the medium-run would also provide breathing space to ensure that the current investment generates the expected growth dividends.

B. Supporting the Exchange Rate Peg

Keeping domestic debt low

11. Fiscal policy contributes to protecting the peg by keeping net domestic debt low (MEFP ¶ 4). Cape Verde made commendable progress in reducing the stock of net domestic debt below 20 percent of GDP during the 2006–10 PSI. The authorities achieved their objective two years ahead of schedule. Staff projects net domestic debt to stay below 20 percent of GDP in 2010 and 2011, but the debt ratio increases slightly. Staff agreed with the need to keep net domestic debt low, and advised resisting pressure on domestic borrowing as external financing is scaled back over the medium term.

12. Faced with weak revenue, the government has been holding current expenditure below budget in 2010 to minimize the need for domestic borrowing. Despite an acceleration in VAT collection, tax revenues have been below budget through August, reflecting weaker activity than foreseen at the time of the MTFF and 2010 budget preparation. In response, the authorities have stepped up the collection of tax arrears (MEFP ¶ 6). They also took bold measures to curb current spending—despite pressures during an election year—including by freezing new hiring in the public sector. The authorities have held down spending on wages and salaries, and domestically financed capital spending, but they have protected social spending such as pensions and subsidies to the poor. In the remaining months of the year, domestic revenues are expected to accelerate slightly and additional budget support from the European Union should contribute to higher grants.

Text Table:

2010 Fiscal Developments

(percent of GDP)

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Source: Cape Verde authorities and staff calculations.

GDP is measured at the equivalent fraction of the year.

Building and stabilizing reserves

13. Monetary policy is geared toward maintaining the euro peg. The BCV raised its policy rate during the international crisis reflecting heightened global risk premia. In spite of the severe shock, foreign reserves fell only marginally and the peg held firm. Global risk indicators (such as the EMBI spread) subsequently dropped, but the BCV has been cautious in its response. It reduced its policy rate only in January 2010 by one percentage point to 4.25, and the spread with the Euribor remains large.

uA01fig06

Interest rates

(in percent)

Citation: IMF Staff Country Reports 2010, 349; 10.5089/9781455212712.002.A001

14. To support the peg, monetary policy focuses on ensuring gradual reserve accumulation (MEFP ¶ 9). The BCV has set a high minimum reserve requirement and a policy rate well above Euribor. The authorities view this restrictive monetary stance as necessary to encourage inflows of emigrant deposits, which respond gradually and at long and variable lags to interest rates, and to restrain private sector credit that would fuel imports. They are cautious about lowering the policy rate and reserve requirements until foreign reserve accumulation is definite and the global environment rebounds.6 Staff supports the BCV’s cautious monetary stance given the benefit of further building foreign reserve buffers and the current uncertain global environment. Staff also agreed to support efforts to better understand the monetary transmission mechanism, particularly the impact of interest rate changes on emigrant deposits and foreign reserves, to improve policy effectiveness. Staff advised to closely monitor the composition of capital flows and adopt macro-prudential regulations to minimize risks associated with interest-rate sensitive inflows. To reduce distortions to financial intermediation, staff also recommended to reduce the minimum reserve requirement or allow treasury securities to satisfy part of the requirement.

15. The BCV considers their monetary framework to be procyclical. An economic slowdown in Cape Verde’s main trading partners in Europe would call for a tighter monetary stance at home to offset the impact of sluggish export growth on the balance of payments and reserves. Thus, even though limited capital mobility may provide some scope for independent monetary policy, the BCV cannot exploit it given the required focus on stabilizing the balance of payments. While agreeing that a larger reserve buffer should be accumulated at the rate of 0.1 month of imports per year, staff argued that prudent fiscal policies should be the main instrument for reserve accumulation.

