Economic Review

Bifm Economic Review 1st Quarter 2008

In common with much of the rest of the

world, Botswana experienced a mixed set

of economic developments during the first

quarter of 2008. While the most recent

growth data and related indicators show

that the economy performed strongly

through 2007, recent months have been

less positive. Inflation has risen sharply,

and shows signs of increasing further over

the next few months before beginning to

fall towards the end of the year. Botswana

also faces uncertainty due to power supply

problems in Southern Africa, and the

impact of economic slowdown in the major

developed economies as a result of the

credit crunch and the associated crisis in the

financial sector, which could affect export

performance.

Economic Growth

The economic growth data released along

with the 20087 Budget, covering the

period July 2006 to June 2007, confirmed

earlier indications that there had been

a strong growth recovery in late 2006

and early 2007. Overall GDP growth rose

from (a revised) 0.6% in the previous year

(2005/6) to 6.2% in 2006/07. The growth

recovery in the non-mining private sector

was particularly impressive; after several

years of a downward growth trend, growth

picked up from (a revised) 5.7% to 9.7%.

The recovery in growth was broad-based,

with transport and communications, trade,

manufacturing and construction the fastest

growing sectors, and all showing much

faster growth than in the previous year.

Although this is only one year of data, these

growth results show that some economic

diversification has taken place, which is

in turn consistent with the picture that

has been emerging recently of successful

export diversification. The revival of the

manufacturing sector, which achieved

growth of 12%, is particularly significant,

as the sector had been struggling for several

years. Export data suggest that the textiles

sector has been growing rapidly, but apart

from this it is unfortunately not possible to

distinguish which particular component of

the manufacturing sector has done well,

as the CSO classes 75% of manufacturing

output simply as “other manufacturing”

(i.e. not meat, beverages or textiles).

Although economic growth has been

impressive, this has not translated into

strong employment growth. Total formal

sector employment rose by only 2.4%

between March 2006 and March 2007,

spread more or less equally across the

private sector and government. This result

is disappointing, as the rapid growth of

the private sector noted above would be

expected to lead to much faster job growth.

But there appears to be inconsistency

between the employment data and the

GDP growth data, which could make one

(or both) of the data series unreliable.

For instance, employment in the fastest

growing economic sector – transport and

communications – supposedly contracted

by 5.1%, even though the sector grew by

20%, and employment in the non-mining

private sector as a whole only grew by

2.2%, even though output grew by 9.7%.

Summary of Economic Developments Dr Keith Jefferis Chairman of Bifm Investment Committee

Introduction

Figure 1: Economic Growth (%)

Source: CSO, Econsult

Figure 2: Economic Growth by Sector (%)

Source: CSO

Economic ReviewHopefully the CSO will be able to improve consistency between various different data sources in future.

The published growth data only cover the period to June 2007, so for the most recent nine months we have to rely on other economic indicators. These suggest that the growth recovery has continued, with data on the real growth of business credit, electricity consumption and government spending all indicating that growth continued to be strong through the second half of 2007.

Nevertheless there are a number of risks to growth going forward. The impact of the problems facing the financial sectors in developed economies is likely, even on the most optimistic forecasts, to lead to a period of slower global economic growth through 2008 and into 2009. The IMF has revised down its global growth forecast for 2008 to 3.7%, with only a slight recovery to 3.8% in 2009. But what is striking is the contrast between projected growth in the major developed economies (only 1.3% in both 2008 and 2009) and that in emerging and developing countries (6.7%). It is encouraging that developing countries appear likely to sustain high growth even with a slowdown in the industrialised countries, an indication of the “decoupling” of growth that has been much talked about. For Africa, forecasts of continued growth of well over 6% are particularly welcome.

Botswana, however, is in a difficult situation. As an export-dependent economy, Botswana

is vulnerable to fluctuations in global

economic growth. Furthermore, Botswana’s

exports are primarily to the major developed

economies that are unlikely to grow rapidly.

The United States is the largest market for

two of Botswana’s three biggest exports

(diamonds and textiles). Taking account of

the ultimate destination of diamonds in the

world market, nearly 70% of Botswana’s

exports go directly or indirectly to the USA,

Europe and Japan, which are all facing a

severe growth slowdown, if not recession.

