Republic of Madagascar: Selected Issues
Author: International Monetary Fund. African Dept.
Publication Date:
30 Jan 2015
eISBN:
9781498353069
Language:
English
Keywords:
ISCR; CR; Madagascar; pass-through; price; les Contrats; representative tax; VAT threshold; terms of trade; lump-sum tax; Current account; Mining sector; Current account balance; Real exchange rates
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In recent years, the IMF has released a growing number of reports and other documents covering economic and financial developments and trends in member countries. Each report, prepared by a staff team after discussions with government officials, is published at the option of the member country.

Abstract

In recent years, the IMF has released a growing number of reports and other documents covering economic and financial developments and trends in member countries. Each report, prepared by a staff team after discussions with government officials, is published at the option of the member country.

Summary of the Tax System

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Source: Ministry of Finance and Budget, IMF (2007) and Deloitte Africa Tax Guide 2013.

Special Tax Regimes/Provisions

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Exchange Rate Assessment1

In recent years, Madagascar has experienced considerable volatility in balance of payment flows. This volatility was driven by large-scale investment in mining projects and by the economic instability stemming from the recent crisis. This makes it difficult to make a definitive assessment of Madagascar’s external stability and competitiveness. While the exchange rate models do not give clear assessment on valuation, a broader range of evidence highlights competitiveness weaknesses.

A. Background

1. Madagascar operates a floating exchange rate regime, but at times has accumulated or sold foreign exchange reserves in order to stabilize the exchange rate in response to volatile balance of payment flows. Recent years have witnessed considerable changes to the structure of Madagascar’s balance of payments. In 2007, two world class mining investment projects began construction. This led to a widening of the current account deficit as these companies imported capital goods and raw materials. This period was also associated with a spike in the price of energy and food - two major import components. The rising current account deficit was largely financed by FDI and private debt inflows. At the same time, donor flows declined abruptly following the political crisis in 2008. On balance, however, these capital inflows dominated current outflows, and the authorities were able to build foreign exchange reserves, which peaked at 4 months of import cover at end-2010 (Figure 1). This period was also associated with a large appreciation of the REER, which rose 18 percent from 2008 to mid-2013.

Figure 1:
Figure 1:

Exchange Rates and Reserves

Citation: IMF Staff Country Reports 2015, 025; 10.5089/9781498353069.002.A003

Sources: IMF staff calculations.

2. From 2012 onwards, capital inflows declined markedly as the construction phase of the mining projects ended, which put pressure on the balance of payments. The central bank also sold foreign exchange to fuel importers at preferential exchange rates in 2012 and 2013. As a result, reserves declined significantly and now stand at around 2 months of import cover. The gradual resumption of donor flows in 2014 has led to some stabilization, and the authorities have not actively intervened in the foreign exchange market since May 2014. However, the foreign exchange market has become illiquid while banks are holding large deposits in foreign currency.

B. Exchange Rate Assessment Models

3. In order to assess Madagascar’s REER against fundamentals, three standard models–the macro-balance approach; the external stability approach; and the equilibrium real exchange rate approach–are each applied in turn.

The Macroeconomic Balance Approach

4. The macroeconomic balance (MB) approach focuses on the current account balance. It compares Madagascar’s actual balance with that of a model-predicted result, designed to reflect the saving-investment decisions in the economy. If the actual and model predicted values are close, this suggests the current account largely reflects underlying fundamentals. If they are divergent, this may be evidence of external imbalances, implying the need for a real exchange rate adjustment. Two related model variants are used in this MB approach–the Consultative Group on Exchange Rate (CGER)2 based toolkit and a variation of the External Balance Assessment (EBA)3 model, which is referred to here as ‘EBA-Lite’. Both use reduced form equations with the current account as the dependent variable, and a number of explanatory variables designed to capture the saving and investment decisions of the economy. The IMF is currently transitioning from the CGER-based toolkit to the EBA-Lite model, but for consistency and comprehensiveness, both results are reported.

5. The CGER-based model gives ambiguous results. The CGER-based version of the MB approach seeks to determine the ‘current account norm’ for Madagascar over the medium-term—a horizon over which domestic and partner-country output gaps are closed and the lagged effects of past exchange rate changes are fully realized. Figure 2 shows that the current account norm is slightly less than the actual level realized in 2013, implying a slight overvaluation of the exchange rate. Using a trade elasticity of -0.4, a REER depreciation of 1 percent would close the gap. Under current forecasts, the model implied current account deficit grows to 6.1 percent of GDP. This is partly driven by a return to more normal growth rates, but mainly because fiscal balances in the rest of the world are expected to tighten relative to Madagascar. This implies a REER appreciation of 5 percent would be enough to close the gap by 2019.

Figure 2:
Figure 2:

Current Account Balance Decomposition (CGER)

(Percent of GDP)

Citation: IMF Staff Country Reports 2015, 025; 10.5089/9781498353069.002.A003

Sources: IMF staff calculations.

6. The EBA-Lite methodology builds on the CGER-based model in three main regards. First, the analysis concentrates on present day fundamentals, rather than a medium term perspective, by controlling for cyclical factors. Second, it differentiates between factors under the control of the authorities (‘policy’ variables) and structural factors. Third, it has wider country coverage and a better model fit (although it has larger confidence intervals).

