On September 1, 2017, the Executive Board of the International Monetary Fund concluded the Article IV consultation with the Kingdom of Swaziland.

Since the 2010 fiscal crisis, Swaziland has experienced a period of macroeconomic stability and recovery. A rebound in South African Customs Union (SACU) revenues, expansionary policies and the peg to the South African rand have contributed to the rebuilding of buffers and supported a growth recovery. Yet, despite its middle-income status, structural impediments have hindered private investment and kept unemployment high, contributing to persistently elevated poverty and income inequality.

Macroeconomic conditions have recently deteriorated. In 2016, two shocks – a prolonged drought and a sharp decline in SACU receipts – severely hit the economy, while an expansionary fiscal policy worsened fiscal and external balances. Growth in 2016 stagnated, as agricultural productions declined, and headline inflation increased sharply, mostly due to rising food prices. Government’s policy of increasing public expenditure, while SACU revenues declined, widened the FY16/17 deficit to about 10½ percent of GDP. Public debt rose and domestic arrears accumulated, while the current account deteriorated and international reserve coverage declined below 3 months of imports. The economic slowdown and government’s domestic arrears have started having adverse effects on the banking sector’s asset quality, with non-performing loans (NPLs) rising.

Fiscal policy remains on an expansionary course, while the monetary stance has tightened. Despite a pickup in SACU revenue, the 2017 budget envisages a continuation of large fiscal deficits, and further increase in public debt. In the context of the peg to the South African rand, in early 2017 the Central Bank of Swaziland raised its policy rate above South African Reserve Bank’s rate.

The outlook is fragile, with an unsustainable fiscal policy. Growth is projected to pick up in 2017 due to the end of the drought and increasing SACU revenue, and turn negative thereafter as fiscal and external positions weaken. The large fiscal deficit would contribute to further reduce international reserves and bring public debt above sustainability thresholds.

Downside risks dominate the outlook. The main risk stems from further tightening in budget financing. Additional risks arise from deteriorating banks’ asset quality, lower SACU revenue and demand for key exports. With a fragile outlook, the materialization of risks could trigger abrupt fiscal adjustment. Linkages between domestic financial institutions and the government could further amplify the negative impact of shocks on the economy.

---

Staff report

Context: High vulnerability and limited buffers

Swaziland is a small middle-income economy particularly exposed to external shocks and with significant structural challenges. After a sharp decline in revenue from the South African Customs Union (SACU) in 2010 that prompted a fiscal crisis, revenue bounced back, fiscal and external balances improved, and buffers were rebuilt. The peg to the South African rand contributed to moderate inflation, and growth recovered. However, growth has been low compared to the pre-crisis period and other middle-income countries. The current account remains heavily dependent on SACU revenue and exports concentrated on a few products. More recently, an expansionary fiscal policy has depleted buffers, leaving international reserve coverage below adequate levels and prompting a rapid increase in public debt. Moreover, despite its middle-income status, Swaziland faces widespread poverty and a high HIV prevalence rate. Unemployment remains high and little responsive to growth, contributing to elevated income inequality.

In 2016, a prolonged drought and a sharp decline in SACU revenue severely hit the economy.

• Real GDP stagnated (1.1 percent in 2015) as agriculture and hydro-power production declined because of the drought, with negative effects on other sectors of the economy. Declining private demand largely offset the impact of an expansionary fiscal policy.

• The decline in SACU transfers (about 4¼ percent of GDP), coupled with strong demand for imports and lower exports (particularly for agricultural products), reduced the current account surplus to ¾ percent of GDP (10.8 percent of GDP in 2015). On the positive side, the net international investment position improved somewhat, although mainly reflecting short-term trade credit assets. However, other buffers have thinned, and end-year international reserve coverage declined to below 3 months of projected imports. More recently, reserve coverage has fallen further to 2.6 months of imports (May 2017).

