On February 14, 2018, the Executive Board of the International Monetary Fund concluded the Article IV consultation with the Kingdom of Lesotho.

While Lesotho has grown faster than its regional peers over the last decade, partly driven by capital intensive mining and infrastructure projects, high levels of unemployment, poverty, and inequality persist. GDP growth is expected to be around 3 percent in FY 2017/18, below the average of 4.1 percent for the past decade, and driven by mining and agriculture. Over the next three years, GDP growth is expected to be led by mining and construction related to the Lesotho Highlands Water Project Phase II.

An expansionary fiscal stance has shielded the economy from external shocks recently, but at the cost of shrinking buffers. A steep decline in Southern African Customs Union (SACU) transfers, a major source of government revenue, will result in a fiscal deficit that is likely to exceed 6 percent of GDP for the second year. The government is financing the deficit by using its deposits at the Central Bank of Lesotho (CBL), causing a sharp drop in the CBL’s international reserves. The drop in reserves is compounded by weaker remittances and demand for exports, particularly from South Africa.

With SACU revenues only expected to recover in FY 2020/21 in line with the cyclical upswing in South Africa, the outlook is fragile. Addressing the fiscal and external challenges remains difficult in an environment of high inequality and weak institutions. While tax revenues are already relatively high, there is scope for expenditure measures, including by reducing the very high public wage bill. However, efforts by the authorities to stabilize the political environment, including by implementing the recommendations of the Southern African Development Community (SADC), should contribute to macroeconomic stability.

The banking system is generally sound, but its impact on growth is limited and formal financial access remains low. While further work will be necessary to reduce the high levels of household debt, banks’ capitalization and liquidity are sufficient to weather major shocks. Rapid growth in the mobile money sector has brought a welcome increase in financial inclusion levels. Speedy implementation of the new supervision framework for the non-bank financial sector has the potential to further strengthen stability. Improvements to financial access and oversight would complement private sector development efforts, which are critical to reduce inequality. The new government’s focus on promoting more labor-intensive sectors such as agriculture and tourism and reducing red tape to open a business also could help stimulate the demand for labor.

---

Staff Report

Context: High vulnerabilities amidst political fragility

Economic performance in Lesotho is subject to spillover-driven volatility. Customs revenues, which are pooled at the Southern African Customs Union (SACU) level, are dominated by South Africa’s import demand. Thus, Lesotho’s fiscal revenues are subject to considerable external volatility. In addition, South Africa’s economic conditions directly affect remittances. Lesotho’s exports are concentrated (diamonds, textiles, and water), further increasing volatility.

In addition to these economic vulnerabilities, Lesotho has been suffering for decades from political fragility and military interference in politics. In 2017, Lesotho elected a new, four party coalition government – the third government in five years. Ambitious political reforms initiated by the new government are guided by Southern African Development Community (SADC) reform recommendations after the 2014 attempted military coup. They aim at addressing human rights violations, but also to mitigate political instability through constitutional reforms. However, political fragility persists as evidenced in the recent killing of the army commander by officers. In response, several SADC member countries deployed military to Lesotho at the government’s request.

Political fragility has complicated much-needed reform efforts to make growth broad-based and inclusive. Strong growth of 4.1 percent on average over the past decade has not made inroads into unemployment, and poverty remains stubbornly high. At 23 percent, the HIV/AIDS rate is among the highest in the world.

Expansionary fiscal policy shielded the economy from a large SACU revenue shortfall (around 7 percent of GDP compared to the FY 2014/15 peak), but with buffers dwindling quickly, severe vulnerabilities developed:

• Real growth for the last three years averaged 3 percent, driven by textile manufacturing, which benefitted from the Rand/dollar depreciation, and more recently, by a strong recovery of agriculture after the severe droughts of 2015 and 2016.

• Inflation peaked at 6.2 percent in March 2017, mainly on higher food prices after the droughts.