7. The EBA-Lite methodology predicts that Madagascar should have a current account balance of -4.1 percent of GDP, compared to the actual level of -5.6 percent. This would require a 3.6 percent depreciation to close this gap. The decomposition (Figure 3) of this estimate shows that the large decline in reserves in 2013 played an important role in maintaining this deficit. Projections for 2014 and onwards suggest that this ‘policy variable’ will not be as large. The decomposition also shows that demographic factors, in particular Madagascar’s relatively young population, boost saving and hence raise the current account norm. However, while this may be the case in many advanced and emerging markets, it is not clear that this relationship would hold for low-income countries where subsistence consumption (virtually all income is consumed) is more prevalent. Stripping out the theoretically ambiguous demographics factors gives a current account norm of -5.5, which is closer to the actual. A REER depreciation of 0.2 percent would close this gap.

Figure 3:
Figure 3:

Current Account Balance Decomposition (EBA-Lite)

(Percent of GDP)

Citation: IMF Staff Country Reports 2015, 025; 10.5089/9781498353069.002.A003

Source: IMF staff calculations.1/ This is attributed to policies which differ from ‘desirable’ levels. The effect here is small as the impact from selling reserves cancels out the effect of an overly tight fiscal policy.2/ Includes: relative productivity; oil and natural gas trade balance; projected GDP growth; safer institutional/ political environment index; the output gap and the commodities terms of trade.

The External Stability Approach

8. The external stability approach compares the current account balance to a country’s net foreign asset (NFA) position. It determines what level of balance would stabilize the NFA position at its current level, using the following equation:

CAs=g+π(1+g)(1+π)⁢NFAs(1)

where: CAs – stabilizing level of the current account balance;

  • g – estimated steady state growth rate of GDP;

  • π – estimated steady state deflator;

  • NFAs – initial NFA position which is stabilized.

9. The NFA ratio in 2013 is estimated to be -48 percent of GDP, implying that a current account of around 3 percent is required to stabilize this ratio. Table 1 summarizes the assumptions for Madagascar. This suggests a relatively large gap with the 2013 level, with an implied required REER depreciation of 5 percent. This analysis, however, assumes that the current NFA is equal to Madagascar’s ‘steady-state’. In practice, a low-income country such a Madagascar may find it optimal to borrow and invest at present in order to boost growth and reduce poverty in the future. An alternative experiment, therefore, might be to consider where the NFA position would stabilize assuming that the current account remains at current levels. Using Equation 1, the implied NFA position for Madagascar would be -81 percent of GDP. This is arguably too high a level for a low income country, so should be viewed as an upper bound.

Table 1:

Debt Stabilizing Current Account

(Percent)

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Sources: IMF staff caculations.

The Equilibrium Real Exchange Rate Approach

10. In contrast to the previous two methods, the equilibrium real exchange rate (ERER) approach focuses directly on the exchange rate as the dependant variable, instead of the current account. It is a reduced form model (based on the CGER-toolkit), which includes five key explanatory variables–terms of trade, productivity, government consumption, initial NFA and remittances. The baseline ERER model suggests a fairly significant currency overvaluation of around 17 percent. This result is driven in large part by Madagascar’s relatively weak productivity vis-à-vis the rest of the world. The model results are, however, sensitive to structural breaks in the data. The large-scale mining investments, which began in 2008, subsequently caused a significant shift in the composition of Madagascar’s exports and private capital flows. If this potential structural break is controlled for, the model-implied overvaluation falls to a more modest 2.5 percent (Figure 4).

Figure 4.
Figure 4.

EER Fair Value Estimates

(Index)

Citation: IMF Staff Country Reports 2015, 025; 10.5089/9781498353069.002.A003

Source: IMF staff estimates.

C. Survey Measures of Competitiveness

11. There has been a deterioration in survey measures of competitiveness over the last few years. While it is difficult to make a direct assessment of how these structural factors may affect the equilibrium exchange rate, they can be useful in identifying bottlenecks in trade and foreign investment, which have an important bearing on external equilibrium. The World Bank Doing Business Report ranks Madagascar 163rd out of 189 countries in the overall index for 2014, a deterioration from 157 the year before (Table 2). The World Economic Forum’s Global Competitiveness Index also shows deterioration in recent years. Since 2007, Madagascar’s rank has declined from 111 to 130 according to this measure (Figure 5). The deterioration in surveys of competitiveness is consistent with the apparent deterioration of the REER.

Table 2A.

Doing Business Indicators for Madagascar

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Source: World Bank.
Figure 5.
Figure 5.

Competitiveness Indicators

Citation: IMF Staff Country Reports 2015, 025; 10.5089/9781498353069.002.A003

Source: World Bank, World Economic Forum.

1

Prepared by Alex Pienkowski.

2

This uses a similar methodology to the official CGER analysis outlined here Exchange Rate Assessments: CGER Methodologies

3

The model uses a similar framework to the External Balance Assessment, but for a wider sample of countries. See External Balance Assessment (EBA): Technical Background of the Pilot Methodology for more details on the original model.

Other IMF Content

Other Publishers

Cover IMF Staff Country Reports
Republic of Madagascar: Selected Issues
Author: International Monetary Fund. African Dept.
Volume/Issue:
Volume 2015: Issue 025
Publisher:
International Monetary Fund
ISBN:
9781498353069
ISSN:
1934-7685
Pages:
64
DOI:
https://doi.org/10.5089/9781498353069.002

Exchange Rates and Reserves

Current Account Balance Decomposition (CGER)

(Percent of GDP)

Current Account Balance Decomposition (EBA-Lite)

(Percent of GDP)

EER Fair Value Estimates

(Index)

Competitiveness Indicators