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Republic of Congo- Concluding Statement of the 2012 Article IV Mission1

By International Monetary Fund (IMF)
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BRAZZAVILLE, Republic of the Congo, June 14, 2012/African Press Organization (APO)/ -- Good progress was made under the Three-year ECF program but tougher steps lie ahead. Macroeconomic stability is in place, a procurement code has been adopted and net external debt is negative. Yet, for development to reach the population, fundamental reforms are needed not only aimed at industrialization but also at making growth more inclusive. The time has come to consolidate the gains to date and take ownership of reforms which break vested interest and strengthen governance through steadfast implementation of the various action plans in place. Specifically, actions are needed to strengthen the policy making framework, raise the quality of public spending and improve the business climate. Efforts are also needed to mitigate the risks posed by the supplemental budget.

I. Outlook and Risks

1. The outlook is favorable, provided that policy intentions are followed through to implementation. Barring a massive and permanent negative oil price shock, the key issue is not the financing of development, rather how to use oil resources effectively in support of inclusive growth. Prospects for a takeoff in non-oil growth rest on two pillars—construction of a foundation of basic infrastructure and full implementation of the action plan to improve the business climate. Growth will be driven by public investment, natural resources (mining, forestry) and telecoms, with increasing contributions from agro-industry, transport and services. Prospects for new oil discoveries and mining activities are favorable, and comprise sizable upside risks.

2. External risks are mostly conjunctural and appear manageable, while domestic risks are of a longer term nature. As always, the volatility of oil prices warrants a cautious stance.

In the event of a deepening of the European crisis, Congo faces the same potential risks to confidence and the external payment system as other countries in the CFA zone, which are attenuated by the French convertibility guarantee.

In the event of a rapid loss of confidence in the local currency or banking system, a swift, forceful and clear public statement by the BEAC and government to restore confidence will be required to avoid a deposit run and flight to quality.

Risks of a large and protracted drop in the oil price, while high, are allayed by large regional foreign exchange holdings and fiscal buffers. However, in the event of a prolonged negative shock, contingency plans to reduce expenditure will be required.

High public spending contained in the supplemental budget poses potential risks to macroeconomic stability through higher inflation. Transportation capacity may become strained, with higher construction demand potentially crowding out the availability of basic consumption goods and foodstuffs. Additional demand is unlikely to be met with a strong supply response. Policy should aim to protect the most vulnerable groups without recourse to further administered prices. Consideration should be given to strengthening the social safety net.

The largest risk posed by the supplemental budget is to expenditure quality. If fully implemented, domestically financed capital expenditure will have risen from 515 billion CFA in 2010 to 1,297 billion CFA in 2012, without a commensurate increase in capacity and staffing. Investment spending should be aligned with absorptive and implementation capacity.

Apart from the supplemental budget, domestic risks are of a longer term nature, centered on uncertainties about the ability of public investment and structural reform to raise future growth and deliver promised poverty reduction. Mitigation of these risks requires sustained and bold policy actions, including in the area of governance.

II. Near-term Policies—Mitigating Risks posed by the Supplemental Budget

3. Taken at face value, the supplemental budget adds nearly 25 percent of non-oil GDP to an already large spending envelope contained in the original budget and doubles the non-oil primary deficit relative to 2010. While the overall balance will remain in surplus, the envelope is too large to be spent effectively in the remaining months of the year given weak absorptive capacity and implementation constraints, as well as the time required to use quality control processes such as the procurement code. Higher imports will push the current account down to near balance, eliminating the previously large overall surplus. Moreover, part of the spending will exert inflation pressures given the limited supply response due to the possible emergence of strains in transport capacity.

4. We fully recognize the need to address the fallout of the catastrophe of March 4. We also realize that the supplemental budget was put together in order to quickly unlock budgetary resources and launch a swift reaction. However, now that initial payments to those affected have been made, actions should be well thought out and planned to ensure that the spending reaches the desired target and is not wasted. We welcome the work being carried out by the High Level Reconstruction Committee to identify priority projects and the medium term costing of the government's response, and have the following recommendations.

