IMF Executive Board completes Fourth PSI Review for Tanzania and concludes 2016 Article IV Consultation
On July 18, 2016, the Executive Board of the International Monetary Fund (IMF) completed the fourth review of Tanzania’s economic performance under the program supported by the Policy Support Instrument (PSI) and also concluded the 2016 Article IV consultation with Tanzania.
The PSI for Tanzania was approved by the Executive Board on July 16, 2014. Following the Board discussion, Mr. Min Zhu, Deputy Managing Director and Acting Chair, made the following statement:
“Tanzania’s macroeconomic performance has been strong under the Policy Support Instrument. Growth has remained close to 7 percent and inflation is moderate. Most quantitative program targets for end-2015 were met, while progress on structural reforms slowed due to the transition to the new government.
“The macroeconomic outlook is favorable, supported by the authorities’ ambitious development agenda, although risks are tilted to the downside. Sustaining high growth and implementing the development agenda while preserving fiscal and external sustainability will require a range of reforms. Somewhat higher fiscal deficits could be sustained for a few years while keeping a low risk of debt distress. However, creating fiscal space for higher infrastructure investment through sustained efforts to raise domestic revenue and increasing spending efficiency, particularly in public investment, is imperative.
“The implementation of the 2016/17 budget will be a first test of the authorities’ capacity to reconcile these various objectives. Careful prioritization and implementation of expenditures will be required to ensure that spending does not exceed available resources and to avoid domestic arrears accumulation.
“Despite significant progress in recent years, financial development remains low. Further development would support higher growth, as well as improve the overall effectiveness of macroeconomic policy. Beyond credit growth, financial development will require further improving access, particularly for businesses, and reducing high borrowing costs. Further development of the interbank and government debt markets is also desirable.
“Vigorous reforms will be required to foster further structural transformation of the economy. The authorities’ focus on creating a better environment for business and job creation is welcome, like the authorities’ strong drive against corruption. Improving the financial sustainability of the public electricity utility, TANESCO, is critical for the development of the energy sector. Tanzania could also benefit from the completion of the East African Community common market.”
The Executive Board also completed the 2016 Article IV Consultation with Tanzania.
Tanzania has achieved strong growth and macroeconomic stability over the past two decades. This performance was the result of market-oriented reforms and prudent macroeconomic policies. Growth has been driven by construction, services, and basic manufacturing, and the economy has become more diversified. Inflation, while still volatile, has remained moderate. Poverty has decreased but remains high (at 28.2 percent of the population, based on the national poverty line) with a large population of underemployed youth, and despite substantial progress toward the Millennium Development Goals (MDGs), Tanzania is likely to have missed about half the 2015 targets.
Growth has remained strong and inflation moderate in the past two years. Real GDP grew by 7 percent in 2015, with activity particularly buoyant in the construction, communication, finance, and transportation sectors. Inflation remained in single digits throughout 2015, averaging 5.6 percent, despite the significant exchange rate depreciation in the first half of 2015. Inflation in April 2016 was 5.1 percent, close to the authorities’ target of 5 percent. The external position recorded mixed developments. The current account deficit declined from 10.7 percent of GDP in 2013/14 to a projected 8.6 percent in 2015/16, mainly due to lower oil prices. The surpluses in the capital and financial accounts, however, narrowed due to lower donor support and foreign direct investment related to natural gas exploration. International reserve coverage is estimated to have declined somewhat to 3.6 months of prospective imports of goods and services in June 2016. The banking system appears sound overall, but there is wide variation within the system. The level of financial development has improved in recent years, though at a gradual pace.
Implementation of the 2015/16 budget has faced challenges. While the budget was built on ambitious but realistic revenue projections, it still had to be adjusted for external financing shortfalls and to make room for expenditures carried over from 2014/15 and some of the new government’s priorities in education. The revised budget targets a lower overall deficit of about 3.25 percent of GDP (compared with 4.2 percent in the original budget and the program). Available information (on a cash basis) for the first three quarters suggests that this target is well within reach, reflecting a significant slowdown in the execution of capital expenditures. The stock of expenditure arrears decreased during the third quarter of the fiscal year (January-March 2016), reflecting the partial clearance of construction arrears and reversing an increase during the first two quarters.