C. Safeguarding Financial Stability and Developing Markets

16. Though the onshore banking sector remains sound, the crisis spawned some vulnerabilities. The overall capital adequacy ratio of onshore banks stood at about 12 percent at end-June 2010 (Table 8). Two banks fell below the minimum regulatory capital requirements, due to connected lending and off-balance sheet transactions. Asset quality and profitability sharply deteriorated because of spillover effects from the global crisis, which affected foreigners’ second-home real estate market and the construction sector. 7 Higher provisions also contributed to the decline in profitability. However, funding held up well. Emigrant deposits—which constitute about 37 percent of the total banking sector deposits and originate predominately from Portugal, France, and the United States—remained steady and grew by over 5 percent (y-o-y). Although the first and third largest domestic banks are majority-owned by a Portuguese state bank, which had a favorable result in the recent European Union stress tests, parent funding of domestic banks is relatively small.

17. The authorities are making progress to safeguard financial stability (MEFP ¶ 12–13). The draft new banking law, under discussion by the council of ministers, would bring all banks under a single banking law; thereby leveling the playing field and increasing competitiveness within the sector. The BCV is in the process of producing the first financial stability report on an annual basis. The regulatory and supervisory framework is being improved by: (i) establishing a macroprudential unit within the BCV; (ii) moving gradually toward risk-based supervision; (iii) enhancing both the off-site and on-site supervision procedures; (iv) strengthening the skills of the banking supervision staff; (v) developing prudential regulations on interest rate, foreign exchange, and credit risks; and (vi) strengthening IT systems to facilitate effective supervision. Staff supported the BCV’s plan to expand and formalize the standing financial stability committee to include the Ministry of Finance (MoF) in a memorandum of understanding (MoU). The MoU should set out an action plan to distribute duties for financial stability between the BCV and MoF and develop an effective public communication strategy.

18. Staff urged the BCV to continue to enhance banking supervision. The short-lived episodes of non-compliance with the regulatory capital requirements are a source of concern.8 One bank was marginally under-capitalized, while another bank (with relatively small market share) was under corrective actions. The BCV should enhance its supervisory framework to allow for detection of potential banks weaknesses and take corrective actions at an early stage. A deeper understanding of each bank’s strategy and business model should complement current compliance-based supervision. Additionally, with high interest rates, onshore banks have started attracting non-resident deposits, which are exempt from reserve requirements. The authorities and staff agreed on imposing a punitive minimum reserve requirement and adopting prudential regulations to minimize any destabilizing capital inflows.9

19. The authorities continue to develop primary and secondary markets for government securities, and enhance monetary operations (MEFP ¶ 10–11, Box 3). Issuing fungible securities at a uniform price in the primary market and publishing the auction calendar well in advance are important steps for fostering a liquid debt market. Staff also supports the authorities’ fiscal-monetary coordination agreement to use treasury securities as the main instrument of monetary policy, and thereby enhance the effectiveness of the monetary transmission mechanism. Furthermore, as the National Social Security Institute (INPS) dominates and distorts the primary market for government securities, staff urged the authorities to improve the process of auction assignment by allowing the INPS to participate in the non-competitive group. Equally important, the INPS should finalize its investment policy guidance, including investing some of its portfolio abroad, and set up an investment committee.

Liquidity Management and Monetary Operations

Although the fixed exchange rate regime limits the room for conducting independent monetary policy, the BCV can still play a role in liquidity management. High and volatile excess liquidity in the banking sector has complicated liquidity management, and discourages interbank transactions. The BCV has relied on open-market operations to sterilize excess liquidity using BCV bills, and has set high reserve requirements (16 percent of deposits).

A liquid debt market and market-based instruments could facilitate liquidity management and monetary operations. Government bonds are still not fungible, and the primary market is dominated by the INPS, thereby creating market fragmentation and limiting liquidity in the secondary market. The recent reforms to improve the government primary market and use the treasury securities as the main instrument for monetary operations (MEFP ¶ 10 and 13) will help foster a liquid debt market. In addition, a sound liquidity management framework will encourage financial market development and enhance the monetary transmission mechanism. To accomplish this, the deposit and lending facilities at the BCV could be improved by allowing repo and reverse repo operations (using treasury securities) to absorb and inject liquidity in the financial system. The interest rates on those facilities would set a corridor on market interest rates. Additionally, the BCV could consider allowing treasury securities to satisfy part of the required reserves and/or remunerate required reserves.

