Report No. 35359-LS Lesotho Country Economic Memorandum Growth and Employment Options Study April 21, 2005 Poverty Reduction and Economic Management I Southern Africa Africa Region Document of the World Bank LEC Lesotho Electricity Corporation LFCD Lesotho Fundfor Community Development LFS Labor Force Surveys L H W P Lesotho Highlands Water Project LISP Local Initiative Support Program LMA Lesotho Manufacturers Association LNDC Lesotho National Development Corporation LPMS Livestock Product Marketing Service LRA Lesotho Revenue Authority MFA Multi-Fibre Agreement NGO Non-Governmental Organizations PESS The Peak Season Survey PRS Poverty Reduction Strategy PRSP Poverty Reduction Strategy Paper RMSM-X Reduced Minimun Standard Model - Extended RSA Republic o f South Africa SACU South African Customs Union SADC Southern African Development Community S A M Social Accounting Matrix SME Small and Medium Enterprises S M M E Small, Medium and Micro Enterprises SRV Senqu River Valley SSIP Small-scale Industries Project TVET Technical and Vocational Educationand Training UNCTAD United Nations Conference on Trade and Development U N D P UnitedNations Development Programme VAT Value-Added Tax W A S A Water and Sewerage Authority WB World Bank WDR World Development Report WHO World Health Organization WTO World Trade Organization Vice President: Gobind Nankani Director: RitvaReinikka Sector Manager: EmmanuelAkpa Task Team Leader: Vandana Chandra 11 This report was prepared by Vandana Chandra (Team Leader) and Shashi Kolavalli (consultant). Final edits of the grey cover report were made'by Zeljko Bogetic and Preeti Arora. Substantive contributions were made by Jock Anderson (RDV), Preeti Arora, and T. Raparla (AFTP 1, macroeconomic projections), Thilak Ranaweera (DECDG, macroeconomic projections), Pooja Kacker (research assistance) and the following consultants: B.Rajaratnam (Labor Force Survey analysis), Conningarth Economists South Africa (Social Accounting Matrix ( S A M ) for Lesotho), Professor Amos Golan, American University, Washington D.C. and Jean Pascal Nganou (SAM modeling), S. Phafane, N. Leleka, and Sechaba Consultants - Lesotho, (secondary and tertiary sectors), N.Mokitimi, M.Marake, M.Mochibelele, M.Mphale- Lesotho (agriculture andruraldevelopment). The team would like to extend a special thanks to the Government of Lesotho for useful comments on the green cover draft. In particular, we acknowledge valuable comments from Dr. M. Majoro (PS, Finance and Development Planning) and Mr. Geoffrey West (Advisor, Ministryo fFinance andDevelopment Planning). The team appreciates valuable comments and suggestions from peer reviewers T. Manuelyan-Atinc (East Asia PREM), P. Fallon (IMF) and E. Favaro (PREMEP). It also thanks L.Des Azcarte (PREMPR), L.Engstrom (IMF), J. Green(MF), A. Gelb (DECVP), B.Jones (AFTHl), S. Klasen(Consultant), A. Macoun(AFTUl), J. Sackey (AFMSL),and J. Sokol (Consultant, QAC). Earlier comments received at the initial review from AFTPI colleagues helped in the development o f the report. And finally, the team would like to acknowledge the guidance and assistance provided by P. L e Houerou (Acting Vice President& CIO, Sector Manager AFTP1 untilJuly 2003), D.S. Go (AFRCE) andE. Akpa (Sector Manager). D-Cubitt(AFTP1) and E. Tchapda (AFTP1) supported the process with the formatting of the report. ... 111 TABLE OF CON'TENTS ABBREVIATIONS AND Acronyms .................................................................................. Acknowledgements ............................................................................................................. ...i 111 Preface................................................................................................................................... 1 Executivesummary .............................................................................................................. 3 Growth. Poverty and Employincnt .Maiii Dcvelopinents......................................... 4 Key Constraints and Challenges ................................................................................ 5 Towards a Broad based. Pro-Poor Growth and Employment Strategy...................... 8 Core Policy Refomis................................................................................................ 12 1 . Geography. environment. people and institutions ............................................. -16 Introduction.............................................................................................................. 16 Ecological zones....................................................................................................... 16 Land and Soils.......................................................................................................... 16 Natural Environment................................................................................................ Water ........................................................................................................................ 17 18 Infrastructure ............................................................................................................ 19 The People................................................................................................................ 19 Summary .................................................................................................................. 21 2. Macroeconomicdevelopmentsand issues ............................................................ 22 Introduction.............................................................................................................. 22 Macroeconomic Developnieiits................................................................................ 23 Structural changes .................................................................................................... 24 Savings and Investnieiit............................................................................................ 27 Sectoral Composition o f Growth ............................................................................. Sectoral Shifts and Growth ...................................................................................... 30 31 Accounting for Sources of Growth, Employment and Poverty usingthe S A M Model ....................................................................................................................... Macro Environment ................................................................................................. 38 34 Fiscal and Debt Management................................................................................... 41 Fiscal Challengesand Medium Term Prospects...................................................... 45 45 Prospects...................................................................................................... Challenges.................................................................................................... 47 Trade ........................................................................................................................ 48 Development Strategies ........................................................................................... Prospectsfor cxporls - Tmde17rzfawmsiAGUA Opportunilies................49 50 Future ProspectsAnd The Links With RSA............................................................ 51 Recommendations.................................................................................................... 51 3. Poverty. employment and labor ............................................................................ 54 Introduction.............................................................................................................. 54 Incidence of Poverty ................................................................................................ 55 Geographic. Demographic and Gender Aspects o f Poverty .................................... 56 Income Sources and Poverty.................................................................................... 56 Employment ............................................................................................................. 59 Atti-ihzites of the w g e enJp1oyet.l.................................................................. 62 Incoines .................................................................................................................... 63 Wugedetern.incir.is ..................... ........................................................... 63 Policy Implications for IncreasingWage Employment and Reducing Poverty.......66 Labor Skill Requirements of Economic th...................................................... 65 Social Development: Health and Educational Status............................................... 68 ~alr~iitriiion ................................................................................................. 68 E-ITlUAlDS..................................................................................................... 68 Editcation ..................................................................................................... 69 Access lo Basic Services.......................................................................................... 70 Recommendations.................................................................................................... 70 4. Secondary and Tertiary activities ......................................................................... 74 Introduction.............................................................................................................. 74 Export Manufacturing.............................................................................................. 75 FIJI 76 LOW teclinologv eticluve ............................................................................... 76 FDTClimate andProspect for Exports..................................................................... 77 Textiles.............................. ....................................................................... 77 Divers$cntioii qf rtiai-kels............................................................................ 79 Political stnhiliq.......................................................................................... 79 Administrative hnssles/go\~c..ncirrce.............................................................. 79 Lniid Legislntioii .......................................................................................... 80 li~r~istriict~resewices .......................................................................... and 80 Regionnl conzpetifiiwiess............................................................................. 81 84 SME Developinent Strategy..................................................................................... Small and Medium Size Enterprises (SMEs) ........................................................... 86 Hostile eusironmeiit ..................................................................................... 87 Bo~deprocedures ....................................................................................... Y 88 Land and ir.ust.1ict.r. ............................................................................... 88 Limited skills ................................................................................................ 88 Creditprovision nnd recovery ..................................................................... 89 Skills and Infrastructure Pre-requisites Tor Growth in Secondary and Tertiary 90 Recommendations .................................................................................................... Sectors...................................................................................................................... 91 5. Agricultural and Rurai Development .................................................................. 95 Introduction.............................................................................................................. 95 Rural Dimensions of Einplo.vment. Income and Poverty......................................... 95 Non-FamiActivities................................................................................................. . . . 97 Resource Base and Infrastructure............................................................................. 97 Lutid arid Iive.ytock........................................................................................ 97 99 Sector Development Strategies ................................................................................ Agricziltuvcil sei+ces .................................................................................... 99 Recent Developments............................................................................................. 101 C.'omme~ci~ii~ation ..................................................................................... 101 Markets....................................................................................................... Best Practices and Key liinitations......................................................................... . . 102 Collective iris.itu.....I.s ................................................................................. 103 Recommendations.................................................................................................. 103 5. Prospects and options .......................................................................................... 105 Introduction ............................................................................................................ 106 The Model.............................................................................................................. 108 ~ u ~ t i p l .................................................................................................. i ~ r s 110 Siniulations Examining the Trade-offs between Growth, Job Creation and Poverty ................................................................................................................................ 110 Macroeconomic Framework Siinulations - Base Case - ....................................... 112 Towards a BroadBased, Pro-poor Growth Strategy - ........................................... Core Recomineiidatioiis to Coniplcment thc RecommendedStrategy..................117 134 Pointers for future research..................................................................................... 138 References ......................................................................................................................... 140 List of Tables Table 2.1 :Growth rate of GDP and GNP in Lesotho. 1980181 - 23 Table 2.3: Key structural resource flow indicators for I,esotho {share of GNP).................24 Table 2.2: National Inc~ine/E~~enditureClassification ...................................................... 2003104.......................... Table 2.4: Key stiuctural resource flow indicators ibr Lesotho (share of GDP).................25 26 Table 2.5: Growth rate of aggregatedeinand cornponents .................................................. 29 Table 2.6: Composition of foreign savings financing doinestic expenditurc....................... Table 2.7: Sectoral composition and growth rates - 1980181-2001102 ............................... 29 33 Table 2.8: Accounting for growth, job creation and poverty duringthe high-LHWP period (1987/88-1998/99)- siinulatioiis froin tlic SAM-based niodd ............................... 37 Table 2.9: Accounting for growth, job creation and poverty during the post-LHWP period (1999100- 2001102) -. 38 Table 2.10: Key Macroeconomic Environment Indicators .................................................. simulations from the SAM-based model............................. 40 Table 2.1 1: Fiscal accounts as a share of GDP.................................................................... 43 Table 3.1: Incidence, severity and depth ofpoverty (198617 aiid 199415) .......................... Table 2.12: Sectoral coniposilion ofpublic spending in Lesotho, shares of GDP...............44 55 Table 3.2: Incidence o f poverty (1993 and 1909)................................................................ 55 Table 3.3: Main sources o f income in Basotho l-lH (1986B7 - 1994195) ........................... 57 Table 3.4: Simulated effects of alternative poverty rcduciiig strategies from the S A M Table 3.5: Population 10 years and above by current economic activity (1999) .................58 Model ....................................................................................................................... Table 3.6: Distributionof Lcsotho-cmploycd individuals. 1999......................................... 60 61 Table 3.7:Estimated probability of employment o f young men and woinen with various personal characteristics ............................................................................................ 63 Table 3.8: Skillrequirements for growth: cstiinatcs from the Lesotho SAM model siinulatioiis ............................................................................................................... 66 vi Table 4.1: Wages coinparisoils with SADC countries. 1999............................................... Table 4.2: Investmeiit enviroiiinent in light nianufacturing inLesotho, 1999..................... 82 83 Table 4.3: Skills and infrastructure pre-requisites for selected growth strategies inthe secondary andtertiary sectors.................................................................................. 01 Table 6.1:Base case - growth, eniployment and poverty impact of declining miners' remittalices and LHWP investnients simulations fi-on1the SAM-based model.....111 Table 6.2: Base Case Scenario Growth Simulations from SAM; Macroecoiioinic projections fiom RMSM-X - Key growth rates" - 2004105 - 2010111.................114 Table 6.3: Base Case Scenario-GDP Growth Simulations from SAM; Fiscal projections from RMSM-X 2004105 2010111 .................................................................... 115 Table 6.4: Base Case Scenario- CDP GroLvth Simulations firom SAM Balanceof Paymentsprojections from RMSM-X 2004105 - 2010111 ................................. - 116 Table 6.5: Simulations from the SAM: effect of various extcrnal andpolicy shocks on growth, employment and poverty base ycar 2000:'O 1 (shocks adjusted to current - year)........................................................................................................................ 123 Table 6.6: HighCase RecorninendedStrategy Scenario Growth Siiniilations from SAM; Macroeconoinic projections fi-om RMSM-X Key growth rates- 2004105 - .- 2010111................................................................................................................... 126 Table 6.7: HighCase Rcconinieiided Strategy Scenario Growth Simulations from SAM; Fiscal projections fiom RMSM-X - 3004105 2010111 ............................. - 128 Table 6.8: HighCase - RecommendedStrategy Scenario.-Growth Simulations froin S A M ; Balance o f Paymentsprojcctions from RMSM-X-2004105 - 2010111......129 Table 6.9: Financing the high-growth Recommended Strategy PC comparisonswith the Base Case Medium-term projectioiis basedon the KMSM-X -2005106 -201011 1 ................................................................................................................................ 130 Table 6.10: Balance of payments pro-jectionscorresponding to the financing option proposed for the Recommended Strategy siniulations from the RMSM X ........131 Listof Charts Chart 2.1: Sectoraldistribution of GNP during the prc- aiidpost-LHWPperiods .............30 Chart 2.2: Sectoral distribution of GDP during the pre- and post-LHWP periods .............31 Chart 2.3: Fiscal deficitsisurpluses as a share of GDP......................................................... 41 Chart 3.2: Relatioilship between years o f education and wage earnings.............................41 Chart 3.1: Distributionof wage employees by sector, 1099................................................ 64 Listof Boxes Box 2.1:Micro-economic impact of the Lesotho Highlands Water Development ..............33 Box 2.2: Lesotho Social Accounting Matrix (SAM ) 2000 ................................................. 35 Box 3.1: Voices ofthe Basotho............................................................................................ 73 Box 4.2: SandstoneQuarrying in Lesotho ........................................................................... 86 Box 4.1:Tourism ................................................................................................................. 81 Box 4.3: Construction in Lesotho ........................................................................................ 89 vii PREFACE This CEM is the first comprehensive Bank report after the last Country Economic Memorandum (CEM) on Lesotho published almost 20 years ago. This CEM was prepared as an input for Lesotho's Poverty Reduction Strategy (PRS). Various sectoral committees were established to provide inputs to the Technical Working Group responsible Ibr developing the PRS. The PRS was submitted to the World Bank and the IMF in 2005. The CEM was built on local inputs, supporting government's on-going efforts andhelpingbuild capacity. The CEM represents a synthesis of detailed background studies conducted for sectors and activities considered to have a significant growth potential. To foster capacity building, these studies were coniniissioned to local academics and businessmen. The studies comprised four activities believed to have potential for diversification inagriculture (production of vegetables and fruits; dairy; poultry and meat; and wool and mohair) and eight others, mostly services, on which information at the sectoral level is sparse (construction, sandstone mining, hotels, trade, business services and IT, transport, restaurantsamong others). The findings of the case studies had been shared with stakeholders in two workshops -oneonagricultureandtheotheronthe roleofthe privatesector. Theoutcomesof these workshops were incorporated in the CEM. As part o f the technical assistance to support private sector development, representatives from several business organizations were invited to the private sector workshop in which they selected a coordinator to represent them. Subsequently, with donor support, Business Network o f Lesotho (Biznet Lesotho) was established. The network organized consultations with their members in districts, articulated their concerns in a position paper that served as an input to the PRS, and initiated dialogue with the govei-nment. In addition to the sector studies, the CEM makes three other new value-additions to the existing knowledge base. The CEM analyzed information from the 1999 Labor Force Survey conducted by the Bureau o f Statistics with a particular focus on the role o f education and skills in developing apro-poor employment strategy. The CEM developed and used a Social Accounting Matrix (SAM) based model for Lesotho to understand the trade-offs between growth, job creation and poverty reduction associated with different strategies; it has also informed the PRS. To buildcapacity, a hands-on training workshop for several goveinment staff from the ministries o f planiiing, finance and agricuiture was conducted. Subsequently, a small workshop was organized to discuss how the SAM based model could be 1 utilized to examine the impacts of various policies and their contribution to growth, employment and poverty alleviation. 0The CEM assessed the fiscal feasibility of the growth strategy, using the SAM- based model, as well as various financing options and their iinplicatiotis for fiscal sustainability. 2 EXECUTIVESUMMARY 1. Lesotho experienced sluggish economic growth and limited impact on poverty reduction over the past 17years. Real GNP per capita grew at a rate o f only 1percent per annum during 1987188-1997198. However, it has remained virtually stagnant since 1999100, Domestic unemployment numbers, presently around 25 percent, continue to rise. The numbers of poor and ultra-poor has gone up. The challenge for the Government o f Lesotho (GoL), as reflected inits first Poverty Reduction Strategy (PRS), is to ensure strong and sustainable growth with poverty reduction. 2. The purpose of this Country Economic Memorandum (CEM) is to contribute to the ongoing debate about how to accelerate growth and achieve development goals in the Vision 2020. The CEM, therefore, provides an analysis of the nexus between growth, employment and poverty in Lesotho; identifies key cross-cutting and sectoral challenges to economic growth; and proposes a broad based, shared-growth strategy that i s cognizant of external risks. 3. With the end of the first phase of the Lesotho Highlands Water Project (LHWP) and declining remittances, Lesotho's garment exports became the main engine of growth and formal employment; but this is now changing. This was due to the government's commitment and ability to exploit the preferential trading opportunity provided under the African Growth and Opportunities Act (AGOA) and the Multi-Fibre Agreement (MFA). However, the future i s uncertain as recent changes inthe preferential trading arrangements with the elimination o f quotas under the MFA have made the garment industry less competitive relative to the large, efficient producers, including China and India. 4. The CEM argues that sustained growthlpoverty reduction will require transforming the temporary preferential access into a more durable competitive advantage. To this end, Lesotho will need to expand its export base beyond the garment sector, including in service sectors such as tourism. This will also necessitate major policy reforms with investments ininfrastructure. Inthis regard, the analysis inthe CEM is complemented by the ongoing development o f a Private Sector Development Strategy for Lesotho. 5. The CEM also argues that after prolonged cuts in public investment, the economy is in a relatively comfortable fiscal situation from which to launch a more concerted investment led growth strategy. There is clear fiscal headroom for several years ahead to support a strategy o f timely, adequate, and focused investments inphysical infrastructure and human capital to support private sector led growth. At the same time, it is critical that public resources are used efficiently and all infrastructure investments effective, The ongoing multi-year public expenditure review exercise-jointly by the Bank and the Government-will help the government focus on core functions, remove . excessive interventions in domestic markets, and identify productive investments that will help the authorities attain its development objectives. GROWTH, POVERTY AND EMPLOYMENT - MAINDEVELOPMENTS Growth trends 6. Since the early 198Os, Lesotho's economy was subject to major external shocks and structural changes. In early 1980s, only half o f Lesotho's GNP was generated within its borders; the remainder was largely remitted by its male residents employed in the South African mines. Since then, Lesotho experienced sluggish growth, in large part due to major external shocks. Between the two long periods - 1980181-1987188 and 1987188-1997198, growth trends in GDP and GNP moved in opposite directions. Two structural changes occurred - the launching o f the Lesotho Highlands Water Project (LHWP) and the amval ofthe textile and garments industry from across the border inthe Republic o f South Africa (RSA). Both were associated with large scale investments financed by foreign capital inflows and accelerated growth in GDP. About the same time, a third external shock emerged in the form o f declining miners' remittances. The share o f the latter in GNP fell to 36 percent in 1987188-1997198 from 48 percent during 1980181-1987188. Combined with the deterioration in the terms o f trade, this led to a decline in net factor incomes from abroad and forced some convergence between GDP and GNP. By 1997198, the share o f GDP inGNP was 76 percent, up from 49 percent in 1980181. 7. After lackluster growth in the 1980-199Os, since 1999100, GNP growth has averaged only 1.4 percent per annum, largely because of a further decline in remittances. In 2001102, their share in GNP was only 21 percent. GDP growth has decelerated to 3 percent per annum, partly because o f the decline in LHWP investments, andpartlybecause o fthe general slowdown inthe service sectors. As a result, the export- oriented garment industry continues to be the lone engine o f economic growth. While macro stability i s conducive to growth, the recent appreciation o f the loti vis-&vis the dollar-if itcontinues-may hurtexports. Poverty and Employment 8. Sluggish growth has been accompanied by high poverty, inequality, and unemployment. Poverty associated with per capita consumption is adversely affected by the low growth in the per capita GNP. As a result, nearly 60 percent o f the population continues to be poor and a third lives in extreme poverty. The incidence of poverty is higher in rural areas, in larger households with more children and older people and inde jure women headed households. The lack o f employment opportunities for retrenched miners returning to Lesotho worsened poverty in rural areas where non-poor households who were most dependent on remittances as the primary source o f household income, slipped below the poverty line. Waged employment opportunities in the LHWP and the garment industry were insufficient and most workers in rural households remained unemployed or were underemployed in subsistence agriculture. Unemployment remains highat about 25 to 35 percent. Inequality inLesotho is one ofthe highest inAfrica. The poorest decile accounted for only 0.27 percent o f the total expenditure compared to 52 percent bythe richest decile in 1994. 4 9. Low incomes and HIVlAIDS have exacerbated food insecurity among the Basotho. Lesotho produces only 30 percent ofthe food requiredto feed its population in a normal year. The agricultural sector is vulnerable to the vagaries o f the weather, requiring additional food assistance in drought years. A third o f the population is estimated to require emergency food assistance this year. A third o f the households also indicate that they always face difficulties obtaining food. Malnourishment is significant. About 35 percent o f the children are wasted and 25 percent are stunted. At the same time, the high incidence of HIV and AIDS in Lesotho (on average, while almost 33 percent o f the adults are living with HIVIAIDS, the infection rate may be close to 42 percent in urban areas) has also become a major cause of poverty. The impact on households i s severe and often leads to depletion of assets to cover medical and burial costs while loosing income earning opportunities as the productive members die, Approximately 6 percent of the households have members who have been illfor more than three months or have died after an extended illness; an equal proportion of households are raising orphans, largely without any public support. The cost of the epidemic is borne privately by households. The economic consequences of AIDS in Lesotho have not been analyzed fully, but preliminary estimates of the cost to the economy andthe public sector are very high. 10.Based on the analysis of the 1999 Labor Force Survey and available poverty data, the CEM finds that in Lesotho, waged employment-and its determinants- provides the main avenue out of poverty. Moreover, education, age and technical training, in addition to location and gender have a strong influence on one's chances o f being wage employed and the level of earnings. Education and experience enhance earning opportunities. But earnings increase only marginally with schooling until about 11years, but then triple with one additional year of education: Skilled labor is in short supply. KEYCONSTRAINTS CHALLENGES AND Cross-CuttingChallenges 11.Small size and dependence on RSA. Lesotho has always been limited by its small market and peculiar location,but its dependence on South Africa declinedin recent years. Lesotho is a very small country with territory of about 30,000 sq km and a populationo f less than 2 million people, surrounded completely by the Republic o f South Africa (RSA). Its growth prospects are, therefore, strongly influenced by its links with RSA. Untilthe 1980~~ almost half o f Lesotho GNP was generatedinSouth Africa, by its mining remittance income. By the end of the 1990s, the situation was being reversed. Lesotho now produces nearly 80 percent of its GNP. Much o f its exports comprising 40 percent o f GNP in2003104 came from an FDI-driven garments sector that is independent of RSA. Lesotho has, however, remained dependent on RSA for many critical services such as banking, medicalreferrals and higher education etc. 12.As a member of the South African Customs Union (SACU), Lesothohas a fairly liberal trade regime under a common tariff structure. There is relatively easy movement of goods and services across the borders. Because a large share o f its population and economic activity are concentrated close to the borders, some of the non- s tradable that would otherwise be produced in the country are imported. Basotho producers face stiff competition from RSA producers. 13. The challenge for policy makers is to exploit the proximity to its advanced neighbor and tailor the spillover to its own advantage. This could imply (i) using the design o f RSA's institutions as a template for many o f its own institutions with appropriate modifications; (ii)using RSA's superior services more pro-actively to promote its own development goals, including - arrangements with RSA's agricultural extension agencies to provide timely services to Basotho agriculture and livestock farmers; (iii) twinningwith RSA's tourism authorities to include andpromote Lesotho as a destination; and (iv) twinningwith RSA authorities to simplify visa processes. 14.~ a t u r aresources and ~nfrastructure. The country's natural resources - water, l land, grazing fields are not used efficiently. Water is abundant in Lesotho, but its temporal and spatial availability i s not suited to meet the needs o f the country. It is plentiful in the mountains from where it is exported through the LHWP to water-scarce RSA. The infrastructure to harness water to meet Lesotho's domestic water needs is inadequate. Despite the potential in the manufacturing sector (e.g., garments), without adequate industrial water and treatment, pollution will remain a problem and is likely to threaten garment exports to increasingly environmentally-conscious global markets. Conflicts exist between domestic, agricultural and industrial users. Substantial hydro- electric potential supposedly exists but the costs o f generating and distributing it widely are prohibitive. The potential to export power will depend on long-term power agreements with RSA, which has surplus capacity and hence cheaper power. With less than 10percent arable land, productivity in commercial agriculture has limitedpotential and is constrained by the absence o f irrigation. The cultivated lands are degrading from soil losses and nutrient mining. So are the grazing fields, as measures to ease grazing pressures have been ineffective. Lesotho's natural beauty and alpine conditions are unique in Africa and can support small-scale tourism and spur rural development in the absence o f a vibrant agricultural economy. 15. Poor infrastructure is inadequate and constrains economic and human development. It prevents tourism development; in particular, the absence o f roads prevents the rural population from accessing markets, schools and health facilities. In Maseru, too, where roads in general are adequate, the neglect o f the railhead at Maseru Station is hampering the development o f the sandstone quarrying and other manufacturing sectors. Sectoral Constraints to Growth 16.~anufacturingand exports. Manufacturing contributes 16 percent to GDP and consists of mostly foreign-owned, export-oriented firms; about a third is accounted for by textile, the largest employer in the sector. Almost 50 percent o f all large firms are in textiles and garments which contribute 5-6 percent of GDP, but employs 70 percent o f the workers (about 56,000 last year) in the sector, making it the largest employer in Lesotho. The more capital-intensive food and beverage firms that were initially parastatals, employ about 8 percent of the workforce. Most FDIflows have gone into these two sub-sectors. There is potential for growth o f the textile and garment industry and its exports, but several areas o f vulnerability exist. There are at least four 6 major constraintslrisks to the growth of the sector: expiration of the preferential access under MFA, looming change in the AGOA rules of origin, the appreciation o f the currency, the narrow export base linked to a single market, and the enclave nature o f the sector. 17. The first constraint to manufacturing and exports is due to the expiration, in January 2005, of preferential access under the Multi-fiber Arrangement (MFA). The expiration o f the MFA leveled the playing field. Inthe free for all competition, Lesotho's garment exporters will only be protected by a tariff-free status. Without a timely and significant expansion inthe textile industryto enable sufficient fabric production, and an increase inproductivity, a major threat looms over the garment sector. 18. The second and related constraint is due to uncertainty after 2007 when AGOA's rules of origin clause will kick in. This will require firms in Lesotho (who presently import almost all inputs, except labor, from China) to either use locally produced fabric (which is produced by only one firm and will need massive capacity expansion) to benefit from tariff-free access to the US markets or risk the relocation of the industryto cheaperAsian countries. 19. A more recent risk is posed by an appreciated currency that is eroding the competitiveness of Lesotho's garment exports. As the GoL does not have the exchange rate policy lever, it cannot do much except to lobby with RSA to mitigate the impact. At least for now, this is perceived as a temporary phenomenon that will be corrected either by the market or ifit persists for too long, by the South Africa ReserveBank. 20. Finally, Lesotho's exports include a narrow range of productsto a single market financed largely by FDIs.With the expiration of the MFA, Lesotho's textile exports will have to compete with some o f the most efficient producers inthe world, including China. Unless the productivity of labor improves, it will be difficult for the garment industry to diversify into higher value added products which face reduced competition. There is a risk that FDIwill be relocated to more competitive countries. 21. The manufacturing sector has virtually no backward linkages with the rest of the economy; it is almost an enclave. All the inputs are imported and expatriates hold all technical and supervisory positions as these skills are in short supply inthe domestic market. FDI inflows did not result in the transfer of technology or diffusion of knowledge as evident from the absence of Basotho-owned firms after 25 years o fhousing the garment industry. Considerable illwill exists between the management and the low- skilled Basotho workers and between expatriate industrialists and the Basotho businessmen, who feel that GoL favors foreign-owned businesses over them, especially as they do not contribute to government revenues. 22. SMEs and services. The small and medium enterprises (SMEs) face constraints related to the weak economy and local entrepreneurship, property rights and the rule of law, finance, and the bureaucratic red tape. SMEs are primarily Basotho- owned, include formal and informal enterprises in construction, mining and services. Only about 20 percent are in manufacturing. The LHWP spurred growth in local construction and services such as business, IT, hotels, and tourism. Local construction industry is dependent on GoL contracts while the service sector is constrained by the 7 weak economy and domestic entrepreneurship. The absence o f property rights and laws that enforce repayment o f commercial loans has led to the general paucity o f commercial credit for domestic firms. The majority o f service oriented SMEs are in wholesale and retail trade and are owned by the Basotho. Foreigners own large formal service entities such as hotels, grocery chains but are forbidden by the Trading Enterprises Regulations Act of 1999 from owning businesses such as mini-supermarkets. Increasing the participation of foreigners in trade raises concerns among the Basotho who blame the bureaucracy for illegally favoring expatriates by easing the rules for tax collection and refhnds at the border. SMEs also face problems in credit recovery from customers andthe govemment. Most SMEs feel that the government's strategy to provide training and business services is irrelevant, 23. Agriculture. While limited in growth potential, GoL has focused on agriculture, which is central to the livelihood of the poor, but the outcomes in terms of diversificationwere not satisfactory. The strategy o f diversified, intensive cultivation in the lowlands, especially in horticultural crops (such as asparagus) with an export potential, and extensive cultivation in the mountains with improved management o f grazing, did not pay off. State interventions were reduced, particularly in maize marketing, but vestiges o f intervention such as in mechanization continue. The anticipated diversification did not occur because o f poor physical and institutional infrastructure. Some commercial ~ig~-yalueproduction and processing is taking place, particularly in niches for fresh produce. Commercial producers are also constrained by the inability to compete with imports where processing is required, high cost o f inputs purchased in RSA, and the lack o f access to adequate land. Public institutions failed to effectively support the sector. 24. The Public Sector. Weak governance has hampered developmental efforts in Lesotho, but recently difficult decisions were made in the public sector. In spite o f past strategies consistently focused on a private sector-led strategy to reduce poverty, the decision to make difficult political choices and implement them was less forthcoming. The "political" aspect o f governance i s strengthening now, and the democratic government that came into power in 2002 has made some difficult decisions and launched some critical reforms in the public sector. The government consulted extensively with communities on the PRSP and its vision. The "administrative" aspect o f governance, what may be labeled as "capacity" -- the availability o f skilled individuals, appropriate organizations to pursue development objectives and suitable incentives structures inthe public sector - continues to be a limitation. The educational system that made Lesotho one o f the more literate countries in the region does not produce enough skilled individuals; even more worrisome is the fact that the public and the private sectors inLesothoarenot able to retainskilled individuals. TOWARDSBROADBASED, PRO-POOR GROWTH A AND EMPLOYMENT STRATEGY 25. Major poverty reduction in medium term requires much higher real GNP growth (5-6 percent) and per capita growth (at least 4 percent), but policy options are limited. The report examines various options and trade-offs, using a social accounting matrix ( S A M ) based model of Lesotho's economy for 2000. Analysis using the Lesotho S A M shows that policy options for Lesotho which can promote economic growthand alleviate poverty are limited. 26. No single growth strategy or sectoral intervention will be sufficient to support growth required to make a significant dent in poverty. 27. Two-pronged strategy. Given the natural endowments and economic structure, two broad sources of growth are economically viable and have strong growth potential: e high-value commercial agricultural production and processing (fruits, vegetables, poultry, wool and mohair), and e higher value manufactured exports (diversified away from low grade garments) such as those made from woven and knit fabrics, electronics, furniture, sandstoneetc. 28. High-value agricultural production and processing is presently underdeveloped but has a strong potential for export to niche markets. Background studies conducted for this report and recent work indicate that because of its altitude and soil, Lesotho has a natural comparative advantage in the production of such commodities. The Basotho private sector has a natural edge in this area. Rural Basotho households are likely to benefit from its expansion. However, structural factors are binding constraints for this source o f growth: infrastructure to facilitate transport, access to commercial land, lack o f relevant skills and low labor productivity. Developments associatedwith AGOA and the MFA have created urgency for timely expansion of textiles to facilitate growth of garment exports under AGOA in 2008. The shortage o f skilled labor, especially in supervisory and professional positions and low labor productivity are some o f the other critical factors constraining diversification within manufacturing. Without the necessary public goods, like infrastructure, expansion inmanufacturing cannot be sustained. 29. Impact on Poverty. The CEM analysis based on a modeling exercise suggests that these two sources of growth could reduce poverty by creating more and better- paying jobs. In rural areas, agro-production and processing will directly benefit rural households although the number ofjobs created will be fewer than those in subsistence agriculture. In urban areas, expansion in garments will create significant wage employment. The spillover from these two sectors will lead to significant expansion in the service sectors creating a virtuous cycle o f more growth, better paying jobs and a reduction inpoverty, Better infrastructure and skills will also facilitate growth inservice sectors such as tourism, which will helpjob creation everywhere. 30. Availabiliq of Public Goods. Public investment complementary to private activity is essential. As private sector expansion in commercial agro-production and processing, and manufactured exports (of which garments are primary) is contingent upon the availability o f public goods, public investment in these public goods i s itseIfa source o f growth. Some public goods like the availability o f land for commercial fming and grazing rights can be addressed through policy reforms. Others such as public provision of necessary infrastructure and skills need significant and sustained political and fiscal commitment inthe form of public investment. Skills, capacity development, 9 and gains in productivity and competitiveness will require a longer time than infrastructure and transport delivery that can also be accelerated through public-private partnerships. The contribution o f public investment to growth will be large and sustained as investment i s lumpy. Once the fixed cost has been incurred, the returns are sustained over the longer term if the stock o f investment i s maintained. This is evident from the LHWPexperience, 31. Quuntijjdng the Strategy. The CEM analysis identifies three key scenarios whereby interventions by the public and private sectors will support this growth strategy. e An increase o f about 45 percent inpublic irzvestment in infrustructure such as roads, water, electricity, etc. (M 400 million based on 2005106 prices, phased in increments o f M 100 million each over 4 years). This will cumulatively contribute 4 -5 percent of GDP growth, and 12,000 new jobs provided the quality o f the investment is highandthe projects are fast paced, Timing is o f essence as the growth outcome is contingent upon a significant increase in private investment in agro-production and processing, manufacturedexports and related services. e An increase in private ilzvestinent (growth rates o f 5 - 10 percent in manufacturing and agriculture) to support higher growth in ugro- production andprocessing, as well as related expansion inmanufacturing and services (about 10 percent cumulatively over 2005106 levels, equivalent to M 238 million. This i s assumed to be phased over 4 years in increments o f M 60 million per year). The growth dividendfrom a scaling up o f agro-production and processing is about a 2 percent increase inGDP growth, and 25,000 mostly low skilled but better paying livelihoods in agriculture and rural activities, Only a small proportion o f the jobs created will be skilledjobs, e A 40 percent increase in garment exports will create significant GDP growth o f about 4 - 5 percent and create about 21,000 jobs, halfo f which will be inthe urban labor market. It is assumed that the export growth and diversification in manufacturing will be fully financed by udditionu2 FDI inflows o f about US$ 5 million in 2005106 rising to US$ 15 million in 2010111. These effects are contingent upon timely and proactive public action to retain and attract new investors to Lesotho's textiles and garments sector; this requires the GoL makes a credible commitment to providing basic infrastructure and skills that are needed for private investors to scale up private investment and installed capacity in the textiles and garment industry. 32. The total gains in GDP growth from the three elements of the Recommended Strategy covering public and private investment are estimated to cumulatively range around 10 - 12 percent with potential to generate about 45,000 jobs on a net basis. Ifthese actions and investments are phased over 4 years, the growth dividend will add 1-3 percent of GDP growth per annum during 2006107 -2010111. Over the medium term, instead of GDP growth ebbing at 3-4 percent per annum, it can rise to 6-7 percent 10 per annum, On the other hand, ongoing external shocks to miners remittances (5 percent cut) and LHWP investments (15 percent cut) are expected to chip away at most 2 percentage points o f GDP growth and over 10000jobs. As these have largely happened, they do not dampen the medium term projections, 33. Over a period of 3 - 5 years, the Recommended Strategy aims to achieve a GDP growth rate of 6 - 7 percent per annum. This is sufficient to raise GNP per capita by almost 4-5 percent per annum in the 2009110 - 2010111 period and make a dent on poverty in the medium term. The hike in public investment is assumed as early as 2005106 starting with an initial M 100 million in fast paced infrastructure projects. As a share o f GDP, this is expected to raise the share o f public capital expenditures to 10 percent. With growth in GDP accelerating, this ratio rises less than expected over the medium term as the foundation o f the Recommended Strategy is based onprivate sector- Zed growthfaci~~tated by the public sector. As the set of core reforms is undertaken, private investment will also grow fast. Export growth accelerates to about 6 percent per annum, Fiscal revenues stay at about 38 percent o f GDP, but the overall higher growth rates will expand the ZeveZs significantly, making room for larger current spending on services to support new public investments (more teachers in higher education, better maintenance o f new roads, more public transport facilities etc.). It is also assumed that public-private partnerships will reduce the expenditure burden on the budget and speed project implementation. If current spending is capped at about 34 percent o f GDP, there will be more room for capital investment to rise to 10 percent o f GDP. Overall government expenditures rise to 44 percent o f GDP, but shift in favor o f investment. Assuming an increase in capital grants, the fiscal deficits are expected to rise from 3 to a sustainable less than 5 percent o f GDP inthe medium term. 34. Fiscal Sustainability. If public investments are, indeed, productive, fiscal sustainability is assured under realistic assumptions. Since the starting position o f total public debt as a share o f GDP is fairly comfortable, fiscal sustainability will depend upon how the deficitslhigher public investment is financed; and how quickly it translates into improved infrastructure and skills that can attract new private investment. In 2004105, the total debt to GDP ratio was 55 percent and was projected to decline consistently to 47 percent by 2010111 (referred to as the Base case). Under assumptions inChapter 6, analysis shows that even ifGoL does not receive additional capitalgrants, if investments are channeled into productive projects, additional public investments will preserve fiscal sustainability if they are financed on concessional terms. In short, the Recommended Strategy i s fiscally sustainable and there is no threat o f debt distress. 