Perhaps reflecting the impact of the slowing

of growth in the USA, Botswana’s diamond

exports in the last three months of 2008

were 27% lower than in the same period

in 2006. While there is no immediate

problem from this – the foreign exchange

reserves are maintained at high levels

specifically to cope with such situations –

a deep or prolonged recession in the US

would require eventual adjustment to lower

export earnings and government revenues.

A second risk to growth is the ongoing

power supply crisis in southern Africa. This

is discussed further in a feature later in

this Review.

Inflation

The first quarter of 2008 provided more

bad news on inflation, which rose sharply

from 8.2% at the end of 2007 to 9.8%

in March 2008. This was largely driven by

higher food and fuel prices; over the past

12 months, food prices rose by 18%, while

those for “operation of personal transport”

(which is mostly petrol and diesel costs) rose

by 22.5%. These price increases, combined

with their high weights in the CPI basket,

led transport and food costs together to

contribute 6.8% to the overall inflation rate

of 9.8% in the year to March. Underlying

2

Figure 4: Global Growth Forecast, 2008 (%)

Source: IMF

Figure 5: Inflation: Botswana vs. Trading Partners

Source: CSO, Econsult

Figure 3: Business Growth Indicators (Quarterly)

Source: BPC, BoB, Econsult

Economic Reviewthese price increases were higher prices in international markets; for instance the prices for the key food grains wheat, rice and maize were up 108%, 103% and 66% respectively in the year to March, and the price of crude oil was up 50% over the same period.

The upsurge in inflation is not unique to Botswana, and inflation is generally rising around the world. South Africa has experienced a similar increase in inflation, which of course feeds through to Botswana through import price rises. The only good news on inflation is that because it is being experienced worldwide, there has been little change in Botswana’s relative position with regard to inflation, and hence there is little impact on international competitiveness.

Inflation prospects for the remainder of the year are not particularly good, however. International oil prices keep on rising, and

these will eventually feed through to retail

prices. Despite the substantial increases

in petrol and diesel prices on April 15th,

Botswana fuel prices still lag international

prices by a considerable margin, and further

large price increases are likely.

While there is little that can be done about

the rising cost of fuel imports, one policy

response that could help would be to

liberalise domestic fuel prices. At present,

fuel prices are rigidly controlled by the

government, in an outdated system that

prevents competition from playing a role

in making the industry more efficient and

bringing prices down. As an initial reform, it

would be a straightforward move to change

the regulated fixed price into a maximum

price, thereby allowing fuel retailers to

charge lower prices if they wished to do so

to attract more customers. This would enable

price competition to operate, and in areas

with many filing stations – such as the urban

areas where the majority of the population

lives - this is likely to result in lower prices for

consumers, and make a small contribution

to keeping inflation in check.

The likelihood of further increases in

fuel and food prices means that inflation

will probably keep rising for a few more

months. Our current forecast is for inflation

to rise from current levels to peak around

12%, before declining from October

onwards; however inflation is likely to

remain in double digits for the foreseeable

future. Of course this forecast is subject

to much uncertainty given the difficulties

in predicting what is likely to happen to

fuel prices and the extent of second-round

effects; much will depend on what happens

to other regulated prices such as public

transport fares and electricity tariffs.

3

The Bank of Botswana (BoB) presented its 2008 Monetary Policy Statement (MPS) on February 25th. The MPS introduced some potentially far-reaching changes to the monetary policy framework, although it will

take some time so see how much difference

the changes make in practice.