Ensure that additional spending is aimed at addressing the crisis. We note that of the supplemental capital expenditure 17 percent is for defense, 77 percent is for public works including housing and 4 percent for health and education. While defense spending is required to relocate barracks outside of the city, it will be equally important that sufficient funding is provided to international operations charged with ensuring that munitions storage is conducted in line with best practice to avoid future explosions.

Limit public investment spending in line with absorptive and implementation capacity.

Use project prioritization to make room for needed reconstruction spending. Projects in train in basic infrastructure should continue, with lower priority projects delayed and reappraised in the context of the 2013 budget.

Ensure spending quality by conducting a detailed assessment and costing of spending items, and use quality control measures, including but not limited to the procurement code. Continue to work toward improving public expenditure quality (see below).

Improve transparency through recording spending against crisis mitigation outcomes and making the results public.

Refrain from introducing additional distortions in the economy, such as additional price controls.

III. Anchoring Fiscal Policy

5. While Congo is in the privileged position of having large natural resource wealth, this poses a key challenge of how to anchor fiscal policy in both the near as well as medium term. A key consideration for inclusive growth is macroeconomic stability. High oil price volatility calls for establishing a revenue stabilization buffer to avoid having to adjust or delay projects when oil prices fall (i.e., undesirable procyclical policy), while absorptive and implementation capacity limit the amount of spending which can be executed efficiently in each year. While a scaling up of investment is desirable, a fiscal anchor can be useful in guiding government in answering the question: in any given year, how much to spend and how much to save.

6. Given that traditional methods for anchoring fiscal policy (i.e., Permanent Income models, Debt Sustainability Analysis) are ill-suited to resource-rich countries with development needs, we recommend the following anchor:

Adopt a simple oil revenue rule to smooth the projected oil revenue which will be made available to the budget (adjusted revenue). Staff analysis indicates that employing an 8-year moving average (5 historical years and 3 years of forward projection) reduces volatility relative to actual prices by about 25 percent after 4 years while still allowing the budgetary price to react to market shocks. In years where actual revenue is above adjusted revenue, the additional revenue would be saved in a stabilization fund established for this purpose, and in years when actual revenue is below adjusted revenue, funds would be withdrawn from the stabilization fund to allow projects to continue. The stabilization fund should be governed by law and audited as part of budgetary procedures.

Base the level of capital expenditure during the scaling up period on an assessment of (i) the infrastructure gap, (ii) absorptive capacity and (iii) implementation capacity. Proper sequencing of spending should also be a determining factor.

Finally, calibrate the revenue and expenditure paths to ensure consistency with a fiscal sustainability framework based on total net wealth (financial and physical) and savings objectives. Once the initial stabilization fund is sufficiently large to cover a high share of possible oil price shocks, additional revenue windfalls could be held in the form of wealth. Strong institutional arrangements should be put in place to govern the management of natural resource wealth.

IV. Strengthening fiscal policy—spending pressures and expenditure quality

7. One key tool for addressing rising current and capital spending pressures is to raise expenditure quality. Adoption of a results-based management framework for ministries, assignment of payment controllers to each ministry, placement of a dedicated procurement officer in each ministry and the work toward a functional classification of expenditure are all welcome steps in the right direction. In this context, devolution of public investment projects up to one billion CFA to line ministries should strengthen accountability and improve spending outcomes, albeit with some lag. We are cognizant of the challenges the government faces in the areas of onsite inspection and pervasive rent-seeking behavior by public officials, and agree with the need for all control measures to be used to their full potential in all ministries. While supporting the government's efforts, we also have the following recommendations.

Continue to implement phase II of the action plan to improve public investment (PAAGIP II), with particular emphasis on strengthening capacity in project appraisal, selection and implementation at both the central government and line ministries. Maintain close collaboration with development partners.

Conduct an audit of the use of the procurement code together with development partners. Provide further training to support project appraisal, selection and implementation given the increase in project size carried out by line ministries.

Improve oversight and reporting of investment outcomes through on-sight audits and ex-post evaluations by external auditors, and report the findings to parliament.

More broadly, strengthen the institutional and technical capacities of the key oversight bodies such as the Supreme Audit Authority, State Inspectorate General and Anti-corruption commission and publish annual reports.