35. Ad~inistrative,Social and Political Feasibility. The government has a track record of implementing a complex LHWP under sharp capacity constraint. Inthe late 1980s when the LHWP started, the GoL had far less experience and capacity to manage such a large investment project. Its political will has made it happen and the results are clear from the rapid increase in GDP growth that followed during the high- LHWP period. From an implementation perspective, Lesotho's construction sector was quite underdeveloped at that time and much o f the initial construction was performed by South African firms. There has been much learning since. Today, several Basotho construction companies bid alongside international firms. Moreover, the use o f public- private partnerships, as in the case o f the LHWP should be availed once again to speed implementation. Socially, the Recommended Strategy speaks to the vision o f the PRSP, 1 1 so it should have strong endorsement. Moreover, there are no single andsufficiently large sources o f growth that provide good alternatives to the broad-based shared growth strategy being recommended. It helps to diversify away from the garment sector into high value commercial agro-production and processing, and makes an appeal for enlarging the textiles and garments sector to create even morejobs and exports, Above all, the strategy is fiscally sustainable and consistent with the PRSP. For the skeptics, the experience o f the LHWP provides proof that if the political will exists, implementation o f the Recommended Strategy i s entirely feasible. 36. Impact of HIV/AIDS. HIVJAIDS has had major direct and indirect impact on Lesotho's society and economy. The direct effect o f the HIVlAIDs epidemic will be on the size and composition o f population. The population o f Lesotho is projected to reach 2.8 millionby 2015, about 23 percent lower than without AIDS. Life expectancy, which has already declined, is projected to fall further to about 31 years, instead of climbing to nearly 65 percent. The majority o f deaths will take place among 15-49 year olds. Because the skills o f this working age group are generally low and substitutable, the negative effects were not yet apparent from a 2000 survey o f Lesotho employers. As more than 40 percent of the workers in Lesotho are in the public sector, the costs to the public sector will be significant, via reduced productivity from higher absenteeism and morbidity, increased pension payments due to early retirement, and hiring and training costs. The productivity losses were estimated to be M 10 million, or about 1.3 percent o f the wage billin 1999120.These costs are projectedto increase to about 1.8 percent ofthe wage bill by 2015. The epidemic's total cost to the public sector could be around 5 percent o f the wage bill. Where there is less overstaffing and skill substitution possible, like the AIDS related deaths of school teachers inrural areas, the detrimental effects are becoming more apparent. Victims of HIVlAIDS and other catastrophic illnesses, the aged, disabled, and orphans are unlikely to benefit from job creation, and the strategies identified above. This set o f individuals should be supported by direct transfers andsafety nets. COREPOLICYREFORMS 37. The high growth scenario of the Recommended Strategy requires multiple policy reforms in severaE core areas that are consistent with the GoL's own priorities and the PRS. Only such multiple reforms have a chance o f translating into higher growth, better jobs and lower poverty. There are no easy solutions that can accomplish the goals o f the PRS without concerted public action to support private sector-led growth. The discussion below pertains largely to "what" needs to be done as opposed to "how". Modalities related to the latter are broadly identified in the PRS and are being further refined on the basis o f additional ongoing analytical work on the private sector development strategy and public sector expenditure reviews. Similarly, the report does not address exactly "how much" public investment i s needed -the numbers presented are intended to serve as illustrative indicators as this issue, too, requires further sector specific work. 38. A core set of necessary policy reforms are recommended in the following seven areas: (i) preferential trading arrangements; (ii)property rights; (iii) infrastructure; (iv) education and skills development; (v) governance; (vi) private sector development; and (vii) social safety nets. 12 e Ensuring a timely response to changes in trade preferences and AGOA opportunities.GoL needs to urgentlytake pro-active measures to retain existing investors and attract new investors to Lesotho's textiles industry to ensure sufficient production o f textiles by 2008, when it will need to comply with AGOA's rules o f origin clause. It also needs to ensure that infrastructure and utilities do not constrain scaling up or expansion o f the textiles and garments firms. Public-private partnerships with local and foreign firms might help. Also, measures are needed to improve skills and labor productivity to boost the competitiveness o f its manufacturing sector. This will require careful studies of the lessons o f experience o f successful countries and sensible applications to the local context. e Strengthening property rights. Three issues are key here: Land institutions, communal grazing, and visas. The need for reforming land institutions and improving land use are widely accepted but politically sensitive. The consequences o f no land reforms to provide adequate incentives for both domestic and foreign investors without diluting "Basotho" control to unacceptable levels need to be debated widely. Extensive consultations on the draft white paper on land reforms would provide such an opportunity, and also help to develop broad based support for required reforms. It would be useful to consider alternatives such as facilitating longer leases, if further concentration o f land ownership inthe country and foreign ownership are socially unacceptable. Finally, terms under which visas are issued and the costs o f obtaining visas discourage expatriate investors from bringing in the required skilled individuals into Lesotho. The same barriers hinder the flow o f tourists into Lesotho: for example, the issuance o f only single entry visas i s a deterrent to visitors who may want to cross the border for a few hours to conduct business in RSA and return to Lesotho. These practices need to be changed to expand exports-oriented manufacturing and tourism. a Investing in public infrastructure. Public infrastructure needs to be developed to harness the country's water resources for human, industrial and irrigation needs; expand and improve the road network; enlarge electricity coverage; and handle imports and exports at the Maseru railhead, which i s critical to export-manufacturing. The earlier development plans that had envisaged multipurpose water projects to meet the domestic demand invarious sectors need to be implemented. Improved roads and irrigation development are critical to develop rural markets and commercialize agriculture. Roads are also essential to improve access to the mountains that have tourism potential and to facilitate growth o f non farm activities. More importantly, improved roads will enhance access to schools, hospitals and woolsheds. Expanding electricity is critical to supporting growth o f rural industries and services, Finally, infrastructure for the treatment o f industrial wastewater needs to be developed to reduce pollution, and measures need to be introduced to encourage conservation. Infrastructure development i s particularly challenging as the population i s dispersed over a difficult terrain. 0 Improving delivery and outcomes of education and training. To improve the productivity of its abundant but low skilled labor, the GoL needs to improve the delivery and outcomes o f both educatiodtraining. Secondary school enrolments in the country are as low as 20 percent. In spite o f the recent improvements ineducational infrastructure, the demand for education beyond primary levels and the success rates are unacceptably low. Some surveys suggest that the high cost o f secondary education is one o f the reasons for low demand. The reasons for poor performance o f the educational system need to be examined. Attention also needs to be paid to vocational training, as the country does not have the institutions that develop the kinds o f skills that are required in the economy. A good start would be to examine why the existing training organizations including the one that was expected to train workers for the textile industryhave failed. Options to explore the scope for public-private partnerships in vocationalltechnical training to effectively gear training to meet the skills needs may be another way to go. 0 Significantly strengthening governance and capacity. Poor capacity in terms o f the absence of adequate skills, suitable institutions and incentive structures undermines development planning and administration. Poor capacity is often cited as the reason for the lack o f effective implementation o f projects. One of the constraints mentioned by the local private sector is the difficulties in working with the government. Governance needs to be improved through simplification o f regulations and more effective administration through a responsive and accountable bureaucracy. Enhancing skills will be challenging. As a recent employment policy paper suggests, retaining trained individuals is more important than merely training individuals in the bureaucracy. Lesotho needs a better-paid, more effective, and perhaps, a smaller bureaucracy. The need for civil service reform, which has been on the policy agenda for two decades without significant progress, is finally being addressed. As long as the civil service is not able to offer better administration, the government cannot make hard choices and implement reforms. 0 Creating more favorable climate for durable private sector development. Lesotho has been fairly successful in attracting foreign investors to take advantage o f its trade preferences. These temporary advantages need to be consolidated by public interventions that will continue to attract new investments, especially in textiles to facilitate further expansion o f the garment industry. As the Diagnostic Trade Integrated Study (DTIS) suggested, Lesotho needs to make itself regionally more competitive for investments, possibly to take advantage o f the access it has to its neighboring markets. An important aspect o f developing an industrial base in the country is, as the country has been planning, to reduce the gap that exists between the foreign-owned, export 14 oriented manufacturing firms and the indigenous firms in terms o f managerial and technical capabilities. Both indigenous entrepreneurs and foreign investors will benefit from government action in the areas identified above - improved access to land, skills development, improved infrastructure and a more responsive bureaucracy. The domestic entrepreneurs who compete with cheaper goods and services from RSA will benefit particularly from the provision o f comparable physical and institutional infrastructure. Special efforts need to be made to facilitate the diffusion of skills from the export-oriented sector. Proactive measures, such as public-private initiatives in training are needed to "integrate" the export sector with the rest o f the economy. Political andlor social tensions that exist between expatriate businessman and the domestic entrepreneurs and work force, need to be eased to benefit from diffusion andimprove the investment climate. e Strengthening safety nets and care for HIV/AIDS affected. Direct measures are needed to improve the welfare o f the poor, as the bulk o f the children and elderly are in poor households, A significant proportion o f the poor households cannot benefit from employment creation. Families faced with catastrophic illnesses such as HIVlAIDS and death of productive members, and those caring for orphans also need direct public assistance through safety nets provision. Presently, the burden of the epidemic i s borne privately by almost all affectedhouseholds. 1. GEOGRAPHY,ENVIRONMENT,PEOPLEAND INSTITUTIONS INTRODUCTION 1.1 Lesotho is a small country of less than 2 million people with an area of approximately 30,000 sq km that is surrounded by the Republic of South Africa (RSA). Its size, resource endowments, geography that places it within the richest country in southern Africa as well as its ecological limitations have implications for the organization o f economic activity within the country and cross border movement o f labor andgoods. ECOLOGICALZONES 1.2 The country has four ecological zones: lowlands, foothills, mountains and the Senqu River Valley (SRV). The lowlands, comprised of a narrow strip 20-50 km wide along the western border, cover 17 percent of the country's land and support about most of the population of about 2.1 million. The mountains, at an elevation greater than 2,000 meters, cover nearly 60 percent of the territory and support about a quarter of the population. The foothills with an elevation ranging from 1,800 and 2,000 meters are a narrow patch betweenthe lowlands and mountains. LAND SOILS AND 1.3 Only about 10 percent of the land is cultivable, and soil degradation is a serious problem. A small portion of land is suitable for intensive cultivation and more than 80 percent of it is in the lowlands. Animal and human pressures on land are high. Lesotho's population density increased from 53 personsper sq kmin 1986 to 61 persons in2000; the pressure on arable lands was 588 persons per sq km in 1996 (KoL 2000). Overall, Lesotho's soils are low in fertility.' Soil fertility varies across the zones from low fertility (lowlands) to moderate (foothills) and high (hills, black soil). Black soils in the hills has better structure and water retention capacity, but are generally shallow and vulnerable to sheet erosion (KoL 1996a). Against this background, soil degradation i s a major andpersistentproblem due to gully formation. InMafeteng for example, erosion is severe across nearly one-half o f the arable land(KoL 2001e). Steep topography, torrential rains and the absence of tree cover contribute to high rates of soil erosion. Overgrazing contributes to soil erosion in both croplands and rangelands (World Bank 1993). Although terracing, strip cropping and contour farming are widely practiced, intense pressure from human and livestock populations has led to tillage and grazing of vulnerable areas. Road building and conservation programs may have triggered gully formation insome fields (Showers 1996). Sheet erosion is the dominant form of soil loss, although gullies are more visible inthe country. Productivity estimates suggest that 1.1 percent of the area is most productive; 11.Ipercent is very productive; 25.5 percent is moderately productive and 50.2 percent is moderatelyproductive with careful treatment (KoL 1996a). 16 1.4 The rangelands, which are critical to Lesotho's livestock economy are also degrading. Rangeland inventory indicates that 25 percent of the rangelands are inpoor condition characterized by the increase in unpalatable plant species, reduction in plant cover and accelerated soil loss. The principal reason is overstocking-1 50-300 percent of carrying capacity (KoL 1989)2; it may be more severe in the lowlands, foothills and the SRV than inthe mountains (KoL 2001~).Areas at higher elevations andcattle postsused for summer grazing do not show signs o f severe overgrazing; they may be under-stocked duringthe first three months ofthe grazing season (KoL 2001d). WATER 1.5 Though water is seemingly abundant in the aggregate, water needs are not met adequately. The key water sources are groundwater and three major rivers - Senqu (Orange), Makhalengand Mohokare -which drain south-west. Total water availability in the country is estimated to be 159 m3/second. Although Lesotho presently faces only water quality and dry season problems, by 2025 - assuming that the populationexpands to a size o f about 3.4 million - the country will be water stressed (Hirji et al. 2002).3 Water supply is also highly variable due to extreme variations in rainfall (TAMS). Surface water is abundant where the potential to use it is limited. Similarly, the potential for groundwater extraction is limited by low well yields. Except for the area around Maputsoe where the yields are higher than 50 liters per second, the potential for groundwater exploitation is low (FAO). The cost of extracting and delivering groundwater may exceed the ability or willingness o f consumers to pay inmany smaller towns because large scale extraction o f groundwater requires a battery o f low yielding wells. 1.6 Safe drinking water needs are not met adequately in either rural or urban areas. Inmany urban areas, conflicts are emergingover the domestic and industrial uses of water, Though plentiful in the mountains, water may not be potable because o f contamination from a large animal population (Eales et al.). In 9 out o f 12 towns, colifom levels are high. In peri-urban areas, one half of the population may not have access to safe water, Inaddition to utility management deficiencies, adequatewater is not available in the lowlands. WASA's water supply is not adequate to meet both consumer and industrial demands. With the establishment o f a denim plant, the textile industry anticipates usinga third o f the water available for Maseru, an area inwhich humanneeds are not met adequately. The release o f LHWP water into the rivers to meet lowlandneeds duringthe dry season is now under consideration. 1.7 Both surface and groundwater are used to meet human and livestock needs. Spring water is used primarily in the mountains; in the lowlands, water from both borewells and springs is utilized, A survey o f 209 water projects in the Maseru region indicated that 33 percent were wells fitted with hand pumps, 27 percent were gravity-fed from springs, and the remaining 37 percent were a combination o f hand pumps and protected springs (Eales et al.). Nearly 90 percent o f the water supplied by WASA to 'Some specialists suggest that overstocking per se is not the problem; with better management through rotation etc., the rangelands can support the existing animal population. Water stress is defined as availability o f 1,000 to 1,700 cu mof freshwaterlpersodyear. 17 urbanareas is drawn from rivers. Anecdotal evidence suggeststhat springs maybe drying upbecauseo freducedpercolation from loss of vegetation and soil (Eales et al.). 1.8 Over the years, the small-scale irrigation systems failed because of weak collective management (Hall 1992). Nearly 12,000 ha of land, in irrigable units o f 200 ha or more, are estimated to be suitable for irrigation. O f this, about 2,500 ha are suitable for irrigation with the runo f the river systems (TAMS 113). Presently, less than 3,000 ha o f land is irrigated. Irrigation projects that frequently coerced individuals into joining them lacked failed to discourage shirking and resolve conflicts (Hall and Cole quoted in Johnston 1996). 1.9 Water, which is plentiful in the mountains of Lesotho, is exported to South Africa through the LHWP project. The LHWP adds value to southwesterly flows - that eventually flow into South Africa - by diverting them north-west to flow into the water scarce Gauteng region o f South Africa. The project is also designed to generate hydroelectric power in Lesotho. The LHWP now has the capacity to deliver 17 m3/sec. With the completion of phase 1B of the project, it can be increased to 28 m3/sec. The total capacity of all the planned phases is 70 ni3/sec, out of a total national estimated availability o f 159m3/sec. However, as anticipated, South Africa may not needthis water for another 5 to 7 years as its water demand has been reduced from the demographic effects o f AIDS and demand managementmeasures (World Bank 1998). 1.10 Lesotho generates adequate power through the LHWP to meet its domestic needs but the power generation costs are higher than what it costs to buy power from South Africa. The latter primarily because o f the high financing costs o f the project. The costs of electricity generation can be reduced to reasonable levels if the power plant is operated at full capacity and excess power i s exported but the potential for power exports is currently limited by the size o f the market. Lesotho will have to develop long term power sales agreements with South Africa to be able to sell power inthe SADC region. South Africa, which has 90 percent o f the region's power generation capacity, also has surplus capacity, but it generates power using low grade coal. The prospects for developing sales agreements will depend on growth in the demand for power in the coming years and preference for hydro power which is cleaner and more suited to meetingpeak demand. 1.11 Water pollution, primarily from industrial sources, is also a concern. The waste water treatment plant in Thetsane is unable to treat nearly 5 Mllday o f wastewater from the garment industries. The textile factories discharge their waste water into the Mosenyathe stream, which flows into the Mohokare river (Salm et a12002). By 2005, the industrial effluents that need to be treated are estimated to reachnearly 12 Mllday. NATURAL IRONMENT ENV 1.12 Lesotho's scenic beauty is a valuable natural resource that is inadequately Africa has a distinct landscape and biodiversity rich inplant and other wild specie^.^ The exploited. The Maloti-Drakensburg range along Lesotho's eastern border with South The area contains 2,153 plant species, 295 bird species, 60 mammal species and 49 reptiles and amphibians. 18 vegetation is Austral Afro-alpine (World Bank 2001g). Excessivelivestock grazing, crop cultivation in steep slopes, uncontrolled burning, alien invading species and human encroachment threaten this asset (World Bank 2001g). Some of the rural areas have as much potential as South Afi-ica's Drakensberg Range which supports a thriving tourist industry. Historic relics in the country include Stone Age cultural artifacts and cave paintings o f the Bushmen. By virtue of topography and elevation, Lesotho has interesting areas with alpine conditions that are unique in Africa. The International Tourism Organization study of 1995 favorably assessed the opportunities for attracting not only vacationing South Africans to Lesotho but also Europeans and other African nationals. Poor infrastructure (roads, drinking water and power supply), and lack of effective policies and programs, however, are major limitations that constrain growth inLesotho's tourism sector. INFRASTRUCTURE 1.13 Rural infrastructure is inadequate for facilitating access to markets and the growth of agriculture and non-agricultural activities, particularly in the mountains. The roads network is relatively extensive in economically active areas in the lowlands. Butmost of the roadsinthe mountains, except those developed as part ofthe LHWP, are not all-weather roads. The population in the most populated outer fringes is better connectedwith South Africa than with locations within the country. Telecommunications are weak. The number of mainlines per 100 people is less than 1, compared to the world average penetration o f over 10 per 100 people (World Bank 2001a). Inthe urban areas, the coverage is nearly 6. Access to electricity is also poor: only an estimated 20,000 of the nearly 400,000 householdswere connected to the electricity grid in 1995. 1.14 Being surrounded by a richer country with superior infrastructure has advantages. Though landlocked, Lesotho has access to South Africa's ports. But poorly developed infrastructure within Lesotho's borders (e.g., railhead at Maseru) creates major bottlenecks for the movement of goods. As Lesotho is a member o f the SACU customs union, the Basotho cross borders freely to buy goods and services, thereby placing domestic producers in direct competition with producers in South Africa. South African border towns thrive on providing goods and services that the Basotho are not capable of providing. However, such free movements also offer the potential to reverse the movement of goods and services if Lesotho's producers can develop a competitive advantageinproduction. THEPEOPLE 1.15 After accounting for excess mortality due to AIDS, in July 2002, Lesotho's population was estimated to be 1.8 million with declining life expectancy due to HIVIAIDS, and out-migration.' Population is growing at the rate of less than 1percent per annum, down from 1.3 percent per annum in the 1990s. Little more than one half o f the population is in the productive age group: 0-14 years, 39 percent; 15-64 years, 56.3 percent, and 65 and over, 4.5 percent. Life expectancy at birth has been declining, estimatedto be 47 years in2002. About one third o fthe adult population i s HW-positive 5 World Bank official estimates, 2004. 19 and about 30 percent lives in urban areas. The net migration rate is -0.63 migrantl1,OOO population. 1.16 Agriculture has played somewhat of a unique role in Lesotho in that it is not the mainstay of rural households or of the economy. Though culturally attached to land, the Basotho have always sought diversified livelihoods - perhaps, because the land alone does not provide adequate livelihoods. Initially as sharecroppers and later as mine workers, the Basotho migrated out o f rural areas to take advantage o f opportunities, mostly in South Afkica.6 Although two-thirds o f the population live in rural areas, engaged in some form o f agriculture, some suggest that the rural Basotho can hardly be called farmers (Turner 2001). 1.17 The Basotho have a long history of movement across the border in search of livelihood opport~nities.~ Being a part of a country that was well integrated with the regional economy, the Basotho worked in South Africa and traded their surplus for manufactured goods, guns and clothes in the last century. In 1875, three-quarters o f the able-bodied men were seeking passes to work outside the territory for short or long periods (Ferguson 1993). Inthe 1960s when migration was at its peak, nearly 25 percent o f the de jure population o f Lesotho was living outside the country (Epprecht 1996). Though they seek opportunities elsewhere, the Basotho maintain roots in their country.* They do not view themselves as foreigners in South Africa and feel that South Africa owes them for their role in dismantling apartheid, Inreturn, Basotho migrants tend to be more welcome into RSA than migrants from other countries. 1.18 Linkages between the two countries are strong at various levels. Basotho cultural and business networks transcend Lesotho's borders. In the past, the Basotho depended on RSA for livelihoods. Though mining jobs have declined, migration continues. In addition to low skilled workers who cannot find work in the country, the educated Basotho migrate because o f opportunities in RSA. The bulk o f the consumer goods and services are imported from RSA. The country still imports nearly 80 percent of the food consumed. Technical dependence i s high both in the private and public sectors. Lesotho still makes use of South African judges and most training is conducted in RSA institutions. Foreign investments in the country beginning with the Lesotho Highlands Development Project are largely South African. Although East Asians dominate the textile industry, the South African investments are in critical services such as finance, transport, hotels and business services, Because o f lack o f adequate skills in the country, private businesses depend on South African businesses for services such as equipment maintenance, bookkeeping and auditing, All the animal stocks are imported from South 6Asthe nuniber of Basotho eniployed in SA mines has halved between 198U and 1999, the share of migrants working in mines declined froin nearly 89 percent to 45 percent between I994 and 1999. The nuniber of non-mining migrants increasedfrom 14,000 in 1994, to 56,WO in 1990. Fcacr inigrants arc ablc to enter miningjobs now: nearly 80 percent of those in mining in 1999had already worked for tnorc than 3 ycurs. 'Male migration has affected gcnder relations in l.esotlio. As nien do not nccd skills for mining, they tend cattle until old enoughto work inmines. Girls are better educated. Boys under 5 fare worse in inalnutrition than girls. Women are represented adequately in bureaucracy and politics. The 5ocicty is traditional and niale dominated - laws do not perniit wonicn to own land or be treiitcd as udults but ivonicn cnjo!; significant areas of autonomy froin inale control. However, migration patterns are chanpinp. Female niigrution is replacing niale niigration (Ulicki andCrush 2000). * Only about a third of the Basotho would like to tdic tip perni;inent rcsidcncc in South Africa; about 30 percent would like to retire there, but only 10 percent ~ o u l like to bc btiriod In South Afiica (McDonald et al 2000). d 20 Africa. Farmers also buy their inputs from private traders and South African cooperatives. 1.19 The desire of the Basotho to overcome this sense of dependency on RSA is strong. The Basotho seem to desire "open" borders, but an "independent" economy and political identity. Many rural Basotho still see unification with South Africa as the best hope for the future: in a recent survey, nearly 40 percent o f the Basotho indicated that Lesotho should integrate with South Africa (McDonald et a1 2000). On the other hand, understandably, some o f the development strategies that have been enthusiastically accepted by the country - food self-sufficiency, local entrepreneurship development, and so on - have focused on developing a more independent economy that is free from South Africa. SuMMA RY 1.20 Lesotho has limited natural resource base, hence the need to invest in infrastructureto overcomethe natural constraints to moredynamic growth. Only 10 percent o f the land is suitable for cultivation and only a portion of it is suitable for intensive cultivation. The natural resources are subjected to considerable human and animal pressures. The soils are o f limited fertility, and degrading from soil erosion and nutrient mining. Water resources are abundant in Lesotho but are not utilized efficiently. Investment in water storage and transport is inadequate and the potential for irrigation limited. The LHWPdiverts southwesterly river flows inthe mountains to the northwest to export water to a water scarce region in South Africa. But infrastructure required to meet the domestic and industrial water needs in the plains of Lesotho i s lacking. Although only 5 percent o f the households have access, the power generated in Lesotho i s adequate to meet domestic demand at highcosts. Physical infrastructure as inroads, water supply and electricity is poor. Close linkages with RSA offer opportunities to borrow certain institutions but "dependence" is somethingthat the country would like to minimize. 1.21 In the remainder of this report, the demand for infrastructure in terms of both its quality and quantity as an explicit input is evaluated in the context of growth and employment policy interventions. Chapter 6 discusses explicitly the potential o f infrastructure both as a direct source o f growth in the construction and utilities sub-sectors as well as an indirect input in the economic sectors - industry, agriculture and services. 21 2. MACROECONOMIC DEVELOPMENTSAND ISSUES INTRODUCTION 2.1 Lesotho is a very small, mountainous, low-income country with limited arable land and other resources and largely unskilled Iabor force. Its 1.8 million people produce the GNP o f approximately US$ 1.4 billion (GDP o f approximately US$ 1.1 billion), making it the poorest SACU country. About 82 percent o f its GNP is produced domestically and the remainder is comprised o f remittances from those employed in the mines o f South Africa. Between 1980181- 1986187, its per capita GNP averaged about US$488. During 1987188-1997198, it rose to US$685 but began slipping towards the end o f the 1990s. For the period, 1998199 - 2002103, Lesotho's per capita GNP averaged US$597. In 2003104, due to a significant appreciation o f the exchange rate, this statistic was elevated to US$795, although in real terms, its downward trend continued. Its 2004 GNI per capita (World Bank Atlas method) was estimated at $740. 2.2 Historically, the economy has been fashioned by its larger and wealthier neighbor, the Republic of South Africa (RSA), which compietely surrounds it, Like Namibia, Botswana, and Swaziland, and South Africa, Lesotho also participates in both the Common Monetary Area (CMA) and the Southern African Customs Union (SACU). Its currency is pegged to the South African Rand. RSA determines the trade, exchange rate and monetary polices for all SACU members including Lesotho. Besides policy dependence, Lesotho shares one o f the most open borders with RSA - over three quarters o f its trade, with the exception of manufactured exports, is with RSA; and most o f its sophisticated services such as medical referrals, higher education, and commercial bankingare imported from RSA. Historically and untilthe early 1990sclose to halfof its GNP originated in remittances from Basotho miners employed in the South Africa and almost half o f the Basotho male labor force worked in these mines. But the 1990s witnessed a sharp decline in mining opportunities so that today, only 18 percent o f Lesotho's GNP is generated inRSA. Despite this dependence, the Basotho share a strong sense o f national identity. Inthe 1990s, a series of favorable external shocks nudgedthe economy towards greater economic independence: FDI from East Asia to a rapidly growing garments export sector mostly for the U S market (In 2002, Lesotho became Africa's largest exporter o f garments to the US) and phenomenal increase in external investment which financed the Lesotho Highlands Water Project with associated growth rate. While these shocks nearly doubled GDP growth rates and created new jobs, they were insufficient to compensate for the negative impact o f declining remittances. As a result, country's growth and poverty reduction was disappointing inthe 1980-90s(Table 2.1). 2.3 Lesotho's economic growth in the past decade was sluggish and, therefore, poverty did not decline. Its GDP and GNP trends charted mirror trajectories inopposite directions. On the one hand, GDP growth doubled to 6 percent per annumover 1987188- 1997198 from about 3 percent during 1980181-1986187. On the other, remittances from Basotho miners in RSA, the key driver o f GNP growth, recorded a sharp decline. Consequently, GNP growth trends veered in the opposite direction. Growth in real per 22 capita GNP halved from 2 percent during 1980/81-1986/87 to 1 percent per annum during 1987188-1997198. Since 1999/009, it has stagnated at 0.2 percent per annum (Table 2.1).1° On average, poverty remained virtually unchanged during the entire period. It worsened in the rural areas where many non-poor households that were most dependent on remittances as the primary source of household income, slipped below the poverty line. Poverty also worsened as retrenched miners returning to Lesotho did not find well-paying employment opportunities in the domestic market, While there was a marginal increase in waged employment opportunities due to the LHWP and growth in the garment industry, most workers in rural households remainedunemployed or resorted to subsistence agriculture. More recently, GDP growth has decelerated to about 3-3.5 percent per annum. Unemployment'' continues to be highat 25 - 30 percent. The growth, poverty and unemployment are, therefore, major concerns among policy makers. 1980181- 1987188- 1998199;1999100 2000101 2001102 2002103 2003104 1999100- 1986-87 1997-98 1 03104 Pre High Post Post Post Post Post Post Post LHWP ,LHWP ~LHWP ! LHWP LHWP LHWP LHWP LHWP LHWP GNP 4.2 3.0 -6.5 -0.3 0.7 1.0 3.8 2.8 1.6 Consumption n.a. 2.8 -10.7 -0.8 -0.2 -0.7 9.3 -1.1 1.3 GDP including LHWP 2.8 6.0 -3.5 0.5 1.9 3.3 3.7 3.2 2.5 GDP excluding LHWP 2.8 5.4 -3.1 3.1 2.5 4.2 3.5 3.1 3.3 GNP per capita growth rate 1.9 1.0 , -8.0 -1.7 -0.7 -0.3 2.5 1.5 0.2 Consumptionper capita n.a. 0.7 -12.1 -2.3 -1.5 -2.0 7.9 -2.4 -0.1 growth rate , 1 Memo Items I GNP per capita US$ 1 488 1 685 1 668 1657 1597 1522 1543 795 1 623 MACROECONOMIC DEVELOPMENTS 2.4 Between the early and late 198Os, Lesotho's economy went through significant structural changes. In the early 1980s, nearly one half o f Lesotho's national income was produced domestically; the remainder was generated either through remittances from Basotho workers in South Africa or from foreign transfers.I2 In 1983184 for example, workers remittances were equivalent to 48 percent o f GNP (about 84 percent o f GDP). Aggregate consumption was 79 percent o f GNP (138 percent o f 1998199was an exceptional year when political strife followed by civil riots caused investment andper capita GNP growth to drop sharply by about 8 percent. Io For the period 1998199-2003104,GNP per capita grew at (-) 1.1percent per annum, The unemployment rate, a key statistics in the report requiring explanation, is derived from the Labor Force Survey for Lesotho which usedstandard definitions set by the ILO for these countries. See chapter 3 for a more detailed discussion. '' Because o f the significant share o fnet factor income from abroad, GNP as opposed to GDP is a more appropriate measureo f Lesotho's economic resources. Inthis chapter and elsewhere inthis report, where appropriate, statistics are presented with reference to GNP. The statistical appendix contains corresponding tables with reference to GDP. 23 GDP), and almost all tradables consumedby the Basotho were imported. Imports stood at 63 percent o f GNP (114percent o f GDP, Table 2.2). Table 2.2: National IncrtnieiExpenditure (`lassification (Share of (.;SI') 1980/81- 1987188- 1998/99 1999100 2000101 ZOOl/OZ 2002103 2003104 1999100- 1986-87 1997-98 2003l04 Share of GNP (Yo) Pre High Post Post Post Post Post Post Post L H W P L H W P L H W P L H W P L H W P L H W P LHWP LHWP L H W P GDP 57 67 78 79 80 82 82 82 81 Net factor income from 43 33 22 21 20 18 18 18 19 abroad GNP 100 100 100 100 100 100 100 100 100 Unrequited transfers 5 13 12 13 12 14 14 13 13 GNI 105 113 112 113 112 114 114 113 113 Consumption 79 98 95 94 94 92 97 93 94 Public 18 18 28 30 28 25 28 26 27 Private 61 80 67 65 65 67 69 67 67 GNS 8 15 18 19 19 22 17 18 19 Public 6 3 12 17 14 14 12 11 14 Private 2 12 5 2 4 8 5 7 5 GDI 8 32 37 37 33 33 31 28 32 Public 10 12 8 7 6 10 8 6 7 Private -2 6 12 21 19 17 17 17 18 LHWP n.a. 16 18 10 9 6 6 4 7 Exports of GNFS 5 13 21 20 26 38 43 39 33 Importsof GNFS 63 77 75 72 73 81 89 78 79 Resource balance -6 -18 -20 -18 -15 -11 -14 -10 -13 Remittances 48 36 25 24 23 21 21 20 22 Memo Items: RemittanceslGDP 84 56 33 30 29 26 25 25 28 ConsumptiodGDP 138 148 121 120 117 113 119 114 117 lGDPlconsumption ImportslGDP 114 115 95 92 91 99 109 95 97 70 76 79 76 82 84 85 80 Source: BOS, IMFand WB staff estimates, January 2005. See statistical appendix for data inTable 2-2 represented in shares of GDP *Notes: 1-k compriseof SACU revenues including non-duty receipts; 2-1' Gross national income less consumption; _?-/foreignsavings. **Constiniption data is only a\aiI:ibk for 1080i87 and is incoinplctc. STRUCTURALCHANGES 2.5 Starting around 1986-87, there were two major, FDI-related structural changes. The first was the construction o f the Lesotho Highlands Water Project (LHWP) that resulted from a 1987 agreement between Lesotho and RSA. The second was the emergence o f the gannent industry. It has today emerged as a leading wage employer with considerable growth potential if timely actions are taken by the GoL to retain foreign investors in the post-AGOA Iand post-MFA period that started in 2005. Annual foreign direct investment (FDI) inflows as a share of GNP to finance these two developments are estimated at around 3 percent in 1988189. Since 1999100, they have averaged 2-3 percent o f GNP per annurn,l3 During 1988-93, LHWP-related FDI was much larger than FDI in the garment industry, After 1998199, this trend reversed, Also, the LHWP attracted large inflows o f grants and loans, the latter as large as 17 percent of GNP in 1998199, but declined sharply since as the LHWP transitioned into its completion stage (Table 2.3 (shares o f GNP) and 2.3 (GDP)). 2.6 The third structural shock was related to the labor market. Between the mid- 1980s and early 1990s, the remittances of Basotho miners employed in RSA that had in the previous decade averaged about 48 percent of GNP in 1980181-1986187 at the peak o f Basotho employment in RSA, fell dramatically. Between 1991 and 2000, as the number of miningjobs in South Africa halved, remittances tumbled and were only 24 percent o f GNP in 1999100. As a result of these trends, the gap betweenGDP andGNP narr~wed'~: the share o f domestically generated national income (GDPIGNF) increased from 57 percent during 1980181-1986187 to 67 percent during 1987188-1997198, and measured82 percent by 2003104 (Table 2.3 and 2.4) Table 2.3: Key structural resource flow indicators for Lesotho (share of GNP) 1980181- 1987188- 1998199 1999100 2000101 2001102 2002103 2003104 199910. 1986-87 1997-98 03104 Pre High Post Post Post Post Post Post Pre LHWP LHWP LHWP LHWP LHWP LHWP LHWP LHWP LHWP FDI 0.8 1.8 2.3 2.8 2.9 2.9 3.1 3.1 3.0 LHWP Loans and grants 0.0 2.5 14.1 9.0 3.9 8.4 9.8 6.4 7.5 Unrequitedtransfers(SACU 5.1 12.9 12.5 13.4 12.1 13.9 13.7 12.5 13.1 etc.) Other grants to GoL 3.0 0.3 -12.6 -5.7 -0.5 -0.2 0.8 0.6 -1.0 GDP 56.7 67.0 78.3 78.9 79.9 81.7 81.6 81.9 80.8 Immigrantremittances 47.7 36.4 25.5 23.9 22.9 21.1 20.7 20.1 21.8 Source: BOS, IMFand WB staff estimates, January 2005 2.7 The fourth shock was associated with official transfers. As a result o f LHWP- related capital equipment imports into Lesotho and non-duty transfers, total SACU transfers that were about 5 percent of GNP prior to 1987188, increased to 13 percent in the 1990s (Table 2.2); they have stabilized at that level since but are expected to decline somewhat after 2006107.Als0, after the completion o f the first phase o f the LHWP, in 1996, royalties from the water exported to South Africa began to accrue and measured US$ 15 million (1.1 percent of the GNP) in 2003104. In addition, capital grants about 3 percent o f GNP in the late 1980s. After RSA's transition to democracy in 1994, they dropped to 1.5 percent o f GNP. Recently, capital grants to the government havemeasured about 1percent of GNP. l3Initially, the LHWP was financed by FDIbut after 1992193, its construction was financed mostly by loans and grants. Incontrast, FDIinto the textiles and garment industry has grown. l4Deterioration inthe terms o ftrade also contributed to the narrowing ofthe gap betweenGDP and GNP. 2s Table 2.4: Key structural resourceh indicatorsfor Lesotho (shareof GDP) i t 1980181- 1987188- 1998199 1999100 2000101 2001102 2002103 2003104 19991 1986-87 1991-98 03/04 Pre High Post Post Post Post Post Post Pri LHWP LHWP LHWP LHWP LHWP LHWP LHWP LHWP LHWI FDI(LHWP & garment 1.4 2.6 2.9 3.5 3.7 3.6 3.8 3.8 3.7 industry) LHWP Loans andgrants 7.0 6.7 17.2 8.8 2.2 1.8 1.2 0.6 2.9 Unrequitedtransfers (SACU 9.0 19.0 16.0 17.0 15.2 17.0 16.8 15.3 16.2 etc.) Other grants to GoL 5.4 0.8 -16.1 -7.2 -0.7 -0.3 1.0 0.8 -1.3 GDP 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Immigrant remittances 84.4 55.6 32.5 30.2 28.7 25.8 25.4 24.6 27.0 Source:BOS, IMFand WB staff estimates,January 2005 2.8 By the end of the 199Os, the LHWP, the garment industry, and the decline in worker remittancestransformed the structure of Lesotho's economy in fundamental ways. The economy produced more, consumed less, invested more and exported more than before (Table 2.2). In2003104, about 81 percent of Lesotho's GNP was produced domestically relative to 72 percent a decade ago. Remittances from miners and other immigrants were only 20 percent o f GNP in 2003104 relative to 35 percent ten years earlier. Imports as a share o f GNP declined from 78 percent o f GNP in 1993194 to about 72 percent in 2000101, though import dependence has since gradually increased. Private investment and exports as a share o f GNP increaseddramatically. 2.9 Structural indicators shown in Table 2.3 suggest three phases in the developmentof Lesotho's economy between 1980 and 2001. Although the shocks had varied sources, the phases are defined with respect to LHWP activity because o f its overwhelming effect on the economy. 1980181 - 1986187, the pre-LHWP period when the domestic economy (GDP) grew at 2.8 percent per annum; Lesotho produced domestically only 57 percent of its GNP andrelied heavily on RSA inthe form o f remittances. 1987188- 1997198,the high-LHWP period when GDP growth averaged 6 percent per annum. LHWP and textile and garment industry developed but employment opportunities for the Basotho in RSA mines declined. About two third o f GNP was produced locally and remittances comprised only about 36 percent o f GNP. The share o f private investment in GNP, while rising rapidly, was still small at 6 percent o f GNP (Table 2.2). The economy remained significantly dependent on South Africa. Post-1998199, the post-LHWP period when GDP growth has slowed down to about 3 percent per annum and there is a significantly smaller flow o f LHWP- related loans and grants. Lesotho's economy has transformed into an export- driven economy that produces domestically more than 80 percent o f its GNP. Remittance income, while still important, has declined to 18 percent o f GNP and private investment, mostly in the manufactured exports sector has emerged as a critical indicator o f growth with a share in GNP of 18 - 19 percent in the past three years. Even more impressive is Lesotho's economic independence from RSA - its sources of growth are services and manufacturing, especially garment exports; both are completely independento f RSA. 2.10 In the remainder of this report, various aspects of Lesotho's economic development and their implications for its growth and employment options are cast in referenceto the three time periods identified above. SAVINGS AND INVESTMENT 2.11 The most striking aspect of this structural transformation is the shift away from the pre-LHWP consumption-driven economy towards a post-LHWP production- and export-oriented economy. There is one important exception - the increase in government spending on education and health should be considered an investment in human capital. A part of the increase in the share o f GDP (in GNP) occurred becauseworker remittances declined and forced cuts in imports and GNP. Even though the LHWP is winding down, its lingering investments measured about 4 percent of GNP in2003104 (Table 2.2), continue to contributeto GDP growth. The key source of the expansion in GDP, however, i s related with increased domestic private investment and exports, Ina nutshell, compared to the pre-LHWP period, Lesotho's economy inthe post-LHWP periodis characterizedby: e distinctly visible private sector that contributes substantially more to national income by investing and exporting; and, it consumes less than it didinthe high-LHWP-era. e a public sector that has grown significantly in size (civil service and parastatals); as a result, it consumes significantly more - slightly inexcess o f one quarter o f GNP. With the exception o f more social spending on education and health which may be considered investments in human capital, it also invests significantly less in the economy although GoL i s making an effort to reversethis trend; and e an autonomous LHWP enclave whose contribution to GNP was predominant in the 1987188 - 1997198 period, but i s rapidly waning; in 2003104, its investment accounted for only 4 percent of GNP relative to as muchas 18 percent in 1998199. 2.12 FDI finance private investment in export-oriented manufacturing,especially in textiles and garments and construction, transformed Lesotho's economy. It especially changed dramatically the informal and subsistence-type private sector into a modern private sector that began to produce and export more in the post-LHWP period. Compared to the pre-LHWP period when private investment was nil," during the high- LHWP period it increased to 6 percent of GNP in the manufacturing and local construction sectors. Inthe post-LHWP period, barring 1998199,16 it has held steadily at 19 percent of GNP (Table 2.2). The impressive rise in private investment numbers has Consistent time series data for the full pre-LHWP period is not available. The (-) 1.9 percent statistic for 1980181- 1986187,derived as a residual from national accounts, should be treated as equivalent to 0. l6The civil strife of 1998199ledto large scale loss o f property and foreign businesses. 27 facilitated high growth in manufactured exports (Table 2.5). Between the pre-LHWP period and 2003104, the share o f exports, primarily manufactures, grew steadily from 5 to over 40 percent o f GNP. Exports recorded growth rates of 18 percent per annum during the high-LHWP era and have accelerated to over 30 percent per annum in U S dollars since 2001102 (Table 2.5). Apparently, a sufficient number o f push-factors exist potentially but there are a few factors that pose severe medium term challenges for private investment and exports. IfGoL can overcome these in a timely fashion, it can exploit the push factors to strategically develop more o f the domestic private sector and maintain the momentum developed by the foreign-owned and FDI-driven, export- oriented private sector. 2.13 Foreign savings" financed most of the growth in domestic investmentduring the high-LHWP period. As national savings were insufficient and financial intermediation weak, the economy's reliance on foreign savings increased to 17 percent o f GNP per annum during the high-LHWP era. Since 1999100, Lesotho's reliance on foreign savings remained high (Table 2.2). As most of the large firms, especially in the manufactured exports sector, are dependent on foreign savings, it seems that any future increase in domestic private investment will need to be financed largely by additional foreign savings. This underscores the importance o f maintaining a favorable investment climate that can (i)continue to attract foreign savings to finance growth in Lesotho; and (ii) domesticprivatesavingsinLesothoasopposedtooutflowstoprivatebank retain accounts inSouth Africa. 