A. Fiscal Policy to Reduce Vulnerabilities and Foster Inclusiveness

8. Fiscal deficits and debt ratios have increased in recent years. The fiscal deficit, which was below 4 percent of GDP in 2007, stood at 6.7 percent of GDP in 2011. Higher deficits were justified to a large extent by the response to successive shocks. Meanwhile, the public debt-to-GDP ratio has increased continuously and is expected to exceed 45 percent in 2012.

9. High deficits constrain fiscal policy and raise sustainability issues. Fiscal space has decreased in recent years and this limits the authorities’ ability to conduct counter-cyclical policies. In addition, the financing of deficits at the current level is challenging. An updated debt sustainability analysis (DSA, Supplement 1) shows that current fiscal deficit levels are incompatible with long-term sustainability. Vulnerabilities have increased, as illustrated by financing difficulties in early 2012 ahead of the presidential election that led to delays in paying suppliers, which have since been largely resolved. Senegal remains at a low risk of debt distress only under the assumption of fiscal consolidation and further strengthening of debt management.

10. The authorities are fully aware of these challenges and have taken action to keep the fiscal deficit under control in 2012. Budget execution was prudent in the first half of the year. Efforts to deliver on President Sall’s promise of a more modest, accountable, and efficient state are underway. The number of ministries was reduced significantly, the senate and the vice-presidency were abolished, the rationalization of diplomatic representation abroad has started, and a number of public agencies were closed or merged. Efforts are also made more broadly to reduce the cost of running the government (e.g., use of telephone lines, water, and vehicles). These measures, together with some delay in implementing certain energy investments, are likely to keep the 2012 fiscal deficit below 6 percent of GDP, a welcome development bucking earlier trends. However, such a deficit level still raises financing challenges, which this year will be addressed through high recourse to the regional market and a large loan from France.

MEFP ¶11-12

11. The authorities intend to keep reducing the fiscal deficit in 2013 and the medium term, while addressing the country’s social and development needs. Their fiscal objective, supported by staff, is to reduce the deficit below 5 percent of GDP in 13–14 2013 and below 4 percent by 2015. Reconciling these various objectives will require a significant improvement in public spending efficiency. Staff noted that it would take sustained efforts over several years to deliver lasting results and to make space for critical new programs, such as the recently announced multi-year plan to address floods. This will also require strong political leadership to overcome vested interests as well as good administrative capacity. The authorities acknowledged this and have already taken action in a number of areas. Efforts to reduce the cost of running the government will continue and produce their full impact in 2013 and beyond. A comprehensive streamlining of agencies starting in 2013 is also expected to generate substantial savings in the medium term. Finally, the authorities are working on rationalizing expenditure in key sectors such as education and health (with World Bank assistance) and on more cost-effective support to the most vulnerable segments of the population. In this regard, energy subsidies will be substantially reduced next year and in the medium term.

MEFP ¶13-14

12. Improving the efficiency of the social safety nets is another important objective. Social safety nets remain very limited and as a result the authorities rely to a large extent on food and fuel price subsidies.¹ Staff recognized that these subsidies are easy to implement but they have the major drawback of being poorly targeted, which makes them very costly. Explicit subsidies to electricity consumption, as measured by the annual budgetary transfer to the power utility SENELEC to compensate for the tariff gap, are expected to amount to about CFAF 100 billion in 2012 (1.4 percent of GDP), as last year. Total losses in the electricity sector, which eventually have to be borne by the budget, may even exceed significantly this amount (Annex I). Electricity subsidies exceed public health spending and reduce the scope for priority expenditures. They tend to benefit richer households; the poor, particularly in rural areas, are indeed typically not connected to the electricity grid. For these reasons, the authorities intend to cap electricity subsidies at CFAF 80 billion in 2013, which will require substantial savings based on current projections (about CFAF 45 billion, or 0.6 percent of GDP). Part of the savings would come from efficiency gains at the power utility SENELEC, which will be restructured operationally and financially; there is indeed significant scope for such gains, given that power losses exceed 20 percent of supply. The envisaged savings would also require reconsidering the tariff if oil prices remain high. In parallel, the authorities are working on broader and better-targeted social safety nets to be introduced in 2013.

