With a recovery in diamond exports expected to be sluggish, large fiscal and external deficits are likely to persist for the next several years. A slower-than-expected recovery in diamond demand would add to pressure on the external and fiscal positions. Directors noted that Botswana also faces the challenge of diversifying from diamond production and tackling high unemployment, HIV/AIDS prevalence, and income inequality.

Directors agreed that the recent marked increase in expenditures raises concerns about spending quality and fiscal sustainability. As a large part of this increase reflected outlays for infrastructure investment, a return to a more sustainable level of spending could take place as these projects are completed. They called for the authorities to scale back the public sector wage bill to create fiscal space for the recurrent costs associated with the completed projects, as well as for social spending. Directors noted that on current fiscal policies, the fiscal adjustment to achieve fiscal sustainability in the medium term would be larger than currently envisaged.

Directors encouraged the authorities to consider a fiscal rule that is based on the nonmining primary deficit as a share of nonmining GDP rather than the present rule, which limits overall expenditure relative to GDP. They noted that such a rule would provide a clearer picture of the underlying fiscal stance and be a better indicator of longer-term fiscal sustainability. Directors also encouraged the authorities to develop a Medium-Term Expenditure Framework in order to improve public expenditure management and increase spending efficiency.

Directors agreed that the weak outlook for growth and easing of inflationary pressures had provided room for easing monetary policy in 2009. Directors generally welcomed the recent easing of monetary policy. They encouraged the authorities to continue to weigh carefully the balance of inflation risk in their monetary policy decision.

Directors noted that the crawling peg has resulted in greater stability of the real effective exchange rate. They also noted staff's assessment that the real effective exchange rate is modestly overvalued. The limited scope for real exchange rate adjustment underscores the need for fiscal consolidation and structural reform to ensure medium-term external stability and competitiveness. Over the medium term, a few Directors encouraged greater exchange rate flexibility if the inflation objective were to become the primary monetary policy anchor.

Directors observed that the global financial crisis has not had a significant adverse impact on the banking sector to date. Nevertheless, they urged the authorities to remain vigilant, as the marked economic contraction expected in 2009 could increase stress on bank balance sheets. Directors welcomed the establishment of the Non-Bank Financial Institutions Regulatory Authority, but noted that further steps are needed to enhance its capacity, including through technical assistance, given the sizable reform agenda ahead. They encouraged the authorities to address the remaining issues from the FSAP recommendations.

Directors noted that Botswana needs to accelerate economic diversification in order to reduce vulnerability to shocks in the diamond trade. They urged the authorities to ensure that the increased spending on infrastructure, education, and health results in outcomes that are commensurate with these additional expenditures. They also called on the authorities to accelerate key structural reforms, which would reduce the cost of doing business and enhance productivity.

Background

Sound macroeconomic management, supported by strong institutions and good governance, has underpinned strong economic growth in Botswana for the past four decades. Annual real gross domestic product (GDP) growth averaged nearly 10 percent per year from 1960 through 2008, supported by increased mining production and more recently by stronger growth in the nonmining economy as the mining sector has matured. As a result, real per capita income increased from US$250 in 1960 to US$4,800 in 2008 (in constant 2000 US$).

Prudent management of diamond revenues, together with high minerals prices, resulted in large fiscal and external surpluses in recent years. International reserves amounted to 21 months of imports of goods and services by end-2008, boosted by the accumulation of sizable fiscal savings.

Despite this impressive progress, considerable social challenges remain. HIV/AIDS is a serious problem, while poverty, unemployment, and income inequality are all high for a middle-income country. In addition, the economy continues to rely heavily on diamond mining, which is expected to decline after 2020.

After several years of robust growth, real GDP growth slowed to 2.9 percent in 2008 due to a decline in mining output. The decline in diamond exports, together with a large increase in public infrastructure-related imports, reduced the current account surplus to 7 percent of GDP in 2008 from an average surplus of 15.6 percent of GDP during 2005-2007. The nonmining primary deficit (NMPD) increased to 28.6 percent of non-mining GDP in 2008/09 from 16.8 percent in 2007/08, reflecting a large increase in public investment and further growth in the wage bill.

The real effective exchange rate has stabilized since the shift to the crawling peg regime in May 2005, although Botswana's higher inflation vis-à-vis its trading partners resulted in a modest appreciation in 2008 and early 2009. The 12-month inflation rate fell to 8.4 percent in May 2009 from 15 percent in mid-2008, mostly reflecting reduced pressure on fuel and food prices. With inflationary pressures easing, the Bank of Botswana has reduced its main interest rate by 400 basis points since December 2008 with a view to stimulating economic activity.

The financial sector has weathered the global economic downturn thus far, although non-performing loans have edged up in late 2008 and early 2009. There has been notable progress on supervision of the nonbanking financial sector, including the establishment of a Non-Bank Financial Institutions Regulatory Authority (NBFIRA). There are still several recommendations from the 2007 Financial Sector Assessment Program (FSAP) mission that remain on the agenda.

The current global economic crisis has reduced demand for diamonds and contributed to a significant deterioration in the economic outlook. The economy is now projected to contract sharply in 2009, and large fiscal and external deficits are anticipated. Inflation has slowed considerably and is projected to fall to 7 percent by the end of 2009. Looking ahead, Botswana's near-term macroeconomic outlook is uncertain, with significant downside risks in the event of a slower than expected recovery in diamond demand. Two large electricity generation projects should boost output as they come online in 2012-13.