The key features of the old monetary policy

framework included:

• ashort-term(annual)inflationobjective,

and a medium-term inflation objective,

based on expected inflation rates of

major trading partners; the attainment

of the inflation objective would therefore

result in the maintenance of inter-

national competitiveness (by matching

international inflation); this was changed

slightly in recent years following the

introduction of the crawling exchange

rate peg, which allows the Botswana

inflation target to be slightly higher than

international inflation;

• the main monetary policy instrument

was short-term interest rates (Bank Rate/

BOBC rate);

• the intermediate targetwas the rateof

growth of bank credit;

• monetarypolicychangesweredetermined

on the basis of the actual rate of inflation

vis a vis the objective, and the rate of

Feature: The New Monetary Policy Framework

Figure 6: Fuel and Crude Oil Prices

Source: DEA, US EIA, Econsult

Figure 7: Inflation

Source: CSO

Economic Review4way as in the past - will be a crucial

determinant of policy; hence the quality

of the inflation forecast becomes crucial,

and this in term depends on the quality

of the Bank’s medium-term inflation

forecasting model;

• while short-term inflation modelling

and forecasting is quite easy, being

primarily momentum driven, medium-

term forecasting is much more difficult;

it depends upon both high quality

modelling (i.e. a model which can be

shown to perform well in forecasting on

the basis of historical data) and the ability

to accurately forecast a range of real

activity variables (e.g. the rate of future

economic growth, the level of capacity

utilisation in the economy, productivity

growth, government spending, and real

and nominal economic shocks); it also

depends on the quality of the statistical

data on which model is estimated;

• the model should also be capable of

producing a range of forecasts under

different scenarios, with different

probabilities attached;

• thecredibilityofmonetarypolicyactions

would be enhanced if BoB publishes its

inflation forecasts, and in due course

details of the model itself.

The changes represent a partial move

towards the adoption of inflation targeting.

In particular, the adoption of a medium

term inflation target/objective, and the use

of a model and medium-term forecasts to

determine policy changes, are a common

feature of inflation targeting regimes.

However, there are key differences which

mean that the new monetary policy

framework is some way from being a fully-

fledged inflation targeting (FFIT) regime.

One of the most crucial aspects of FFIT is

that the inflation target must dominate

all other macroeconomic policy objectives,

including exchange rate or fiscal policy

objectives. Botswana of course maintains

a pegged exchange rate, determined by

government, and BoB does not have control

over this important component of monetary

policy and determinant of inflation. FFIT

countries all have floating exchange rates.

In addition, fiscal policy is not managed

so as to minimise its inflationary impact.

Furthermore, there is no clear mandate for

BoB to pursue price stability above all other

objectives (whether a statutory objective or

a statement of government policy), and BoB

cannot at present be held fully accountable

for achieving the target.

Inflation targeting has generally been

quite successful in achieving low inflation

across a wide range of countries, although

the current environment of cost-driven

increases in global inflation will provide

inflation targeting regimes with a severe

test. However, it has generally been adopted

by medium or large economies, and there

is limited experience of its use in small

open economies such as Botswana where

inflation is primarily imported and hence

determined by external factors.

As noted above, the 2008 monetary policy

changes in Botswana can be seen as a

“halfway house” towards the adoption of

full inflation targeting. Whether it works

depends crucially on the performance of the

inflation forecasting model and its modelling

of the monetary transmission mechanism,

which will become apparent over the next

2-3 years. However, the adoption of FFIT

would depend on much more than this,

as it would require reform of the Bank of

Botswana Act, and an explicit commitment

to the framework from government. It

would also require a move towards much

greater exchange rate flexibility, with either

a market-determined floating exchange

rate, or at the very least an acceptance that

in the event of conflict between exchange

rate and inflation objectives, the latter

would take precedence. A more flexible

exchange rate policy would in turn require

a new mechanism for building up foreign

exchange reserves and saving mineral

revenues, and would also run the risk

that the exchange rate would appreciate,

leading to competitiveness problems of the

kind that emerged prior to the devaluations

of 2004 and 2005.

credit growth vis a vis the intermediate

target, as well as the growth rate of

government spending and an assessment

of real economic activity.

The changes introduced in the 2008 MPS

include:

• dropping theannual inflationobjective,

and henceforth focusing only on the

medium term objective;

• droppingtheintermediatecreditgrowth

target;

• monetary policy changes will be

determined on the basis of the deviation

between forecast medium-term inflation

and the medium-term objective, i.e. policy

will be adjusted in order to bring the

medium-term inflation forecast in line

with the inflation objective;

• therewillbelessfocusonmeetingshort-

term objectives for inflation and credit

growth.

What are the implications of these changes?