Government’s policy of increasing public expenditure, against declining SACU revenue, widened the fiscal deficit and created budget financing shortfalls. The FY16/17 deficit widened to 10½ percent of GDP (4.6 percent in FY15/16) as SACU revenue declined and, on the spending side, a salary review increased wage costs and transfers and capital outlays reached the highest level since 2010, largely undoing the adjustment achieved during the 2010 fiscal crisis. Gross financing needs increased to 21¾ percent of GDP. The government increasingly tapped domestic markets and, in addition, resorted to central bank financing and accumulated domestic arrears (about 5⅓ percent of GDP at end March 2017). While still relatively low, public debt jumped to 25⅓ percent of GDP (from 18.7 percent), including domestic arrears. Against these developments, market pressures intensified, resulting in declining coverage ratios and rising yields for government securities.

Economic slowdown and government’s financing shortfalls have started adversely affecting the banking sector. Since 2012, credit growth to the private sector has averaged 11½ percent, but decelerated to 7½ percent in 2016 as corporate lending growth turned negative. However, credit to households for mortgages and durables remained buoyant, contributing to increase household indebtedness. At the same time, banks’ asset quality deteriorated, with NPL rising rapidly and exceeding 10 percent of total loans (end-March 2017). As government’s financing needs increased, banks’ direct exposure to the public sector rose and holdings of government securities reached about 11 percent of banks’ assets.

Aware of the long-term challenges, authorities have adopted plans to boost growth and foster social and economic transformation, but results have been mixed. In the context of their 2022 vision, authorities have increased public investment, and deployed incentives to boost private investment and economic diversification. However, the impact of these initiatives has been limited, particularly on private investment, employment and economic diversification. On the positive side, macroeconomic stability has been maintained. However, implementation of recent staff’s advice has been uneven, especially in the fiscal area, and new challenges are rising.

Policy discussions

Swaziland’s key challenge is to preserve macroeconomic stability against low SACU revenue and make inroads in reducing poverty and income inequality. With an expansionary fiscal policy contributing to an unsustainable outlook and external and financial vulnerabilities, discussions focused on the need for: (i) fiscal adjustment to bring the fiscal deficit in line with available financing, contain public debt dynamics and preserve external buffers; (ii) managing risks from fiscal and financial sector linkages and the large non-bank financial sector; and (iii) advancing structural reforms to generate sufficient growth and jobs to reduce poverty and inequality.

---

Selected Issues paper

I. The economic impact of fiscal vulnerabilities: A balance sheet approach

Government’s balance sheet vulnerabilities have been rapidly rising, becoming a potential source of macro-financial risks for the economy. Banks and nonbank financial institutions, businesses and households have large exposures to the government and, in some cases, their own vulnerabilities. In this context, a fiscal shock can rapidly propagate into the economy through the financial sector. The financial sector is also likely to amplify the impact of shocks on the economy, possibly opening the way to deep recession. In the case of an extreme shock with difficulties in servicing debt, the banking system capitalization would be significantly hit. Staff analysis highlights the need for fiscal consolidation and for strengthening the CBS’s role in monitoring and managing macro-financial risks.

Since 2015, the government’s balance sheet, liquidity, and risk exposures have been rapidly deteriorating, raising concerns about the impact on other sectors of the economy. As in many countries, the government in Swaziland is a major economic player with strong linkages with both the financial (banks and non-bank financial institutions) and nonfinancial sectors (businesses and households). As the government’s balance sheet deteriorates, all exposures to the government become a potential source of vulnerabilities for the sectors linked to the government and for the whole economy. Relying on the balance sheet analysis (BSA), this paper examines the nature of balance sheet vulnerabilities the government in Swaziland faces, and how fiscal shocks could transmit through the economy via balance sheet linkages and affect other economic sectors.

II. Investment, employment, and inclusive growth in Swaziland

Since 2010, growth in Swaziland has been sluggish and private investment declining, while unemployment remained high and employment has been little responsive to growth.

• Sluggish growth and declining investment rates. Growth performance over the last decade has been held back by a negative contribution to growth by capital formation, which has been associated with a decline in the private investment to GDP ratio. Despite a recent increase in public investment, overall investment has declined from 16.7 percent of GDP in 2000 to 8 percent of GDP in 2015.

