On January 29, 2016, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Kingdom of Lesotho, and considered and endorsed the staff appraisal on a lapse-of-time basis.

Real GDP growth averaged about 4.5 percent a year from 2010 to 2014, before dipping to an estimated 2.6 percent in 2015, mainly reflecting recent weaknesses in the manufacturing and construction sectors and spillovers from slower growth in neighboring South Africa. At the same time, unemployment rates have remained high, especially among the youth, and the incidence of poverty is virtually unchanged from a decade ago. Most health, education, and social indicators have shown little or no improvement, even with considerable government spending in these areas (about 30 percent of GDP a year). Looking ahead, real GDP growth is projected to remain about 2.5-3.0 percent in 2016, but could be lower depending on the severity of the current drought. Inflation is expected to remain moderate at around 5-6 percent, despite rising food prices and the recent depreciation of the South African rand.

Overall Government expenditures remain comparatively high. Government expenditures have amounted to about 60 percent of GDP or more in recent years, with spending becoming increasingly slanted toward recurrent expenditures. The government wage bill rose to 21.5 percent of GDP in 2014/153 – the highest in sub-Saharan Africa – and is budgeted to increase to 23 percent of GDP in the current fiscal year. Lesotho relies heavily on revenues from the Southern African Customs Union (SACU) for government financing, but these revenues have been highly volatile. After a sharp drop in 2010/11-2011/12, SACU revenues rebounded to an average of about 29 percent of GDP a year over the following three years. The rebound in SACU revenues contributed to Lesotho’s recovery from a severe fiscal crisis and supported the rebuilding of fiscal and external buffers, with official international reserves reaching 6.3 months of imports by end-March 2015. However, SACU revenues have fallen once again. After slipping to R 6.6 billion (about 26 percent of GDP) this year, Lesotho’s allocation will drop sharply to R 4.5 billion (about 16 percent of GDP) in 2016/17, with much of this decline expected to be long-lasting.

Lesotho’s current business environment has weakened, partly because of political difficulties around the collapse of the country’s first coalition government in 2014. Despite early elections in February 2015 and a smooth transition to a new coalition government, tensions have persisted. Implementation of Lesotho’s National Strategic Development Plan (NSDP) has stalled in this environment and investment has slowed. Also, some development partners have dampened their economic support.

Executive Board Assessment

In concluding the 2015 Article IV consultation with the Kingdom of Lesotho, Executive Directors endorsed staff’s appraisal, as follows:

Lesotho achieved solid economic growth for several years with only moderate inflation. In recent years, the authorities were able to rebuild fiscal buffers and international reserves, largely due to a temporary rebound in SACU revenues. However, there has been little progress in the fight against poverty and unemployment, despite considerable spending on social sectors and transfers.

Lesotho faces a challenging economic outlook. The imminent sharp drop in SACU revenues could threaten macroeconomic stability, unless a major fiscal adjustment is implemented. While existing buffers provide a cushion to allow an orderly adjustment over the next 2-3 years, it is critical that the authorities take a substantial first step in the upcoming fiscal year to ensure credibility. Containing recurrent expenditures – most importantly, the extraordinarily large government wage bill – should be central to the adjustment effort. In addition, social protection can be better targeted toward the most vulnerable. The measures that the authorities intend to include in the 2016/17 budget would indeed make a significant contribution toward fiscal adjustment.

Reforms to strengthen public service administration and public financial management are urgently needed, not only for a successful fiscal adjustment, but to also improve the delivery of government services. A lack of basic controls – such as the inability to fully reconcile government bank accounts on a regular basis – contributes to severe government inefficiencies. Staff urges the authorities to make good use of extensive technical assistance currently available to build capacity in critical management areas.

To achieve greater inclusiveness, the private sector needs to step up job creation. Implementation of the National Strategic Development Plan, which provides a viable approach for transitioning from government dependence to private sector led growth over the longer term – particularly in sectors with potential for high employment – needs to be restarted. In the near term, to quickly stimulate job growth, measures could be taken to eliminate unnecessary obstacles and bottlenecks to doing business. Continued implementation of the Financial Sector Development Strategy would improve access to credit and financial services.

To ensure financial stability, building capacity for bank and nonbank supervision and coordinating on cross-border supervision need to be continued. While indicators point to a generally sound financial system, the authorities need to remain vigilant regarding weak individual institutions and financial linkages to sectors that would be affected by fiscal adjustment.

The loti’s parity with the South African rand has served Lesotho well by supporting macroeconomic stability and integrating the economy with the region. It is critical that an adequate level of international reserves is maintained to ensure this exchange rate regime.

Looking ahead, a rules-based approach to fiscal policy could strengthen fiscal discipline and better manage volatile revenues. Building up the institutional PFM framework, including robust medium-term planning and budgeting, is a necessary first step toward this goal.