1. The Executive Board, in July 2012, approved a three-year arrangement under the Extended Credit Facility (ECF) in support of São Tomé and Príncipe’s economic reform program. Important macroeconomic gains were made in the first year and a half of the program. However, by 2014, the program went off track due to a number of factors, including lower than projected prospects for oil production, a challenging external environment, delays in introducing measures due to the general elections in October of 2014, and the contraction of an external loan with a level of concessionality below the threshold of 50 percent stipulated under the program.

2. Following the general elections which was won by a strong majority of the main opposition party, the new government that was formed has expressed its commitment to pursue the reforms started earlier to address the economic and financial challenges facing São Tomé and Príncipe and put the economy on a strong growth path while also addressing the issue of poverty.

3. The authorities consider that corrective measures cannot realistically be implemented before the expiration of the current Arrangement in July 2015. Therefore, they have decided to cancel the existing ECF arrangement and request a new three-year ECF arrangement to support their medium-term economic reform program. The new ECF supported program is expected to address the priorities of the new government, notably in the social sectors, while consolidating the gains achieved thus far. It will also play a critical role in catalyzing support from the donors’ community.

Recent Economic Developments and Performance under the ECF Arrangement

4. The economy of São Tomé and Príncipe is highly vulnerable to developments in the global economy. While macroeconomic performance has been positive since 2012, it has not been sufficiently strong and diversified to improve economic prospects and reduce poverty significantly. Real GDP growth averaged 4.5 percent during the period 2012-14, but has been less than envisaged in the ECF program because of the challenging external environment and less favorable prospects for oil production. However, in 2015, economic activity appears to be picking up fueled by higher than anticipated increase in foreign direct investment, the launching of new donor-financed projects, and improved performance in the tourism sector. Helped by the exchange rate peg to the euro since 2010, inflation has fallen significantly from 16 percent to 6.5 percent in March 2015, the lowest 12-month rate in two decades.

5. In the fiscal area, the authorities continued their efforts to improve the domestic primary deficit which reached 0.8 percent of GDP in 2013. However, in 2014, it increased again to 3.4 percent of GDP as a result of revenue underperformance and expenditures overruns. Despite the authorities’ efforts, Government arrears have accumulated on a net basis since 2012. The authorities are concerned about the arrears and have taken steps to make progress in the resolution of cross arrears among the Treasury, the oil importing enterprise and the state electricity company. In this regard, they have put together a ministerial team in April 2015 to audit and confirm claims by creditors, and they have developed a comprehensive plan to clear the outstanding stock of arrears over the next five years. This plan was a prior action for the new ECF supported program.

6. In the monetary sector, the growth of monetary aggregates continues to be in line with the requirements of maintaining the exchange rate peg arrangements. Bank credit to the private sector, after a boom in 2010–12, started to contract in 2013 as a result of the over-indebtedness of the business sector and households, rising non-performing loans (NPLs) and the lack of bankable projects.

7. In line with the weaker economic activity, the external current account deficit declined to 30.3 percent of GDP in 2012–14, but the trade deficit remained at about 37.4 percent despite the encouraging growth in cocoa exports. The Central Bank’s international reserves remained at a comfortable level of 3.8 months of imports cover at end-March 2015.

8. The financial sector has been adversely impacted in recent years by loose credit stance and weak enforcement of prudential standards during the oil prospects boom years of 2010–12. NPLs increased to 18 percent in 2014 and the Central Bank had to intervene in two banks.

9. The performance of the ECF-supported program approved in 2012 has been mixed. While all of the 2013 quantitative targets performance criteria were met, and the first two reviews concluded as scheduled, there were slippages and delays in program implementation in 2014, notably as regards fiscal targets and structural reforms. Also, the contracting in March 2014 of a loan to finance public investment projects which did not meet the level of concessionality required under the program delayed subsequent reviews and resulted in a loss of momentum.

Medium term Policy and Reform Agenda

10. The authorities are committed to pursue their efforts to achieve macroeconomic stability, sustainable economic growth and poverty reduction as formulated in the National Poverty Reduction Strategy Paper (PRSP-II) covering the period 2012–16, and the Program of the Constitutional Government of São Tomé and Príncipe approved in 2014. The PRSP-II, whose coverage ends in 2016, will be updated so that both documents continue to serve as reference for the 2015–18 economic and financial policies.

Fiscal policy and debt sustainability

11. The authorities will continue to rely on a cautious non-oil baseline scenario. The 2015 budget was developed with this concern and aims at restoring the thrust of the previous program’s fiscal stance by redressing the budgetary slippages incurred in 2014. In this regard, the authorities have focused on addressing poor tax collection, rising personnel costs and the net increase in arrears.

12. A primary deficit of 2.7 percent of GDP will be targeted in 2015 and will be further reduced to 1.5 percent by 2018. To achieve these outcomes, the authorities are mindful of the need to improve tax administration and enhance revenue mobilization. In this regard, tax revenues are targeted at 15 percent of GDP in 2015 and the Government will seek to raise them by a cumulative 1.5 percent to 16.5 percent by 2018. The authorities have adopted a comprehensive plan to resolve the problem of cross-arrears, and its implementation should also yield additional customs revenue from the oil importing company ENCO. Other measures envisaged to further expand the tax base are the survey of tax payers which should yield 16,000 new taxpayers and the introduction of the VAT during the program period for which the technical assistance of the Fund will be requested.

