Public Information Notice No. 06/100

Public Information Notice: IMF Executive Board Concludes 2006 Article IV Consultation with Cape Verde

August 24, 2006

On July 31, 2006 the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Cape Verde and approved Cape Verde's request for a three-year Policy Support Instrument (PSI).¹

Background

Cape Verde's economic and policy performance has strengthened significantly over recent years. International reserves have built up, adding credibility to the exchange rate peg to the euro; the fiscal position has improved, with fiscal restraint maintained through the recent election cycle-a marked break from the past; and important progress has been made with privatization and other structural reforms. Reflecting the stronger policy environment, growth has averaged 5½ percent since 2000, supported by rising inflows of external financing from official and private sources.

Following a Fund staff-monitored program in the second half of 2001, the authorities' economic program in 2002-05 was supported by an arrangement with the IMF under the PRGF. With the PRGF arrangement having ended in July 2005, the government has requested that its economic program for 2006-09 be supported by the IMF under the PSI. The government's medium-term development strategy is set out in the Poverty Reduction Strategy Paper (PRSP), which focuses on combating poverty and promoting private sector-led growth. In particular, the PRSP includes measures to strengthen education, training, health care, and sanitation, underpinned by improvements in governance and the development of infrastructure.

Considering recent developments, GDP growth is estimated to have increased to nearly 6 percent in 2005, supported by increased private investment-especially in tourism related construction-and a higher execution rate of public investment projects. After falling for much of 2003-05, prices have recently increased sharply: food prices have risen as a result of temporary, supply-driven factors, and regulated prices of fuel, electricity, and water have increased following the rise in international oil prices and the elimination of fuel subsidies (see below). In view of the negative impact of these price rises on private sector purchasing power, coupled with some delays in implementing the 2006 public investment program, GDP growth in 2006 may be slightly weaker than in 2005-possibly around 5½ percent.

The current account deficit declined to 4½ percent of GDP in 2005 (from over 14 percent of GDP in 2004), mainly because of strong growth of exports and remittances, along with importers' use of broader-based and cheaper sources of supplies. This improvement in the external position enabled Cape Verde's official international reserves to continue to build, reaching 3 months of prospective imports at the end of 2005 (up from 2.4 months a year earlier). Strong capital inflows, together with lower reserve requirements and slow private sector credit growth, have led to an increase in excess liquidity in the banking sector. In response, banks have increased their holdings of foreign assets and pursued domestic lending opportunities more aggressively, while the Bank of Cape Verde has started to sell central bank securities to absorb liquidity.

The buildup in official reserves has been supported by ongoing fiscal restraint. The overall fiscal deficit (including grants) was just over 5 percent of GDP in 2005: while higher than in 2004, the outturn for 2005 reflected an increase in the provision of concessional external loans and a delay in the disbursement of external grants. With the deficit financed in part by government asset sales, domestic debt declined to 33 percent of GDP at end-2005.

On the structural front, the government is moving forward with a range of reforms to improve public financial management and public administration. The government is also close to completing its privatization agenda, with TACV (the national airline) currently being restructured in preparation for its privatization and the bidding process getting under way for ENAPOR (the port operator). An important step in addressing the long-standing financial difficulties facing Electra (the electricity and water company) was the increase in electricity and water tariffs (by 25.4 and 13.3 percent, respectively) as of June 1, 2006, following the government's decision to eliminate fuel subsidies in the 2006 budget. The independent economic regulatory agency has also signaled its commitment to fully implement an automatic mechanism to adjust these tariffs to reflect changes in input costs and provide incentives for efficiency improvements.

Executive Board Assessment

Directors recognized that the government's economic strategy has been anchored by a build-up in international reserves that has strengthened the exchange rate peg to the Euro; improvements in the fiscal position despite election pressures; and progress in privatization and other structural reforms.

Directors observed that Cape Verde's strengthened macroeconomic stability and policy credibility have supported solid economic growth and sound development prospects. They commented in particular on the pickup in foreign direct investment over recent years, along with the strong outlook for investment, especially in tourism and infrastructure. However, while medium-term prospects are favorable, Directors noted that Cape Verde remains vulnerable to external shocks and dependent on foreign aid and remittances.

Directors agreed that the policy priority is to work to accelerate growth within a stable macroeconomic environment. Key requirements are to safeguard the exchange rate peg, contain fiscal risks, and improve management in the public sector. They concurred that the fixed exchange rate has served Cape Verde well-noting the favorable evolution of the real exchange rate and exports, and they welcomed the focus on increasing foreign exchange coverage in support of the exchange rate peg.

Directors lauded the authorities' commitment to fiscal restraint to help address pressures that may arise over the long term from public pension liabilities, a growing demand for public services, and a decline in concessional external support. They welcomed the authorities' plans to create fiscal space by reducing domestic debt as a share of GDP, rationalizing the current system of tax exemptions, and better prioritizing public spending. Directors also emphasized the importance of the measures taken in the 2006 budget to eliminate fuel subsidies and clear arrears, and noted that containing the wage bill will be essential for achieving budget objectives.

Directors agreed that the authorities' macroeconomic objectives will be supported by measures to improve public sector management, especially in drawing up and executing budgets, and reforming the civil service to increase capacity and productivity. They endorsed the attention to public sector and regulatory reform, and urged the authorities to complete the privatization agenda and push ahead with measures to improve the business environment.

Directors noted the recent energy sector developments that have resulted once again in the state's acquisition of a majority shareholding in Electra. They emphasized the need to avoid fiscal risks from this source and called on the authorities to ensure that Electra is run on commercial terms and under a regulatory framework that will support much needed investment in electricity and water supplies. Directors strongly supported Cape Verde's commitment to ensuring that financial sector development, especially in the rapidly growing offshore financial center, takes place under institutional and regulatory conditions that are in line with international best practice. Implementing the AML/CFT legislation will be important, as well as criminalizing terrorist financing in line with the UN Convention.

In welcoming the PRSP annual progress report, Directors encouraged the authorities to continue pursuing reforms consistent with the PRSP pillars. They urged implementation of the recommendations of the Joint Staff Advisory Note, including on improving the quality of primary education, access to health services, and the scope and timeliness of data for monitoring the PRSP.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.