While macroeconomic management has been able to deliver fiscal sustainability and macroeconomic stability, the quality of fiscal management deteriorated until recently in some areas (e.g., expenditure arrears control) and the pace of reform has abated in recent years. The modernization of monetary policy has made only limited progress in the past two years. The business environment remains challenging and the perception of corruption has increased substantially. As a result, program performance under the PSI has been mixed. The government’s second Five-Year Development Plan (FYDP II), published in June 2016, aims to address these issues. It focuses on economic transformation through industrialization and human development. To facilitate private sector-led growth, the government aims to provide critical infrastructure and create a business environment that is conducive to job creation. The government also aims to reduce poverty by improving social services (education, health, housing, water and sanitation), enhancing income security, and promoting social protection. The plan will start being implemented with the 2016/17 budget.
Growth has remained strong and inflation moderate. Real GDP grew by 7 percent in 2015, with activity particularly buoyant in the construction, communication, finance, and transportation sectors. Inflation remained in single digits throughout 2015, averaging 5.6 percent, despite the significant exchange rate depreciation in the first half of 2015. Inflation in April 2016 was 5.1 percent, close to the authorities’ target of 5 percent.
The external position recorded mixed developments. The current account deficit declined from 10.7 percent of GDP in 2013/14 to a projected 8.6 percent in 2015/16, mainly due to lower oil prices. The capital and financial account surpluses, however, have narrowed, reflecting lower donor support and lower FDI related to natural gas exploration. International reserve coverage has declined somewhat to a projected 3.6 months of imports of goods and services in June 2016, reflecting no accumulation in 2015/16 and the projected large increase in imports in 2016/17. The shilling depreciated sharply against the U.S. dollar in 2014/15 (about 25 percent) and experienced high volatility. While the shilling depreciated a bit further since mid-2015, the situation in the foreign exchange (FX) market has normalized, with improved liquidity and participation by commercial banks. Following the opening of the capital account to East African Community (EAC) investors in 2015, the authorities plan to extend the liberalization to all foreign investors.
Unrealistic budgets and weak commitment controls led to the accumulation of large arrears to suppliers and pension funds in recent years. The overall cash fiscal deficit remained relatively low in 2013/14 and 2014/15, at 3.3 percent of GDP. However, once corrected for significant budget expenditure arrears accumulation, the fiscal deficit actually was in the 4-4.5 percent of GDP range.1 Budget execution in recent years was affected by unrealistically high revenue projections and financing shortfalls, which required inefficient intra-year expenditure adjustment mostly falling on investment. Delays in adjusting the budget and weak commitment controls were key factors behind the accumulation of arrears.
Implementation of the 2015/16 budget has also faced challenges. While the budget was built on ambitious but realistic revenue projections, expenditures still had to be adjusted for external financing shortfalls and to make room for expenditures carried over from 2014/15 and some of the new government’s priorities in education. The revised budget targets a lower overall deficit of about 3¼ percent of GDP (compared with 4.2 percent in the original budget and the program). Available information (on a cash basis) for the first three quarters suggests that this target is well within reach, reflecting a significant slowdown in the execution of capital expenditures. The stock of expenditure arrears decreased during the third quarter of the fiscal year (January-March 2016), reflecting the partial clearance of construction arrears and reversing an increase during the first two quarters.
While central government debt has increased to about 38 percent of GDP, debt vulnerabilities remain limited. This increase reflects both fiscal deficits and the impact of the recent depreciation of the shilling on dollardenominated debt. External borrowing on nonconcessional terms has increased rapidly in recent years, partly to make up for dwindling aid.
Outlook and Risks
The government’s second Five-Year Development Plan (FYDP II) focuses on economic transformation through industrialization and human development. To facilitate private sector-led growth, the new government aims to address the infrastructure gap, which remains large in Tanzania (see table below for a cross-country comparison), and create a business environment that is conducive to job creation. The government also aims to reduce poverty by improving social services (education, health, housing, water and sanitation), enhancing income security, and promoting social protection. The plan will start being implemented with the 2016/17 budget.
