1. On behalf of the Zambian authorities, we thank staff for frank and productive consultations and a thorough and incisive set of papers. The authorities had wide-ranging discussions with staff, which helped pinpoint the main challenges and inform the policy agenda going forward, and they appreciate the continuing engagement with the Fund. The authorities broadly agree with staff’s assessment of the Zambian economy, although they have a more optimistic view on growth prospects, as well as some important qualifications to convey to the Board regarding the policy mix and creating buffers to external shocks. The following elaborates on some of these qualifications and provides further information on some recent developments.

Recent developments, risks and outlook

2. After almost a decade of robust growth and macroeconomic stability, the Zambian economy is facing increased challenges. The authorities and staff agree that the positive outcome over the past decade was a result of both domestic and external factors. In particular, the authorities’ prudent macroeconomic management and strong reforms were supported by exogenous factors, such as the sustained period of favorable copper prices and improved investor sentiments, which helped increase FDI. Over the past year, the weight of exogenous factors on fiscal efforts was evident when international commodity prices and the strengthening dollar exerted increasing pressure not only on external sector performance, but also on debt sustainability, inflation, mining production levels, and the pace of fiscal consolidation.

3. While the Zambian authorities consider the staff report balanced overall, they believe that it underplays the role of global economic developments in 2014, and their impact on fiscal performance in 2015. In this regard, the authorities underscore the potential for a more favorable scenario for 2015, given the signs of a more favorable external environment and the new mining taxation regime, which together with steadfast implementation of reforms to improve the business environment will reinvigorate investor confidence, raise copper production in the near future and boost growth more generally.

The fiscal stance and the overall policy mix

4. The authorities remain committed to fiscal sustainability and have taken measures to contain the fiscal deficit in 2015. Specifically, the authorities are undertaking measures to close the K18.0 billion deficit, which include the sale of maize stocks by FRA, a reduction of spending on goods and services, which has already been approved by Cabinet and the deferral of capital spending, and full cost recovery in fuel pump prices, which should be achieved by July 2015, following a first increase on May 13, 2015.

5. On taxation, while cognizant of the need to strengthen revenue mobilization, the Zambian authorities emphasize the need to be mindful of the political economy and the often cited issue of policy consistency. The authorities are of the view that there is limited scope to raise taxes in the near-term, and it would be difficult to do so midway through the year. Regarding VAT refunds, the authorities are actively working to eliminate the backlogs caused by the tightening of documentation requirements, including through a streamlining of administrative procedures.

6. Regarding the overall policy mix, the Zambian authorities are faced with the challenge of tightening fiscal policy, while promoting growth and creating space for priority infrastructure and social spending, in an unfavorable global climate. In recent months, the policy response has relied more on monetary policy, given the need to avoid excessive volatility in the kwacha, after the rapid depreciation in the first quarter of 2015. However, the authorities remain committed to implementing the fiscal adjustment measures discussed with staff, and to continue rebalancing the policy mix and rebuilding fiscal buffers. They consider these measures critical to build resilience against heightened vulnerabilities.

7. As regards financing, staff has expressed some concern about external borrowing. However, given the limited size of the domestic capital market, the higher cost of domestic borrowing, and the need to crowd-in the private sector, the Zambian authorities consider that external financing will need to remain among the financing options.

Mining tax regime

8. The direct contribution of the mining sector to government revenues (royalties, corporate income tax) has increased with higher copper production and prices, although it remains low, at just over 2 percent of GDP to government revenue, while the sector accounts for 30 percent of GDP. With increasing copper production, higher sector value-added and prices, the expectations for a higher contribution have risen, which prompted the government to introduce changes to the mining fiscal regime in the 2015 budget. From a system comprising a uniform royalty rate (6 percent), corporate income tax and a variable income tax, the regime was switched to a royalty only system, with differentiated rates for underground mines (8 percent) and open cast mines (20 percent).

9. The change to a royalty only regime would have provided a more predictable source of income, and raised total revenue by an estimated 1 percent of GDP. However, the introduction of the regime coincided with falling commodity prices, resulting in a greater burden on the mining sector and risks to growth that could not have been anticipated. The announcement of the regime led to suspension of investment plans in some mines, while others were placed in “care and maintenance” status.

10. The authorities recognize that the new regime, which will take effect in July, will have negative implications for this year’s budget, but they also note that, over the medium-term, the regime should attract greater investment in the sector and boost copper production. The decision in April to readjust the regime was largely motivated by concerns about growth in the face of these adverse external developments. Cabinet has approved the revision of the tax structure and the Income Tax Act will be duly amended.

Monetary policy and the removal of interest rate caps

11. As regards monetary and exchange rate policies, the Zambian authorities remain committed to maintaining exchange rate flexibility. They also intend to continue rebuilding international reserves to reach at least four months of import coverage in the medium term. In addition, the Bank of Zambia recently tightened monetary policy to reduce the liquidity constraints in the banking system and stabilize the currency. The Bank of Zambia stands ready to tighten monetary policy further, should circumstances warrant. Following the introduction of a policy rate in 2012, the authorities are continuing to build the structures necessary for a successful transition from reserve money targeting to using the policy rate for monetary purposes.

12. The Zambian authorities agree with staff that interest rate caps on commercial bank lending may have become a binding constraint on credit to SMEs, given rising treasury bill rates. The authorities are actively working with the World Bank to complete analytical work to inform the policy direction.

Reducing external vulnerabilities

13. It is clear that Zambia is facing significant external challenges following the recent period of declining copper prices and production, which underscores the need to strengthen buffers to cushion the economy against external shocks. The authorities agree with staff on the assessment of the challenges. They also agree that the planned fiscal adjustment will play an important role in relieving pressure on the current account balance, as will exchange rate flexibility. As mentioned above, clarity on mining tax regime will help attract FDI and portfolio inflows and support reserve build-up. There will be a need to diversify the export base, including by alleviating supply side constraints related to infrastructure, quality of goods and other factors. This is an area where there is scope for further collaboration with the Fund and Bank.

14. Regarding the exchange rate, the staff report concludes that the kwacha is over-valued, which suggests that further depreciation would be needed. While the authorities welcome staff’s attention to using a broader set of indicators for the exchange assessment, they consider that given the divergence with the ERER assessment and the uncertainties about data quality and methodology, the interpretation of the EBA-Lite results may warrant greater caution.

Conclusion

15. I could not conclude without reiterating the strong commitment of the Zambian authorities to prudent fiscal and monetary policies, sustained debt management practices and deeper structural reforms to boost competitiveness, promote inclusive growth and accelerate poverty reduction.