8. Efforts should also be made to increase non-oil revenue collection, notably in customs, and rationalize current expenditure. Non-wage current expenditure is rising rapidly, and pressures are expected to intensify over time as operations and maintenance costs start to kick in. At the same time, social spending outcomes have been poor, marked by an increase in maternal mortality, falling access to health services and low quality of education.

Re-double efforts to improve non-oil revenue collection. Measures should be taken to broaden the tax base, eliminate exemptions and further improve administration, while working toward an overhaul of the unduly complex tax system.

Steps should be taken to identify areas for non-wage current expenditure rationalization, including in the areas of subsidies and non-social transfers, in order to make room for rising operations and maintenance costs associated with scaled up capital spending.

Social spending allocations in health and education should be protected, while improving public service delivery. A public expenditure tracking diagnostic should be conducted jointly with donor organizations in both sectors to identify the main areas of leakage, with line ministries held accountable for poor social outcomes under the results based management framework.

V. Reforms to Raise the Inclusiveness of Growth

By its nature, the oil sector is not inclusive—growth is often volatile, production is capital intensive and rents are not widely distributed.2 In order to make growth more inclusive the government must not only efficiently transform oil income into growth enhancing capital and social expenditure, but implement policies to improve the business climate, develop the financial sector and strengthen the labor market. This should be supported by gains in institution building, governance and transparency.

Business climate, financial sector and labor market

9. Raising the inclusiveness of growth requires a multidimensional approach. Improving the business environment without removing constraints to obtaining credit or addressing the labor skills mismatch will not be effective. Beyond the actual business environment lays the difficult challenge of improving governance and the rule of law which are key to strengthening the broader business climate. Given the broad-based nature of the reforms, strong collaboration among ministries is critical to success.

10. Progress in raising the inclusiveness of growth has been uneven. Public investment and reforms to the legal framework are moving forward, while SME issues and financial sector development have lagged. The reported fall in unemployment has been offset by rising underemployment and increasing participation in the informal sector. Apart from the infrastructure gap, one of the biggest stumbling blocks to overcoming jobless growth is governance. The lack of property rights, uncertainty regarding the upholding of contractual agreements, weak investor protection and challenges to starting a business hold back private sector development. Moreover, the weak demand side of the formal labor market is insufficient to address endemic youth unemployment, especially in light of the sizable labor skills mismatch. Our key recommendations comprise:

Go beyond simply taking the measures contained in the action plan to improve the business climate, to fully implement the measures in line with the spirit of the reform. Contractual agreements signed with the private sector should be respected, and over time the government's role should be limited to providing key public infrastructure and an attractive legal and regulatory environment capable of enforcing the rule of law.

Avoid creating a dual tax regime for business through Special Economic Zones. While we understand the government's desire to jump start industrialization and the presumed synergies between firms operating in the zones and local SME suppliers, a first best approach would be to improve the overall business climate which levels the playing field for all businesses. This includes reform of the tax system to reduce complexity, lower rates and eliminate parafiscalité. It is especially important to avoid providing tax incentives to firms who would have invested in Congo without receiving such incentives. Moreover, use of public-private partnerships warrants caution, and requires a strong institutional framework that minimizes contingent liabilities.

Press forward with implementation of the Financial Sector Strategy in order to facilitate the banking sector's provision of credit to the private sector. Recent efforts to reduce the cost of land titles and to train judges in OHADA law are welcome, and should be supported by actions to strengthen contract enforcement and build capacity of SMEs. Slow progress in adopting the draft new SME law may impede moving forward with implementation of a guarantee fund (FIGA) to increase access to credit. Consensus among ministries regarding the appropriate legal form of the FIGA will be important.

Begin to address labor supply issues. As a first step, conduct a skills assessment with development partners aimed at understanding the gap between private sector labor skills needs (demand) and current supply, which can be used to inform education and training policies.

1 Prepared by IMF staff and presented to the government of the Republic of Congo at the conclusion of the 2012 Article IV Consultation discussions held May 15–25, 2012. The mission is grateful to the authorities for their warm hospitality and continued close cooperation.

2 Characteristics of inclusive growth include: high and sustained growth which is broad-based across sectors, inclusive of a large part of the country's labor force, and promotes equality of access to markets and resources.