Public Information Notice No. 09/81

Public Information Notice: IMF Executive Board Concludes 2008 Article IV Consultation with Djibouti

July 9, 2009

On September 17, 2008, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Djibouti.¹

Background

Djibouti’s macroeconomic performance improved significantly, but inflationary pressures are intensifying. Real GDP growth accelerated to 5.3 percent in 2007, driven mainly by FDI concentrated in the construction and port services, while the contribution of public services to real GDP declined to 14.5 percent. The share of investment in GDP grew to about 42 percent. This rapid expansion, combined with the surge in food and oil import prices, pushed inflation from 3.5 percent in 2006 to 13.9 percent year-on-year in June 2008. In response, the authorities have eliminated consumption tax rates on five basic food items, and reached agreement with importers and retailers to cap their profit margins on these and other basic items.

The overall fiscal deficit remained at about 2.6 percent of GDP in 2007, even as the basic fiscal deficit (which excludes externally financed revenue and expenditure) narrowed from 7.2 percent in 2006 to 4.9 percent in 2007. Tax revenue declined by about 1 percent of GDP, as a result of tax exemptions granted to new investments and sluggish job creation. This decline was offset by an exceptional collection of overdue taxes. The decline in current expenditure from 30 percent of GDP in 2006 to about 26.5 percent in 2007, was more than compensated by a strong increase (3.7 percent of GDP) in public investment. Government external arrears at end-2006 have been repaid, but new accumulations led to disbursement delays in some loans. External public and publicly guaranteed debt remained at about 60 percent of GDP.

After remaining stagnant for several years, credit to the private sector increased by 23 percent in 2007, owing in part to a real estate and construction boom and increased competition. The arrival of three new foreign banks in 2006–07, increasing the total to five, has fostered competition by reducing spreads and widening the range of financial instruments. Broad money growth slowed down to 9.6 percent due to a lower accumulation of banks’ foreign assets. The capital adequacy ratio remained well above minimum requirements and asset quality improved. Greater confidence in the currency board and in the banking system led to a decrease in dollarization from 52.4 percent of total bank liabilities in 2006 to 51.4 percent in 2007, reducing financial vulnerability.

The deteriorating current account balance reflects mainly a surge in imports financed by foreign investment, but also the increase in food and oil prices. The external current account is estimated to have shifted into a deficit of about 25 percent of GDP in 2007—but this has been more than offset by the large capital and financial account surplus, resulting in a small increase in gross official reserves to US$130 million at end 2007 (equivalent to a currency board cover of 116 percent). The real effective exchange rate has depreciated by a cumulative of 24 percent in 2001–07, relative to its 2000 average, reflecting mainly the weakening of the U.S. dollar. Nevertheless, a variety of indicators, including high domestic production costs, suggest that competitiveness remains weak.

Significant progress has been achieved in the implementation of structural reforms. All key pending structural benchmarks of the 2005 Staff Monitored Program were implemented. In particular, progress was made in the areas of fiscal transparency, civil reform and the legal framework for private sector companies. The quality of monetary and balance of payment statistics is being strengthened with Fund technical assistance, and an assessment of the Anti-Money Laundering/Combating the Financing of Terrorism (AML/CFT) system was conducted by the Fund’s legal department in 2007, in the context of a forthcoming Financial Sector Assessment Program (FSAP).

The short-term outlook for growth is favorable, driven by a solid pipeline of large investment projects. Real GDP would increase by 5.9 percent in 2008. Inflation is expected to be slightly above 8 percent at end-2008, but would decline gradually thereafter as world food and oil prices ease. Revenue and expenditure measures are expected to reduce the overall fiscal deficit to 1.9 percent of GDP in 2008, while the current account deficit is projected to remain at about 33 percent of GDP, as foreign direct investment (FDI)-related imports remain high.