• The drop in SACU revenues, lower remittances, and weaker demand for Lesotho’s exports are responsible for the widening of the current account deficit to 7.4 percent of GDP in FY 2016/17 from under 5 percent of GDP the previous fiscal year. The international reserves to import coverage has been declining from its 6-month peak in March 2016 to around 4 months by March 2017, reflecting spillovers from South Africa, the depreciation of CBL’s Rand holdings, and the expansionary fiscal stance. The external position remains broadly in line with medium-term fundamentals and desirable policies (Annex IV).

• The government responded to the SACU shortfall by allowing the fiscal deficit to increase. Lower-than-expected domestic revenues in the first half of FY 2017/18 added to the revenue shortfall. The fiscal deficit of around 6 percent of GDP for two consecutive years was financed by drawing down sizable buffers in form of government deposits at the CBL, which has been mirrored in the loss of international reserves. Measures in the FY 2017/18 budget to contain the wage bill – one of the highest in the world  – were broadly offset by higher recurrent spending to implement a campaign promise to raise old-age pension.

Outlook and Risks

The SACU revenue shortfall is projected to deepen further over the next two years, confronting the new government with large adjustment needs as buffers have already been used aggressively. Reserve coverage is projected to drop to 3.6 months of imports by the end of the current fiscal year, compared to an optimal reserve level of around 4½ to 5 months. While SACU revenue projections are subject to a large margin of error beyond FY 2018/19, current projections anticipate a recovery only by FY 2020/21. Without decisive fiscal adjustment measures, government deposits available for deficit financing would be already depleted during FY 2018/19.

Growth prospects are tilted to the downside except for the positive growth effect from large foreign-financed investment projects. In case of fiscal adjustment, expenditure cuts would weaken growth prospects in the short term. Without adjustment, arrears accumulation and rising uncertainty would be a drag on growth over the medium term. There is also a risk that a delay of measures could force a drastic and disorderly fiscal adjustment later, which would create negative spillovers into the real economy and the financial sector. The growth impulse from mining and the LHWP II project will only create temporary employment during the construction phase. Finally, there is some scope to increase external financing with a sizable grant element for high quality public infrastructure projects, which would mitigate fiscal adjustment’s drain on growth.

The main external risks would be channeled to Lesotho through the tight links with South Africa. Lower global growth and an increase in global financial volatility would weigh negatively on South Africa’s economic outlook which would delay the cyclical recovery of SACU revenues and activity for Lesotho. In addition, South Africa’s slow progress in structural reforms and political tensions could negatively impact the already declining longer-term trend for SACU revenues. While the new government’s efforts to address human rights violations around the 2014 attempted coup reduced the immediate risk of losing African Growth and Opportunity Act’s (AGOA) preferential access to the U.S., Lesotho’s export concentration in textiles creates additional risk.

Policy Discussions

Discussions with the new government centered around the following priority reforms: (i) Establishing a fiscal framework that ensures sustainability in an environment vulnerable to external shocks and constrained by the Common Monetary Area (CMA) pegged to the Rand, while protecting the poor. (ii) Improving conditions for private sector employment and inclusive growth, including by advancing financial sector reform and access to finance. While discussions during the mission on how to address the current fiscal imbalance were productive, there are indications that reaching a political consensus on the way forward has been difficult.

Private Sector Development

The government’s focus on private sector development has the potential to ease the pain of the fiscal adjustment. Discussions focused on how to prioritize reforms with a focus on widening growth beyond capital-intensive projects to strengthen the growth-employment nexus and ease poverty and inequality (Annex VII). The government is in the process of developing a new National Strategic Development Plan (NSDP II) that will reflect these priorities.

Reducing Red Tape

A comprehensive strategy to abolish red tape will be part of the NSDP II, but some progress is already under way. The government pointed to ongoing reform efforts like the implementation of the one-stop shop for business registration, even though further work is necessary to integrate all elements of the registration process. With assistance from a World Bank project, the cost and time for obtaining construction permits has dropped; guidelines for a risk-based inspection regime for new businesses are being developed. Preparations are also underway to establish product standards so that local producers would gain access to new export markets, and for local agricultural producers to be able to sell to large retail chains in Lesotho.

