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IMF Executive Board concludes 2016 Article IV Consultation with Namibia

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IMF Executive Board concludes 2016 Article IV Consultation with Namibia

IMF Executive Board concludes 2016 Article IV Consultation with Namibia
Photo credit: Ministry of Finance

On December 2, 2016, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Namibia.

Since the financial crisis, Namibia has experienced remarkable growth and economic progress. Strong policy frameworks and expansionary domestic policies have contributed to macroeconomic stability, robust growth, and rising living standards. Yet, deep-rooted structural impediments have kept unemployment high and unresponsive to growth, contributing to persistently high inequality.

In 2015, growth remained strong, but vulnerabilities increased. Despite a severe drought, real GDP grew by 5.3 percent buoyed by construction in the mining and housing sectors, and expansionary fiscal policy. However, with strong domestic demand and declining Southern African Customs Union (SACU) revenue, the current account registered a double-digit deficit. In combination, the large fiscal deficit, the depreciation of the Namibian dollar along with the South African rand, to which it is pegged, and the issuance of a Eurobond in November 2015 increased public debt to about 40 percent of GDP, close to the median of similarly-rated emerging economies. At the same time, continued rapid credit growth contributed to fast growing residential real estate prices and elevated household indebtedness. Headline inflation rose to 6.9 percent in September, from the 3.4 average in 2015, mostly due to rising food prices caused by the drought.

Fiscal and monetary policies are on a tightening course. The government has revised the FY16/17 budget and announced the intention to reduce the fiscal deficit in the coming years. In the context of the peg with the South African rand, the Bank of Namibia raised its policy rate in 2015 and in 2016 to 7 percent, at par with the South African Reserve Bank’s rate.

The outlook remains positive with considerable vulnerabilities and risks. Growth is projected to temporarily weaken in 2016 to 1.6 percent as the construction of large mines ends and the government starts consolidating; it would then accelerate to about 5 percent in 2017-18 as production from new mines ramps up. However, without further deficit reduction, public debt is projected to increase above 60 percent by 2021. On the positive side, the current account deficit is expected to narrow to around 5 percent of GDP on the back of larger mining exports. Inflation is anticipated to decline to 6 percent by 2017 as food prices normalize.

Downside risks dominate the outlook and stem mainly from possible further declines in SACU revenues and commodity prices, lower growth in mining and construction, and sudden corrections in housing prices and domestic credit. With limited buffers, shocks could be amplified by abrupt policy responses, especially if combined with sovereign credit rating downgrades. Linkages between banks and non-bank financial institutions could further amplify shocks.


Staff Report

Context: Robust growth with growing vulnerabilities

Since the financial crisis, Namibia has experienced robust growth and resilience to shocks, but vulnerabilities have been building up while unemployment remains high. Despite being a small commodity-dependent economy exposed to external shocks, since 2010, average annual real GDP growth exceeded 5 percent. The peg to the South African rand contributed to moderate inflation. However, four years of expansionary fiscal policy have led to a sharp increase in public debt. The current account deficit has widened, and the international reserve coverage has declined below safe levels. At the same time, strong credit growth and supply constraints have contributed to fast-growing housing prices and high household indebtedness. Yet, unemployment remains high and little responsive to growth, contributing to maintain high income inequality, second only to South Africa.

In 2015, growth remained strong, but external and fiscal vulnerabilities gained prominence.

  • Despite a severe drought, real GDP grew by 5.3 percent (6.5 percent in 2014) buoyed by construction in the mining and housing sectors, and expansionary fiscal policy. Strong public consumption and investment underpinned growth. Accommodative monetary conditions contributed to further boost bank credit and domestic demand. The economy, however, decelerated in the first half of 2016, with real GDP contracting in 2016Q2 as growth in construction and government services slowed down.

  • Strong domestic demand and declining SACU transfers widened the current account deficit to 13.7 percent of GDP (7.6 percent in 2014). On the positive side, the 2015 Eurobond issuance improved reserve coverage to 2.8 months of projected imports (Annex I). However, other external buffers have thinned: external debt increased to about 51 percent of GDP (42¾ percent in 2014); external gross financing needs rose to 31 percent of GDP, well above the average of past years; and, the net international investment position, while still positive, declined to 4 percent of GDP from 15 percent in 2014. Moreover, since December 2015, reserve coverage has fallen, to 2.2 months of imports (August 2016).

  • Expansionary fiscal policy caused the fiscal deficit to widen to an estimated 10.2 percent of GDP as subsidies and capital spending increased and SACU revenue declined. The large deficit, combined with the issuance of the 2015 Eurobond and currency depreciation (because of the peg to the South African rand), led public debt to jump to 39.8 percent of GDP (from 25.5 percent), above the authorities’ threshold of 35 percent of GDP and the median of similarly rated emerging market economies. The expansionary fiscal stance also increased government’s gross financing needs, covered in part by the Eurobond and in part by purchases of government securities by domestic financial institutions. These developments led to pressure on sovereign credit ratings, with Fitch revising Namibia’s ratings outlook from stable to negative in September 2016.