The macroeconomic outlook is favorable. Growth is projected to remain strong at about 7 percent in 2016, on the back of low oil prices (a positive shock for Tanzania), continued strong growth in certain sectors (e.g., services) and the scaling up of public investment. For the medium term, in the absence of a detailed quantitative macroeconomic framework for FYDP II at the time of discussions, staff designed a baseline scenario assuming public investment scaling up. Noting that many of the authorities’ priority investments would require several years to be implemented, staff assumed that capital expenditures would remain high over a few years. The investment effort would help keep growth at about 7 percent during that period; growth would then revert to its 15-year average of about 6½ percent. Inflation is expected to remain close to the authority’s medium-term target of 5 percent, provided that the BoT maintains a tight monetary policy stance. The external current account deficit is projected at around 9 percent of GDP in 2016/17 and to remain elevated the medium term, as the implementation of FYDP II would lead to high capital spending and imports.
Risks to the outlook are tilted to the downside. Key external risks include the tightening of global financial conditions, which could result in higher financing costs and/or make external budget financing difficult, and a significant slowdown in China and other large emerging markets, which could affect external demand and the financing of key infrastructure investments and thereby growth (Annex II). Domestic risks include the possibility of fiscal slippages due to spending pressures stemming from FYDP II’s implementation, continued challenges to raise the required revenue and financing for the budget, and in the medium term slow reforms that could affect potential growth.
Discussions revolved around how to sustain high growth and implement the new government’s priorities while preserving fiscal and external sustainability. This will require mobilizing additional domestic revenue, realigning spending priorities, and creating fiscal space for infrastructure investment, as FYDP II aims to do. At the same time, the targeted transformation of the Tanzanian economy requires administrative and institutional reforms to promote credible policy implementation, higher efficiency of public spending, deeper financial intermediation, and an improved business environment.
Raising Public Investment While Mitigating Risks
The draft 2016/17 budget envisages a large increase in public investment and revenue and targets a deficit of about 4.5 percent of GDP. The tax revenue to GDP ratio is expected to increase by about 1 percentage point, through a strengthening of tax administration and tax policy measures. The nontax revenue to GDP ratio would increase by about 1.5 percentage point, owing to higher contributions of parastatals to the budget (including a large one-off transfer on account of retained earnings) and higher efficiency in the collection of various fees. On expenditure, the draft budget proposes a large change of the composition of spending in favor of investment. Current expenditure would be contained through a hiring and nominal wage freeze and efforts to significantly reduce the cost of running the government. Capital expenditures would more than double as a share of GDP, bringing development spending to about 11 percent of GDP in 2016/17.4 The budget sets aside about 1.5 percent of GDP to clear budget expenditure arrears. Higher project financing and external non-concessional borrowing (ENCB) would help finance the investment effort and higher fiscal deficit.
Mobilizing Additional Revenue
Tanzania’s tax revenue, at about 13 percent of GDP in 2015/16, is low by international standards. This reflects to a significant extent poor VAT performance. Staff analysis suggests that the tax revenue gap in Tanzania was about 4 percent of GDP in 2009-13, and assuming an unchanged tax potential would still be about 2-3 percent of GDP presently (Box 1).
Box 1. Tax Revenue Gap in Tanzania
Tanzania’s tax revenue performance lags behind that of comparable countries. Tanzania had a tax-to-GDP ratio of 11.9 percent of GDP in 2011-13, well below the average of EAC countries (13.1 percent of GDP) and that of LICs (14.7 percent of GDP). This reflects to a significant extent poor performance in VAT collection. While EAC countries collected an average of 4.4 percent of GDP in VAT revenue in 2011-13, Tanzania only managed to achieve 3.3 percent of GDP. The VAT revenue underperformance appears to be driven by a low tax productivity associated with administrative inefficiency, low taxpayer compliance, and policy gaps.