MEFP ¶15, 27-28

13. Better public financial management (PFM) will improve government efficiency and transparency. The authorities have almost completed the transposition into national law of the WAEMU directives on PFM and are now working on their implementation. A comprehensive audit of agencies is ongoing, and its conclusions will be used to design a restructuring plan in 2013. An audit of the civil service is also ongoing, which will help the authorities control the government payroll. To improve expenditure efficiency, the authorities will start using cost-benefit analysis for larger investment projects included in the 2014 budget, based on the the project evaluation guide they expect to have by end-2012. The completion of the single treasury account, expected by early 2013, will facilitate cash management. Finally, the authorities intend to improve transparency in land operations.

MEFP ¶20-25

14. Strengthened debt management will also contribute to reducing vulnerabilities. Progress was made last year in building capacity with the creation of a public debt directorate combining the two units that had previously managed domestic debt and external debt separately. The new directorate prepared the authorities’ first medium-term debt strategy, which recommends extending the maturity of the debt issued on the regional market–which has a very short average maturity–to reduce rollover risks, as well as continued priority to concessional financing to keep borrowing costs low. Occasional recourse to nonconcessional borrowing would be considered when needed.

MEFP ¶16

B. Moving to Higher, Sustainable, and Inclusive Growth

15. Further poverty reduction requires sustained high growth. Developments in the past two decades suggest that poverty reduction is highly sensitive to growth in Senegal (Annex II). Substantial poverty reduction was achieved when growth was robust (1995–2005). Conversely, lower growth in the recent period has not allowed for significant poverty reduction or increase in living standards. A growth accounting exercise suggests that growth is mostly explained by factor accumulation. Total factor productivity (TFP) has actually declined since 2006 (Annex III).

16. Growth is hampered by a range of obstacles, as clearly shown in the authorities’ new poverty reduction strategy. Among them infrastructure gaps (energy and transportation); access to land and financing and protection of property rights; and inefficiencies in government operations. This includes a range of issues, such as a complex and distortive tax system; the quality of public expenditure; anti-competitive regulations and practices; and lack of transparency. Finally, some sectors with large growth potential (e.g., agriculture, tourism) have performed poorly in recent years.

17. The authorities and staff agreed that improving transport and energy infrastructure was critical for growth prospects. Some of the related challenges are being addressed through a number of large projects, such as the new international airport, which is expected to be completed by 2014, and the toll highway (whose section to Diamniadio is expected to be completed by the summer of 2013). They will help deal with the excessive concentration of economic activity in the Dakar area. A comprehensive reform of the power sector is also critical. With a lack of proper maintenance and delays in making investments, the supply of electricity has become insufficient, unreliable, and costly. This situation culminated in a major power crisis in 2010–11. An emergency plan (“Takkal”) was put in place in 2011, which has allowed a significant reduction of power outages but at a very high cost. Large investments to restore power supply and increase generation capacity with more cost-effective technologies would help lower the cost of doing business, especially in manufacturing.² From this perspective, the strategy on new investments and restructuring SENELEC, the power utility, needs to be finalized and implemented as soon as possible.

MEFP ¶26-28, 32

18. Addressing infrastructure gaps will raise challenges. Based on a general equilibrium model developed by staff, the authorities and the mission discussed the possible impact of different public investment and financing paths on growth and debt sustainability. The results confirm that increased public investment would have a positive impact on growth, but also that the mode of financing matters a lot. Relying exclusively on fiscal adjustment to finance higher public investment looks unrealistic, while relying on nonconcessional borrowing could lead to permanently higher debt ratios and debt sustainability problems. The best option from a growth and debt sustainability perspective is therefore to rely on concessional resources. The model also illustrates the importance of improving the public investment management process to improve investment efficiency (Annex IV and Box 1). Raising TFP through reforms actually seems as high a priority as scaling up public investment at the current juncture.