Domestic demand has been partly fueled by strong credit growth that has contributed to fast-rising housing prices and high household indebtedness. Since 2010, credit growth to the private sector averaged 13¾ percent (13.8 in 2015), although slowed down in early 2016 (Figure 5). Corporate lending and mortgage loans, particularly to households, drove credit growth and supported rising housing prices that over the period increased on average by 14 percent. At the same time, household indebtedness reached about 90 percent of disposable income in 2015 (81 percent in 2013), higher than in South Africa and close to the level of advanced economies.

Against this background, monetary and fiscal policy have recently turned on a tightening course. After averaging 3.4 percent in 2015, in 2016 headline inflation started rising and reached 6.9 percent in September, mostly due to higher food prices reflecting the drought, and increases in rental costs and administrative prices. In the context of the peg to the South African rand, the Bank of Namibia (BoN) raised the policy rate, both in 2015 and 2016, to reach 7 percent on par with the South Africa Reserve Bank (SARB)’s rate. In addition, with the FY16/17 budget (March 2016) and mid-year revised budget, the government started implementing spending reductions and announced medium-term fiscal consolidation plans to bring public debt on a declining path.

Acknowledging long-term challenges, the government elected in 2015 has devised plans to boost growth and increase employment, while preserving macroeconomic stability. In the context of their 2030 vision, authorities are articulating a new national development plan (NDP), and implementing industrial policies to support labor-intensive sectors. However, the impact of some past initiatives, including tax incentives, has been limited, particularly on job creation and economic diversification, and a review is ongoing. At the same time, macroeconomic stability has been maintained, with the latest economic policies broadly reflecting recent Fund’s advice.

Outlook and Risks

The economy will slow down in 2016 and vulnerabilities are rising. As the construction of large mines comes to an end and the government starts consolidating, real GDP growth is foreseen to slow temporarily to 1.6 percent in 2016. Inflation is expected to decline to 6 percent only by end-2017 as food prices normalize. Growth is projected to accelerate to above 5 percent in 2017-2018, as production from the new Husab uranium mine ramps up, before converging to a long-term rate of about 4 percent. However, because of low SACU revenue over the medium-term, future fiscal deficits are expected to remain large and public debt to increase to above 60 percent of GDP by 2021. Financing the government would require significant shifts in asset allocations of domestic financial institutions, possibly crowding out private sector credit. On the positive side, larger mining exports and tighter domestic policies would halve the trade deficit to about 12⅓ percent of GDP, with the current account deficit stabilizing at around 5 percent of GDP. In this context, SACU transfers and capital and financial flows will continue playing a key stabilizing role in the Namibian economy and in financing future trade deficits.

Risks to the outlook are tilted to the downside. The main external risks to the Namibian economy arise from further commodity price declines as China rebalancing proceeds, accelerated fall in SACU revenue as the South African economy continues to slow, and lower demand for exports and domestic services as growth in the European trade partners and Angola remains sluggish. Domestic risks are equally prominent and weigh heavily on the outlook, especially from slower growth in the mining and construction sectors, sudden correction in overvalued housing prices and domestic credit, and possible funding risks from the government’s large financing needs and slower fiscal adjustment.

The limited buffers could potentially force abrupt policy responses that would amplify the adverse impact of shocks. Should risks materialize, exports and growth would decrease, creating further pressure on fiscal and external accounts, and international reserves. Given the limited buffers, shocks could prompt an abrupt fiscal adjustment that would exacerbate the negative short-term impact on the economy, as the effects of appropriate fiscal and structural reforms would take time to materialize (Annex II). The impact would be particularly damaging if accompanied by downgrades of the sovereign credit rating, which could prompt further increases in interest rates for both the public and private sector. In addition, sharp reversals in housing prices, coupled with elevated household indebtedness, could negatively affect financial intermediation through a deterioration in banks’ asset quality and profitability, and in turn growth.

Policy Discussions

Namibia’s key challenges are to preserve macroeconomic stability and make inroads in reducing high unemployment and income inequality. With recent expansionary fiscal policy contributing to rising public debt and external vulnerabilities, discussions focused on the need for: (i) anchoring additional fiscal adjustment in a credible medium-term plan that minimizes the negative impact on growth; (ii) managing risks from overvalued housing prices and the large non-bank financial sector; and (iii) advancing structural reforms to generate sufficient jobs to reduce unemployment and inequality.