2.14 In contrast to the private sector, structural change influenced the public sector quite differently. During the high-LHWP period, as GDP growthjumped from 2.8 to 6 percent per annum, and SACU transfers increased, government revenues also increased and the public sector generated budgetary surpluses. The paucity of domestic employment opportunities inthe face o f large-scalejob losses inthe South African mines motivated government to expand the civil service. Consequently, public consumption increased considerably and grew at over 5 percent per annum during the high-LHWP period (Table 2.5). In the post-LHWP era, in spite o f the demand for critical public investment in utilities and infrastructure required to support private sector development, growth inpublic consumption was slow to level off. For the period, 1999100- 2003104, public consumption grew at O S percent per annum (Table 2.5), albeit from a level in excess o f 25 percent o f GNP inrecent years.18 Its share in GNP shrank to 26 percent in 2003104 fiom 30 percent in 1999100(Table 2.2 and 2.5). l7Foreignsavings are defined asgross national savings less gross domestic investment. '*In retrospect, 1998199was an outlier when public consumption grew by 19 percent. Ifthis year is included, the the period 1998199-2003104. averagegrowthinpublic consumptionrises to 3.6 percent per annum, otherwiseit remainsat 0.5 percent per annumfor 28 Table 2.5: Growth rate of aggregate demand components 1980181- 1987/888- 1998199 1999100 2000101 2001102 2002103 2003104 1999100 1986-87 1997-98 2003101 Pre High Post Post Post Post Post Post Pos LHWP LliWP LI-IWI' LIHWP LHWP LHWP LHWP LHWP LHWI GDP 2.8 6.0 -3.5 0.5 1.9 3.3 3.7 3.2 2.5 Consumption n.a. 2.8 -10.7 -0.8 -0.2 -0.7 9.3 -1.1 1.3 Public n.a. 5.5 18.8 6.1 -4.7 -9.7 14.7 -3.7 0.5 Private n.a. 2.2 -19.1 -3.7 1.8 3.2 7.3 0.0 1.7 l9 GDI n.a. 24.4 -12.1 -0.7 -9.9 0.3 -3.3 -6.7 -4.1 Public n.a. 6.9 -48.3 -12.7 -7.3 62.0 -16.8 -21.3 0.8 Private n.a. 26.4 15.6 78.2 -9.9 -4.8 0.5 5.7 13.9 LHWP n.a. 23.5 2.6 -46.3* -11.5 -33.2 8.3 -22.6 -21.1 Exports of GNFS 1.6 18.8 5.4 -4.1 29.9 47.3 19.4 -7.7 17.0 Imports of GNFS n.a. 5.9 -14.5 -3.1 0.9 12.4 14.5 -10.1 2.9 Net factor income from 6.4 -2.4 -15.9 -3.2 -3.8 -8.1 4.2 1.0 -2.0 abroad GNP 4.2 3.O -6.5 -0.3 0.7 1.o 3.8 2.8 1.6 Memo item Exports, E0.b inUS$ -11.0 18.7 -3.0 -1.6 18.4 31.7 29.8 32.7 22.2 lno&inal growth11 Source:BOS, IMFand WB staff estimates, January 2005; *Note: the sharp decline in the LHWP investmentis due to the phasing down of the LHWP. 2.15 Expansion in public consumption came at the expense of critical public investments. The latter's share rose from 10 percent during the pre-LHWP to over 12 percent of GNP during the high-LHWP period when GoL financed complementary infrastructure for the LHWP. However, in the post-LHWP period when Lesotho started attractingcritical private investmentin non-LHWP sectors such as garments, the share of public investmentdeclinedto about 7 percent of GNP, Since 1999100, it has grown at less than 1 percent per annum, after a steep decline of 13 percent in 1998199. With the exception of 2000101, GoL has not had the fiscal space to expand this vital driver o f growth andpovertyreduction. Table 2.6: Composition of foreign savings financing domestic expenditure 1980181-1987188- 1999100- 1986-87 1007-98 199~~~~~999/002000/0120011022002/032003/042003/04 LHWP 1.1IVVP r..Post Pre lligh Post Post Post Post Post Post F iw P ,HWI' HWP LHWP LHWP LHWP LHWP rants ingovcrnmentbudget -47.3 1.3.1 4.2 6.7 8.4 11.7 13.2 11.1 9.7 -1 1.o 10.4 11.6 15.5 20.1 27.7 22.5 30.2 22.2 0.0 s4.0 87.5 57.8 58.3 85.8 43.4 50.8 57.4 0.0 18.6 - 1.o -23.3 -25.5 7.8 0.2 -33.0 -17.5 17.0 -19.1 24.0 39.0 50.2 -6.8 -6.4 -19.0 15.5 19.6 -1.0 -20.0 5.5 -4.1 5.3 11.2 30.0 9.5 122.6 -6.9 -5.7 -1.2 -7.3 -31.4 16.0 30.0 3.1 ~inancingoftlie current account 100.0 I00.0 IOO.O 100.0 100.0 100.0 100.0 100.0 100.q/ Source: BOS, IMFand WB staffestimates, January 2005 (-)denotesabuildupinreserves. 19 Forthe period 1998199-2003103,the averagegrowth in privateconsumptionwas -2 percent per annum. Private consumptiondeclinedby 19percent in 1998199. 29 2.16 In the post-LHWP period, the composition of foreign savings has shifted away from loans and in favor of FDI flows and grants (Table 2.6). The rise inthe non- LHWP component of FDI has been an encouraging development, especially in comparison to other sub-Saharan economies. As a share of total foreign savings, FDIrose from 15 percent during the pre-LHWP period to 30 percent in 2003104 (Table 2.6). Capital grants played an important role in financing domestic consumption and investment inthe 1980s and 1990s.Untilrecently, a large proportion o f these grants were financing construction o f the LHWP but their share i s phasing rapidly as the LHWP approaches completion in 2007. Grants seem to have leveled off at 13 percent o f foreign savings. With the start of the LHWP construction, foreign loans became the single largest source o f foreign savings in Lesotho. A large proportion o f these are comprised o f water transfer payments loans associated with the financing arrangements with RSA. Other investments associated with non-LHWP loans recorded negative flows inrecent years as Lesotho sought to reduce its external indebtedness, accumulate reserves and use only concessionary sources o f finance (Table 2.6). SECTORALSHIFTS AND GROWTH 2.17 The sectoral composition of GNP reflects the outcomes of these structural changes. Domestic production expanded dramatically as evident from the change in the share of GDP in GNP (Table 1). Two factors underlay this transformation: one, the share of net factor incomes in GNP declined drastically, and two, there were significant structural changes within the domestic sector. Chart 2.1: Sectorat distribution of GNP during the pre- and post-1,HWP periods 1980181-1986187 1999100-2003104 Primary Seconda 22% 19% 6% 9% 2.18 Lesotho's pre-LHWP economy was essentially a consumption-based economy financed by remittances; it changed dramatically in the LHWP period. The primary and secondary sectors jointly accounted for about 28 percent o f GNP. The remaining one fifth o f GNP was generated in the tertiary sector, mostly inwholesale and retail trade activity with RSA (Chart 1). Since 1998199, the economy i s remarkably different: factor income from RSA has more than halved to 20 percent o f GNP (Chart 1). The shares o f the tertiary and secondary sectors are equal and the two jointly account for almost 60 percent of the GNP,with more production for domestic consumption andtrade, 3I) and less reliance on foreign income transfers. All these are positive trends, The question is: `Is the pattern o f growth underlying the potential for a modem economy sustainable?' To answer this, we turn to developments in the real sectors that are the main drivers o f GDP growth and the external trading environment that threatens the foundations of Lesotho's secondary sector growth. 2.19 Overall, GDP growth doubled from 3 to 6 percent per annum between the pre- and high-LHWP periods, but collapsed by nearly half during the post-LHWP era (Table 2.1). Because of large scale destruction caused by the civil unrest o f 1998199, this year is treated as an outlier and excluded from the discussion inthis section. During 1999100 - 2003104, GDP grew at 2.5 percent per annum, Ifthe direct contribution o f the LHWP is excluded, it grew at 3.3 percent per annum. Duringthe same period, GNP grew at only 1.6 percent per annum primarily because o f declining remittances. Net foreign income transfers have declined at 2 percent per annum since the late 1980s. The gradual convergence of GNP and GDP trends suggests an interesting trade-off, Going forward, the Basotho have the opportunity to develop an economy that i s largely controlled by them and driven by domestic as opposed to external or foreign (RSA) sources o f growth, But, the halving of GDP growth rates since 1999100 indicates that the room for policy mistakes or maneuver is limited. Relatively easy slices o f the growth dividends in the form o f the LHWP or miners remittances will not be available in the future. The challenge o f propelling growth and employment rests squarely on economic policies. SECTORAL COMPOSITION OF GROWTH 2.20 In the past quarter century, structural change led to a significant reallocation o f economic resources (labor, capital) that altered the sectoral composition of domestic production. Between 1980181 and 2003104, a decline o f nearly 10 percent in the contribution o f the primary sector to GDP and a marginal decline inthe share o f the tertiary sector was absorbed directly and equally by manufacturing and other secondary sectors, signifyng a first step inthe evolution o f a modem economy (Charts 2). Chart 2.2: Sectoral distribution of GDP during the pre- and post-LHWP periods 1980181-1 986187 I999100-2003104 Indirect Primary Terti sec 37 Other 13% secondary Other 2% secondary 15% 6% 2.21 Poverty statistics suggest that the proportion of households dependent on livelihoodsinthe primary sector increased.Inthe pre-LHWP period, crops contributed 14 percent and livestock 10 percent o f GDP. During the high-LHWP period, the contribution o f both crops and livestock contracted; in the post-LHWP era, the trend continues: crops now contribute 10 percent and livestock 6 percent of GDP. Unlikeother sectors, the primary sector was protected from the structural shocks. But its performance was vulnerable to cycles o f droughts and good weather, resource degradation and institutional factors. Its growth rates were highly unstable, from close to zero inthe pre- LHWP era to about 2 percent duringthe high-LHWP. Since 1999100, the primary sectors have grown at 0.5 percent per annum, mostly on account o f the drought in 2002 (Table 2.7). 2.22 Within secondary activity, the key drivers of growth are local construction, utilitiesand manufacturing.Prior to the LHWP, electricity and water accounted for less than 1 percent, and manufacturing and local construction each contributed about 10 percent o f GDP. The crux o f the structural transformation o f these sectors lay in the two external shocks o f the late 1980s: LHWP and FDI flows into garments. e First, the FDI-financed LHWP-construction sub-sector grew at 116 percent per annum and contributed 6 percent o f GDP during the high- LHWP period, Although its inter-sectoral linkages were fewer, the LHWP had positive spillovers in utilities and local construction. Growth in electricity and water escalated to 23 percent and local construction grew at 5 percent per annum. In recent years, with the winding down o f the LHWP, the sub-sector is contracting sharply; in 2002103, the share o f LHWP-related construction was only 2 percent o f GDP. But utilities and local non-LHWP construction are performing well. They jointly account for about 20 percent o f GDP and are one o f the few but visible signs o f spillovers from the LHWP to the domestic economy. e Second, FDI-driven, export-oriented investments in garments in the late 1980s propelled growth in manufacturing at 8-10 percent per annum throughout the 1980s - 90s. After having achieved a critical size, in recent years growth in the sector has settled at 5 percent per annum. In 2001, the legislation o f AGOA provided further impetus to garment exports. By 2003104, the share o f manufacturing in GDP increased to nearly 17 percent; the share o f the overall secondary sector rose to 38 percent, up from 22 percent in the pre-LHWP period, Excluding LHWP- construction, the secondary sector accounted for 35 percent o f GDP in 2003104, signaling a substantive base for a potentially modern economy. Table 2.7: Sectoral coniposition and growth rates - 1980181-2001102 1981182- 1987188- 1998199 1999100 2000101 2001102 2002103 2003104 1999100* 1986-87 1997-98 2003104 Pre High Post Post Post Post Post Post Post LHWP LHWP LHWP LHWP LHWP LHWP LHWP LHWP LHWP Share of GDP Primary Sector (crops, 24.3 18.9 16.8 17.4 17.5 16.8 15.7 15.2 16.5 livestock) Secondary sector 24.5 31.6 33.7 34.2 35.3 35.9 36.6 36.7 35.8 Manufacturing 9.8 12.6 14.1 14.1 14.6 15.2 15.6 15.7 15.1 Construction 13.1 10.8 8.9 10.6 12.0 12.8 13.0 13.0 12.3 LHWP construction 5.7 5.9 3.6 2.9 2.1 2.2 2.3 2.6 Electricity & water 1.3 2.3 4.8 5.8 5.7 5.7 5.7 5.6 5.7 rertiary sector 39.3 36.7 37.7 37.5 36.9 36.5 36.4 36.5 36.8 Wholesale and retail 6.7 7.4 8.0 7.5 7.2 7.2 7.3 7.5 7.3 trade Public administration 7.8 6.7 7.3 7.2 6.9 6.6 6.4 6.1 6.6 Education 9.2 8.0 8.0 8.1 8.2 8.2 8.3 8.4 8.2 Indirect taxes 12.0 12.8 11.7 10.8 10.3 10.8 11.3 11.5 10.9 GDP at market prices 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Nei factor income 84.1 50.7 27.7 26.7 25.2 22.4 22.6 22.1 23.8 GNP 184.1 150.7 127.7 126.7 125.2 122.4 122.6 122.1 123.8 Growth Rates Primary Sector (crops, 0.4 2.3 3.5 3.9 2.2 -0.6 -3.2 -0.1 0.5 livestock) Secondary sector 2.3 10.0 -8.9 2.1 5.2 5.0 5.7 3.5 4.3 Manufacturing 8.1 8.2 -2.6 0.8 5.3 7.6 6.3 4.0 4.8 Construction -1.0 5.4 -12.6 20.4 15.6 9.9 5.5 2.6 10.8 LHWPconstruction 116.6 -8.3 -39.3 -16.6 -26.5 10.5 8.1 -12.7 Electricity & water 3.9 22.8 - 1 8.8 22.8 -0.9 4.2 2.7 2.5 6.3 Tertiary sector 3.4 5.0 1.o 0.0 0.1 2.2 3.4 3.6 1.9 Wholesale and retail 7.0 7.0 -4.4 -4.8 -2.6 3.0 5.0 6.5 1.4 trade Public administration 4.9 4.0 7.8 -1.9 -1.8 -1.3 0.6 -1.3 -1.1 Educaiion 1.1 4 s 2.7 1.7 2.1 4.1 4.4 4.6 3.4 GDP at market prices 2.8 6.0 -3.5 0.5 1.9 3.3 3.7 3.2 2.5 Net factor inconie 6.4 -2.4 -15.9 -3.2 -3.8 -8.1 4.2 1.o -2.0 4.2 3.0 -6.5 -0.3 0.7 1.o 3.8 2.8 1.6 2.23 The share of the tertiary or service sectors in GDP declined marginally between the pre- and post-LHWP periods. Except for post and telecommunication, wholesale and retail trade and to a minor extent, health and social services, all other service-oriented sub-sectors contracted. Significant contraction occurred in education, transport, financial intermediation and residential real estate. In general, growth trends in services move in concert with overall growth in Lesotho and are unlikely to rise unless the rest of the economy, Le., primary and secondary sectors, grows rapidly. 1 Box 2.1: Micro-economic impact of the Lesotho Highlands Water Development With near coinpletion of Phase IR of`tlie 1TILVP. the capacity to divert water to RSA has increased to nearly 3Om' isec. The sum o f T.IIWI' c.rpenditutzi and revenues from 1987 to 2002 are estimated to amount to about five times the I994 Gl)i'. The piqect has given T,esotho both transitory benefits from construction, resettlements and development. and inore permanent benefits that derive from royalty, 53 37 electricity generation capacity and infrastructure. 7'hc project was also dcsigiied to contribute directly to povei-ty reduction through the use of water reventies for rural dcvclopmcnt. In this context, its benefits are less clear. During the first stage ofconstruction (Phase 1A) that u a s coniplc~cdin 1996, nearly 22,720 person years of Basotho labor were hired giving them earnings of nearly M4C)I) million. 'The Basotho also obtained contracts worth nearly M70 million, and coiisiiltancy lvorth M16 million, nearly 8 percent o f all the consultancies. Duringphase 1B. the Easotho benc3iiledfroin nearly 8,900 jobs accounting for nearly 12,500 man-years of work. The Basotho, whose wages were pegged to those prevailing in the Free State inRSA, earned M499 million in current or 540 million in 2002 prices or nearly 7 percent o f 2002 GDP. Both skilled and unskilled labor benefited fi.0111 this eniployment. Of the 8,900 jobs, about 2,100 involved semi-skilled and 2,919 involved unskilled indi\iduals. Those from the highlands affected by the project filled neatly 2,400 jobs and those that came froin the rest o f the country tilled another 3,300. Additionally, through contracting and sub-contracting, the Rasotlio received ncarly M98 million for about 1,700 man- years o f work. Under major works, Basotho wcrc paid 14 1 10 niillion in consultancy, Unlikc the f i s t phase, nearly 50 percent ofthe supervisory consultants \ ~ r F3asotho in pliase 1I3,The LHDA also employs nearly c 500 Basotho. So far their earnings were about M 310 million. They have acquired new skills and learned to implement major projects. The Basotho also obiaineci non-construction consultancies worth MI11 million for 331 man-years o f work. The infrastructure built through the project inciucies roads, bridzes, houses. power and teleconununication es for resettleineiit and devdopmciit. 'lhe roads have increased access to the mountains and created a bypass around Maseru easing trai'tk in the city. 'I'he iiifiastructure was built at a cost of nearly M1,SOO nlillion in phase 1B. 'The bluela projec~will make Lesotho self sufficient in electricity. Tourism is being developed in the project area through the establishment of three nature reserves and a project to buildcapacity for tourism developinent. Water royalties from the 1,HWP began to flow in I990 and meastiid 3.6 percent o f GDP in that year. Since 1998199 they have averaged 1.4 percent of GDP. A significant portion of the revenues was placed initially inthe Lesotho Highlands Revenue Fund(1.JIIW) for riiral development. By 1998, M189 million committed to community-based public works program is estima~etlto have provided employment to nearly 138,000 people. The Lesotho Fund for Coiiimiinity Deselopiiient {LFC'D) was launched in 2001 to bring in greater accountability to stakeholders. The LFCD reccivcd M40 million in 2000-01 and M30 million 2001-02 and showed a cumulative expenditure o f M93 million by thc end of 2002, offering employment to 3,702 workers 011 a full time basis. The funds havc gonc into building 1,100 km o f rural roads, 210 earth-fill dams, SO foot bridges and forcshy and soil conservation works. i Iowever, there are concerns about the allocation o f funds in violation o f establishcd criteria, with implications for the targeting o f funds to poorer areas, comiunily commitment to prqjects supported, and thc capacity of communities to manage large projects, Additionally, the local government structures which were intended to play a key role in community driven development are still not in place. Source: LHDA (2003) ACCOUNTING FOR SOURCESOF GROWTH, EMPLOYMENT POVERTY AND USINGTHE SAM MODEL 2.24 A social accounting matrix (SAM)-based model (Box 2.2) was used" to decompose the marginal contributions to growth, employment and poverty of the following structural shocks: decline in miners' remittances, LHWP investment, and expansion of the textile and garment industry. As discussed earlier, these shocks first thrust Lesotho's economy onto a trajectory o f 6 percent per annum GDP growth during 2o Inchapter 6, the modelis usedto analyze the trade-offs betweeneconomic growth, job creationand poverty reduction of alternate development policies that encompass elements of a development strategy for Lesotho. -;4 the high-LHWP era and later, starting in 1999100,depressed it back to a trajectory o f only 3-4 percent growth per annum. In this section, we decompose the contribution o f these three shocks to aggregate growth, employment and poverty. As the model approximates Lesotho's historical economic trends well, it can also be used to analyze the economic effects o f policy shocks for the short and medium term. For example, for the high-LHWP period, the model yields GDP growth rates averaging 6.2 percent per annum, close to actual growth rates o f 6 percent per annum. This rate o f growth can be decomposed as follows: (a) 4.8 percent growth associated with LHWP investments; (b) 2.3 percent growth from the increase in garment exports; and (c) 1.0 percent reduction ingrowth due to declining migrant remittances (Table 2.8). BOX2.2: L.esotho Social Accounting Matrix (SAM 2000 The Lesotho national accounts based S A M includes data fiom the 1994-95 household expenditure survey, 1999 labor force survey, 2000 agricultural ceiisus and information from the Central Bank for the year 2000. It comprises 53 activities and 57 coniiiioditks, 10 occupational groups for labor, 6 types of capital owners, 6 types of enterprises, 10 types of houscholils covering ufhan, rural mountains, lowlands and Senqu River Valley with distinctions hctwwn rural and urban houscliolds, and various breakdowns of government revenues and expcncliturcs. `l'licre are two accounts for parastatals, one for LHDA, and the other for remainder ofthe private sector. Annex 2 has the details. 2.25 At the sectoral level, the model simulations predict history with reasonable accuracy and shed light on backward and forward linkagesbetweensectors as well as the goods, services and the labor markets. These are discussed next, The three shocks have offsetting effects on growth mainly through household incomes and aggregate demand. For example, the model shows that the primary sector (agriculture, livestock and forestry) gained about 4 percent in response to the LHWP and garment sector shocks, but half o f this growth was offset by dampened demand due to shrinking remittance incomes. In sum, primary sector growth averaged only 2 percent per annum, close to the actual o f 2.3 percent. Growth in manufacturing GDP (garments, processed food, beverages, bricks, wood, paper etc.) at 10percent per annum (the actualwas also 10 percent) was driven by garment exports, which increased at over 8 percent, creating many new jobs and boosting household incomes. The model also shows that LHWP-related activity raised demand for manufactured products by an additional 2 percent, but half o f this was trimmed away by declining remittances. Construction sector growth, a combination o f local and LHWP-specific construction activity, was almost entirely propelled by LHWP investments and measured 17 percent per annum. Model results indicate that the service sectors recorded growth rates ranging between 2 - 6 percent. The fastest growing sectors were transport, communications, business and financial services. Although the LHWP shock dominated the hike in growth rates, ineach case, the positive impact o f LHWP and garment sector expansionwas eroded by declining remittances. 2.26 The key insight of the model is that while GDP growth was sustained at 6.2 percent per annum for a decade, it was neither accompanied by sufficient job creation nor significant increase in household income. Per annum growth in employment was less than 4 percent and in average household income less than 2 percent - far below the growth rates required to reduce poverty. Why did high GDP growth duringthe high-LHWPnot lead to adequatejob creation and reducepovertg'? 2.27 The model shows that the narrow base and pattern of growth defined by the nexus between growth, job creation and poverty explains much of this conundrum (Table 2.7). It was characterized by at least four features. e First, the sectors that support the poor grew slowly-the primary sector, which i s predominantly subsistence and home to the bulk of the rural poor, and wholesale and retail trade, which supports the poor in the informal sector. A substantia1 contraction in the share o f primary sector GDP (Table 2.6) during the high-LHWP period triggered large-scale losses in rural job opportunities. The adverse poverty effect of this phenomenon was exacerbated by a contemporaneous increase in the proportion o f poor returning to the rural areas as retrenched migrants or unemployed. Secondly, growth was excessively capital-intensive while decline in remittances hurt jobs-economy-wide job creation predicted by the model to total 17,000 (annually) at a rate of 3.7 percent per annum was insufficient to reduce unemployment rates o f over 25 percent. The model indicates that the incremental employment effect o f the 3 shocks varied. According to the simulations, the capital-intensive LHWP activity augmented GDP growth by about 5 percent, but added only 3 percent to employment growth or only 1,400 new jobs economy-wide. The labor- intensive garment industry contributed 2.3 percent to growth and an equivalent amount to employment by generating 10,000 jobs. Incontrast, declining remittances diminished GDP growth by 1 percent but trimmed employment growth by 1.6 percent or destroyed 7,600 jobs in the domestic labor market through a decline inaggregate demand. e Third, rural areas benefited little from the LHWP and the garment sector growth. Approximately 40 percent or 6,800 o f the new jobs were inthe primary sector inwhich the average earnings are not highenoughto pullhouseholds out o fpoverty. This meager gain was offset fully, as about 90 percent or 6,800 o f the job losses also occurred in the primary sector due to falling remittances. On balance, the model shows that in the rural sector, which hosts primary production, GDP growth was meager (2 percent) and had no significant effect on employment-it was nearly "job- less". e Lastly, the bulk of the jobs created were in manufacturing andlor urban areas. The model estimates that about 32 percent (or 5,400) o f the 21As noted inthe section on fiscal policy, the weak impact of the LHWP on employment growth was understood at the time o f its inception. Distribution policy was then supposed to channel these for investment inrural infrastructure to reduce poverty. Ex post, weak implementation o f government's distribution policy failed to channel resources to the rural areas and so, didnot have the intended poverty effect. 30 new jobs were in manufacturing, an urban activity that provides low but above poverty-line wages, especially in textiles. Construction created another 17 percent of the new jobs but as these jobs were dominated by LHWP activity (civil engineering and building construction), they required high-skilled workers who came mostly from RSA. Inlater years, as local construction took off, there were more local construction job opportunities for the Basotho. 2.28 In sum, the model is also usefulin explaininghow GDP growth declinedto 3- 4 percentper annumin the post-LHWPperiod(1998199 -2000101). The model yields GDP growth of 3.6 percent after 1999100, a combined effect of the following: (a) 2.3 percent decline inGDP fueled by persistentlydeclining remittances; (b) 3 percent growth in GDP related to LHWP investments which, although declining, were still fairly large; and (c) 2.8 percent growth in GDP attributable to the steady performance of garment exports. I Increase in Rise in Declinein LHWP garment Combinedeffect of all GDP mowth -1.o Yo 4.8 % 2.3 96 1 6.2 % Number ofjobs created - 7,600 14,000 10,000 17,000 Employment growth -1.6 % 3.1 Yo 2.3 % I 3.7 % Household income effect: Change inincome -- High distribution -2.1 % 2.5 Yo 1.2 % 1.7 % income households -1.9 % 2.5 % 1.2 % 1.7 % Low income households -3.3 % 2.2 % 1.3 % 2.1 % - Urbanhouseholds - Rural - 1.0% 1.6 % 0.9 % 1.5 % households - 4.1 Yo 4.3 Yo 2.0 % 2.2 % 2.29 The sharp decline in growth to about 3-4 percent per annum in the post- LHWPperiodhas not helpedto improvethe povertysituationin Lesotho.Themodel shows that net annual job creation is about 3,000, equivalent to an employment growth rate o f less than 1percent. Declining remittances account for annualjob losses o f about 18,000 (4 percent per annum decline injobs), mostly in primary production. The other two shocks have countered some o f the job destruction: rising garment exports have createdover 13,000 new wagejobs (3 percent growth) and lingering LHW investments have created an additional 9,000 jobs (2 percent growth) (Table 2.8). The poverty implications are twofold. First, net job creation was inadequate to reduce poverty, Second, the paucity o f alternative domestic job opportunities, especially inrural areas has had a disproportionate impact on rural poverty. Last, while garment sector growth has contributed crucially to poverty reduction, the numbers remain small, relative to the overall pool ofunemployed. Table 2.9: Accountingfor growth, joh creation and povertyduringthe post-l,IiWP period(1999100 -2001102) -simulations from the SAM-basedmodel Increase in Rise in Combined'effect Decline in LHWP garment of all 3 shocks Contrib~t~on to: remittances investment exports combined GDP growth --18,200 2.3 % 3.0 Yo 2.8% 3.6 Yo Number ofjobs created 9000 13,000 3,800 Employment growth - 4.0 % 2.0 % 3.0 Yo 1.0 % Household inrnma offort. Change inincome distribution -- 4.6 5.0 % 1.6 Yo 1.6 % -1.7 % - Highincome households - Low income % 1.6 Yo 1.6 Yo -1.9 % households - 7.9 % 1.4 % 1.6 % - 0.3 % - Urbanhouseholds - Rural - 2.4 % 1.0 % 1.1 % -0.2 % households - 9.9 % 2.7 % 2.5 % -4.6 % 2.30 As CMA and SACU member, Lesotho's key macroeconomic fundamentals - exchange and interestrates-have always been heavilyinfluencedby South Africa's macroeconomic policy. The exception is fiscal policy. Generally, the macro policy environment has been conducive for growth. e Lesotho's inflation rate typically lagged South African inflation. CPI inflation declined from 14 percent per annum during the pre-LHWP era to 8 percent in the post-LHWP period. Despite the oil shock, in 2003104 inflation had dropped to 6.7 percent. 0 The average devaluation o f the Loti, pegged at par with the South African Rand, has been steady, averaging 19, 7 and 6 percent per annum during the pre-, high- and post-LHWP periods. 0 The nominal interest rate, proxied by the T-Bill rate, has been sticky. From 13-14 percent per annum in the pre-LHWP period (implying a negative real interest rate as inflation was around 14 percent per annum), the nominal rate fell to 11 percent per annum in the post-LHWP period, Recently, after the South African Reserve Bank, the Central Bank o f Lesotho lowered interest rates. The 92 day treasury rate fell to 8 percent in2004105. 0 During the pre-LHWP period, fiscal deficits inclusive of grants amounted to 14 percent o f GNP per annum (24 percent o f GDP, Table 2.10). With the initiation of the LHWP, project-related investments led to substantial revenue increases and generated fiscal surpluses in several years. In the post-LHWP period, grants in the range of 2 percent o f GNP (2.6 percent o f GDP) and public borrowing have financed the deficits. The current account has always been in deficit given Lesotho's large dependence on imports, ranging from 6 percent to over 18 percent o f GNP. With the winding of the LHWP project, the current account deficits have 38 declined. In2003104, it was 10percent o f GNP and 13 percent o f GDP (Table 2.10). 0 Starting in 1992193, Lesotho total public debt statistics escalated fkom 7 to 45 percent o f GNP when the GoL engaged in foreign loan financing, Table 2.9). Duringthe high LHWP period, as GoL's capital needs were high.Inspite of GoL's preference for concessionary, long term borrowing, total public debt (mostly foreign) continued rose to a peak of 2001102 at 85 percent of GNP. There has since been a steep decline. In 2003104, Lesotho's total public debt was recorded at comfortable 53 percent o f GNP. Inrecent years, however, the rise in domestic financing at higher-interest rates may suggest the need for lower cost financing. In the 1990s, as Lesotho's dependence on FDI flows increased, its own political climate and stability assumed increasing importance in foreign investor decisions. By the late 1990s' the clothing and garment industry had developed its own momentum. The 1998 civil strife left garment industry unaffected22butit did affect other foreign businesses and most did not return after the riots, The peaceful 2001 elections has restored stability but Lesotho's political stability will continue to remain a concern for investors in medium term. The attitude o f foreign investors will also depend upon how GoL positions itself vis-a-vis changes o f the post-AGOA I and post-MFA environment. 22Apparently, the factories were well protectedby private guards and the foreign investors and their families escapedunhurt as they resided across the border inSouth Africa. 39 Table 2.10: Key Rlacroeeononiic Environment Indicators 1986-87 1997-08 2003104 P('e High Port I h t Post Post Post Post Post I II\VIP I l.lIW1' 1 ll\tP I H\\PI IIMP I IIWP i,HWP 1 HWP LHH'P CPI (period average) - inflation 14.3 12.0 7.3 7.5 6 5 10.1 9.7 6.7 8.1 Nominal average exchange rate 1.s 3.2 5.7 6.3 7.4 9.1 9.8 7.3 8.0 (LotilUS$) Average devaluation per aimurn* -19.3 -7.3 -23.2 -6.1 -18.8 -27.8 -4.2 26.3 -6.1 Treasury billrate (IFS Line 60c) 13.4 13.6 12.5 9.1 9.5 11.3 12.0 12.0 10.8 Fiscal balance exclu. grantsiGXP -13.8 -4.8 -4.1 -14.8 -3.1 -1.8 -6.6 -1.1 -5.5 Fiscal balance incl. grants/GNP -13.8 -2.5 -2.2 -13.0 -1.5 0.5 -3.5 0.6 -3.4 Current account bal. fincl. official -6.3 -18.0 -19.6 -18.0 -14.6 -10.5 -13.9 -10.3 -13.5 transfers)/GNP FDIflowsJGNP 0.8 1.8 2.3 2.8 2.9 2.9 3.1 3.1 3.0 Grants as a share o f GNP 0.0 -2.4 -1.8 -1.8 -1.6 -2.3 -3.1 -1.7 -2.1 GDPiGNP 56.7 07.0 75.3 78.9 79.9 81.7 81.6 81.9 80.8 Total public debt/GNP 17.7 34.4 6 1 2 72.0 S0.5 85.6 65.2 52.6 71.4 oiw. foreign debU'GNP 0.0 24.1 58.4 60.7 65.8 72.2 51.7 42.0 58.5 domestic debtiGNP 17.7 10.3 3.4 12.1 14.7 13.4 13.5 10.6 12.9 Memo items Fiscal balance excl. grants,'CDP -24.0 -8.0 -5.2 -18.7 -3.9 -2.2 -5.1 -1.4 -6.8 Fiscal balance incl. graritsiGDP -24.0 -4.7 -2.8 -16.4 -1.8 0.6 -4.2 0.7 -4.2 Current account hal. (incl. official - 1 I.2 -26.4 -25.0 -22.8 -18.2 -12.9 -17.0 -12.6 -16.7 transfers)iGDP FDUGDP 1.4 2.6 2.9 3.5 3.7 3.6 3.8 3.8 3.7 Grants as a share o f GDP 0.0 -3.4 -2.4 -2.3 -2.0 -2.8 -3.8 -2.1 -2.6 Total public debt/GDP 31.2 49.3 79.0 92.3 100.8 104.8 79.9 64.2 88.4 O.W. foreign debdGDP 0.0 33.2 74.6 77.0 82.4 88.4 63.3 51.3 72.5 domestic debU'GDP 31.2 16.1 4.4 15.4 18.4 16.4 16.6 12.9 15.9 )*A positivenumberdenotesan appreciation. ISource: BOS, IMF and World 3nnk stfl~estimflies,Jnnunty 2005. 2.31 Overall, GoL needs to be credited for creating a investment conducive economic environment. This especially so when evaluated in terms o f private sector investment, export diversification into manufactured goods, an increasing share of secondary activity and overall growth in spite o f declining miners remittances and the LHWP. The country's 17 year old garments and textile industry thrived but remains completely foreign owned. However, locally owned investment continues to be constrainedby highreal interest rates and poor access to capital markets. 40 FISCAL DEBTMANAGEMENT AND Chart 2.3: Fiscal dcticits1surplusesas a share of GDP I I -X- Fiscal balancebeforeglantiGDP -Fiscal balanceafter gran#GDP II I I Source: BOS, IMF and World Bunk stuflesiiiiintes, Jnnrinry 2005, 2.32 Fiscal balaizces. Since the late 1980s, Lesotho has benefited from a relatively comfortable fiscal situation. During 1993194-1 998199 or the high-LHWPperiod, revenue growth was strong and GoL enjoyed a period o f fiscal surpluses or negligible deficits (Chart 2.3). Fiscal deficits exceeded 10 percent o f GDP (including grants) on only two occasions: inthe mid-1980s and in 1999100when the privatization o f two domestic banks and one-time exceptional financing o f the Muela power plant occurred. On both occasions, GoL was pro-active in implementing a series o f IMF-supported medium-term structural adjustment programs which reduced the deficits. Donor grants also helped (Chart 2.3). With the exception of 1999100, the deficit inthe post-LHWP period averaged about 4 percent of GDP inclusive o f grants. After a surplusof about 1percent of GDP, in 2004105, it is estimated at 4.6 percent o f GDP (IMF, January 2005). Nevertheless, there are at least three fiscal challenges. First, current expenditure growth must be controlled. Second, the efficiency o f current spending and the quality o f capital projects must be improved. And third, fiscal space from available fiscal surpluses and additional financing must be used to knd fighting HIVlAIDS pandemic, raise the quality and quantity of technical education, and build the physical infrastructure. Several uncertainties underscore the need for meeting these challenges: SACU revenues are expected to decline by about 1-2 per annum; the future o f the garment industry. If these challenges are not met, this will further erode the growth outlook and the existing fiscal headroom. 2.33 Fiscal revenues.Currently, fiscal revenues average 40 percent of GDP with little scope for sizeable increases. They averaged 20 percent o f GDP in during the p r e - L H W era (Table 2.10). Fiscal revenues have three main components: (i) customs or SACU revenues (47 percent of all revenues), (ii) non-customs taxes (35 percent) and (iii) non- tax revenues (18 percent). During the high-LHWP period, SACU non-duty transfers peaked in 1997198 and are now on decline. They are comprised o f (i)customs receipts, and (ii) non-duty SACU receipts. As non-duty SACU receipts are 2.5 times the duty receipts, overall SACU revenues depend more on Lesotho's ability to negotiate a 41 favorable allocation for itself from SACU. According to the recently re-negotiated SACU formula, the share o f SACU revenues is expected to decline in the medium term by almost 2 percent of GNF'. Non-customs tax revenues comprise mostly of individual income taxes and sales taxes that were replaced by the VAT in 2003. The largest component ofnon-tax revenues is water royalties. 2.34 Budgetaty Grants. Grants emerged as an important source of government revenues in the years prior to the elimination o f apartheid in RSA in 1994195. Donor grants amounted to 1.5 percent of GDP during the high-LHWP era (Table 2.11). Since 1999100,grants increased and averaged 2.6 percent o f GDP per annum. Comparedto the financing required to fund the PRSP, however, grants remain low. 42 Table 2.1 I: Fiscal accounts as a shave of GDP ihare of GDP (YO) 1998199 1999100 2000101 2001102 2002103 2003104 198112- 198718- 1999- 8617 9718 200314 Lvenue and grants 45.1 43.1 44.8 43.5 43.1 42.4 19.7 42.0 43.4 Revenue 42.8 40.8 42.8 40.8 39.3 40.3 19.7 40.5 40.8 of which: a) Tax Revenue 33.3 33.3 31.6 34.8 33.3 33.9 16.1 34.2 33.4 -Customs 20.4 20.9 18.3 21.0 19.0 I6.7 8.2 21.0 19.2 evenue(SACU) - Noncustoms tax 13.0 12.4 13.3 13.7 14.3 17.2 6.4 12.6 14.2 evenue Income tax 7.6 7.4 7.6 8.5 8.6 10.0 3.2 5.8 8.4 Individual income tax 5.5 5.4 5.1 5.4 5.2 5.8 2.0 3.6 5.4 Corporate tax 1.3 1 .o 2.1 2.3 1.8 2.8 1.o 1.7 2.0 Other income tax 0.9 1.o 0.5 0.7 1.5 1.4 0.2 0.5 1.o Sales tax I value-added tax 4.6 4.2 4.6 4.4 4.4 6.1 2.4 5.4 4.7 Petrol levy 0.7 0.8 1.o 0.7 1.1 0.9 0.6 1.o 0.9 Other tax revenues 0.1 0.1 0.1 0.1 0.2 0.2 0.3 0.4 0.1 b) Non-tax revenue 9.4 7.5 11.2 6.0 5.9 6.5 3.6 6.3 7.4 Water royalties 2.4 2.4 2.2 2.6 2.7 2.3 0.0 0.4 2.4 Interest on deposits 4.4 I.3 1 .o 0.2 0.3 0.2 0.0 2.6 0.6 Other non-tax revenues 2.7 3.7 7.9 3.2 2.9 4.0 3.6 4.9 4.3 Grants 2.4 2.3 2.0 2.8 3.8 2.1 0.0 1.5 2.6 Sxpenditure & net lending 48.0 59.5 46.7 43.0 47.3 41.7 43.7 49.3 47.6 hrrent expenditure 38.2 40.9 39.7 33.8 37.0 34.3 35.8 31.1 37.1 Wages and salaries 16.5 14.7 15.1 14.5 14.0 13.2 12.4 13.6 14.3 Interest payments 2.5 3.2 4.4 3.0 2.8 2.5 2.9 3.1 3.2 External interest 1.9 1.8 2.6 1.8 1.4 1.1 1.3 1.2 1.7 Domestic interest 0.6 1.4 1.8 1.1 1.4 1 .s 1.6 2.0 I.5 Other expenditure 19.2 22.9 20.2 16.3 20.1 18.6 ma. 8.2 19.6 2apital expenditure& net 9.8 18.6 7.0 9.1 10.4 7.3 7.9 18.2 10.5 ending Capital expenditure 9.8 8.5 7.7 10.9 10.8 7.4 7.9 18.2 9.1 Domestically funded 4.6 4.4 3.O 5.5 4.2 3.7 0.0 3.8 4.1 Externally funded 5.2 4.1 3.9 5.4 6.6 3.8 0.0 5.1 4.8 Grant funded 2.4 2.3 2.0 2.4 3.1 1.6 0.0 2.5 2.3 Loan funded 2.8 I.8 1.9 3.0 3.6 2.1 0.0 4.3 2.5 Net lending 0.0 10.1 -0.7 -1.8 -0.4 -0.1 0.0 0.0 1.4 )vera11 balancebeforegrants -5.2 -18.7 -3.9 -2.2 -8.1 -1.4 -24.0 -8.9 -6.8 herall balanceafter grants -2.8 -16.4 -1.8 0.6 -4.2 0.7 -24.0 -5.8 -4.2 rota1financing 2.8 16.4 1.8 -0.6 4.2 -0.7 24.0 2.8 4.2 External financing 0.4 -1.3 -4.2 -0.8 0.7 -0.3 10.5 6.6 -1.2 Loan drawings 2.8 1.8 1.9 3.0 3.6 2.1 0.0 8.0 2.5 Amortization -2.4 -3.0 -6.1 -3.8 -2.8 -2.4 0.0 -2.0 -3.6 Financinggap -1.1 -0.8 -0.3 0.0 0.0 0.0 0.0 0.2 -0.2 Domestic financing ~- " 3.6 18.5 6.4 0.2 3.5 -0.4 13.5 -4.0 5.6 `ource.BOS, IMF and World Bank stafleslininies, Jniiimi~2005 2.35 Current Expenditures. Historically, current expenditures supported a largepublic sector. Current expenditures declined fiom 36 to 31percentof GDP between the pre- and high-LHWperiods, but the trend was reversedinthe post-LHWP era. In2003104, GoL 43 was able to curb spending at 34 percent o f GDP (Table 2.11). Inrecent years, the wages and services bill as well as `other expenditures' have been trimmed. Some aspects o f a civil service reform were im lemented inthe early 1990s' but tougher reforms to improve transparency and efficiency2 were not. A 1996197 action plan to revisejob classification ! andgrading andintroduceperformance evaluation procedures was also not implemented. There was some success with parastatal reforms, which included liquidations (e.g., Lesotho Trading Corporation), downsizing (e.g., bus system) and reorganization. A Privatization Bill established the legal authority in 1995. Fiscal adjustment in the early 1990s enabled public debt retirement, which reduced interest payments as GoLbecame a net creditor to the banking system. After 1998, cumulative payments o f arrears due to SACU and South Africa, and higher than expected recurring costs o f vehicle leasing have added new fiscal pressures. Table 2.12: Sectoral composition of public spending in Lesotho, shares of GDP Share of GDP (YO) 1998199 19991002000101 2001102 2002103 2003104 198112- 198718- 1999- 8617 9718 200314 Total expenditure and net 48.0 59.5 46.1 43.0 41.3 41.1 43.1 49.3 41.6 lending General public services 8.7 20.0 7.9 6.3 7.3 10.5 9.7 4.9 10.4 Defense 7.8 8.6 6.5 6.8 6.6 7.8 5.8 6.0 7.3 Education 12.8 12.2 9.4 11.0 13.6 10.1 6.8 9.5 11.3 Health 3.6 3.4 4.1 2.8 2.8 2.7 2.6 3.7 3.2 Social security, welfare 0.9 0.9 1.0 0.7 0.7 0.7 0.6 0.9 0.8 andhousing Economic affairs & 10.7 9.1 5.0 9.6 10.6 10.1 15.5 18.4 8.9 services Other (residual) 3.5 5.2 13.2 3.3 3.9 3.9 2.6 5.8 5.9 Source: BOS, IMF and World Bonk s f ~ ~ e s f i i ~ i oJoiiuory 2005 ~ e s , 2.36 Capital expenditures. Controlling capital expenditures has been the unfortunate residual in the budget. During the high-LHWP period, in spite o f GoL's target of 12 percent o f GDP, capital expenditures reached close to 18 percent o f GDP largely because o f investments in the hydroelectric component o f the LHWP. The GoL established a special unit to manage the public sector investment program (PSIP) with World Bank assistance. While GoL sought to use the PSIP to achieve Lesotho's development priorities, its capital expenditures were guided by LHWP-related priorities. In 1999100 when the fiscal deficit rose to 19 percent of GDP due to the closure o f the state-owned Lesotho Agricultural Development Bank and Lesotho Bank and the amortization o f short-term debts o f the Muela hydroelectric power project, GoL once again cut capital expenditures to restore fiscal stability, They have been cut gradually to 10 percent o f GDP between 1999100 - 2003104, In the past year, they were only 7 percent o f GDP, a level that has compromised investments inhumanand physical capital. 2.37 Sectoral Pattern of Public Expenditures. The pattern o f sectoral expenditures largelyreflects trends inrecurrent and capital expenditures (Table 2.12). Compared to the pre-LHWP period, while the share o f general public services is unchanged, the shares o f education and health have increased significantly. Expenditures on education increased from 7 to 11 percent o f GDP during 1980181- 2003104, among countries with the highest 23These features appeared inIMF and World Bank reconmended programs as early as the 1990s. 44 spending on education in Africa. However, most o f this increase was absorbed by a rise inwages and salaries. Total spending on health has risen relative to 1980181but slipped somewhat in the post-LHWP period. Since the 1998 unrest, defense spending has also risen significantly at the expense o f water, transport and power, which are now constraining private activity. Aggregate spending on these `economic services' dropped from over 18 percent during 1987188 - 1997198 to 9 percent o f GDP during 1999100 - 2003104. 2.38 Fiscal ~ ~ ~ a g e ~Over~thef1990s, GoL sought to use the revenue boom due to e z . the LHWP to reduce rural poverty but this had limited success. From the outset, it was well understood that the LHWP would contribute significantly to growth but not muchto employment and the rural poor, Government's fiscal policy was envisioned as the primary instrument to link the LHWP to the rural poor by channeling a portion o f the revenues from the project to the Lesotho Fund for Community Development (LFCD), its redistribution arm. The remaining revenues from the LHWP were channeled directly into the budget. GoL created the LFCD to channel 75 percent o f the SACU revenue windfall including water royalties towards rural development. However, weak and politicized implementation of the LFCD failed to channel resources to the rural communities to reduce poverty. Also, GoL intended to use the PSP to prioritize longer term public investments to achieve its development priorities, but capital expenditures served LHWP priorities when revenues were plentiful and became residual when fiscal pressures accumulated, The result was that public investment intended for long term rural infrastructure development never occurred. GoL also adopted a borrowing strategy with a clear preference for grants and concessional longer-term loans. Because o f GoL's prudent stance, foreign debt service as a share o f exports was within manageable levels at 14 percent in 2001102. Finally, part of the revenues from the LHWP were directed into replenishing Lesotho's stock of foreign reserves. Over the 1990s' its reserve position rose to a comfortable level o f 6-7 months o f imports o f goods and services. The recently established Lesotho Revenue Authority (LRA) is expected to strengthen tax administration and improve domestic revenue collection. Reforms are underway to increase domestic revenues by revising the oil levy and property income tax rates. The ongoing financial sector reform is expected to make fiscal administration more transparent. FISCAL CHALLENGES AND MEDIUM TERMPROSPECTS Challenges 2.39 Fiscal policy in Lesotho is the key macroeconomic instrument for achieving poverty reduction; it managed to reduce public debt but public investments have suffered. All other macroeconomic policy instruments are determined by RSA. In 2001102, public debt peaked at 104 percent o f GDP before declining significantly and now projected to reach 47 percent by 2010111. The emergence of fiscal surpluses created some fiscal space for over due public investment, But the scale o f public investment required for a higher growth trajectory has not been achieved. This is in part due to the narrow revenue base and rigid government expenditures. 45 2.40 On the revenueside, GoL does not have much control over large portions of its public revenues. SACU or customs revenues account for nearly 50 percent of the total revenues. While the favorable compensation for Lesotho afforded by the SACU stabilization fund protects it from sharp reductions resultingfrom a fall inLHWP-related capital imports, further trade liberalization inthe mediumterm will reduce overall SACU revenues. The other revenue sources rest on a narrow domestic tax base - especially income taxes - that is unlikely to grow unless growth picks up. Pressure to use corporate taxeslsubsidies to attract FDI, especially to attract investments inthe textile industry after 2007 will increase. Non-tax revenues (e.g., water) are limited by Lesotho's treaty with South Africa. Also, dependence on grants adds to its fiscal vulnerability. 2.41 On the expenditureside, there are significant rigiditiesand new demands. At 13 percent o f GDP, wages and salaries bill, i s large but politically difficult to reduce, especially with unemployment rates in excess o f 25 percent. New public investment in physical and human capital will increase the demand for additional public services. In education, even though expenditures have risen, investment in technical and tertiary education, and improvements inthe quality of existing education and health require even more public spending. Going forward, the challenge will be to conserve precious fiscal resources where possible through cuts and divestiture, and expand them as inthe case of necessary investments ininfrastructure and human capital. 2.42 Since budget envelope alone will be insufficient to finance new expenditures warranted by the PRSP, medium-term grant commitments should be sought from the donors. So far, external concessional resources and grants have kept interest expenditures low, which is expected to continue in the future. The ratio o f domestic debt to GDP is presently lowz4; it can be raised to finance new investments, but raising this ratio will be costly as domestic interest rates.exceed foreign interest rates considerably. Grants are the preferred option. To reduce the uncertainty associated with annual grant commitments, the government may want to elicit a medium term commitment from major external donors after presenting them upfront with a medium term financial package with a realistically `costed' PRSP. For its part, GoL must improve both quantity and quality of public investment, especially in rural areas (e.g., rural roads), to ensure strong returns andjustify medium term donor support. 2.43 Finally, to accommodate strategic growth-enhancinginvestments,GoL must overcome institutional and capacity constraints, including via public-private partnerships. InLesotho's environment, the government is likely to have tofirst make the adequate investments to create the public goods that increase returns to private investments but this, too, requires stronger capacity. Other governments with weak capacity have overcome such challenges by entering into public-private partnerships, as is presently the case inseveral Asian countries. InLesotho, the construction of the LHWP itself demonstrates that these partnerships can deliver major investments if the contracts are appropriately specified. 24In2003104,as ashareofGDP, external debt was only 51percent and domestic debt 13percent. 45 Prospects 2.44 Lesotho's medium term fiscal position is expected to remain strong. The starting position in 2004105 i s strong with the surplus o f 4.6 percent o f GDP because of higher revenue collections and cuts in current expenditures. In the medium term, revenues are expected to decline by at least 1 percent o f GDP per annum as SACU revenues fall, while some o f the negative impact will be offset by better collection. Overall, revenues are expected to stabilize around at least 41 percent o f GDP in the medium term. Assuming that annual real GDP growth holds as 3.5 - 4 percent, prevailing fiscal measures aimed at controlling waste and improving efficiency of current expenditures is maintained, total public expenditures and net lending are raised to 44 -45 percent o f GDP, Lesotho's fiscal situation in the medium term would remain strong. In this base scenario drawn from IMF projections (January 2005)' in the medium term (2005106 - 2009110), Lesotho's fiscal deficit (inclusive o f grants o f about 2 percent of GDP) is expected to be inthe comfortable rangeof 1.5 to 2.8 percent o f GDPper annum. Total public debt to GDP ratio would settle at a sustainable level o f 46 percent of GDP in 2009110. 