Staff cautioned the government regarding changes under consideration in the draft Minerals and Mining Bill. Duplicating regulatory structures, imposing local participation requirements, and forcing domestic processing and beneficiation in a very specialized sector would increase costs and thereby create disincentives for future investment. Instead of trying to enforce mines to source locally, the government should focus on a fiscal regime that ensures a fair share of economic rents to the public. A rent tax in line with international best practice would be a more efficient tool to achieve this objective than the current practice of government equity participation according to IMF TA.

Sectoral Reform Focus

In view of high unemployment, especially youth unemployment, the government is aiming at developing productive, labor-intensive sectors. The government has identified tourism, technology and innovation, agriculture, and manufacturing as priority sectors for the NSDP II. While the Fund team acknowledged that there is strong evidence of the growth potential of these sectors, the government should evaluate existing programs before deciding on potentially costly new programs to promote these reforms. This would also address concerns in the business community that these programs are vulnerable to corruption. The government pointed out that based on recommendations of a World Bank sponsored review, the Lesotho National Development Corporation is being restructured to serve better its mission of private sector development, but agreed that a comprehensive review of existing instruments would be useful.

Over the long-term, the government and Fund staff agreed that better education and health spending efficiency will not only contribute to fiscal adjustment, but is also essential to improve labor productivity, facilitate access to opportunities, and, consequently, reduce inequality. Despite strong economic integration with South Africa, wages in Lesotho remain very low. For instance, anecdotal evidence suggests that manufacturing wages in Lesotho range from a fifth to a third of what South African workers receive. Low wages reflect a deficient labor productivity caused by weak human capital. Improving the quality of education and health care is therefore critical to raise labor productivity and living standards.

Annex IV. External Sector Assessment

The external position of Lesotho weakened in 2016/17 because of a decline in SACU revenues and lower exports, but remained broadly in line with medium-term fundamentals and desirable policies. Over the medium term, the large current account deficit is expected to persist as the new government deals with the vulnerabilities associated to spillovers from South Africa. Rand volatility and weaknesses in competitiveness pose challenges for policy making in Lesotho.

The current account deficit deteriorated in 2016/17 due to a steep drop in SACU transfers of about 7 percent of GDP and lower diamonds exports. SACU transfers dropped by almost half in FY 2016/17 compared to the peak of 24 percent of GDP in FY2014/15. Lesotho’s imports represent about 90 percent of GDP and their financing is highly dependent on SACU transfers. As SACU transfers are highly correlated with South African imports, they will decline further in FY 2018/19 and are expected to bottom out only in FY 2019/20. Over the medium term, they are projected to recover in line with the cyclical upswing in South Africa. The current account will also be subject to large capital grants in the near term with the beginning of the Lesotho Highlands Water Project Phase II, which will be only partly offset by imports of capital goods. Over the long term, the project will contribute to exports. Risks also arise from Lesotho’s export concentration with over 25 percent (mainly textiles) directed to the United States, exposing the country to volatility in the Rand/dollar exchange rate.

FDI inflows have contributed to financing in recent years, but cannot offset the drop in SACU transfers. FDI inflows reached about 4 percent of GDP in 2014/15 and 2015/16, partly reflecting investments in diamond mining. Moving forward, international reserves in months of prospective imports are projected to decline as there are no offsetting factors to the sharp drop in SACU revenues.

The EBA-lite current account model points to an exchange rate that is broadly in line with Lesotho’s fundamentals. For the EBA-lite current account approach, the current account norm is based on a cross country panel regression, cyclical factors, and desirable medium-term policy levels. It considers a broad set of factors such as desirable level of policies, cyclical factors, aid and remittances. The EBA-lite current account deficit norm of 6.6 percent of GDP is just slightly lower than the 7.4 percent of GDP deficit for FY 2016/17.

Real effective exchange rate developments are driven by factors that originated in South Africa and broadly mirrors nominal exchange rate movements. The depreciation trend from 2011 to 2016, has been partly offset by the recent Rand appreciation.

Considering the effect of the importance of SACU transfers and the currency peg on the EBA-lite models, the Loti appears to be broadly in line with current fundamentals. Lesotho’s external position is heavily determined by the economic developments in South Africa, in particular the outsized influence of SACU transfers and the volatility of the Rand vis-à-vis the dollar.

