Bifm Economic Review

QUARTERLY ECONOMIC REVIEW

Economic Review

Economic Review Economic Review Economic Review

Botswana beef in the EU, and would have ledto the ending of beef exports to Botswana’smost lucrative market, which would have beendisastrous for the Botswana Meat Commission(BMC), Botswana’s cattle farmers and the ruraleconomy.

Nevertheless, EPAs have been controversialin some quarters. One of the main concernshas been in respect of EU demands forprogressively liberalised access to developingcountry markets (in fact this is not specificallyan EU demand, but is a requirement if theEPAs are to be consistent with WTO rules).This is not relevant in Botswana’s case, asSouth Africa already has such an agreementwith the EU (the SA-EU Trade & DevelopmentCo-operation Agreement), which in practiceapplies to Botswana due to its membershipof SACU. Hence, in practical terms, the interimEPA involved no further concessions onBotswana’s part. A second concern relatesto the EU’s desire to include services and“new generation” trade issues (such asintellectual property and public procurement)in the EPAs; these issues are not included inthe interim EPA and will be addressed as fullEPAs are negotiated.

Inflation & Monetary Policy

For most of the year, inflation developmentswere positive; the inflation rate declinedsharply from 8.5% at the end of 2006, andby March was below 7% and hence withinthe Bank of Botswana’s inflation objectiverange. However, towards the end of the yearinflationary pressures started mounting, and

2 3Bifm Economic Review 4th Quarter 2007 4

By most accounts the economic conditionsin 2007 represented a s ignif icantimprovement on 2006. Inflation was down,exports grew strongly, government improvedits ability to spend its budget, and businessconfidence was up. Due to lack of data wedon’t really know what was happening toeconomic growth and employment, but it isfair to assume that both should haveperformed reasonably well. So far, Botswanahas been relatively immune from the impactof the turmoil in major financial markets andthe sub-prime crisis. Looking forward to2008, however, things may not be so rosy,

with developments in the internationaleconomy – economic slowdown and risinginflation - impacting adversely on Botswana.

Review of 2007

Output & Business Confidence

No GDP data have been published since theend of 2006 and so we are in the usual NewYear “black hole” with regard to informationon overall economic growth; although theCSO has undertaken to produce and publishquarter ly GDP data promptly , thiscommitment has generally not been fulfilled.However, growth indicators suggest thatthere has been a strong recovery, with thegrowth of business credit, governmentspending and non-mining electricityconsumption all rising sharply during theyear (see Figure 1). Other indicators tell asimilar story: applications for business tradinglicences in the second half of 2007 rose by13.5%, while non-mineral exports were up121% in the first nine months of 2007, bothcompared to the same periods in 2006.

The improvement in business conditions isshown in the results of the Bank ofBotswana’s biannual Business ExpectationsSurvey. The latest results, for the second halfof 2007, show a continuation of the

improvement in confidence that has beenevident over the past 18 months. Theimprovement is particularly striking for firmsfocused on the domestic economy, of which77% reported that current businessconditions were satisfactory, compared withonly 21% in September 2005. An even higherproportion (85%) expect business conditionsto improve through 2008. While the surveysurprisingly shows declining confidenceamongst exporters, this may mainly reflectthe small size of the exporter sample in thesurvey.

A number of factors lie behind this upturnin business conditions and confidence.Domestically, government spending has beenramped up, with expenditure in the first ninemonths of 2007 rising by 22% compared to2006. Most of this increase was indevelopment spending, which rose by 60%over the first nine months of 2006. This mayshow that government has managed toovercome some of the implementationconstraints that have held back developmentprojects in the past. While a high proportionof development spending flows out of thecountry (e.g. expenditure on constructionmaterials and HIV/AIDS drugs), it nonethelessstimulates the domestic economy through

benefitted from recovery from the Foot &Mouth Disease outbreak in 2006, as well as

drought (encouraging cattle sales), and asupply response to higher prices. Nickel and

copper benefitted from higher worldcommodity prices, especially earlier in theyear. Textiles benefitted from strong demand

growth in the region and internationally, andsuccess in utilising the opportunities offeredby international trade agreements such as

the US Africa Growth and Opportunity Act(AGOA). All exports benefitted from improvedinternational competitiveness under the

crawling peg exchange rate regime.

As a result of good export performance,

combined with a slower rate of growth ofimports, the balance of payments continuedto run a healthy surplus, estimated at P10.2

billion for the first nine months of 2007(compared to P10.3 bn for the whole of2006). The foreign exchange reserves have

continued to rise, reaching P58.5 billion (US$9.7bn) at the end of September, an estimated

32 months of import cover.

One important trade development thatoccurred at the very end of 2008 was the

signing of an interim Economic PartnershipAgreement (EPA) between Botswana and theEuropean Union (as did Lesotho, Namibia,

Swaziland and Mozambique). The interim EPAprovides for improved access for Botswana

beef to the EU, with reduced tariffs (zerocompared to 5% under the previous CotonouAgreement) and no quotas. Failing to sign the

EPA would have led to much higher tariffs on

by December it was back up to 8.1%. Thiswas driven primarily by developments inglobal food and energy markets. By the endof 2007, international oil prices had risen byover 80% from their low point in earlyJanuary 2007, and there were also sharpincreases in food commodity prices, notablyfor fooodgrains (maize, wheat etc.) and dairyproducts, with The Economist foodcommodity price index up 37% over theyear. The impact of these developments wasfelt globally, and most countries experiencedrising inflation. Although Botswana’s relativeposition was not affected – by Novemberthe inflation differential between Botswanaand major trading partners had fallen to itslowest level for some time – the increase ininflation was nonetheless unwelcome.Fortunately, underlying inflation remainslower, with the trimmed mean core inflationmeasure falling to 7.4% in December.

On the monetary policy front, the Bank ofBotswana maintained its inflation objectiverange of 4%-7% for 2007, along with amedium term objective of 3%-6%. Onceinflation fell within the range, the Bank feltable to reduce interest rates by 0.5% inJune, leading to a reduction in the Bank Rateto 14.5%. This was maintained until the endof the year, despite concerns about risinginflation and domestic demand pressures.Of particular concern was the growth ofbank credit, which increased from 18.6%annually at the end of 2006 to 27.8% inNovember 2007, and remained outside ofthe BoB’s target range for credit growth of11-14% throughout the year.

The Botswana Stock Exchange (BSE)experienced a “year of two halves”, with acontinuation of 2006’s rapid growth in theDomestic Companies Index (DCI) throughto August, during which time the index roseby 60%. From August onwards, however,the situation was reversed, and by the endof the year the DCI had declined by 15%from its peak; over the year as a whole, theindex was up by 36%. The decline in theBSE DCI coincided with the decline in stockmarkets around the world, especially themajor developed markets. However, it does

not appear that the two were linked. By the

middle of 2008, valuations on the BSE hadreached unrealistically high levels; for instance,

price/earnings (p/e) ratios for the commercialbank shares that dominate the BSE were

over 30, and the domestic market as a wholehad a p/e ratio in the low 20s. Many

commentators argued that a correction wasoverdue, regardless of international

developments, and this appears to have beenwhat has happened. With p/e ratios for the

banks at just over 20, and for the market as

a whole at 15.5 at the end of the year,valuations are now more realistic. The prices

of dual listed mining shares on the foreignboard of the BSE followed similar trends,

rising by 33% between January and Augustbut then falling by 13% through to

December, largely reflecting trends ininternational metals prices.

The Outlook for 2008

The beginning of 2008 has been characterised

by unusually high levels of uncertainty in theglobal economy. The sub-prime crisis in the

US has spread internationally, and althoughit was initially hoped that this would be short-

lived and contained, the impact has persisted.Moving into the New Year, fears of recession

in the USA are intensifying, with manycommentators rating the chances of recession

at 50-50. Two scenarios can be envisaged.If the US does not slip into recession, but

simply experiences a period of slower (or

zero) growth, global economic activity willtemporarily weaken and growth will fall

below trend. Nevertheless, the impact wouldbe short-lived and, supported by a likely

easing in monetary policy around the world,global growth would rebound in the second

half of the year. However, if the US doesslide into recession, with a period of negative

economic growth, job losses and acontraction in real incomes, this is likely to

have a widespread impact on the worldeconomy. Global growth would slow

significantly and the existing credit marketproblems would intensify. In this scenario, a

global slowdown could persist well beyondthe end of 2008.

What are the implications for Botswana? Asa highly trade-dependent economy, theimpact of changes in global economic activityare potentially far-reaching. The USA is thelargest market for Botswana’s exports, asthe major world consumer of diamonds andthe primary market for Botswana’s textileexports. Any slowdown in US growth,especially if led by a drop in consumerexpenditure, would negatively affectBotswana’s exports. However, if suchproblems are largely confined to the USAand are short-lived, then other sources ofeconomic growth (Europe and majordeveloping countries) will help to cushionthe impact. But if US recession leads to asharp slowdown in global economic activity,with the impact widely felt, then Botswana’sexport earnings could fall significantly. Thevalue of copper-nickel exports has alreadybeen adversely affected by falling metalsprices in the second half of 2007, and thiswould be intensified by a global recession.As a result, Botswana’s three major exports(diamonds, copper-nickel & textiles), arevulnerable to a US-led global slowdown. Thiswould be compounded be a weakeningdollar, the currency in which all three ofthose exports are priced, further reducingexport earnings.

The tightening of credit conditions andincrease in risk aversion in major financialmarkets, even if prolonged, should have nomajor influence on Botswana. As the countryis a net creditor, and the government doesnot borrow on international markets, therewill be little direct impact, although projectsrequiring major loan finance – such as theMmamabula Energy Project – might findraising such loans more difficult, or moreexpensive. Notwithstanding the tighteningof international liquidity, domestic financialmarkets should remain highly liquid.

Domestically, the main economic problem islikely to be inflation, with several nasty shocksdue in the first half of the year. Rising inflationmay in turn lead to higher interest rates. Asin 2007, there will be continued pressurefrom high food and oil prices, and domesticfuel prices are likely to be the main driver of

Botswana inflation in the coming months.Fuel prices are adjusted on a monthly basisto reflect the cost of crude oil on internationalmarkets as well as refining and transportationcosts. Domestic price changes thereforereflect international crude price changes,albeit with a lag and an element ofstabilisation. As Figure 4 shows, domesticpetrol prices generally reflect internationalcrude prices with a lag of around 4 months.As a result, the recent sharp increase ininternational oil prices from $70 to $100 abarrel towards the end of 2007 has not yetbeen reflected in domestic pump prices.While crude prices went up by 58% during2007, domestic pump prices only rose by20%, even with December’s substantial pricehike. Should crude prices remain at currentlevels, domestic fuel prices would have torise from the current level of P5.60 a litre(for petrol in Gaborone) to nearly P7 to fullyreflect this – a further increase of 20% ormore. Fuel has a weight of around 7% inthe new CPI basket, so this alone wouldnearly 1.5% directly to inflation, which wouldbe compounded by the impact on highertransport costs, public transport fares etc.

Other possible inflation shocks could comefrom domestic electricity prices and BotswanaHousing Corporation (BHC) rentals. The latterhave not been adjusted for four years, andBHC has been lobbying Government to approvea rental increase – although the magnitude ofany such increase should be small given thatprivate sector housing rentals have been largelystagnant over this period, and BHC rentals aresupposedly market-related. Perhaps a moreserious threat arises from increases in electricitytariffs. Electricity prices are rising steeply in

South Africa, the source of around 70% ofBotswana’s electricity. A new supply contractbetween South Africa’s Eskom and theBotswana Power Corporation (BPC) came intoeffect on 1 January 2008, and is much lessfavourable to Botswana than the previouscontract, both in terms of prices and stabilityof supply – the result of which is that Botswanais now much more exposed to both tariffincreases and supply disruptions from SouthAfrica than it had been previously. In addition,BPC needs to generate funds to contribute tothe financing of new domestic generatingcapacity. Substantial electricity price increasesare likely in 2008, and although electricity costsonly have a weight of 1.5% in the CPI basket,they feed through widely to other prices andwill push up inflation further.

The combination of these developmentsmeans that inflation will continue to rise fromthe December level of 8.1%, and could easilyreach double digits by mid-year if internationaloil and food prices remain high and thereare substantial increases in BHC and BPCtariffs. On the positive side, it is unlikely thatoil prices will rise much further from currentlevels – in the absence of higher levels ofgeopolitical instability in the Middle East –as a slowdown in global growth will putdownward pressure on oil prices. Hence it ispossible that the direct impact of oil priceson inflation will be short-lived, although theindirect impact via other costs could belonger-term.

Although the BoB maintained unchangedinterest rates at the last meeting of theMonetary Policy Committee in 2008, despiterising inflation and credit growth, this situation

is likely to change in 2008. Expect a muchmore hawkish tone in the Monetary PolicyStatement to be released in February, andincreases in interest rates in the first half ofthe year, even though with inflation beingprimarily driven from outside of Botswana,the potency of monetary policy is limited.

The changed electricity supply situation isnot just a price threat, but could hinderinvestment and growth as well. With thevirtual certainty that Botswana will increasinglyexperience interruptions in supplies fromSouth Africa over the next five years, andwith no new domestic supply capacity dueonline before 2011, the problem is serious,especially for the energy-intensive miningsector that is the bedrock of the economy.To date, little public information has beenprovided by BPC on these problems and howthey are going to be addressed, and a moreinformative approach by BPC and theGovernment would help the private sectorto plan appropriately.

Botswana’s financial markets should remainrelatively immune from the turmoil in globalfinancial markets in 2008. More reasonablevaluations on domestic stocks shouldencourage a resumption of buying activityand the DCI should bottom out in the firstquarter. In the bond markets, expectationsare high that Government will announce aprogramme of regular bond issues to coincidewith the maturity of the BW002 bond on 1st

March. This would help to boost liquidity inthe bond market and support the yield curve,which in turn provides a foundation for bondissues by the private and parastatal sectors.

Summary ofEconomicDevelopmentsDr Keith JefferisChairman ofBifm InvestmentCommittee

Economic Review5employment and expenditure on locallysupplied goods and services. One of theweaknesses of the Botswana economy is thatthe domestic private sector still remainsheavily dependent upon governmentspending – something that has to change inthe longer term – but it means that govern-ment can boost economic activity throughincreasing spending in the short term, whichseems to have been happening recently.

Outside of this, the upsurge of mineralprospecting activity, the implementation ofnew mining and minerals processing projects,and the likelihood of further large mining-related projects in the medium term, haveshown dynamism in one sector of theeconomy that is not dependent upongovernment spending. Important ongoingprojects include the construction of the newDiamond Trading Company (DTC) facility andthe opening of several new diamond cuttingfactories in Gaborone, the construction ofthe Norilsk Nickel Activox refinery nearFrancistown, and the Diamonex diamondmine near Lerala, all of which are providingan important boost to economic activity intheir respective areas. Looking further ahead,agreement is close to being reached on theMmamabula coal/power project, and changesto the Mines & Minerals Act and the ElectricitySupply Act to accommodate the project havenow been passed.

Trade & Balance of Payments

Externally, the regional and internationaleconomic environments have been supportivefor much of the year, with buoyant globaleconomic growth as well as strong growthin the Southern African region. This hashelped Botswana’s trade performance. Totalexports for the first nine months of the yearwere up 37% (in pula terms) over the sameperiod in 2006. What is interesting is thesources of this growth. Although diamondsremain by far the largest export, at around65% of the total, the growth of diamondexports over this period was only 19%. Themore dynamic export sectors were meat (up86%), nickel (& copper) (up 118%) andtextiles (up 182%). These performancesreflected a variety of factors; the meat sector

Figure 1: Inflation

Source: BoB, CSO, Econsult

Real business creditElectricity cons. (non-mining)

Real govt.exp.

Introduction

Government is currently in the process ofpreparing National Development Plan 10(NDP 10), which will run from the 2009/10financial year until 2015/16. NDP10 will coveran important period in Botswana’s economicdevelopment, and will have to address issuesof high unemployment, slow economicdiversification, high levels of dependencyupon government, and budget sustainability.In this feature we address this latter issue, inparticular the fiscal issues that NDP 10 willneed to address to ensure smooth adjustmentto lower mineral revenues in future.

Revenue Prospects

In recent years the government budgetoutturn and trends have been mixed. A fewyears back the budget was in deficit, for thefirst time in many years, due to rapidly risingexpenditure and weak revenues, and therewere genuine concerns that budget trendswere unsustainable. As a result expenditurehad to be restrained, and a new Fiscal Rulewas introduced in the Mid-term Review ofNDP�9. The current budget position is morefavourable, due to improved revenues andreduced spending, and in the last twofinancial years (2005/06 and 2006/07) therehave been significant surpluses. However,reduced spending has been due more to aninability to spend available resources than toa budgeted reduction in spending, and shouldnot therefore be seen as a planned outcome.

While the immediate budget position isreasonably favourable, the position is muchless positive in the medium and long term.The Fiscal Rule introduced in the Mid-TermReview of NDP�9 specifies that governmentexpenditure should be set at 40% of GDP,

on the basis that this represents the averagelevel of government revenues expectedduring the remainder of NDP�9, leading toa balanced (and therefore sustainable)budget.

