A Concluding Statement describes the preliminary findings of IMF staff at the end of an official staff visit (or 'mission'), in most cases to a member country. Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, or as part of other staff monitoring of economic developments.

The authorities have consented to the publication of this statement. The views expressed in this statement are those of the IMF staff and do not necessarily represent the views of the IMF's Executive Board. Based on the preliminary findings of this mission, staff will prepare a report that, subject to management approval, will be presented to the IMF Executive Board for discussion and decision.

Washington, DC: An International Monetary Fund (IMF) team led by Mr. Andrew Tiffin held meetings in Maseru with the authorities of Lesotho and other counterparts from the public and private sectors and civil society from June 3 to 14, 2024, as part of the 2024 Article IV consultation. Discussions focused on the mix of fiscal and monetary policies to ensure macroeconomic stability and debt sustainability, as well as the structural reforms needed to create jobs, reduce poverty, and facilitate the transition to private-sector-led growth.

Context and outlook

IMF staff estimates suggest that real GDP growth picked up modestly in FY23/24 to 2.2 percent, up from 1.6 percent in the previous year. In large part, this reflects accelerated construction from the Lesotho Highlands Water Project (LHWP-II). However, a decline in competitiveness in the apparel sector and lower diamond prices have depressed exports.

Inflation is easing. Headline inflation was 7.1 percent in April, up from 4.5 percent in July 2023, but down from a peak of 8.2 percent in January 2024. The recent increase in inflation is largely due to exogenous factors such as higher regional food prices, elevated transportation costs, and Rand depreciation. The impact of these factors is expected to ease going forward. Similarly, the gap between CPI inflation in Lesotho and South Africa mainly reflects the larger share of food in Lesotho's CPI basket and is expected to narrow.

Lesotho's fiscal balance registered a sizable surplus in FY23/24. South African Customs Union transfers were higher by more than 10 percent of GDP, compared with FY22/23. But even amid these windfall inflows, recurrent spending declined as a proportion of GDP, owing to a moratorium on public sector hiring and the adoption of the new Public Procurement Act. This outcome marks a welcome change from prior patterns in which windfall SACU transfers have often been matched with procyclical and ultimately unsustainable increases in spending. The net impact has been a fiscal surplus of 6.1 percent of GDP in FY23/24, which has helped lift gross international reserves to 4½ months of imports--strengthening the peg--and helped bring Lesotho's public debt down to 61.5 percent of GDP from 64.5 percent in FY22/23.

Looking ahead, the outlook for external government revenues has improved significantly. Another year of windfall SACU transfers (6 percentage points of GDP above the 10-year average) will again bolster fiscal and external balances in FY24/25. But these transfers are expected to fall sharply starting in FY25/26. Helping fill the gap, however, the recently renegotiated water royalty rates under the Treaty with South Africa on the LHWP-II represent an additional and significant source of revenue--with total royalties now projected at around 6½ percent of GDP in FY24/25 (compared to 3½ percent of GDP before), even with a scheduled outage in deliveries, rising to over 12½ percent of GDP in FY25/26, and then settling at around 9½ percent of GDP every year over the medium term.

New revenues present the authorities with a unique and valuable opportunity. Unlike many other countries in sub-Saharan Africa, which are grappling with a region-wide funding squeeze and reduced foreign-exchange inflows, Lesotho has a chance to chart a different course. But the main challenge for the authorities will be to ensure that this opportunity is not wasted. A striking lesson from the country's recent history is that greater public spending has typically not resulted in higher living standards. As a proportion of GDP, for example, government spending in Lesotho is well above international norms--with recurrent and capital spending at 40 percent and 10 percent of GDP, respectively, more than double the SACU average. But this spending has not been matched by improved economic performance. Twenty years ago, the average growth rate of per capita income in Lesotho was the highest in the SACU region. Now it is the lowest. Indeed, real per capita incomes have shrunk by 10 percent since 2016, and unemployment and inequality remain high. Considering the possible uses of Lesotho's new revenue stream, therefore, the main goal of the authorities should be to ensure that this time is different, and that these funds are saved wisely and spent strategically.