2.45 This provides GoL the unique opportunity to create additional fiscal. space and adopt more pro-growth fiscal posture, for two reasons. First, higher growth, betterjobs and lower poverty are key PRSP and fiscal policy objectives. To achieve the 4 percent growth assumed in the base case scenario, GoL needs to make large and sustained public investments in infrastructure and services, including higher quality human capital. These are necessary inputs but not sufficient25 for growth. Otherwise private investment, presently driven by FDI in the manufactured export sector is likely to move to other, more competitive locations. Absent natural comparative advantage in garments, GoL must strive to nurture Lesotho's competitive edge by providing the public inputs to boost the productivity o f its export industry. Second, a pro-growth fiscal stance does not pose any fiscal sustainability problems in the medium term. If reforms manage to curb waste, support productive investments, improve quality o f spending, and lower cost o fborrowing, this stance will be both feasible and sustainable. 2.46 Incremental increases in public investment will not suffice. There is no substitute to adequate public investments over the next 2 - 5 years to boost growth to levels higher than 4 percent per annuin in the longer term. It is a matter o f political choice: invest in the short term to reap higher growth dividends in the medium term or settle for a low public investment- low growth scenario in the longer term. The recent expiration of the MFA and onset o f AGOA I1have changed significantly and globally the international garment industry environment for foreign investors. In the absence of real assurances (exemplified by action) that GoL is serious about improving investment in infkastructure and human capital, and productivity in the garment industry, they may move to alternative destinations. The Recommended Strategy for such a fiscal stance is discussed indetail inChapter 6. 25A sufficient condition is upgrading and preserving the competitiveness o f an industry. This requires productivity improvements which require creative public policies that enable skills and technological upgrading inthe private sector. The GoL may wish to learn from the experience of some successful countries such as inEast Asia, South Asia and Chile. 47 TRADE 2.47 For an open economy, trade has always been central to Lesotho's economic fortunes. Partly because of its narrow productive base, its dependence on imports ranged close to 79 percent of GNP in recent years. Trade-weighted tariff declined from 30 percent in the later 1980s to less than 7 percent in 1998. Almost everything the Basotho consume from food, clothing to machinery, and services are imported from South Africa. Lesotho's exports have undoubtedly grown in recent years, but empirical analysis o f trade performance is difficult because of unreliable data.26Exports of goods increased significantly during the high-LHWP period. By 2003104, they measuredUS$ 505 million and accounted for a third of GDP. The share of non-factor service exports in GDP has ranged around 5-6 percent of GDP. Since 1996, exports of water to South Africa have fetched Lesotho royalties that have averaged 1 -2 percent of GDP (Table 2.11). From being stagnant in the pre-LHWP period, exports of goods grew at an annual rate of 18 percent in the high-LHWP period (1988189 - 1997198). In the post LHWP period, this trend has nearly risen further to about 20 percent per annum primarily from increased garment and textile export facilitated by AGOA (BOS and IMF). Inthe ast two years, 2001102 - 2002103, growth of goods exports has exceeded 30 percent!' The product group with the largest share in Lesotho's exports, nearly 80 percent of merchandise exports, i s "miscellaneous manufactured articles" and "manufactured goods classified by material" that include garments, clothing, footwear, other leather products, furniture and electronics. The second largest group in 1999 was machinery and transport goods (6-10 percent), followed by beverages and tobacco (7-9 percent), and food and live animals (about 5 percent) (Annex 1). 2.48 North America and SACU are the primary destinations for Lesotho's exports. Nearly one half of exports went to each o f them in 1999.28 Exports to North America consist largely of textiles and clothing that currently enjoy preferential treatment underAGOA andMFA. The expiration ofthe MultiFiber Arrangement (MFA) in2005- a development that should greatly increase the level of international competition for Lesotho's exports could potentially erode the competitiveness of Lesotho's exports. In the early 1980s, Lesotho imported about US $450 million worth of goods and non-factor services. When the construction of the LHWP beganaround 1987-88, there was a spurt in merchandiseimports; during the high-LHWP period, the level o f imports almost doubled to U S $834 million per annum. During years of peak construction between 1991 and 96, LHWP-related capital imports ranged around US $113 million per annum. By 2000101, capital imports had declined to U S $34 million, and the overall imports were down to U S $700 million. As a share of GDP, imports o f goods and non-factor services have declined from around 114 percent in the early 1980s to 95 percent in 2003104 (BOS, National Accounts). BOS national accounts suggest that imports o f goods and non-factor services grew at 6 percent per annum during the high-LHWP period. After 1998, import growth 26See Annex 1for details on Lesotho's trade statistics and the Diagnostic Trade Integration Study (2003) for a thorough discussion o f issues. 27BOS andCBLtrade statistics providecontradictory export growth estimates o faggregate and sub- categories, which yield misleading performance measures(Yeats 2002). For more details, see Annex 1, Tables 11.5 onwards. 28As there are large annual variations inshares, changes inLesotho's export shares to these markets cannot be assessedfrom the available information. 48 has leveled off at 3 percent per annum (Table 2.5).29 SACU and Asia are the primary origins o f Lesotho's imports. At least 90 percent o f the total merchandise imports originate inSACU. Prospectsfor exports Trade preferenceslAGOA Opportunities - 2.49 Until2001, virtually all of Lesotho's exportsto the UnitedStates enteredwith preferential treatment. This was due to the African Growth and Opportunities Act (AGOA) o f 2000, under the special nile for LDCs clothing and apparel (HTS categories 61 and 62). The special exemption for clothing imported tariff- and quota-free from African LDCs under the expired in 2004. The US replaced the treaty with AGOA I1 which grants duty-free access even after 2007 if the clothing is made with inputs manufactured either in Lesotho or in a `qualified' country such as the US or RSA. Thus far, Lesotho's cost advantage was based in part on imports o f all fabrics from low cost China. N o w these fabrics will have to be manufactured in Lesotho, which does not have a large textile industry. While the switch to the domestic production o f the fabrics is good news for growth and job creation, there is potential uncertainty. Although a denim mill was installed by foreign investors a few years ago in anticipation o f AGOA 11, it is unclear if such efforts will be scaled up by the foreign investors. Further, the pre- requisites for scaling up of the textile and garment industry requires inputs - electricity, water, roads etc. - which are not available in adequate supply. It is, however, fiscally feasible for the GoL to provide these inputs to retain the textile and garment foreign investors inthe country. 2.50 Lesotho's competitive advantage is also tied to the expiration of Multi Fiber Agreement (MFA). Until 2004, the MFA curtailed through quotas Asian clothing exports to the US, providing a window o f opportunity to low income producers like Lesotho to export to the US. The MFA allowed Lesotho's small garments exports cluster to grow into a US$ 500 million industry by 2003104. The MFA expired inJanuary 2005, allowing unrestricted access to lower cost-high productivity Asian producers in the U S market, (For a fbller discussion o f the implications of the MFA, see Box 11.1inAnnex 1). This will squeeze the price differential betweenAsian, especially Chinese, and Lesotho's garment exports even more. However, it' the country can expand production capacity, it can take advantage o f its good labor standards and tariff free status in the U S market to attract investors to invest in increasing the production o f textiles that can feed the garment industry when the rules of origin clause under AGOA I1sets in after 2007. One investor started setting up a denim mill in 2002. Others may enter the industry if public infrastructure is sufficient. 2.51 Against the background of MFA's expiration and AGOA 11's initiation, Lesotho's garment industry must re-position itself for global competition. The challenge is to build the capacity to espand exports outside the simple clothing and apparel category into newer categories within clothing and apparel in the same product line and higher grade product lines such as leather products, furniture, simple electronics etc. Lesotho's manufacturers are not taking advantage o f AGOA preferences to export products other than clothing (Schuler, 2001). Diversifying into other products may help ~~ 29Importsdatareportedby CBL and BOS shows that the two sources are not consistent. 49 Lesotho to continue to export to the US in the future, If successful, this will help diversification. The expiration o f the MFA will level the ground for all exporters. Lesotho may not be competitive in simple garment and apparel exports, but may have a niche in higher-grade products, similar to the case of East and South Asia when China entered the global market. 2.52 GoL also needs to take a pro-active stance to improve the productivity of its workforce for both the garment industry and, more generally, for private sector growth. Lesotho will have to face fierce competition from other global producers in every export sector. While no less urgent, this issue is not discussed in this report that considers anchoring the threatened textile and garment industry as a first step. FDI investments have enabled Lesotho to develop its textile industry to emerge as the leading exporter to the United States. Lesotho's ability and limitations to attracting FDI and opportunities available to Lesotho to expand its exports are discussed in Chapter 4 inthe context of secondary and tertiary activities. DEVELOPMENT STRATEGIES 2.53 Poverty alleviation has been the focus of government's development plans and the Bank's assistance to the country since the beginning of the 1990s. The Bank's strategies, beginning with an overall emphasis on "maintaining and deepening" structural reforms in the early 1990s, have included in various forms: private sector development; removing capacity constraints in the public sector or improving institutional capacity; related and somewhat overlapping, human resource development; achieving environmental sustainability; agricultural diversification and capturing the benefits fiom Lesotho Highlands Water Project (World Bank 1994, 1996 & 1998). 2.54 Private sector growth has been the pillar of the growth strategy. Private sector growth has been sought through the privatization o f parastatals, rationalization of public utilities, development of indigenous entrepreneurship particularly to develop small and medium enterprises, creation o f a favorable environment for investors, and direct support to investors through the construction o f factory shells, and so on. Privatization of public enterprises and the yet-to-be completed civil service reform have been the thrust o f removing the capacity constraints. In agriculture and the rural sector, the focus has been on reducing grazing pressures through greater conimunity controls over grazing and removal o f market distortions to encourage private sector-led diversification away from food grains into crops inwhich the country has a comparative advantage. 2.55 The direct attention on fostering labor-intensive growth in the mid-1990s anticipated employment generation in both the agricultural and light manufacturing sectors. In agriculture, the strategy was to increase the profitability o f part time small-scale farming and livestock activities througha shift from extensive grain production to labor-intensive activities, particularly through the removal o f market distortions and better provision o f infrastructure. The development o f labor-intensive agriculture was also considered to be an effective way to target the poor. Although appropriate strategies have been in place for more than a decade-the country's development plans are aligned with those o f development partners- the country has been slow inintroducing the needed policies and implementing them. SO FUTURE PROSPECTS ANDTHELINKS WITHRSA 2.56 Prospects for future growth in Lesotho are influenced by its strong and close links with RSA, its external constraints and the strong desire for a more independent development in the future. The emergence o f the garments industry and the construction o f the LHWP turned Lesotho's development trajectory ina direction that was pointed away from RSA. With further impetus from AGOA, Lesotho is today Africa's largest exporter of garments to the US markets. In 2001, Lesotho exported only one half of its total exports o f US$300 million to SACU through RSA; the remainder, consisting o f mostly garments, was destined for the U S market. As discussed in chapter 4, ifGoL is strategic, it can spur growth by exploiting its acquired comparative advantage in garments and textiles even further. There is ample potential for growth with diversification in products and markets. The construction o f the LHWP itself was an enclave but it didpromote local constiiiction, telecommunications and IT sectors 2.57 Despite the constraints of its small size and poor resource endowments, Lesotho can still exploit the proximity to South Africa for its sustained growth. The transition from a relatively primitive economy of the pre-LHWP era o f the 1980s to a modern economy exporting manufactures to the U S market has not been uniform- there are many gaps in services, regulations and institutions which continue to impair growth. Examples o f such gaps include the absencc of an investment code, modern marketing and business advisory services, property rights, especially for lenders, and the timely availability of agricultural extension services. Lesotho's future growth perfonnance will depend, to a large extent, on the speed with which GoL is able to bridge such gaps, Some of the areas in which GoL can readily exploit RSA's superior institutions are (i) using RSA's institutions as models with appropriate modifications such as an investor's guide, code protecting property rights especially in the case of credit providers, environmental regulations for pollution control, and solid and liquid waste disposal inthe manufacturing sector, marketing and business advisory centers etc.; and (ii)using RSA's superior services more pro-actively to promote its own development goals. Examples o f the latter include arrangements with RSA's agricultural extension agencies to provide timely services to Basotho agriculture and livestock farmers, twinning with RSA's tourism authorities to include Lesotho's destinations in its itinerary as opposed to trying to establish its own institutions, twinning with RSA's visa issuing authorities to include Lesotho when they issue visas to foreign tourists, collaborating with RSA's marketing chains to facilitate the export o f sandstone from Lesotho etc. RECO~ IMENDATIONS 2.58 To continue to export clothing to the US, Lesotho must develop its own textile industry and this will require bolstering its competitive edge by investing in basic infrastructure. Medium term prospects suggest that even if GDP grows at about 4 percent per annum, it will be insufficient to reduce poverty and meet the goals o f the PRSP. Growth prospects are now somewhat tenuous, Until recently, garment exports grew at over 30 percent per annum. In 2004105, external trade arrangements changed the rules of the game (MFA, AGOA 11). Textiles are a relatively undeveloped industry as Lesotho's clothing industry imported all its fabrics from China until now. To continue to export clothing to the US, Lesotho must develop its own textile industry. This will hinge on GOL's ability to bolster Lesotho's competitive advantage by offering the basic S I physical factors - electricity, water, roads - to retain existing foreign investors and attract new ones. A relatedchallenge i s to undertake pro-active measuresto raise productivity. 2.59 Growth in private investment, both foreign and domestic, is necessary for higher growth. The government needs to ensure that the economy maintains its competitiveness in attracting FDI. Current sources o f growth are export manufacturing, local construction and some o f the services, The finance minister in his first budget speech identified tourism as an area that the country will try to develop in addition to manufacturing and construction. 2.60 How much private investment will grow and whetlier it will be adequate to reducepovertywill depend upon the following. Favorablepolicy environment and public investments in physicaland human capital. These policy factors are needed to spur private sector growth, Since the level o f public investment i s already low, any future increase in it will have to come from a combination o f (a) savings from reductions in recurrent expenditures (such as from ongoing reforms to stem waste and reduce spending through divestiture o f public enterprises); (b) a larger fiscal pot (taxable base) facilitated by a faster growing economic pie (GDP); and (c) foreign savings (grants and concessional loans). Continuing with its current borrowing stance that seeks external grants and concessionary longer term financing will serve the government well in the future. High-interest rate domestic financing will not be sustainable. Prudent fiscal management, timely action in implementing the investment plan, and careful attention to the quality of public spending. An analysis o f Lesotho's medium term fiscal prospects shows that if prudently managed, there is fiscal headroom to make significant increases in public investment in the short to medium term without jeopardizing fiscal sustainability. Timely implementation of broad-based poverty reduction strategy, The government's commitment to capacity building will play a critical role in its ability to implement some o f the challenging reforms necessary for higher growth. Lesotho's future prospects'will always be influenced by RSA and it could exploit these unique links for its development goals. GoL could (a) continue to reinforce its competitive edge to attract FDI, (b) exploit its small size and proximity to RSA to piggy-back on RSA's strong institutions and well developed service sectors. GoL could simply template many institutional designs from RSA such as the investment codes, property rights for lenders, environmental regulations for the disposal o f manufactured effluents, etc.; it could also be more pro-active in simply striking arrangements to use RSA's superior services such as selected agricultural exteiision services, visas for foreign tourists through RSAconsulates, twinningarrangements with RSA's tourism agency etc. 2.61 Faster economic diversification and higher exports will be necessary to create more and better job opportunities and reduce poverty. For higher economic growth, GoL needs to ensure that investment rises even higher. It can attract more private investment by exploiting fiscal space in pursuit o f higher growth. It needs to 1) continue with existing reforms to improve the efficiency o f existing public consumption; 2) improve the quality of public investments; and 3) selectively and strategically invest in public infrastructure and services to boost private investment, especially in sectors that are labor absorbing. The latter is essential to pre-empt a pattern o f job-less growth, Economic diversification in the secondary and tertiary sectors cannot occur unless GoL finances investments inphysical and human capital. 2.62 Exploiting the prevailing fiscal headroom to make significant public investments will be key to successful fiscal policy. Public debt situation i s good in the short- and medium-term. GoL, therefore, has a window o f opportunity to finance strategic public investments required for higher growth. Continuing with the ongoing trimming of current expenditures and waste to raise efficiency, and ensuring the quality of public investment are key. But GoL also needs to finance substantial new investment through a combination o f new grants and concessionary financing. 2.63 Finally, implementing this agenda will also require strong political will to build public sector capacity and an effective bureaucracy to implement difficult public decisions. GoL's ability to identify a strategy o f shared growth and its ability to take the necessary measures to implement it timely require a strong government commitment to build capacity in the public sector. First, it at the highest level of govement, GoL needs to make a commitment to systematically and continuously work with development partners, public-private partnerships and even friendly governments to develop, nurture and retain niaiiagenieiit ski1Is. Second, for continually reinforcing the country's competitive edge to attract FDI, a different set of public sector skills are required. 3. POVERTY,EMPLOYMENTAND LABOR INTRODUC-HON' 3.1 The key finding of the CEM is that the job creation is central to Lesotho's poverty alleviation strategies. In this chapter, we first examine poverty and its causes and links with employment, largely based on published information. Poverty data indicate that jobs are the main avenue out of poverty in Lesotho. Then, we examine Lesotho's ernploynent situation based on our analysis of the 1999 Labor Force Survey data, with particular focus on characteristics h i t distinguish the wage employed from other participants inthe labor force, and the factors that influence average earnings o f the wage employed. 3.2 The proportion living on US$1 per day or less was 36 percent in Lesotho, higher than in neighboring countries, but other indicators of human development are more favorable. Poverty rates are 38 percent in Mozambique, 35 inNamibia, 23.5 in Botswana and only 7.1 percent in South Africa (WDR, 2005). However, Lesotho's human development indicators compare favorably with other countries. Lesotho's adult literacy rate o f 81 percent was comparable to that of South Africa (86 percent) and Namibia (83 percent). Its illiteracy rate for women was 2 percent-the best in Africa (WDR 2000). In2002,30Lesotho's humandevelopment index was 145, well below South Africa, Cape Verde, Swaziland and Botswana in sub-Saharan Africa (Human Development Report, 2004). 3.3 This picture must be somewhat qualified as poverty data for Lesotho are quite dated and do not permit a rigorous analysis of poverty and inequality trends or other characteristics of the poor. Household studies conducted between 1986 and 1999 suggest that the incidence of poverty remained unchanged during this p e r i ~ d . ~ ' Employment and income indicators would suggest that the country barely managed to cap its poverty during a period o f fairly decent GDP growth but declining worker remittances. Inequality measures also suggest that this country, characterized by extreme inequality, has not become more egalitarian, However, Lesotho's delivery o f essential services such as water, sanitation, housing and transport to both the poor and the non- poor may have improved. 30Later scores are not available. 3'There are two sources o f informationon poverty in Lesotho: the Bureau o f Statistics (BOS) and the SechabaConsultants. The BOS undertook household surveys in 1986-87 and 1994-95, the data from which were analyzed recently. The Sechaba Consultants conducted household surveys in 1990, 1993 and 1999. While there are problems with all these surveys-particularly relating to weights and sample selection - their general findings are consistent: poverty inLesotho didnot decrease between any two surveys conducted by the same source. The BOS is conducting its next national household survey in2003, 54 Po\ crt? Line (PL) I111-8lkertyLine(%PL) 1980 7 I C / ) , 5 I986i7 199415 Incidence ~ 58 8 ~ y.: ~ 34.7 _ 38.6 _ _ _ Depth j2.S 35 J, 17.7 21.4 Severity 22.8 2. 0 11 8 14.9 Table 3.2: Incidence of g90wrty (1993 and 1999) Urban l,o~lla~~d/l'oottiill~ 1toiiiitai l/Sici~qu 11 \ ;?llq Total 1993 19W 1993 19v 109i 1999 1993 1999 Destitute 26.4 24 3 48 47 Y 06 1 68.7 49.3 49 Poor 39.6 44 4 65.3 67 8 78 (1 83.3 64.8 67.7 3.6 The estimate of inequality in Lesotho is one of the highest in Africa. In 1994, the poorest decile accounted for only 0.27 percent o f the total expenditure compared to 52 percent accounted for by the richest decile (May et al. 2002). The Gini coefficient for the country increased from 0.60 to 0.66 between 1986187 and 1994195. Inequality 32The official povertyline is based on an "expenditure based basket" that supplies 2,200 kilo calories per day per adult equivalent, the minimumdaily requirement by internatioiial noms. It amounted to M 124per personper month in2001 prices. One halfof this amount - per capita espcnditure of hl 62 per month-defines ultra poverty. 33The SechabaConsultants set the poverty line at half the average expenditure per adult equivalent inthe population, andultra poverty at one-fouith of the average expenditure. They were M70.48 andM35.24 per monthper capita in2000. They estimated the cost o f acquiring a basket o f goods that provides the caloric requirement of 2,500 per day to be M36.26 per month per capita. 55 appeared to have declined among urban residents and increased among rural residents, as well as between urban and rural residents.34 GEOGRAPHIC, DEMOGRAPHICGENDER AND ASPECTS POVERTY OF 3.7 The incidence of poverty was higher in rural than urban areas, and among larger, old-headed households (May et al., 2002). Between 1986187 and 1994195, poverty incidence rose from 63 to 72 percent i n rural areas - compared to 27 percent in urban Maseru, for example - but, the proportion o f poor households living inrural areas declined from 92 percent to 82 percent.35Within rural areas, poverty was higher in the mountains and the Senqu Valley. It was as high as 77 percent in the mountains in 1994, In1986, one out ofthree households livedin deep poverty inthe mountains; by 1994, one intwo did. Poor and ultrapoor tendto be larger households with greaterage-dependency, and are headed by older individuals. Ultra poor households, on average, have one additional child under 16 and nearly double the number of individuals aged 60 and above compared to non-poor households. Therefore, nearly two thirds of the children under six, children o f school-going age, and more than 70 percent of the elderly live in poor households (May et al. 2002). Also, the heads o f poor and ultra poor households are older (55 years) thanthose o f non-poor households (46 years). 3.8 Female headed households make up about 30 percent each of a11 households in Lesotho, and most of them are poor. Dejure female headed households seem to do worse than male and defacto female headed households. Nearly 62 percent o f them are poor compared to nearly 58 percent of the male headed households and 55 percent of de facto female headed households. In 1994, more than two thirds of the dejure female heads were widows whose average age was 56, 5 years more than that o f male heads and 11years more thanthat o fdefacto female heads. Women bear a disproportionate share o f the burden o f poverty. With declining wage earning opportunities for men, the burdenof taking care of family needs is falling on women. Female migration to work on seasonal, menial jobs under conditions worse than those in the mines is replacing male migration (Ulicki and Crush 2000). As many as 70 percent o f the female migrant workers in the Free State are estimated to have an unemployed spouse at home. INCOMEANDPOVERTY SOURCES 3.9 The changes in various sources of incomes between 1986187 and 1994195 give an indication of how the changing structure of the economy may have influenced poverty dynamics in Lesotho (Table 3.3). In 1986, 35 percent o f the households indicated that remittances were their primary income source, but only 23 percent did in 1994195. Subsistence farming that provided iiicome for 22 percent o f the households increased to support 32 percent o f the households. Similarly the proportion of families that had wages and salaries as the main income source increased from 17 to 27 percent. 34Existing household survey data does not permit a consistent analysis o f inequality inLesotho. A proper analysis of consumption trends using data frombudget susveys and national accounts is also not possible. 35The share of the urban population has beenincreasing rapidly inLesotho, fromabout 3 percent in 1966to 34 percent in2000. 56 Table 3.3: Main sources of income in Basotho i iH (1986/87 - 1994195) SourTe: May et (112002. 3-10 How structural changes influenced poverty bccomes apparent from changes in the income sources of poor and the non-poor households. In 1986187, cash remittances from migrant workers were the primary income source for 40 percent o f non- poor households, but only 28 and 31 percent o f ultra poor and poor households - clearly, households with migrants were the better off. On the other hand, 31 percent o f ultra poor households and 28 percent of poor households derived their primary income from subsistence agriculture. In contrast, only 14 percent of the non-poor households derived their main income from subsistence - Le., non-poor households were less dependent on subsistence farming. In 1994195, the dominant source o f income among the non-poor households was wages and salaries.36 The proportion deriving primary income from remittances was down to 21 to 23 percent - nearly the same for all categories. Nearly one-half o f the households that received remittances were non-poor; evidently, the remaining must have been pushed into poverty for lack of other sources that provided adequate income. The ultra poor and poor liouselioltls increased their dependence on subsistence agriculture: 48 and 43 percent of households respectively, derived primary income from subsistence agriculture - despite any evidence o f growth in the sector. Wages and salaries were the dominant source o f household income among the non-poor. As a result, the communities in Lesotho associate poverty with declining work opportunities and problems with agriculture (Leboela and Turner 2002). The source o f income is a fairly good predictor o f the economic status of households. Nearly 79 percent of the households whose primary income was subsistence farming were poor, while only 35 percent o f those with wage incomes were poor.37 3.11 Basotho livelihoods are based on a bundlc of subsistence strategies. The CARE? Livelihood Study (Turner 2001) identifies iivc main livelihood sources: (i) agriculture, horticulture and livestock; (ii)govemmcnt and its activities; (iii) wage employment and education; (iv) the informal sector; and (v) family and security 36Available analyses do not indicate the source or sector from which ihe wage and salary incomes were derived but it is likely that some of it was related to the emergence o f the local construction industry, a spillover from the LHWP, and some o f it was derived from work in the garment and services sectors that were expanding inthe 1990s. 37Logistical regression suggests that rural households were three timcly more likely to be poor than urban households; households with heads older than 64 years were three times more likely to be poor than households with heads younger than 24 years; households in subsistence farming were twice as likely to be poor than household that had wages and salaries as their main income source (May et al. 2002). 57 outcomes. Inpoorer areas such as the rural foothills and mountains, households depend ona larger number o fincome sources than i11 richer areas: urbanhouseholds receive more than three quarters of their total income from a primary source, whereas, in the mountains, only 18 percent o f the income comes from the primary source. The bulk o f the income in rural areas also comes from own production - nearly 50 percent o f consumption in the rural mountains is from own production. In the mountains nearly 50 percent o f the households produce vegetables. Another 20 percent o f the household income is from gifts or remittances. Marijuana (mntelconiie), usually intercropped with maize by about 70 percent o f the farmers is the main cash crop (GOL 1997). 3.12 Simulations from the SAM Model highlight the potential effects of direct government transferslsubsidies to the poor and other sectoral growth strategies on the incomedistribution of households (Table 3.4). Two types of shocks are simulated: (i) government transfers topoorhouseholds, and(ii)modest growthinvarious direct sectors, as well as the Recommended Strategy achieved through a variety o f policy reforms and government actions to benefit the poor in a permanent manner (discussed more fully in chapter 6). As expected, direct transfers or subsidies to the poor raise the incomes of poor households the most but require large public expenditures that will not be fiscally sustainable. They are also unlikely to have a sustainable impact on poverty by making the beneficiary households economically independent over time-if the 38The Recommended Strategy is discussed fully in chapter 6. It is based on a case o f heavy investment in public infrastructure and a set o f core policy reforms and government actions triggering off a private sector responsethat amounts to production increasesof about 10% inmanufacturing and services and 5% in commercial agriculture. 5s government decides to cancel the income transfers, the beneficiaries will slip back into poverty. With this caveat, column 2 shows that an iiicrease o f 50 percent or M40 million per year (in2000 prices or M51million in2003104 prices) inwelfare transfers to the poor can raise their households incomes by 5-6 percent (Table 3.4).39 In contrast, among growth scenarios, only those that directly affect rural agriculture such as commercial agriculture, favor rural poor households disproportionately more than the urban poor or rich households. In commercial agriculture, for example, output must rise by 20 percent for incomes of rural poor households to increase by 3 percent. Growth strategies targeted at the informal or garment sectors tend to favor the urban poor more than the rural poor. An increase of 20 percent in garment exports can increase the incomes o fthe urbanpoor and rural rich households by 2-3 percent compared to 1.6 percent for the rural poor who typically do not find wage employment.40 3.13 The Recommended Strategy for poverty reduction (last column) relies on a big boost from public investment in infrastructure (25 percent), reinforced by core reforms. These reforms and policy actions are in the areas o f property rights, education and skills development, goveimance and capacity building, and private sector development, the Recommended Strategy i s premised on a private sector response in all economic sectors large enough to raise overall economic growth rates to levels that permit incomes o fthe rural poor to rise by about 5 percent. However, it needs to be noted that even ifeconomic growth i s attained at levels suflicient to benefit the bulk o f the rural poor, the Recommended Strategy maintains that there will still remain a case for direct government support in the form o f safety nets for those who are unemployable - such as the elderly, orphans, disabled and the victims and families o f disease and disasters. EMPLOYhiEi v ~ 3.14 Recent labor force surveys suggest that more than a quarter of Lesotho's labor force was unemployed in 1999. As in other dcveloping countries, with the bulk of the labor force engaged in infomial activities, employment measures are not reliable Ina poor country, as a quarter o f the population in productive age group could not be not doing anything, the data most likely represents population that i s underemployed or that does not consider itself to be employediworlting". Of the estimated 10 and above population o f nearly 1.32 million, nearly 940,000 were cconornically active - implyinga labor force participation rate o f nearly 70 percent (Table 3.5).42 Seventy three percent o f them (687,000) were employed o f which 589,000 worked in Lesotho and the balance o f 98,000 inRSA. 39These simulations do not indicate how many households will be able to rise above the poverty line through suchtransfers. For this, a proper analysis o f a more recent household survey is required. 40Inthe case ofallprogramsandgrowthscenarios evaluated, the clianges inincome are the outcome of both direct and indirect effects captured inthe model through the backward and forward linkages in roduction. More detailed analysis o f the characteristics o f the uiieiiiployecl is not available. "The figures inTable 1 diffcr 1'wmIhose in the publislicd Labor i:gwe Survey Report 1999atid are based on revised estimates by the BOS and World Rank k)llw~iii.g rc-\\ zigiiling and re-adjustment for some duplicate observations. A 2002 \XIfax survey estimates an ecoiioinically active population o f 875,000, and an unemployment rate of 23 percent or[helabour Lorce aged 15 anti above (World Bank CWIQ, 2003). 59 3.15 The employment trends are tiarricr to establish.43 The 1997 and 1999 Labor Force Surveys (LFS) estimate that the cco~ioinicallyactive population increased by about 125,000 per year over the two years; and unemployment declined from 40.5 percent to 27.3 percent, which suggests that the two surveys are not comparable. A more reasonable estimate i s that the labor force has been growing at 2.8 percent per year during the 90s with nearly 24,000 individuals entering the labor force annually (Labor Policy 2000). Unemployment is not likely to have declined, as the private sector has not generated enough jobs to keep up with labor force growth. Formal establishment surveys44indicate that the number o fpaid employees decreased from 71,668 in 1997 to 47,392 in 1999, and then increased marginally to 5 1,691 in 2000. However, the number o f jobs may have increased during an earlier period: the BOS estimates that employment in the formal private enterprises inmanufacturing, construction, retail, catering, transport and financial services nearly doubled, from nearly 60,000 to 112,000 between 1994 and 1999. Table 3.5: Population 10 !.cars :tnd a f m x by current economic activity (1999) [Activity Status Including Escluding Total Populatioii 10 & above 1.324.447 1,226,387 Eco. Active Population 939.97 1 541,911 Labor Force Participation Rate pero t I 70.97 68.65 Enqdoyed in Lesotho I 589.564 589,564 Employed inRSA 1 98,060 Total Employed I 687.624 589,564 Unemployed 252,347 252,347 Employment Rate -Percent 3 . 1 5 70.03 Unemployment Rate Percent 26 85 29.97 3.16 Underemployment may characterize both the employed and the unemployed. Nearly 69 percent o f all employed, about 406,000, were in subsistence farming. Only about 24 percent o f the employed or iiearly 140,000 were paid employees in 1999-those that have the highest chances of escaping poverty (Table 3.6). More than two thirds o f those not engaged in subsistence farming - nearly 125,000 - were in the private sector. As expected, a larger portion of them -66 to 70 percent -was inthe private sector in urban areas compared to rural areas.4sAnd, almost 66 percent of the total in the private sector (more than 75 percent in rural areas) worked in firms with 5 or fewer employees, presumably in informal enterprises. Also, nearly 60 percent of the business enterprises in rural areas were located inowners' homes. 43Unemployment trends are also not nieaningfulunless underemployment can be measured accurately because the unemployed are absorbed in unproductive informal activities in which they are counted as employed. 44The BOS has conducted formal establishment surveys annually since 1997 to obtain informationon employment, labor supply and labor donand. The surveys are conducted mainly inurban centers and covered 1,794 establishments in 1997 and 2,215 in 1999. 45Nearly 55 percent o fthem were enpged inprivate personal business, presumably informal activities, another 32.1 percent were employed iiiprivate formal establishments, 10.9 percent ingovernment and the remaining 2.4 percent inparastatals (BOS 2002). 00 Table 3.5: I)istributioii of f,esotl~o-ei~iployed individuals, 1999 Type of activity Sumber Share Type of emplo>er Number Share Total employed in Lesotho 5,Y0,561 100`ZO Subsistence -105.610 W`% Non-subsistence 181.944 3 I !;i NolI-\\tbststet1cc 183,944 100% - Wage einployed 140,Oc)O 23% - (ioiernrnent 47,825 26% - Pnvate HHemployees 17.087 34;) - Paiaslatals 11,037 6% - Ownaccount 29.178 S"6 - I'rivate sectoi 125,082 68% - Eniployers 3.537 1`)h 3.17 Industries with significant shares of the paid employees in Lesotho in 1999 were construction; agriculture, hunting and forestry; private households with employees; manufacturing; and wholesale and retail trade (Chart 3.1). The leading employers inmanufacturing - which has 10 percent o f the wage employed - are firms in textile and clothing (71 percent), leather and footwear (14 percent) and food and beverages (8 percent) (Establishment Survey), The remaining 6 percent o f the workers in the registered firms were evenly distributed over sandstone and brick making, furniture and printing, chemicals and other related activities. Little less than a third o f the paid workers are in elementary occupations, about 12 percent are craft and related trade workers, about 11 percent each are "service workers and shop and market sales," and "skilled agriculture and fishery workers," and only about 9 percent are professionals. Chart 3.1 : Ilistrihution of`'IIage cntployccs by sector, 1999 Education Transport, Wholesale & Private HH with forestry 14% 61 Attributes of the wage employctl 3.18 An econometric analysis of the 1999 Labor Force Survey data shows that personal characteristics such as age, education, gender, location and whether the individual has gone through technical training distinguish the wage employed from others in Lesotho's labor market. Education and age, independently and together considerably influence the employment status. Only 40 percent o f those without any education and with standard 1 to 7 education, and one in two o f those with form 1to 5 education are employed, while more than 80 percent of those with DiplomalA-level or higher education are employed. An econometric estimate o f the probability o f being in paid employment as a function o f personal characteristics is as follows:46 xplanatory variables Piiraiiwtws liaiigc of' cxplanatory variables Intercept - 2.4 Age 0.1 121 C'uiitinuous Croin 10 to 90 years Age squared 4).OO140 Education -0.2435 Coiitiiiuous ii.oni 0 to 15 years Educationsq 0.0084 Age*Educadon 0.00482 Gender 0.4453 Malt := 1; Female = 0 Location 0.0149 1:1.11311-7.1:Rural - 0 Technical training 0.8 106 'lraining = I:1x0 trainiiig = 0 3.19 Wage employment is highest among those between 30 to 59 years of age: close to 60 percent o f thein are wage employed compared to 40 percent of younger and older individuals. Education further improves the employment chances o f those in this age group. One in two o f those in this age group with 0 to 7 years o f education are employed while those with 8 or more years o f education have a greater than 70 percent chance o fbeing employed. 3.20 Technical training, in addition to education, improves one's chances of being wage employed. Excluding subsistence farmers, three-quarters o f those who received technical training were employed compared to only 40 percent o f those without it. The survey is not clear whether tlic respondents received technical training before or after they were employed. Ifthe latter applies, the causation may not be as strong it appears. 3.21 Males and urban residents have greater chances of being wage-employed. The probability o f female unemployment i s more than 10 points higher than male unemployment (23 percent and 37 percent; 52 percent to 61 percent when subsistence farmers are excluded). As one might expect, emplopelit rates are lower inrural areas.47 Excluding those engaged in subsistence farming, the probability o f wage employment for those inurbanareas is one intwo comparedto one inthree inrural areas. 46This analysis is done excluding those 'employed' insubsistence farming. 47Almostone-half o f the unemployed -more than 60 percent in the mountains -have been unemployed for more than 2 years, and more than tn.o-thirds of them have never worked before. 62 3.22 The estimated probabilities of employment of males and females in the 20 to 25 year range with various characteristics are presented in Table 3.7. Males and females inthis range typically have 8 and 9 years o f education in urban areas and 5 and 7 years in rural areas. An urban male in the selected age group with 8 years o f education has a 75 percent probability of being employed, while a woman with the same characteristics, but an extra year o f education has only about a 65 percent chance o f being inwage employment. Young rural men and women with primary education, but without technical training have less than one-third chance o f beingwage-employed, Table 3.7:Estimated probability of employrnent of young men and women with \arious personalcharacteristics I 24 perccnt R i i i ~ l 20-25 7 No Sou,u.c 4nnlj5 1 %o/'IOP(~iiihoi Foici Gri-lei IIorldlla/iX INCOMES 3.23 Monthly earnings of wage employees vary by gender, locationand sector: the median monthly income o f males is M572 coinpared to M385 for females; and M637 in urbanareas compared to M290 in rural areas. The median earning o f all wage employees is M462 per month. Median earnings vary significantly across industry o f employment capturing wage differences in the sector of work (private or public), education and experience. The median monthly earnings were the highest in defense, education, health and social work and electricity, gas and water (M1,000+), followed by financial and business services (M900-M999), transport (M600-M699), hotels and restaurants (M600), manufacturing (M400-M499), construction (M300-M399) and domestic work (M100- M199). The three sectors that have a significant share o f the paid employees - construction, manufacturing and households - offer the some o f the lowest salaries. Within manufacturing, wages are lower in the textile industry - M744 per month compared to M925 in leather, M1, 059 in furniture making and M949 in all establishments (BOSIMES). `*In contrast, a Basotho miner earned about M2, 100 per monthin 1998. Wage determinants 3.24 Historically for the Basotho, obtaining a job in the South African mines did not require education. The boys grazed cattle until they were old enough to work in mines. Declining mining opportunities have changed the situation. The attributes that that distinguish the wage employed from others determine the average earning. Education, 48The BOS estimates of average wages in manufacturing are almost twice that o f LFS estimates, possibly because their survey includes only formal establishments that are likely to pay more than informal establishments. 6-3 which has a correlation coefficient with earnings of 0.48, is an important factor. This strongrelationship o f earning with education is, however, not linear. 3.25 Earnings increase marginally with schooling up to about 11years after which they rise steeply and then level off again. The monthly earnings almost triple between 11and 12years ofeducation(Chart 3.2). Technical education also has a dramatic impact on earnings: individuals with tcclinical training had a median income o f M1, 500 compared to M350 for others. Chart 3.2: Relationship hctiicen years of education and wage earnings Median income by education Median month1 0 2 4 6 8 10 12 14 16 18 No of Years of education Number of years of education 3.26 Work experience, indicated by the number of years in the current occupation also has significant effect on earnings: those with less than 6 months in the current occupation earned M250 per month compared to M850 per month by those with 5 to10 years, andM1,500 by individuals with 10 or more years o f experience. As we see earlier, gender and locality also have a bearing on earnings. The estimated relationship is as follows:49 Log(monthly earnings) +++0,554 (technical =6.98 + 0.0758(Education) 0.170 (work experience) - 0.00721 (work experience)2 0.0332 (age) - 0.000374(age)' +++0.284 training: No =0, yes = 1) 0.5 12 (gender: female = 0, male = 1) (locality: rural = 0, urban = 1) 0.182 (sector: private = 0, govemment/p~astatal=1) 49All the variables inthe modelare significant at 5 percent level except the interaction term between education and technical training. The model has an R-square of 0.48. 64 ++ 0.253 0.254 (Occupation: high skilled= 1, low skilled = 0) (education* technical training) 3.27 An increase in education from 10 to 15 years increases monthly earnings from less than M300 to more than M900. Technical training adds about M200 to monthly earnings. In addition to both education and experience, the occupation, which to some extent is related to education, also accounts for some o f the earning differences. Other factors that segment the market are gender, locality, and importantly, the sector: median incomes are the highest in parastatals (M2,OOO per month), followed by government (M750) and the private sector (M350). The minimum wages set by the government for various occupations are usually lower than prevailing wages in formal employment. However, the local private sector contends that the stipulated minimum wages are uneconomical in certain service activities, such as security services. 3.28 Our model estimates that of the total value contributed by labor as a factor of production, more than 50 percent comes from high skilled workers engaged in commercial rural activities (dairy, feedlot cattlc, potiltry, forestry, commercial farming), and in m a i i ~ ~ ~ a ~ ~andr sen4ccs. In thc clothing and textiles sector, for ~ i i i i g example, the bulk (70 pel-cent) o f the value added comes from higher skilled workers (of which 20 percent is relalcd to craftsinen aiitl tradesmen aiid 50 percent to high skilled technicians, professionals, inanagcrs, and supervisors): only 30 perccnt is generated by the large propoition or less skilled plant aiid imachini: operators and assemblers. Subsistence agriculture, rlotiies~icand infoma1 activitics are the only activities that are viable with lowcr skillcd ~tol-kcrs. 3.29 Model simulations show that with existing production technology, a 10 percent increase in gross output in most sectors that have commercial activity can contribute 1 - 3 percent to GDP. Commercial agriculture and garments and textiles contribute only about 1 percent and livestock less than 0.5 percent" to growth (Table 3.8). The simulations are useful in providing estimates o f the type o f labor force skills required to achieve these growth rates. For example, o f the potential number o f new jobs that can be created in each sector, the share o fjobs for high skilled workers varies from 9 percent innon-garment manufacturing (leather, electronics, bricks, beverages etc.) to 54 percent in public infrastructure and utilities. The more service oriented the sector, the greater the demand for higher skills. The need for high skilled labor to achieve growth in infrastructure and utilities, which in turn, are essential for growth in other sectors, i s urgent and deserves attention. - 50 One reasonfor this could be that livestock farming i s still predonlinantly subsistence innature; livestock i s generally not traded by the Basotho. 