However, the long-term prospects are formuch lower levels of government revenuesas a proportion of GDP. Current and recentrevenues are high due to the exceptionallyhigh profitability of the diamond industryand the high rate at which those profits aretaxed. In the medium term, production andprofits at these mines will decline asproduction moves underground and costsrise. While some new diamond mines areexpected to open, these will be much smallerthan the existing mines, have a relativelyshort life, and are unlikely to be nearly asprofitable as the Debswana mines.Furthermore, as the economy diversifies –whether into other mining activities or intonon-mining activities – tax revenues willdecline in relation to the size of the economyas enterprises taxed at more “normal” ratesbecome more important. In the long term,the government’s tax and other revenueswill most likely decline to around the averagein sub-Saharan Africa of 25%-30% of GDP.This will require a major (downward)adjustment in the level of governmentspending, which will have to grow moreslowly than the economy as a whole.

The Need to Adjust

This point was made strongly in a recent IMFpublication, which considered the impactof declining diamond production and themove underground on the government. Theanticipated dramatic decline in diamondrevenues between 2021 and 2029 is shownin Figure 6. This shows that diamond revenueswill grow at a healthy rate over the nextdecade, after which time they will declinesharply as production goes underground,and in just over 20 years from now, by 2029,will fall to zero as known diamond reservesare depleted.

The implications of this are clear: (i) effortsto diversify the economy must be intensified,and (ii) the government budget must beplaced on a sustainable adjustment path toa much lower revenue level. The earlier thisadjustment begins, the less traumatic anddrastic it will be. But even a smoothadjustment requires considerable cuts, withbudgeted expenditure falling by up to 1%of GDP each year for the next 15 years.

However, the current starting point of theadjustment process is not as bad as it couldhave been, because government spending

Feature:FiscalSustainabilityIssues in NDP10

Economic Review6has recently been significantly belowbudgeted levels due to underspending andlack of implementation capacity. Althoughexpenditure has been budgeted at 40% ofGDP following the Fiscal Rule, actual spendingwas only around 31-32% of GDP in the2005/06 and 2006/07 fiscal years. But thelong term need for much lower spendingmeans that the emphasis now and duringNDP�10 should not be on ramping upgovernment spending to match revenues,but to make government expenditure moreefficient and focused on long-termsustainability.

Budgetary Principles for NDP�10

In the short-to-medium term this means theGovernment should be spending less than itis earning, and accumulating the balance –i.e., returning to the days of significant budgetsurpluses. This has two benefits. First, itfacilitates the smooth adjustment ofexpenditure levels to lower revenues in thelong term. Second, it means that government(and the nation) can accumulate significantsavings balances that can be used to financefuture expenditure and supplement othersources of revenue as mineral revenuesdecline. Essentially this means building upreserves (both government savings andnational foreign exchange reserves) that canbe used as a capital fund that will generatea permanent future income flow withoutconsuming the capital base of the fund. Thisinvolves treating current mineral revenues

primarily as a resource to build up a capitalasset that can provide long-term annuityincome. The basis for this is already in place,in the form of the Government InvestmentAccount (GIA) at the Bank of Botswana, andthe Pula Fund component of the foreignexchange reserves. However, the balance inthese accounts, especially the GIA, wouldneed to rise sharply if the resulting annuityincome is to be meaningful.

There will also need to be a change inbudgetary principles, with allocations frommineral revenues to long-term savings madeactively before spending decisions are made,rather than as a passive residual dependingon budget outcomes, as at present. It alsomeans that the Government’s accumulatedsavings (balances at BoB) and the nation’ssavings (the foreign exchange reserves) shouldbe viewed as a resource to facilitate andcushion the adjustment process rather thanas a resource to finance a higher level ofspending in the short term.

A second important fiscal issue to beaddressed in NDP10 relates to the balancebetween recurrent and developmentspending. The NDP�9 MTR specified a targetof 30% of total spending allocated todevelopment spending, in order to boost theoverall national investment rate. Lookingfurther ahead, this may not be appropriate.Many public sector investment projects arearguably yielding very low economic (andsocial) returns, especially those involving theprovision of very expensive physical

Figure 6: Projected Revenues from Diamonds

Figure 4: Petrol and Crude Oil Prices Figure 5: Inflation

Figure 2: Business Confidence Index(% of firms rating current business conditions satisfactory)

Survey DateAll Exporters Non-exporters

Source: BPC, BoB, Econsult Source: BoB

Source: CSO, Econsult

Source: Econsult , Dept. of Energy Affairs, US EIA Source: BoB, Econsult

Source: IMF, 2007

(i) For instance, in South Africa government revenues account for26% of GDP

(i) IMF (2007) Botswana: Selected Issues and Statistical Appendix.The projections are based on data from the Ministry of MineralResources and Water Affairs and Debswana.

infrastructure in increasingly remote ruralareas. At the same time, allocations torecurrent spending may be insufficient tomaintain existing infrastructure. Roads are acase in point: a combination of poormanagement and insufficient resourcesmeans that maintenance of the existinginfrastructure is inadequate, while resourcesare being devoted to building new roads inareas with very low traffic volumes. This isunlikely to represent rational allocation andmanagement of scarce resources. HenceNDP�10 needs to ensure greater efficiencyin the use of public financial resources,especially as the availability of such resourceswill decline in coming years.

Key initiatives could include: re-introducingeffective project appraisal techniques andreducing the number of politically drivendevelopment projects; introducing properproject management skills in the public sector,including parastatals; taking better accountof the recurrent expenditure implications andresource needs stemming from developmentprojects; improving productivity and efficiencyin the public sector workforce, if necessaryby downsizing, and terminating ineffective

activities; transferring activities to the privatesector and contracting out under perform-ance related management arrangements;and making better use of international bestpractice techniques in public sector resourceallocation and expenditure decisions in boththe recurrent and development budgets.

Figure 3: Export Growth, 2006–7 (Jan – Sep)f’cast

Bifm Economic Review

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Botswana beef in the EU, and would have ledto the ending of beef exports to Botswana’smost lucrative market, which would have beendisastrous for the Botswana Meat Commission(BMC), Botswana’s cattle farmers and the ruraleconomy.

Nevertheless, EPAs have been controversialin some quarters. One of the main concernshas been in respect of EU demands forprogressively liberalised access to developingcountry markets (in fact this is not specificallyan EU demand, but is a requirement if theEPAs are to be consistent with WTO rules).This is not relevant in Botswana’s case, asSouth Africa already has such an agreementwith the EU (the SA-EU Trade & DevelopmentCo-operation Agreement), which in practiceapplies to Botswana due to its membershipof SACU. Hence, in practical terms, the interimEPA involved no further concessions onBotswana’s part. A second concern relatesto the EU’s desire to include services and“new generation” trade issues (such asintellectual property and public procurement)in the EPAs; these issues are not included inthe interim EPA and will be addressed as fullEPAs are negotiated.

Inflation & Monetary Policy

For most of the year, inflation developmentswere positive; the inflation rate declinedsharply from 8.5% at the end of 2006, andby March was below 7% and hence withinthe Bank of Botswana’s inflation objectiverange. However, towards the end of the yearinflationary pressures started mounting, and

2 3Bifm Economic Review 4th Quarter 2007 4

By most accounts the economic conditionsin 2007 represented a s ignif icantimprovement on 2006. Inflation was down,exports grew strongly, government improvedits ability to spend its budget, and businessconfidence was up. Due to lack of data wedon’t really know what was happening toeconomic growth and employment, but it isfair to assume that both should haveperformed reasonably well. So far, Botswanahas been relatively immune from the impactof the turmoil in major financial markets andthe sub-pr ime crisis. Looking forwar d to2008, however, things may not be so rosy,

with developments in the inte rnationaleconomy – economic slowdown and risinginflation - impacting adversely on Botswana.

Review of 2007

Output & Business Confidence

No GDP data have been published since theend of 2006 and so we are in the usual NewYear “black hole” with regard to informationon overall economic growth; although theCSO has undertaken to produce and publishquarter ly GDP data promptly , thiscommitment has generally not been fulfilled.However , growth indicators suggest thatthere has been a strong recovery, with thegrowth of business credit, governmentspending and non-mining electricityconsumption all rising sharply during theyear (see Figure 1). Other indicators tell asimilar story: applications for business tradinglicences in the second half of 2007 rose by13.5%, while non-mineral exports were up121% in the first nine months of 2007, bothcompared to the same periods in 2006.

The improvement in business conditions isshown in the results of the Bank ofBotswana’s biannual Business ExpectationsSurvey. The latest results, for the second halfof 2007, show a continuation of the

improvement in conf idence that has beenevident over the past 18 months. Theimprovement is particularly striking for firmsfocused on the domestic economy, of which77% reported that current businessconditions were satisfactory, compared withonly 21% in September 2005. An even higherproportion (85%) expect business conditionsto improve through 2008. While the surveysurprisi ngly shows declining confidenceamongst exporters, this may mainly reflectthe small size of the exporter sample in thesurvey.

A number of factors lie behind this upturnin busin ess conditions and confid ence.Domestically, government spending has beenramped up, with expenditure in the first ninemonths of 2007 rising by 22% compared to2006. Most of this increase was indevelopment spending, which rose by 60%over the first nine months of 2006. This mayshow that government has managed toovercome some of the implementationconstraints that have held back developmentprojects in the past. While a high proportionof development spending flows out of thecountry (e.g. expenditure on constructionmaterials and HIV/AIDS drugs), it nonethelessstimulates the domestic economy through

benefitted from recovery from the Foot &

Mouth Disease outbreak in 2006, as well asdrought (encouraging cattle sales), and asupply response to higher prices. Nickel and

copper benefitted from higher worldcommodity prices, especially earlier in the

year. Textiles benefitted from strong demandgrowth in the region and internationally, andsuccess in utilising the opportunities offered

by international trade agreements such asthe US Africa Growth and Opportunity Act(AGOA). All exports benefitted from improved

international competitiveness under thecrawling peg exchange rate regime.

As a result of good export performance,combined with a slower rate of growth ofimports, the balance of payments continued

to run a healthy surplus, estimated at P10.2billion for the first nine months of 2007(compared to P10.3 bn for the whole of

2006). The foreign exchange reserves havecontinued to rise, reaching P58.5 billion (US$9.7bn) at the end of September, an estimated

32 months of import cover.

One important trade development that

occurred at the very end of 2008 was thesigning of an interim Economic PartnershipAgreement (EPA) between Botswana and the

European Union (as did Lesotho, Namibia,Swaziland and Mozambique). The interim EPAprovides for improved access for Botswana

beef to the EU, with reduced tariffs (zerocompared to 5% under the previous Cotonou

Agreement) and no quotas. Failing to sign theEPA would have led to much higher tariffs on

by December it was back up to 8.1%. Thiswas driven primarily by developments inglobal food and energy markets. By the endof 2007, international oil prices had risen byover 80% from their low point in earlyJanuary 2007, and there were also sharpincreases in food commodity prices, notablyfor fooodgrains (maize, wheat etc.) and dairyproducts, with The Economist foodcommodity price index up 37% over theyear. The impact of these developments wasfelt globally, and most countries experiencedrising inflation. Although Botswana’s relativeposition was not affected – by Novemberthe inflation differential between Botswanaand major trading partners had fallen to itslowest level for some time – the increase ininflation was nonetheless unwelcome.Fortunately, underlying inflation remainslower, with the trimmed mean core inflationmeasure falling to 7.4% in December.

On the monetary policy front, the Bank ofBotswana maintained its inflation objectiverange of 4%-7% for 2007, along with amedium term objective of 3%-6%. Onceinflation fell within the range, the Bank feltable to reduce interest rates by 0.5% inJune, leading to a reduction in the Bank Rateto 14.5%. This was maintained until the endof the year, despite concerns about risinginflation and domestic demand pressures.Of particular concern was the growth ofbank credit, which increased from 18.6%annually at the end of 2006 to 27.8% inNovember 2007, and remained outside ofthe BoB’s target range for credit growth of11-14% throughout the year.

The Botswana Stock Exchange (BSE)experienced a “year of two halves”, with acontinuation of 2006’s rapid growth in theDomestic Companies Index (DCI) throughto August, during which time the index roseby 60%. From August onwards, however,the situation was reversed, and by the endof the year the DCI had declined by 15%from its peak; over the year as a whole, theindex was up by 36%. The decline in theBSE DCI coincided with the decline in stockmarkets around the world, especially themajor developed markets. However, it does

not appear that the two were linked. By the

middle of 2008, valuations on the BSE had

reached unrealistically high levels; for instance,price/earnings (p/e) ratios for the commercial

bank shares that dominate the BSE wereover 30, and the domestic market as a whole

had a p/e ratio in the low 20s. Manycommentators argued that a correction was

overdue, regardless of internationaldevelopments, and this appears to have been

what has happened. With p/e ratios for thebanks at just over 20, and for the market as

a whole at 15.5 at the end of the year,valuations are now more realistic. The prices

of dual listed mining shares on the foreignboard of the BSE followed similar trends,

rising by 33% between January and Augustbut then falling by 13% through to

December, largely reflecting trends in

international metals prices.

The Outlook for 2008

The beginning of 2008 has been characterisedby unusually high levels of uncertainty in the

global economy. The sub-prime crisis in theUS has spread internationally, and although

it was initially hoped that this would be short-lived and contained, the impact has persisted.

Moving into the New Year, fears of recessionin the USA are intensifying, with many

commentators rating the chances of recessionat 50-50. Two scenarios can be envisaged.

If the US does not slip into recession, butsimply experiences a period of slower (or

zero) growth, global economic activity willtemporarily weaken and growth will fall

below trend. Nevertheless, the impact wouldbe short-lived and, supported by a likely

easing in monetary policy around the world,global growth would rebound in the second

half of the year. However, if the US does

slide into recession, with a period of negativeeconomic growth, job losses and a

contraction in real incomes, this is likely tohave a widespread impact on the world

economy. Global growth would slowsignificantly and the existing credit market

problems would intensify. In this scenario, aglobal slowdown could persist well beyond

the end of 2008.

What are the implications for Botswana? Asa highly trade-dependent economy, theimpact of changes in global economic activityare potentially far-reaching. The USA is thelargest market for Botswana’s exports, asthe major world consumer of diamonds andthe primary market for Botswana’s textileexports. Any slowdown in US growth,especially if led by a drop in consumerexpenditure, would negatively affectBotswana’s exports. However, if suchproblems are largely confined to the USAand are short-lived, then other sources ofeconomic growth (Europe and majordeveloping countries) will help to cushionthe impact. But if US recession leads to asharp slowdown in global economic activity,with the impact widely felt, then Botswana’sexport earnings could fall significantly. Thevalue of copper-nickel exports has alreadybeen adversely affected by falling metalsprices in the second half of 2007, and thiswould be intensified by a global recession.As a result, Botswana’s three major exports(diamonds, copper-nickel & textiles), arevulnerable to a US-led global slowdown. Thiswould be compounded be a weakeningdollar, the currency in which all three ofthose exports are priced, further reducingexport earnings.

The tightening of credit conditions andincrease in risk aversion in major financialmarkets, even if prolonged, should have nomajor influence on Botswana. As the countryis a net creditor, and the government doesnot borrow on international markets, therewill be little direct impact, although projectsrequiring major loan finance – such as theMmamabula Energy Project – might findraising such loans more difficult, or moreexpensive. Notwithstanding the tighteningof international liquidity, domestic financialmarkets should remain highly liquid.

Domestically, the main economic problem islikely to be inflation, with several nasty shocksdue in the first half of the year. Rising inflationmay in turn lead to higher interest rates. Asin 2007, there will be continued pressurefrom high food and oil prices, and domesticfuel prices are likely to be the main driver of

Botswana inflation in the coming months.Fuel prices are adjusted on a monthly basisto reflect the cost of crude oil on internationalmarkets as well as refining and transportationcosts. Domestic price changes thereforereflect international crude price changes,albeit with a lag and an element ofstabilisation. As Figure 4 shows, domesticpetrol prices generally reflect internationalcrude prices with a lag of around 4 months.As a result, the recent sharp increase ininternational oil prices from $70 to $100 abarrel towards the end of 2007 has not yetbeen reflected in domestic pump prices.While crude prices went up by 58% during2007, domestic pump prices only rose by20%, even with December’s substantial pricehike. Should crude prices remain at currentlevels, domestic fuel prices would have torise from the current level of P5.60 a litre(for petrol in Gaborone) to nearly P7 to fullyreflect this – a further increase of 20% ormore. Fuel has a weight of around 7% inthe new CPI basket, so this alone wouldnearly 1.5% directly to inflation, which wouldbe compounded by the impact on highertransport costs, public transport fares etc.

Other possible inflation shocks could comefrom domestic electricity prices and BotswanaHousing Corporation (BHC) rentals. The latterhave not been adjusted for four years, andBHC has been lobbying Government to approvea rental increase – although the magnitude ofany such increase should be small given thatprivate sector housing rentals have been largelystagnant over this period, and BHC rentals aresupposedly market-related. Perhaps a moreserious threat arises from increases in electricitytariffs. Electricity prices are rising steeply in

South Africa, the source of around 70% ofBotswana’s electricity. A new supply contractbetween South Africa’s Eskom and theBotswana Power Corporation (BPC) came intoeffect on 1 January 2008, and is much lessfavourable to Botswana than the previouscontract, both in terms of prices and stabilityof supply – the result of which is that Botswanais now much more exposed to both tariffincreases and supply disruptions from SouthAfrica than it had been previously. In addition,BPC needs to generate funds to contribute tothe financing of new domestic generatingcapacity. Substantial electricity price increasesare likely in 2008, and although electricity costsonly have a weight of 1.5% in the CPI basket,they feed through widely to other prices andwill push up inflation further.