Building Resilience for Today

As an immediate priority, the authorities should rebuild Lesotho's external buffers. At its core, a large part of Lesotho's macroeconomic stability depends on the exchange rate peg against the Rand. This peg has served the economy well, allowing Lesotho to draw on the credibility of South Africa's monetary framework, ensuring that inflationary expectations in Lesotho are well-anchored, and ultimately providing a backstop against fiscal slippages. The credibility of the peg depends on the country's stock of international reserves. As the economy recovers from a prolonged global crisis, gross reserves are only now approaching 4½ months of imports--the minimum threshold at which the IMF considers reserves to be adequate for a credit-constrained economy like Lesotho. In a global economy characterized by larger and more frequent shocks, there is ample room to strengthen further Lesotho's reserve buffer.

Additionally, the authorities should also consider boosting resilience by reducing Lesotho's public liabilities. Until very recently, public debt has trended steadily upward, rising sharply during the COVID pandemic. The IMF's Debt Sustainability Analysis suggests that, although the risk of debt distress is still "moderate," there is little scope to absorb any further shocks. These might easily push debt to a level where the risk of debt distress is high. Lesotho's improved fiscal situation will naturally allow the authorities to scale back new borrowing, but to build increased resilience against future shocks the authorities should also consider retiring existing debt more rapidly. As a priority, the authorities should at minimum clear domestic arrears (1 percent of GDP) as soon as possible.

Ensuring that new revenues result in greater savings will require continued fiscal prudence. To this end, the authorities should maintain or strengthen their efforts to control spending and enhance domestic revenues.

Contain the wage bill. Lesotho's wage bill (as a share of GDP) is the highest among SACU members and triple the sub-Saharan African average. Reducing the amount spent on wages was a key recommendation of last year's Article IV consultation. And measures undertaken by the government over the past year have been a critical step in the right direction--even with automatic notch increases and a COLA adjustment, compensation of employees decreased by about 1 percent of GDP. This effort should continue, with a continued moratorium on hiring, streamlining of the establishment list, and regular reviews of the compensation system. It should be noted, however, that reducing the wage bill is not an end in itself. Ultimately the main objective is a fair and performance-based public employment system that rewards higher productivity and ensures better delivery of public services.

Improve tax policy design and strengthen tax administration. The Tax Policy Unit has been established and key staff are being hired. With help from the IMF, the unit's ability to accurately forecast revenue and improve tax-system design should be strengthened. On tax administration, a phased reform strategy to address identified weaknesses in core functions should be developed in line with the IMF's 2023 TADAT assessment. Prompt approval of the two tax policy bills and tax administration bill could help address identified deficiencies in many areas.

Improve the efficiency of social spending to target the most needy. Social spending is several times that of neighboring countries as a share of GDP but is dominated by poorly targeted schemes. For example, the tertiary loan bursary fund education scheme (2.7 percent of GDP) provides loans to many who typically do not need support and fail to repay (loan recovery is only 2 percent). The introduction of means testing, or the more effective recovery of loans, would free resources for other more effective social support initiatives elsewhere. A better targeted safety net will also be critical to build resilience to climate-related shocks and food insecurity. The authorities should enhance the operation of existing cash transfer programs, streamline the identification and registration of beneficiaries under various social assistance programs, and accelerate the deployment of new benefit delivery tools.

In support of efforts to control spending, the authorities should redouble their efforts to enhance Public Financial Management. Without these measures in place, there is a danger that new revenues will simply be wasted.

Budget preparation and execution must be strengthened to enhance budget credibility. This requires improved expenditure control through better collaboration between departments, monitoring and identification of misappropriated funds, and regular and timely audits. More broadly, the authorities should implement the Medium-Term Expenditure Framework to better align policy objectives with budget allocations over a multi-year timeframe and enhance long-term planning. In addition, the deployment of the new IMF Public Investment Management Information System should improve public investment planning and allocation.