05 Table 3.8: Skill requirements for growth: estimates from the Lesotho SAM model sirniilstioiis ;killed workers as 94 of totaljobs 1 12O.i 1 0% 54`% burce: Lesotho S A M hosed itiodt.1, 3)02 3.30 The estimated numbers of high skilled workers required are also illustrative for growth enhancing human capital development policies. For example, nearly 1,500 and2,600 skilled workers would be requiredto increase output by 10percent ingarments and textiles andpublic infrastructure. Inmany of the sectors more than 20 percent o f the "high skilled" manpower includes senior managers, professionals and technical professionals. While these numbers appear to be small, the prevailing mismatch between skill availability and supply and Lesotho's inability to retain skilled labor suggest that bridgingthis gap will not be easy. POLICYIMPLICATIONS FOR INCREASING WAGE EMPLOYMENT REDUCING AND POVERTY 3.31 Avenues out o f poverty are private o r government wage employment, and migration, and all are more promising for those with higher education. Inaddition to private and government employment, emigration to RSA where wages for skilled workers are higher, provides alternative route out o f poverty. However, as clear from the LFS evidence, the prospects of finding wage employment in either the domestic private sector in Lesotho, government or RSA market are significantly enhanced with higher education (beyond 13 years) and skills. 3.32 In the medium- to longer-term, the prospects for wage employment in Lesotho will depend o n the productivity o f its workforce. This relates to both the level and quality o f education and skills training, as well as access to better technologies o fproduction. For example, knowing how to type is not sufficient - the worker must also have access to a computer in the workplace or a better sowing machine inthe factory to 06 produce more in the same 8 hour workday. Larger demand is also necessary as productivity leads to scaling up. Improving productivity is a complex process with a strong public goods aspect, The role o f government is to find creative ways o f facilitating technological adaptation in finns and faiins, and improved human capital to cope and apply the new technologies at the level of workers. Increasingly, financial capital flows are channeled to countries that offer a labor force that can be characterized as `high productivity-low cost,' It should be able to use relatively sophisticated or automated production technologies. China and India are two examples, For Lesotho, the implication of this global phenomenon is that if it does not start to invest in improving productivity soon, its low cost-low productivity labor may turn into a disadvantage in the medium term. There are two immediate policy implications for government. * One, in the well established garment industry, GoL should explorepublic- private p~rtiiersliipoptioiis to iiivest in worker training. The availability of a skilled workforce should boost incentives for firms to engage in technological learning, Le., upgrade existing technologies and adapt new ones. Then GoL will need to explore how this can be facilitated. Why should goveiwnent do this? Higher productivity implies higher GDP growth. If the private firms are hesitant, a thorough institutional analysis should reveal why this is so andwhat should be done about it, Two, in the relatively underdeveloped local private sector in agriculture, manufacturing and services, GoL needs to first focus on growing the sector so that it can link to a global supply chain by acquiring global competitiveness in non-traditional exports - wool and mohair, sandstone, fruits and vegetables etc. The first priority here would be to provide the basic inputs for domestic firms to start expanding (the focus o f this report) while designing policies to raise productivity. 3.33 Greater efforts on the part of GoL are required in the area of human capital development. Specifically, this implies policies and actions that (i) increase entry and completion in education at levels beyond the primary - i.e., secondary school and higher education; (ii) determining why many existing vocational training programs (TVET) are not benefiting student$' and makingTVET more relevant for the labor market (iii) form partnerships with the private sector in expanding options for technical training for the labor force, and (iv) exploring options for improving labor productivity in the garment and all other productive sectors. A useful way forward is to first determine why earlier programs to promote training did not succeed. The Labor Force Survey indicates that the returns to investment in higher education and skills in Lesotho are high and that there i s a shortage of skills. Infomiation from existing vacancies and investors also suggests that there i s a shortage o f skills at almost all levels except the lowest. While these factors strongly support the case for government involvement in sldls development, it needs to be recognized that ex post s l d s training, the country may not be able to retain all the trained individuals as it is relatively easy for one to emigrate to a higher paying skilled job in RSA or elsewhere. This prospect, however, does not weaken the case for investment in skills development: if investment in skills development empowers the Basotho to find well payingjobs that help them to escape poverty on a sustainable basis '`Apparently manyrecentgraduates from vocational scliools do not find jobs. 67 either in Lesotho or elsewhere, GoL's goal of povei-ty reduction i s attained. Moreover, remittances from skilled Basotho may be a permanent substitute for remittances from relatively less skilled miners, an option that is no longer available to large numbers o f Basotho workers. SOCIAL DEVELOIWENT: HEALTH EDUCATIONAL STATUS AND Malnutrition 3.34 In a recent welfare sursey, nearly 42 percent of the householdsindicated that they had difficulty satisfying the food needs of the households in the year previousto the survey; nearly one half of them indicated that they have problems `often'; the other half indicated `always' (KoL 2002).52 Although in recent consultations lack of food is mentioned - particularly by women and in lowlands and foothills - as an important aspect o f poverty, hunger itself was not mentioned as a significant problem (Box 5.1) (Leboela and Turner 2002). However, recent evidence indicates malnourishmentamong children: nearly 47 percent are stunted, 12 percent are wasted and 22 percent are underweight (KoL 2002). 3.35 The BOSlUNICEF survey of 1996 estimated moderate53 malnutrition ranging from 6.2 to 17.8 percent in different districts, and in excess of 10 percent in 6 districts (BOS 1998). Severes4malnutrition ranged from 2.1 to 6.3 percent, exceeding 5 percent in four districts. While moderate malnutrition may result from poor feeding practices, severe malnutrition is believed to result from food shortages and poverty (BOS 1998). The Sechaba Consultants (2000) also report that weight for age has worsened between 1993 and 1999. The proportion o f children whose weights are less than two standard deviations below the standards for their age increased from 13 to 16 percent. The proportion o f children with deficiencies in height for age remained the same at 46 percent. HIVlAIDS 3.36 An estimated330,000 adults" (15-49 age-group) - an adult rate of 31 percent -and27,000 children (0-15 age-group) infectedwith HIV were alive at the endof 2001 (UNAIDS 2002). The number o f deaths of adults and children during 2001 is estimated to be 25,000. In 2002, 6.4 percent o f the households in the country indicated that they had someone aged 15-49 in the household who was too illto perform normal duties for 3 months or had died after being illfor about 3 months in the past 12 months (KoL 2002).56And, the estimated number of children living at the end of 2001 who have lost one or more parents to AIDS i s 73,000 (UNAIDS 2002). In 2002, 6.3 percent of the households indicated caring for children between 0 15 who lost one or both parents. As - "In1994,householdsinthepoorestfourdecileshadameanfoodexpenditureofMI6perpersonper month, between42 to 50 percentof their total expenditure. Households inthe richest decile spent M200per month on food, 16percentofthe total expenditure (May et a12002) "Proportionofchildrenunderfiveu,hofallbelowminus standarddeviationsfrommedianweightforage 2 ofWHO reference population. "Proportionofchildrenunderfivewhofallbelowminus3standarddeviationsfrommedianweightforage of WHO reference population ''Ofthem, 180,000 or nearly 55 percent were women. 56The survey didnot rnention AIDS per se. 68 a result o f AIDS, the population o f Lesotho i s expected to be 23 percent lower than it otherwise would be in 2015 (World Bank 2000). The most significant consequence will be that life expectancy in 2015 will be about 31 years less than it would otherwise be: it may decline to about 35 years by then. 3.37 Despite data limitations, it is clear that the epidemic is likely to impoverish many families. As the projections suggest, most of the deaths will take place among people in the economically most- productive age group. Many Basotho families with single income earners indicate that they are vulnerable because of poor health conditions (Turner 2001). The effect of the epidemic i s also beingdealt with privately. Nearly all the households in the survey indicated needing help to take care of the sick. A third o f them received help from family and neighbors, and about 60 percent of them made use o f government services. About one half o f them indicated they had no problems with the services received, but about 20 percent each indicated services being too expensive and waiting lines being too long (GoL 2002). Strangely, in the PRSP community consultations, the need for assistance to cope specifically with the effects o f AIDS was not raised, perhaps, because o f the reluctance to publicly admit the epidemic's severity. 3.38 As noted already, most of the children lived in poor households in 1996. Ensuringthat AIDS orphans will be taken care of adequately will be a challenge for GoL. Inthe recent survey, more than 80percent ofthe households indicated that they needed help intaking care o f orphans. More than 60 percent o f them received help from family and neighbors. The only other source o f assistance was from government, which was usedby about 14percent of the households, About 20 percent o f the households indicated that they had family problems intaking care o f the orphans (GoL 2002). 3.39 The conditions in Lesotho continue to be favorable to the spread of the disease. The industrial sites offer a mine-like situation for the spread o f the disease. Most of the workers are females who have migrated from different parts o f the country. As the wages are low, many o f them may feel the need to supplementtheir incomes. Sex work is an easy option. Surveys indicate that many o f the prostitutes in Maseru were previously garment workers, who may have found sex work to be an easier option than working in garment factories (Salm et al. 2002). Education 3.40 While the educational system has made the population fairly literate:' it has been less effective on other measures of broader education. In 1999,72 percent o f the adults over 15 were literate; women were more literate than men (82 percent to 60 percent). Literacy was higher in urban areas (85 percent in Maseru, for example), but only 50 percent inthe rural mountains. Primary school enrollments are nearly 85 percent, but the enrollment falls to about 26 percent at the secondary level (KoL 2002). Nearly three quarters o f those who do not attend school indicate expenses as the reason for not attending. Nearly 60 percent o f the households were 2 hours away from the nearest secondary school. 57Definedas having completed at least standard4. i t 0 3.41 Beyond primary schooling, the participation of the poor in the educational system remains very weak. The proportion o f children from the lowest quintile inhigher classes decreases from 22 percent in class one to less than 8 percent in form E. Distance to schools, difficult terrain, poverty and cultural practices are some of the factors that keep children out o f schools. Nearly 90 percent o f the poorest households compared to about 50 percent o f the houscholds in the richest quintiles reported that highfees was the mainreason for children to drop out o f school.s8In 1995, a larger proportion ofthe heads of poor and ultra poor households had no education compared to non-poor households - 45 and 49 percent compared to 28 percent (May et a1 2002). School enrollments are also lower: 77 percent o f the boys in non-poor households are in school compared to 56 percent inultra-poor households. ACCESS BASICSERVICES TO 3.42 Improved access to primary education has given Lesotho one of the highest levels of literacy in Africa, but much remains to be done to raise access to basic services. A well-established system of primary health care has eradicated polio and other diseases that affect other parts o f Africa. However, in rural communities, inadequate roads, poor health services, poor sanitation, and lack of clean water rank highamong the problems that the Basotho perceive to be hindering achievement o f their national vision (KoL 2002). Similarly, most Basotho appear to live in "adequate" housing. In recent consultations, people indicatcd dissatisfaction with housing particularly in peri-urban areas -inadequate shelter emerged as an issue in30 percent of the consultations. 3.43 Access to clean water has increased, but major rural-urban differences remain, and access to electricity is extremely low. Access increased from 52 percent o f the households in 1990 and 64 percent in 1993 to nearly three-quarters o f the households in 1999. However, inurban areas, nearly 90 percent have access to pipedwater while in rural areas, only 60 percent do. Even in rural areas, nearly 75 percent o f the households have access to clean water within 15 minutes. The provision o f sanitation, however, is not as widespread. Nearly one half o f the rural households do not have any sanitation compared to only 10 percent in urban areas (KoL 2002). Finally, an estimated 5 percent of the households (20,000 o f the 400,000) had access to electricity in 2001. The government intends to connect about 13 percent o f the households by 2010. According to the 1996 Census, the principal energy sources for lighting, heating and cooking are paraffin, wood and wood. RECOMMENDATIONS 3.44 An analysis of the 1999 Labor Force Survey using logistical regressions shows that age, education and technical training, gender and location have a strong influence on one's chances of being wage employed and the level of earnings in Lesotho. Therefore, technical training alone can increase the probability o f employment o f an urban male from 55 to 74 percent. Education and experience have a strong influence on earnings. Mere literacy does not seem to make much o f a difference either in improving one's chances o f being in wage employment or in determining monthly earning. But education, particularly beyond the 11th standard appears to triple wage ''Startingwiththe year 2000, the governmentintroducedfree educationfor grade one students. 70 earnings. These findings support the general observation that skilled individuals are in short supply. The employers inthe country indicate that the shortage of skilled workers is a limitation to business and employment growth. On the other hand, those that graduate from some of the vocational schools indicate difficulties in finding suitable employment; this suggests that the skills imparted by the vocational schools are not very relevant for the labor market and need to be re-oriented. 3.45 Since wage employment alone cannot help many avoid poverty, increased investment in educatioii aiid skills traiiiiizg are needed to address capacity problems in government and in the private sector, and also attract high paying jobs that require an educated workforce. The challenge for the government is to (i) increase participation ineducation beyond the primary levels, especially in secondary schools and (ii)increase investments in s l d l s training possibly through partnership with the private sector, and more importantly, make existing training such as TVET, relevant for the labor market. Further research is required to first determine whether the existing technical and vocational education programs benefit the trainees. Research i s also necessary to determine why earlier programs to promote technical training in collaboration with the private sector failed. Model simulations show that increasing the supply of skilled labor is essential to achieve higher growth. It also needs to be recognized that expost training, the country may not be able to retain all trained individuals as many are likely to emigrate to RSA's markets which pay substantially higher wages to skilled workers. If the government's ultimate goal i s to reduce poverty and this goal is achievable on a sustainable basis through skills development o f the Basotho who can then find well paying wagejobs either in Lesotho, RSA or elsewhere, then there exists a strong rationale for significant investments in skills development. 3.46 The following actions are warranted to reduce poverty through enhanced economic opportunities and direct transfers. 1. Provide suitable incentives for the generation of additional wage employment in the private sector. Wage employment gives the Basotho the greatest chances o f escaping poverty, as agricultural and other informal enterprises do not provide adequate livelihood. 2. Improve human capital development through more, better and higher education and skills training. The skills level o f the labor force needs to be improved to bridge the skills gap in the country and also better equip the Basotho to fill non-mining opportunities as migrants. GoL needs to promote policies that (i)increase participation in education in secondary schools and higher; (ii)increase investments inskills training possibly through partnership with the private sector; and (iii) make existing training such as TVET, relevant for the labor market. Careful research to determine whether existing TVET i s relevant and why earlier worker training programs conducted in collaboration with the private sector failed is necessary. 3. Raise productivity. In the medium to longer term, GoL needs to identify and implement policies that can raise productivity in firms and farms, through entrepreneurs and workers who use superior technologies o f production. As this process must necessarily follow issues o f a larger supply o f technical and higher skills, and training, it i s not explored indetail here. 71 4. Develop rural non farm activities. Livelihood opportunities have to be improved in rural areas, as the bulk o f the poor live in these areas. The potential for commercial agriculture is limited, particularly to adequately support the current rural population. The development of non-farm activities will be critical. Building on other non- agricultural sources such as the rural environment - that supports a thriving tourism industry in South Africa - seems a promising way to facilitate rural development. 5, Assist H I V I A I D S affected and other "needy" households through safety nets. Catastrophic illnesses and deaths caused by HIViAIDS and other fatal illnesses can push families into poverty. The bulk o f the children and the disabled and aged live in poor households, are unemployable and therefore also "needy." So, poverty alleviation has to go beyond employment creation to reach the elderly and children. The Basotho households faced with illness and death o f family members, and those that are taking care of orphans, have been coping without much government support. GoLneeds to establish safety nets to addresstheir needs. 12 I Box 3.1:Voices of the Basotho The Government of' l.r.soilio organiml conwhations ai 101 locarionsaround the country seekingconimunity input into thc poverty reduciion str'iiqy pq~ci(PRSI') mtl nt IO7 locations scclting responseson various aspectsof the ' proposed national vision. The coiisiiltaiions lidii i.ur:il 1 ~ 5 onl> .3 pcrccni : ofthe locations were in urban areas; thc rcst were equally split in the low1;iiid.; foorliills and niountaiti y u valley. 'l'hc objcctiic was to gain insights into comniunity perceptions of po\w!y, obserwcl poiCI ly trends. pro1)Ieiiis faccd by them, ilic causes of poverty, and finally stratcgics to deal with vaiious prohlciii. The PRSP consultations \\ere opcii. In the case of the national vision, the participants were asked to rcspondto drfficiiliics in x l i i c i iiig iavioui aspects ofthe vision, which include: A stable and unitcd dcinoarucy A prosperous nation A nation at peace \siih itselfiind neighbors A healthy nation A well-dcvclopcd huni;in rcsoui'cc b A healthy enviroiimcnt A strong economy ,A technologically ivcI1 equipped Lcso[ho. People associate povcrtq with tirieni~)l~~yiiicni. 01'food, cloihing and other basic needs such as access to lack rural conimunitics and clean natcr. T h e arc gcndcr and i.cgional differences in perceptions: men eniphasizc employment, while wonicii fi)cus on lack orfood, clothiiii; and other basic needs; greater cniphasis is placed on lack o f food in lowlands, and on uncrnploytncnt in the niouiit;iins. l'lic loivland coniinunities indicate that poor farming, mine retrenchmentsand uneniploynient arc soinc oi' the trends of pwcrry in the Ins! 10 years: in the mountains, cominunities felt that the trends wcrc srock rhcfr. poor fhriiiin.c, ani1 harsh catlicr conditions. The short and long term problems \\. mentioned arc agriculture, poor state of the cconoiii~~titicnij~l~~~ii~etit. poor licalth and sutitation, inadequate roads and infrastructure. For wonicn. uneniploynicnt and poor iicaltli and sanitation conditions w r c of greater concern than agiculttire and roads. For men. iigi.icu1ttu-e. and poor ccononiy uerc folloued by poor roads and inadequate security and law enforcement. Unemploynieiit is: a concern :iinon~all 1171: groups, but tirban residentsplace higher priority than others on lack of clean ~iitcr.iiiid absence of fiwd aid For the clcicrly and disabled. Agriculturul problcnis werc the most cited causes o f povcrty. folloised hy t ~ ~ i c ~ ~ i p l o1poor i c ~ ~ ~ ~hc;ilthi tsanitation and \\ater supply, politics - concern . with deteriorating values and diniinishcd coiiccrn iiir eiiah other. A prosperous nation ancl strong ccoiioiny ai-e t\vo clcnicnts of the vision that focus on the economy. People ii felt that a prospcmis nation I Sonc with p:'odticti\c ngi~rculiiirc,ciiiploynient. good health, rcduccd crinic, and help for the agedidisabled. A strong ccononiy, on tlic other liniid, is one with cniploynient crcarion. agricultural developnient, roads and bridgcs, irrigerion&ms and vilhgc police posts. The liiiiitarions to achieving various elements are unemployment, bad roads, theft, poor licuitli services, poiw sanirzition, poor tiirniing, puiitical strife and lack of water. Placed in broad categories. 1ie;ilth 5mitatioii Lind t t m r is the most Iiniiliiig factor ibllowed by politics!goveimance, economy;:etnployinenf, sccuriiy a i d cduc61[ioii, l'lic pi~oposc~l str:itcpics for achic\ ing a prosperous nation are agricultural dcvelopnicnt, cmployiiicnt gcncratiim. hcircr infi.asirticiurc, dcvelopiiicnt of sinall entcrprises, home industries and sniall fiiniily busin .For 3 strong economy. income generating acrivitics: roads and agricultural extension, good fanning pixliccs. c i ~ n ~ i i ? u n iin~ igeneri arc interesled in selt'-hclp projects that involve sniall- ~ s scale village developnieiir pi~ojcct.; Io ivliicli thcy can conlribule labor aiicl niateriA. The other interests are road construction, agricultural dcielopnierit. clean vatel' supply. factories, hospitals, and irrigation. Though they arc kecn on self-help projccts. thcy seein to bclicvc that the go\criinicnt has the skill and rcsotirccs to nxikc devclopment happen, To develop agricullure, for exaiiiple, ihcy \\nntcd pro\ ision o f iniproved inputs. aid in the foini of equipments, extension services, inputs supply points, aiid yovernmcnt subsidy on basic services. 4. SECONDARYAND TERTIARYACTIVITIES INTRODUCTION 4.1 Lesotho's secondary sector, comprised of manufacturing, construction, and utilities (electricity and water) grew steadily at 8 to 9 percent per annum in the last two decades and increased its share in GDP to about 37 percent in 2003104 from 25 percent in 1980-86. The share o f services in the economy fell from 40 percent in the early eighties to about 36 percent by the end o f the decade. LHWP construction benefited the development o f services such as business and information technology, and hotels and lodges. Wholesale and retail trade is one o f the few sub-sectors that i s still growing - its share in GDP increased from G to 8 percent. In general, growth in the service sectors tracks overall economic growth in Lesotho. 4.2 The Government has followed a dual strategy: attracting Foreign Direct Investments, and supporting the establishment and expansion of Basotho-owned enterprises of all sizes. The preferential access that Lesotho's manufactured exports have to western markets, especially the US., is the key incentive for foreign investments inthe country. The Lesotho NationalDevelopment Corporation (LNDC) was established in 1980 to promote foreign investment, particularly in manufacturing, by offering serviced industrial sites. The Basotho Enterprises Development Corporation (BEDCO) was established to meet the financial, training, entrepreneurial development needs o f the indigenous small business. Though exports have been the objective for the local private sector as well, domestic enterprises have competed mainly with RSA firms to provide products and services in the domestic market. Some o f the projects such as the Business Advisory Promotion Service (BAPS), the Small-scale Industries Project (SSIP), and the industrial and agro-industries projects were initiated to assist indigenous entrepreneurs. The Trading Enterprises Regulations Act o f 1999, intended to protect indigenous entrepreneurs, forbids foreigners from engaging incertain businesses. 4.3 Lesotho has been fairly successful in attracting Foreign Direct Investments (FDI) compared to countries similar in size and endowments (DTIS, 2003). Inthe development of Basotho owned enterprises, on the other hand, the government has been less successhl, The export-oriented manufacturing sector is largely in the hands o f foreign-owned enterprises, and so are some o f the critical services. The export-oriented manufacturing sector remains an enclave with few backward linkages with local firms. The local private sector i s largely engaged in meeting the domestic demand for products and services competing with imports, primarily from RSA. 3reaking the dichotomy between largely foreign-owned export-oriented manufacturing, and mostly informal domestic enterprises continues to be an important objective o f the country (GoL 1997). To place the sectoral developments in the context o f government policies, the discussion in the rest of the chapter will be organized along export-oriented manufacturing and Small andMicro Enterprises (SMEs) to cover the rest o f the enterprises. 1. Export Maiiufactur~ii~. This includes mostly foreign-o.ltned firms, but does not cover all foreign-owwcd enterprises in the country. Forcigiiers own many o f the services, such as the business aitil IT scrvices, holcls. car rentals, air travel, insurance, teleconiniiii'iicatioiis, and financial services. '1 he output i s entirely for exports. 74 2. SMMEs. These include largely Basotho-ownetl, usually small enterprises in all sectors, but nios1Iy in services. Not all of then1 `ire Basotlict-owned. Non-Basotho citizens and non-citizens arc cngagcd in smalI tradc. SMME output is largely for the domestic market, except fbr products such as handicrafis. EXPORT MANUFACTURING 4.4 Manufacturing began in the country soon after independence. The Government of Lesotho adopted an import substitution strategy and established several parastatals, such as Loti Bricks, Lesotho Flour Mills, and Maluti Mountain Brewery. Lesotho's manufacturing includes the production o f food and beverages, textiles and clothing, and "other" manufacturing (footwear and leather products, and a few consumer electronics). Food and beverage production accounted for the bulk o f manufacturingGDP before FDIflowed into textile and clothing and "other manufacturing" in the mid 1980s. In 1995-2001, food and beverages and textiles and clothing each accounted for 5 to 6 percent o f GDP, and `other manufacturing' contributed 3 percent of GDP. Textiles and garments and `other manufacturing' have also emerged as important foreign exchange earners for Lesotho, as they account for over 77 percent o f the exports today. 4.5 The changed composition of manufacturingtowards garments has enhanced employment in the sector. Manufacturing now employs about 50,000 workers, nearly one in four in the private sector. The newer firms in textile and other manufacturing are more labor-intensive. In 2000, the top 3 employers in large manufacturing were textiles and clothing (71 percent), leather and footwear (14 percent), and food and beverages (8 percent). A textile firm employs, on average, about 600 workers. The average employment in the leather and footwear firms, whose number has increased from 4 to 6 inrecent year, declined from over 900 in 1999 to 550 in 2000. Eleven firms inthe food and beverage sector employ about 145 workers each. Clothing and leather firms that are more labor-intensive than other industries also employ more female labor: 90 percent o f the workforce in the clothing firms is female while in other sectors such as food and beverages, its share is only about 20 percent, In 2002, it was estimated that if the government could provide adequate land and utilities to companies that expressed interest incoming to Lesotho, an additional 50,000 jobs could be generated inthe garment and textile firms in the following five years (Salm 2002). More recently, with the expiration o f the MFA in January 2005 and the renewal o f AGOA, this outlook is somewhat dampened as the garment sector globally i s re-adjusting to the implications o f Asia's quota-free access to the U S market, There has been turnover as some Chinese firms have folded up in Lesotho and elsewhere globally. At the same time, signals from large American retailers showing their willingness to buy garments made in Lesotho in appreciation of better labor standards in the country suggest that this could be a temporary adjustment process that may result in some entrants. It is simply too early to tell. 4.6 Foreign direct investments (largely from Asia) have driven growth in manufacturingsince the mid-eighties. More than 90 percent o f the FDIinLesotho has gone into garment manufacturing. Lesotho has become Africa's largest garment exporter to the US. Currently, thirty-eight o f the 55 affiliates o f international firms are engaged in 75 the manufacture o f garments for exports. The other fimis make footwear, electrical products, electronics (TV assembly), food processing, plastics and umbrellas. All the firms are located in LNDC's industrial estates, in accordance with Lesotho's policies. Most o f the foreign investors are Asians with investments primarily in textile firms. In December 2001, a total o f 27 textile and clothing firms operated 38 factories. Twenty- five of them were subsidiaries o f Taiwanese companies, only one was Basotho owned. Lesotho's textile and garment industry produces denimjeans, knit garments, woven and knit apparel, and printed and embroidered garments primarily for export, increasingly to the North American market. O f the 38 factories, 27 produce only for the US and Canada, 6 only for South Africa, 3 only for the US, Canada and South Africa. Products o f the footwear, electronic and electrical firms, and three food processing firms - owned by South Africans - are exported to the RSA. FDI 4.7 A combination of factors - RSA firms wanting to sidestep apartheid-related sanctions, incentives offered by the GoL, cost effective labor, and preferential access to EC and U S markets - led RSA-based firms to move to Lesotho in the early 1980s (Salm et al. 2002). The second wave of investments came in the late 1980s when Lesotho obtained exception to the requirement that at least two manufacturing processes should take place inthe exporting country (Cumulation) to access the EUmarkets, as a member o f the Lome convention. This enabled only C M T operations to take place in Lesotho while the cloth itself could be woven or knitted elsewhere. It encouraged relocation o f a few RSA operations, and a large number o f fresh investments from Taiwan, as the investors also felt that Lesotho offered literate, trainable and compliant labor and an industrial environment relatively free o f regulations. These investments, made between 1987 and 1990, are leading the growtli o f the industry (Salm et al. 2002). As the exemption to cumulation expired after 8 years, some o f the textile firms closed, and others shifted their attention to the U S market, although the products were subjected to 17 percent tariffs and quotas. The introduction o f African Growth Opportunities Act o f 2000 (AGOA), which waived all tariffs and quotas for firms in African LDCs, again offered substantial advantages to textile firms in Lesotho. The firms in Lesotho responded to the opportunities by expanding their operations: between March and November 2001, employment inthe textile firms increased from 20,587 to 32,233. 4.8 As a share of gross capital formation, FDI flows rose significantly between the high- and post-LHWP period. Over the same period, the share of FDI in GDP increased from 2.6 percent to about 4 percent of GDP. On a per capita basis, Lesotho received annual FDI o f $15 during 1996-2000, compared to $6 in LDCs. Its FDI stock was $417 million; in per capita terms it was $194 compared to $55 in other LDCs. The investments were fairly highrelative to its size as well: its stock i s $464 per 1,000 GDP, compared to $194 for LDCs and $364 in SADC countries. The share o f FDI in gross fixed capital f o r m a t h is also on par with other countries, but LNDC contributions to some extent distort the picture (UNCTAD 2003). Low technology enclave 4.9 Export manufacturing has few backward linkages with the rest of manufacturing in the country. The local content o f exports, except for value added by 70 labor, is negligible. Almost no work is subcontracted to smaller firms. All the inputs including packaging are imported. The inputs, shipped from the Far East to East London inRSA, reachMaseruby rail. The textile industry makes only a marginal contribution to human capital development, as it hires mostly low skilled workers who receive minimal training, Expatriates - an estimated 13,000 - fill most o f the technical and supervisory positions. The companies also make a minimal contribution to government revenues, a factor that may lead to social tension between the Basotho-owned and FDIentrepreneurs (DTIS). 4.10 Although expatriate-managed textile firms have been operating for nearly two decades, managerial and technical capabilities have not diffused among the local population. As a result, this did not lead to establishment o f similar operations or, at least, the emergence o f enterprises capable o f subcontracting work from larger firms. The paucity ofprofessional and managerial sltills among the Basotho appears to be one o f the reasons. The challenging nature of the globally-integrated textile industry itself - the need for a long term relationship with large buyers to market the products, the ability to deliver: large quantities at short notices, and the need to penetrate the global supply and marketing chains to enter the industry - is a barrier to entry for the Basotho, especially given Lesotho's weak industrial base (Salm et a12002). Lesotho's textile firms andplants are a part o f a network o f larger global companies that supply the inputs and market the products for them. 4.11 Manufacturing in Lesotho is focused on low-technology and low skill activities. The textile industry produces a narrow range o f products for a narrow range o f markets, The investments associated with export-oriented FDI in the textile industry are usually "footloose" (UNCTAD 2003). A continued flow o f FDIto retain and buildon an existing textile industrial base i s usually associated with deepening in terms o f backward integration, raising o f quality, and so on (La11 2002). Lesotho also needs to diversify into production of other products that have preferential access to the western markets, the country lacks the industrial base and capabilities needed to set up more advanced facilities (UNCTAD 2003). FDICLIMATE AND PROSPECTFOREXPORTS Textiles 4.12 The preferential treatments offered by AGOA Ibenefited Lesotho's garment sector significantly in terms of increased foreign investment and export growth. Until 2004, Lesotho's exports to the US market were protected by a 17 percent tariff under AGOA. In January 2005, the MFA that protected Lesotho's garment exports by granting some o f the most efficient Asian producers (Including China) only quota- restricted exports expired. With the exception o f the AGOA-related tariff-free status that Lesotho still enjoys, all garment producers must now compete alongside the Asian producers whose share i s expected to rise significantly, squeezing out many smaller producers. At the end o f 2004, AGOA Iwas replaced by AGOA 11. The latter requires that after 2007, Lesotho's clothing firms use fabric produced either in Lesotho or in a `qualified' country such as the U S or RSA. Until now, all the fabric and other inputs are imported from China. To remain cost effective and continue to export, Lesotho will have to develop the capacity to produce textilesifabrics domestically. Against the background 77 of these two major global developments, what are the prospects o f Lesotho's garment exports? Several factors will be important, 4.13 The most important issue is that these global developmentsare not surprises. They were well known in 2000 when AGOA was legislated. Presumably, the actors of the global garment supply chain that invested in Lesotho in the past few years factored these risks into their decisions. After all, FDIincreased from US$33 millionin2002103 to US$ 45 million in2003104, and i s estimated at US$60 million in 2004105 (although it is projected to decline thereafter). The installation o f the denim mill is no accident - it was done in preparation for 2007 when the rules o f origin clause will apply and garment exporters will have to use locally made fabric. In the past, when similar preferential access to the EUmarkets was withdrawn, several firms decided to leave Lesotho. But this time around, some companies have established denim-weaving plants in the country or acquired them inRSA to produce all their raw material in the region. 4.14 The challenge for the Gold is clear: can it be proactive in increasing the supply of vital public inputs such as infrastructure and utilities to attract new investment in the textile and garment sectors? The Recommended Strategy in this report contends that there is no alternative large enough source o f growth and exports that can immediately compensate for the garment industry. The country needs this domestic high growth-high employment node. The risk of delayed public action is that if the textile industry is unable to expand and produce sufficient fabric to fuel the garment exports by 2007, foreign investors in this `footloose' industry will shift to other lucrative locations that offer them better infrastructure and better quality labor. There is a limited window o f opportunity for the GoL to exploit Lesotho's attractiveness as a location with fair labor standards. 4.15 Also, competition from Asian exporters in the low value added garments will intensify and may displace Lesotho's exports unless there is timely diversification into higher grade garments such as knits and woven fabrics. Knittingplants have not yet been established, but they are believed to be far easier to establish than weaving plants (Salm et a1 2002). On the one hand, without the trade privileges, the competitive basis for the textile industry seems fragile and narrow (UNCTAD 2003). On the other hand, the fact that the firms that are aware o f cost structures worldwide are integrating backwards i s an indication that they expect to be able to compete effectively in western markets with Lesotho-based production. However, the investors who are interested in setting up weaving and knitting plants locally encounter obstacles related to land availability, factory shells, transportation, water and electricity supplies and bureaucratic hassles (UNCTAD 2003; Salm et a12002). Unless GoL acts timely to provide these vital inputs, it may not be able to retain existing investors and attract new investment. 4.16 In a tightly integrated global market, the low cost-iiiiskilled labor competitive advantage is a transient factor. In fiercely competitive industries like the global garment chain, exporting is closely tied to being hooked into the chain. This requires continual skills and technological upgrading and other productivity-improving measures to keep costs down and remain in the chain. The expiration o f the MFA has exposed Lesotho to severe competition from `high skill-low wage' exporters. To prevent the industry from seeking destinations with a more skilled Labor force, GoL needs to identify and take pro-active measures to boost the productivity o f the work force. In order o f 7s priority, the first step shouldcomprise o f measures to retain the garment and textile firms inthe short term buta close second should bemeasures that can boost the productivity of workers. This requires a careful study as there is no single policy that has delivered on this from uniformly in countries that have been successful at raising productivity both at the level o f the firm and the workers. Diversificationof markets 4.17 As Lesotho's internal market is small, it may not be able to attract significant amounts of domestic market-seekingFDI. However, as a member o f SACU, it has not taken advantage o f the access it has to RSA and the neighboring countries to attract investments to cater to these markets. It could potentially attract labor-intensive operations, with its wages being lower than iiiRSA (UNCTAD, 2003) and other SACU members (Table 1). Although there are a few firms manufacturing for the RSA market, how labor-intensive manufacturing and services fare in Lesotho in comparison to RSA does not appear to have received from policymakers the kind o f attention that manufacturing for the western markets has. Some o f the potential areas inwhich Lesotho could exploit the regional market are assembly and packaging, call centers, data entry, and so on (UNCTAD, 2003). The other possible areas in which Lesotho may be able to attract FDI and become competitive are tourism (Box l), horticulture and mining (La11 2002). Politicalstability 4.18 Perceptions of stability are slowly changing for the better. Though the social unrest and the 1998 riots - in which the businesses of foreigners were targeted for destruction, but the textile firms were left untouched - may have affected investor perceptions o f political stability in country, recent developments, particularly the peaceful transfer o f power after the 2002 elections, may have done much to allay those fears. However, resentment against foreign investors is still strong in the country. Despite the number o f jobs that have been created in the textile industry, the local population does not have a favorable opinion of the investors (Sahn et a12002). The general feeling is that foreigners exploit Basotho workers without beinggood corporate citizens by paying taxes or being socially responsible in other ways. The foreign investors also perceive they are not really welcome in the country: they indicated in a recent survey that they would always be regarded as outsiders regardless o f how long they operated in the country (Salm et al. 2001). Administrative hassledgovernance 4.19 Although the government has made certain improvementssubsequent to the findings of FIAS in 1997, administrative hassles still prevail. Antiquated legislation, such as the Licensing Act o f 1969 (ILA) and the Companies Act of 1967, introduced when the industrial strategy was biased towards import substitution, still shape the industrial climate (Kumar 2002). In 1998, a company law that proposed simplification o f the registration process and procedures was debated, but it has still not been enacted, Lesotho still needs an investment promotion law to regulate and promote investments and to provide assurance to foreign investors against expropriation, nationalization, non- discriminatory treatment, international arbitration and freedom o f investment in 79 permissible areas (Kumar, 2002). However, Lesotho's practice on admission and treatment o f foreign investors is o f a high standard. They need to articulate a good legal basis for current good practice (UIVCTAD, 2003). One o f the areas that needs immediate attention is the issue of visas and work permits. Only single entry visas are issued andthe procedures to obtain residency and work permits are complex, discouraging expatriate operations andtourism.59 LandLegislation 4.20 Land laws are overly restrictive and discourage privatization and long term investments. Under the Land Act o f 1979, "land can only be held by a citizen who is a Basotho," and not by an individual o f foreign or non-Basotho origin. Foreign businesses can only sub-lease for a limited duration (Kumar 2002). The LNDC assists foreign investors with land leases, but it has to first lease tracts o f land for industrial purposes from the government, and the process which requires ministerial consent for all subleases is cumbersome and time consuming. As firms can only be established in existing LNDC estates, the investments are limited by LNDC's capacity to offer serviced sites. Sub-lease o f titles presents risks to foreign investors, and borrowing against a sub-lease, particularly from foreign-owned banks that cannot take ownership is problematic (UNCTAD, 2003). The existing land policy also discourages long-term fixed investments, as it is likely to attract only `footloose,' low value-adding industries. The Land Review Policy Commission (2000) noted that the existing land policy i s a deterrent to ongoing privatization, as in the absence o f the ability to own or lease land long-term, foreign investors have little incentive to participate as majority shareholders in Lesotho's privatizationprogram. Infrastructure and services 4.21 Concentrated along the borders, Lesotho businesses can make use of the superior infrastructure in South Africa, but poorly developed transport infrastructure within the country can still create bottlenecks. The neglect o f the Maseru Rail station i s an example. The infrastructure and services that Lesotho has provided in enclaves to foreign investors have reached their limits. The constraints include electricity, telecommunications, reliable water supply to the industrial estates, availability o f serviced industrial land and pre-built factory shells and handling capacity at the Maseru Railhead (DTIS, 2003). These limitations are likely to constrain the expansion o f the garments and textile industry and hinder diversification into other light manufactures such as leather, furniture, electronics etc. (Table 2). Inadequate facilities for treating the effluents o f the textile firms may also jeopardize access to,western markets that are sensitive to producers' environmental records (Salm 2001). ''AsLesotho has a limitednumber of diplomatic missions abroad, many foreign visitors without direct access to a Lesotho embassy have to visit the Lesotho embassy inPretoria to obtain a visa. The visa process and its fees (M 1,000) are a deterrent to tourists and busiiiessmen alike. 80 Box 4.1:Tourism Tourism is still a m a l l industry tlial dircctly and iiidirectly coiitribiiterl to 2.2 and 3.7 percent of GDP, and accounted for direct and indirect cmploynicnt of'.;.J and 5.7 p '111 of the employed in 1998 (LTB 2000). The attractions. as noted alrcatly, arc alpine coiiditious that arc unique in the continent, scenic beauty of the mountains, cultural herilage, rich flora and f'auiia and the recently created potential for water recreation. The environnient provides cuiisidrrahlc poteittia! for rleseloping hiking and pony-trekking. The number o f tourisls eiilering the coirnlry is oil ]he dccline, ' 1 ' 1 ni~irilzerreached jls peak at 416,882 in 1992, ~ declined lo 225.000 in 1998. and hits conliiiucci to decliric vince t!icn. The most ofthe tourists are locals visiting friend and relativcs and South Africans. Only a11esiimattid ilOOO came from America, Europe and Asia. Perhaps it i s unreasonable to expect the iiumher of'tourists 10 go back to pre-apartheid levels, as what brought many South Africans to 1,esotho tlien was political reasons. Recently, the I.IIWI' has opcneci tip sonic of' the iiiaccessible areas in the liighlands to tourists and also created the poteiitial fix devclopiiig i w c r rccmtion. I-he Maloti toiirism foiwn. a cooperative effort o f the GoL, Eastern Cape and the Free State, proniotes tiit: di\.elopiiieiit and marketing o f tourism along the Maloti route. The Maloti'I)rakcnsburp Taiisf'roiiiier cctiiservation progi.am seeks to assist communities learn conservation and eco-tourism skills. 'fhc hi@laiids iiatural esoiirccs and iura1 income cnhaiiccniciit project I directs more than a third of the rcsoirrccs to cco-tourisin devclopnicni. An Austrian investor in a joint veuture with the GoL is developing a s m w sports facility - -alpine style ski slopes and an accotnmodatioi~ village - at a cost of $12 million (1!N 2002). Tlic 1,csotlirt '1-ourism Board is bcing restructured to establish the Lesotho Tourism Dc\~lopnicntCorporation (L'J'DC'). ~vliicliis cxpcctcd to niarket Lesotho more effectively. However, several Pdctors coilstrain the dc\.c.lupnieiit of tourism. Environniental degradation threatens the basis for lourism. 