The combination of these developmentsmeans that inflation will continue to rise fromthe December level of 8.1%, and could easilyreach double digits by mid-year if internationaloil and food prices remain high and thereare substantial increases in BHC and BPCtariffs. On the positive side, it is unlikely thatoil prices will rise much further from currentlevels – in the absence of higher levels ofgeopolitical instability in the Middle East –as a slowdown in global growth will putdownward pressure on oil prices. Hence it ispossible that the direct impact of oil priceson inflation will be short-lived, although theindirect impact via other costs could belonger-term.

Although the BoB maintained unchangedinterest rates at the last meeting of theMonetary Policy Committee in 2008, despiterising inflation and credit growth, this situation

is likely to change in 2008. Expect a muchmore hawkish tone in the Monetary PolicyStatement to be released in February, andincreases in interest rates in the first half ofthe year, even though with inflation beingprimarily driven from outside of Botswana,the potency of monetary policy is limited.

The changed electricity supply situation isnot just a price threat, but could hinderinvestment and growth as well. With thevirtual certainty that Botswana will increasinglyexperience interruptions in supplies fromSouth Africa over the next five years, andwith no new domestic supply capacity dueonline before 2011, the problem is serious,especially for the energy-intensive miningsector that is the bedrock of the economy.To date, little public information has beenprovided by BPC on these problems and howthey are going to be addressed, and a moreinformative approach by BPC and theGovernment would help the private sectorto plan appropriately.

Botswana’s financial markets should remainrelatively immune from the turmoil in globalfinancial markets in 2008. More reasonablevaluations on domestic stocks shouldencourage a resumption of buying activityand the DCI should bottom out in the firstquarter. In the bond markets, expectationsare high that Government will announce aprogramme of regular bond issues to coincidewith the maturity of the BW002 bond on 1st

March. This would help to boost liquidity inthe bond market and support the yield curve,which in turn provides a foundation for bondissues by the private and parastatal sectors.

Summary ofEconomicDevelopmentsDr Keith JefferisChairman ofBifm InvestmentCommittee

Economic Review5employment and expenditure on locallysupplied goods and services. One of theweaknesses of the Botswana economy is thatthe domestic private sector still remainsheavily dependent upon governmentspending – something that has to change inthe longer term – but it means that govern-ment can boost economic activity throughincreasing spending in the short term, whichseems to have been happening recently.

Outside of this, the upsurge of mineralprospecting activity, the implementation ofnew mining and minerals processing projects,and the likelihood of further large mining-related projects in the medium term, haveshown dynamism in one sector of theeconomy that is not dependent upongovernment spending. Important ongoingprojects include the construction of the newDiamond Trading Company (DTC) facility andthe opening of several new diamond cuttingfactories in Gaborone, the construction ofthe Norilsk Nickel Activox refinery nearFrancistown, and the Diamonex diamondmine near Lerala, all of which are providingan important boost to economic activity intheir respective areas. Looking further ahead,agreement is close to being reached on theMmamabula coal/power project, and changesto the Mines & Minerals Act and the ElectricitySupply Act to accommodate the project havenow been passed.

Trade & Balance of Payments

Externally, the regional and internationaleconomic environments have been supportivefor much of the year, with buoyant globaleconomic growth as well as strong growthin the Southern African region. This hashelped Botswana’s trade performance. Totalexports for the first nine months of the yearwere up 37% (in pula terms) over the sameperiod in 2006. What is interesting is thesources of this growth. Although diamondsremain by far the largest export, at around65% of the total, the growth of diamondexports over this period was only 19%. Themore dynamic export sectors were meat (up86%), nickel (& copper) (up 118%) andtextiles (up 182%). These performancesreflected a variety of factors; the meat sector

Figure 1: Inflation

Source: BoB, CSO, Econsult

Real business creditElectricity cons. (non-mining)

Real govt.exp.

Introduction

Government is currently in the process ofpreparing National Development Plan 10(NDP 10), which will run from the 2009/10financial year until 2015/16. NDP10 will coveran important period in Botswana’s economicdevelopment, and will have to address issuesof high unemployment, slow economicdiversification, high levels of dependencyupon government, and budget sustainability.In this feature we address this latter issue, inparticular the fiscal issues that NDP 10 willneed to address to ensure smooth adjustmentto lower mineral revenues in future.

Revenue Prospects

In recent years the government budgetoutturn and trends have been mixed. A fewyears back the budget was in deficit, for thefirst time in many years, due to rapidly risingexpenditure and weak revenues, and therewere genuine concerns that budget trendswere unsustainable. As a result expenditurehad to be restrained, and a new Fiscal Rulewas introduced in the Mid-term Review ofNDP�9. The current budget position is morefavourable, due to improved revenues andreduced spending, and in the last twofinancial years (2005/06 and 2006/07) therehave been significant surpluses. However,reduced spending has been due more to aninability to spend available resources than toa budgeted reduction in spending, and shouldnot therefore be seen as a planned outcome.

While the immediate budget position isreasonably favourable, the position is muchless positive in the medium and long term.The Fiscal Rule introduced in the Mid-TermReview of NDP�9 specifies that governmentexpenditure should be set at 40% of GDP,

on the basis that this represents the averagelevel of government revenues expectedduring the remainder of NDP�9, leading toa balanced (and therefore sustainable)budget.

However, the long-term prospects are formuch lower levels of government revenuesas a proportion of GDP. Current and recentrevenues are high due to the exceptionallyhigh profitability of the diamond industryand the high rate at which those profits aretaxed. In the medium term, production andprofits at these mines will decline asproduction moves underground and costsrise. While some new diamond mines areexpected to open, these will be much smallerthan the existing mines, have a relativelyshort life, and are unlikely to be nearly asprofitable as the Debswana mines.Furthermore, as the economy diversifies –whether into other mining activities or intonon-mining activities – tax revenues willdecline in relation to the size of the economyas enterprises taxed at more “normal” ratesbecome more important. In the long term,the government’s tax and other revenueswill most likely decline to around the averagein sub-Saharan Africa of 25%-30% of GDP.This will require a major (downward)adjustment in the level of governmentspending, which will have to grow moreslowly than the economy as a whole.

The Need to Adjust

This point was made strongly in a recent IMFpublication, which considered the impactof declining diamond production and themove underground on the government. Theanticipated dramatic decline in diamondrevenues between 2021 and 2029 is shownin Figure 6. This shows that diamond revenueswill grow at a healthy rate over the nextdecade, after which time they will declinesharply as production goes underground,and in just over 20 years from now, by 2029,will fall to zero as known diamond reservesare depleted.

The implications of this are clear: (i) effortsto diversify the economy must be intensified,and (ii) the government budget must beplaced on a sustainable adjustment path toa much lower revenue level. The earlier thisadjustment begins, the less traumatic anddrastic it will be. But even a smoothadjustment requires considerable cuts, withbudgeted expenditure falling by up to 1%of GDP each year for the next 15 years.

However, the current starting point of theadjustment process is not as bad as it couldhave been, because government spending

Feature:FiscalSustainabilityIssues in NDP10

Economic Review6has recently been significantly belowbudgeted levels due to underspending andlack of implementation capacity. Althoughexpenditure has been budgeted at 40% ofGDP following the Fiscal Rule, actual spendingwas only around 31-32% of GDP in the2005/06 and 2006/07 fiscal years. But thelong term need for much lower spendingmeans that the emphasis now and duringNDP�10 should not be on ramping upgovernment spending to match revenues,but to make government expenditure moreefficient and focused on long-termsustainability.

Budgetary Principles for NDP�10

In the short-to-medium term this means theGovernment should be spending less than itis earning, and accumulating the balance –i.e., returning to the days of significant budgetsurpluses. This has two benefits. First, itfacilitates the smooth adjustment ofexpenditure levels to lower revenues in thelong term. Second, it means that government(and the nation) can accumulate significantsavings balances that can be used to financefuture expenditure and supplement othersources of revenue as mineral revenuesdecline. Essentially this means building upreserves (both government savings andnational foreign exchange reserves) that canbe used as a capital fund that will generatea permanent future income flow withoutconsuming the capital base of the fund. Thisinvolves treating current mineral revenues

primarily as a resource to build up a capitalasset that can provide long-term annuityincome. The basis for this is already in place,in the form of the Government InvestmentAccount (GIA) at the Bank of Botswana, andthe Pula Fund component of the foreignexchange reserves. However, the balance inthese accounts, especially the GIA, wouldneed to rise sharply if the resulting annuityincome is to be meaningful.

There will also need to be a change inbudgetary principles, with allocations frommineral revenues to long-term savings madeactively before spending decisions are made,rather than as a passive residual dependingon budget outcomes, as at present. It alsomeans that the Government’s accumulatedsavings (balances at BoB) and the nation’ssavings (the foreign exchange reserves) shouldbe viewed as a resource to facilitate andcushion the adjustment process rather thanas a resource to finance a higher level ofspending in the short term.

A second important fiscal issue to beaddressed in NDP10 relates to the balancebetween recurrent and developmentspending. The NDP�9 MTR specified a targetof 30% of total spending allocated todevelopment spending, in order to boost theoverall national investment rate. Lookingfurther ahead, this may not be appropriate.Many public sector investment projects arearguably yielding very low economic (andsocial) returns, especially those involving theprovision of very expensive physical

Figure 6: Projected Revenues from Diamonds

Figure 4: Petrol and Crude Oil Prices Figure 5: Inflation

Figure 2: Business Confidence Index(% of firms rating current business conditions satisfactory)

Survey DateAll Exporters Non-exporters

Source: BPC, BoB, Econsult Source: BoB

Source: CSO, Econsult

200&

150%

100%

50%

0%

-50%

Source: Econsult , Dept. of Energy Affairs, US EIA Source: BoB, Econsult

Source: IMF, 2007

(i) For instance, in South Africa government revenues account for26% of GDP

(i) IMF (2007) Botswana: Selected Issues and Statistical Appendix.The projections are based on data from the Ministry of MineralResources and Water Affairs and Debswana.

infrastructure in increasingly remote ruralareas. At the same time, allocations torecurrent spending may be insufficient tomaintain existing infrastructure. Roads are a

case in point: a combination of poormanagement and insufficient resourcesmeans that maintenance of the existinginfrastructure is inadequate, while resourcesare being devoted to building new roads inareas with very low traffic volumes. This isunlikely to represent rational allocation andmanagement of scarce resources. HenceNDP�10 needs to ensure greater efficiencyin the use of public financial resources,especially as the availability of such resourceswill decline in coming years.

Key initiatives could include: re-introducingeffective project appraisal techniques andreducing the number of politically drivendevelopment projects; introducing properproject management skills in the public sector,including parastatals; taking better accountof the recurrent expenditure implications andresource needs stemming from developmentprojects; improving productivity and efficiencyin the public sector workforce, if necessaryby downsizing, and terminating ineffectiveactivities; transferring activities to the privatesector and contracting out under perform-ance related management arrangements;and making better use of international bestpractice techniques in public sector resourceallocation and expenditure decisions in boththe recurrent and development budgets.

Figure 3: Export Growth, 2006–7 (Jan – Sep)f’cast

Bifm Economic Review

QUARTERLY ECONOMIC REVIEW

Economic Review

Economic Review Economic Review Economic Review

Botswana beef in the EU, and would have ledto the ending of beef exports to Botswana’smost lucrative market, which would have beendisastrous for the Botswana Meat Commission(BMC), Botswana’s cattle farmers and the ruraleconomy.

Nevertheless, EPAs have been controversialin some quarters. One of the main concernshas been in respect of EU demands forprogressively liberalised access to developingcountry markets (in fact this is not specificallyan EU demand, but is a requirement if theEPAs are to be consistent with WTO rules).This is not relevant in Botswana’s case, asSouth Africa already has such an agreementwith the EU (the SA-EU Trade & DevelopmentCo-operation Agreement), which in practiceapplies to Botswana due to its membershipof SACU. Hence, in practical terms, the interimEPA involved no further concession s onBotswana’s part. A second concern relatesto the EU’s desire to include services and“new generation” trade issues (such asintellectual property and public procurement)in the EPAs; these issues are not included inthe interim EPA and will be addressed as fullEPAs are negotiated.

Inflation & Monetary Policy

For most of the year, inflation developmentswere positive; the inflation rate declinedsharply from 8.5% at the end of 2006, andby March was below 7% and hence withinthe Bank of Botswana’s inflation objectiverange. However, towards the end of the yearinflationary pressures started mounting, and

2 3Bifm Economic Review 4th Quarter 2007 4

By most accounts the economic conditionsin 2007 represented a s ignif icantimprovement on 2006. Inflation was down,exports grew strongly, government improvedits ability to spend its budget, and businessconfidence was up. Due to lack of data wedon’t really know what was happening toeconomic growth and employment, but it isfair to assume that both should haveperformed reasonably well. So far, Botswanahas been relatively immune from the impactof the turmoil in major financial markets andthe sub-pr ime crisis. Looking forwar d to2008, however, things may not be so rosy,

with developments in the inte rnationaleconomy – economic slowdown and risinginflation - impacting adversely on Botswana.

Review of 2007

Output & Business Confidence

No GDP data have been published since theend of 2006 and so we are in the usual NewYear “black hole” with regard to informationon overall economic growth; although theCSO has undertaken to produce and publishquarter ly GDP data promptly , thiscommitment has generally not been fulfilled.However , growth indicators suggest thatthere has been a strong recovery, with thegrowth of business credit, governmentspending and non-mining electricityconsumption all rising sharply during theyear (see Figure 1). Other indicators tell asimilar story: applications for business tradinglicences in the second half of 2007 rose by13.5%, while non-mineral exports were up121% in the first nine months of 2007, bothcompared to the same periods in 2006.

The improvement in business conditions isshown in the results of the Bank ofBotswana’s biannual Business ExpectationsSurvey. The latest results, for the second halfof 2007, show a continuation of the

improvement in conf idence that has beenevident over the past 18 months. Theimprovement is particularly striking for firmsfocused on the domestic economy, of which77% reported that current businessconditions were satisfactory, compared withonly 21% in September 2005. An even higherproportion (85%) expect business conditionsto improve through 2008. While the surveysurprisi ngly shows declining confidenceamongst exporters, this may mainly reflectthe small size of the exporter sample in thesurvey.

A number of factors lie behind this upturnin busin ess conditions and confid ence.Domestically, government spending has beenramped up, with expenditure in the first ninemonths of 2007 rising by 22% compared to2006. Most of this increase was indevelopment spending, which rose by 60%over the first nine months of 2006. This mayshow that government has managed toovercome some of the implementationconstraints that have held back developmentprojects in the past. While a high proportionof development spending flows out of thecountry (e.g. expenditure on constructionmaterials and HIV/AIDS drugs), it nonethelessstimulates the domestic economy through

benefitted from recovery from the Foot &

Mouth Disease outbreak in 2006, as well asdrought (encouraging cattle sales), and asupply response to higher prices. Nickel and

copper benefitted from higher worldcommodity prices, especially earlier in the

year. Textiles benefitted from strong demandgrowth in the region and internationally, andsuccess in utilising the opportunities offered

by international trade agreements such asthe US Africa Growth and Opportunity Act(AGOA). All exports benefitted from improved

inte rnational competit iveness under thecrawling peg exchange rate regime.

As a result of good export performance,combined with a s lower rate of growth ofimports, the balance of payments continued

to run a healthy surplus, estimated at P10.2billion for the first nine months of 2007(compared to P10.3 bn for the whole of

2006). The foreign exchange reserves havecontinued to rise, reaching P58.5 billion (US$9.7bn) at the end of September, an estimated

32 months of import cover.

One importa nt trade development that

occurred at the very end of 2008 was thesigning of an interim Economic PartnershipAgreement (EPA) between Botswana and the

European Union (as did Lesotho, Namibia,Swaziland and Mozambique). The interim EPAprovides for improved access for Botswana

beef to the EU, with reduced tariffs (zerocompared to 5% under the previous Cotonou

Agreement) and no quotas. Failing to sign theEPA would have led to much higher tariffs on

by December it was back up to 8.1%. Thiswas driven primarily by developments inglobal food and energy markets. By the endof 2007, international oil prices had risen byover 80% from their low point in earlyJanuary 2007, and there were also sharpincreases in food commodity prices, notablyfor fooodgrains (maize, wheat etc.) and dairyproducts, with The Economist foodcommodity price index up 37% over theyear. The impact of these developments wasfelt globally, and most countries experiencedrising inflation. Although Botswana’s relativeposition was not affected – by Novemberthe inflation differential between Botswanaand major trading partners had fallen to itslowest level for some time – the increase ininflation was nonetheless unwelcome.Fortunately, underlying inflation remainslower, with the trimmed mean core inflationmeasure falling to 7.4% in December.

On the monetary policy front, the Bank ofBotswana maintained its inflation objectiverange of 4%-7% for 2007, along with amedium term objective of 3%-6%. Onceinflation fell within the range, the Bank feltable to reduce interest rates by 0.5% inJune, leading to a reduction in the Bank Rateto 14.5%. This was maintained until the endof the year, despite concerns about risinginflation and domestic demand pressures.Of particular concern was the growth ofbank credit, which increased from 18.6%annually at the end of 2006 to 27.8% inNovember 2007, and remained outside ofthe BoB’s target range for credit growth of11-14% throughout the year.