The World Bank and the World Economic Forum competitiveness indicators highlight Lesotho’s struggles. Lesotho is among the worst ranked SACU members in both the 2017 Ease of Doing Business and the 2016-17 Global Competitiveness Report overall rankings. Access to financing is pointed out as the most problematic factor for doing business in Lesotho, followed up by corruption and inadequate supply of infrastructure.

---

Selected Issues paper

Macrofinancial linkages in Lesotho

This paper provides further background on the macrofinancial sector analysis that informed Lesotho’s 2017 Article IV consultation. Lesotho’s financial sector is small, concentrated, and lacks financial inclusion, although mobile banking services and financial cooperatives offer some encouraging potential. Exposure to developments in South Africa and dependence on revenues from the Southern African Customs Union (SACU) are Lesotho’s most important vulnerabilities. Shocks to SACU revenues can become a source of systemic risk by affecting the fiscal position and the balance of payments. The financial system will be affected by both channels, with substantial implications if the shock is permanent. While the available data are not sufficient to model and quantify the exact impact of a shock across all sectors, it is still possible to analyze the macrofinancial linkages and to assess resilience and buffers in the system.

This paper focuses on two potential consequences of a severe SACU revenue shock for the financial system: A decline in reserves that may threaten the sustainability of the hard currency peg with the South African rand, and the impact of a forced fiscal consolidation on household income and the quality of credit to households, affecting both bank and nonbank lenders. It turns out that financial shallowness and lack of inclusion may be a defining feature of the formal banking system, raising questions about potential trade-offs between inclusiveness and financial stability. Hence, we further explore nontraditional instruments and institutions that have potential to foster financial inclusion.

Some Key Characteristics of the Financial Sector

Banks are the largest component of Lesotho’s financial sector, but pension funds and insurance also play an important role. Three foreign-owned banks and one public bank hold 50 percent of the system’s total assets. Funeral and life insurance is popular in Lesotho, and insurance companies represent nearly a fifth of total assets, but this number includes assets on behalf of group pension products offered by insurance companies. The public pension fund and private collective investment schemes (such as mutual funds and other asset management companies) are also significant.

Bank lending is concentrated toward private resident households. Uncollateralized personal loans and mortgages make up 50 percent and 17 percent of the lending portfolio, respectively. Only one third of loans are directed to business enterprises. Banks are therefore significantly exposed to the financial health of private households. Households often borrow from multiples types of lenders, such as money lenders and financial cooperatives. The credit bureau, originally created in 2014, now covers most formal financial institutions, mitigating information asymmetries and allowing households to build up a credit record.

Compared with countries of similar size and income, Lesotho’s loan-deposit ratio is low, averaging less than 60 percent over the past six years. Interestingly, the loan-deposit ratios of these countries are inversely correlated with the interest rate spread between loans and deposits, a measure of the efficiency of financial intermediation (higher spreads signal higher costs of credit). The underlying cause appears to be the higher interest rate on loans that is needed to produce a comparable net interest margin, when the yield-producing loan base is small compared to the deposit base.

Banks in Lesotho hold an unusually large share of liquid foreign assets placed at banks in South Africa. An obvious question is whether banks’ NFA holdings are high because the loandeposit ratio is low, possibly due to the lack of bankable projects, or whether lending is subdued because of the large NFA holdings. One potential motive that may tilt banks’ portfolio choice toward a large share of liquid foreign assets could be self-insurance under Lesotho’s hard currency peg, given the absence of a lender of last resort.

Mobile Banking and Financial Inclusion

Mobile banking and nonbank financial institutions offer the largest potential for fostering financial inclusion in Lesotho. Since its introduction in July 2013, the use of mobile financial services has exploded, and 60 percent of Lesotho’s total population are now registered mobile money users. The industry is dominated by two companies (EcoCash and M-Pesa), but given the increased significance of e-payments, nearly all banks surveyed have indicated that they plan to offer mobile banking services, too. The CBL supervises mobile payments operators, and a new set of regulations has been enacted in March 2017.

