1.      Decision of the Committee

At its meeting held on the 6^th September 2005 , the Central Bank of Lesotho Monetary Policy Committee (MPC) decided  to adopt a  target range for Central Bank of Lesotho Net International Reserves (NIR) for the period July to September 2005  of  (United States) $400.0 to $450.0 million[1]. The new target range, which represents an increase of $50.0 million on both the lower and the upper band, reflects better than expected macroeconomic outturn  particularly government budgetary operations. At this range, the  NIR will be in excess  of broad money(M2) by about 40 percent. The Committee is satisfied that at this level, the target level of NIR is sufficient to cope with the demands of the economy . This in turn will allow the Central Bank to continue to maintain the fixed exchange rate arrangement between the local currency, loti, and the South African currency,  the rand. The fixed exchange rate arrangement allows Lesotho to benefit from lower South African imported inflation, currently targeted at  between 3 and 6 percent.

Regarding domestically generated inflation, particularly inflation generated from the demand-side of the economy, the committee noted that there were no immediate threats. Accordingly, no measures were taken in this regard.

 2.   Inflation Developments During the second quarter of 2005

The Committee noted that the inflation rate continued to decline during the second quarter of 2005 and,  as a consequence, ended the quarter at 3.1 percent from  3.7 percent in March. Continued low price increases for imported food items and other household equipment continued to drive the inflation rate down. However, administered prices, particularly water and electricity tariffs increased at rates that are well above the rate of inflation. Electricity tariff index increased by 18 percent while water index increased by 8 percent. Water tariffs have been increasing by rates above inflation over the past two years reflecting a change in the pricing policy by the Water Authorities. Water tariffs in Lesotho have always contained an element of subsidy. It is not clear how long the process of unwinding of the subsidy will last.

Developments in relation to international prices of oil pose a significant risk to the inflation outlook. The price of oil has increased significantly since the last meeting of the Committee. During the first quarter of 2005, the price of crude oil averaged averaged $44.19 per barrel. It has since increased by 48 percent to around $65 at the time of the current meeting.  Should this trend continue, inflation will increase. 

The Committee turned its attention to assessing inflation pressures emanating from the demand side of the economy. Real economic growth in Lesotho is anticipated to be 0.9percent in 2005.  On the other hand real money supply as measured by M2 declined by 4.5 percent during the second quarter of 2005. On the basis of these developments, the Committee concluded that there were no immediate inflation pressures from the demand side of the economy. 

 2.     Prospects for the Maintenance of the Fixed Exchange Rate Arrangement

The present fixed exchange rate regime has served Lesotho well by allowing the country to benefit from the low-inflation environment in South Africa. The South African Authorities are currently targeting an inflation rate of between 3 and 6 percent with the latest official measure of inflation, the CPIX , measured at 3.5 percent in June 2005. The committee is convinced that in order for Lesotho to continue to benefit from this favourable South African inflation target, it would be critical to maintain the fixed exchange rate arrangement.

In this regard, balance of payments developments are a critical factor in determining the prospects for Lesotho to continue in the fixed exchange rate arrangement. Accordingly, the committee turned its attention to balance of payments developments and outlook.

2.1    Balance of Payments Developments

The long-term current account deficit during the period 1998 to 2004 has remained at or 5 percent if one excludes Lesotho Highlands Water Project(LHWP) activities, which are transitory.  However, from 2005 onwards,the long-term current account deficit is expected to widen further to around 6 percent of GDP as a result of Lesotho’s loss of competitiveness in the garments markets following the expiry of the system of quotas. At this new level, the current account deficit will exceed net capital inflows by some 3 percent of GDP. This means that there will be a financing gap of about 3 percent of GDP, which will be met from existing stock of foreign reserves.  Consequently, measures are required to address the long-term balance of payments outlook. 

In this regard,  the Committee noted that during the period under review,  progress has made in respect to restoring Lesotho’s competitiveness. The Government has signed a pre-compact agreement with the United States Millenium Challenge Corporation (MCA). Under the Agreement, the MCA will finance a number of feasibility studies related to policy reforms needed for unlocking private sector development. The signing of the Agreement represents tangible evidence that measures will be taken to address bottlenecks to private sector development and more importantly for restoring Lesotho’s competitiveness. 

There are signs that the impact of the phasing out of the quota system  on Lesotho’s export sector may not be as severe as initially anticipated. In fact, circumstantial evidence suggests that a turnaround may be emminent. Two  reasons could be advanced for this development. The fisrt is that the retailers in the United States where 80 percent of Lesotho’s exports are destined, have adopted a policy of retaining exports from Lesotho in order to maintain a diversified supplier base. Secondly, a weaker rand has helped to improve the competitiveness  of Lesotho’s exports.

 2.2    Short-Term Balance of Payments Outlook

Government budgetary operations are an important component of the cyclical factors affecting the balance of payments outlook. In this regard, the Committee noted that there has been a significant, yet unexpected, improvement in the fiscal balance. According to Central Bank of Lesotho estimates, the budget outturn for 2004/05 fiscal year resulted in a huge surplus of around 8.3 percent of GDP compared with a budgeted surplus of 2.7 percent of GDP. Detailed data are not yet available, but it is anticipated that government expenditures were significantly lower than originally budgeted for.

The Committee noted that although this large surplus is a welcome development  from a macroeconomic stability point of view,  it has posed challenges for monetary policy formulation. The NIR targets that were previously thought to be realistic have turned  out to be out of line following significant fiscal data revisions. Accordingly, the Committee urged the relevant Authorities to expedite reforms aimed at improving data quality.

The favourable fiscal situation is expected to continue into the current fiscal year of 2005/06. Central Bank projections indicate that as a result of larger that expected Southern African Customs Union (SACU) revenues, the first tranche of which was received in June 2005, the fiscal balance will register a surplus of some 1 percent of GDP compared with a budgeted deficit of 2.6 percent of GDP.  

The Committee noted that the better than expected fiscal outlook has in fact led to a situation where the actual level of NIR has been higher than its target range of (United States) $350.0 to $400.0 million. During the first quarter of 2005, the actual level of NIR exceeded the target range by at least $60.0 million. During the second quarter of 2005, the  excess increased to at least $100.0 million. Consequently, the Committee adopted a higher target range for NIR of (United States) $400.0 to $450.0 million for the period July to September 2005.  

E.M. Matekane

Governor