The Botswana Stock Exchange (BSE)experienced a “year of two halves”, with acontinuation of 2006’s rapid growth in theDomestic Companies Index (DCI) throughto August, during which time the index roseby 60%. From August onwards, however,the situation was reversed, and by the endof the year the DCI had declined by 15%from its peak; over the year as a whole, theindex was up by 36%. The decline in theBSE DCI coincided with the decline in stockmarkets around the world, especially themajor developed markets. However, it does

not appear that the two were linked. By the

middle of 2008, valuations on the BSE had

reached unrealistically high levels; for instance,price/earnings (p/e) ratios for the commercial

bank shares that dominate the BSE wereover 30, and the domestic market as a whole

had a p/e ratio in the low 20s. Manycommentators argued that a correction was

overdue, regardless of internationaldevelopments, and this appears to have been

what has happened. With p/e ratios for thebanks at just over 20, and for the market as

a whole at 15.5 at the end of the year,valuations are now more realistic. The prices

of dual listed mining shares on the foreignboard of the BSE followed similar trends,

rising by 33% between January and Augustbut then falling by 13% through to

December, largely reflecting trends in

international metals prices.

The Outlook for 2008

The beginning of 2008 has been characterisedby unusually high levels of uncertainty in the

global economy. The sub-prime crisis in theUS has spread internationally, and although

it was initially hoped that this would be short-lived and contained, the impact has persisted.

Moving into the New Year, fears of recessionin the USA are intensifying, with many

commentators rating the chances of recessionat 50-50. Two scenarios can be envisaged.

If the US does not slip into recession, butsimply experiences a period of slower (or

zero) growth, global economic activity willtemporarily weaken and growth will fall

below trend. Nevertheless, the impact wouldbe short-lived and, supported by a likely

easing in monetary policy around the world,global growth would rebound in the second

half of the year. However, if the US does

slide into recession, with a period of negativeeconomic growth, job losses and a

contraction in real incomes, this is likely tohave a widespread impact on the world

economy. Global growth would slowsignificantly and the existing credit market

problems would intensify. In this scenario, aglobal slowdown could persist well beyond

the end of 2008.

What are the implications for Botswana? Asa highly trade-dependent economy, theimpact of changes in global economic activityare potentially far-reaching. The USA is thelargest market for Botswana’s exports, asthe major world consumer of diamonds andthe primary market for Botswana’s textileexports. Any slowdown in US growth,especially if led by a drop in consumerexpenditure, would negatively affectBotswana’s exports. However, if suchproblems are largely confined to the USAand are short-lived, then other sources ofeconomic growth (Europe and majordeveloping countries) will help to cushionthe impact. But if US recession leads to asharp slowdown in global economic activity,with the impact widely felt, then Botswana’sexport earnings could fall significantly. Thevalue of copper-nickel exports has alreadybeen adversely affected by falling metalsprices in the second half of 2007, and thiswould be intensified by a global recession.As a result, Botswana’s three major exports(diamonds, copper-nickel & textiles), arevulnerable to a US-led global slowdown. Thiswould be compounded be a weakeningdollar, the currency in which all three ofthose exports are priced, further reducingexport earnings.

The tightening of credit conditions andincrease in risk aversion in major financialmarkets, even if prolonged, should have nomajor influence on Botswana. As the countryis a net creditor, and the government doesnot borrow on international markets, therewill be little direct impact, although projectsrequiring major loan finance – such as theMmamabula Energy Project – might findraising such loans more difficult, or moreexpensive. Notwithstanding the tighteningof international liquidity, domestic financialmarkets should remain highly liquid.

Domestically, the main economic problem islikely to be inflation, with several nasty shocksdue in the first half of the year. Rising inflationmay in turn lead to higher interest rates. Asin 2007, there will be continued pressurefrom high food and oil prices, and domesticfuel prices are likely to be the main driver of

Botswana inflation in the coming months.Fuel prices are adjusted on a monthly basisto reflect the cost of crude oil on internationalmarkets as well as refining and transportationcosts. Domestic price changes thereforereflect international crude price changes,albeit with a lag and an element ofstabilisation. As Figure 4 shows, domesticpetrol prices generally reflect internationalcrude prices with a lag of around 4 months.As a result, the recent sharp increase ininternational oil prices from $70 to $100 abarrel towards the end of 2007 has not yetbeen reflected in domestic pump prices.While crude prices went up by 58% during2007, domestic pump prices only rose by20%, even with December’s substantial pricehike. Should crude prices remain at currentlevels, domestic fuel prices would have torise from the current level of P5.60 a litre(for petrol in Gaborone) to nearly P7 to fullyreflect this – a further increase of 20% ormore. Fuel has a weight of around 7% inthe new CPI basket, so this alone wouldnearly 1.5% directly to inflation, which wouldbe compounded by the impact on highertransport costs, public transport fares etc.

Other possible inflation shocks could comefrom domestic electricity prices and BotswanaHousing Corporation (BHC) rentals. The latterhave not been adjusted for four years, andBHC has been lobbying Government to approvea rental increase – although the magnitude ofany such increase should be small given thatprivate sector housing rentals have been largelystagnant over this period, and BHC rentals aresupposedly market-related. Perhaps a moreserious threat arises from increases in electricitytariffs. Electricity prices are rising steeply in

South Africa, the source of around 70% ofBotswana’s electricity. A new supply contractbetween South Africa’s Eskom and theBotswana Power Corporation (BPC) came intoeffect on 1 January 2008, and is much lessfavourable to Botswana than the previouscontract, both in terms of prices and stabilityof supply – the result of which is that Botswanais now much more exposed to both tariffincreases and supply disruptions from SouthAfrica than it had been previously. In addition,BPC needs to generate funds to contribute tothe financing of new domestic generatingcapacity. Substantial electricity price increasesare likely in 2008, and although electricity costsonly have a weight of 1.5% in the CPI basket,they feed through widely to other prices andwill push up inflation further.

The combination of these developmentsmeans that inflation will continue to rise fromthe December level of 8.1%, and could easilyreach double digits by mid-year if internationaloil and food prices remain high and thereare substantial increases in BHC and BPCtariffs. On the positive side, it is unlikely thatoil prices will rise much further from currentlevels – in the absence of higher levels ofgeopolitical instability in the Middle East –as a slowdown in global growth will putdownward pressure on oil prices. Hence it ispossible that the direct impact of oil priceson inflation will be short-lived, although theindirect impact via other costs could belonger-term.

Although the BoB maintained unchangedinterest rates at the last meeting of theMonetary Policy Committee in 2008, despiterising inflation and credit growth, this situation

is likely to change in 2008. Expect a muchmore hawkish tone in the Monetary PolicyStatement to be released in February, andincreases in interest rates in the first half ofthe year, even though with inflation beingprimarily driven from outside of Botswana,the potency of monetary policy is limited.

The changed electricity supply situation isnot just a price threat, but could hinderinvestment and growth as well. With thevirtual certainty that Botswana will increasinglyexperience interruptions in supplies fromSouth Africa over the next five years, andwith no new domestic supply capacity dueonline before 2011, the problem is serious,especially for the energy-intensive miningsector that is the bedrock of the economy.To date, little public information has beenprovided by BPC on these problems and howthey are going to be addressed, and a moreinformative approach by BPC and theGovernment would help the private sectorto plan appropriately.

Botswana’s financial markets should remainrelatively immune from the turmoil in globalfinancial markets in 2008. More reasonablevaluations on domestic stocks shouldencourage a resumption of buying activityand the DCI should bottom out in the firstquarter. In the bond markets, expectationsare high that Government will announce aprogramme of regular bond issues to coincidewith the maturity of the BW002 bond on 1st

March. This would help to boost liquidity inthe bond market and support the yield curve,which in turn provides a foundation for bondissues by the private and parastatal sectors.

Summary ofEconomicDevelopmentsDr Keith JefferisChairman ofBifm InvestmentCommittee

Economic Review5employ ment and expenditure on locallysupplied goods and services. One of theweaknesses of the Botswana economy is thatthe domest ic private sector still remain sheavily dependent upon governmentspending – something that has to change inthe longer term – but it means that govern-ment can boost economic activity throughincreasing spending in the short term, whichseems to have been happening recently.

Outside of this, the upsurge of mineralprospecting activity, the implementation ofnew mining and minerals processing projects,and the likelihood of further large mining-related projects in the medium term, haveshown dynamism in one sector of theeconomy that is not dependent upongovernment spending. Important ongoingprojects include the construction of the newDiamond Trading Company (DTC) facility andthe opening of several new diamond cuttingfactories in Gaborone, the cons truction ofthe Norilsk Nickel Activox refin ery nearFrancistown, and the Diamonex diamondmine near Lerala, all of which are providingan important boost to economic activity intheir respective areas. Looking further ahead,agreement is close to being reached on theMmamabula coal/power project, and changesto the Mines & Minerals Act and the ElectricitySupply Act to accommodate the project havenow been passed.

Trade & Balance of Payments

Externally, the regional and internationaleconomic environments have been supportivefor much of the year, with buoyant globaleconomic growth as well as strong growthin the Southern African region . This hashelped Botswana’s trade performance. Totalexports for the first nine months of the yearwere up 37% (in pula terms) over the sameperiod in 2006. What is interesting is thesources of this growth. Although diamondsremain by far the largest export, at around65% of the total, the growth of diamondexports over this period was only 19%. Themore dynamic export sectors were meat (up86%), nickel (& copper) (up 118%) andtextiles (up 182%). These performan cesreflected a variety of factors; the meat sector

Figure 1: Inflation

Source: BoB, CSO, Econsult

Real business creditElectricity cons. (non-mining)

Real govt.exp.

Introduction

Government is currently in the process ofpreparing National Development Plan 10(NDP 10), which will run from the 2009/10financial year until 2015/16. NDP10 will coveran important period in Botswana’s economicdevelopment, and will have to address issuesof high unemployment, slow economicdiversification, high levels of dependencyupon government, and budget sustainability.In this feature we address this latter issue, inparticular the fiscal issues that NDP 10 willneed to address to ensure smooth adjustmentto lower mineral revenues in future.

Revenue Prospects

In recent years the government budgetoutturn and trends have been mixed. A fewyears back the budget was in deficit, for thefirst time in many years, due to rapidly risingexpenditure and weak revenues, and therewere genuine concerns that budget trendswere unsustainable. As a result expenditurehad to be restrained, and a new Fiscal Rulewas introduced in the Mid-term Review ofNDP�9. The current budget position is morefavourable, due to improved revenues andreduced spending, and in the last twofinancial years (2005/06 and 2006/07) therehave been significant surpluses. However,reduced spending has been due more to aninability to spend available resources than toa budgeted reduction in spending, and shouldnot therefore be seen as a planned outcome.

While the immediate budget position isreasonably favourable, the position is muchless positive in the medium and long term.The Fiscal Rule introduced in the Mid-TermReview of NDP�9 specifies that governmentexpenditure should be set at 40% of GDP,

on the basis that this represents the averagelevel of government revenues expectedduring the remainder of NDP�9, leading toa balanced (and therefore sustainable)budget.

However, the long-term prospects are formuch lower levels of government revenuesas a proportion of GDP. Current and recentrevenues are high due to the exceptionallyhigh profitability of the diamond industryand the high rate at which those profits aretaxed. In the medium term, production andprofits at these mines will decline asproduction moves underground and costsrise. While some new diamond mines areexpected to open, these will be much smallerthan the existing mines, have a relativelyshort life, and are unlikely to be nearly asprofitable as the Debswana mines.Furthermore, as the economy diversifies –whether into other mining activities or intonon-mining activities – tax revenues willdecline in relation to the size of the economyas enterprises taxed at more “normal” ratesbecome more important. In the long term,the government’s tax and other revenueswill most likely decline to around the averagein sub-Saharan Africa of 25%-30% of GDP.This will require a major (downward)adjustment in the level of governmentspending, which will have to grow moreslowly than the economy as a whole.

The Need to Adjust

This point was made strongly in a recent IMFpublication, which considered the impactof declining diamond production and themove underground on the government. Theanticipated dramatic decline in diamondrevenues between 2021 and 2029 is shownin Figure 6. This shows that diamond revenueswill grow at a healthy rate over the nextdecade, after which time they will declinesharply as production goes underground,and in just over 20 years from now, by 2029,will fall to zero as known diamond reservesare depleted.

The implications of this are clear: (i) effortsto diversify the economy must be intensified,and (ii) the government budget must beplaced on a sustainable adjustment path toa much lower revenue level. The earlier thisadjustment begins, the less traumatic anddrastic it will be. But even a smoothadjustment requires considerable cuts, withbudgeted expenditure falling by up to 1%of GDP each year for the next 15 years.

However, the current starting point of theadjustment process is not as bad as it couldhave been, because government spending

Feature:FiscalSustainabilityIssues in NDP10

Economic Review6has recently been significantly belowbudgeted levels due to underspending andlack of implementation capacity. Althoughexpenditure has been budgeted at 40% ofGDP following the Fiscal Rule, actual spendingwas only around 31-32% of GDP in the2005/06 and 2006/07 fiscal years. But thelong term need for much lower spendingmeans that the emphasis now and duringNDP�10 should not be on ramping upgovernment spending to match revenues,but to make government expenditure moreefficient and focused on long-termsustainability.

Budgetary Principles for NDP�10

In the short-to-medium term this means theGovernment should be spending less than itis earning, and accumulating the balance –i.e., returning to the days of significant budgetsurpluses. This has two benefits. First, itfacilitates the smooth adjustment ofexpenditure levels to lower revenues in thelong term. Second, it means that government(and the nation) can accumulate significantsavings balances that can be used to financefuture expenditure and supplement othersources of revenue as mineral revenuesdecline. Essentially this means building upreserves (both government savings andnational foreign exchange reserves) that canbe used as a capital fund that will generatea permanent future income flow withoutconsuming the capital base of the fund. Thisinvolves treating current mineral revenues

primarily as a resource to build up a capitalasset that can provide long-term annuityincome. The basis for this is already in place,in the form of the Government InvestmentAccount (GIA) at the Bank of Botswana, andthe Pula Fund component of the foreignexchange reserves. However, the balance inthese accounts, especially the GIA, wouldneed to rise sharply if the resulting annuityincome is to be meaningful.

There will also need to be a change inbudgetary principles, with allocations frommineral revenues to long-term savings madeactively before spending decisions are made,rather than as a passive residual dependingon budget outcomes, as at present. It alsomeans that the Government’s accumulatedsavings (balances at BoB) and the nation’ssavings (the foreign exchange reserves) shouldbe viewed as a resource to facilitate andcushion the adjustment process rather thanas a resource to finance a higher level ofspending in the short term.

A second important fiscal issue to beaddressed in NDP10 relates to the balancebetween recurrent and developmentspending. The NDP�9 MTR specified a targetof 30% of total spending allocated todevelopment spending, in order to boost theoverall national investment rate. Lookingfurther ahead, this may not be appropriate.Many public sector investment projects arearguably yielding very low economic (andsocial) returns, especially those involving theprovision of very expensive physical

Figure 6: Projected Revenues from Diamonds

Figure 4: Petrol and Crude Oil Prices Figure 5: Inflation

Figure 2: Business Confidence Index(% of firms rating current business conditions satisfactory)

Survey DateAll Exporters Non-exporters

Source: BPC, BoB, Econsult Source: BoB

Source: CSO, Econsult

Source: Econsult , Dept. of Energy Affairs, US EIA Source: BoB, Econsult

Source: IMF, 2007

(i) For instance, in South Africa government revenues account for26% of GDP

(i) IMF (2007) Botswana: Selected Issues and Statistical Appendix.The projections are based on data from the Ministry of MineralResources and Water Affairs and Debswana.

infrastructure in increasingly remote ruralareas. At the same time, allocations torecurrent spending may be insufficient tomaintain existing infrastructure. Roads are a

case in point: a combination of poormanagement and insufficient resourcesmeans that maintenance of the existinginfrastructure is inadequate, while resourcesare being devoted to building new roads inareas with very low traffic volumes. This isunlikely to represent rational allocation andmanagement of scarce resources. HenceNDP�10 needs to ensure greater efficiencyin the use of public financial resources,especially as the availability of such resourceswill decline in coming years.

Key initiatives could include: re-introducingeffective project appraisal techniques andreducing the number of politically drivendevelopment projects; introducing properproject management skills in the public sector,including parastatals; taking better accountof the recurrent expenditure implications andresource needs stemming from developmentprojects; improving productivity and efficiencyin the public sector workforce, if necessaryby downsizing, and terminating ineffectiveactivities; transferring activities to the privatesector and contracting out under perform-ance related management arrangements;and making better use of international bestpractice techniques in public sector resourceallocation and expenditure decisions in boththe recurrent and development budgets.

Figure 3: Export Growth, 2006–7 (Jan – Sep)f’cast

Bifm Economic Review

QUARTERLY ECONOMIC REVIEW

Economic Review

Economic Review Economic Review Economic Review

Botswana beef in the EU, and would have ledto the ending of beef exports to Botswana’smost lucrative market, which would have beendisastrous for the Botswana Meat Commission(BMC), Botswana’s cattle farmers and the ruraleconomy.