The wide diffusion of mobile money in the past four years is an indicator for progress in financial inclusion. Unfortunately, the last comprehensive data for Lesotho available from the World Bank’s financial inclusion database is from 2011, so it is not possible to compare the ascendance of mobile money with progress in other areas. In the absence of conclusive data, it is worthwhile to take a look at the potential of other nonbank financial institutions to widen and improve access to credit and other financial services.

Financial cooperatives (SACCOs) suffer from structural problems, but offer potential for enhancing financial inclusion. SACCOs are supervised by the Cooperatives Department in the Ministry of Small Business, Cooperatives, and Marketing (MoSBCM). There is currently a gap in the reporting of financial data due to some hardware problems that occurred during a recent move, but the Ministry has established a new reporting template that will cover all districts of Lesotho, and the new Cooperative Data System is scheduled to come alive in early 2018. Many of the SACCOs of older generations face demographic challenges, as they are closed to new members, and the MoSBCM is organizing workshops to advise them on how to merge. The MoSBCM is also encouraging the creation of a single financial cooperatives league, which would allow younger and older SACCOs to join forces and share infrastructures and members. The medium-term objective is to strengthen the SACCOs such that they can provide financial services not only to their individual members, but also to other nonfinancial cooperatives. However, this will require more differentiated legislation than the General Cooperatives Act. A draft law for financial cooperatives has been prepared in the MoSBCM, and it should be brought to the cabinet level as soon as possible.

Appropriately, the 2012 Financial Institutions Act now requires the supervision of large financial cooperatives by the Banking Supervision Department of the CBL. But Boliba Savings and Credit, the largest financial cooperative with more than 65,000 members, has not yet completed its licensing process and is currently supervised neither by the CBL nor by the MoSBCM. Moreover, it appears that the governance structure of Boliba is not appropriate for an institution with more than 65,000 members. Boliba has been recapitalized a few years ago; while an eventual bailout, if required, could pose some moderate fiscal risk, there is no systemic risk for the financial system.

Microfinance Institutions. While serving a similar client base, microfinance institutions (MFIs) are regulated separately from financial cooperatives and report to the CBL. The regulation also provides for deposit-taking MFIs, but there are currently only credit-only MFIs operating in Lesotho. The industry is in an infant stage and it is too early to assess their impact, but they, too, hold potential to foster financial inclusion.

Conclusions

Under the baseline scenario, the financial system is well endowed with ample foreign exchange and capital buffers, which are sufficient to prevent a confidence crisis or systemic spillovers to the rest of the economy. This is confirmed by the results of the CBL’s stress-testing exercises, which subjected the banking system to significant hypothetical credit and liquidity shocks. In the baseline scenario used for Lesotho’s 2017 Article IV consultation, the current shock to the SACU revenues recedes in 2020-22. Under these assumptions, gross international reserves of the CBL would gradually decrease from 3.6 months of imports (2017/18) to 1.9 months of imports (2021/22). Over the same period, the overall fiscal balance would improve from -6.5 to 0.3 percent of GDP.

Under an extended shock scenario, the fall in SACU revenues would be permanent, raising questions over the medium-term sustainability of the exchange rate peg. Predicting the timing of a speculative attack under rational expectations has been a widely researched topic, going back for nearly 40 years. In practice, it is difficult to specify the exact reserves threshold under which a confidence shock with an ensuing speculative attack becomes likely. But it is an established finding that a foreign currency run would occur well before international reserves have fallen to zero. Such a nonlinear event would come with severe and multiple repercussions in the real economy, including a contraction of bank credit, default by households and private sector business, a collapse of fiscal revenues, bank failures, and further next-round spillovers and spillbacks.

To prevent the dire consequences of such an extended shock, proactive fiscal consolidation will need to be the principal policy instrument. An orderly adjustment, initiated in time, is necessary to maintain confidence and mitigate the negative impact of fiscal consolidation on domestic demand, household income, and economic growth. Fiscal measures should be complemented by monetary policy instruments that strengthen domestic liquidity control. Macroprudential measures, such as debt-service-to-income ceilings for consumer lending, could also be used to enhance household resilience to income shocks.