3 February, 2000

Mr. Michel Camdessus
Managing Director
International Monetary Fund
700 19^th Street, N.W.
Washington, D.C. 20431

Dear Mr. Camdessus:

Economic growth in Lesotho has slowed recently and fiscal and balance-of-payments pressures have built up. In collaboration with Fund staff, the Government of Lesotho has developed an economic program for the period January-September 2000 as the first step in tackling these difficulties. The Government hopes that this program will pave the way for discussions on a three-year program that will be supported by the Fund under the Poverty Reduction and Growth Facility, in the latter part of this year.

The attached Memorandum on Economic and Financial Policies describes the government's medium-term economic strategy and the objectives and policies for the program period January-September 2000. The Government hereby requests Fund assistance in monitoring the implementation of the program.

The Government of Lesotho believes that the policies and measures set forth in the attached Memorandum are adequate to achieve the objectives of the program, but will take any further measures that may become necessary for this purpose. The Government will continue to consult with the Fund on its economic and financial policies, and will provide the Fund with such information as the Fund requires to assess the Government's progress in implementing the economic and financial policies described in the Memorandum.

The Government, in collaboration with Fund staff, will review the program no later than end-May 2000.

3.  Economic performance began to deteriorate in the late 1990s with the winding down of activity in Phase IA of the LHWP, the attainment of close to full production capacity in the manufacturing sector, and a reduction in miners' remittances from abroad. The political disturbances of September 1998, which resulted from discontent with the results of the 1998 general elections and led to the intervention of Southern African Development Community (SADC) troops, also adversely affected economic activity. As a result, real GDP declined by almost 4 percent in fiscal year 1998/99 (April/March), and is projected to show only minimal growth in 1999/2000 (Table 1). Inflation remains moderate, falling to 6.8 percent in the 12 months ended October 1999. In the absence of concerted action by the government, economic growth is expected to remain sluggish in the medium term, for two reasons. First, Phase 1B of the LHWP, which started in 1998 and runs through 2005, is much smaller than Phase 1A and its economic impact will be correspondingly lower. Second, continued rationalization of mining production methods in South Africa further dim the prospects for mining employment there for Lesotho workers.

4.  The fundamental challenge facing the Government of Lesotho is to guide the economy back to the path of sustained high economic growth. The need for growth-oriented economic policies is made even more urgent by the various regional free trade initiatives under consideration. Lesotho-based enterprises would be at a competitive disadvantage if structural impediments to investment and exports, particularly those in the utilities sector, are not removed.

5.  Budgetary pressures have built up. Revenue has fallen in percent of GNP, in part reflecting declining customs revenue as investment imports have come down; and it may be further eroded over the medium term by the revision of the Southern African Customs Union (SACU) revenue-sharing formula and by tariff reductions as regional trade liberalization progresses. Expenditure pressures arise from costs associated with the closure of the Lesotho Agricultural Development Bank in September 1998 and the privatization of the Lesotho Bank in August 1999, debt service obligations and cost overruns associated with the construction of the Muela hydroelectric power plant, the need for new elections as part of the compromise reached by political parties following the disturbances of September 1998, and an upward drift of wages and salaries aimed at minimizing wage differentials with neighboring countries for skilled personnel. The budget deficit before grants nearly tripled to 4.3 percent of GNP in 1998/99, despite a significant reduction in capital expenditure (Table 2 and 3). After grants, the budget registered a deficit after years of surplus, and the government had to use domestic financing for the first time in several years. Preliminary data for the first half of 1999/2000 show a budget deficit after grants of 8.2 percent of GNP, which reflected recapitalization of the Lesotho Bank amounting to 8.6 percent of GNP.

6.  Balance of payments pressures also emerged in 1998/99. The external current account deficit narrowed, as lower imports stemming from lower investment offset reductions in miners' remittances and official grants. However, reduced capital and direct investment inflows led to a balance of payments deficit for the first time in several years (Table 4). The balance of payments has continued to deteriorate in 1999/2000: international reserves fell by US$29 million in the first half of the fiscal year. Gross reserves were the equivalent of just over 8 months of imports at end-October 1999.

II. The Medium-Term Economic Strategy

7.  The government's medium-term economic strategy is designed to lay the basis for sustained economic growth and poverty reduction in the context of macroeconomic stability. Quantitatively, it seeks to restore economic growth to around 3 percent a year, keep inflation at about 6 percent a year (roughly in line with trends in inflation in South Africa), and maintain gross international reserves at the equivalent of at least 6 months of imports of goods in the medium term.