D. Reducing Fiscal Risk in State-Owned Enterprises

20. The fiscal risk arising from state owned enterprises is still a challenge that needs to be addressed (MEFP ¶ 7). The government has undertaken reforms to the loss-making public electricity and airline companies, but with no drastic improvement in profitability. The recent Law of State Enterprises and Public Managers provides a framework for better management of SOEs. To reap the benefit of the framework, the authorities plan to introduce and enforce managerial incentive contracts linked to enterprise performance. Short-term efforts will also focus on improving operational and commercial efficiency within the firms.10 The staff urged authorities to move forward with this reform agenda. Staff considered that private sector involvement can also help to restore profitability, as long as public-private contracts are well designed and appropriately share costs and risks.

E. Social Policies to Protect the Vulnerable

21. PSI-supported policies contributed to the strong record of social development in Cape Verde (Box 4). Cape Verdean authorities have a long-standing commitment to social development. The Poverty Reduction Strategy documents have reaffirmed this commitment by pursuing a multi-pronged development approach to address priority areas such as social cohesion and human development (MEFP ¶8).11 The authorities emphasized that macroeconomic stability is at the core of the country’s multi-pillar development strategy. As a result, PSI-supported policies continue to play an important role in the overall reform framework.

F. Sustaining Medium-term Growth

22. The PIP is central to sustaining medium-term growth in Cape Verde not only because of its overall reach and size, but also due to its relevance at the project-level. The PIP specifically addresses fundamental infrastructure bottlenecks to economic activity in Cape Verde. These include: insufficient wharf space for vessels, inadequate port equipment for cargo handling, deficient airport facilities across islands, lacking logistics to support intermodal transportation, underinvestment in energy generation and water production. Tackling such issues is expected to reduce costs to private sector investment, boosting the country competitiveness and growth prospects.12

23. Over the medium-term, the tourist industry has the potential to act as an engine of growth. Secular trends are favorable: as global growth rebounds and as increasing numbers of the global population reach retirement age, the tourist industry has the potential to expand faster than other industries. Government efforts to improve infrastructure and private initiatives such as transportation should help reduce constraints in the industry, but challenges still remain. Additional infrastructure needs are likely to arise, particularly in transportation; education and training will need to be targeted to the skills required in the tourist and other growth industries; and land registration will need to be improved to facilitate reliable and sustainable development zones. Moreover, staff and the authorities agreed on the importance of integrating the tourist industry with the domestic economy to ensure balanced broad-based growth.

24. Staff and the authorities agreed that policies should further encourage competitiveness and diversification. The authorities emphasized that their PIP will create conditions for diversifying the economy. Additional regulatory improvements (e.g. in Information and Communications Technologies) could help spur diversification into other potential export industries. Staff view price and wage flexibility as well as inter-island mobility are useful to preserve growth and employment against any negative demand shocks, but consider that existing labor market restrictions may hinder a competitive business environment and deter formal employment growth. While tax incentives may have helped nurture a nascent tourist industry, the objective over the medium-run should be to create a level playing field with all industries contributing efficiently and equitably to finance development.

Cape Verde’s Social Policies

In 2010, Cape Verde has made substantial progress toward accomplishing its MDG targets. Social development has been noteworthy and has matched the economic transition to middle-income status.

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Source: Government of Cape Verde and World Development Indicators

Social policies have focused on fostering labor market participation and providing direct assistance to vulnerable groups (unprivileged children, poor elderly individuals, females who are head of households, those in chronic poverty and with disabilities). Some key social programs include:

Education. Policy has focused on improving quality, ensuring equity, and achieving measurable results. A gradual decentralization in the management of programs has also contributed to the recent strong record: Elementary school is mandatory for six years and net enrollment rate increased from 53.9 percent in 2001 to 62 percent in 2008. Transition rates from elementary to the next school cycle increased from 70.7 percent in 2001 to 82.9 percent in 2008. Recently, local universities have been constructed and will allow youth the option of pursuing undergraduate studies in the country.

Health. Policy aims to achieve an accessible and encompassing coverage for treatment and preventive care. The National Health Services is being re-organized to guarantee that the strong performance of health indicators are maintained and continue to support human capital development. Additionally, the country continues to build capacity for public health surveillance to deal with risks such as dengue fever and other diseases.