Annex I. External Sector Assessment

External Sector Imbalances and Long-Term Vulnerabilities

Since 2006, Namibia’s current account (CA) balance has been constantly deteriorating, raising the possibility that structural vulnerabilities are building up. Following stable surpluses in the first half of the 2000s, the CA balance turned negative in 2009 and reached a deficit of 13.7 percent in 2015. The deterioration has been mainly driven by a widening trade deficit (25 percent of GDP in 2015), despite a REER depreciation, only partially offset by higher SACU transfers that have smoothed the impact on the current account. The larger CA deficits have been largely financed by increased FDI and lower portfolio outflows.

The recent CA deterioration is explained mainly by changes in volumes with price variations playing a minor role. With the Namibian economy recovering fast from the global financial crisis, over 2012-15 import volumes grew on average 7 percentage points faster than export volumes, contributing negatively to the CA. Changes in terms of trade (on average 1 percent per year) and in other non-trade flows played only a minor role, with the exception of 2012 when SACU transfers temporarily increased absorbing part of the trade deficit.

On average, fast-growing private investment and declining public savings have underpinned the CA deterioration. While there are significant fluctuations across years, the widening CA deficit has been driven by a rapid increase in private investment (rising on average 0.9 percentage points of GDP per year over 2010-15), particularly in 2012 and 2014. However, at the same time, public savings have on average declined by 1.3 percentage points of GDP per year, reaching a lower point in 2015, as the fiscal deficit peaked.

A sizable component of the trade deficit appears to be structural rather than cyclical, suggesting that CA deficits should be expected in the future. Different methods can be used to isolate the structural and cyclical components, including the Hodrick-Prescott (HP) and the Baxter-King’s Band-Pass (BP) filters, and informed identification of one-off imports (e.g., machinery, fuel) related to the construction of new large mines, and other cyclical components.

All these methods suggest that in 2015 the structural component of the CA deficit was about 8½ percent of GDP, comparable to the CA norm estimated under the IMF’s EBA-lite CA model (see below). In this context, SACU transfers and financial flows will continue to play a key stabilizing role in the Namibian economy to finance future trade deficits.


Selected Issues

Calibrating “growth-friendly” fiscal consolidation in Namibia

The authorities in Namibia have embraced ambitious fiscal consolidation plans, and the key challenge is to minimize the negative effects on growth. Depending on the size, pace and composition, fiscal consolidation can negatively affect growth both in the short and long term. In the short term, consolidation reduces domestic demand and, depending on short-term multipliers, growth. Fiscal consolidation could also introduce or exacerbate distortions and negatively affect potential growth. Minimizing the negative impact of consolidation on growth is especially important in Namibia where unemployment is close to 30 percent (with more than 40 percent of youth unemployed), and income inequality is the second highest in the world.

This paper assesses the impact on growth of alternative fiscal consolidation strategies using model simulations. With the 2016-2018 Medium-Term Fiscal Framework (March 2016), the authorities embraced a three-year fiscal consolidation plan, focusing on reducing current expenditure and containing capital spending growth. Additional consolidation efforts for FY16/17 were envisaged in the 2016 Mid-Year Budget Review. However, recent macroeconomic projections suggest that an additional cumulative adjustment of about 5 percent of GDP is needed to put public debt on a declining path and secure sustainability. Given the significant size of the additional adjustment, two issues are important for growth: the pace and the composition of the adjustment. This paper assumes that the additional adjustment is equally split over the next three fiscal years, and focuses on how to design the composition of the correction to minimize the impact on growth.

To gain insights on what would be a growth-friendly composition of the fiscal adjustment, the paper relies on the DIGNAR model developed at the IMF (Debt, Investment, Growth and Natural Resources). The model is calibrated to reflect the main features of the Namibian economy. DIGNAR is a dynamic general equilibrium macroeconomic framework that encompasses a set of policy variables. On the revenue side, it includes changes in income and consumption taxes. On the expenditure side, it includes changes on current expenses and capital spending. Moreover, the model allows assessing the impact of fiscal structural reforms of revenue administration and public investment management.

Alternative Fiscal Consolidation Options

Three alternative fiscal consolidation scenarios are considered given the baseline. The baseline reflects measures already announced in the 2016 Medium-Term Fiscal Framework for the period 2016/17-2018/19, and recent revisions to the FY16/17 budget. These measures focus on: reducing non-wage expenditures in real terms, and containing the growth rate of government investment (with suspension of several capital projects in FY16/17), with very limited changes on the revenue side. However, as the macroeconomic outlook has deteriorated, despite consolidation plans, public debt would be non-sustainable. In line with Fund’s advice, about 5 percent of GDP in additional measures is needed over the next three years to bring public debt on a declining path. This paper considers three possible strategies (scenarios) to achieve such an adjustment:

  • Scenario 1: Expenditure-based consolidation. This strategy foresees an additional permanent reduction in current expenses by 1.7 percent of GDP per year over the period FY17/18-FY19/20.