The overall impact should be positive. The

previous focus on short-term objectives

was problematic, in that monetary policy

changes work with a fairly long lag (typically

12-24 months) and hence any changes

made in response to current inflation (in

relation to the annual target) would not

have had an effect within the desired time

frame. So moving towards a medium term

target makes sense in terms of the time

lags involved in the impact of monetary

policy. There have also been concerns

over the usefulness of credit growth as

an intermediate target, its responsiveness

to changes in monetary policy and its

links to inflation - i.e. whether it actually

functioned as an intermediate target as

intended. The new framework should also

enable a more measured monetary policy

response to short-term changes in inflation.

It is also more in keeping with international

practice.

For the changes in monetary policy to be

effective, however, there are several key

requirements:

• the divergence between the medium-

term inflation forecast and the medium-

term inflation objective – set in the same

Economic Review5Feature: Power Supply Issues

required, and is usually reached in winter) reached around 500MW in 2007.

As Figure 9 shows, electricity demand and consumption are very closely related to the level of economic activity. In the non-mining sector of the economy, growth of 1% translates to approximately a 1.6% increase in electricity consumption. If this relationship is maintained, a shortfall in electricity supplies could have a major negative impact on growth: a 10% cut in power supplies would lead to a fall of 6-7% in non-mining GDP.

Over the next few years it is likely that the electricity supply situation will become much tighter, due to a combination of supply shortfalls and rising demand. There are a number of large mining projects, notably the Tati Nickel Activox refinery near Francistown, which will lead to sharply increased electricity demand over the period to 2012. Unless significant demand-management measures - including higher prices - are put in place, it is also likely demand from the non-mining sector, including households, will continue to grow steadily; as noted above, this has been increasing at around 9% a year.

On the supply side, the most important pending development is the reduction in “firm supply” from Eskom under the new Eskom/BPC contract; this was 410MW in 2007, and has been reduced to 350MW in 2008 and 2009, and will fall further to 250MW in 2010 and 150MW in 2011.

Figure 10 shows recent and forecast peak demand. Peak demand determines the level of installed capacity (or firm import supply commitments) needed. The chart assumes that non-mining demand will continue to

One of the major economic developments in the first quarter of 2008 has been the emergence of serious electricity supply problems in South Africa and their spill-over into Botswana, leading to serious supply interruptions in late January and early February. This reflects the reduced level of firm supplies from South Africa under the new Eskom/Botswana Power Corporation (BPC) contract from January 1, 2008 as well as the shared impact of load shedding in South Africa. The impact on Botswana has been considerable, with lost production, reduced productivity and additional costs facing many businesses. Unlike South Africa, however, there are no reports of mining production being adversely affected in Botswana.

Figure 8 shows Botswana’s sources of electricity used in recent years. Around 80% of electricity is imported, with 70% from Eskom. Domestic supply (from BPC’s Morupule power station) accounts for around 20%. Morupule supply has been declining slowly, presumably reflecting the aging of the power station and the resulting maintenance needs. On the demand side, mining accounts for around one-third of total consumption. Over the past decade, mining demand has been increasing at around 5% a year, and non-mining demand at 9% a year. Peak demand (which is the key determinant of the generation capacity

grow at almost 10% a year, while mining demand includes the impact of anticipated new projects, giving total demand growth of around 11% a year and a capacity requirement of 750MW by 2011. The power supply shortfall (the difference between projected demand and anticipated supplies from Morupule and Eskom) therefore rises from around 100MW in 2008 to some 500MW in 2011.

Various strategies are in place to meet this shortfall. Imports of up to 60MW from Cabora Bassa in Mozambique, via Zimbabwe, are supplementing supplies (although they were not available during the crisis period in January and February due to problems with transmission links in Zimbabwe). There is also a tentative scheme to re-open the mothballed Bulawayo power station in Zimbabwe, using coal from Botswana, which could provide Botswana with a further 45MW of power. However, this is progressing slowly, with no firm indication of when this power will be available. Clearly, power supplies originating from or transiting through Zimbabwe are unreliable.

