The Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation [1] with the Kingdom of Lesotho.

Lesotho’s economy continues to face a number of challenges in the wake of the pandemic. Climate shocks, delays to infrastructure projects, high food and fuel prices, declining diamond prices, layoffs in the textiles sector, and weak regional and external demand are weighing on activity. High public expenditure also continues to distort incentives and hinder private sector development.

Headline inflation remained elevated averaging 8.4 percent in FY22/23, two percentage points higher than the year before. Furthermore, food inflation rose to 10.4 percent during the same period. To anchor inflation expectations and support the exchange rate peg, the Central Bank of Lesotho has continued to track the policy rate changes of the South African Reserve Bank, raising rates by 425 basis points since November 2021.

The government is prioritizing fiscal consolidation on the back of windfall transfers from the Southern African Customs Union (SACU), which have helped alleviate near-term pressures on financing and reserves. However, the fiscal deficit deteriorated to 7.7 percent in FY22/23, due to lower revenue and rigid expenditure, with public debt increasing to almost 60 percent of GDP.Efforts to restrain expenditure have been hampered by persistent weaknesses in public financial management. The current account deficit is projected to widen to 7.9 percent of GDP in FY22/23, mirroring developments with the fiscus. As of end-March 2023, gross international reserves (excluding the second phase of the Lesotho Highlands Water Project) had declined to 3.8 months of imports.

Despite ample liquidity in the financial sector, credit growth only increased slightly to

8.7 percent year-on-year by the end of FY22/23 despite tighter financial conditions. Overall, credit to the private sector remains broadly flat at around 20 percent of GDP with banks primarily lending to households.

Looking ahead, the outlook is subdued with real GDP projected to grow at 2.1 percent in FY23/24 and average the same over the medium term. In the absence of stronger consolidation, the fiscal position is projected to deteriorate over the medium term due to lower SACU transfers, wage bill pressures, and recapitalization of the pension fund. The government is encouraged to push ahead with upfront growth-friendly fiscal adjustment to ensure debt sustainability and safeguard the exchange rate peg, alongside broad-ranging structural reforms to support the transition from government-centric to private sector-led growth.

Executive Board Assessment[2]

In concluding the Article IV consultation with Kingdom of Lesotho, Executive Directors endorsed the staff appraisal as follows:

Staff commends the new government on their bold reform agenda and encourages them to make the most of the economic, financial, and political window of opportunity. With the health crisis largely abated, staff welcomes the government’s vision of a smaller and more efficient public sector with a high quality of service delivery that provides space for the private sector to grow. The SACU windfall, if well-managed, also provides the opportunity to build buffers and finance a durable, growth-friendly fiscal consolidation, through a well-paced sequence of reforms and CD.

The recommendations of the 2022 Article IV consultation still stand. The fixed exchange rate means adjustment must fall on fiscal policy and structural reforms. If unchanged, current policies could result in abrupt adjustment with a significant impact on growth and inequality. The gradual weakening in the external position, which is assessed in FY22/23 to be weaker than that implied by fundamentals and desired policies, underlines the fragility of the current economic model and the need to consolidate public finances.

Fiscal sustainability will require determined efforts to contain spending upfront and implement PFM reforms, without which Lesotho’s boom-bust fiscal cycle will continue. Despite the recent SACU windfall, pressures are expected to resume over the medium term, risking reserves and debt sustainability once again. Critical for adjustment is reducing current spending (notably public sector wages) and rationalizing public investment, complemented by broad PFM reforms. Tax policy and revenue administration measures can also improve fiscal outcomes in the near term, while minimizing the impact on growth. In this way, the government would find itself better placed to finance key development priorities and stronger social safety nets.

Alongside, broad-ranging structural reforms will be vital for the economy to transition to durable, resilient, inclusive, job-rich, and sustainable private sector-led growth. Staff strongly encourages efforts to improve the business environment, strengthen financial stability, and enhance business lending. As the public sector recedes, enlarging financial access and improving the business environment will be critical. Therefore, the premium on undertaking reforms to address credit constraints, insolvency frameworks, consumer protection, and governance and corruption vulnerabilities as soon as possible to restore investor confidence and create a growth-friendly environment is higher than ever. A governance diagnostic can build on the commitments from the 2020 RCF/RFI.

Staff strongly encourages the authorities to continue their efforts to increase capacity, improve data quality, and coordinate closely on macroeconomic policies. High data quality and information sharing are critical for policymaking—from measuring economic performance to forecasting. Close coordination between fiscal and monetary authorities is also necessary to balance competing objectives for spending, debt, and reserves and ensure consistency of macroeconomic policies with the exchange rate regime. In the absence of coordination, credibility will suffer, and confidence will be lost.

Staff recommends that the next Article IV consultation for Lesotho be held on the standard 12-month cycle.