  • Scenario 2: Revenue and expenditure-based consolidation. This “balanced” strategy achieves the same fiscal adjustment as in scenario 1 (1.7 percent of GDP adjustment per year over three year), but assumes that a quarter of the adjustment is achieved by increasing indirect taxation. In this context, the additional benefits from improving tax collection efficiency are also considered.

  • Scenario 3: Investment-friendly consolidation. This strategy follows scenario 2, and, in addition, assumes a change in the composition of expenditures. In particular, the strategy entails an additional one-percent-of-GDP reduction in current expenses to finance a corresponding increase in public investment. In this context, the growth benefits of structural reforms in public investment management are also considered.

Growth Impact of Alternative Consolidation Plans

Additional consolidation through spending reductions (scenario 1) is expected to have substantial cumulative negative effects on growth. Under this scenario, public debt would decline and reach about 43 percent of GDP by 2021/22. However, over the three-year consolidation period, the cumulated negative effects on growth is almost 1.2 percent, relative to the baseline scenario (Figure 1, red lines). The effect of adjustment on growth is partly contained by the significant openness of the economy, with large shares of imports in government purchases, and the assumption that spending reductions occur in unproductive current expenditures.

A combined strategy of revenue and expenditure measures (scenario 2) has lower negative effects on growth than a pure expenditure-based adjustment. Combined revenueexpenditure measures would result a public debt path similar to scenario 1. However, the negative impact on growth, relative to the baseline scenario, is smaller than under scenario 1. This result is mainly due to the combined effect of two factors: (i) the increase in revenue is attained through increasing consumption taxes, characterized by a lower distortionary impact than income taxation; and (ii) the model includes a significant share of financially-constrained agents, who are “hand-tomouth” and do not increase savings in response to the increase in taxes.

Improving revenue administration has the potential to limit further the negative impact on growth. Revenue administration in Namibia has substantial room for improvement (see IMF, 2016). We consider the impact of improving tax collection efficiency to achieve a one percent of GDP increase in tax revenues. In the DIGNAR model, better collection efficiency is assumed not to have substitution effects for saving and labor decisions (only income effects), thus allowing to reduce the overall spending adjustment at limited macroeconomic costs. In this context, an adjustment that includes improvements in tax collection efficiency has in general smaller negative effects on GDP. In the case of scenario 2, it would reduce the cumulative growth loss by a fifth to less than 0.8 percent, compared to the case with no revenue efficiency gains.

The investment-friendly consolidation strategy (scenario 3) is the most pro-growth adjustment strategy of all. In the DIGNAR model, public investment feeds into the accumulation of public capital, which in turn is assumed to raise the productivity of private factors, thus boosting overall growth. As a result, freeing resources to increase capital spending can yield significantly improved growth paths. Starting with scenario 2, increasing investment by one percent of GDP (financed through lower current expenditures) is estimated to mitigate the growth effects of adjustment to around 0.4 percent over 2017/18-2019/20. In addition, as public capital accumulates over time, the differences in the growth impact between the two scenarios widen over the medium term and by 2021, the cumulated growth effect for scenario 3 is positive and one percentage points higher than under the combined revenue and expenditure consolidation strategy. Better growth outcomes also benefit the fiscal performance, with improvements, albeit small, in the public debt ratio path.

Structural reforms improving the efficiency of public investment can further reduce the negative effect of consolidation on growth, and potentially strengthen growth. Not every dollar of capital expenditures usually translates into a one-dollar increase in productive public capital. Structural reforms improving project design, selection, implementation and governance can, therefore, significantly reduce wastes and enhance the quality of public infrastructure. This means that a greater fraction of investment expenditures turns into productive public capital.

Overall, minimizing the negative impact of fiscal consolidation on growth requires to combine revenue and expenditure measures, together with fiscal structural reforms. Although multipliers in Namibia seem to be low, the needed additional fiscal adjustment to bring public debt on a declining path can have significant cumulative effects on growth. To minimize these effects, combining reductions in current expenditure with increases in indirect taxes appears to be the best strategy because such a combination better exploits the relative low distortionary impact of indirect taxation on investment and labor decisions, and allows to sustain essential public services. Even better growth outcomes can be attained if this strategy is accompanied by: (i) a change in the expenditure composition in favor of public investment, (ii) structural reforms in public finance management that raise the level of investment efficiency, and (iii) reforms improving tax collection efficiency. In fact, unlike current expenditures, public investment increases the stock of public capital in the economy, which in turn raises the productivity of private factors for production. A greater investment efficiency translates into a larger part of each dollar of investment expenditures being effectively turned into public capital. Finally, improving the tax collection efficiency, by enlarging the tax base, raises government revenues and ease pressures on public debt, allowing the government to set tax rates at a relatively lower level.

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