• High unemployment and employment little responsive to growth. Over the last few years, the unemployment rate has remained persistently high at around 28 percent of the labor force, and higher than in other lower-middle income countries (the regional estimated unemployment rate is 5.3 percent). In addition, despite growth recovered in the post-2010 crisis, employment has changed little, making it unresponsive to growth and signaling a possible structural phenomenon. Staff analysis confirms the limited inclusiveness of growth in Swaziland.

Promoting growth and employment are critical developmental priorities for Swaziland. They are essential to address the high poverty rate (63 percent of the population lives in poverty) and income inequality (one of the highest in the world). Acknowledging these priorities, authorities have developed and have been implementing an Investor Roadmap (2005), and a post-2010 crisis Economy Recovery Strategy (2011), and have established a Swaziland Investment Promotion Authority (SIPA) to attract and promote domestic and foreign investment.

What Explains Low Private Investment and Responsiveness of Employment to Growth?

International comparisons suggest that specific structural impediments are limiting both private investment and the responsiveness of employment to growth. Three factors seem to play a role.

a) Skill Mismatches

Swaziland has very high skills mismatches in the labor market, which are usually associated with poor employment and investment performance. Following Estevao and Tsounta (2011), we construct, with some adjustments due to data availability, a skill mismatch index for 139 countries. According to the index, Swaziland has one of the highest skills mismatch index in the world, ranking 136th out of 139 countries. One possible source of such mismatch can be found in lower educational attainments particularly at the secondary and tertiary level compared to other lower middle income countries, i.e., there is a relatively low supply of skilled labor force in Swaziland. Past studies have shown that high skill mismatches are typically associated with higher unemployment rates. Moreover, a gap between occupational skills needed in given industries and those available in the labor force is likely to affect firms’ decision to invest as industries might find difficult to grow without an adequately skilled labor force.

b) Disconnection Between Wage and Productivity Trends

Disconnection between wages and productivity dynamics is hurting investment and keeping unemployment rates high. Swaziland has a large gap between wage dynamics and productivity trends. In particular, given the prominence of the public sector in the economy, fast increasing public wages generally drive private sector wages, generating a gap with productivity. Cross-country analysis suggests that this gap is associated with both high unemployment and low private investment rates. Previous studies find that real wages growth above labor productivity trends can contribute to keep unemployment rates high. At the same time, rising labor costs hurt firms’ profitability, which negatively affects investment decisions and new investments as well as competitiveness, thus discouraging foreign investment. Cross-country correlations for lower-middle income countries show that in general the gap between wages and productivity is associated to lower investment and higher unemployment.

c) Rigidities in the Business Environment

Swaziland presents several weaknesses in the business environment that can potentially limit job creation and investment. Swaziland’s ranking in the Global Competitiveness indicators has recently worsened, and in the 2015-2016 period the country ranked 128th out of 140 economies. Swaziland ranks clearly below the average of middleincome countries in legal contract enforcement (it attains 1.59 compared to an average of 4.1 points, on a 1-10 scale), higher education and training (3.1 against an average of 3.9 points, on a 1-7 scale), and the business impact of HIV (with an index of 2.1 compared to an average of 5, on a scale 1-7 with high indicating less negative impact) given the very high HIV prevalence in the country. This highlights areas that affect competitiveness where there is significant room for improvement. that improved quality of the business and institutional environments is associated to better growth and employment performance.

Dividends from Structural Reforms

Staff analysis suggests that lower skills mismatches and better connection between wages and productivity have the potential to increase private investment. Following IMF (2015), estimating an investment accelerator model for middle income countries during 2005-2014 suggests that skill mismatches are negatively correlated to investment and better connection between wages and productivity is positively associated to investment. In addition, more flexible frameworks in determining wages (a measure of labor market rigidities) support higher investment. There are indications that business environment indicators, such as protection of property rights are positively related to investment.

Swaziland may benefit from implementing structural reforms that boost private investment, and strengthen the nexus between employment and growth. Structural measures aiming to reduce skills mismatches by improving educational outcomes in the population, aligning wage growth with productivity, strengthening institutions, and reducing rigidities in the business environment seem to be at the forefront of private sector development, boosting investment and sustainable job creation.