'l'he ran&~ntis containing globally sigiiificant biodiversity are subjected to grazing pressures (World I3ank 200I$)..i\iici there are 110 protected areas nor is there conservation management capacity. Infrastructure is w'eak. Awilablc ai.co~niiiocia~ioiiis inadequate, much o f it below standard, and concentrated In the Maseru area. iVii,ate sector overall remains weak. The entire legal structure surrounding business development. property laa.. insurance and regulation, conflict resolution, loan parantees and tourism rcgulalioii must be tipg~atlcilif' the prii'ute sector is to be enticed to participate (World Bank ZOO1g). Tedious border proccdiires also ciircotiragc \'isitors. Regionalcompetitiveness 4.22 While the advent of the textile industry in Lesotho was fortuitous, it is an advantage that can be built on. However, how the situation in Lesotho compares with its neighbors is also critical for attracting FDI. Lesotho is not the only country in the region with preferential access to western markets: both Namibia and Botswana have been granted L D C status under AGOA, The Africa Competitiveness Report 2 ~ ~ ~ / 2 ~ ~ 1 6 ' provides some insights into Lesotho's ratings relative to its neighbors in the sub region (see tables 6C1 - 6C5 in Annex 1). Unfortunately, the 2002103 Global Competitiveness Index of which the Africa Competitiveness Index i s a subset did not include Lesotho in its sample. M,The Africa Competitiveness Indices presented in tables C1 - C9 are coiistructed from an indexbased on survey data and an index based on quantitative data by Wariier and Sachs. The following 6 factors comprise the index: openness, government, finance, infrastructure, labor, institutions. S I Table 4.1 :Wages comparisons with SADC countries, 1999 Country Cost of uiiskilIec.1lahor Cost of skilled labor Lesotho LIS5 0.75 pel hour LSJ 1 00 per hour Botswana L'SS 1 45 pel houl N A SouthAfrica Is4.30pelhour LIS$ 7.88 per how Mozambique I'SS 0 25 pci hotti ISfs2.00perhour Mauritius IS%0.65pelIIOIII IIS$1.89pelhow 4.23 Lesotho's advantage over other countries in the SADC region is its abundant pool of low-cost unskilled labor. The average cost of Basotho labor i s US$0.75 per hour compared to US$1.45 in Botswana (Table 1). Average wages in Lesotho are about the same as in Tanzania and Vietnani, and somewhat lower than in India, Bangladesh and China. However, cheap low skilled labor per se is declining in importance as a competitive advantage (UNCTAD 2003). But worker productivity is also low: it ranges from 33 to 70 percent of similar operations in Asia (UNCTAD 2003). And, Lesotho does not have an adequate supply of workers with technical and managerial skills, as there are no institutions that impart skills needed in the main industry. The paucity of all types of technical, professional, and managerial skills may have constrained Lesotho from diversifying into higher value added products such as furniture, leather and consumer electronics and packaging (Table 2, Bates 1999). However, Lesotho's has one o f the highest ratings for labor market flexibility, as measured by the ease of prevailing hiring and firing practices (Table 6C1 in Annex 1). An additional advantage that Lesotho has over Swaziland, Botswana, and Namibia is that population centers and labor are concentratedalong the RSA border which enables investors to live in RSA and commute to work (UNCTAD 2003). 4.24 Lesotho ranks high in the region in terms of openness, Le., the level of import tariffs or quotas and favorable exchange rate policies to expand exports (Table 6C4 inAnnex 1). Botswana, South Africa, Namibia and Swaziland rank as the top four S D C countries that offer competitive financial and tax incentives; Zimbabwe, Malawi, and Namibia have introduced export processing zones that offer a zero rate o f corporation tax and other benefits (World Economic Forum, 2001). Lesotho's corporate taxes on manufacturing are competitive among SACU members (UNCTAD 20002). However, Lesotho may not be competitive in other sectors. Although foreign investors needto bribeto gain access to utilities, obtaining licenses, permits and customs clearance i s not perceived as a serious problem in Lesotho. Other countries in the region seem to offer better governance (Table 6C2 in Annexl). 82 Table 4.2: Investment envitwinierit in light manufacturing in Lesotho, 1999 jurisdictions Sotit11 Africn Rawinaterials Very imporraiit 100 `%iinported Neutral Market access Very impomnt C:oinpctitc)is eii,joy same access Neutral Electricity RcIiabiIity and lotv-cosi ih s tIy supp1y, nre1iable ii Negative Water Not vcry iinpcirtaiit I:os tly supply. ~ i r ciablc ii l Neutral I Laboravailability IHighly skilled engineers, 1Sliori~~gcorski!lcd workers aiid I Negative I Labor costs Iiiiportant Coiiipctilive Positive Market access Rclativcly iiiiportiint Cciinpctitors have same access Neutral Quality of life h'ccd tci attract {sorkcrs Not compcliti\:c Negative Supporting industries Important to supply chain Very limited Negative Technical support scrviccs 1Nccded for repairs. Very limited Negative support I I Water I Not vcrv iinoortant I tlich cost. ~tnrcliable 1 Neutral I I Labor costs I Negative 1 Labor costs lntcnsc competition fi.om ;i\.cq cornpetill\ c Positive pictuic rzslrictiviii Capital cost Highcapital intensity Uoi compeiilivc Negative Market size vely ii11poita11t Sinall iolumei, not c(wipctitivc Negative From materials and natural Very iiiiportaiit licquired to iinpoit materi a k Negative resources Electricity Lo\v-cost a i ~ dicl~ablc iiiyhco inputs are imported from RS.4. Supply outlets are located throughout the city. 111hlasciv alotic. for cx;iiiipIc. there are more than 100 haidware shops. But, because of poor infrastructure and transport costs, materials arc" priced niucli higher in the inountains. Cement blocks are also produced tliroughout thc country. 1mt only close to iirlxin centers, as ivater and power supply are required. The quality of material produced in distunt arcas ofrcii tcnds to be poor. Substantial discornits can be obtained on bulk purchases of' major coiistnictioii inpiits sucli as cciiient. concreting materials, steel, window and doorframes and i.ootiny iiiaterials. S m l l contrac1ors \~11rtundcrtnke smallcr projects in distant ~ areas rural areas work with sinailer margins than larger con1racto~s,as they inay have no option but soiirce ~ their supplies locally. The case studies suggest that the cuntraclors in the coun~rydo iiot gi't adequaie work, as the work i s largely supported by public expenditures, \vliicli also c l i p m l on external aid flows. The contractors also coinplain about the dii'liculties ol' Svorkiny. will1 the posci-nmeiil: procurement processes are often not transparent; payments are iiot pronipt. Siringent prrtcurcinetit requirernwts often leave them out o f consideration for work i'unileci by rnihilatcrill organi,;itioris. 'l'lic tinaiicial institutions are not willing to work with indigenoils contractors. 'I'hc loc;il coniractors wc~uldlike --as in Iiorswana - the goveiiunent to require outside contractors to work with tliein. so h i t they can bcncfit fi.oni the cxperience. Soiirce: Phafaiie 2002 I Credit provision and recovery 4.39 Limited access to credit for Basotho SMEs is widely recognized. Often overlooked is the absence o f institutions to facilitate credit recovery, a concern o f small businesses, and a significant portion o fwhose sales may be on credit. 4.40 These concerns of the private sector would suggest that the local private sector is constrained by transaction-cost-enhancing and production-limiting factors as much as, if not more than, knowledge or entrepreneurship-limit in^ factors presumed under the 4 4 b ~ ~ iservices" approach to its development. The package of n e ~ ~ reforms and investments recommended in the recent white paper seem to acknowledge some of these limitations, as they seek to improve both institutional and physical infrastructure, in addition to improving access to credit and instituting preferences to local busine~ses.~~ SKILLSAND INFRASTRUCTURE PRE-REQUISITES FOR GROWTH IN SECONDARY AND TERTIARY SECTORS 4.41 In sum, developinga skilled labor force and infrastructure are pre-requisites for growth and job creation in export manufacturing firms and SMEs in the secondary and tertiary sub sectors in the country. The model estimates that the strategies discussed earlier in this chapter - diversification o f products and markets, continued support for expansion o f the textile industry and promotion o f local SMEs - can have fairly significant economic effects. Under reasonable assumptions, these strategies can raise GDP growth by 1 - 6 percent and employment growth by as much, but not without enhanced provision o f the two pre-requisites. The estimates are shown in Table 3. 4.42 With the exception of a strategy of continued support to garment exporters, the growth in exports assumed are modest:the market and product line diversification strategy scenarios assume an increase in exports o f M9O-109million (less than 6 percent o f total exports@'), and the strategy for growth in local SMEs assumes an expansion of 10 percent. To achieve these growth rates, production o f electricity, water and telecommunications services must rise by 1 - 2 percent for each activity. A more comprehensive strategy - one that involves all four strategies listed in Table 3 - would require significantly larger increases in infrastructure provision. An increase inthe supply o f road and air transport o f as much as 10 percent alone i s required to support growth of 10 percent in local SMEs; and o f 6 percent to support a strategy o f product line diversification away from gaiment expoi-ts. Similarly, estimated skills requirements suggest that 15 - 30 percent o f the newjobs created by these strategies will require higher skilled labor. Clearly, the policy implications are straightforward - without a substantial investment in skill development and infrastructure, growth and job creation in the export manufacturing and SMEs sub sectors are unlikely to be significant. They include creating an enabling legal and regulatory environment by changing the mandate of BEDCO and LNDC to remove the dichotomy between indigenous and foreign enterprises, simplifying processes, and improving infrastructure, water, roads and electricity, and market places for fresh produce and stalls in convenient locations in urban and rural areas (GoL 2000m). 66In2000,Lesotho's trade statisitcs registeredexports ofM1,776 million. 90 Table 4.3: Skills and infrastructure pre-requisites for selected growth strategies in the secondary and tertiary sectors Minimumgrowth in public infrastructure: - Electricityproduction 0.8% 1.2% 4.0% 1.9% RECOMMENDATIONS 4.43 Lesotho has followed a dual strategy for its private sector development: one, more successful, for international investors, and another, for domestic entrepreneurs. The first has focused on offering tax incentives and provision o f infrastructure in enclaves, to take advantage o f the preferential access the country has to western markets, and the other, for domestic entrepreneurs that has focused on the provision of credit and entrepreneurship/ management training to potential entrepreneurs. Lesotho has been fairly successful in attracting foreign direct investment, creating an export-oriented manufacturing sector that is dominated by foreign-owned firms and becoming Africa's largest exporter to the US market today. But it has been less successful in developing indigenous enterprises. They are mostly small and informal enterprises engaged primarily in trade, services, local construction, sandstone quarrying and, to a limited extent, in manufacturing. Some o f the important services, however, are provided by foreign-owned enterprises. While the manufacturing sector exports the products, the indigenous enterprises provide goods and services for the domestic market, 1 in competition with imports. Moreover, despite the operation of expatriate-managed manufacturing in the country for nearly two decades, there is little difhsion o f managerial and technical skills. There are no backward linkages. The indigenous private sector opines that the environment in Lesotho, which began with the domination o f the market by parastatals, has been and still is hostile to them: the bureaucracy is unsympathetic; regulations, including land leasing and registration processes are burdensome; border processes and tax collection measures unnecessarily tie up working capital; the skills required are in short supply; and most importantly, the state o f infrastructure -- roads, water supply and electricity - is a limitation. 4.44 There are several critical challenges the GoL must meet. The implications o f AGOA I1 and the MFA suggest that the primary challenge is to provide basic infrastructure and offer incentives to attract new investments inLesotho's relatively small textile industry that can produce fabric for the garment sector. A logical way i s to build on the investments that it has attracted into the garments industry: retain them by facilitating backward integration and encouraging additional investments inmeasures that increase productivity, reduce costs and enhance synergy from existing investments to make the industry more competitive. Lesotho also needs to diversify its products and move into higher value products, which could be exported with trade preferences, at least inthe short run. As Lesotho is a small country, it may not be able to attract investments that aim to sell products i n Lesotho. But Lesotho has not adequately utilized the access it has to neighboring markets as a member o f SACU. Lower wages in the country could potentially attract production o f labor intensive products for the neighboring markets, In addition, Lesotho could develop comparative advantage in areas such as tourism and some o f the agricultural products. Creating adequate employment in the country and supporting FDI into more advanced operations in the country will require developing a domestic entrepreneurial base. A key aspect o f developing the local private sector is facilitating greater diffusion o f technical and managerial capabilities from the export oriented manufacturing sector. 4.45 The measures needed to strengthen the local private sector are congruent with those measures that will make Lesotho a more favorable destination for foreign investment for export to western markets as well as the neighboring countries. Strengthening the domestic private sector, in addition to promoting growth and employment in the country, will also contribute to the development o f an export oriented sector that is rooted in the country, diversified, and one that facilitates transfer o f knowledge. The following actions needto be taken: 4.46 T o adjust to developments related with AGOA I1 and the MFA, reinforce Lesotho's competitive advantage to attract new iizvestment into tlze textile industry to scale up production for the garments exports industryby 2007. This implies strategically relaxing the binding constraints to the supply-side in a timely manner to facilitate expansion o f the textile industry. Belated action in this area could result inthe relocation o f garment firms to alternative international destinations where they can find good infrastructure and cheap skilled labor. GoL may wish to explore the option o f public- private partnerships to speed implementation and infrastructure delivery. 4.47 Improve access to land. Introduce reforms that make land available for investors for development and facilitate transfer o f land from one person to another, or fiom one use to another. Ownership itself is not essential; long term leases would be adequate. Widen discussion with communities and the local private sector on the white paper to develop policies that are favorable to businesses and commercial agriculture. Without resolvingthe land use issue, scaling up o f the local private sector i s not possible. 4.48 Improve access to creditfor the local private sector. Larger foreign firms in the garment sector have access to both foreign and local capital markets and can shop around for cheaper investment and working capital. But a weak financial and legal system, especially a commercial court that enforces repayment, provides disincentives for the local banking system to extend credit to the local private sector. A reform o f the legal system to redress this binding constraint to firm expansion i s necessary to relax this bindingconstraint on growth. 4.49 Invest in iizfr~structzfre.The limits o f enclave infrastructure have been reached; their development to sustain investments may not be sustainable. Private sector participation in infrastructure development i s essential. The most effective way to help Zocal enterprises to compete effectively with imports i s to give them comparable physical and institutional infrastructure. The priority should be on improved provision o f roads, water supply and electricity. Infrastructure development is essential for rural development, particularly for the development o f agro-industries, intensification and diversification of agriculture. Improving water supply and waste water treatment to reduce industrial water pollution will be critical. 4.50 Enact sound investttierrt Inw. The good practices o f the country need to be codified. There is need for a well articulated foreign policy and a modern foreign investment law. 4.5 1 Improve processes/goVeriiaiice/traitsyareiicy. Bureaucratic processes need to be simplified. The dialogue that the government has begun with the local private sector needs to be continued. Difficult issues such as land reforms may be resolved through more open dialogue. 4.52 Streamliize border control. Reduce the time taken to process movement o f goods. Examine potential ways to reduce the time taken to recover VAT. Simplified processes and swifter movement through borders could potentially make Lesotho a more favorable site for production than its neighbors. 4.53 Develop skills. GoL needs to examine why the vocational training system inthe country i s not adequately meeting the skills needs o f the private and the public sector. Public-private ventures would be useful to make training relevant. 4.54 Reform bureaucracy. In addition to changing the law and regulations, the bureaucracy needs to be responsive to the private sector, 4.55 "Integrate export-manIifacturing. " I t would involve enhancing dissemination o f technical and administrative capabilities, improving the local content o f exports, and reducing tensions between labor and management in export firms and between the local 03 private sector and the investors. Currently, the local private sector resents inducements offered to external investors. The situation needs to be changed to one that is perceived to be non-zero, in which the local private sector and labor can expect to grow with the export oriented sector. Enhancing technical and managerial capabilities is critical. Investing in publicly supported training for the export sector would be one way to draw the sector into working with the government. Depending on how much the export firms currently spend on training, they may have strong incentives to participate in public- private training initiatives. A public-private training facility would provide an avenue to encourage the training of more Basotho for technical and managerial positions. However, examining why a training center that was funded by DFID was closed down recently would be a good start. 5. AGRICULTURALAND RURALDEVELOPMENT INTRODUCTION 5.1 Lesotho moved from being a food exporter in mid to late 1800s to a food importer by the early 1900s. In the mid-l800s, the country produced enough food inthe fertile Caledon Valley to export maize and wheat. The Basotho farmers, who were integrated with the regional economy, adopted technologies such as plows to respond to demands in the regional food grain market (Ferguson 1997). The loss o f fertile land west of the Caledon River, the return of sharecroppers from RSA in 1913, and curtailment o f permanent out-migration to RSA increased pressures on land (Bardill and Cobbe 1985, Lundahl and Peterson 1991). Land degradation due to use patterns, diminished export opportunities and, perhaps, the availability o f more remunerative opportunities inmining for the rural Basotho have transformed a surplus-producing agricultural sector to one that i s subsistence innature. Presently, the country produces only about 15 percent o f the food consumed inthe country. 5.2 Despite limited growth potential, agriculture and resource management are important as large segments of the population depends on agriculture. Economic and social costs o f ignoring agriculture are high (KOL 1997). Developing Lesotho's agriculture has always appeared to be an effective way to target the poor: analysis suggests that two-thirds of the income generated from increases in output from field crops and cattle accrue to the poor (World Bank 199517). Agriculture has served as a fallback livelihood option for the rural population. As work opportunities for the rural population have diminished, particularly in RSA mines, living conditions in the rural areas o f Lesotho have stagnated, increasing dependence on agriculture and pressures on natural resources, RURALDIMENSIONSEMPLOYMENT, Ih'COhlEAND POVERTY OF 5.3 As noted earlier, more than two-third's of the population lives in the rural areas, The 1999 Labor Force Survey estimates that 1.05 million or 82 percent of the 10 years and above population in the country was in the niral areas (KoL 2001~).The total number o f "household heads" in the rural areas was estimated to be 326,184 in 1999 (KoL 2001a). The same survey estimates the total number of "agricultural household" members to be 1.3 The practice o f agriculture extends beyond rural areas in Lesotho: urban areas contained an estimated 47,000 "farming households" in 1999100. Many of the commercial poultry and dairying operations are located inperi-urban areas. 5.4 A little more than 25 percent of the rural population is unemployed, but the bulk of the population - more than 80 percent - is engaged in low productive agriculture that does not offer adequate livelihood; if subsistence agriculturists are excluded, two thirds are unemployed. "Skilled agricultural workers" make up 3 percent 67 Agricultural households are defined as (a) households that were operating at least one field of arable land and (b) household that were raising at least one cow or five or more goats and or sheep. 5)5 o f the rural labor force, but only 1.5 percent o f the wage earners are in subsistence agriculture. Presumably, they include, according to various estimates, 12,000 to 14,000 shearers who work seasonally for 6 to 7 months (Hunter 1987) and 14,000 permanent farm workers (KoL 2001~). `Sltilled agriculture', forestry and fishery are the second lowest paying sectors inthe country. 5.5 For the bulk of the rural households, agriculture is the occupation and primary source of income. Nearly 90 percent of the ruralhouseholdheads indicated that they practiced farming in 1999 (KoL 2001a). Agriculture includes crop and livestock production. Of the agricultural households, 67 percent had only fields, and 25 percent only livestock. It would appear that only about one-third o f the households maintain animals. Crops are usually fully consumed, while livestock production usually provides cash income. 5.6 Whether dependence on agriculture has increased is not clear. Between 1986 and 1994-95, the proportion of households with subsistence agriculture as their primary income source increased from 22 percent to 32 percent (May et al. 2001). In the 1999 Agricultural Census, 46 percent of the households reported that "subsistence farming" was their "main source of income", compared to 53 percent a decade ago (KoL 2001a). Including households that have "cash crop" (8 percent) and "livestock" (7 percent) as their main income sources, the proportion of households drawing primary income from agriculture increases to nearly 60 percent. The estimated number o f agricultural households also increased from 229,300 in 1989190 to 290,984 in 1999100 (KoL 2001a). But, the "main occupation" o f agricultural household heads is not always agriculture: only 4 percent indicated that they were own-account workers; nearly 20 percent indicated that they were unpaid family workers; some 23 percent indicated that they were wageworkers; 10 percent were casual laborers and 20 percent were homemakers; and nearly 10 percent o f the agricultural household heads do not make any contribution to their agricultural operations. 5.7 Agriculture does not provide an adequate source of livelihood - more than 95 percent cannot produce their food requirements - households depend on a number of sources for livelihood. Other income sources include wage employment, government programs, informal activities and help from others. The sale ofjoala68 is a common informal activity inrural areas. 5.8 An unusual aspectof poverty in Lesotho is that landowners in rural areas are seemingly no better off than the landless (May et al. 2002). Although access to landis perceived to be a safety net, the incidence of poverty i s higher among landowners. The size or number of fields cultivated seems to matter, but not always, because access to complementary resources appears to be independent o f the size o f the holding. Those with small holdings, and female-headed households with large holdings but without a wage-earning family member may not have access to the required resources. Share cropping is a strategy adopted to gain access to other essential inputs: the "very poor" and the "poor" state that obtaining good yields and share cropping are important strategies to improve their livelihood status (Turner 2001). As there is considerable mismatch between Sorghumbasedbrew, (1G labor, land and the other household endowments, the practice o f mafisa and share cropping i s widespread: more than 70 percent of the fields are sharecropped according to the most recent census. NON-FARM ACTIVITIES 5.9 In contrast to many developing countries, non-farm activities have not developed adequately in rural areas. Because of open borders and proximity to RSA, the demand for some of the "non-tradables," particularly in urban areas, that would otherwise be produced in the rural areas is met fi-om imports (e.g., World Bank 1995b). The development of an agricultural input supply system that i s normally an important source of rural non-farm activity and the basis of backward linkages also has not taken root. The bulk of the inputsused in agriculture, except draft power and labor, comes from South Africa. Most o f the traded surplus from agriculture also leaves the country without processing, Almost all o f the wool and mohair, the two major export commodities, leave the country in raw form. The domestic use of wool and mohair is limited to several groups o f women who manufacture mohair and woolen articles, primarily for sale to tourists, and to a limited extent, for exports. As noted already, the other rural resource, Lesotho's scenic natural beauty,, has not been exploited through the development of tourism. RESOURCE AND INFRASTRUCTURE BASE 5.10 The average Basotho agriculturist works with limited natural resources under risky agro-ecological conditions. The producers are further handicapped by poorly developed infrastructure, and institutions such as land laws that are not conducive for efficient use o f land. The rainfall in the country, which ranges from less than 600 mm inthe far west to 1,100 mminthe extreme east, is inadequate andunreliable. SRV, which is a rain shadow area, receives the least rainfall: 500-600m1n. The rainfall is 600 to 800 mm inthe lowlands; 800-950 inn1 in the foothills and 600-1,400 mm inthe mountains, Annual evapo-transpiration exceeds precipitation in both lowlands and mountains (KoL 1996a). Crop failures are common and drought the dominant reason, Maize, the most popular crop in the country, i s more susceptible to drought than are wheat and beans. In Thaba Tseka for example, the probability o f harvesting less than 50 percent o f the planted area is 20 percent (KoL 2001d). Hailstorms that occur on average 6 to 8 times a year add further to risk o f crop failure. Land and livestock 5.1 1 The Basotho mostly operate ~mallhoIdings.6~ The majority (54 percent) operated less than 0.5 ha; 29 percent operated areas between O S and 0.99 ha. The ownership o f land is unequal although "universal" access to land was the basis of the traditional land distribution system. The bottom 20 percent of the population owns 5.3 percent o f the land while the top 20 percent own 37.5 percent o f the land (KoL 2000). Landlessness increased from 7.2 percent o f the households in 1949150 to nearly 33 percent in 1996 (KoL 2000). In the mountain districts, such as Thaba Tseka, the -____.. 69Holding sizes are often stated interms of number of fields operated. The average field inLesotho is 0.48 ha. The average agricultural household has 4.5 people. One-third had 2 to 3; another one-third had4 to 5. 5,7 household distribution o f those with fields alone, fields and livestock, livestock only and without livestock or fields i s as follows: 21 percent, 53 percent, 9 percent, and 17 percent (KoL 2001d). 5.12 The views on whether the traditional land distribution system offers adequate tenure are diverse. The laws o f Lerotholi were the basis for land allocation in which gazetted chiefs or headmen were responsible for "fairly and responsibly" allocating land to their subjects, but many chiefs did not distribute land fairly (KoL 2000, p.25). Several aspects of the laws - such as allocation determined to provide land that was just enough for subsistence, and reversion o f land to the chief 011 the death of the subjects or in the absence o f cultivation - did not offer tenure security or incentives to increase land productivity. The Land Act o f 1979 sought to remove these limitations by transferring allocation rights to village development councils and introducing certificates of ownership. But few farmers have taken advantage of the 1979 Act to convert allocations to lease-rights because o f the cumbersome processes involved, 5.13 Although the chiefs andlor village development councils are still the major forces mediating control of land, informal arrangements largely determine how the land is used. In 1999, 61 percent o f the fields held by households were allotted by the chiefs, 21 percent were inherited and 16 percent were given by relatives (KoL 2001a, p.15). But owners cultivated only a little more than 20 percent o f the fields. Nearly 70 percent ofthe fields were sharecropped under informal agreement^.^' 5.14 Like land, animal ownersliip is concentrated. A little more than one-half o f the households with fields also have cattle (KoL 2001b). Less than one-quarter of the landowners maintain sheep." As the Basotho maintain livestock primarily for status - they are usually exchanged for other items o f social value - the stocks are depleted only as a last resort (Dana 1997, Ferguson 1997). A survey indicated that 85 percent of the sellers at a cattle auction were sellingbecause o f the "need to buy food." 5.15 Resource endowments, land use patterns, animal pressures and conditions for the practice of agriculture vary among zones. The pattern in Thaba Tseka district, which traverses all the four zones, i s illustrative. Inthe high mountains, there is access to summer grazing, ownership o f grazing animals is widespread, soils are rich brown loams, temperatures are low, rainfall is high, crops are highly vulnerable to frost and hailstorms, and the cropping pattern includes maize (50 percent), summer wheat (40 percent) and peas and potatoes (10 percent). In the SRV, the climate i s dry, risk o f drought is high; there is severe overgrazing as there is no access to suinnier grazing, cattle numbers are declining, a large share of population i s without animals, and the cropping pattern includes maize (50 to GO percent), sorghum (30 to 40 percent) and some beans and vegetables. In the tablelands, flat to gently rolling areas have free-draining soils, and there may not be access to summer grazing; maize occupies more than 80 percent o f the area. Lateral valleys along tributaries of the Senqu are moist in the summer and are 70Only a small portion of the households owns the required implements: less than 40 percent ofthe households had ploughs, one in five owned planters, and 15 percent had harrows (KoL 2001a). 71The sheep population has declined by about 20 percent in the past decade. The stock has increased inthe easterndistricts (lowland and foothills) and declined in the western mountain districts, presumably because ofstock theft (KoL 2001b). 0 x sheltered from frost, wind and snow in the winter. Cash crops such as peas and potatoes are grown inrich alluvial soils inthe valleys (KoL 2001d). Agricultural services 5.16 Publicly provided agricultural services fall broadly under two categories: the more traditional research and extension services that aim to identify/develop and disseminateldeliver appropriate technological packages to producers, and services related to input supply and marketing o f outputs. The research and extension services for crops andlivestock are undergoing reorganization and are destinedto beprovidedby a "unified extension service". Extension services are inadequate particularly in remote areas, often because o f inadequate staffing. The inadequacy may be more fundamental in that the extension service may not have reliable technical packages to increase maize yields, for example, to deliver to farmers (Erikson 1996). 5.17 M o r e than 40 Livestock Improvement Centers (LICs) managed by the Department of Livestock Services (DLS) provide advice to farmers on livestock management practices, breed improvement and provide veterinary and parasite controi services. Animal dipping has been made compulsory to control parasitic infestations. Dippingfacilities are offered at nearly 200 locations throughout the country; one dip tank i s offered for nearly 10,000 ha. Livestock Product Marketing Service (LPMS) also operates 95 woolsheds through the country, offering shearing, grading and marketing services to wool and mohair producers, The woolsheds are slated for privatization. Policing is an underprovided service that is affecting economic activities, particularly in remote areas. Stock theft, which has always been a problem inthe region, has emerged as a major threat to livestock production. During2000, 7,368 livestock were reported to be stolen inthe Thaba Tseka district alone (KoL 2001d). SECTOR DEVELOPMENT STRATEGIES 5.18 Initially, the KOL vigorously pursued a strategy of self-sufficiency in food grains, a key element of which was the promotion of capital-intensive cultivation methods facilitated by state-organizations co-opting farmers into participation. These efforts proved to be ineffective as maize and wheat yields that could recover the costs o f mechanized farming could not be obtained (World Bank 1985). Recent surveys suggest that if improved seeds and fertilizers are used the maize yields required to break- even are around 1.7 tlha (Gay and Hall 2001). But the average yields of most o f the crops are less than 1 tiha. The absence o f suitable technical packages for poor soils and the risky environment in Lesotho appears to have been the principal reason for the failure o f several projects aimed at increasing food grain productivity. The farmers seem to maintain low-input agriculture to avoid production risks arising from rainfall variability and epidemics (Johnston 1995). Food self-sufficiency has now been replaced by sector development strategies that seek crop diversification. 5.19 The crop diversification strategy aims to replace food grain production, primarily of maize, with crops such as vegetables, fruits and nuts, in whose production the country may have a comparative advantage. The absence of scale economies and relatively higher returns were considered to be two factors that offered 90 promising prospects for horticulture in Lesotho (World Bank 1985). The crops identified for expansion under diversification included asparagus for export, vegetables and fruits such as cabbage, potatoes, tomatoes, onions, apples, pears and peaches, that are presently imported (World Bank 1995a). 5.20 The diversification strategy was targeted to particular areas and groups of producers. Agricultural intensification, including activities such as stall-fed dairying, was sought in the lowlands and foothills with the expectation that a small group o f commercial farmers would raise productivity; extensive production was expected to continue in the mountains (World Bank 1985). However, modifications to communal grazing were considered to be necessary for extensive production in the mountains. The strategy suggested, inter alia, that "policies will need to be exactly on target to realize the modest growth potential" (World Bank 1986, p.16). 5.21 Distorted private-sector incentives and inadequate infrastructure, particularly irrigation and poor research and extension services, were identified as the major constraints to growth of nontraditional crops (World Bank 1995a). Of particular concern were pricing, trade and processing policies that discouraged diversification away from maize. The thrust o f the diversification policy, therefore, was to enable market forces to develop a type o f agriculture that was competitive (World Bank 1995b). Facilitating private-sector growth became the "organizing principle" for policies and services. 5.22 Anticipated diversification away from maize production has not taken place. Maize production is estimated to have increased from 171,000 tons in 1989-1990 to 277,600 tons in 1999-2000 (KoL 2001a). Market interventions, particularly those relating to maize marketing, have been reduced. As a result o f several projects, some of the desirable legal changes relating to land tenure, range management, grazing control, functioning o f development councils and so on, have been realized. But they havenot had the desired impact. The inability to improve grazing conditions is a notable failure. Some of the reasons for failure include poorly designed grazing control measures that have not worked out elsewhere in southeni Africa, and the absence o f detailed preparation (KoL 1995a). Limitedcapacity to implement and lack o f ownership o f some o f the projects also have contributed to failure. The government may also have had little interest in rural development strategies, and that Bank's strategies for poverty alleviation may have overplayed the opportunities thought to exist through crop diversification, increased growth o fhighvalue crops and labor-intensive production (World Bank 2001b). 5.23 The private sector has not developed adequately to provide the services critical to enhancing agricultural productivity. On the other hand, weak private sector development may suggest limited production potential under natural conditions andlor the presence o f institutionalilegal barriers. Efforts over the years to facilitate commercialization, such as initiation o f egg circles, producer associations, processing o f asparagus, feedlots and abattoirs have not been successful. A combination o f factors may have contributed to the lack o f effectiveness o f these efforts which have resulted in the establishment of parastatal organizations, voluntary associations o f producers, and a few commercial ventures. In some cases, attempts to innovate organizations were made in an environment that offered perverse incentives - often strict limitations on private-sector participation. In other cases, the usual inefficiencies associated with public management 100 may have been the source o f ineffectiveness. More importantly, the complexities and difficulties inherent in coordinating small-scale production to seek benefits fiom economies o f scale - even with suitable incentives - may have been underestimated. RECENT DEVELOPMENTS 5.24 Despite less than adequate performance, some developments in response to changingpoliciesprovide hope for the future. Case studies o f best practices inwool and mohair, vegetables and fruits, poultry and meat, and dairy - activities that represent seemingly important opportunities for agricultural diversification - offer useful insights on how a section of the producers have succeeded in enhancing productivity, particularly by overcoming institutional andinfrastructure limitations. Commercialization 5.25 Only a small proportion of the production is commercial or traded in the sense that production is intended for exchange in markets. Only 7.7 percent o f the agricultural households indicated cash cropping as their main source of income (KoL 2001a). For example, an estimated 411 farmers in the country were engaged in commercial vegetable production in 1986.72Sheep and goat production can be considered to be entirely commercial, but only a small proportion o f the households seem to earn regular cash income from selling animals and their products. And, only 3 percent o f the cattle are reared for meat or milk production (KoL 2001b). 5.26 Market opportunities, reflecting competitiveness and the feasibility of production, determine the prospects for commercial production. The markets for selected activities include both the domestic and international markets: vegetables, fruits, eggs, poultryand dairy can be sold inboth domestic and international markets; and wool and mohair are sold mostly in the international market. Opportunities for sale in the domestic market depend upon the competitiveness of domestic production. The bulk o f what is consumed domestically i s imported: for example, in 1985, an estimated 56 percent of the vegetables and nearly 85 percent o f 4 million kilograms of chicken consumed were imported. Markets 5.27 Basothoproducerstake advantageof market niches resultingfrom consumer preferencesand Iocationai advantages. Most o f the vegetable producers o f commonly usedvegetables such as cabbage, carrots and beetroots, sell their produce to local vendors at their gates. A significant portion o f the milk produced i s also sold at the farms or delivered to nearby schools. However, milk collection dairy depots represent important year-round market opportunities, although producers receive less for their milk from dairies than from final users (M2 to 2.5 compared to M 1.3 per liter). Eggproducers also sell directly to consumers, schools inmany cases, andto small food stores. The producers of products such as eggs and chicken that require packaging and processing and need to be sold in urban areas - as demand in rural areas may not be adequate to sustain 72Nearly 300 of whom were producingasparagus, 101 production - face competition from imports. Wool and mohair are marketed through government-operated woolsheds or private traders.73 Productivity and competitiveness 5.28 Significant improvements in productivity have been achieved but this does not necessarily point the direction in which the entire industry is likely to move. In wool and mohair production, for example, selected producers had achieved lambing and kiddingrates higher than 80 percent compared to 50 percent inthe country. Wool yields rangedfrom 3.5 to 6 kgper animal, and mohair yields ranged from 1to 4 kgper animal. 5.29 The producers compete directly with imports except in the case of wool and mohair that are exported. Even vegetables producers who try to supply to urban markets in large quantities complained o f competition. The cost o f milk production is obviously higher than it i s in RSA, as dairy farmers in some areas complained o f RSA farmers selling milk at one half price they were selling at. The prices that the Basotho farmers receive from their dairy are twice as high as what the South African producers do. As noted earlier, Basotho farmers face difficulties inselling to larger urban stores that require processing and packaging for products such as poultry and eggs. Whether expanded production in these activities can be supported by domestic demand, particularly with competition froin well-organized production inRSA, is not clear. While, on the one hand, expansion o f domestic production may seem to be constrained by competition from more efficient producers in RSA, on the other hand, as production is expanded, the local producers may learn and achieve operational scales that enable them to compete more effectively with imports. Competition from producers inRSA is largely a hnction o f location. Improvements inroads and power supply that might enable better storage and higher production in the rural areas will also facilitate freer movement of cheaper imports. BESTPRACTICESAND KEY LlMITATlONS 5.30 The select "best practices" observed suggest, to some extent, what may be essential to achieve higher levels of productivity. All the vegetable growers, for example, irrigated their crops, which is consistent with an observation frequently made that diversification into vegetable production will require irrigation. Using improved stock or enhancing the genetic potential of the stock was critical in wool and mohair production and in dairying. All the selected sheep and goat producers maintained their own breeding males to upgrade their stocks. The dairy farmers utilized artificial insemination services offered by the DLS. Disease and pest prevention measures such as vaccination and animal dipping were also critical to their operations. Culling was another common practice, and what many producers identifiedas one critical to achieving high levels of productivity. 5.31 Many producers indicated that inability to lease or buy land is a constraint. Many dairy producers, as anticipated in the diversification strategy, practice stall- feeding, but not all of them had enough land to produce their own feed. Some of them had leased land to produce fodder. Though they could buy fodder, they "Nearly52percentoftheanimalsareshorninprivatewoolshedsin30locations. 102 indicated that their operations would be more viable if they could produce fodder. Many of the dairy farmers in peri-urban areas also did not have adequate space to exercise their animals or maintain them under adequately hygienic conditions. In nearly all the cases of wool and mohair production, producers had adequate grazing, as they were able to send their animals to cattle posts in the mountains. The producers felt that open grazing was essential for sheep and goats to keep them healthy and also reduce urine and dung staining of wool and mohair. 5.32 Compared to RSA farmers, Basotho producers are at a disadvantage. The bulk o fthe inputs-nearly all the breedinganimals, fertilizers, medicinesandpesticides - are purchased inRSA from cooperative societies, often at higher prices, as they are non- members. Nearly all the inputs for poultry feed that i s mixed in a plant locally and some of the fodder used in stall-fed operations come from RSA. The only local inputs that are used in agriculture are labor and transport. Labor use appeared to be higher than in "traditional" production, particularly in dairying and vegetable production, but most of the producers are keen to mechanize their operations to the extent possible. Collective institutions 5.33 Though the Basotho are believed to be not inclined to work together, the case studies noted several informal collective arrangements. A group o f dairy farmers take turns delivering milk. Many producers also pooled their input purchases to take advantage o f bulk discounts on input purchases and to reduce transport costs. As noted earlier, members o f Lestsoe-la-Lihoai society process and market broilers collectively. There is a wool and mohair growers association with some 4,300 members - nearly one- quarter o f the producers in 1987 - who market their produce through government- operated depots. There is also an anti-theft stock association. However, there are some problemsldifficulties that the producers have not been able to overcome on their own. They included the following: (i> Stray breeding in grazing fields; commercial producers usually keep their breeding males separate from the females, a practice not commonly followed by others, (ii) Unreliable insemination services, a limitation to improving stock and minimizing calving intervals, essential to maintain reasonable levels o f productivity (iii)Poorveterinaryservices; animaldippingfacilitiesarenotmadeavailable ina timely manner. (iv> Poor infrastructure; the absence o f all-weather roads, water and electricity supply require RECOMMENDATIONS 5.34 A workshop of stakeholders was organized to identify the key constraints to developing Lesotho's agriculture and elements of a strategy to develop the sector. The thrust o f the discussion was on the potential for increasing productivity o f crops and 103 livestock, and identifying infrastructural developments and institutional changes needed to support agriculture and rural development. A number o f critical factors were Technological packages, such as the Machobani system, are available to improve crop productivity. But, they have not been adequately assessed under various conditions to offer the farmers a menu o f technologies for different agro-climatic conditions and resource endowments. The technologies that are now offered to farmers are not appropriate, largely because they have been developed without paying particular attention to farmer concerns. The thrust o f research in the country should be on findingtechnologies appropriate to small farmers. Lesotho farmers do not have adequate resources to buy the necessary inputs or invest in critical requirements, such as irrigation, for crop intensification, The poor state o f public infrastructure increases the need for private investments. The plan that the MOA and the Central Bank are developing to make credit more easily available to farmers should be implemented soon. The system o f land distribution that is inpractice does not ensure that land is made available to those who can use it most effectively. The government needs to consult more widely before it prepares its white paper on land reforms. Also, grazing ranges need to be managed better. Overstocking per se may not be a problem; improved range management, in terms of rotation and so on, can support the existing stock. Fodder production needs to be increased. Better utilization o f land i s essential. The farmers do not have access to markets or market information. Establishing markets, by building a goat abattoir for example, may encourage commercial production. Lesotho also needs to seek niche markets for products such as blankets. Public services are weak. How extension can be improved needs to be examined. The government may need to subsidize critical inputs such as electricity to improve incentives for commercialization. The supply o f power, for example, is essential for developing irrigation. However, the poor do not often benefit from subsidies; the subsidies need to be better targeted. New institutions need to build on the experience o f local institutions such as burial societies. Linking Basotho farmer institutions with their counterparts inRSAwould be beneficial. The actions necessary in this sector are: 5.35 Access to land. Although informal sharecropping is widespread the general perception is that land is inthe hands o f those who do not necessarily put it to good use, L 04 It appears that the absence of a market for land for either sale or leasingrental is a constraint for the expansion of commercial farming. Many o f the commercial farmers seem to prefer purchase o f land. Grazing lands need to be managed better. 5.36 Better infrastructure. Inadequate infrastructure, particularly roads, electric supply and irrigation, hamper intensification. Diversification through the production o f high value crops, stall fed dairying and animal production in the lowlands requires improved infrastructure first: roads, irrigation, electricity and water supply. Given the difficulty o f developing infrastructure for a population sparsely distributed over a difficult terrain, government needs to be strategic in developing infrastructure, by considering Lesotho's resource endowments and spatial aspects that favor commercialization. 5.37 M o r e efficient agricultural services, The role o f the government in providing essential services to farmers needs to be re-examined, The absence o f technical packages may be a limitation for improving crop productivity and for diversification, Given that state supported research and extension systems have not been successful, it may be necessary to focus public efforts on more effective provision o f critical services such as disease prevention and artificial insemination that may not be provided for by the private sector in remote areas, and consider linkages with South African research and farmer organizations to deliver technologies and information. 