8.  The government's medium-term economic policies eventually will be set in the context of a comprehensive poverty reduction strategy, preparation of which will begin in early 2000. This strategy and its implications for macroeconomic policies will be described in a Poverty Reduction Strategy Paper (PRSP), an interim version of which will be completed in the second half of 2000. The PRSP will be prepared on the basis of an open participatory process. The medium-term economic strategy will be revised as necessary to make it consistent with the PRSP.

9.  Given Lesotho's small size, limited natural resource endowment, and low domestic savings, at the core of the medium-term strategy are policies to enhance export competitiveness and attract foreign direct investment. These include institutional, regulatory, and other reforms to boost private investment and exports, prudent fiscal management to promote macroeconomic stability and support longer-term growth and poverty reduction efforts, and development of the government's capacity for macroeconomic management. Given the uncertainties surrounding the traditional sources of economic growth, the government will target manufacturing and other non-traditional activities, such as tourism, as the main engines of future growth. An effort will be made to diversify manufacturing exports toward high-value-added goods.

10.  The proposed strategy is important for macroeconomic stability as well as growth, because the factors that lowered growth were also responsible for the emergence of balance of payments and, to some extent, fiscal pressures. The deterioration of the budget balance needs to be corrected because it could render the existing exchange system unviable, and this will be an important objective of the medium-term program. Export-led growth will be the main means of restoring external balance. In recent years the government has borrowed substantially on nonconcessional terms, which has contributed to the recent fiscal problems. To contain the fiscal burden and keep the external debt within manageable limits, the government will hereafter restrict its external financing to grants and concessional loans.

11.  The basic fiscal strategy will be to avoid domestic financing in the budget in order to preserve external stability. To back up such a strategy, the government will take steps to enhance revenue, restrain expenditure, and increase concessional financing. Revenue mobilization will be the key element of fiscal adjustment in the medium term. A program of strengthening of tax administration will be drawn up, and the tax net will be widened and made more effective with the introduction of the value-added tax (VAT) in fiscal year 2000/01. The government will periodically adjust specific taxes and fees in line with inflation to prevent an erosion of the real revenue base. A public expenditure review has been initiated to restructure current expenditure, put relatively more emphasis on the social sectors, and privatize the operations of certain government functions; and a comprehensive program of public administration reform is now getting underway. The latter involves decentralization, improvement of human resource management, revision of the compensation system and decompression of wages to improve the competitiveness of government employment, introduction of incentives and a performance appraisal system, restructuring of Ministries, and a lowering of the government wage bill through natural attrition and right-sizing of the civil service. Institution strengthening measures also include the establishment of a Fiscal Analysis and Policy Unit at the Ministry of Finance to assist in the design and implementation of fiscal policy.

12.  Lesotho's scope for implementing an independent monetary policy is limited because of its membership in the Common Monetary Area (CMA), the fixed parity between the maloti and the South African rand, and the joint circulation of the two currencies within the country. Within these constraints, the Central Bank of Lesotho will seek to keep broad money growth in line with the growth of nominal GDP. To strengthen monetary control and help develop a money market, the Central Bank is considering the introduction of indirect instruments of monetary policy and the phasing out of direct instruments. The banking system has been strengthened with the closure of the Lesotho Agricultural Development Bank and the privatization of the Lesotho Bank. Bank supervision has been reinforced by restructuring of the bank supervision division at the Central Bank (through the creation of an on-site/off-site surveillance section and a supervisory/regulations section), the passage of the Financial Institutions Act, and the imminent submission of the Central Bank Bill to Parliament. The payments system is being modernized, including the cross-border payments system. Interest rates, which were de-regulated in June 1998, will continue to be market-determined.

13.   Lesotho intends to maintain its membership in the SACU and CMA, as well as the parity between the maloti and the rand, and has ratified the SADC trade protocol. The government will maintain a liberal trading system free of quantitative restrictions on imports. The existing licensing system that limits imports of beer and other products will be reviewed with the objective of abolishing them. The government is also formulating a competition policy in accordance with WTO guidelines, and will assist firms to maximise their access to the SADC and other foreign markets by gathering and disseminating information about potential market opportunities. Efforts will be made to diversify the manufacturing and export base, to reduce the dependence on the textiles and leather industries.