To build further trust in PFM, the authorities should strengthen internal controls within the integrated financial management system (IFMIS). Some procurement and contracting processes continue to be performed outside IFMIS, which is one of the leading causes of arrears. Based on the IMF internal controls assessment, the authorities should accelerate the deployment of digital signatures to strengthen payment processes and prevent the accumulation of arrears.

The authorities should also continue their efforts to ensure a comprehensive analysis and management of fiscal risks. Several fiscal risks have materialized in recent years, including from collapsed public private partnerships; unquantified arrears; and contingent liabilities from loans and guarantees issued to state-owned enterprises (SOEs). The authorities should further strengthen the effectiveness of SOE management and reporting and provide for the preparation and disclosure of a fiscal risk statement as part of the annual budget process.

As a matter of priority, therefore, pending Public Financial Management (PFM) legislation should be passed as soon as possible. Currently, the most pressing items include i) the Public Financial Management and Accountability Bill; ii) the Public Debt Management Bill; and iii) secondary legislation to implement the 2023 Public Procurement Act. Together, this legislation will improve the efficiency and transparency of procurement, enhance fiscal responsibility and budget processes, strengthen financial management and fiscal reporting, and underpin other laws (such as public procurement, digitalization, SOE oversight) with strong controls, oversight arrangements, and financial-reporting and transparency requirements. They will also help ensure that the government's public borrowing plan is well integrated with the budget process.

Building Prosperity for Tomorrow

Beyond building buffers, the authorities should also take steps to quickly establish a well-governed savings framework (stabilization fund). The main aim of this framework would be to accumulate savings to ensure a stable source of government funding going forward, which in turn would allow for steady and uninterrupted service delivery even in the face of volatile SACU transfers. With sufficient savings, Lesotho's stabilization fund might also help finance future development spending, such as infrastructure investment. To be effective, however, a stabilization fund should be anchored by a clear and credible fiscal rule, which guides the pace of savings and the conditions under which funds are deposited and withdrawn. The fund should also be set within a firm legal framework, with a clear governance and accountability structure that is independent from political influence, safeguarding Lesotho's savings until they can be used wisely. In this regard the authorities should continue to work closely with development partners to set up a stabilization fund and fiscal rule, which are well tailored to Lesotho's short-term funding needs and longer-term development goals.

Improved public investment management is needed to increase the quality of capital spending. Before Lesotho's savings are allocated for investment or infrastructure projects, sufficient controls should be put in place to ensure that this investment represents value for money. Large capital expenditure--more than double the SACU average--has not generated a capital stock of a comparable quality. Moreover, owing to longstanding capacity constraints, the capital budget continues to be severely under executed. Authorities should take steps to boost the efficiency of public investment, including by creating a centralized asset registry, establishing a prioritized project pipeline and enhancing capacity for project management and monitoring.

To ensure sustainable and job-rich growth, public investment will need to be accompanied by broad structural reforms. Better service delivery and higher-quality investment will be helpful. But the prevailing government-led growth model has struggled to deliver high-quality growth and has instead resulted in an economy with a small and undiversified private sector--contributing to low productivity, anemic private investment, declining competitiveness, and high informality. In parallel, therefore, the authorities should accelerate efforts to unlock the potential of the private sector.

Developing a national strategy for financial inclusion is imperative. Evidence suggests that access to finance remains a key challenge, particularly for small and informal firms, due to limited financial intermediation and a weak regulatory environment. This in turn undermines expansion of the private sector and job creation. The authorities have tried to address this through various interventions, including partial credit guarantees, establishment of a moveable asset registry (LERIMA), and supervision and support of a credit bureau. But impact so far has been limited. A broad financial inclusion strategy to better coordinate these efforts, including a through renewed focus on digital financial services, should be a priority. Ongoing efforts are also needed to build capacity for micro-, small- and medium-sized enterprises (such as preparing "bankable" business proposals), as well as to enhance collateral ownership and loan repayment enforcement, improve utilization of the credit bureau, and reduce regulatory barriers for financial innovation.