5.38 Non-agricultural bases for rural development. Crop and livestock activities alone may not be able to create adequate livelihood opportunities for the rural population, It is not clear how much employment can be created with labor intensive agricultural diversification. It i s necessary to develop other activities that make use o f rural endowments. Tourism and sandstone quarrying, for example, are two areas that seem to offer potential. Developing rural infrastructure particularly roads is fundamental to developing tourism and commercializing agriculture. 6. PROSPECTSAND OPTIONS INTRODUCTION 6.1 Some development strategies contribute more to growth, but do little for job creation and poverty reduction, while others may affect poverty significantly but offer little growth. The same applies to external shocks. The poverty implications o f alternative growth options are better understood by examining the underlying economic structure at a disaggregated level. This approach sheds light on the nature o f the inter- sectoral linkages in its various goods and factor markets and explains how external shocks and policies influence growth, employment and poverty. Development strategies normally include a range o f policy actions that differ in scope depending upon their nature and cost. As noted throughout this report, in Lesotho the critical link between growth and poverty i s the labor market. Historically, this link surfaced through miners remittances but with the declining trend in the latter, developments in the domestic market have assumed greater importance. During the decade o f the high-LHWP era, it was apparent that the record high growth in GDP barely trickled down to the rural poor even though the project was built in the heart o f Lesotho's tallest mountains which also span many o f its rural areas. Today, wage employment in various productive sectors, mostly urban-based (excluding the informal and domestic help sectors), increases one's chances o f escaping poverty the most. 6.2 Why and how much one source of domestic growth can reduce poverty while another can exacerbate it is valuable information for policy makers. This chapter examines the potential trade-offs between growth, job creation and poverty associated with various elements o f development strategies usinga social accounting matrix (SAM) based model o f Lesotho's economy for 2000.74 It also proposes a broad-based, shared- growth strategy for Lesotho. Broad-based implies a strategy that focuses on growth across agriculture, industry and services, and `shared-growth, implies a strategy that ensures that the poor and non-poor benefit from higher growth. First, we briefly discuss the structure o f the economy using the SAM to highlight the linkages, especially how income and expenditure flows map onto different types o f labor, enterprises, households and regions. In the second part, we discuss various policy simulations from the model. The objective o f these simulations is to highlight the nature o f the tradeoffs (between growth and employment) between individual components o f a development strategy for Lesotho and show (i) that there is no single magic policy bullet for growth and poverty reduction; and (ii) the limits to what sectoral interventions can achieve. These exercises lay the basis for the Recommended Strategy that aims to (a) almost double GDP growth fiom its presently projected rate o f 3-4 percent per annum over the medium (b) l4The 2000 SAM for Lesotho consists o f a Macro S A M and a detailed micro SAM. It was produced by Conningarth Consultants, Pretoria, South Africa, using consultants and data from the BOS. It was later balanced by Amos Golan, American University, Washington, D.C.. The model was developed by the World Bank. The sceptical reader needlook no farther back than the high LHWP erabetween 19871'88- 1997198 when as a consequence of the construction o f the LHWP and growth in the garment industry, GDP growth averaged 6 percent per annum inthe face o f declining miners remittances. The intersectorallinkages and 106 yield a 3-5 percent per annum increase inper capita GNP or 4 - 6 per cent increase inper capita GDP. These results are derived from the model and should be treated as illustrative of the possibilities for growth over the next 5 - 6 years rather than exact point estimates for any particular year. The recommended growth strategy i s intended to facilitate significant strides towards the objectives identified in the recently completed PRSP. The idea is to demonstrate what i s possible, but more importantly, what i s required to get there. These results are (1) driven by the assumption of a population growth rate o f 0.91 percent per annum. A higher population growth rate will reduce the per capita growth in GDP or GNP. (2) assume that no other negative external shocks (except for phased out LHWP investments and a drop in remittance income incorporated inthe base year, and lower SACUrevenues duringthe projection period) will occur. 6.3 In analyzing the potential for growth in various sub-sectors of the economy, the SAM-based model identifies the pre-requisites for growth. These are measured in terms of infrastructure (water, electricity, roads, transport, telecommunications etc.), human capital (number o f workers with various occupational skills) and so on. As these are specified in the SAM in financial terms, the corresponding investment rates for all inputs except skills can be derived. As an explicit production function for the converting each unskilled worker into a skilled one is unavailable. The skills-pre-requisite is specified in terms o f the number o f workers required to operate with other inputs (investment capital for example) to achieve a certain growth rate. Although policy reforms are not explicitly modeled, the structure o f the model allows to identify what type o f reforms are needed to obtain the growth response. For example, an expansion in commercial non-traditional crops assumes that the planted area can be expanded, 6.4 The output of the SAM-based model is a set of growth (employment and household income growth rates) at the sub-sector level and their associated financial costs, Specific policy reforms required at the sub-sectoral level to achieve those growth rates are also specified. The growth rates are time neutral and should be treated as the effect of one-off shockslpolicies. As the CEM also focuses on medium term prospects, reasonable assumptions can be made regarding how long it might take policy makers to implement a policy reform or how long a shock may last. For example, it is reasonable to analyze the growth impact o f a large increase in public investment in the SAM. To use this for medium term projection, it i s reasonable to assume that it i s likely to take 3 - 4 years for the GoL to implement it. The growth estimates generated by the SAM-model can then be phased into the macroeconomic framework for projections. Why is this necessary? Growth estimates are best developed from a microeconomic foundation such as the SAM. However, the limitation o f the S A M is that it i s neither dynamic, nor is it appropriate for macroeconomic projections that focus on macroeconomic consistency issues. Macroeconomic projections also have their own pitfalls as they cannot generate growth rates. As the CEM incorporates both the real sector growth story and its medium term fiscal implications, it uses both models. This approach also ensures macroeconomic consistency and examines options for financing the investments implied by the SAM- based model. The process o f connecting the micro and macro projections is, to a certain extent, iterative. The ultimate goal i s to assess whether the growth rates and the related investment bill generated by the SAM-based can be financed without jeopardizing the economic multipliers reveal that this outcome is achievable with a certain pattern of growthproposed inthe Recommended Strategy. t 07 country's fiscal sustainability over the medium term. This exercise i s conducted within the medium term macroeconomic framework. Two cases are used. First, the base case examines the effects o f recent external shocks since 2000101, assuming the existing status quo on the policy front, i.e. all ongoing and planned policy reforms are assumed to continue. This generates the medium term scenario which i s consistent with the IMF's medium term projections (January 2005). e Second, the high case assumes pro-active policies by the GoL to counter the external shocks, especially those facing the garment export industry; it also contains the Recommended Strategy. The fiscal sustainability o f this case i s also discussed. 6.5 How the potential impact o f the HIVIAIDS epidemic i s likely to dampen the prospects o f any growth strategy i s discussed but not modeled.76 The last section focuses on the set o f "core" government policies and actions" that together with the RecommendedStrategy form the recommendations of this report. THEMODEL77 6.6 The Lesotho S A M is built on the basis of national accounts, data from the 1994-95 household expenditure survey, 1999 labor force survey, 2000 agricultural census and information from the Central Bank and Bureau of Statistics for the year 2000. There are 53 activities and 57 commodities, 10 occupational labor categories, 6 types o f capital owners, 6 types o f enterprises, 10 types o f households covering lowlands (urban), foothills, Senqu River Valley and mountains, with distinctions between rural and urban households, and various breakdowns o f government revenues and expenditures. There are two accounts for parastatals, one for LHDA, and the other for the remainder o f the private sector. A detailed discussion o f the S A M and the model based on it is presented inAnnex 2. 6.7 The Macro-SAM maps the aggregate relationships between producers, consumers, government and the rest of the world. I t indicates that since intermediate inputs account for 58 percent o f production, the share o f value added in the economy is quite low - labor contributes 23 percent and capital the remainder to total production. Only 19 percent o f production is exported, the rest is used domestically either as intermediate or final goods. Producers remunerate owners o f labor and capital for their contribution to production, but, as private ownership of land i s not prevalent,78 private rentals to land owners do not occur separately. Labor income is derived fiom employment infirms (45 percent), governmentjobs (18 percent), and work inRSA inthe form o f remittances (36 percent). Households receive income from labor including remittances, capital, intra-household transfers and government subsidies. Labor income, 76The type ofstatistics required to model the effects ofHIVlAIDS is not available for Lesotho. Moreover, the effect of HIVlAIDSis typically modelled inail inter-generational model and cannot be accommodated inthe SAM. A detaileddescription o fthe model and its policy simulations is presentedinAnnex 2. 78Traditionally all land is owned by the village chiefs who reserve the right to assign land for private use to individuals. There is no formal land market 108 which includes remittances, is the largest source (87 percent) o f household income. Households use their income to purchase goods and services (90 percent), send transfers to other households, pay taxes (6 percent) and save (3 percent). Similarly, enterprises or firms receive income from dividends and profits and expend it on the distribution o f profits to households (49 percent), taxes (17 percent), and savings (34 per~ent).~'About 59 percent of government's income is derived from SACU revenues and transfers; the rest comes from taxes on firms' profits (18 percent) and households incomes; grants from donors were only 5 percent and water royalties from the sale o f water to RSA about 4 percent in 2000. About 50 percent o f government expenditures are spent on goods and equipment and almost 33 percent on wages and salaries; debt payments absorb 6 percent and investment the remainder. 6.8 The micro SAM providesusefulinformationon the linkagesbetweenvarious economic activities and the factor and goods markets through the specification of input-output relationships. It confirms that the higher the value added by labor, the higher the level o f remuneration to labor and the higher the poverty impact o f an activity ifitsshareinGDPisalsolarge.AccordingtotheMicroSAM,valueaddedbylaborand capital sums to about 42 percent; labor alone contributes 23 percent but this number is not uniform across activities. Value added by labor i s the highest in agricultural and livestock activities (48 - 58 percent) reflecting the prevalence o f relatively labor- intensive technology, but it i s only 13 percent in agro processing industries that are relatively capital intensive, around 20 percent in clothing and garments, and wool and mohair processing. In the service sectors, the range varies. Value added by labor is the highest (around 38 - 45 percent) in quarrying, road transport, trade, real estate, and financial services. Inbuildingconstruction, value added i s about 21 percent but it falls to 9 percent in civil engineering related construction. The relation between value added by labor and its impact on poverty reduction i s moderated by a sector's contribution to GDP. Hence, even ifvalue added by labor i s large, if the share o f the sector in GDP is small, the overall poverty impact will also be small. 6.9 Skills requirements and skill levels of individuals in poor and non poor households further influence how growth in various sectors affects poverty, As the poor are usually less skilled, they are likely to gain from growth strategies which benefit the activitieslsectors that employ less skilled workers. Of the total value added by labor, the share contributed by high skilled workers (defined as all except plant and machine operators and assemblers, elementary laborers and subsistence farmers) exceeds 50 percent in dairy and feedlot cattle, poultry, forestry, modern agriculture, manufacturing and service sectors." Inclothing and textiles for example, 30 percent o f the value added comes from less skilled plant and machine operators, and 20 percent from craftsmen and tradesmen (high skilled); the remainder comes from highly skilled technicians, professionals, managers, supervisors etc.. Subsistence agriculture and domestic and informal activities are the only sectors that use mostly less skilled labor. ''Theprivate firms sector invests about 22 percent, the LHWP authority about 8 percent and government about 8 percent o f domestic value added (GDP). Occupational categories are legislators and senior managers, professionals, technical and associate professionals, clerks, service workers, shop and market salesmen, skilled agriculture and fishery workers, craft and related trade workers, plant and machine operators and assemblers, elementary laborers and subsistence farmers. 109 6.10 The Micro S A M also maps flows into high and low income households in five geographic regions: urban and rural lowlands, foothills, mountains and Senqu River Valley (SRV). The urban high-income households derive 91 percent o f their income from high skilled work and the remainder from enterprise profits, while the rural high-income households derive about 78 o f their income from equal amounts ofhighand low skilled work, and the remainder from enterprise profits (21 percent).*' While low income households also derive about 80 percent o f their income from labor, almost all comes from low skilled jobs - mostly elementary occupations in urban areas and subsistence farming inrural regions. The poor houseliolds also receive 12percent oftheir income as gifts from other households, and about 9 percent in the form o f government and foreign transfers (including remittances) (see Table 2 inAnnex 2). Multipliers 6.11 Multipliers reflect how much a unit increase in the demand andlor productionof an activityor commodity affects productionin each of the sub-sectors, commodities, payments to various types of labor and capital, returns to firms and household incomes. The multipliers in an activity are small if the leakages from an economy are large - this may be due to a large proportion o f imported inputs, taxes and savings. Inthe production sectors, large shares of intermediate inputs lead to low value added (to labor and capital) and hence small value added multipliers. All value added multipliers for Lesotho's production sectors are under 1.3; they are the highest in agriculture and livestock and certain service sectors but low inmanufacturing (Table 3 in Annex 2). Inmost African economies, value added multipliers typically range from 1.3 - 1.5 (Haggblade, Hazel and Brown 1989; Haggblade and Hazel 1990; Lewis and Thorbecke 1990). 6.12 From a policymaker's perspective, growth can be maximized by targeting sectors that havehigher multipliers.However, the gains from a large multiplier maybe offset by the sector's small size. For example, while the largest poverty impact comes from increases inagricultural and livestock-related activities, these sectors have relatively small shares in GDP, and so have a smaller growth and poverty impact (they support more livelihoods but at very low levels o f income, relative to poultry farming or a wage job inthe garment industry). SIMULATIONSEXAMINING TRADE-OFFS THE BETWEEN GROWTH, JOBCREATlONAND POVERTY 6-13 The SAM model simulations can be used in several ways to study the implications of alternative growth policies in Lesotho in the medium term. Paramount to the search for a Recommended Strategy i s an assessment of the various options that the government can exploit in the medium term, their associated fiscal costs, feasibility, and other inputs requirements, and information regarding the growth and job creation outcomes associated with each option. As noted is chapter 2, to achieve a significant and sustained reduction inpoverty in Lesotho, a sufficiently large rise inGNP per capita is required. The main detemiinants o f Lesotho's GNP are remittances from 81The modeluses a povertyline ofM500permonth. 110 Basotho miners (20 percent of GNP) which are external as GoL cannot control them, and GDP growth (80 percent of GNP) which GoL COM affect through policy intervention. S A M simulations - Base case tz,hcn the status quo is inai~itajned- no new reforms 6.14 As a starting point, a base scenario is modeled in a SAM-simulation that incorporates two recent external shocks: decline in remittances and LHWP investments. Compared to 2000101, the year for which the latest SAM is available, miners remittances declined from 23 percent to about 20 percent o f GNP in2003104; and LHWP-related investments have nearly dried up as the project is nearing completion in 2007. Table 6.1 shows the growth, employment andpoverty impact ofthese two shocks. Table 5.1: Base case - growth, enrploymentand poverty impact of declining mitiers' remittances and LHWP investments simulationsfrom the SAM-based model mount of investmentishockin hlillion Ongoing external shocks: decline iiiiuincrs rcinittances and LHWP investments -the low case -simulations from the SAh4-hased model 6-15 After declining at 2 percent per annum during the late 1980s and 1997198, the drop in immigrant remittances accelerated; the average growth for 1998199 - 2003104 was about (-) 4 to (-) 5 percent per annum (Table 2.5).82 As this trend is not expectedto reverse itself, how this negative external shock affects Lesotho's economy in any one year is analyzed. Of approximately M1, 746 millions remitted by Basotho immigrants in 2000101, over 70 percent was channeled towards low skilled labor. The S A M simulation shows that a 5 percent decline in remittances reduces household incomes directly by M 87 million. As overall demand i s dampened, GDP growth falls by 1percent, reducing employment by 1.6 percent or about 7,600 jobs (Table 6.1, column 2). Most of the latter are in the agricultural and livestock sectors where many subsistence 822002103 was an exception when n i n e workers received an 11 percent wage hike. 111 farmers are subject to further Underemployment and poverty. As remittances also finance fminputs and implements, they affect farm production directly and it declines. In contrast, manufacturing output i s unaffected because it i s independent o f domestic demand and exported. Least skilled workers will be most affected as they experience income losses o f over 3 percent. In contrast, incomes o f high skilled workers who are employed mostly in manufacturing, services and government will fall by less than half (1.5 percent). Rural household incomes will decline far more (4 percent) than those o f their urban counterparts (only 1 percent). 6.16 In additionto decliningremittances,Lesotho is also experiencinga declinein LHWP investments associated with Phase IB of the project. Since 1998199, LHWP- related construction has declined by 17 percent per annum and is nearly zero. To analyze the effect of this shock on growth, a negative shock o f 15 percent (equivalent to M 83 million in LHWP investments) was simulated. I t shows that completion o f the LHWP depresses GDP growth by about 1 percent, primarily through a 3.3 percent decline inthe output of the construction sector. As the LHWP has very few backward linkages, other sectors are relatively less affected (about 0.5 percent). The fall in employment is also small (0.58 percent) as the project i s highly capital intensive. Overall, about 2,700 jobs are lost; o f these, 17 percent are in the construction sector. The poverty effect on household incomes is small (-0.5 percent). High skilled workers experience income losses that exceed those o f low-skilled workers, mainly because the project employs mostly skilled engineers and architects. As this effect maps into household incomes, high income households lose slightly more than low income households (Table 6.1, column 3). 6.17 In sum, model simulations suggest that if the prevailing trends in the two external shocks continue, Lesotho's economy experiences a decline of at least 2 percent in GDP growth and 2 percent per annum in employment, equivalent to a destructionof almost 10,000 jobs per annum in the mediumterm (Table 6.1, column 4). Mucho fthis decline is concentrated in(a) the agricultural and livestock sectors where the bulk o f the jobs are closer to underemployment and subsistence activities and supports the less skilled and poor; and (b) construction sector where the bulk o f the jobs employ highly skilled, non-poor construction workers. Both shocks affect poverty adversely. MACROECONOMIC FRAMEWORK SIMULATIONS BASECASE- - 6.18 the projectionperiod is 2005106 -2010111. It is assumed that (1) the GoL will continue In the macroeconomic framework, 2004105 is treated as the base-year and to comply with the IMF program goals (explicitly or implicitly) and curtail public consumption at 36 percent o f GDP over the next 3 years and 33 percent in the outer years. Public investment will be no higher than 8 - 9 percent o f GDP; (2) the prevailing macroeconomic prices will persist over the medium term, Le., inflation will settle at around 5 percent per annum, nominal interest rates at 5-6 percent for lending from banks to the private sector and 8-9 percent per annum for loans to government; the nominal exchange rate will depreciate at 2 percent per annum after the appreciation last year. These assumptions are shown inTable 6.2 - 6.4. To introduce the growth projection &om the SAM-simulations into the macroeconomic framework, additional assumptions are necessary. As the S A M model simulates the effect o f a single or multiple shocks independent o f the time, the use o f its GDP-growth projection as an input into the 112 macroeconomic framework is premised on how long we think the assumed shock will take to pan out over the projection period. The two modeled shocks - remittances and LHWP investment - are ongoing and incorporated in the base year (2004105) and modeled forward. Two other medium term shocks, expected to occur in the near future, are also introduced. While the effects are not yet visible, the expiration o f the MFA in January 2005 i s expected to dampen the growth o f garment exports, starting in2006107. SACU revenue transfers to Lesotho fiom RSA, while still high, are expected to decline starting in2005106. 6.19 Table 6.2 shows the cumulative effects of these shocks on key macroeconomic variables. Relative to the high LHWP period when GDP grew at about 6 percent per annum, inthe projections period, GDP growth is projected at about 4 percent per mum. Aggregate demand will be dampened when lower growth in garment exports slows to about 3 percent per annum after 2007108 from 6 percent presently. Lower domestic demand will chip private consumption (growth will slow down to about 3 percent per annum) and private investment (share will drop from 27 percent in 2003104 to 21 percent of GDP in2010111). A shrinking taxable base will apply fiscal pressures. Weaker private sector growth andjob cuts will make it difficult for the GoL to cut current expenditures. The axe will fall on growth in public investment. This was true o f developments in 2004105 when the share o f public consumption bouncedback to 36 percent of GDP from 34 percent in the previous year. Over time, this trend will dampen private investment even more and so on. Table 6.2: Base Case Scenario - Growth Sirniilations from SAM; Macroeconomic projections from RiVlSIL2-X - Key growth rates* - 2004105-2010111 2004105 2005106 2006107 2007108 20081'09 20091'10 2010111 ;rowth Rate of GDP at market prices 3.oo% 3.50% 4.00% 4.00% 4.00% 4.00% 4.00% Consumption Growth -3.2% 13.2% 5.2% 4.4% 4.1% 4.4% 4.8% Investment Growth (GDI) 3.8% -2.2% 9.1% 8.1% 7.3% 6.9% 3.3% Import (GNFS) growth -4.0% 14.3% 7.0% 5.5% 5.0% 5.2% 4.2% Export (GNFS) growth 3.2% 6.1% 4.0% 3.5% 3.4% 3.4% 2.9% leal Per Capita Growth Rates: GrossNationalProduct (GNP) 3.0% 2.8% 2.2% 2.1Yo 2.1% 2.1% 2.1% Gross Domestic Product (GDP) 2.1Yo 2.6% 3.1% 3.1% 3.1% 3.1% 3.1% Per Capita US$ Levels: 653 766 771 779 787 795 804 ;oods Market (YO)share of GDP Exports 47.5% 41.5% 40.7% 39.2% 37.9% 36.8% 35.6% Imports 98.2% 85.3% 88.2% 84.1% 81.8% 79.3% 77.0% Consumption 116.7% 112.1% I18.3% 115.0% 113.4% 111.7% 110.3% Private 92.3% 86.0% 92.8% 90.1% 89.8% 88.2% 87.0% Public 24.4% 26.1% 25.5% 25.0% 23.6% 23.5% 23.3% Investment 34.0% 31.7% 29.1% 2!l.8% 30.4% 30.8% 31.1% Private 26.6% 23.8% 20.6% 20.7% 21.1% 21.6% 21.9% Public 7.4% 7.9% 8.5% 9.1% 9.3% 9.2% 9.2% ;hareof GDP (YO) GDP at factor costs 78.2% 83.1% 84.5% 85.9% 86.4% 86.7% 86.7% Agriculture 14.6% 14.4% 14.2% 14.1% 14.0% 14.0% 14.0% Industry 41.1% 39.8% 38.8% 38.8% 39.0% 39.1% 39.3% Manufacturing 18.2% 18.1% 18.3% 18.4% 18.6% 18.9% 19.1% Services 22.5% 29.0% 31.6% 33.0% 33.4% 33.5% 33.4% 4emo items: Nominal ExchangeRate p.a.(LCUIUS$) 6.34 6.46 6.59 6.72 6.86 7.00 7.14 DevaluationRate(p.a.) -13.0% 2.0% 2.0% 2.0% 2.0% 2.0% 2.0% Real ExchangeRate Index (LCUKJSS) 86.6% 83.2% 80.1% 78.0% 76.0% 74.2% 72.4% Inflation(p.a.) 5.6% 5.4% 5.5% 5.4% 5.2% 5.1% 5.1% Nominalinterest rate-Private loans 5.6% 5.4% 5.5% 5.4% 5.2% 5.1% 5.1% Nominal interest rates-govt loans - 9.2% 9.4% 8.7% 8.6% 8.4% 8.3% 8.3% Source: Basecase, RMSM-X projections and SAM simulations (DataSources: 1MFand BOS) Note: * Detailsare presentedin Annex 3, Table 6.2a Annex 6.20 The base case scenario is essentially one of declining exports, low GDP growth and fiscal adjustment to curb larger deficits and higher pubiic debt. Slower growth in the taxable base and the drop in SACU revenues contain public revenues as a share o f GDP at about 41 percent inthe next 3 years and 38 percent inthe outer years of the projection period. If grants remain at their present level o f 2 percent o f GDP, donor the fiscal deficit over the medium term will settle at about 2.5 percent. This is sufficient to reduce the burden o f total public debt as a share o f GDP to 47 percent from the prevailing level o f 55 percent (Table 6.3). Sufficient fiscal headroom will exist as evident fiom the debt projections. I n the base scenario, Lesotho 'sfiscal situat~onwill be strong with respect to its debt sustainability. Whether this will also reinforce the sustainabili~ of economic growth and move the country closer to the vision of the PRSP is a dflerent matter which is addressed next. 114 Table 6.3: Base Case Scenario - GDP Growth Simulations from SAM; Fiscal projections from RMSM-)I' -_2004105 - 2010111 (YO)Share of GDP incurrent prices 2006107 2007108 2008109 2009110 2010111 Total Revenues (excl. grants) 40.2% 30.0% 38.8% 3 ~ 4 % 38.0% Total Direct Taxes 9.9% 10.1% 10.4% 10.5% 10.5% Total Indirect Taxe's 24.9% 23.50;;, 23.0% 22.5% 22.2% Customs revenue (SACU) 16.7% 16.7% 16.7% 16.7% 16.7% Total NonTax Revenue (water royalties etc.) 5.4% 5.3% 5.4% 5.4%) 5.3% Foreign Grants 2.2'%1 2.2% 2.2% 2.2% 2.5% Total Expenditures 45.0%) 43.8%) 43.7% 43.2% 42.2% Current Expenditures 35.8% 34.4% 34.5% 34.1% 33.3% Interest Payments 1.4?40 1.5% 1.5% 1.6% 1.7% Capital Expenditures 9.1%) 9.3% 9.2% 9.2% 9.0% Government Deficit (excl.grants)(-)/GDP -4.S% -4.8% -4.9% -4.0% -4.2% Government Deficit (incl.grants)(-)/GDP -2.5% -2.6%) -2.7% -2.6% - 1 .8%1 Memo item: PrimaryDeficit(-)/GDP -3.3%3 -3.3% -3.4% -3.3% -2.5% Total debu'GDP 5 1.7% 50.5% 49.5% 48.7% 47.0% Domestic debu'GDP 10.3% 10.6% 10.5% IO.l?/o 8.7% Foreign debu'GDP 41.4% 39.9% I " 39.1% 38.6%) 38.3941 Source: Basecase, RMSM-X projectionsand SAM siiiiulations (Data Sources: IMFandBOS) 6.21 The comfortable fiscal headroom in the fiscal budget will be complemented with. an improving balance of payments situation in the Base Case (Table 6.4). In spite o f a decline in exports in the medium term, and the corresponding fall in FDI inflows, Lesotho's current account deficit will improve over the next few years as the burden o f large interest payments declines. In iiominal terms, in 2010111, the level of external debt, after allowing for existing commitments and some new loans to finance the current account, is expected to exceed the 2003104 level by only US$ 20 million. Similarly, in2010111, external debt service i s projectedto be no larger than figure o fUS$ 45 millionreached in 2003104. According to the Base Case, inthe mediumterm, Lesotho will not be a debt-distressed country. 115 Table 6.4: Base Case Scenario - GDP Growth Siniulations from SAM Balance o f Payments projuctioas from RMSkI-X - 2004105 - 2010111 2003104 2004105 2005106 2006107 2007108 2008109 2009110 2010111 US$ million Exports o f Goods & Nonfactor Services 556 608 638 660 687 714 742 768 Imports of Goods & Nonfactor Services 1149 1248 1381 1416 1480 1540 1604 1655 Total FactorPayments 30 25 22 21 19 17 16 19 Interest Payments 13 18 16 15 13 11 10 12 Total FactorReceipts 292 369 421 428 438 445 454 473 Labor income Receipts 263 331 377 387 396 404 413 426 Current Official Grants (incl. SACU) 173 260 241 251 250 262 273 281 Current Account Balance -150 -27 -94 -88 -115 -126 -141 -141 excl. all official transfers -323 -288 -335 -330 -364 -388 -414 -422 incl. all official transfers - I33 -1 -69 -61 -86 -95 -108 -107 Capital Account Capital Official Grants 17 26 25 27 29 31 33 34 Direct ForeignInvestment 4s 60 41 46 42 42 47 48 LHWP net financing 76 38 0 0 0 0 0 0 Net Disbursement -5 -10 17 42 57 70 78 81 O.W. Gapfill 0 0 14 30 31 32 31 31 Debt andDebt Service(LT+ST+IMF): Total DOD(US$M) 702 683 681 688 698 708 715 722 Debt Service (US$M) 44 61 53 52 46 46 40 4s Gross Reserves (months imports GFS) 4.4 5.0 4.7 4.8 4.7 4.7 4.7 4.7 Source: Basc case, RMSM-X projections mil S;lM simuIa1i(itis (nomS[itii-c,cs: lhll~ and BOSI Note: Details are presented in Annex 3, Table 6 . 2 ~ * Annex 6.22 For at least two reasons, the Base case scenario is not o ~ t for the people ~ ~ ~ 2 and policy makers of Lesotho. 1) GDP growth projections at 4 percent per annum will support growth inper capita GNP o f only 2 percentg3per annum (per capita GDP growth at 3 percent), far less than what is needed to make a significant dent in poverty in the medium term (Table 6.2). These projections are inconsistent with the vision o f the PRSP. 2) The Base Case medium term projections in Table 6.2 and Table 6.4 show that export growth, driven by garment exports to the U S will decline from 6 percent per annum in 2005106 to about 3 - 4 percent after 2007108. However, these projections do not incorporate the risk that the nearly 100 percent foreign-owned (mostly Chinese-owned) garment industry may simply fold up and move out o f Lesotho to other cheaper locations with better infrastructure and labor costs! The expiration o f the MFA in January 2005 has turned, what was until last year a mere hypothesis, into a somber prospect. Current estimates suggest that as giant Asian producers, China and India, enlarge their share in the next few years to nearly 80 percent o f the U S market, at least some smaller, and relatively highcost-low skill garment producers will be squeezed out. Lesotho could be one o f them unless GoL is willing, through proactive policies to act expediently to retain the garment industry inLesotho. With the key source of better paying private sector wage jobs (compared to those from subsistence or the informal sector) at risk, social peace will also be at risk. Worse still, if the clothing industry folds up then manufacturing, the key engine o f growth inthis modern economy will be rapidly eliminated. 83This assumedapopulation growthrate of0.91percent per annum. Ifthe populationgrowthis higher, the per capita growth inincome will be even lower. 110 6.23 Another risk that has surfaced since last year is related with the appreciated exchange rate which is eroding the competitiveness of Lesotho's garment exports. In the short term, while there i s little the government can do about the exchange rate directly, it can certainly send positive signals to investors through pro-active policies to improve the industry's competitiveness in the medium term. Fast tracking political commitment and fiscal investments in physical and human capital, as well as other core elements of the Recommended Strategy can also be instrumental in allaying investor fears while they tide over the exchange rate problem. Inthe medium term, if the market does not, the South African Reserve Bank is likely to restore the currency to competitive levels, TOWARDS A BROADBASED,PRO-POOR GROWTH STRATEGY - The rationale 6.24 From a social, economic growth, and PRSP perspective, the base case scenario seems unsustainable in the medium to longer term. If the lone source o f modern economic growth driven by the garment industry, is at risk, other social and economic objectives such as social peace, job creation and poverty reduction will also be threatened. On the other hand, suppose the gannent industry somehow manages to survive the threat o f elimination from the global supply chain but its spectacular rates o f export growth decline. In this scenario, the GDP growth rates projected in the Base Scenario (Table 6.2a) might be even lower. The bottom line: without proactive measures, Lesotho may not have a garment industry; however, even if some exogenous force preempts this, the resulting growth rates will render the vision of the PRSP a far cry. The challenge for the GoL i s to exploit the comfortable fiscal headroom and a reasonably manageable fiscal situation in the medium term (Table 6.2b and 6.2c), and use fiscal policy to support the country's goal of spurringgrowth to reducepoverty. 6.25 The RecommendedGrowth Strategy is premisedon the concept of exploiting Lesotho's relatively stable macroeconomic environments4and fiscal headroom to enable policy actions needed to diversifythe domestic economy by buildinga strong, diversified and export-oriented private sector. For this, at least two industries need to be treated as critical growth drivers. They broadly cover activities inmanufacturing and agriculture. Except for tourism, the role of services is seen as a supporting one. The two drivers are: e the thriving gannent sector. To begin with, immediate policy actions are needed to retain and attract new investments inLesotho's textiles sector to save the garments industry from shifting overseas after 2007 when the rules of origin clause under AGOA I1starts. Starting in 2008, Lesotho's garment sector should use fabric made locally so it can continue to benefit from tariff-free protection inexporting to the U S under ACOA 11. e the nascent but potentially high growth and export-oriented, commercial agro-production and processing sector. While small, the highvalue output 84Lesotho's appreciated exchange rate is considered a temporary phenomenon. Inany case, GoL has no control over it. 117 of this sector (wool and mohair, vegetables and fruits, poultry and meat, dairy products etc.) i s a critical source o f rural production and processing. 6.26 The expansion of the textile and garment industry, and the nascent agro- production and processing industry is presently constrained by the availability of basic public infrastructure, utilities and human capital inputs that GoL needs to redress. The SAM-model demonstrates that when the two main productive sectors - high-value agriculture and industry - grow, they have positive spillover effects on the services sectors. Usingpublic investment inphysical and human capital to spur growth in these private sources of growth can propel economy-wide growth through inter-sectoral linkages. Because o f the small size of the domestic market, the only magic bullet for increasing growth is to scale up exports of goods to external markets inwhich the country already has a presence (such as the U S in the case o f garments) and new destinations in which it i s competitive (vegetables, fruits, mohair etc.). There i s no single sector or sub- sector o f critical mass that can generate sufficient growth in Lesotho. Hence a broad- based approach that covers both agriculture and industry and spills into services i s needed to diversify the country's economic and export base. Such an approach will necessarily support a shared-growth strategy as it will benefit high-value, export-oriented production in urban and rural areas. All economic classes can participate and benefit from this growth process. 6.27 The Recommended Strategy requires government commitment and action in three ways: e Maintain the ongoing reforms initiated in agreement with the M F earlier, including fiscal measures to improve revenue collection, improve the efficiency o f current expenditures and reduce wastage. These measures will conserve valuable fiscal resources that are needed to support new public investments proposed below. e Undertake a substantial public investment program to fill the growing deficit in physical infrastructure, utilities and human capital (including both skills development and the containment o f HIVIAIDS); and e Implement a set o f core policy reforms and programs in the following areas: better governance and capacity building in the public sector; development of technical skills; HIVIAIDS control and prevention programs; policies to develop Lesotho's private sector by leveling the playing field for domestic investors, especially in sectors other than garments; and protection o f property rights to facilitate the extension o f credit to the domestic private sector. 6.28 Many reforms such as those in the area of improving revenues, reducing wastage, publicsector reform, decentralizationetc., are already beingimplemented. Others such as substantive public investments in physical infrastructure and skills are being addressed only at the margins, primarily because these high-cost public investments were squeezed to secure fiscal sustainability. With the fiscal situation now under control, it is prudent for policy makers to use the fiscal instrument to support growth. As the three broad areas in the Recommended Strategy suggest, it involves more 118 thanjust large scale new public investments in infrastructure and skills development. Attention to quality and efficiency in existing and new public expenditures will be critical, but equally important will be the rapid implementation o f other policy reforms to maximize the growth impact o f higher levels of public investment. The outline for the remainder o f this chapter is as follows. The policy actions outlined in Iabove are fairly straightforward: focus on efficiency in revenues, current and capital expenditures to reduce fiscal waste and free up resources for expansion in critical public services, These are well understood and not repeated. 0 Part Io f the Recommended Strategy is addressed inthe next section, A. It examines the microeconomic implications o f three proposed elements for Part 11. These involve significant public and private investment programs that can facilitate substantial expansion in public infrastructure to support private sector growth and exports. The SAM-based simulations demonstrate what these investments should be and what they can do for growth. Three investmentlexport shocks are proposed: (1) a 40 percent increase in garment exports following pro-active GoL policy- and public investment interventions to retain and grow the industry in Lesotho, and take advantage of AGOA I1to expand tariff-free exports to the US. (2) a 10percent increase inprivate investment to result in a 15 percent increase inthe production and processing of high-value agricultural exports. (3) a 45 percent increase incapital investment inpublic infrastructure and skills development. Jointly (1) - (3) forni afew elements o f the Recommended Strategy. 0 Section B evaluates the macroeconomic feasibility o f these three elements. 0 Section C assess the fiscal sustainability o fthese three elements. 0 Section D turns to the critical issue o f human capital in the context o f the looming skills deficit (the subject o f Chapter 3) and the impact of HIVIAIDS. While not modeled explicitly, the policy implications for training and HIVlAIDS mitigation are discussed. 0 Section Ebrings together parts I,I1and I11o f the Recommended Strategy, explicitly discusses the core policy reforms and concludes. A: Recommended Strategy - Part I:groxvth, cmptoynient and poverty iinplications of the three key elements*' of the proposed investinciitiexpor1~~~ drivers ~icro-si~ulatioizsfrom the SAM-positive shock toprivate sector growth through a shock to maI~ufacturedexports arid high value agriculture andprocessing 6.29 Timely public actions to retain and expand investment in the textiles and garments industry has had and can continue to have significant economic effects. We use the word `elements' to clarify that underlying the numerical assumptions inthe framework and SAMmodel such as rate o fpublic investment or human capital requirements are other vital policy reforms (land reform, capacity building reform, HIVIAIDS mitigation reforins etc.) without which these numerical numberscannot support the expected growth rates. These are discussedinsection D. 119 Recent FDI flows into the industry, especially after the legislation o f AGOA in 2000 confirm this. While the expiration o f the MFA exposes Lesotho's garment exports to fierce competition from more efficient Asian competitors, Lesotho is not facing entry bamers. It is an incumbent player in the US market: it enjoys the position of Africa's largest garment exporter, and houses finns like Lee, Levis Strauss and others. It also enjoys a reputation for fair labor standards, a feature that i s requiredby WTO standards and increasingly valued by American buyers. It gives Lesotho's garment exporters an edge over Asian exporters who are frequently criticized for non-compliance with the WTO andILOrecommended labor standards. 6.30 If the GoL can organize basic public infrastructure and finance technical skills development to lure foreign investors to stay and expand investments in the country, Lesotho will continue to enjoy a tariff-free status even after 2007. While this challenge is not easy, it is not implausible for the GOL. Some investors have already demonstrated a willingness to invest: recently, large fixed investments in a denim mill to prepare the country for 2007 when the rules o f origin clause applies are evidence. The challenge for GoL is: scaling up. Can it attract other investors so that the supply o f domestically produced fabric is sufficient to meet the demands o f the local garment industry? Some other critical reforms such as improving the social relations between local and foreign investors, etc. are also necessary and are discussed more fully inchapter 4. If the challenge is met timely, there is potential for garment exports to increase substantially inthe mediumterm, assuming that diversification to higher valuedknits and woven fabrics will occur. 6.31 The appreciation of the Maloti in the past year presents a different type for challenge for garment exporters. It i s also a challenge that the GoL has no control over. Itcould lobbywith the SouthAfrican Reserve Bankto correct the distortion ifthe market fails to do so. As RSA's manufactured exports are also affected adversely by the recent appreciation, there is a possibility that there may be some corrective action. Ifnot, inthe medium term, Lesotho's manufactured exports, and indeed all its exports outside the CMA rand-zone are at risk. Fornow, this is perceivedas a temporary phenomenon. 6.32 Model simulations show that if the exchange rate is not appreciated (as is the case currently), garment exports can rise by almost 40 percent (M 352 million in 2000101 prices) if GoL makes available in a timely manner the following material infrastructure inputs: e increase inthe supply o f electricity and water (3 percent each); e freight transport (2 percent); e telecommunications (4.5 percent); e an increase of almost 6,000 skilled workers is needed: over 1,200 in each highskilled occupationalcategory except clerks andtechnicians, as shown inTable 6.3, column6. 6.33 A 40 percent increase in garment exports will cause overall production in manufacturing to increase by 17 percent and in most service sectors by 3-5 percent. 120 Agricultural output will increase less as the clothing sector has weak backward linkages, but overall, GDP growth will increase by 5 percent, providing a massive boost to employment growth (4.5 percent). O f the 21,000 newjobs that will be created economy- wide, 42 percent will be inthe garment sector and 45 percent inthe agricultural sectors. As the garment sector supports wage employment, its poverty impact is large. Incomes of high skilled workers will grow by more (3 percent) than those of low skilled workers (2 percent), even though more of the latter will find new jobs. In spite o f its urban location, the regional distribution of income will be biased in favor o f rural areas: rural household incomes will rise by 4 percent relative to a 2 percent rise in urban incomes (Table 6.3, column 6). 6.34 I t is often asserted that more should be done to promote growth in agriculture in rural Lesothowhere most of the poor reside.In2000, about 20 percent of the total agricultural and livestock production or about M 246 million was generated from non-traditional or improved crops, fruits and vegetables, poultry, wool and mohair, and forestry; the remainder was from subsistence fanning. As the natural resource endowments for farming are quite limited in the rural mountains o f Lesotho (Chapter 4), it is useful to analyze with the help of the model the pay offs from growth-enhancing public policies. 6.35 Model simulations indicate that a 15 percent increase in commercial agricultural output can raise GDP growth by almost 2 percent and create 25,000 new jobs, albeit, most of the new jobs will be rural and will, at best, shift many from underemployment to low paying employment. As this type of growth is expected to lead to only marginal increases (1 percent) in household incomes, the impact on rural poverty will be small (Table 6.3, column 5). For a 15 percent increase in commercial farm production, the explicit shock inprivate investment needed in2000101 terms was M 159 million, equivalent to 10 percent of total private investment. In inflation adjusted terms, this amounts to an injection of M 238 million in 2006107 and about 10 percent o f total private investment. This is modeled as a one time injection in the SAM. For the purposes o f the macroeconomic framework, it is assumed that this boost will be split across 4 years at the rate of M60 million in2006107 risingto M69 millionin2009110. In addition to a host o f reforms and actions (listed more f d l y in chapter 5) on the part o f GoL, the following inputswill also be needed: land will have to be transferred out of subsistence agriculture as there is little surplus land in Lesotho. In this context, amending property rights to permit land owners to rentllease arable land to individuals who can make better use of it will play an important role; e 1percent increase in water and electricity for commercial farms. Although the water and electricity inputs seem small, given the prohibitive costs of connecting the rural areas to the power grid and difficulty of irrigating the foothills andmountains, these are major challenges for GoL (Table 6.3). about 0.5 percent increase in freight transport to lift farm produce to distant markets; and 121 availability of 2,700 new skilled agricultural workers - 220 managers and professionals, 294 service workers etc. to provide technical advice to farmers. Fiscal policy shock to public investment 6.36 A significant expansion in private investment-led growth in the textiles and garments industry and commercial agricultural production and processing cannot occur without necessary policy reforms and large scale public infrastructure investments targeted towards export-oriented production. A public investment shocks6o f about M 272 million (or 57 percent of total public investment in2000 levels) is simulated. For 2005106, the inflation-adjusted equivalent i s M 400 million (an increase o f 45 percent of total public investment). The simulation shows that in response to this shock, GDP growth will rise by almost 5 percent creating about 12,000 new jobs. Growth is driven most by an increase in public construction, infrastructure and utilities. Production would rise by 27 percent in roads and air transport, 32 percent in electricity, 38 percent in water and 30 percent in telecommunications and postal services, sufficient to trigger a significant expansion in the productive sectors and meet household demand for better services. Since these activities have strong forward linkages, most service sectors would expand by about 9 percent. Through the rise inhousehold expenditures and the associated demand for agricultural production, output in agriculture could increase by about 2 percent. Such an increase inpublic investment i s bound to elicit a strong response from private investors, especially in manufacturing (but this is not modeled here, although it is modeled in the previous section), The capital and skill intensive nature o f construction and utility provision generates income gains which accrue largely to capital- owners (4 percent compared to 2 percent for labor) and high-skilled workers (3 percent compared to 0.6 percent for less skillcd workers). On average, high and low income households would gain evenly (about 2 percent), but rural household incomes would rise by twice as much (3.2 percent) as urban household incomes (1.6 percent) (Table 6.3 column 7). 