Job creation and empowerment. A number of initiatives target the youth, who have high rates of unemployment. The objective is to create an integrated system linking general education, professional training and employment, through (i) active labor market policies such as apprenticeship, internship and first-job programs, and (ii) private sector involvement in training. The initiatives help match training with labor demand and allow youth to directly benefit from the development process.

School feeding program. This internationally-recognized program provides free meals to nearly 80,000 children in the country, contributing to improved nutrition and human capital development.

Social pension. Non-contributive pension payments are available to those in need. The government, with support from municipalities and the civil society, screen and identify candidates for the program.

Gender equality. Implementation of public policies to democratize access to education across gender has led Cape Verde to achieve gender parity in primary and secondary education.

Water, sanitation and social housing. The government is carrying out public investment to guarantee access to basic public services and decent living conditions.

IV. Program Monitoring and Risks

A. Program Monitoring

25. For monitoring performance under the program, quantitative assessment criteria, quantitative indicative targets, and structural benchmarks have been proposed (MEFP Tables 1 and 2). The assessment dates will be end-March 2011 and end-September 2011 with corresponding semi-annual reviews.13 The quantitative targets include ceilings on net domestic borrowing of the central government, net domestic assets of the BCV, and accumulation of non-concessional external debt; and a floor on net international reserves of the BCV. Targets to be monitored on a continuous basis include ceilings on accumulation of domestic and external arrears, non-accumulation of short-term non-concessional external debt and a floor on the regulatory capital of commercial banks. Structural benchmarks aim at strengthening the tax base, the debt management, the financial sector, the fiscal-monetary coordination, the government securities market, and promoting fiscal accountability.

B. Statistical Issues

26. Progress has been made in improving economic and financial statistics, though further improvements in data are needed. The data are broadly adequate for surveillance. The production-based GDP is compiled by the National Statistical Institute (INE) with long delays, and labor market data on unemployment is published only on an annual basis. The ongoing efforts by the INE to finalize the 2010 census should assist other government agencies in adopting sound policies. Staff agreed that there is a need to strengthen the national accounts, and consider technical assistance in this area as a priority.

C. Program Risks

27. The main program risks consist of renewed adverse external shocks and fiscal pressures ahead of elections. Worsening economic conditions in Europe could spill over through a decline in tourism, second home purchases of foreigners, FDI, remittances, and official bilateral support, which thereby could weaken the economic recovery and build up of reserves. On the domestic front, the forthcoming elections are expected to be close, creating incentives for a short-term boost in spending. However, the authorities stressed their commitment to holding spending to budget, and have strongly implemented this commitment so far this year.

V. Staff Appraisal

28. Cape Verde has demonstrated notable economic and policy resilience. In the face of adverse global shocks, the government used its policy buffers to provide macroeconomic stimulus. The economy is now rebounding strongly and is poised for solid growth over the medium term.

29. The authorities should complete the public investment program underway, but limit new external borrowing in order to restore fiscal buffers. The temporary acceleration of the public investment program is appropriate, given the need to improve infrastructure, the availability of funding on concessional terms, and usefulness of countercyclical stimulus. However, foreign-financed spending would need to be scaled back without resorting to new foreign borrowing, to rebuild fiscal buffers against negative shocks. Foreign-financed projects should be selected exclusively on the basis of pro-growth or pro-poor objectives.

30. The peg to the euro continues to serve Cape Verde well. This arrangement provides a stable anchor for economic stability, while allowing some flexibility in the escudo’s exchange rate vis-à-vis currency cross rates. Staff analysis shows that the escudo’s real effective value against other currencies is broadly in line with its fundamentals.

31. The government should maintain low domestic debt as the main instrument to support the peg. A continued low level of domestic borrowing will be required to sustain a gradual accumulation of foreign exchange reserves. Net domestic debt should be kept below 20 percent of GDP, including by tightly controlling recurrent spending, improving tax administration, and rationalizing tax exemptions. Stronger efforts are also required to address fiscal risk arising from a few public enterprises.