Providing a stable, predictable, and well-regulated business environment is also essential. For larger firms, needed reforms include measures to reduce the cost of doing business, a reduction in the stake of large state-owned enterprises in businesses and utility companies; and efforts to boost broader private investor confidence--including through transparent, consistent and clear regulatory frameworks, greater policy consistency, and a clear long-term strategy for infrastructure development. To reverse the long-term decline of some industries (e.g., textiles) and take full advantage of new opportunities, the authorities should focus on coordinating and streamlining the efforts of the Lesotho National Development Corporation (LNDA) and the Basotho Enterprise Development Corporation (BEDCO). The authorities should also enhance the regulatory framework for the establishment, operation, and oversight of SOEs, while developing a strategy for the gradual privatization of non-performing SOEs to enhance efficiency and attract investment.

Mitigating corruption and strengthening the rule of law is essential to restoring confidence, investment, and growth. Recent fraud cases and growing arrears point to underlying vulnerabilities in payment and procurement processes within government, underscoring the need for the transparency and accountability that would result from successful PFM reform. More broadly, strengthening key bodies such as the Office of the Auditor General and the Directorate on Corruption and Economic Offences (DCEO) would also send a strong signal of the government's resolve, and help incentivize private sector development. In this regard, the increased funding and expansion of the DCEO has been most welcome.

The IMF team thanks the Lesotho authorities and other counterparts for the candid and productive discussions.

Lesotho: Selected Economic Indicators, 2018/19-2026/27 1/

Population (thousands; 2022 est.): 2,306

Per capita GDP (US$, 2022): 1,163

Quota (current, millions SDR): 69.8

Poverty rate at national poverty line (percent, 2017 est.): 49.7

Main exports: Diamonds, textiles, water

Literacy rate (2021): 81.0

Key export markets: South Africa, U.S.

2019/20

2020/21

2021/22

2022/23

2023/24

2024/25

2025/26

2026/27

2027/28

Act.

Projections

(Percentage change)

Real GDP growth (%, including LHWP-II)

-2.9

-5.3

1.7

1.6

2.2

2.7

2.4

1.9

2.1

Real GDP growth (%, excluding LHWP-II)

-1.9

-3.0

4.4

1.4

1.5

1.6

1.7

1.8

1.9

Inflation (%)

4.9

5.4

6.5

8.2

6.5

6.7

5.8

5.6

5.3

(Percent of GDP)

Revenue

47.8

54.4

48.8

44.6

56.5

63.4

61.1

57.9

55.7

of which: SACU transfers

18.1

26.2

16.7

14.0

24.5

25.6

19.3

18.5

17.5

Recurrent Expenditure

40.0

43.0

38.6

40.5

40.8

40.6

40.4

40.5

40.6

Capital Expenditure

13.5

11.4

15.5

9.6

9.6

16.1

14.1

13.9

14.0

Fiscal balance

-5.7

0.0

-5.4

-5.5

6.1

6.7

6.6

3.5

1.1

Public debt

58.2

54.7

58.4

64.5

61.5

59.9

59.7

59.8

59.8

Broad money (% change)

-4.5

12.2

0.0

8.7

15.2

3.9

5.0

5.1

5.4

Credit to the private sector (% change)

12.9

-3.0

6.7

8.7

12.5

9.0

8.1

7.9

8.2

Interest rate (%)

3.9

3.5

2.8

4.6

4.8

N.A.

N.A.

N.A.

N.A.

Current account

-6.1

-5.7

-9.0

-13.7

-1.0

0.1

-2.1

-2.1

-3.0

CA excl. LHWP-II imports

-4.1

-2.3

-6.5

-9.5

5.6

4.4

1.9

0.3

-1.3

FDI, net

-1.5

-1.3

1.5

-0.8

1.9

1.9

1.9

1.9

1.9

External debt

46.4

42.9

42.3

47.2

47.8

46.6

46.4

46.2

46.2

REER (% change)

-2.1

-6.0

8.7

-1.9

-6.9

N.A.

N.A.

N.A.

N.A.

1 The fiscal year runs from April 1 to March 31.