86We use the word `elements' to clarify that underlying the numerical assumptions inthe framework and S A M model such as rate o f public investment or human capital requirements are other vital policy reforms (land refonn, capacity buildingreform, HIViAIDS mitigation reforms etc.) without which these numerical numbers cannot support the expected growth rates. These are discussed in section D. i22 Table 6.5: Simulations from the SARI: eflect of various external and policy shocks on growth, employment and poverty - base year 2000101 Aggregate effects - overall --High income houscholds - i .90'% -0.48'!4i -2,3S'!.Z O,YLi'!,ii 2.49?41 2.29% 4.44% Low inconie households -3.3094 -0.4 1% -3,71?4 2.44Yh 2.620/; 1.69% 4.89% Crhan houwholds Plant andmachine Summing up: Growth implications o f tlic 3 kcy iiivestnicnt/cxport related elements o f the Recommended Strategy 6.37 Ifaccompanied by other "appr~priate"~'policy interventions (listed inI11 earlier), the three elements of the growth strategy modeled are expected to raise economic growth by about 10-12 percent over tlie base scenario (Table 6.3). As shown in chapters 4 and 5, and in the preceding section, if the investments are o f high quality and sufficiently large, they will elicit a positive supply response from private investors; this, inturn, can raise econoniic growth even further. The SAM-analysis o f the various shocks is illustrative o f what it tnkes to get various levels ~ n ~ p a t t e r n ofsgrowth and jobs, Evidently, there is neither any single policy option nor too many policy combinations that can orchestrate subst~~ntialincreases in GDP growth andjob creation to make a significant and sustainable dent on poverty. 6.38 The export shock contributes about 4.6 percent to GDP growth; the private investment shock adds about 2 -3 percent, and an increase o f about 45 percent inpublic investment ininfrastructure such as roads, water, electricity i s expected to increase GDP growth by 5 percent if in addition to the quantity o f public investment, its quality i s also improved. 6.39 public infrastructure and utilities as follows: electricity provision - 42 percent; water - The public and private investment shock is expected to lead to growth in 50 percent, freight transport - 29 percent, and telecommunications - 35 percent. To boost growth by 10 - 12 percent (cumulatively), the corresponding increase in human capital required is about 13,000 new skilled workers - managerial (18 percent), technical (8 percent), servicemen and clerks (19 percent), craftsmen o f all types (50 percent) andplant operators (5 percent) (Table 6.3, column 8). Of course, skills development is more likely over the next 10 years as opposed to the next 5 years shown in our projections. Its costs are not built into the projections. Skills development also warrants a major shift away from over-emphasis on primary skills and towards relevant industrial skills (while their production and costs are not modeled in this report, how many and which ones are broadly needed i s explicitly modeled and listed inTable 6.3). Recurrent expenditures will also have to be adjusted to support the new investments (the fiscal implications of this strategy are discussed inthe next section). 6.40 The incremental gain of 10- 12 percent in GDP is expected to generate about 45,000 jobs on a net basis. Many o f these associated with agriculture will provide low- income livelihoods but those associated with high value agro-production and processing, manufacturing and services will be better paying or `good' jobs that place the earners above the poverty line. The labor market is the most critical link between growth and poverty. Incomes of low-skilled workers are likely to decline minimally (-0.3percent) while those o f high-skilled workers will rise by nearly 7 percent. The main reason for this 87 As noted elsewhere and summarized in this chapter, these core recommendations include policy legislation for land reform, property rights, tax incentives to attract FDI and Basotho private investors as well as adequateprovisiono f skills. 88 As some rural roads may not pass the cost-benefit test, it will be important to ensure that the rural infrastructure investments are carefully targeted. How this can be done is not addressed inthis reports but one way forward is to use information available in the latest agricultural census to map areas where such interventions are likely to have high returns. 123 is the focus of the Recommended Strategy on high value production inboth the rural and urban areas. Without this, poverty reduction is not possible in Lesotho on the scale envisioned in the PRSP. Ordinarily, stagnation or a decline in the earnings o f the less skilled would be tantamount to poverty worsening, but accompanying measures to increase the level of skills are necessary and strongly recommended - else the growth strategy will not materialize. Incomes o f the rural poor and low income households rise more (almost 5 percent) than their urban or high income households (Table 6.3, column 8). Iftimely public action is taken, over 4 years this cumulative growth potential can raise real incomes significantly. Note, the 4 - 5 percent increase in the incomes o f poor and rural households are consistent with the 4 -5 percent per annum rise inper capita GNP in the medium term (projected by the macroeconomic framework). The pattern o f growth is shared inthe Recommended Strategy. B: RecoininendedStrategy -Pait 11: inacrocc onomic implications o f the three key investmeiit/export drivers proposed in A. 6.41 For the purposes of the macroeconomic framework, the total (public and private) investment shock of about M 638 million (M400 public million. and M238 million. private in 2005106 prices) implies an increase of about 17 percent in gross national investment.It is assumed to be spread over 4 years and amounts to 4.5 percent per annum. Like the investment and exports shocks that are spread out, the growth outcomes are also phased over the medium tenii. The expansion in public investment (increases of just over 10 percent per annum for four years) is expected to lead to substantial growth inpublic infrastructureand uti1ities. 6.42 Although the Recommended Strategy is not tied to any specific year, there are at least two urgent reasons for starting its implementation in the current fiscal year (2005106). First, in January 2005 started the clock ticking on the remaining life o f the garment industry. Without timely interventioiis from GoL to retain foreign investors in the country and enable them to expand textile production through the provision o f public infrastructure before 2007, some or all o f the firms may relocate to lower cost destinations, Second, relative to a few years ago (2000101 - 2001102 for example), the public debt burden is significantly lower and charting a downward trend. There i s sufficient fiscal headroom to finance the necessary level of public investment over the next few years to support private sector growth. A rare window o f opportunity exists between now and 2007. I t i s easier to woo and entice existing foreign firms to stay in a sector with proven export potential than to attract new firms to unknown industries, especially when natural resources are scarce, 6.43 Like its tinzing, the room for maneuver with respect to the speed and implementation of reform is limited. The external deadline for making credible fiscal commitments in public infrastructure and completing other recommended reforms is 2007; this i s set externally by global events in the textile and garments industry. 6.44 In the medium term framework in Table 6.4a, it is assumed that the Lesotho will continue to enjoy a sound macroeconomic environment determined primarily by South Africa. The base case assumptions are modified in the following way: (1) phased injections o f M l O O million o f public investment start in 2005106 and are maintained in real terms over the next three years (implication: M 105 million. in 125 2006107; M 111 million. in 2007108; and M 117 million. in 2008109; total of M400 million in2005106 prices). (2) The private sector response to public investment is lagged by a year, i.e. its starts in 2006107 with a shock o f M60 million per year and is adjusted for inflation over a 4 year period(totaling M238 million). (3) Consistent with the timing of public and private investment, the export and GDP growth shocks are phased in over this time period. The medium term growth projections are shown in Table 6.6. (4) Ongoing external shocks to miners' remittances (5 percent cut) and LHWP investments (15 percent cut) are expected to have already chipped away 2 percentage points o f GDP growth (Table 6.6). This is modeled in the S A M simulations whose base year is 2000101. They are also incorporated more precisely in the medium term framework as we now have the advantage o f actual data or estimates for base year 2004105. Tabfe 6.6: High Case - Reconirnerirkd Strategy Scenario - Growth Simulations from SAM; Macroecononiic pi*oajertioiisfrom IWSM-X - Key growti1 rates - 2004ios -2010111 2004105 2005106 2006107 2007108 2008109 2009110 2OlOlll 3rowth Rate o f GDP at market prices 3.00% 3.50% 4.50% 6.00% 6.50% 6.75% 6.75% Consumption Growth -3.16% 11.24% 5.40% 6.61% 6.70% 6.86% 6.91% InvestmentGrowth (GDI) 3.78% 10.00% 7.43% 8.05% 8.90% 12.77% 10.07% Import (GNFS) growth -3.96% 16.89% 7.21% 7.27% 7.49% 8.85% 8.11% Export (GNFS) growth 3.18% 6.74% 5.87% 5.70% 6.33% 6.33% 6.63% RealPer Capita Growth Rates: GrossNationalProduct (GNP) 3.04% 2.83% 2.60% 3.75% 4.22% 4.47% 4.54% 'er Capita US$ Levels: 653 766 771 783 806 834 865 Soods Market - (YO)shareof GDP Exports 47.5% 41.5% 41.0% 39.9% 38.8% 37.7% 36.6% Imports 98.2% 85.3% 90.1% 85.7% 83.2% 80.7% 79.1% Consumption 116.7% 112.1% 116.3% 112.9% 11 1.5% 109.9% 108.2% Private 92.3% 86.0% 90.8% 87.9% 87.9% 86.4% 84.9% Public 24.4% 26.1% 25.5% 25.0% 23.6% 23.5% 23.3% Investment 34.0% 31.7% 32.8% 32.9% 32.9% 33.0% 34.3% Private 26.6% 23.8% 23.4% 23.2% 22.9% 22.9% 24.3% Public 7.4% 7.9% 9.4% 9.7% 10.0% 10.1% 10.0% Shareof GDP (YO) 3DP at factor costs 78.2% 83.1% 84.6% 86.3% 87.1% 87.7% 88.0% Agriculture 14.6?'0 14.4% 14.1% 13.8% 13.4% 13.1% 12.7% Industry 41.1% 40.0% 38.9% 38.8% 38.7% 38.6% 38.5% Manufacturing 18.2% 18.2% 1S.3% 18.2% 18.0% 18.0% 18.1% Services 22.5% 28.8% 31.6% 33.7% 35.0% 36.1% 36.9% Source: Highcase, RMSM-X pvojcctioiis and S U A siiiw:atiwis iIlaia Sour 6.45 The investment shocks complimented with the accompanying reforms in the Recommended Strategy are envisaged to increase GDP growth by 0.5 percent in 2006107, 2 percent in the following year gradually rising to increments of 2.75 percent per annum in 1009110 (Table 6.6). The sustained shocks to public and private investment are expected to raise the share of investment in GDP by about 3 percent over the base case in2010111. Higherrates o f export growth (5- 6 percent) relative to the base case (3-4 percent per annum) will lead to higher demand for imported intermediate inputs. Similarly, higher overall growth will raise the share o f imports in consumption. Over the medium term, as the country gets better at agro-processing and manufacturing, 126 . especially in the production of textiles for the garment industry, its dependence on imported intermediate inputs will decline, at least in textiles. 6.46 Compared to per capita GNP growthof only 2 percentper annuminthe base case, the Recommended Strategy is projected to support growth in per capita GNP of about 3 percentin the first year risingto 4 - 5 percent per annumin the medium term. For the bulk of Basotho resident in Lesotho, the per capita growth in GDP inthe Recommended Strategy i s twice as high (nearly 6 percent per annum) as that in the Base Case (3 percent per annum), and the pattern o f growth i s shared. 6.47 Are tlie growth rates eizvisioned by the ~ecommeIadedStrategy feasible? A supply response of this magnitude i s entirely feasible in Lesotho's economy as evident from the sharp hike in GDP growth during the high-LHWP era (1986187 - 1997198when the average was 6 percent per annum). It happened not too long ago - it can happen again. Co-incidentally, the key engine of growth at that time was large investments in infrastructure and utilities associated with the construction o f the LHWP project. Although for different reasons, the Recommended Strategy is also based on a large investment shock to domestic infrastructure targeted at agriculture and industry, Hence a similar impact is economically feasible. The biggest bang in growth will come from a significant expansion in the service sectors which account for almost half of GDP, The boost ininvestment will increase the demand for inputs - local and imported intermediate goods and services, all types o f labor sltills particularly highskilled workers, and capital. The service sectors will grow between 13 - 20 percent; local construction, a direct beneficiary of infrastructure expansion, will grow at 8 percent, 6.48 This begs a more critical question: is the Rc~oIn~endedStrategy politically, bureaucratically arid udmiIiist~af~ve1~~feasible? Nearly 20 years ago, when the government was less experienced, Lesotho's PO litical, bureaucratic and administrative systems were able to harness the political will and administrative capacity to facilitate the LHWP construction project. As Lesotho's local construction industry was then in its infancy, the bulk of the construction activity was managed by South African firms, Significant learning occurred - at least for the local construction industry - from the LHWP experience. Today, there is a sizable and still flourishing local industry; a few firms now bid alongside foreign contractors; othcrs will be drawn from global markets, especially South Africa. In a nutshell, if the political will to implement the Recommended Strategy exists, Lesotho's bureaucratic and administrative capacity, now more experienced, can rise to meet the challenge once again, just as the LHWP i s windingdown. * Table 6.7: High Case - Recommended Strategy Scenario - Growth Simulations from SAM; Fiscal projections from RMSi\l-X - 2004105 - 2010/11 I(%) Share of GDPincurrentprices 2003104 2004105 2005106 2006107 2007108 2008109 2009110 2010111 Total Revenues (excl. grants) 40.3% 45.5% 41.5% 40.1% 38.6% 38.2% 37.5% 36.8% Total Direct Taxes 10.0% 9.6% 9.8% 9.9% 10.1% 10.4% 10.6% 10.6% Total Indirect Taxes 23.9% 30.5% 26.3% 24.8% 23.1% 22.3% 21.4% 20.9% Customsrevenue (SACU) 16.7010 16.7% 16.7% 16.7% 16.7% 16.7% 16.7% 16.7% Total Non Tax Revenue(water royalties 6.5?'0 5.4% 5.4?/0 5.4% 5.4% 5.4% 5.4% 5.3% etc.) ForeignGrants 2.1% 2.6% 2.2% 2.2% 2.2% 2.1% 2.1% 2.2% Total Expenditures 41.7`% 44.3% 46.0% 45.7% 44.6% 44.7% 44.3% 43.5% CurrentExpenditures 34.3% 36.5% 36.6% 35.9% 34.5% 34.6% 34.3% 33.7% Interest Payments 2,5'i'0 1.7% 1.6% 1.5% 1.6% 1.7% 1.9% 2.1% CapitalExpenditures 7.3"iO 7.9% 9.4% 9.7% 10.0% 10.1% 10.0% 9.8% Government Deficit (excl.grants)(-)/GDP -1.4?`0 1.2% -4.5% -5.6% -5.9% -6.5% -6.9% -6.6% Government Deficit (incl.grants)(-)/GDP O,??/o 3.8% -2.3% -3.3% -3.7% -4.4% -4.8% -4.4% Memo item: Primary Deficit(-)/GDP 1.29'0 2.9% -2.9% -4.0% -4.4% -4.9% -5.0% -4.5% Total debt`GDP 64.2% 55.4% 53.9% 53.1% 52.0% 51.5% 51.4% 50.9% Domestic debt`GDP 12.9% 8.7% 10.1% 11.8% 13.0% 14.2% 15.5% 16.2% Foreinndebt`GDP 51.3% 46.7% 43.9% 41.2% 39.0% 37.2% 35.9% 34.6% i - Source: HighCase, RMSM-Xproject~onsand SAM simtilations (Data Sources. IMFand BOS) 6.49 Table 6.7 shows the fiscal situation consistent with the Recommended Strategy in Table 6.6. The rates o f taxation and the existing trend in current public expenditures is similar to that in the Base case. On-going reforms to curb waste and improve the efficiency of fiscal expenditures are assumed to continue. The ratios o f revenues and public expenditures to GDP in Table 6.7 are quite similar to those in the Base Case because higher GDP growth expands the taxable base to accommodate level increases inrevenues and expenditures, This provides sufficient room for higher current spending to support the Recommended Strategy (as in health to curb the HIVlAIDS epidemic, education to develop more skills etc.). If the level o f grants remains at the prevailing level o f 2 percent of GDP, the fiscal deficit inclusive o f grants will rise from 3.3 percent o f GDP in 2006107 to 4.8 percent in 2009110 and 4.4 percent in 2010111. In. the Base Case, the corresponding statistics are 2.5 percent in 2006107 declining to 1.8 percent in2010111. Options for financing the deficit need to be explored. InTable 6.7, for jll~st~ative purposes, the entire deficit is assumed to be financed by domestic debt, which as a share of GDP, rises to 16 percent in 2010111. 6.50 Table 6.8 indicates the current account deficit that will arise if the Recommended Strategy is implemented as scheduled. The increase in public and private investments and higher consumption will spillover into a larger (net) import bill leading to a current account deficit o f about US$106 million in 2006107 risingto US$270 million in 2010111. Assuming that the existing loan commitments and FDI- inflows and grants from the Base Case are unchanged, a financing gap of US$ 51 million i s likely to emerge in2006107 and grow to US$191 million in the last year o f the projection period. The corresponding Base Case numbersare US$ 30 - 31 million throughout the projection period. Table 6.8: High Case - Recommended Stralvgy Scenario - Growth Simulations from SAM; Balance of Payments projections from RblSM-X-2004105 -2010111 IUS s million 2003104 2004105 100V06 2006107 2007108 2008109 2009110 20101ll Exports of Goods & Nonfactor Services 556 608 642 676 718 768 821 881 Imports o f Goods & Nonfactor Services 1149 1248 1411 1450 I543 1644 1773 1900 Total Factor Payments 30 25 22 21 19 18 18 21 Interest Payments 13 18 16 15 13 12 11 14 Total Factor Receipts 292 369 42I 429 439 447 457 47s Labor income Receipts 263 33 1 371 387 396 404 413 426 Net Factor Income 262 344 399 408 420 429 440 457 Current Official Grants (incl. SACU) I73 260 24I 25 I 250 262 273 281 Net Foreign Transfers 181 269 250 260 259 272 283 292 Current Account Balance -150 -27 -120 -106 -145 -175 -229 -270 Capital Account Financing requirements(US$ million.) 207 152 I82 168 207 244 303 361 Current account deficit 150 27 120 106 145 175 229 270 Longterm amortizations (excl. IMF) 29 41 36 35 30 30 25 2s Reserves Changes o f Monetary Auth. 36 91 32 26 29 35 44 58 IMFCredit (net) -7 -8 -6 0 3 5 5 5 Financingsources 207 152 131 117 136 147 159 171 Official capital grants 17 26 25 27 29 31 33 34 Private investment (net) 121 98 41 46 42 42 47 48 Longterm Disbursements excl IMF & 24 31 39 41 57 68 73 78 Gapfill Other capital flows 46 -3 26 -3 9 6 6 10 Financinggap 0 0 51 51 72 97 144 191 GrossReserves (months imports GFS) 4.4 5.0 4.7 4.8 4.7 4.7 4.7 4.7 C: Recommended Strategy -Part 11: is it fisc,~llysustainable? 6.51 The fiscal feasibility of the Recommended Strategy depends on how the GoL plans to fillthe financing gap. Two assumptions seem reasonable: ifthe GoL makes a credible commitment to support private sector growth as discussed inthe Recommended Strategy, i t i s fair to assume that the level of FDI and capital grants for budget support will increase. These are reflected in Table 6.10. Relative to the Base Scenario, capital grants from donors to the G o L for direct budgetary support are assumed to increase by US$ 5 million per annum during 2006107 - 2007108 and US$ 6 - 7 million per annum thereafter. As a share o f GDP, this implies an increase in the budgetary grants fi-om 2 percent presently to about 4 percent in the outer years. These estimates are fairly conservative - any grants in excess of these levels will create additional fiscal space for more public spending. Table 6.9 displays the budgetary implications of the Recommended Strategy. As noted earlier, while the share o f current public spending as a share o f GDP is maintained at 33 - 34 percent as in the Base Case, the substantial expansion in GDP i s assumed to accommodate larger current expenditures to facilitate improved service delivery. Relative to the Base scenario, the fiscal situation in the Recommended Strategy scenario appears to be vastly improved, primarily because GDP growth is propelled by large public and private investment shocks that support a path of high and sustained growth. Even though the fiscal deficit without grants is large, especially inthe outer years, it is fiscally sustainable ifthe G o L finances it through grants or cheaper external debt purchased on concessional terms as opposed to costly domestic 129 debt at interest rates o f nearly 8 - 9 percent per aiinum. The projected decline in foreign debt and indeed, overall debt, as a share o f GDP offers the option o f substituting domestic debt with fast disbursing IDA loans at 0.75 percent interest rates, 10 years o f grace and a 35 year payment period. These terms push out the repayment period and curtail interest costs, freeing valuable public resources for large scale productive investments. Taking advantage o f a fast growing economy, such a financing option is likely to contain the share o f domestic dcbt from its prevailing level o f 10 percent o f GDP to 8 - 9 percent o f GDP, and total public debt at around 40 percent o f GDP by 2010111 compared to nearly 50 percent inthe Base Case. Table 6.9: Financing the high-growth ReeumnienrlctlStrategy & comparisons with the Base Case Medium-term projections based on the KMSM-X - 2005106 - 2010111 Interest PaymentslGDP 2.5%) 1.7% 1.6%) 1.4% 1.5% 1.5% 1.6% 1.7% Current ExpenditureslGDP 34.3% 36.5% 36.6% 35.8% 34.4% 34.5% 34.1% 33.3% Govt.Deficit (excl.grants)(-)/GDP -1.4'i.b 1.2% -3.6% -4.8% -4.8% -4.9% -4.9% -4.2% Foreign GrantslGDP 2.1%) 2.6% 2.2% 2.2% 2.2% 2.2% 2.2% 2.5% Govt.Deficit (incl.grants)(-)lGDP 0.7% 3.8% -1.4% -2.5% -2.6% -2.7% -2.6% -1.8% Total Public (foreign & dom) debv'GDP 64.2% 55.4% 53.0% 51.7% 50.5% 49.5% 48.7% 47.0% Domestic debt'GDP 12.9% 8.7% 9.2% 10.3% 10.6% 10.5% 10.1% 8.7% 51.3% 46.7% 43.9% 41.4% 39.9% 39.1% 38.6% 38.3% 34.3% 36.5% 35.6% 35.0% 33.6% 33.6% 33 -1.4'h 1.2% -3.5% -4.6% -4.9% -5.5% -5 2.1%) 2.6% 2.2% 4.1% 4.0% 4.0% 3. 0,7%;, 3.8% -1.3% -0.5% -0.9% -1.6% -2 6.52 Several financing options can be explored. Table 6.5 illustrates that under fairly conservative assumptions regarding donor grants and FDI, if the GoL prefers a portfolio comprised o f 8 - 9 percent o f domestic debt and the remainder inconcessional financing, it will have suf$cient fiscal headroom to finance a significant public investment program starting in 2005106. An increase in the share o f domestic debt will impose a larger debt burden, and will raise the level o f current expenditures on interest payments. There is some marginfor this to occur. The mediumterm scenario will be sensitive to the interest rate at which domestic debt is contractcd. Suppose the GoL does not receive add~tion~Z donor grants presently assumed at about 2 percent o f GDP in the outer years o f the projection period. Fortunately, the foreign debt to GDP ratios over the next 5 - 6 years decline from 44 percent presently to 30 percent by 2010111, and provide favorable conditions for GoL to use loan-finance for its development agenda. In short, in the absence o f additional grants, concessional loan finance is a viable option to promote higher growth. The numbers confirm that there i s no imminent threat o f debt-distress in the medium term. There are, however, at least two risks. One, the GoL may make the necessary investment but these may be delayed or may not be implemented before 2007 130 with the speed necessary to retain foreign investors in the country, This can lead to a delayed or lower growth response and put the fiscal situation under pressure. The second risk i s that the GoL does not seek concessional or grant financing. If the additional investment is domestically financed, the debt burden could squeeze the fiscal headroom needed to attain PRSP targets. The critical challenge will lie in seeking concessional finance and effecting rapid i ~ i p l e ~ e ~ t totelicit~ the private sector response necessary ~ i o i for the growth o f the national economic pie. Unless growth picks up rapidly, the fiscal indicators with GDP in the denominator will threaten the sustainability o f the Recommended Strategy. The LHWP experience suggests that if the GoL sets its mindto it, itcanhappen. Table 6.10: Balance of payments 13rojectioiis corresponding to the financing option proposed for the R e c o ~ i ~ ~ eStrategy~.-~simulations from the RMSMX n c l ~ 2003104 2004105 2005106 2006107 2007108 2008109 2009110 2010111 Financing requirements Base - 207 152 144 147 167 179 190 201 Current account deficit 150 27 94 88 115 126 141 141 Other financing requirements 57 125 50 59 52 53 49 60 Financing Sources Base - 131 83 144 147 167 179 190 201 17 26 25 27 29 31 33 34 121 98(60) 41 46 42 42 47 48 (45) Other capital flows n.e.i.(LT disb 69 29 65 44 65 74 79 88 0 0 14 30 31 32 31 31 207 85 131 150 9 104 57 76 27 131 83 131 17 26 25 45 GO 41 69 -3 26 0 0 51 0 0 40 bt indicators Base - 702 683 681 688 698 708 715 60% 47% 43% 41% 39% 36% 34% 32% Debt Service i GDP 3.8% 4.2% 3.4% 3.1% 2.6% 2.4% 1.9% 2.0% Debt Service I Total Exports ebt indicators Recommemded - 5.2% 6.3% 5.O% 4.7% 4.1% 3.9% 3.4% 3.6% DOD (US$M) 702 683 671 656 736 816 953 1110 GDP 60% 47% 43% 41% 40% 40% 43% 45% i GDP 33% 4.2% 0.02% 0.06% 0.16% 0.20% 0.20% 2.06% Total Exports 5.2% 6.3% 0.03% 0.09% 0.25% 0.34% 0.36% 3.73% 003/04, the net FDlJow wns 6.53 Table 6.10 complements Table 6.9 with balance of payments projections consistent with the financing strategy proposed above. Between the Base Case and the Recommended Strategy, FDIi s assumed to increase by US$Sinillion in 2006107 to US$ 10 million in2007108 and US$ 15 million thereafter. Capital grants channeled for direct budget support also rise though by smaller amounts. Incorporating these two sources o f incremental financing raises the financing gap from US$ 14 to 40 million in 2005106. It widens over the medium term to reach US 180 million in 2010111 compared to U S 31 million inthe Base Case. Assuming the IDA-Fast Disbursingoption is exercised to fill this gap, Lesotho's external debt in US$rises from a stock o f 683 million in 2004105 (presently) to US$ 1110 in2010111 (compared to US$722 in the Base Case). However, the dividends from higher investments and growth will help to contain the ratio o f foreign debt to GDP at 45 percent in 2010111 compared to 32 percent in the Base Case. Higher growth will also facilitate a lower debt service burden. Relative to the Base Case, over the medium term the ratio o f debt service to exports or GDP will be significantly lower in the Recommended Strategy because the additional loan financing i s assumed to be concessional with a long grace period, longer maturity and negligible interest rates (0.75 percent per annum). Besides a larger economic pie (GDP) will help to reduce these ratios contrary to the perception that additional borrowing imposes a heavier debt burden. This exercise demonstrates that if the additional borrowing is channeled into productive investment (as evident in higher growth) and contracted at concessional rates, it is actually possible to use the fiscal instrument to raise growth sufficiently to meet the goals o fthe PRSP. D: Human capital issues and thc inillact oftllViAII3S 6.54 Chapter 3 focused on the labor market as the most important linkage between growth and poverty reduction in Lesotho. With the diminishing role o f remittances, employment in the domestic labor market especially in waged jobs in manufacturing, industry or services, business ownership or engagement in high-value rural production are the only means of moving out of poverty. While the main thrust o f the Recommended Strategy is onjob creation as the primary means o f poverty reduction, some o f the poor are unlikely to benefit from it. Examples o f the latter include unemployable individuals such as the aged, disabled, orphans and victims and families of HIVlAIDS and other catastrophic illnesses. As noted in chapter 3, this set o f individuals should be supported by direct transfers and safety nets. The increase in fiscal revenue enabled by an acceleration ingrowth is expected to make available the requisite increases in public resources to finance safety nets for the unemployable. It is assumed that ongoing efficiency-improving, revenue raising meaiis o f fiscal management will be maintained as part ofthe Recommended Strategy. 6.55 While in the country as whole, nearly one in three adults is living with HIVl AIDS, the infection rate may be as high as 42 percent among those in urban areas such as Maseru. The government of Lesotho now places as much importance on controlling the spread o f the epidemic as on poverty alleviation and job creation. The epidemic is likely to have significant demographic and economic consequences. As noted earlier, many families that depend on single earners may be pushed into poverty, as they lose their breadwinners and bear the cost o f the disease - loss o f incomes, cost o f treatment and care, and so on - privately. The likely impact on various sectors, 132 particularly food production and the ability of the bureaucracy to deliver critical services have not been examined, However, limited information available on the prevalence of the disease does permit (with modeling) an examination o f some o f the consequences of the epidemic. 6.56 The direct effect of the epidemic will be on the size and composition of population. The population of Lesotho is projected to reach 2.8 million by 2015, but about 23 percent lower than it would otherwise bc without AIDS. Population growth will be reduced by increased mortality and reduced fertility. By 2010, the number of AIDS- related adult deaths may exceed the number o f estimated total deaths in the absence of AIDS. The majority o f deaths will take place among 15-49 year olds. Unlike the case of a planned reduction in population growth, a decline in the population growth rate due to deaths in the economically active segment, will leave the Basotho population with higher dependency ratios and their attendant implications for the household's economic status and investments in human capital development, particularly the education o f children. The life expectancy o f the Basotho, which has already declined, is projected to fall further to about 31 years by 2015, instead of climbing to nearly 65 percent, as anticipated inthe absence ofAIDS (World Bank 2000). 6.57 The loss of individuals in their most productive age group has implications for their workplace. These effects have not become evident in Lesotho, as yet. AIDS- related deaths have not become major concerns in the textile firms (Salm et al. 2002). The older factories that have had workers with them or a while are facing a greater number o f deaths than others. The effect o f AIDS deaths may not be evident, because the workers are largely low skilled, can be replaced with marginal training costs, and the turnover i s high even without AIDS. In a 2000 survey too, Basotho employers indicated that unlike the case o f the neighboring countries, the loss o f work days due to A D S was not significant in Lesotho. More than 40 percent o f the workers Lesotho are inthe public sector either directly or indirectly. They earn higher incomes than those in the private sector reflecting, to some extent, their superior education and skill levels. Assuming that the public sector workers are affected by the epidemic as much as the general population, the effect on the public sector could be considerable, with implications for the delivery o f critical services, such as health and education. 6.58 The costs to the public sector are both direct and indirect through reduced productivity from higher absenteeism and morbidity. The direct costs include increased pension payments due to early retirement, and hiring and training costs. The productivity losses resulting from absenteeism and morbidity were estimated to be M 10 million, or about 1.3 percent o f the wage bill in 1999!20. These costs are projected to increase to about 1.8 percent o f the wage bill by 2015. The direct costs - pension and gratuity payments, hiring and retraining costs to replace lost workers - are, on the other hand, projected to increase from 0.1 percent o f the wage bill in2001 to about 2 percent by 2015. The epidemic's total cost to the public sector could be around 5 percent of the wage bill (World Bank 2000). The effect o f AIDS related deaths may not immediately become apparent where there is considerable overstaffing, and functions o f those who have died can be assumed by others. On the other hand, AIDS related deaths o f school teachers inrural areas, whose functions cannot be easily assumed by others, is becoming more apparent. 6.59 The death o f population in the most productive age group, affects economic growth and per capita income through changes in labor productivity, decline in labor force growth and human capital or average experience of the workforce (Haaker 2002). AIDS also impacts thc overall economy through the effect it has on savings and investments. Private and public expenses on mitigation take resources away from other more productive investments. The rate o f return to capital may decline because o f a fall in productivity, increase in personnel expenditures and a possible increase in the capital-labor ratio, discouraging overall investment (Haaker 2002). Under the assumptions that in Lesotho, AIDS epidemic will reduce the number o f workers available by nearly 40,000, decrease worker remittances, and lower government and private savings, the model projects that between 1986 and 2015, the GDP will grow at the rate of 3.6 percent per annum instead of 4.4 percent per annum without AIDS, that is, a decline of eight tenths of a percent in the annual GDP growth (World Bank 2000). 6.60 On HIVIAIDS, policy makers must to continue to partner with external agencies like the UN and other proactive African countries to evaluate the options and fiscal costs of actionslprograms necessary to curb the epidemic and alleviate the suffering o f the victims and their families. This area lies outside the scope o f this report but is a critical agenda for further research. The policy implications will need to be guided by a Lesotho-specific assessment o f the problem, E: The full Recommended Strategy bringing it dl logcther 6.61 The first five chapters of this report have analyzed in depth the growth, employment and poverty implications o f Lesotho's geography, natural resources, people and institutions; major structural shocks and their macroeconomic outcomes; labor market and poverty-related livelihood issues; sources o f growth in the secondary and tertiary sectors; and agriculture and rural development. Available information as well as substantive new information was generated to conduct this exercise. Our objective is to highlight the broad areas o f policy reform and pin point specific actions where we have sufficient information to do so. An example o f the broader approach is to suggest that the government work through public-private partnerships to accelerate skills development to attract investment in high-value export-oriented activities. An example of more specificity is recommending that the GoL do whatever i s necessary to make the Maseru rail terminal, a vital transport node for the garment export industry, more functional andbusiness-oriented. There is a deliberate hesitationinavoiding a long list o f recommendations. The idea is to prioritize and let the policy makers choose whatever institutions seem most appropriate to implement the necessary reforms. This approach is also conducive to greater ownership o f reforms and is consistent with a government whose capacity i s already overstretched by several ongoing reform processes. CORE RECOMMENDATIONSTO COMPLEMENT THE RECOMMENDED STRATEGY 6.62 The preceding chapters (1- 5) show and the modeling exercises in this chapter demonstrate more precisely that even though some sectors offer greater potential for overall growth and employment creation, the policies and actions that GoL needs to take to accelerate growth are fairly common for nll sectors of the economy. As emphasized in the Rcconimended Strategy, the public investments proposed will not trigger the desired private investment response in Lesotho unless they 133 are accompanied by the "core" set o f policies and actions that are fundamental to achieving higher levels of growth. The most urgent o f these that has arisen with the expiration o f the MFA in January 2005 is proactive public action to attract more investment in Lesotho's textiles sector to facilitate garments exports after 2007. Other such policies and actions are flagged throughout the chapters and also summarized below. 6.63 Not all these recornmendations are new, and many may seem relevant for any developing country, but they are rooted in the above analysis of Lesotho's specific challenges. The government o f Lesotho has made advances inmany o f the areas recommended, more enthusiastically in some areas than in others. However, as noted throughout this document, and highlighted here again, progress is not adequate in many areas. These recommendations are fairly consistent with GoL's own priorities as reflected in the PRSP. Our recommendations pertain largely to "what" needs to be done with explication o f tlie conditio~eiiviroiimeiit that needs to be achieved. The recommendations are less clear on "how" or "how much;" this is deliberately so, because it requires further sector-specific work and a careful studyof the instit~ti~ns maybe that most suitable to deliver the task. However, we do recommend some approaches and also highlightwarranted shifts inemphasis where deemed appropriate. 6.64 (1) Pro-active policy actions to retain existing and attract new foreign investment in the textiles and garments industry. That the expiration of the MFA in January 2005 would expose Lesotho's garment exports to intense competition from low- cost-high skill Asian producers in the US market was always known. In spite of this common knowledge (AGOA and the MFA), at least one investor made a significant fixed investment in a textile mill to start producing fabric for the garment industry in preparation for 2008 when the rules o f origin clause sets in. While the threat o f a major relocation o f garment firms to overseas locations i s not an empty one, it is entirely avoidable if the GoL takes pre-emptive policy action to attract foreign investors to stay and expand production in Lesotho after 2007. Two constraints need to be overcome: basic public infrastructure and utilities need to be significantly expanded to enable expansion o f the textiles and garments firms; and skills development through industrial training needs to start on a large scale to increase supply o f more skilled persons in supervisory, technical and managerial positions. A1though these requirements are the same as those needed for other productive sectors, the clock is ticking on the textile and garment industry, tlie main driver o f growth in Lesotho. As financing is not a constraint, to accelerate implementation in these two areas, the GoL may wish to partner with the private sector (both domestic and foreign) to deliver these critical inputs.It has worked in the past. 6.65 (2) Property Rights. Three issues that fall under this broad category are land institutions, coniniunal grazing and the issue o f visas. The failure to adequately reform traditional land institutions-i.e., to improve access to agricultural landto those who can put it to better use and to make adequate land available for non-agricultural purposes - and to modify access to grazing in the mountains hampers agricultural commercialization, improved management o f grazing fields, and, more importantly, the growth of industries and services, particularly through foreign direct investments, The need for reforms is widely accepted. Reforms to provide land titles that can be used as collateral and enable formal crop sharing and efforts to redefine access to public grazing 135 are ongoing, but they are not adequate. Making land available to investors "outside o f LNDC" has beenon the agenda for several years, but without muchprogress. 6.66 Reforming land institutions is obviously a sensitive issue. Any reform that may concentrate land or enable foreign ownership may not be politically acceptable. "Common" ownership o f land and universal access to land for subsistence are values that underlie traditional land institutions, although the current land and animal ownership patterns may not reflect these values. Enabling land ownership by foreigners may be viewed as losing the last bit o f control the Basotho have over their country and its resources. The consequences o f not making any changes in land policies and various options available to provide adequate incentives for both domestic and foreign investors without diluting the "Basotho" control to unacceptable levels need to be debated widely. Extensive consultations on the draft white paper on land reforms would provide such an opportunity, and also help to develop broad based support for required reforms. It would be useful to consider alternatives such as facilitating long leases, if further concentration o f landownership inthe country and foreign ownership are socially unacceptable. Issuing longer term leases to local andforeign investors interested in constructing and investing in Lesotho's garment or textile may be a particularly useful option at this point as the clock has starting ticking on the 2007 deadline by which time the country needs to be producing suf$cient fabric to support its garment industry. 6.67 The terms under which visas are issued and tile costs of obtaining visas discourage expatriate investors from bringing in the required skilled individuals into Lesotho.The same barriers hinder the flow o f tourists into Lesotho: for example, the issuance o f only single entry visas i s a deterrent to visitors who may want to cross the border for a few hours to conduct businessin RSA and return to Lesotho. These practices are constraints to expanding exports-oriented manufacturing and tourism, the two areas that the government desires to develop. 6.68 (3) Infrastructure. Infrastructure needs to be developed to harness the country's water resources to more effectively meet the human, industrial and irrigation needs; expand and improve road network; enlarge electricity coverage and more effectively handle imports and exports at the Maseru railhead, which i s so critical to export- manufacturing. The earlier development plans that had envisaged multipurpose water projects to meet the domestic demand in various sectors need to be implemented. Improved roads and irrigation development are critical to develop rural markets and commercialize agriculture. Roads are also essential to improve access to the mountains that have tourism potential and to facilitate growth o f non farm activities, More importantly, improved roads will enhance access to schools, hospitals and woolsheds. Expanding electricity is also critical to supporting growth o f rural industries and services. Finally, infrastructure for the treatment of industrial wastewater needs to be developed to reduce pollution, andmeasures needto be introduced to encourage conservation. 6.69 Infrastructure development is particularly challenging as the population is dispersed over a difficult terrain. It would obviously not make sense to invest in good rural roads or extend the electrical grid t~zroug~~ou~ the country; besides, the resources required for this would be enormous. Roads need to be improved in critical rural and urban areas, which would include both those that have the greatest potential to stimulate the development o f livelihood opportunities and those that can integrate the most isolated 136 communities. Wliile the government can invest its resources for integrating isolated communities, private investments should be encouraged where the potential returns are higher, as for example inthe manufacturing and agro-processing sectors. 6.70 (4) Educationltraining. Labor i s often stated as an abundant resource inLesotho, but it is not skilled enough to perform some o f the essential functions inboth the public and the private sectors. Increasing the skill level of its workforce will be critical to developing a vibrant and diversified private sector that is rooted in the economy, Simulations from tlie SAM model indicate the magnitude o f the skilled workforce required to achieve desired levels o f growth. Being located next to RSA, a richer economy that also faces similar skill shortages, Lesotho cannot expect to retain all o f its skilled workforce. While there is a dearth o f skills in the country, graduates o f many training schools also go without jobs suggesting that either the training is irrelevant for the labor market or there i s structural unemployment. 6.71 Lesotho needs to examine both its educational and vocational training systems. Secondary school enrolments in the country are as low as 20 percent. Inspite o f the recent improvements in educational infrastructure, the demand for education beyond primary levels and the success rates are unacceptably low. Some surveys suggest that the highcost of secondary education is one of the reasons for low demand. The reasons for poor performance o f tlie educational system need to be examined. Attention also needs to be paid to vocational training, as the country does not have the institutions that develop the kinds o f skills that are required in the economy. A good start would be to examine why existing training organizations including the one that was expected to train workers for the textile industry have failed. As private investors do undertake limited on-the-job training, options to explore the scope for public-private partnerships in vocationalitechnical training to effectively gear training to meet the skills need may be another way to go. 6.72 (5) GovernancelCapacity. Poor capacity in terms o f absence o f adequate skills, suitable institutions and incentive structures uiideimines development planning and administration. Poor capacity is often cited as the reason for lack o f effective implementation o f projects. One o f the constraints mentioned by the local private sector is the difficulty in working with the government. Governance needs to be improved through simplification o f regulations and more effective administration through a responsive and accountable bureaucracy. As noted above, enhancing skills will be challenging. As a recent employment policy paper suggests, retaining trained individuals is more important than merely training individuals in the bureaucracy. Lesotho needs a better-paid, more effective, and perhaps, a smaller bureaucracy. The need for civil service reform has been on the policy agenda for two decades without significant progress. As long as the civil service is not able to offer better administration, the government cannot make hard choices and implenient reforms. The ongoing public sector reform is a good beginning but it needs to be accelerated. 6.73 (5) Private sector development. Lesotho has been fairly successful inattracting foreign investors to take advantage o f its trade prefereiices. These temporary advantages need to be consolidated by public interventions that will continue to attract new investments. As the DTIS suggests, Lesotho needs to make itself regionally more competitive for investments, possibly to take advantage o f the access it has to its 137 neighboring markets. An important aspect of developing an industrial base in the country is, as the country has been planning, to reduce the gap that exists between the foreign- owned export oriented manufacturing firms and the indigenous firms in terms o f managerial and technical capabilities. Both indigenous entrepreneurs and foreign investors will benefit from government action in the areas identified above - improved access to land, skills development, improved infrastructure and a more responsive bureaucracy, The domestic entrepreneurs who compete with cheaper goods and services in RSA will benefit particularly from the provision of comparable physical and institutional infrastructure. 6.74 Special efforts need to be made to facilitate diffusion of skills from the export-oriented sector. Proactive measures, such as public-private initiatives intraining, are needed to "integrate" the export sector with the rest of the economy. Creating potential synergies, through public investments in training for the sector for example, can, in addition to improving capacity, attract additional investments. More importantly, political andlor social tensions that exist between expatriate businessman and the domestic entrepreneurslwork force need to be eased to benefit from diffusion and improve the investment climate. 6.75 (7) Safety nets and care for AIDS affected. Direct measures are needed to improve the welfare o f the poor, as the bulk of the children and elderly are in poor households, A significant proportion of the poor households cannot benefit from employment creation. Families faced with catastrophic illnesses such as HIViAIDS and death of productive members, and those caring for orphans also need direct public assistance through safety nets provision. Presently, the burden of the epidemic is borne privately by almost all affected households. POINTERS FOR FUTURE RESEARCH 6.76 The report also identifies certain knowledge gaps and specific pointers for future research, as follows. e Developing countries around the world participate in increasingly competitive global markets where being linkedto or being a participant in a global supply chain is the name o f the export growth game, especially in non-primary production. Lesotho's garment export industry is a classic example. When the domestic market is too small to provoke a strong and sustained growth response, there is no substitute for export diversification and growth. But this requires acquiring the ability to remain globally competitive to attract investment. The GoL may want to look at what policy actions were used by some fast growing countries to improve labor productivity through technological adaptation to attract investment for faster export diversification and growth. e HIV/AIDS-related. In general, there i s a need to examine more fully the impact o f AIDS on poverty both in understanding past performance and in discussing future prospects. This needs to be done when better data is available. e When data from the 2004 householdsurvey i s available, it would be useful to analyze changes in household composition as well as whether there are indeed more children per household in 2004 than in 1994 and 1987. This line of research may show why per capita consumption is stagnating. e A proper analysis of the new and older household surveys would be useful to understand the implications o f high inequality in Lesotho. The 2004 household survey should facilitate such researchnow. e Issues related with the institutional and political background o f Lesotho and their implications for growth and poverty reduction would be useful to analyze. c I REFERENCES Schwab K., L. D. Cook, P.K.Cornelius, .I.]). S.E. Sievcrs, and A. Lt::irncr, (2000), "Tlze Sachs, Africa Coi~~etitive)iess Repor?.~ ~ ~ ( ~OxfiirJ Iinivei-sity1i'i.ess. ` New E'ork, 2000. ~ ~ ~ ~ 1 , ~ Schuler, P.. 2002, "The Initid IinpucI i!f'AG0,4 on US I//ip(>f'l.sj h i i Lt~sotiio, " mimco, World Bank, 2002. Swallow, B. et al. (1987) A Sirt+ve,vu]`Prohir:rioti, L?iliriirioti ciiirl hidwiii:Lg(f Liiertock raid Livestock Froducts iiz Lesotho. Research Division Iieport I