Nevertheless, EPAs have been controversialin some quarters. One of the main concernshas been in respect of EU demands forprogressively liberalised access to developingcountry markets (in fact this is not specificallyan EU demand, but is a requirement if theEPAs are to be consistent with WTO rules).This is not relevant in Botswana’s case, asSouth Africa already has such an agreementwith the EU (the SA-EU Trade & DevelopmentCo-operation Agreement), which in practiceapplies to Botswana due to its membershipof SACU. Hence, in practical terms, the interimEPA involved no further concession s onBotswana’s part. A second concern relatesto the EU’s desire to include services and“new generation” trade issues (such asintellectual property and public procurement)in the EPAs; these issues are not included inthe interim EPA and will be addressed as fullEPAs are negotiated.

Inflation & Monetary Policy

For most of the year, inflation developmentswere positive; the inflation rate declinedsharply from 8.5% at the end of 2006, andby March was below 7% and hence withinthe Bank of Botswana’s inflation objectiverange. However, towards the end of the yearinflationary pressures started mounting, and

2 3Bifm Economic Review 4th Quarter 2007 4

By most accounts the economic conditionsin 2007 represented a s ignif icantimprovement on 2006. Inflation was down,exports grew strongly, government improvedits ability to spend its budget, and businessconfidence was up. Due to lack of data wedon’t really know what was happening toeconomic growth and employment, but it isfair to assume that both should haveperformed reasonably well. So far, Botswanahas been relatively immune from the impactof the turmoil in major financial markets andthe sub-pr ime crisis. Looking forwar d to2008, however, things may not be so rosy,

with developments in the inte rnationaleconomy – economic slowdown and risinginflation - impacting adversely on Botswana.

Review of 2007

Output & Business Confidence

No GDP data have been published since theend of 2006 and so we are in the usual NewYear “black hole” with regard to informationon overall economic growth; although theCSO has undertaken to produce and publishquarter ly GDP data promptly , thiscommitment has generally not been fulfilled.However , growth indicators suggest thatthere has been a strong recovery, with thegrowth of business credit, governmentspending and non-mining electricityconsumption all rising sharply during theyear (see Figure 1). Other indicators tell asimilar story: applications for business tradinglicences in the second half of 2007 rose by13.5%, while non-mineral exports were up121% in the first nine months of 2007, bothcompared to the same periods in 2006.

The improvement in business conditions isshown in the results of the Bank ofBotswana’s biannual Business ExpectationsSurvey. The latest results, for the second halfof 2007, show a continuation of the

improvement in conf idence that has beenevident over the past 18 months. Theimprovement is particularly striking for firmsfocused on the domestic economy, of which77% reported that current businessconditions were satisfactory, compared withonly 21% in September 2005. An even higherproportion (85%) expect business conditionsto improve through 2008. While the surveysurprisi ngly shows declining confidenceamongst exporters, this may mainly reflectthe small size of the exporter sample in thesurvey.

A number of factors lie behind this upturnin busin ess conditions and confid ence.Domestically, government spending has beenramped up, with expenditure in the first ninemonths of 2007 rising by 22% compared to2006. Most of this increase was indevelopment spending, which rose by 60%over the first nine months of 2006. This mayshow that government has managed toovercome some of the implementationconstraints that have held back developmentprojects in the past. While a high proportionof development spending flows out of thecountry (e.g. expenditure on constructionmaterials and HIV/AIDS drugs), it nonethelessstimulates the domestic economy through

benefitted from recovery from the Foot &

Mouth Disease outbreak in 2006, as well asdrought (encouraging cattle sales), and asupply response to higher prices. Nickel and

copper benefitted from higher worldcommodity prices, especially earlier in the

year. Textiles benefitted from strong demandgrowth in the region and internationally, andsuccess in utilising the opportunities offered

by international trade agreements such asthe US Africa Growth and Opportunity Act(AGOA). All exports benefitted from improved

inte rnational competit iveness under thecrawling peg exchange rate regime.

As a result of good export performance,combined with a s lower rate of growth ofimports, the balance of payments continued

to run a healthy surplus, estimated at P10.2billion for the first nine months of 2007(compared to P10.3 bn for the whole of

2006). The foreign exchange reserves havecontinued to rise, reaching P58.5 billion (US$9.7bn) at the end of September, an estimated

32 months of import cover.

One importa nt trade development that

occurred at the very end of 2008 was thesigning of an interim Economic PartnershipAgreement (EPA) between Botswana and the

European Union (as did Lesotho, Namibia,Swaziland and Mozambique). The interim EPAprovides for improved access for Botswana

beef to the EU, with reduced tariffs (zerocompared to 5% under the previous Cotonou

Agreement) and no quotas. Failing to sign theEPA would have led to much higher tariffs on

by December it was back up to 8.1%. Thiswas driven primarily by development s inglobal food and energy markets. By the endof 2007, international oil prices had risen byover 80% from their low point in earlyJanuary 2007, and there were also sharpincreases in food commodity prices, notablyfor fooodgrains (maize, wheat etc.) and dairyproducts, with The Economist foodcommodity price index up 37% over theyear. The impact of these developments wasfelt globally, and most countries experiencedrising inflation. Although Botswana’s relativeposition was not affected – by Novemberthe inflation differential between Botswanaand major trading partners had fallen to itslowest level for some time – the increase ininfla tion was nonetheless unwelcome.Fortunately, underl ying inflation remainslower, with the trimmed mean core inflationmeasure falling to 7.4% in December.

On the monetary policy front, the Bank ofBotswana maintained its inflation objectiverange of 4%-7% for 2007, along with amedium term objective of 3%-6%. Onceinflation fell within the range, the Bank feltable to reduce interest rates by 0.5% inJune, leading to a reduction in the Bank Rateto 14.5%. This was maintained until the endof the year, despite concerns about risinginflation and domestic demand pressures.Of particular concern was the growth ofbank credit, which increased from 18.6%annually at the end of 2006 to 27.8% inNovember 2007, and remained outside ofthe BoB’s target range for credit growth of11-14% throughout the year.

The Botswana Stock Exchange (BSE)experienced a “year of two halves”, with acontinuation of 2006’s rapid growth in theDomestic Companies Index (DCI) throughto August, during which time the index roseby 60%. From August onwards, however,the situation was reversed, and by the endof the year the DCI had declined by 15%from its peak; over the year as a whole, theindex was up by 36%. The decline in theBSE DCI coincided with the decline in stockmarkets around the world, especially themajor developed markets. However, it does

not appear that the two were linked. By the

middle of 2008, valuations on the BSE had

reached unrealistically high levels; for instance,price/earnings (p/e) ratios for the commercial

bank shares that dominate the BSE wereover 30, and the domestic market as a whole

had a p/e ratio in the low 20s. Manycommentators argued that a correction was

overdue, regardless of internationaldevelopments, and this appears to have been

what has happened. With p/e ratios for thebanks at just over 20, and for the market as

a whole at 15.5 at the end of the year,valuations are now more realistic. The prices

of dual listed mining shares on the foreignboard of the BSE followed similar trends,

rising by 33% between January and Augustbut then falling by 13% through to

December, largely refle cting trends in

international metals prices.

The Outlook for 2008

The beginning of 2008 has been characterisedby unusually high levels of uncertainty in the

global economy. The sub-prime crisis in theUS has spread internationally, and although

it was initially hoped that this would be short-lived and contained, the impact has persisted.

Moving into the New Year, fears of recessionin the USA are inte nsifyin g, with many

commentators rating the chances of recessionat 50-50. Two scenarios can be envisaged.

If the US does not slip into recession, butsimply experiences a period of slower (or

zero) growth, global economic activity willtemporar ily weaken and growth will fall

below trend. Nevertheless, the impact wouldbe short-lived and, supported by a likely

easing in monetary policy around the world,global growth would rebound in the second

half of the year. However, if the US does

slide into recession, with a period of negativeeconomic growth, job losses and a

contraction in real incomes, this is likely tohave a widespread impact on the world

economy. Global growth would slowsignificantly and the existing credit market

problems would intensify. In this scenario, aglobal slowdown could persist well beyond

the end of 2008.

What are the implications for Botswana? Asa highly trade-dependent economy, theimpact of changes in global economic activityare potentially far-reaching. The USA is thelargest market for Botswana’s exports, asthe major world consumer of diamonds andthe primary market for Botswana’s textileexports. Any slowdown in US growth,especially if led by a drop in consumerexpenditure, would negatively affectBotswana’s exports. However, if suchproblems are largely confined to the USAand are short-lived, then other sources ofeconomic growth (Europe and majordeveloping countries) wi ll help to cushionthe impact. But if US recession leads to asharp slowdown in global economic activity,with the impact widely felt, then Botswana’sexport earnings could fall significantly. Thevalue of copper-nickel exports has alreadybeen adversely affected by falling metalsprices in the second half of 2007, and thiswould be intensified by a global recession.As a result, Botswana’s three major exports(diamonds, copper-nickel & textiles), arevulnerable to a US-led global slowdown. Thiswould be compounded be a weakeningdollar, the currency in which all three ofthose exports are priced, further reducingexport earnings.

The tighten ing of credit condition s andincrease in risk aversion in major f inancialmarkets, even if prolonged, should have nomajor influence on Botswana. As the countryis a net creditor, and the government doesnot borrow on international markets, therewill be little direct impact, although projectsrequiring major loan finance – such as theMmamabula Energy Project – might findraising such loans more difficult, or moreexpensive. Notwithstanding the tighteningof international liquidity, domestic financialmarkets should remain highly liquid.

Domestically, the main economic problem islikely to be inflation, with several nasty shocksdue in the first half of the year. Rising inflationmay in turn lead to higher interest rates. Asin 2007, there will be continued pressurefrom high food and oil prices, and domesticfuel prices are likely to be the main driver of

Botswana inflation in the coming months.Fuel prices are adjusted on a monthly basisto reflect the cost of crude oil on internationalmarkets as well as refining and transportationcosts. Domestic price changes thereforereflect international crude price changes,albeit with a lag and an element ofstabilisation. As Figure 4 shows, domesticpetrol prices generally reflect internationalcrude prices with a lag of around 4 months.As a result, the recent sharp increase ininternational oil prices from $70 to $100 abarrel towards the end of 2007 has not yetbeen reflected in domestic pump prices.While crude prices went up by 58% during2007, domestic pump prices only rose by20%, even with December’s substantial pricehike. Should crude prices remain at currentlevels, domestic fuel prices would have torise from the current level of P5.60 a litre(for petrol in Gaborone) to nearly P7 to fullyreflect this – a further increase of 20% ormore. Fuel has a weight of around 7% inthe new CPI basket, so this alone wouldnearly 1.5% directly to inflation, which wouldbe compounded by the impact on highertransport costs, public transport fares etc.

Other possible inflation shocks could comefrom domestic electricity prices and BotswanaHousing Corporation (BHC) rentals. The latterhave not been adjusted for four years, andBHC has been lobbying Government to approvea rental increase – although the magnitude ofany such increase should be small given thatprivate sector housing rentals have been largelystagnant over this period, and BHC rentals aresupposedly market-related. Perhaps a moreserious threat arises from increases in electricitytariffs. Electricity prices are rising steeply in

South Africa, the source of around 70% ofBotswana’s electricity. A new supply contractbetween South Africa’s Eskom and theBotswana Power Corporation (BPC) came intoeffect on 1 January 2008, and is much lessfavourable to Botswana than the previouscontract, both in terms of prices and stabilityof supply – the result of which is that Botswanais now much more exposed to both tariffincreases and supply disruptions from SouthAfrica than it had been previously. In addition,BPC needs to generate funds to contribute tothe financing of new domestic generatingcapacity. Substantial electricity price increasesare likely in 2008, and although electricity costsonly have a weight of 1.5% in the CPI basket,they feed through widely to other prices andwill push up inflation further.

The combination of these developmentsmeans that inflation will continue to rise fromthe December level of 8.1%, and could easilyreach double digits by mid-year if internationaloil and food prices remain high and thereare substantial increases in BHC and BPCtariffs. On the positive side, it is unlikely thatoil prices will rise much further from currentlevels – in the absence of higher levels ofgeopolitical instability in the Middle East –as a slowdown in global growth will putdownward pressure on oil prices. Hence it ispossible that the direct impact of oil priceson inflation will be short-lived, although theindirect impact via other costs could belonger-term.

Although the BoB maintained unchangedinterest rates at the last meeting of theMonetary Policy Committee in 2008, despiterising inflation and credit growth, this situation

is likely to change in 2008. Expect a muchmore hawkish tone in the Monetary PolicyStatement to be released in February, andincreases in interest rates in the first half ofthe year, even though with inflation beingprimarily driven from outside of Botswana,the potency of monetary policy is limited.

The changed electricity supply situation isnot just a price threat, but could hinderinvestment and growth as well. With thevirtual certainty that Botswana will increasinglyexperience interruptions in supplies fromSouth Africa over the next five years, andwith no new domestic supply capacity dueonline before 2011, the problem is serious,especially for the energy-intensive miningsector that is the bedrock of the economy.To date, little public information has beenprovided by BPC on these problems and howthey are going to be addressed, and a moreinformative approach by BPC and theGovernment would help the private sectorto plan appropriately.

Botswana’s financial markets should remainrelatively immune from the turmoil in globalfinancial markets in 2008. More reasonablevaluations on domestic stocks shouldencourage a resumption of buying activityand the DCI should bottom out in the firstquarter. In the bond markets, expectationsare high that Government will announce aprogramme of regular bond issues to coincidewith the maturity of the BW002 bond on 1st

March. This would help to boost liquidity inthe bond market and support the yield curve,which in turn provides a foundation for bondissues by the private and parastatal sectors.

Summary ofEconomicDevelopmentsDr Keith JefferisChairman ofBifm InvestmentCommittee

Economic Review5employ ment and expenditure on locallysupplied goods and services. One of theweaknesses of the Botswana economy is thatthe domest ic private sector still remain sheavily dependent upon governmentspending – something that has to change inthe longer term – but it means that govern-ment can boost economic activity throughincreasing spending in the short term, whichseems to have been happening recently.

Outside of this, the upsurge of mineralprospecting activity, the implementation ofnew mining and minerals processing projects,and the likelihood of further large mining-related projects in the medium term, haveshown dynamism in one sector of theeconomy that is not dependent upongovernment spending. Important ongoingprojects include the construction of the newDiamond Trading Company (DTC) facility andthe opening of several new diamond cuttingfactories in Gaborone, the cons truction ofthe Norilsk Nickel Activox refin ery nearFrancistown, and the Diamonex diamondmine near Lerala, all of which are providingan important boost to economic activity intheir respective areas. Looking further ahead,agreement is close to being reached on theMmamabula coal/power project, and changesto the Mines & Minerals Act and the ElectricitySupply Act to accommodate the project havenow been passed.

Trade & Balance of Payments

Externally, the regional and internationaleconomic environments have been supportivefor much of the year, with buoyant globaleconomic growth as well as strong growthin the Southern African region . This hashelped Botswana’s trade performance. Totalexports for the first nine months of the yearwere up 37% (in pula terms) over the sameperiod in 2006. What is interesting is thesources of this growth. Although diamondsremain by far the largest export, at around65% of the total, the growth of diamondexports over this period was only 19%. Themore dynamic export sectors were meat (up86%), nickel (& copper) (up 118%) andtextiles (up 182%). These performan cesreflected a variety of factors; the meat sector

Figure 1: Inflation

Source: BoB, CSO, Econsult

Real business creditElectricity cons. (non-mining)

Real govt.exp.

Introduction

Government is currently in the process ofpreparing National Development Plan 10(NDP 10), which will run from the 2009/10financial year until 2015/16. NDP10 will coveran important period in Botswana’s economicdevelopment, and will have to address issuesof high unemployment, slow economicdiversification, high levels of dependencyupon government, and budget sustainability.In this feature we address this latter issue, inparticular the fiscal issues that NDP 10 willneed to address to ensure smooth adjustmentto lower mineral revenues in future.

Revenue Prospects

In recent years the government budgetoutturn and trends have been mixed. A fewyears back the budget was in deficit, for thefirst time in many years, due to rapidly risingexpenditure and weak revenues, and therewere genuine concerns that budget trendswere unsustainable. As a result expenditurehad to be restrained, and a new Fiscal Rulewas introduced in the Mid-term Review ofNDP�9. The current budget position is morefavourable, due to improved revenues andreduced spending, and in the last twofinancial years (2005/06 and 2006/07) therehave been significant surpluses. However,reduced spending has been due more to aninability to spend available resources than toa budgeted reduction in spending, and shouldnot therefore be seen as a planned outcome.

While the immediate budget position isreasonably favourable, the position is muchless positive in the medium and long term.The Fiscal Rule introduced in the Mid-TermReview of NDP�9 specifies that governmentexpenditure should be set at 40% of GDP,

on the basis that this represents the averagelevel of government revenues expectedduring the remainder of NDP�9, leading toa balanced (and therefore sustainable)budget.

However, the long-term prospects are formuch lower levels of government revenuesas a proportion of GDP. Current and recentrevenues are high due to the exceptionallyhigh profitability of the diamond industryand the high rate at which those profits aretaxed. In the medium term, production andprofits at these mines will decline asproduction moves underground and costsrise. While some new diamond mines areexpected to open, these will be much smallerthan the existing mines, have a relativelyshort life, and are unlikely to be nearly asprofitable as the Debswana mines.Furthermore, as the economy diversifies –whether into other mining activities or intonon-mining activities – tax revenues willdecline in relation to the size of the economyas enterprises taxed at more “normal” ratesbecome more important. In the long term,the government’s tax and other revenueswill most likely decline to around the averagein sub-Saharan Africa of 25%-30% of GDP.This will require a major (downward)adjustment in the level of governmentspending, which will have to grow moreslowly than the economy as a whole.