The estimation of the tax capacity suggests that there is a considerable scope to raise revenue in the medium term. Using the peer analysis and the frontier approach on a sample of 32 LICs with data during 1994-2013, Tanzania’s tax capacity is estimated at 15-16 percent of GDP in 2009-13, that is about 4 percent of GDP above the average tax revenue ratio during the same period. Assuming an unchanged tax capacity, and in light of the increase in the tax revenue ratio in 2015/16, the gap has been reduced to 2-3 percent of GDP.
Enhancing Public Spending Efficiency
Weak revenue collection has affected the level of expenditure, and spending efficiency has been low in certain sectors. Tanzania’s public expenditure was below the average for LICs in recent years, with the gap being larger for investment spending. As mentioned above, weak commitment controls and unrealistic budgets in recent years have led to intra-year expenditure adjustments affecting investment and arrears accumulation. Staff analysis suggests that Tanzania performs poorly in education and investment spending efficiency while health spending efficiency appears to be in line with the average for LICs (Box 2).
Box 2. Benchmarking and Efficiency of Public Spending in Tanzania
Public spending has broadly stabilized in the recent years and remained below the level of comparator countries. A lackluster revenue performance, combined with declining donor assistance and difficulties in securing external financing, has constrained public spending growth. Further, the need to maintain fiscal discipline in the face of revenue and financing shortfalls led to expenditure cuts that fell disproportionally on capital expenditure, thus weakening the composition of spending. Total public expenditure in Tanzania stood at 19.5 percent of GDP on average in 2010-14, well below the EAC average (24.5 percent of GDP), while capital expenditure was the lowest in the region.
There is a significant room to improve public spending efficiency. The latter was assessed using the data envelopment analysis (DEA) approach on a sample of 34 LICs with data for the period 2010-14. The efficiency score of Tanzania for health spending is estimated at 0.86 close to the sample average, using the health-adjusted life expectancy (HALE) to measure the health outcome. Eliminating remaining inefficiencies (i.e., bringing the score to 1) could raise HALE from 53 to 60 years with the same level of spending. Using school enrollment rates as the education outcome, the efficiency of education spending in Tanzania is about a third lower than in the most efficient LICs. Similarly, Tanzania ranks low in the efficiency of public investment, with the efficiency gap estimated at about a third for overall infrastructure quality.
Reforms to improve the allocation of resources in the health and education sectors and strengthen public investment management institutions would help Tanzania improve public spending efficiency. In the health sector, existing reports highlight the need to align staffing of healthcare centers and the provision of drugs to demand and performance, address the shortage of skilled staff, tackle low productivity of staff and the high degree of absenteeism, and strengthen the information management system to better monitor health indicators and performance of healthcare centers. In the education sector, reducing the large disparities of students to teacher ratios across districts, improving the quality of primary education, and improving teachers’ skills are essential. It is important that spending on tertiary education does not crowd out that of lower education levels, whereas student loans should be better targeted and their repayment enforced. Strengthening public investment management institutions would be critical to improve the selection, appraisal, management and evaluation of projects.
Monetary and Financial Sector Policies: Promoting Growth While Preserving Stability
The financial system in Tanzania is dominated by banks. Financial markets, on the whole, are shallow and less developed though a few markets (the interbank and foreign exchange markets) exhibit greater liquidity and depth. Banks are generally well-capitalized and profitable. However, there is wide variation within the system: a few large banks have shown strong financial performance but other banks, primarily smaller foreign-owned banks and community banks, exhibit low profitability and poor asset quality. State-owned banks also have relatively high non-performing loan (NPL) ratios. Tanzania stands out in its large number of banks (57).