19. There is significant scope for further improvement in the business climate. Despite the progress made in a number of areas (e.g., creation of a one-stop shop for business registration, easing of administration procedures for exports and imports), Senegal still ranks poorly in the 2013 Doing Business survey (166th out of 183 countries). Reform efforts are especially needed in the areas where Senegal is still lagging well behind comparator countries, such as paying taxes, registering properties, protecting investors, enforcing contracts and dealing with construction permits. A more effective provision of business-friendly public services would contribute to private sector development too.

20. An ambitious reform of the tax and customs system will be a big step in the right direction. A new tax code will enter into force in 2013. The reform aims at establishing a simpler, equitable and efficient tax system. A new customs code will also be implemented in the course of 2013. This, together with ongoing reforms to improve tax and customs administration, should go a long way towards reducing tax distortions and facilitating the payment of taxes and importation by businesses.

MEFP ¶17-19

Box 1.

Impact of Risks on Medium-Term Growth

An alternative scenario explores risks related to insufficient improvement in public expenditure efficiency. Not all investment spending leads to effective capital accumulation. In the model-based simulations described in Appendix V, it is assumed that one dollar in public investment spending increases the capital stock by 70 cents on average, a relatively high ratio by LIC standards. To explore the risk that public investment may not deliver expected growth because of capacity and/or governance problems, an alternative scenario was developed which assumes a much lower ratio (25 cents to the dollar). This assumption is based on the public investment management index, for which Senegal scores 0.94 out of 4. This would reduce long-term annual growth by about one percentage point, i.e., it would correspond to no TFP increase in the growth accounting framework. Such an outcome would make fiscal consolidation more challenging.

Scenario	Act.	Projections
	2011	2012	2013	2014	2015	2016	2017
	Real GDP growth (percent)
PSI baseline	2.6	3.7	4.3	4.8	5.0	5.1	5.2
Lower investment efficiency in 2013-17	2.6	3.7	4.2	4.2	4.1	4.1	4.1
	Fiscal deficit (percent of GDP)
PSI baseline	-6.7	-5.9	-4.9	-4.3	-3.9	-3.7	-3.5
Lower investment efficiency in 2013-17	-6.7	-5.9	-5.5	-4.9	-4.5	-4.3	-4.1

View Table

Scenario	Act.	Projections
	2011	2012	2013	2014	2015	2016	2017
	Real GDP growth (percent)
PSI baseline	2.6	3.7	4.3	4.8	5.0	5.1	5.2
Lower investment efficiency in 2013-17	2.6	3.7	4.2	4.2	4.1	4.1	4.1
	Fiscal deficit (percent of GDP)
PSI baseline	-6.7	-5.9	-4.9	-4.3	-3.9	-3.7	-3.5
Lower investment efficiency in 2013-17	-6.7	-5.9	-5.5	-4.9	-4.5	-4.3	-4.1

Additional downside risks to growth are related to external factors. Exogenous shocks could affect Senegal significantly, with trade, remittances, FDI, the terms of trade, and aid being the main channels of transmission.

• Under a protracted lower global growth scenario (an annual average 1.6 percentage points below the baseline in 2014-16, a 30 percent drop in oil prices after three years and 20 percent lower nonfuel commodity prices), Senegal’s growth in 2015 would be lower by about ½ percentage point.

• Under a sharp downturn in global growth scenario (2 percentage points lower growth in 2013), Senegal’s growth would be lower in 2013 by about 1 percentage point.