The Need to Adjust

This point was made strongly in a recent IMFpublication, which considered the impactof declining diamond production and themove underground on the government. Theanticipated dramatic decline in diamondrevenues between 2021 and 2029 is shownin Figure 6. This shows that diamond revenueswill grow at a healthy rate over the nextdecade, after which time they will declinesharply as production goes underground,and in just over 20 years from now, by 2029,will fall to zero as known diamond reservesare depleted.

The implications of this are clear: (i) effortsto diversify the economy must be intensified,and (ii) the government budget must beplaced on a sustainable adjustment path toa much lower revenue level. The earlier thisadjustment begins, the less traumatic anddrastic it will be. But even a smoothadjustment requires considerable cuts, withbudgeted expenditure falling by up to 1%of GDP each year for the next 15 years.

However, the current starting point of theadjustment process is not as bad as it couldhave been, because government spending

Feature:FiscalSustainabilityIssues in NDP10

Economic Review6has recently been significantly belowbudgeted levels due to underspending andlack of implementation capacity. Althoughexpenditure has been budgeted at 40% ofGDP following the Fiscal Rule, actual spendingwas only around 31-32% of GDP in the2005/06 and 2006/07 fiscal years. But thelong term need for much lower spendingmeans that the emphasis now and duringNDP�10 should not be on ramping upgovernment spending to match revenues,but to make government expenditure moreefficient and focused on long-termsustainability.

Budgetary Principles for NDP�10

In the short-to-medium term this means theGovernment should be spending less than itis earning, and accumulating the balance –i.e., returning to the days of significant budgetsurpluses. This has two benefits. First, itfacilitates the smooth adjustment ofexpenditure levels to lower revenues in thelong term. Second, it means that government(and the nation) can accumulate significantsavings balances that can be used to financefuture expenditure and supplement othersources of revenue as mineral revenuesdecline. Essentially this means building upreserves (both government savings andnational foreign exchange reserves) that canbe used as a capital fund that will generatea permanent future income flow withoutconsuming the capital base of the fund. Thisinvolves treating current mineral revenues

primarily as a resource to build up a capitalasset that can provide long-term annuityincome. The basis for this is already in place,in the form of the Government InvestmentAccount (GIA) at the Bank of Botswana, andthe Pula Fund component of the foreignexchange reserves. However, the balance inthese accounts, especially the GIA, wouldneed to rise sharply if the resulting annuityincome is to be meaningful.

There will also need to be a change inbudgetary principles, with allocations frommineral revenues to long-term savings madeactively before spending decisions are made,rather than as a passive residual dependingon budget outcomes, as at present. It alsomeans that the Government’s accumulatedsavings (balances at BoB) and the nation’ssavings (the foreign exchange reserves) shouldbe viewed as a resource to facilitate andcushion the adjustment process rather thanas a resource to finance a higher level ofspending in the short term.

A second important fiscal issue to beaddressed in NDP10 relates to the balancebetween recurrent and developmentspending. The NDP�9 MTR specified a targetof 30% of total spending allocated todevelopment spending, in order to boost theoverall national investment rate. Lookingfurther ahead, this may not be appropriate.Many public sector investment projects arearguably yielding very low economic (andsocial) returns, especially those involving theprovision of very expensive physical

Figure 6: Projected Revenues from Diamonds

Figure 4: Petrol and Crude Oil Prices Figure 5: Inflation

Figure 2: Business Confidence Index(% of firms rating current business conditions satisfactory)

Survey DateAll Exporters Non-exporters

Source: BPC, BoB, Econsult Source: BoB

Source: CSO, Econsult

Source: Econsult , Dept. of Energy Affairs, US EIA Source: BoB, Econsult

Petrol (lagged 4 months) Crude Oil

Source: IMF, 2007

(i) For instance, in South Africa government revenues account for26% of GDP

(i) IMF (2007) Botswana: Selected Issues and Statistical Appendix.The projections are based on data from the Ministry of MineralResources and Water Affairs and Debswana.

infrastructure in increasingly remote ruralareas. At the same time, allocations torecurrent spending may be insufficient tomaintain existing infrastructure. Roads are a

case in point: a combination of poormanagement and insufficient resourcesmeans that maintenance of the existinginfrastructure is inadequate, while resourcesare being devoted to building new roads inareas with very low traffic volumes. This isunlikely to represent rational allocation andmanagement of scarce resources. HenceNDP�10 needs to ensure greater efficiencyin the use of public financial resources,especially as the availability of such resourceswill decline in coming years.

Key initiatives could include: re-introducingeffective project appraisal techniques andreducing the number of politically drivendevelopment projects; introducing properproject management skills in the public sector,including parastatals; taking better accountof the recurrent expenditure implications andresource needs stemming from developmentprojects; improving productivity and efficiencyin the public sector workforce, if necessaryby downsizing, and terminating ineffectiveactivities; transferring activities to the privatesector and contracting out under perform-ance related management arrangements;and making better use of international bestpractice techniques in public sector resourceallocation and expenditure decisions in boththe recurrent and development budgets.

Figure 3: Export Growth, 2006–7 (Jan – Sep)f’cast

Bifm Economic Review

QUARTERLY ECONOMIC REVIEW

Economic Review

Economic Review Economic Review Economic Review

Botswana beef in the EU, and would have ledto the ending of beef exports to Botswana’smost lucrative market, which would have beendisastrous for the Botswana Meat Commission(BMC), Botswana’s cattle farmers and the ruraleconomy.

Nevertheless, EPAs have been controversialin some quarters. One of the main concernshas been in respect of EU demands forprogressively liberalised access to developingcountry markets (in fact this is not specificallyan EU demand, but is a requirement if theEPAs are to be consistent with WTO rules).This is not relevant in Botswana’s case, asSouth Africa already has such an agreementwith the EU (the SA-EU Trade & DevelopmentCo-operation Agreement), which in practiceapplies to Botswana due to its membershipof SACU. Hence, in practical terms, the interimEPA involved no further concession s onBotswana’s part. A second concern relatesto the EU’s desire to include services and“new generation” trade issues (such asintellectual property and public procurement)in the EPAs; these issues are not included inthe interim EPA and will be addressed as fullEPAs are negotiated.

Inflation & Monetary Policy

For most of the year, inflation developmentswere positive; the inflation rate declinedsharply from 8.5% at the end of 2006, andby March was below 7% and hence withinthe Bank of Botswana’s inflation objectiverange. However, towards the end of the yearinflationary pressures started mounting, and

2 3Bifm Economic Review 4th Quarter 2007 4

By most accounts the economic conditionsin 2007 represented a s ignif icantimprovement on 2006. Inflation was down,exports grew strongly, government improvedits ability to spend its budget, and businessconfidence was up. Due to lack of data wedon’t really know what was happening toeconomic growth and employment, but it isfair to assume that both should haveperformed reasonably well. So far, Botswanahas been relatively immune from the impactof the turmoil in major financial markets andthe sub-pr ime crisis. Looking forwar d to2008, however, things may not be so rosy,

with developments in the inte rnationaleconomy – economic slowdown and risinginflation - impacting adversely on Botswana.

Review of 2007

Output & Business Confidence

No GDP data have been published since theend of 2006 and so we are in the usual NewYear “black hole” with regard to informationon overall economic growth; although theCSO has undertaken to produce and publishquarter ly GDP data promptly , thiscommitment has generally not been fulfilled.However , growth indicators suggest thatthere has been a strong recovery, with thegrowth of business credit, governmentspending and non-mining electricityconsumption all rising sharply during theyear (see Figure 1). Other indicators tell asimilar story: applications for business tradinglicences in the second half of 2007 rose by13.5%, while non-mineral exports were up121% in the first nine months of 2007, bothcompared to the same periods in 2006.

The improvement in business conditions isshown in the results of the Bank ofBotswana’s biannual Business ExpectationsSurvey. The latest results, for the second halfof 2007, show a continuation of the

improvement in conf idence that has beenevident over the past 18 months. Theimprovement is particularly striking for firmsfocused on the domestic economy, of which77% reported that current businessconditions were satisfactory, compared withonly 21% in September 2005. An even higherproportion (85%) expect business conditionsto improve through 2008. While the surveysurprisi ngly shows declining confidenceamongst exporters, this may mainly reflectthe small size of the exporter sample in thesurvey.

A number of factors lie behind this upturnin busin ess conditions and confid ence.Domestically, government spending has beenramped up, with expenditure in the first ninemonths of 2007 rising by 22% compared to2006. Most of this increase was indevelopment spending, which rose by 60%over the first nine months of 2006. This mayshow that government has managed toovercome some of the implementationconstraints that have held back developmentprojects in the past. While a high proportionof development spending flows out of thecountry (e.g. expenditure on constructionmaterials and HIV/AIDS drugs), it nonethelessstimulates the domestic economy through

benefitted from recovery from the Foot &Mouth Disease outbreak in 2006, as well as

drought (encouraging cattle sales), and asupply response to higher prices. Nickel and

copper benefitted from higher worldcommodity prices, especially earlier in theyear. Textiles benefitted from strong demand

growth in the region and internationally, andsuccess in utilising the opportunities offeredby international trade agreements such as

the US Africa Growth and Opportunity Act(AGOA). All exports benefitted from improvedinte rnational competit iveness under the

crawling peg exchange rate regime.

As a result of good export performance,

combined with a s lower rate of growth ofimports, the balance of payments continuedto run a healthy surplus, estimated at P10.2

billion for the first nine months of 2007(compared to P10.3 bn for the whole of2006). The foreign exchange reserves have

continued to rise, reaching P58.5 billion (US$9.7bn) at the end of September, an estimated

32 months of import cover.

One importa nt trade development thatoccurred at the very end of 2008 was the

signing of an interim Economic PartnershipAgreement (EPA) between Botswana and theEuropean Union (as did Lesotho, Namibia,

Swaziland and Mozambique). The interim EPAprovides for improved access for Botswana

beef to the EU, with reduced tariffs (zerocompared to 5% under the previous CotonouAgreement) and no quotas. Failing to sign the

EPA would have led to much higher tariffs on

by December it was back up to 8.1%. Thiswas driven primarily by development s inglobal food and energy markets. By the endof 2007, international oil prices had risen byover 80% from their low point in earlyJanuary 2007, and there were also sharpincreases in food commodity prices, notablyfor fooodgrains (maize, wheat etc.) and dairyproducts, with The Economist foodcommodity price index up 37% over theyear. The impact of these developments wasfelt globally, and most countries experiencedrising inflation. Although Botswana’s relativeposition was not affected – by Novemberthe inflation differential between Botswanaand major trading partners had fallen to itslowest level for some time – the increase ininfla tion was nonetheless unwelcome.Fortunately, underl ying inflation remainslower, with the trimmed mean core inflationmeasure falling to 7.4% in December.

On the monetary policy front, the Bank ofBotswana maintained its inflation objectiverange of 4%-7% for 2007, along with amedium term objective of 3%-6%. Onceinflation fell within the range, the Bank feltable to reduce interest rates by 0.5% inJune, leading to a reduction in the Bank Rateto 14.5%. This was maintained until the endof the year, despite concerns about risinginflation and domestic demand pressures.Of particular concern was the growth ofbank credit, which increased from 18.6%annually at the end of 2006 to 27.8% inNovember 2007, and remained outside ofthe BoB’s target range for credit growth of11-14% throughout the year.

The Botswana Stock Exchange (BSE)experienced a “year of two halves”, with acontinuation of 2006’s rapid growth in theDomestic Companies Index (DCI) throughto August, during which time the index roseby 60%. From August onwards, however,the situation was reversed, and by the endof the year the DCI had declined by 15%from its peak; over the year as a whole, theindex was up by 36%. The decline in theBSE DCI coincided with the decline in stockmarkets around the world, especially themajor developed markets. However, it does

not appear that the two were linked. By the

middle of 2008, valuations on the BSE hadreached unrealistically high levels; for instance,

price/earnings (p/e) ratios for the commercialbank shares that dominate the BSE were

over 30, and the domestic market as a wholehad a p/e ratio in the low 20s. Many

commentators argued that a correction wasoverdue, regardless of international

developments, and this appears to have beenwhat has happened. With p/e ratios for the

banks at just over 20, and for the market as

a whole at 15.5 at the end of the year,valuations are now more realistic. The prices

of dual listed mining shares on the foreignboard of the BSE followed similar trends,

rising by 33% between January and Augustbut then falling by 13% through to

December, largely refle cting trends ininternational metals prices.

The Outlook for 2008

The beginning of 2008 has been characterised

by unusually high levels of uncertainty in theglobal economy. The sub-prime crisis in the

US has spread internationally, and althoughit was initially hoped that this would be short-

lived and contained, the impact has persisted.Moving into the New Year, fears of recession

in the USA are inte nsifyin g, with manycommentators rating the chances of recession

at 50-50. Two scenarios can be envisaged.If the US does not slip into recession, but

simply experiences a period of slower (or

zero) growth, global economic activity willtemporar ily weaken and growth will fall

below trend. Nevertheless, the impact wouldbe short-lived and, supported by a likely

easing in monetary policy around the world,global growth would rebound in the second

half of the year. However, if the US doesslide into recession, with a period of negative

economic growth, job losses and acontraction in real incomes, this is likely to

have a widespread impact on the worldeconomy. Global growth would slow

significantly and the existing credit marketproblems would intensify. In this scenario, a

global slowdown could persist well beyondthe end of 2008.

What are the implications for Botswana? Asa highly trade-dependent economy, theimpact of changes in global economic activityare potentially far-reaching. The USA is thelargest market for Botswana’s exports, asthe major world consumer of diamonds andthe primary market for Botswana’s textileexports. Any slowdown in US growth,especially if led by a drop in consumerexpenditure, would negatively affectBotswana’s exports. However, if suchproblems are largely confined to the USAand are short-lived, then other sources ofeconomic growth (Europe and majordeveloping countries) wi ll help to cushionthe impact. But if US recession leads to asharp slowdown in global economic activity,with the impact widely felt, then Botswana’sexport earnings could fall significantly. Thevalue of copper-nickel exports has alreadybeen adversely affected by falling metalsprices in the second half of 2007, and thiswould be intensified by a global recession.As a result, Botswana’s three major exports(diamonds, copper-nickel & textiles), arevulnerable to a US-led global slowdown. Thiswould be compounded be a weakeningdollar, the currency in which all three ofthose exports are priced, further reducingexport earnings.

The tighten ing of credit condition s andincrease in risk aversion in major f inancialmarkets, even if prolonged, should have nomajor influence on Botswana. As the countryis a net creditor, and the government doesnot borrow on international markets, therewill be little direct impact, although projectsrequiring major loan finance – such as theMmamabula Energy Project – might findraising such loans more difficult, or moreexpensive. Notwithstanding the tighteningof international liquidity, domestic financialmarkets should remain highly liquid.

Domestically, the main economic problem islikely to be inflation, with several nasty shocksdue in the first half of the year. Rising inflationmay in turn lead to higher interest rates. Asin 2007, there will be continued pressurefrom high food and oil prices, and domesticfuel prices are likely to be the main driver of

Botswana inflation in the coming months.Fuel prices are adjusted on a monthly basisto reflect the cost of crude oil on internationalmarkets as well as refining and transportationcosts. Domest ic price changes thereforereflect international crude price changes ,albeit with a lag and an element ofstabilisation. As Figure 4 shows, domesticpetrol prices generally reflect internationalcrude prices with a lag of around 4 months.As a result, the recent sharp increase ininternational oil prices from $70 to $100 abarrel towards the end of 2007 has not yetbeen reflected in domest ic pump prices.While crude prices went up by 58% during2007, domestic pump prices only rose by20%, even with December’s substantial pricehike. Should crude prices remain at currentlevels, domestic fuel prices would have t orise from the cur rent level of P5.60 a litre(for petrol in Gaborone) to nearly P7 to fullyreflect this – a further increase of 20% ormore. Fuel has a weight of around 7% inthe new CPI basket, so this alone wouldnearly 1.5% directly to inflation, which wouldbe compounded by the impact on highertransport costs, public transport fares etc.

Other possible inflation shocks could comefrom domestic electricity prices and BotswanaHousing Corporation (BHC) rentals. The latterhave not been adjusted for four years, andBHC has been lobbying Government to approvea rental increase – although the magnitude ofany such increase should be small given thatprivate sector housing rentals have been largelystagnant over this period, and BHC rentals aresupposedly market-related. Perhaps a moreserious threat arises from increases in electricitytariffs. Electricity prices are rising steeply in

South Africa, the source of around 70% ofBotswana’s electricity. A new supply contractbetween South Africa’s Eskom and theBotswana Power Corporation (BPC) came intoeffect on 1 January 2008, and is much lessfavourable to Botswana than the previouscontract, both in terms of prices and stabilityof supply – the result of which is that Botswanais now much more exposed to both tariffincreases and supply disruptions from SouthAfrica than it had been previously. In addition,BPC needs to generate funds to contribute tothe financing of new domestic generatingcapacity. Substantial electricity price increasesare likely in 2008, and although electricity costsonly have a weight of 1.5% in the CPI basket,they feed through widely to other prices andwill push up inflation further.

