LESOTHO JULY 2007 ECONOMIC ROUNDUP: GOOD FISCAL POLICY BUT

UNCLAS SECTION 01 OF 02 MASERU 000406

SIPDIS

SIPDIS

DEPT FOR AF/EPS, AF/S

E.O. 12958: N/A
TAGS: ECON ECIN EINV LT
SUBJECT: LESOTHO JULY 2007 ECONOMIC ROUNDUP: GOOD FISCAL POLICY BUT
SLOW GROWTH

REF: Maseru 199

MASERU 00000406 001.2 OF 002



1. SUMMARY: While Lesotho's growth rate remains troublingly
low, the GOL's fiscal discipline has allowed the country to keep
inflation under double digits, maintain sizable foreign currency
reserves, and run a public sector budget which is strongly in
the black. On the good news front, the World Bank recently
approved credits for Lesotho's Private Sector Competitiveness
Project, which will compliment the Millennium Challenge
Corporation's (MCC) efforts in this arena. The GOL's recent
monetary operations have been successful. However, uncertainty
surrounding the future of SACU transfer payments highlights the
need for the GOL to continue to diversify its revenue base. END
SUMMARY.

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Private Sector Competitiveness Projects

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2. In June, the World Bank's Board of Directors approved a
credit of $8.1 million for Lesotho, $4.2 million of which is a
grant to support the GOL's Private Sector Competitiveness and
Economic Diversification Program. The aim of this program is to
create an enabling environment for private sector development.
Approximately 41.6% of this project's cost will be covered by
the World Bank grant, 38.6% will be covered by concessional
financing, and the rest will be allocated from the GOL's budget.



3. The project will target impediments to growth and job
creation, focusing on reducing the cost of doing business,
developing a skilled workforce, and providing loan guarantees to
help small- and medium-sized enterprises to access capital
commercially. The project also aims to develop a regulatory
framework for the leasing industry. These efforts should
dovetail with the $36.1 million Millennium Challenge Account
program in the field of private sector development, which will
focus on capacity building, civil and legal reform, land
administration reform, and payment clearing and settlement
systems.

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Weak GDP Growth, Agricultural Collapse

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4. GDP growth remains weak at just 2.9%, comparing negatively
to the regional average of 5.3%. This sluggish economic
performance is reflected across all sectors of the economy.
Diamond mining has become the second largest contributor to
growth (after textiles and clothing). However, the mining
sector's growth rate declined by 48.2% compared to last year,
when the opening of a new mine in Liqhobong and early finds of
world-class diamonds helped create high growth numbers. The
manufacturing sector recovered following the 2004 expiry of the
Multi-Fiber Agreement, but its growth has now slowed to 11%
largely due to strength of the rand against the dollar (the rand
has appreciated more than 4% since March). Agricultural
production was hard hit by drought, resulting in a projected 47%
production decrease and serious food insecurity (reftel).

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Strong Fiscal Policy

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5. The GOL's healthy government finances reflect strong growth
in tax revenue collection, leading to a fiscal surplus
equivalent to 6.5% of GDP. South African Customs Union (SACU)
transfer payments to Lesotho remain buoyant as result of an
adjustment in the formula used to calculate such payments.
These SACU transfers currently account for 62% of GOL revenue.
While these transfer payments from SACU will likely increase
further in FY 2008, they are expected to decline in subsequent
years. Government expenditures remain huge, totaling 53.5% of
GDP -- 80% of which are recurring expenses. And the
government's share of the total economy continues to grow -- the
government's wages bill and other non-interest current
expenditures increased by 1% and 3.8% of GDP respectively in the
last year.

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Inflation Indicators and Monetary Policy

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MASERU 00000406 002.2 OF 002



6. Growth in M2 (cash in circulation plus net time deposits),
often an indicator of price pressures in the economy, increased
by 5% between May and June. The overall Consumer Price Index
(CPI) registered 7.9% in June, and sizable price increases were
observed in the indices for food, non alcoholic drinks, and
energy. Inflation currently appears under control and does not
threaten the rand/maloti relationship; however, leading
indicators such as M2 growth indicate that it could be cause for
concern in the medium term. Sustained inflation over the past
five years (averaging over 9 percent) has eroded purchasing
power for most wage earners


7. Recent monetary operations have successfully maintained
rand/maloti parity. Lesotho's Net International Reserves (NIR)
are currently a healthy $715.862 million, exceeding the GOL's
target of $450 million by 59% and providing five to six months
of import cover. This above target performance on international
reserves is due to recent diamond and textile sales and the
continuing SACU revenue windfall.

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Dangers Down the Virtuous Road

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8. COMMENT: While Lesotho strode down the virtuous road of
balanced budgets and high foreign currency reserves, healthy GDP
growth did not follow. Optimists hope that programs such as the
MCA Compact and World Bank sponsored private sector development
initiatives can rectify this injustice. Lesotho's current
macroeconomic position indicates that policy challenges face
Lesotho. Transfer payments from SACU will decline, and the high
current levels of government spending based on this source of
financing poses a serious risk to government fiscal
sustainability. Continued improvement in tax collection and
other means to diversify the GOL's revenue base seem the most
logical and constructive escape route from this impending
problem. END COMMENT.
MURPHY