32. The monetary policy stance is appropriately cautious, but the framework could be improved in the medium term. Given the weak global environment, the BCV’s emphasis on shoring up reserve accumulation is well placed. However, a bias toward restrictive monetary policy introduces other risks. Persistent interest rate differentials between Cape Verde and international markets will inevitably invite speculative inflows, increasing vulnerability. In addition, discouraging lending to the private sector can stifle economic diversification and reduce potential growth. Over the medium term, restoring fiscal and reserve buffers will help provide space to counteract shocks and reduce the need for an active monetary policy.

33. Monetary operations and the monetary transmission mechanism could be enhanced. A better understanding of how changes to reserve requirements and policy rates impact bank rates and economic activity would help to calibrate policy actions. To reduce inefficiencies in financial intermediation, high minimum reserve requirements should be reduced or treasury securities allowed to satisfy part of the requirement. The BCV should also improve its standing facilities by using repo and reverse repo operations.

34. The BCV should step up efforts to safeguard the financial system and develop the government securities market. Staff supports the draft new banking law and ongoing efforts to enhance banking supervision. Further efforts are needed to increase staff and training, and strengthen the supervisory capacity for early detection of vulnerabilities. Recent reforms to enhance liquidity in government securities are welcome. Nonetheless, the authorities should reduce the distortion created by the INPS in the government primary market by including INPS in the non-competitive group for auctions and diversifying the INPS’s investment portfolio.

35. While data provision is broadly adequate for surveillance, the authorities are encouraged to continue to improve economic and financial statistics in order to facilitate better monitoring and analysis of developments to guide policy formulation.

36. Staff recommends approval of Cape Verde’s request for a new 15-month PSI. The agreed program will build on the macroeconomic success and structural reforms of the previous PSI supported program, and will help maintain macroeconomic discipline through the forthcoming election period.

37. Risks to the program appear manageable. The authorities have demonstrated their ability to preserve macroeconomic control and stability in the face of election pressures and adverse economic shocks. Staff is confident of their continued commitment to program implementation.

38. Staff recommends that the next Article IV consultation take place within 24 months, in accordance with the decision on consultation cycles in program countries.

Figure 1.
Figure 1.

Cape Verde: Fiscal Performance

(Percent of GDP)

Citation: IMF Staff Country Reports 2010, 349; 10.5089/9781455212712.002.A001

Sources: Cape Verdean authorities and IMF staff estimates.
Figure 2.
Figure 2.

Cape Verde: Monetary Developments.

Citation: IMF Staff Country Reports 2010, 349; 10.5089/9781455212712.002.A001

Source: Bank of Cape Verde.
Figure 3.
Figure 3.

Cape Verde: External Sector Developments.

Citation: IMF Staff Country Reports 2010, 349; 10.5089/9781455212712.002.A001

Sources: BCV and IMF staff estimates.
Table 1.

Cape Verde: Selected Economic and Financial Indicators, 2007–14

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

Excluding grants, interest payments, and foreign financed investments

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

Excluding claims on the offshore Trust Fund.

Table 2.

Cape Verde: Fiscal Operations of the Central Government, 2008–14

(Millions of Cape Verde escudos, unless otherwise indicated)

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

Medium-Term Fiscal Framework

Excluding clearance of arrears and accounts payable

Excluding grants, interest, and foreign-financed expenditure.

Domestic revenue – recurrent expenditure.

External grants + foreign financing.

Including arrears and accounts payable, net of deposits

On the basis of the residency of the creditor or the currency of denomination of the debt, following the “Staff Guidance Note on Debt Limits in Fund-Supported Programs” (Policy Paper, December 22, 2009)

Table 3.

Cape Verde: Fiscal Operations of the Central Government, 2008–14

(Percent of GDP)

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

Medium-Term Fiscal Framework

Excluding clearance of arrears and accounts payable

Excluding grants, interest, and foreign-financed expenditure.

Domestic revenue – recurrent expenditure.

External grants + foreign financing.

Including arrears and accounts payable, net of deposits

On the basis of the residency of the creditor or the currency of denomination of the debt, following the “Staff Guidance Note on Debt Limits in Fund-Supported Programs” (Policy Paper, December 22, 2009)

Table 4.

Cape Verde: Balance of Payments, 2008–14

(Millions of euros, unless otherwise indicated)

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Sources: Bank of Cape Verde; and IMF staff estimates and projections.
Table 5.

Cape Verde: Monetary Survey, 2007–14

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