The combination of these developmen tsmeans that inflation will continue to rise fromthe December level of 8.1%, and could easilyreach double digits by mid-year if internationaloil and food prices remain high and thereare substantial increases in BHC and BPCtariffs. On the positive side, it is unlikely thatoil prices will rise much further from currentlevels – in the absence of higher levels ofgeopolitical instability in the Middle East –as a slowdown in global growth will putdownward pressure on oil prices. Hence it ispossible that the direct impact of oil priceson inflation will be short-lived, although theindirec t impact via other costs could belonger-term.

Although the BoB maintained unchangedinteres t rates at the last meeting of theMonetary Policy Committee in 2008, despiterising inflation and credit growth, this situation

is likely to change in 2008. Expect a muchmore hawkish tone in the Monetary PolicyStatement to be r eleased in February, andincreases in interest rates in the first half ofthe year, even though with inflation beingprimarily driven from outside of Botswana,the potency of monetary policy is limited.

The changed electricity supply situation isnot just a price threat, but could hinderinvestment and growth as well. With thevirtual certainty that Botswana will increasinglyexperience interruptions in suppl ies fromSouth Africa over the next five years, andwith no new domestic supply capacity dueonline before 2011, the problem is serious,especially for the energy-intensive miningsector that is the bedrock of the economy.To date, little publ ic information has beenprovided by BPC on these problems and howthey are going to be addressed, and a moreinformativ e approach by BPC and theGovernment would help the private sectorto plan appropriately.

Botswana’s financial markets should remainrelatively immune from the turmoil in globalfinancial markets in 2008. More reasonablevaluations on domestic stocks shouldencourage a r esumption of buying activityand the DCI should bottom out in the firstquarter. In the bond markets, expectationsare high that Government will announce aprogramme of regular bond issues to coincidewith the maturity of the BW002 bond on 1st

March. This would help to boost liquidity inthe bond market and support the yield curve,which in turn provides a foundation for bondissues by the private and parastatal sectors.

Summary ofEconomicDevelopmentsDr Keith JefferisChairman ofBifm InvestmentCommittee

Economic Review5employ ment and expenditure on locallysupplied goods and services. One of theweaknesses of the Botswana economy is thatthe domest ic private sector still remain sheavily dependent upon governmentspending – something that has to change inthe longer term – but it means that govern-ment can boost economic activity throughincreasing spending in the short term, whichseems to have been happening recently.

Outside of this, the upsurge of mineralprospecting activity, the implementation ofnew mining and minerals processing projects,and the likelihood of further large mining-related projects in the medium term, haveshown dynamism in one sector of theeconomy that is not dependent upongovernment spending. Important ongoingprojects include the construction of the newDiamond Trading Company (DTC) facility andthe opening of several new diamond cuttingfactories in Gaborone, the cons truction ofthe Norilsk Nickel Activox refin ery nearFrancistown, and the Diamonex diamondmine near Lerala, all of which are providingan important boost to economic activity intheir respective areas. Looking further ahead,agreement is close to being reached on theMmamabula coal/power project, and changesto the Mines & Minerals Act and the ElectricitySupply Act to accommodate the project havenow been passed.

Trade & Balance of Payments

Externally, the regional and internationaleconomic environments have been supportivefor much of the year, with buoyant globaleconomic growth as well as strong growthin the Southern African region . This hashelped Botswana’s trade performance. Totalexports for the first nine months of the yearwere up 37% (in pula terms) over the sameperiod in 2006. What is interesting is thesources of this growth. Although diamondsremain by far the largest export, at around65% of the total, the growth of diamondexports over this period was only 19%. Themore dynamic export sectors were meat (up86%), nickel (& copper) (up 118%) andtextiles (up 182%). These performan cesreflected a variety of factors; the meat sector

Figure 1: Inflation

Source: BoB, CSO, Econsult

Real business creditElectricity cons. (non-mining)

Real govt.exp.

Introduction

Government is currently in the process ofpreparing National Development Plan 10(NDP 10), which will run from the 2009/10financial year until 2015/16. NDP10 will coveran important period in Botswana’s economicdevelopment, and will have to address issuesof high unemployment, slow economicdiversification, high levels of dependencyupon government, and budget sustainability.In this feature we address this latter issue, inparticular the fiscal issues that NDP 10 willneed to address to ensure smooth adjustmentto lower mineral revenues in future.

Revenue Prospects

In recent years the government budgetoutturn and trends have been mixed. A fewyears back the budget was in deficit, for thefirst time in many years, due to rapidly risingexpenditure and weak revenues, and therewere genuine concerns that budget trendswere unsustainable. As a result expenditurehad to be restrained, and a new Fiscal Rulewas introduced in the Mid-term Review ofNDP�9. The current budget position is morefavourable, due to improved revenues andreduced spending, and in the last twofinancial years (2005/06 and 2006/07) therehave been significant surpluses. However,reduced spending has been due more to aninability to spend available resources than toa budgeted reduction in spending, and shouldnot therefore be seen as a planned outcome.

While the immediate budget position isreasonably favourable, the position is muchless positive in the medium and long term.The Fiscal Rule introduced in the Mid-TermReview of NDP�9 specifies that governmentexpenditure should be set at 40% of GDP,

on the basis that this represents the averagelevel of government revenues expectedduring the remainder of NDP�9, leading toa balanced (and therefore sustainable)budget.

However, the long-term prospects are formuch lower levels of government revenuesas a proportion of GDP. Current and recentrevenues are high due to the exceptionallyhigh profitability of the diamond industryand the high rate at which those profits aretaxed. In the medium term, production andprofits at these mines will decline asproduction moves underground and costsrise. While some new diamond mines areexpected to open, these will be much smallerthan the existing mines, have a relativelyshort life, and are unlikely to be nearly asprofitable as the Debswana mines.Furthermore, as the economy diversifies –whether into other mining activities or intonon-mining activities – tax revenues willdecline in relation to the size of the economyas enterprises taxed at more “normal” ratesbecome more important. In the long term,the government’s tax and other revenueswill most likely decline to around the averagein sub-Saharan Africa of 25%-30% of GDP.This will require a major (downward)adjustment in the level of governmentspending, which will have to grow moreslowly than the economy as a whole.

The Need to Adjust

This point was made strongly in a recent IMFpublication, which considered the impactof declining diamond production and themove underground on the government. Theanticipated dramatic decline in diamondrevenues between 2021 and 2029 is shownin Figure 6. This shows that diamond revenueswill grow at a healthy rate over the nextdecade, after which time they will declinesharply as production goes underground,and in just over 20 years from now, by 2029,will fall to zero as known diamond reservesare depleted.

The implications of this are clear: (i) effortsto diversify the economy must be intensified,and (ii) the government budget must beplaced on a sustainable adjustment path toa much lower revenue level. The earlier thisadjustment begins, the less traumatic anddrastic it will be. But even a smoothadjustment requires considerable cuts, withbudgeted expenditure falling by up to 1%of GDP each year for the next 15 years.

However, the current starting point of theadjustment process is not as bad as it couldhave been, because government spending

Feature:FiscalSustainabilityIssues in NDP10

Economic Review6has recently been significantly belowbudgeted levels due to underspending andlack of implementation capacity. Althoughexpenditure has been budgeted at 40% ofGDP following the Fiscal Rule, actual spendingwas only around 31-32% of GDP in the2005/06 and 2006/07 fiscal years. But thelong term need for much lower spendingmeans that the emphasis now and duringNDP�10 should not be on ramping upgovernment spending to match revenues,but to make government expenditure moreefficient and focused on long-termsustainability.

Budgetary Principles for NDP�10

In the short-to-medium term this means theGovernment should be spending less than itis earning, and accumulating the balance –i.e., returning to the days of significant budgetsurpluses. This has two benefits. First, itfacilitates the smooth adjustment ofexpenditure levels to lower revenues in thelong term. Second, it means that government(and the nation) can accumulate significantsavings balances that can be used to financefuture expenditure and supplement othersources of revenue as mineral revenuesdecline. Essentially this means building upreserves (both government savings andnational foreign exchange reserves) that canbe used as a capital fund that will generatea permanent future income flow withoutconsuming the capital base of the fund. Thisinvolves treating current mineral revenues

primarily as a resource to build up a capitalasset that can provide long-term annuityincome. The basis for this is already in place,in the form of the Government InvestmentAccount (GIA) at the Bank of Botswana, andthe Pula Fund component of the foreignexchange reserves. However, the balance inthese accounts, especially the GIA, wouldneed to rise sharply if the resulting annuityincome is to be meaningful.

There will also need to be a change inbudgetary principles, with allocations frommineral revenues to long-term savings madeactively before spending decisions are made,rather than as a passive residual dependingon budget outcomes, as at present. It alsomeans that the Government’s accumulatedsavings (balances at BoB) and the nation’ssavings (the foreign exchange reserves) shouldbe viewed as a resource to facilitate andcushion the adjustment process rather thanas a resource to finance a higher level ofspending in the short term.

A second important fiscal issue to beaddressed in NDP10 relates to the balancebetween recurrent and developmentspending. The NDP�9 MTR specified a targetof 30% of total spending allocated todevelopment spending, in order to boost theoverall national investment rate. Lookingfurther ahead, this may not be appropriate.Many public sector investment projects arearguably yielding very low economic (andsocial) returns, especially those involving theprovision of very expensive physical

Figure 6: Projected Revenues from Diamonds

Figure 4: Petrol and Crude Oil Prices Figure 5: Inflation

Figure 2: Business Confidence Index(% of firms rating current business conditions satisfactory)

Survey DateAll Exporters Non-exporters

Source: BPC, BoB, Econsult Source: BoB

Source: CSO, Econsult

Source: Econsult, Dept. of Energy Affairs, US EIA Source: BoB, Econsult

Source: IMF, 2007

Recycling of existing waste(higher production of lower-quality diamonds asunderlined by a lower pricetrend)

Diamond revenuein millions of dollars

Mining goesunderground beforeresources are totallydepleted

2005 2007 2009 2011 2013 2015 2017 2019 2021 2023 2025 2027 2029

7000

6000

5000

4000

3000

2000

1000

0

(i) For instance, in South Africa government revenues account for26% of GDP

(i) IMF (2007) Botswana: Selected Issues and Statistical Appendix.The projections are based on data from the Ministry of MineralResources and Water Affairs and Debswana.

infrastructure in increasingly remote ruralareas. At the same time, allocations torecurrent spending may be insufficient tomaintain existing infrastructure. Roads are acase in point: a combination of poormanagement and insufficient resourcesmeans that maintenance of the existinginfrastructure is inadequate, while resourcesare being devoted to building new roads inareas with very low traffic volumes. This isunlikely to represent rational allocation andmanagement of scarce resources. HenceNDP�10 needs to ensure greater efficiencyin the use of public financial resources,especially as the availability of such resourceswill decline in coming years.

Key initiatives could include: re-introducingeffective project appraisal techniques andreducing the number of politically drivendevelopment projects; introducing properproject management skills in the public sector,including parastatals; taking better accountof the recurrent expenditure implications andresource needs stemming from developmentprojects; improving productivity and efficiencyin the public sector workforce, if necessaryby downsizing, and terminating ineffective

activities; transferring activities to the privatesector and contracting out under perform-ance related management arrangements;and making better use of international bestpractice techniques in public sector resourceallocation and expenditure decisions in boththe recurrent and development budgets.

Figure 3: Export Growth, 2006–7 (Jan – Sep)f’cast

Bifm Economic Review

QUARTERLY ECONOMIC REVIEW

Economic Review

Economic Review Economic Review Economic Review

Botswana beef in the EU, and would have ledto the ending of beef exports to Botswana’smost lucrative market, which would have beendisastrous for the Botswana Meat Commission(BMC), Botswana’s cattle farmers and the ruraleconomy.

Nevertheless, EPAs have been controversialin some quarters. One of the main concernshas been in respect of EU demands forprogressively liberalised access to developingcountry markets (in fact this is not specificallyan EU demand, but is a requirement if theEPAs are to be consistent with WTO rules).This is not relevant in Botswana’s case, asSouth Africa already has such an agreementwith the EU (the SA-EU Trade & DevelopmentCo-operation Agreement), which in practiceapplies to Botswana due to its membershipof SACU. Hence, in practical terms, the interimEPA involved no further concession s onBotswana’s part. A second concern relatesto the EU’s desire to include services and“new generation” trade issues (such asintellectual property and public procurement)in the EPAs; these issues are not included inthe interim EPA and will be addressed as fullEPAs are negotiated.

Inflation & Monetary Policy

For most of the year, inflation developmentswere positive; the inflation rate declinedsharply from 8.5% at the end of 2006, andby March was below 7% and hence withinthe Bank of Botswana’s inflation objectiverange. However, towards the end of the yearinflationary pressures started mounting, and

2 3Bifm Economic Review 4th Quarter 2007 4

By most accounts the economic conditionsin 2007 represented a s ignif icantimprovement on 2006. Inflation was down,exports grew strongly, government improvedits ability to spend its budget, and businessconfidence was up. Due to lack of data wedon’t really know what was happening toeconomic growth and employment, but it isfair to assume that both should haveperformed reasonably well. So far, Botswanahas been relatively immune from the impactof the turmoil in major financial markets andthe sub-pr ime crisis. Looking forwar d to2008, however, things may not be so rosy,

with developments in the inte rnationaleconomy – economic slowdown and risinginflation - impacting adversely on Botswana.

Review of 2007

Output & Business Confidence

No GDP data have been published since theend of 2006 and so we are in the usual NewYear “black hole” with regard to informationon overall economic growth; although theCSO has undertaken to produce and publishquarter ly GDP data promptly , thiscommitment has generally not been fulfilled.However , growth indicators suggest thatthere has been a strong recovery, with thegrowth of business credit, governmentspending and non-mining electricityconsumption all rising sharply during theyear (see Figure 1). Other indicators tell asimilar story: applications for business tradinglicences in the second half of 2007 rose by13.5%, while non-mineral exports were up121% in the first nine months of 2007, bothcompared to the same periods in 2006.

The improvement in business conditions isshown in the results of the Bank ofBotswana’s biannual Business ExpectationsSurvey. The latest results, for the second halfof 2007, show a continuation of the

improvement in conf idence that has beenevident over the past 18 months. Theimprovement is particularly striking for firmsfocused on the domestic economy, of which77% reported that current businessconditions were satisfactory, compared withonly 21% in September 2005. An even higherproportion (85%) expect business conditionsto improve through 2008. While the surveysurprisi ngly shows declining confidenceamongst exporters, this may mainly reflectthe small size of the exporter sample in thesurvey.

A number of factors lie behind this upturnin busin ess conditions and confid ence.Domestically, government spending has beenramped up, with expenditure in the first ninemonths of 2007 rising by 22% compared to2006. Most of this increase was indevelopment spending, which rose by 60%over the first nine months of 2006. This mayshow that government has managed toovercome some of the implementationconstraints that have held back developmentprojects in the past. While a high proportionof development spending flows out of thecountry (e.g. expenditure on constructionmaterials and HIV/AIDS drugs), it nonethelessstimulates the domestic economy through

benefitted from recovery from the Foot &Mouth Disease outbreak in 2006, as well as

drought (encouraging cattle sales), and asupply response to higher prices. Nickel and

copper benefitted from higher worldcommodity prices, especially earlier in theyear. Textiles benefitted from strong demand

growth in the region and internationally, andsuccess in utilising the opportunities offeredby international trade agreements such as

the US Africa Growth and Opportunity Act(AGOA). All exports benefitted from improvedinte rnational competit iveness under the

crawling peg exchange rate regime.

As a result of good export performance,

combined with a s lower rate of growth ofimports, the balance of payments continuedto run a healthy surplus, estimated at P10.2

billion for the first nine months of 2007(compared to P10.3 bn for the whole of2006). The foreign exchange reserves have

continued to rise, reaching P58.5 billion (US$9.7bn) at the end of September, an estimated

32 months of import cover.

One importa nt trade development thatoccurred at the very end of 2008 was the

signing of an interim Economic PartnershipAgreement (EPA) between Botswana and theEuropean Union (as did Lesotho, Namibia,

Swaziland and Mozambique). The interim EPAprovides for improved access for Botswana

beef to the EU, with reduced tariffs (zerocompared to 5% under the previous CotonouAgreement) and no quotas. Failing to sign the

EPA would have led to much higher tariffs on

by December it was back up to 8.1%. Thiswas driven primarily by development s inglobal food and energy markets. By the endof 2007, international oil prices had risen byover 80% from their low point in earlyJanuary 2007, and there were also sharpincreases in food commodity prices, notablyfor fooodgrains (maize, wheat etc.) and dairyproducts, with The Economist foodcommodity price index up 37% over theyear. The impact of these developments wasfelt globally, and most countries experiencedrising inflation. Although Botswana’s relativeposition was not affected – by Novemberthe inflation differential between Botswanaand major trading partners had fallen to itslowest level for some time – the increase ininfla tion was nonetheless unwelcome.Fortunately, underl ying inflation remainslower, with the trimmed mean core inflationmeasure falling to 7.4% in December.

On the monetary policy front, the Bank ofBotswana maintained its inflation objectiverange of 4%-7% for 2007, along with amedium term objective of 3%-6%. Onceinflation fell within the range, the Bank feltable to reduce interest rates by 0.5% inJune, leading to a reduction in the Bank Rateto 14.5%. This was maintained until the endof the year, despite concerns about risinginflation and domestic demand pressures.Of particular concern was the growth ofbank credit, which increased from 18.6%annually at the end of 2006 to 27.8% inNovember 2007, and remained outside ofthe BoB’s target range for credit growth of11-14% throughout the year.