BPC is also about to commence a major expansion of the Morupule coal-fired power station. Morupule B will have a capacity of 600MW (compared to 120MW for the existing plant), so when commissioned will meet almost all domestic requirements. Although it is the stated intention to generate first power from Morupule B by 2010, this appears optimistic, and a more likely scenario is that Morupule B will only be online in 2011 at the earliest. The much larger Mmamabula project, which will provide 2400MW, mostly for export, will only come online in 2013.

Figure 8: Sources of Electricity Figure 9: Growth of Non-mining Electricity Consumption and GDP

Source: CSO, BPC, Econsult

Bifm Botswana Limited Asset 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

Economic Review6To meet the shortfall that is likely to result in 2009 and 2010, BPC has tendered for up to 240MW of short-term generating capacity. This is a common response to supply deficits, and was used extensively in East Africa (Kenya, Uganda and Tanzania) in 2006 in response to shortfalls in hydro power generation due to drought; such “emergency capacity” can be put in place fairly quickly, and is typically diesel powered. The solution adopted in Botswana is likely to be either diesel-powered generation, or possibly gas-fired generation using coal-bed methane.

One way or another it is likely that the required power will be made available and that Botswana will escape severe shortages in 2009 and 2010. The problem, however, will be the cost. Indicative costs of new generation capacity from different power sources are shown in Table 1.

As the table shows, the cost of emergency capacity from small-scale gas or diesel plants is many times higher than that of hydro or coal-fired power, which have been the main sources of power in the region up to now. Current tariff levels in Botswana vary between 40 – 46 thebe/kwh (approx. 6 – 7 US c) for domestic and small business consumers, with lower tariffs for large scale business and mining users. Clearly, current tariff levels are nowhere near enough to cover the cost of emergency power generation, and are unlikely to cover the costs of new coal-fired power generation. Although Botswana electricity tariffs have not been as low as in South Africa, they are still relatively low by world – or even African – standards. Substantial tariff increases – in the region of 50% or more, over and above inflation – are probably necessary to finance the true costs of Botswana’s new generating capacity. BPC has just been granted a 10% - 14% tariff increase by government, but further tariff increases will be necessary over the next 2-3 years to enable BPC to pay for new capacity, to provide an incentive for independent power producers (IPPs), and to provide appropriate signals to consumers to use power more efficiently. Even with such increases, subsidies will be necessary to cover the cost of emergency power

generation. These subsidies could be very expensive: depending on the exact amount of emergency power required, and the price of gas or diesel, the subsidies could amount to P3 billion a year – equivalent to some 10% of government spending and 3% or more of GDP.

While steep price increases will no doubt be unpopular, the experiences of other countries indicates that when faced with a choice, consumers prefer tariff increases to interruptions in supply.

In the discussion of potential sources of power to meet rising needs, in both Botswana and elsewhere in the southern African region, little has been said about the potential of solar power. Clearly Botswana has one of the main inputs – ample supplies of sunshine – and there have been some small scale attempts to use solar as a means of providing electricity and water heating in off-grid areas. For rural electrification, where grid infrastructure costs are high and power usage low, domestic solar installations using photovoltaic technology are already more cost-effective than the provision of grid power to smaller and more isolated

settlements. At a larger scale, however, there is little experience internationally of power stations based on solar energy to provide electricity to the grid, although there are a few experimental plants in Europe, the USA and Australia producing up to 20MW. With current technology, capital costs are high and solar is still relatively expensive when compared to coal or hydro power.

However, the economics of power generation are changing in a direction that is likely to favour solar energy: coal input costs are rising (following higher oil and gas prices); environmental factors weigh against coal with its high carbon dioxide emissions, and changes taking place in solar energy technology are bringing down costs. The development of carbon-offset trading mechanisms under the Kyoto Protocol, where carbon credits can be sold, would provide additional revenue to solar power producers. In the medium-to-long term, large-scale solar power may well prove an attractive alternative (or complement) to coal-fired power generation in Botswana.

Table 1: Approximate Cost of Electricity from Different Sources (New Capacity)

Source Cost (US cents per kWh) Cost (thebe per kWh)

Large-scale hydro 2 - 4 12 – 25

Large-scale coal 6 – 8 40 - 50

Small-scale diesel 25 – 35 160 - 230

Figure 10: Electricity Demand and Supply Projections

Source: Econsult