14.  The government will continue to develop the private sector through privatization of state-owned enterprises and removal of administrative barriers to trade and investment. Public enterprises currently dominate economic activity, but the government plans to privatize commercially viable enterprises and liquidate the others. A Privatization Unit oversees the ongoing privatization program. The government will step up its efforts to attract foreign investment, and a special effort will be made to develop small and medium-sized businesses. The recommendations of a study by the Foreign Investment Advisory Service on administrative barriers to investment will continue to be implemented.

15.  During the period of the staff-monitored program (January-September 2000), the government will begin to implement the policies outlined above. While implementation will take place on a broad front, the program will monitor progress in implementing a limited core set of reforms that are essential for both growth and macroeconomic stability. Economic activity is expected to continue to recover during the program period, and inflation to remain moderate, but international reserves are projected to fall by about US$17 million during the program period.

16.  The budget deficit after grants is projected at 13.9 percent of GNP in the first three quarters of fiscal year 1999/2000, and domestic financing is 15.4 percent of GNP. However, when extraordinary expenditures related to the privatization of the Lesotho Bank and the restructuring of the financing and mode of operation of the Muela hydropower project within the Lesotho Highlands Development Authority (LHDA) are excluded, the budget deficit after grants in this period falls to 1.3 percent of GNP and domestic financing is 2.9 percent of GNP. The government will take steps during January-March 2000 to reduce the underlying deficit after grants for fiscal year 1999/2000 to 0.7 percent of GNP. Such a deficit would result in underlying domestic financing of 2.2 percent of GNP in 1999/2000. The measures to be taken in the period January-March comprise: adjustment of petroleum prices and an increase in the collection of oil levies (see below); and restraint on non-interest, non-wage expenditure, including a freeze on certain current expenditures for the remainder of this fiscal year.

17.  Though the staff-monitored period will run only through September 2000, it will incorporate the budget for 2000/01. Budgetary pressures are expected to remain in fiscal year 2000/01. They arise from an expected decline in customs revenue by almost 2 percentage points of GNP, the cost of the general elections to be held late in the fiscal year (amounting to 2.3 percent of GNP), and the cost of instituting free primary education (amounting to 0.9 percent of GNP). As a result of these pressures, the program envisages a budget deficit after grants of 1.2 percent of GNP and domestic financing of one percent of GNP in 2000/01 (see Table 2). However, when the elections costs are excluded, the budget would show a surplus of one percent of GNP and the government would accumulate deposits in the banking system amounting to 1.2 percent of GNP.

18.  The following revenue-enhancing measures to be taken in 2000/01 will at least partially offset the SACU revenue loss:

• The value-added tax (VAT) will be introduced to replace the present sales tax. The introduction of the VAT is one of the key measures for combating the long-term decline in customs revenue (relative to GNP). It will be introduced at a single revenue-enhancing rate; the higher rate for liquor will be reviewed. The VAT bill is now before the Cabinet, and is expected to be presented to Parliament for approval in early 2000. A VAT implementation unit will be set up in the Ministry of Finance to oversee the introduction of the tax.

• The oil levy will be moderately increased, and a mechanism for automatic adjustment in domestic petroleum prices to reflect movements in international oil prices will be instituted. The petroleum price adjustment mechanism will be designed to ensure that domestic prices are regularly adjusted to fully cover changes in petroleum import costs. The current petroleum pricing structure is rigid. Recent international oil price increases have not been fully passed through to consumers, and oil companies seem to be accumulating tax arrears to the government as a result.

• Administrative fees and charges will be regularly adjusted to keep them in line with inflation.

• Tax administration will be strengthened through, inter alia, training of staff, reduction of high vacancy ratios, extension of the tax-payer identification system to the income tax and customs duties, and computerization of the tax departments. Early in 2000 the Government will commission a study of the problems of tax administration, which will form the basis of an action plan for improving tax administration. Technical assistance for a program of strengthening of tax administration will be sought from the international community. Consideration will be given to the creation of a central revenue authority to unify the existing sales tax, income tax, and customs departments. Strengthening of tax administration is extremely urgent, because it is one of the principal means available to the government to increase revenue.