The Botswana Stock Exchange (BSE)experienced a “year of two halves”, with acontinuation of 2006’s rapid growth in theDomestic Companies Index (DCI) throughto August, during which time the index roseby 60%. From August onwards, however,the situation was reversed, and by the endof the year the DCI had declined by 15%from its peak; over the year as a whole, theindex was up by 36%. The decline in theBSE DCI coincided with the decline in stockmarkets around the world, especially themajor developed markets. However, it does

not appear that the two were linked. By the

middle of 2008, valuations on the BSE hadreached unrealistically high levels; for instance,

price/earnings (p/e) ratios for the commercialbank shares that dominate the BSE were

over 30, and the domestic market as a wholehad a p/e ratio in the low 20s. Many

commentators argued that a correction wasoverdue, regardless of international

developments, and this appears to have beenwhat has happened. With p/e ratios for the

banks at just over 20, and for the market as

a whole at 15.5 at the end of the year,valuations are now more realistic. The prices

of dual listed mining shares on the foreignboard of the BSE followed similar trends,

rising by 33% between January and Augustbut then falling by 13% through to

December, largely refle cting trends ininternational metals prices.

The Outlook for 2008

The beginning of 2008 has been characterised

by unusually high levels of uncertainty in theglobal economy. The sub-prime crisis in the

US has spread internationally, and althoughit was initially hoped that this would be short-

lived and contained, the impact has persisted.Moving into the New Year, fears of recession

in the USA are inte nsifyin g, with manycommentators rating the chances of recession

at 50-50. Two scenarios can be envisaged.If the US does not slip into recession, but

simply experiences a period of slower (or

zero) growth, global economic activity willtemporar ily weaken and growth will fall

below trend. Nevertheless, the impact wouldbe short-lived and, supported by a likely

easing in monetary policy around the world,global growth would rebound in the second

half of the year. However, if the US doesslide into recession, with a period of negative

economic growth, job losses and acontraction in real incomes, this is likely to

have a widespread impact on the worldeconomy. Global growth would slow

significantly and the existing credit marketproblems would intensify. In this scenario, a

global slowdown could persist well beyondthe end of 2008.

What are the implications for Botswana? Asa highly trade-dependent economy, theimpact of changes in global economic activityare potentially far-reaching. The USA is thelargest market for Botswana’s exports, asthe major world consumer of diamonds andthe primary market for Botswana’s textileexports. Any slowdown in US growth,especially if led by a drop in consumerexpenditure, would negatively affectBotswana’s exports. However, if suchproblems are largely confined to the USAand are short-lived, then other sources ofeconomic growth (Europe and majordeveloping countries) wi ll help to cushionthe impact. But if US recession leads to asharp slowdown in global economic activity,with the impact widely felt, then Botswana’sexport earnings could fall significantly. Thevalue of copper-nickel exports has alreadybeen adversely affected by falling metalsprices in the second half of 2007, and thiswould be intensified by a global recession.As a result, Botswana’s three major exports(diamonds, copper-nickel & textiles), arevulnerable to a US-led global slowdown. Thiswould be compounded be a weakeningdollar, the currency in which all three ofthose exports are priced, further reducingexport earnings.

The tighten ing of credit condition s andincrease in risk aversion in major f inancialmarkets, even if prolonged, should have nomajor influence on Botswana. As the countryis a net creditor, and the government doesnot borrow on international markets, therewill be little direct impact, although projectsrequiring major loan finance – such as theMmamabula Energy Project – might findraising such loans more difficult, or moreexpensive. Notwithstanding the tighteningof international liquidity, domestic financialmarkets should remain highly liquid.

Domestically, the main economic problem islikely to be inflation, with several nasty shocksdue in the first half of the year. Rising inflationmay in turn lead to higher interest rates. Asin 2007, there will be continued pressurefrom high food and oil prices, and domesticfuel prices are likely to be the main driver of

Botswana inflation in the coming months.Fuel prices are adjusted on a monthly basisto reflect the cost of crude oil on internationalmarkets as well as refining and transportationcosts. Domest ic price changes thereforereflect international crude price changes ,albeit with a lag and an element ofstabilisation. As Figure 4 shows, domesticpetrol prices generally reflect internationalcrude prices with a lag of around 4 months.As a result, the recent sharp increase ininternational oil prices from $70 to $100 abarrel towards the end of 2007 has not yetbeen reflected in domest ic pump prices.While crude prices went up by 58% during2007, domestic pump prices only rose by20%, even with December’s substantial pricehike. Should crude prices remain at currentlevels, domestic fuel prices would have t orise from the cur rent level of P5.60 a litre(for petrol in Gaborone) to nearly P7 to fullyreflect this – a further increase of 20% ormore. Fuel has a weight of around 7% inthe new CPI basket, so this alone wouldnearly 1.5% directly to inflation, which wouldbe compounded by the impact on highertransport costs, public transport fares etc.

Other possible inflation shocks could comefrom domestic electricity prices and BotswanaHousing Corporation (BHC) rentals. The latterhave not been adjusted for four years, andBHC has been lobbying Government to approvea rental increase – although the magnitude ofany such increase should be small given thatprivate sector housing rentals have been largelystagnant over this period, and BHC rentals aresupposedly market-related. Perhaps a moreserious threat arises from increases in electricitytariffs. Electricity prices are rising steeply in

South Africa, the source of around 70% ofBotswana’s electricity. A new supply contractbetween South Africa’s Eskom and theBotswana Power Corporation (BPC) came intoeffect on 1 January 2008, and is much lessfavourable to Botswana than the previouscontract, both in terms of prices and stabilityof supply – the result of which is that Botswanais now much more exposed to both tariffincreases and supply disruptions from SouthAfrica than it had been previously. In addition,BPC needs to generate funds to contribute tothe financing of new domestic generatingcapacity. Substantial electricity price increasesare likely in 2008, and although electricity costsonly have a weight of 1.5% in the CPI basket,they feed through widely to other prices andwill push up inflation further.

The combination of these developmen tsmeans that inflation will continue to rise fromthe December level of 8.1%, and could easilyreach double digits by mid-year if internationaloil and food prices remain high and thereare substantial increases in BHC and BPCtariffs. On the positive side, it is unlikely thatoil prices will rise much further from currentlevels – in the absence of higher levels ofgeopolitical instability in the Middle East –as a slowdown in global growth will putdownward pressure on oil prices. Hence it ispossible that the direct impact of oil priceson inflation will be short-lived, although theindirec t impact via other costs could belonger-term.

Although the BoB maintained unchangedinteres t rates at the last meeting of theMonetary Policy Committee in 2008, despiterising inflation and credit growth, this situation

is likely to change in 2008. Expect a muchmore hawkish tone in the Monetary PolicyStatement to be r eleased in February, andincreases in interest rates in the first half ofthe year, even though with inflation beingprimarily driven from outside of Botswana,the potency of monetary policy is limited.

The changed electricity supply situation isnot just a price threat, but could hinderinvestment and growth as well. With thevirtual certainty that Botswana will increasinglyexperience interruptions in suppl ies fromSouth Africa over the next five years, andwith no new domestic supply capacity dueonline before 2011, the problem is serious,especially for the energy-intensive miningsector that is the bedrock of the economy.To date, little publ ic information has beenprovided by BPC on these problems and howthey are going to be addressed, and a moreinformativ e approach by BPC and theGovernment would help the private sectorto plan appropriately.

Botswana’s financial markets should remainrelatively immune from the turmoil in globalfinancial markets in 2008. More reasonablevaluations on domestic stocks shouldencourage a r esumption of buying activityand the DCI should bottom out in the firstquarter. In the bond markets, expectationsare high that Government will announce aprogramme of regular bond issues to coincidewith the maturity of the BW002 bond on 1st

March. This would help to boost liquidity inthe bond market and support the yield curve,which in turn provides a foundation for bondissues by the private and parastatal sectors.

Summary ofEconomicDevelopmentsDr Keith JefferisChairman ofBifm InvestmentCommittee

Economic Review5

Bifm Botswana LimitedAsset Management. Property Management. Private Equity. Corporate Advisory Services.Private Bag BR 185, Broadhurst, Botswana Tel: +(267) 395 1564. Fax: +(267) 390 0358. Website: www.bifm.co.bw

employ ment and expenditure on locallysupplied goods and services. One of theweaknesses of the Botswana economy is thatthe domest ic private sector still remain sheavily dependent upon governmentspending – something that has to change inthe longer term – but it means that govern-ment can boost economic activity throughincreasing spending in the short term, whichseems to have been happening recently.

Outside of this, the upsurge of mineralprospecting activity, the implementation ofnew mining and minerals processing projects,and the likelihood of further large mining-related projects in the medium term, haveshown dynamism in one sector of theeconomy that is not dependent upongovernment spending. Important ongoingprojects include the construction of the newDiamond Trading Company (DTC) facility andthe opening of several new diamond cuttingfactories in Gaborone, the cons truction ofthe Norilsk Nickel Activox refin ery nearFrancistown, and the Diamonex diamondmine near Lerala, all of which are providingan important boost to economic activity intheir respective areas. Looking further ahead,agreement is close to being reached on theMmamabula coal/power project, and changesto the Mines & Minerals Act and the ElectricitySupply Act to accommodate the project havenow been passed.

Trade & Balance of Payments

Externally, the regional and internationaleconomic environments have been supportivefor much of the year, with buoyant globaleconomic growth as well as strong growthin the Southern African region . This hashelped Botswana’s trade performance. Totalexports for the first nine months of the yearwere up 37% (in pula terms) over the sameperiod in 2006. What is interesting is thesources of this growth. Although diamondsremain by far the largest export, at around65% of the total, the growth of diamondexports over this period was only 19%. Themore dynamic export sectors were meat (up86%), nickel (& copper) (up 118%) andtextiles (up 182%). These performan cesreflected a variety of factors; the meat sector

Figure 1: Inflation

Source: BoB, CSO, Econsult

Real business creditElectricity cons. (non-mining)

Real govt.exp.

Introduction

Government is currently in the process ofpreparing National Development Plan 10(NDP 10), which will run from the 2009/10financial year until 2015/16. NDP10 will coveran important period in Botswana’s economicdevelopment, and will have to address issuesof high unemployment, slow economicdiversification, high levels of dependencyupon government, and budget sustainability.In this feature we address this latter issue, inparticular the fiscal issues that NDP 10 willneed to address to ensure smooth adjustmentto lower mineral revenues in future.

Revenue Prospects

In recent years the government budgetoutturn and trends have been mixed. A fewyears back the budget was in deficit, for thefirst time in many years, due to rapidly risingexpenditure and weak revenues, and therewere genuine concerns that budget trendswere unsustainable. As a result expenditurehad to be restrained, and a new Fiscal Rulewas introduced in the Mid-term Review ofNDP�9. The current budget position is morefavourable, due to improved revenues andreduced spending, and in the last twofinancial years (2005/06 and 2006/07) therehave been significant surpluses. However,reduced spending has been due more to aninability to spend available resources than toa budgeted reduction in spending, and shouldnot therefore be seen as a planned outcome.

While the immediate budget position isreasonably favourable, the position is muchless positive in the medium and long term.The Fiscal Rule introduced in the Mid-TermReview of NDP�9 specifies that governmentexpenditure should be set at 40% of GDP,

on the basis that this represents the averagelevel of government revenues expectedduring the remainder of NDP�9, leading toa balanced (and therefore susta inable)budget.

However, the long-term prospects are formuch lower levels of government revenuesas a proportion of GDP. Current and recentrevenues are high due to the exceptionallyhigh profitability of the diamond industryand the high rate at which those profits aretaxed. In the medium term, production andprofits at these mines wil l decline asproduction moves underground and costsrise. While some new diamond mines areexpected to open, these will be much smallerthan the existing mines, have a relativelyshort life, and are unlikely to be nearly asprofitable as the Debswana mines.Furthermore, as the economy diversifies –whether into other mining activities or intonon-mining activities – tax revenues willdecline in relation to the size of the economyas enterprises taxed at more “normal” ratesbecome more important. In the long term,the government’s tax and other revenueswill most likely decline to around the averagein sub-Saharan Africa of 25%-30% of GDP.This will require a major (downward)adjustme nt in the level of governmentspending, which will have to grow moreslowly than the economy as a whole.

The Need to Adjust

This point was made strongly in a recent IMFpublication, which considered the impactof declining diamond production and themove underground on the government. Theanticipa ted drama tic decline in diamondrevenues between 2021 and 2029 is shownin Figure 6. This shows that diamond revenueswill grow at a healthy rate over the nextdecade, after which time they will declinesharply as production goes undergr ound,and in just over 20 years from now, by 2029,will fall to zero as known diamond reservesare depleted.

The implications of this are clear: (i) effortsto diversify the economy must be intensified,and (ii) the government budget must beplaced on a sustainable adjustment path toa much lower revenue level. The earlier thisadjustment begins, the less traumatic anddrast ic it wil l be. But even a smoothadjustment requires considerable cuts, withbudgeted expenditure falling by up to 1%of GDP each year for the next 15 years.

However, the current starting point of theadjustment process is not as bad as it couldhave been, because government spending

Feature:FiscalSustainabilityIssues in NDP10

Economic Review6has recently been significantly belowbudgeted levels due to underspending andlack of implementation capacity. Althoughexpenditure has been budgeted at 40% ofGDP following the Fiscal Rule, actual spendingwas only around 31-32% of GDP in the2005/06 and 2006/07 fiscal years. But thelong term need for much lower spendingmeans that the emphasis now and duringNDP�10 should not be on ramping upgovernment spending to match revenues,but to make government expenditure moreefficient and focused on long-termsustainability.

Budgetary Principles for NDP�10

In the short-to-medium term this means theGovernment should be spending less than itis earning, and accumulating the balance –i.e., returning to the days of significant budgetsurpluses. This has two benefits. First, itfacilitates the smooth adjustment ofexpenditure levels to lower revenues in thelong term. Second, it means that government(and the nation) can accumulate significantsavings balances that can be used to financefuture expenditure and supplement othersources of revenue as mineral revenuesdecline. Essentially this means building upreserves (both government savings andnational foreign exchange reserves) that canbe used as a capital fund that will generatea permanent future income flow withoutconsuming the capital base of the fund. Thisinvolves treating current mineral revenues

primarily as a resource to build up a capitalasset that can provide long-term annuityincome. The basis for this is already in place,in the form of the Government InvestmentAccount (GIA) at the Bank of Botswana, andthe Pula Fund component of the foreignexchange reserves. However, the balance inthese accounts, especially the GIA, wouldneed to rise sharply if the resulting annuityincome is to be meaningful.

There will also need to be a change inbudgetary principles, with allocations frommineral revenues to long-term savings madeactively before spending decisions are made,rather than as a passive residual dependingon budget outcomes, as at present. It alsomeans that the Government’s accumulatedsavings (balances at BoB) and the nation’ssavings (the foreign exchange reserves) shouldbe viewed as a resource to facilitate andcushion the adjustment process rather thanas a resource to finance a higher level ofspending in the short term.

A second important fiscal issue to beaddressed in NDP10 relates to the balancebetween recurrent and developmentspending. The NDP�9 MTR specified a targetof 30% of total spending allocated todevelopment spending, in order to boost theoverall national investment rate. Lookingfurther ahead, this may not be appropriate.Many public sector investment projects arearguably yielding very low economic (andsocial) returns, especially those involving theprovision of very expensive physical

Figure 6: Projected Revenues from Diamonds

Figure 4: Petrol and Crude Oil Prices Figure 5: Inflation

Figure 2: Business Confidence Index(% of firms rating current business conditions satisfactory)

Survey DateAll Exporters Non-exporters

Source: BPC, BoB, Econsult Source: BoB

Source: CSO, Econsult

Source: Econsult, Dept. of Energy Affairs, US EIA Source: BoB, Econsult

Source: IMF, 2007

(i) For instance, in South Africa government revenues account for26% of GDP

(i) IMF (2007) Botswana: Selected Issues and Statistical Appendix.The projections are based on data from the Ministry of MineralResources and Water Affairs and Debswana.

infrastructure in increasingly remote ruralareas. At the same time, allocations torecurrent spending may be insufficient tomaintain existing infrastructure. Roads are acase in point: a combination of poormanagement and insufficient resourcesmeans that maintenance of the existinginfrastructure is inadequate, while resourcesare being devoted to building new roads inareas with very low traffic volumes. This isunlikely to represent rational allocation andmanagement of scarce resources. HenceNDP�10 needs to ensure greater efficiencyin the use of public financial resources,especially as the availability of such resourceswill decline in coming years.

Key initiatives could include: re-introducingeffective project appraisal techniques andreducing the number of politically drivendevelopment projects; introducing properproject management skills in the public sector,including parastatals; taking better accountof the recurrent expenditure implications andresource needs stemming from developmentprojects; improving productivity and efficiencyin the public sector workforce, if necessaryby downsizing, and terminating ineffective

activities; transferring activities to the privatesector and contracting out under perform-ance related management arrangements;and making better use of international bestpractice techniques in public sector resourceallocation and expenditure decisions in boththe recurrent and development budgets.

Figure 3: Export Growth, 2006–7 (Jan – Sep)f’cast