Executive Board Assessment

Executive Directors agreed with the thrust of the staff appraisal. They welcomed Djibouti’s strong economic growth driven by large foreign direct investments in the port and other key sectors of the economy. At the same time, Directors noted that the associated increase in inflation has been exacerbated by the surge in food and oil import prices, pointing to the need to contain inflationary pressures as a priority. Ensuring debt sustainability while reducing widespread unemployment and poverty remains a key challenge over the medium term. This will call for strict fiscal discipline and the acceleration of structural reforms to broaden the economic base, enhance productivity, and promote private sector development.

Directors supported the authorities’ economic program aimed at achieving macroeconomic stability, improving competitiveness, and strengthening the external position. They regarded the new Poverty Reduction Strategy (PRS) as a significant step toward addressing key structural bottlenecks. Directors underscored that a successful implementation of the Fund-supported program, which is critical for enhancing the confidence of investors and donors, will require strong program ownership and perseverance. They accordingly called on the authorities to take the necessary actions in this regard.

Directors emphasized the importance of maintaining the fiscal consolidation objective, with a view to controlling inflation and creating fiscal space to finance the poverty reduction strategy. Most Directors considered the fiscal adjustment path appropriate, noting the efforts already taken in, and planned for, 2008, especially those on the revenue front, which would only bear fruit in few years’ time. A few Directors would have preferred a more front-loaded fiscal adjustment path than envisaged under the program, given the limited role of monetary policy under the currency board arrangement, the widening of the current account deficit, and the vulnerability of the budget to external financing conditions. Directors cautioned against reliance on price controls or other restrictions that may hamper the effective functioning of the market. They called for the prompt implementation of a system of targeted subsidies, with World Bank assistance, to alleviate the effects of high food prices on the poor.

Directors welcomed the medium-term objective of reaching a balanced fiscal position. They commended the authorities for the improvements already made in tax administration, and the plan for a comprehensive tax reform, including the introduction of a value added tax (VAT) and the streamlining of tax exemptions. Directors also welcomed the authorities’ commitment to contain current expenditure by improving budget management, intensifying expenditure prioritization, and gradually reducing the wage bill. They called for continued efforts to reform the civil service and enhance fiscal transparency. Directors supported the authorities’ request for Fund technical assistance to strengthen the budget management framework.

Directors stressed that Djibouti’s still high risk of debt distress and vulnerability to a worsening of external borrowing conditions and other external shocks require the authorities’ continued attention. They welcomed the clearance of arrears with multilateral creditors, and encouraged the authorities to negotiate a multilateral agreement with the Paris Club. The upcoming donors’ conference provides a good opportunity to mobilize external financing needed for investment programs on highly concessional terms. Directors welcomed the authorities’ intention to request technical assistance to improve debt management practices to help avoid the accumulation of new arrears.

Directors agreed that the currency board has served Djibouti well, contributing to enhanced confidence and macroeconomic stability. Directors noted the staff’s assessment that the real effective exchange rate appears to be broadly in line with economic fundamentals, and encouraged the authorities to continue their efforts to improve external competitiveness, including by reducing the costs of critical production factors. In particular, Directors saw the need to downsize and improve the management of the two main loss-making public utility companies, and to develop alternative energy sources. They also encouraged the authorities to improve the business climate, including by adopting the new commerce code and enforcing the new labor code.

Directors welcomed the planned introduction of reserve requirements on bank deposits to mop up structural liquidity and help contain inflationary pressures. They stressed the need to reinforce the central bank’s supervision capacities and to update the legal and regulatory framework to keep pace with the rapid expansion of the financial system. The forthcoming FSAP is expected to provide valuable guidance in this regard. Directors also looked forward to the implementation of the recommendations of the recent Report on the Observance of Standards and Codes (ROSC) on AML/CFT issues.

Directors encouraged the authorities to take full advantage of the technical assistance offered by donors to improve the quality of statistics. They stressed, in particular, the importance of completing the population census and the household income and expenditure surveys to help monitor the effects of macroeconomic and poverty reduction policies.