The level of financial development has improved in recent years, though at a gradual pace. A broad measure of financial development suggests that the development of institutions has improved over time but that of markets has lagged. Among institutions, there has been notable improvement in access, particularly for households. The expansion of mobile money and banking is a key driver of this positive development. While nearly two-thirds of adults now have access to formal financial services, the picture for firms is less positive: in the 2013 World Bank enterprise survey, almost 44 percent of firms in Tanzania claimed to face difficulties in accessing finance, the highest proportion in the EAC, with small and medium enterprises facing particularly acute challenges. Further, the level of financial development in Tanzania is lower than might be expected for a country at its current level of income and similar fundamentals, with market development particularly lagging. Finally, financial efficiency is relatively low in Tanzania, with for instance high lending rates.
Improving financial development would likely yield higher growth and greater stability. Based on recent cross-country empirical work done at the IMF, Tanzania stands to benefit substantially from greater financial development. By bringing the level of development up to expected levels given Tanzania’s economic and demographic characteristics, empirical estimates suggest that growth could be higher by up to 1 percent and less volatile.
Improving financial market development in Tanzania would also facilitate macroeconomic policy implementation. The monetary transmission mechanism is weak and seems to have weakened, rather than strengthened, in recent years. There appears to be little correlation between short-term (market) rates and longer-term retail rates, probably reflecting interest rate volatility in the interbank market. The lack of market development also adversely affects fiscal policy by reducing the authorities’ capacity to raise domestic financing at a reasonable cost and run counter-cyclical policies in response to shocks, and raises risks such as rollover risks.
Growth-Enhancing Structural Reforms
The business environment remains challenging. In the 2016 World Bank’s Doing Business survey, Tanzania ranks 139 out of 189 countries and lags behind its regional peers such as Kenya, Rwanda, and Uganda. Getting credit, paying taxes, and trading across borders are mentioned as the biggest issues. The perception of corruption has increased in recent years, while the perception of government effectiveness has decreased. Corruption has directly affected public finances: for instance, corruption at the Port of Dar es Salaam led to significant tax evasion and lower revenue; corruption in the private placement of a bond in 2013 increased financing costs to the government. In addition to the possibility of potential contingent liabilities, the IPTL case and related court proceedings have also likely increased perception of risk by investors. More broadly, corruption has negatively impacted the business climate, with likely negative implications for investment and growth.
Tanzania could become a major producer and exporter of natural gas in the next decade. Recently discovered offshore natural gas, assuming it is exploited, could lead to multibillion dollar foreign investment in the next 5-10 years and make Tanzania one of the largest exporters of natural gas in the region by the mid-2020s. Potentially significant revenue from natural gas (whose size is highly sensitive to a number of parameters, particularly gas prices; see Selected Issues Paper) could play a critical role for the development of Tanzania, if well managed.
The financial sustainability of the public electricity utility, TANESCO, has not been achieved yet, affecting its credibility as an energy purchaser. TANESCO still has a large amount of arrears to gas and electricity suppliers (0.7 percent of GDP in early 2016). A large independent electricity producer (SONGAS) recently decided to shut down partially its operations as a result of TANESCO’s inability to clear its arrears; other investment decisions could also be affected. Despite this context, TANESCO requested a small tariff decrease for the spring of 2016, and a larger one for 2017, anticipating a significant improvement in its financial situation reflecting favorable developments in its production mix.
Reducing External Vulnerability
The external current account deficit is expected to remain high. Tanzania has recorded large current account deficits over the past decade, financed mainly by official flows and FDI. High development and infrastructure needs are expected to continue to lead to large investment-related imports and current account deficits.
Empirical analysis suggests that the exchange rate is broadly in line with fundamentals and desirable policies and that international reserves are adequate. The EBA-lite external sustainability and real exchange rate approaches indicate that the shilling, which was last assessed in 2014 to be somewhat overvalued, is now close to equilibrium (Annex III). The EBA-lite current account approach, however, suggests that Tanzania’s current account deficit is larger than the level consistent with fundamentals and desired policies, implying some overvaluation. This model, however, does not seem to capture well Tanzania’s situation (including substantial imports financed by FDI), as indicated by a very large residual. Moreover, the shilling has not been under significant pressure since mid-2015. According to traditional metrics and a cost-benefit analysis, Tanzania’s reserves at about 3.6 months of imports at end-June 2016 are adequate.