13. On the expenditures side, the authorities intend to scale back personnel costs to their historical average of 8.5 percent of GDP over the program period. To this effect, they envisage to take measures in 2015 which will reduce personnel costs by 0.3 percent of GDP relative to 2014. Spending on goods and services which has been compressed in recent years will be capped at 3.2 percent of GDP. The authorities are committed to make progress in the social sectors and will therefore increase and safeguard social spending by aligning the budget with the objectives of the PRSP-II. To this end, they will continue to improve and modernize public financial management notably by making operational the information management system SAFEe.

14. With regards to financing, the authorities intend to gather budget support to step up public investment and social programs at a donor’s conference to be co-organized with the UNDP in September 2015. However, they will boost the development of the domestic Treasury bill market which could provide contingency resources if delays or shortfalls occur in donor financing.

15. Concerning external borrowing, the government will continue to pursue policies consistent with debt sustainability while implementing its public investment program. The authorities’ plans make room for some additional concessional borrowing of an average of 6.6 percent of GDP annually during the program with a grant element of 35 percent. This borrowing option is consistent with the debt sustainability analysis and does not significantly change the debt sustainability dynamics. The authorities will also strengthen debt management capacity which will be essential for achieving the debt reduction objective under the program. In this regard, the medium-term debt management strategy is being updated and reporting and debt service forecasts improved. Prospective new loans will be carefully assessed in terms of their impact on debt sustainability prior to their contracting.

Monetary policy and financial sector reforms.

16. The authorities will continue to anchor their monetary policy to the fixed peg between the Dobra and the Euro. This policy stance has succeeded in significantly reducing inflation, maintaining a stable exchange rate and an adequate level of international reserves. In order to reverse the fall in credit to the private sector experienced previously, the Central Bank intends to reduce the minimum required reserves on local currency deposits. The Central Bank has introduced an interbank money market and open market operations with the aim to effectively manage the growing excess liquidity in the banking system. It will also establish a deposit standing facility to this effect.

17. Our authorities are mindful that a sound and more inclusive financial sector is paramount for strengthening the resilience of the economy to shocks and achieving sustainable growth. In this regard, they will introduce measures to safeguard financial stability based on an analysis of the causes of past due amounts and NPLs on banks’ balance sheets. A comprehensive strategy will be developed with Fund TA to address these issues.

18. With respect to the regulatory and supervisory framework, the authorities will continue to focus on reinforcing compliance with prudential requirements. In this context, the Central Bank intervened in January 2015 in a bank that failed to meet the minimum requirements and directed three other banks to raise their capital above the minimum required to operate a bank. It has also achieved the process of on-site inspection of all banks as of May 2015. Moreover, the authorities have drafted a new Bank Resolution Law with the assistance of the Fund, which will be submitted to the National Assembly by end-September 2015. A comprehensive plan to help banks deal with high NPLs on their balance sheet will also be implemented by 2016.

19. The Central Bank will continue to strengthen its oversight of all commercial banks. A detailed assessment of banks’ compliance with Basel Core Principles is expected to be carried out by end-December 2016 and Fund TA will be requested for that purpose. Furthermore, the mandate of the Central Bank will be enhanced through a revision of the Central Banking and Financial Institutions Law which will be submitted to the National Assembly by end-December 2015.

The business environment and private sector development.

20. Our authorities recognize the need to continue improving the business climate in order to increase the export base and diversify the economy. They will seek to implement reforms aimed at greater trade facilitation, simplified payment of taxes and reduction of administrative requirements. In this regard, the authorities made an important progress in 2014 by establishing a one-stop-shop for foreign trade which will help exporters’ efforts to access foreign markets. To further increase the economy’s external competiveness, they will develop and submit to the National Assembly by end 2016, a national export diversification strategy and action plan targeting the sectors in which the country has the greatest potential. The implementation of such a plan will entail significant investments in infrastructure notably for the port, airport, roads, and energy to spur growth and the structural transformation of the economy. The authorities will continue to work with the IMF and other partners on creating a window for non concessional borrowing while preserving debt sustainability.

21. Furthermore, they will aim at providing stronger property and investor rights by addressing challenges in the judiciary system, notably the enforcement of collateral. To facilitate easier access to credit, the credit reference bureau will be revamped with the Central Bank investing additional human and infrastructure resources to extend its coverage and enhance its usage. Measures will also be taken to enforce the reporting of relevant, accurate, complete and timely information to the credit bureau by financial institutions.

Conclusion

22. Our São Toméan authorities are requesting a new ECF arrangement which will consolidate their efforts to pursue sound macroeconomic policies, strengthen and diversify the economy. They are committed to implement prudent fiscal and monetary policies and continue to strengthen debt management. In support of their efforts, they are requesting Fund assistance under an ECF arrangement. We would appreciate Directors’ favorable consideration of our authorities’ request.