19.  When extraordinary expenses are excluded, total expenditure and net lending falls by 1.3 percent of GNP in 2000/01. Two-thirds of this decline stems from lower interest payments, which in turn reflects amortization of LHDA-related debt as part of the LHDA restructuring. A small decline in the wage bill is programmed, consistent with an ongoing effort to identify and eliminate "ghost" workers in the civil service and the government's objective of cutting the size of the wage bill relative to GNP. Certain government operations are being outsourced, which also contributes to keeping expenditure down. Capital expenditure, excluding bank restructuring costs, are projected to rise by a small amount. The government will increase spending on education and health by at least 4 percent each in real terms in 2000/01.

20.  Broad money, which has been declining since September 1998, is expected to remain unchanged in 1999/2000 and to grow by 8 percent in 2000/01, driven in the latter year mainly by an increase in the net domestic assets of the banking system. Credit to the economy declines in 1999/2000 because of the repayment of certain loans by the Muela hydroelectric power plant in connection with its restructuring, and is projected to increase by 5.5 percent in real terms in 2000/01.

21.  Several actions are to be taken during the program period to advance the financial sector reforms. There is currently a differentiated reserve requirement of 3 percent on saving deposits, 5 percent on time deposits, and 9 percent on demand deposits. These requirements will be unified at a uniform rate of 5 percent on all classes of deposits. The Central Bank of Lesotho will abolish the commercial bank minimum local assets requirement (currently 60 percent of deposit liabilities) and replace it with a liquidity ratio of 40 percent, and, in conjunction with the planned introduction of indirect instruments of monetary policy, is considering eliminating the remuneration of excess reserves. The success of these actions will depend on the ability of the Central Bank of Lesotho to absorb the excess liquidity of the commercial banks. The government will allow the Central Bank to issue treasury bills for this purpose in the quantities desired. Liquidation of the Lesotho Agricultural Development Bank is expected to be completed by mid-2000. The Lesotho Bank's deposit liabilities and performing loans have been taken over by a new bank, Lesotho Bank (1999) Ltd.; liquidation of the Lesotho Bank itself will commence in June 2000. Regulations for the Financial Institutions Act have just been approved, and the Central Bank Bill has been approved by the Cabinet and will be submitted to Parliament in early 2000. The Financial Institutions Act, which brings banking regulations up to international standards, will be enforced, in particular through the setting up of a system of offsite surveillance of commercial banks and through annual onsite inspections. A commercial court has been set up and will become functional shortly.

22.  Under the program, crucial actions will be initiated to restructure the electricity sector and reduce the high cost of electricity. A debt restructuring plan for the Muela hydroelectric power plant is being worked out. This plan will enable the power plant to lower electricity prices to levels prevailing in South Africa. LHDA will be restructured to enable the power plant to operate as a commercial enterprise. Simultaneously, the government will hire a private firm to assist in the restructuring of the management of the Lesotho Electricity Corporation (LEC). This firm will also undertake a comprehensive program of restructuring of the enterprise as the first step toward its eventual privatization. Pending the restructuring, immediate action will be taken to ensure that LEC collects its revenues and does not accumulate further arrears to LHDA/Muela. Also, an independent telecommunications regulatory authority will be established in the first half of 2000 as called for by the Telecommunications Bill currently before Parliament, and the Lesotho Telecommunications Corporation is expected to be privatized in 2000.

23.  To monitor progress in policy implementation under the program, quarterly quantitative benchmarks have been established (as set out in Table 5) for (a) government revenue, (b) banking system net credit to the government, (c) net foreign assets of the central bank, (d) the contracting of medium- and long-term nonconcessional debt and short-term debt, and (e) nonaccumulation of external payments arrears. Structural performance benchmarks have been established (as set out in Table 6) for measures relating to the introduction of the VAT, strengthening of tax administration, privatization of the Lesotho Telecommunications Corporation, developing a format for offsite surveillance of commercial banks, introduction of a mechanism for automatic adjustment of petroleum prices in line with movements in international prices, and operationalization of the Fiscal Analysis and Policy Unit at the Ministry of Finance. A midterm review of program implementation will take place around May 2000.

24.  The Government of Lesotho will keep the IMF informed of the progress in the implementation of its program. In particular, the government will send to the IMF fiscal and monetary data on a monthly basis, starting in January 2000, and balance of payments data at least on a quarterly basis.

25.  During the program period, the government does not intend to (i) impose or intensify any restrictions on payments and transfers for current international transactions; (ii) introduce or modify multiple currency practices; (iii) conclude bilateral payments agreements that are inconsistent with Article VIII of the Fund's Articles of Agreement; or, (iv) impose or intensify any restrictions on imports for balance of payments reasons.