21. Staff underscored that with an external environment less supportive than before the global financial crisis, domestic engines of growth will be needed too. The focus of the new development strategy (below) on inclusiveness is welcome and will be critical from this perspective, to ensure that growth dividends are widely shared. Growth relying on capital-intensive natural resource projects is unlikely to create a lot of jobs and benefit the rest of the economy, unless these activities are adequately taxed. Conversely, growth relying on higher farm productivity and broader rural job opportunities is likely to generate additional demand and to lead to faster poverty reduction. Financial sector development should also be an important element of an inclusive growth strategy (below).

22. The authorities’ new poverty reduction strategy addresses many of these points. The National Strategy of Economic and Social Development (NSESD) was finalized in November 2012, after extensive consultations with stakeholders.³ It builds on the experience with previous strategies and articulates policies and reforms around three strategic pillars: (i) boosting economic growth, productivity, and wealth creation; (ii) promoting human capital, social protection and sustainable development; and (iii) strengthening governance, institutions, peace and security. It underscores the importance of achieving development objectives within a stable macroeconomic environment. The NSESD includes three macroeconomic scenarios and their costing, which provide a framework for resources mobilization and expenditures prioritization. Preliminary IMF and World Bank staff analysis suggests that the NSESD provides a good diagnostic of issues to be addressed and constitutes a good framework for poverty reduction in Senegal. Staffs recommend the development of more detailed programs in certain sectors, based where possible on existing strategies, to translate the NSESD into specific action plans. Given the level of financing needs (and the projected financing gaps under the various scenarios), staffs recommend that a particular attention be given to the realism, sequencing, cost and financing of programs, including opportunities for private sector participation. Staffs support the authorities’ plan to link priority actions with the budgetary process and emphasize the need to strengthen budgetary planning through development of a medium-term expenditure framework.

C. Strengthening the Financial Sector and External Stability

23. The financial system in Senegal is dominated by the banking sector.⁴ It is composed of 19 commercial banks operating mostly in the three largest cities and representing about 90 percent of the financial system. The banking sector is relatively concentrated, with foreign banks accounting for a large part of the shareholder base. The five largest banks account for 66 percent of assets and collect 79 percent of deposits. A large number of microfinance institutions (MFIs) supply limited financial services targeting lower income households. While they cover both urban and rural regions, about half of the sector’s activity is concentrated in greater Dakar. More people have accounts at MFIs than at banks; this helps raise overall access to the financial system to about 20 percent of the population. Insurance companies (25) account for most of the remainder of the domestic financial system. The regional securities and equity market is a marginal source of funding, except for the government. The interbank market remains underdeveloped.

24. The banking system appears to be relatively robust, with concentration of lending and quality of assets being the main risks. Stress-tests conducted in recent months by the authorities and Fund staff found that liquidity risks and interest rate risks could be withstood, given that banks are highly liquid and the maturity mismatch between assets and liabilities is rather small. Only the concentration of lending was found to be a major source of vulnerability, as loans are extended to a few sectors and companies, and banks’ exposure to the public sector is large. These findings are corroborated by the usual financial soundness indicators, which suggest that Senegalese banks are on average well capitalized, profitable, and liquid, with asset quality being the main concern.⁵

25. Financial depth has increased in recent years. The ratio of broad money to GDP increased from 36 percent in 2006 to 40 percent in 2011. Credit to the economy is currently almost 30 percent of GDP, higher than in most WAEMU countries; it has increased strongly in recent years but remains largely short-term and directed toward trade and food and fuel imports. A benchmarking exercise suggested that Senegal’s financial system’s development and performance were broadly in line with the country’s structural characteristics. However, a comparison with selected countries (Côte d’Ivoire, Kenya, and Morocco) suggested substantial scope for further deepening. Kenya in particular has overtaken Senegal on a number of indicators over the past five years.

26. The still relatively shallow financial system constrains macroeconomic policies, as well as growth and poverty reduction. Constraints on fiscal policy include, among others, rollover risks, higher fiscal costs, and narrower scope for counter-cyclical policy. Shallowness also limits firms and households’ access to financial services, making it difficult to deal with volatility and hampering private investment. Finally, financing long-term public investment, which is crucial to build adequate infrastructure, is difficult.

27. Micro-prudential regulation of banks could be enhanced and supervision strengthened. Some prudential ratios and rules are not in line with international best practices. Banks’ compliance with prudential rules will also need to improve. Some prudential ratios are indeed missed by a large number of banks. Low compliance may point to the need to reconsider certain ratios, but also suggests a need to strengthen bank supervision. New challenges, such as the need to monitor the rapid development of banking groups in Senegal and more generally the region, also call for strengthened supervision. These issues will need to be addressed at the regional level.

28. Staff also suggested that the authorities develop a holistic view of the financial system and systemic risk. At present, no single entity within Senegal has a comprehensive view of the entire financial system, the interconnection of its various components, and where the potential pockets of systemic risk may lie. Such a function should be developed in Senegal as systemic risk is likely to rise in the coming years, with increasing interconnectedness and diversification of the financial system.

29. There was a broad agreement between the authorities and staff on the main obstacles to further financial development. Many of these obstacles which have been well identified in the past few years are commonly found in low-income countries. They include:

• Informational asymmetries. Lack of information on borrowers, due to the limited size of the formal sector, the limited availability of audited company statements and the absence of credit bureaus (and limited use of existing databases at the central bank), increases adverse selection and moral hazard issues, and ultimately leads to credit rationing. Information asymmetries are also an issue for the development of the interbank market.

• Business and judicial environment. A key issue is the absence of formalized property rights in large parts of the country, which increases the difficulty of using land as collateral in lending. Moreover, the judicial process tends to be costly and slow.

• Tax regime. Taxes and fees on banking and stock exchange operations are relatively high, raising the cost of financial services.

• Regulatory and supervision issues. Some regulatory ratios are perceived as excessively constraining and curbing the development of medium and long-term credit. Also, some ratios are not observed by a number of banks, which may affect the credibility of the regulatory and supervisory framework. Another issue is whether the prudential framework is sufficiently responsive to new needs that are likely to emerge first at the national level, but will eventually need to be regulated at the regional level.

• Skills. The lack of appropriate skills may explain why in recent years some MFIs that moved from dealing with micro-enterprises to dealing with SMEs saw their profitability decrease. Banks may face similar challenges moving from larger enterprises to SMEs. The lack of an ingrained financial culture is also often blamed for the very limited recourse to the stock exchange.

30. The authorities have a strategy to address a number of these issues, whose implementation they intend to accelerate. The national consultation on credit took place in 2010 and led to an action plan with specific measures to improve access to credit for both households and firms (particularly SMEs). These measures are grouped in broad categories covering among others: facilitating the use of guarantees; SME debt and equity financing and general support to SMEs; availability of information; cost of credit; financial intermediation and the judicial environment. Progress was made in some areas, such as registering land titles and information provision. Actions to improve the efficiency of the judicial process, such as the training of judges in economic affairs, are however behind schedule, and so are measures aiming at streamlining and improving public support in favor of SMEs. Staff is of the view that this action plan remains largely relevant and that its implementation should be accelerated. A number of identified obstacles will however need to be addressed at the regional level. The regional authorities are working on the development of the interbank market and the strengthening of the public debt market, which they see as priorities. They also intend to review certain prudential rules. These issues will be discussed in more detail during the next regional consultation in early 2013.

MEFP ¶29–31

31. An external stability assessment suggests that external sector risks are manageable (Annex V). Senegal has recorded continuous current account deficits for nearly two decades. Low savings relative to large investment needs imply continued deficits over the medium term, which could become difficult to finance if aid was to decline. Although export performance has been sluggish, inward FDI has picked up somewhat, and remittances have become an important source of foreign exchange. The real exchange rate is broadly in line with economic fundamentals and reserves are adequate. To reduce external vulnerabilities, Senegal needs to implement prudent fiscal and borrowing policies, increase non-price competitiveness, and reduce further external vulnerabilities.