La Paz, Bolivia
August 14, 1998

Dear Mr. Camdessus:

1. The Bolivian government has developed an economic program through 2002 that is designed to achieve faster economic growth and a more substantial decline in poverty. The details of this program through 2001 are explained in the attached Memorandum of Economic Policies and Policy Framework Paper. In support of this program, we are requesting a new three-year ESAF arrangement in an amount equivalent to SDR 100.96 million (80 percent of quota).

2. The government of Bolivia will provide the Fund with such information as the Fund may request in connection with the progress in implementing its program.

3. The government believes that the policies and measures set forth in these memoranda are adequate to achieve the objectives of our program, but will take any other measures necessary for this purpose. During the period of the arrangement, the government will consult with the Managing Director, on its own initiative or at the request of the Managing Director, concerning the adoption of appropriate measures. In any event, Bolivia will conduct with the Fund a review of the first year of the program supported by the arrangement to be completed no later than March 31, 1999. Moreover, while Bolivia has outstanding financial obligations to the Fund arising from loans under the arrangement, Bolivia will consult with the Fund from time to time, at the initiative of the Government or whenever the Managing Director requests consultations on Bolivia's economic and financial policies.

4. To facilitate a wider distribution of the policy framework paper within the donor community, the Government of Bolivia authorizes its transmittal by the Fund staff to any international organization that request it for the exclusive use of the organization.

1. Since 1985 Bolivia has been implementing a medium-term economic strategy designed to achieve high rates of sustainable economic growth, with a steady reduction in poverty. This strategy has been anchored by a strong fiscal policy, which has aimed at avoiding central bank financing of the nonfinancial public sector. Bolivia has also implemented a comprehensive program of structural reforms to dismantle the extensive state intervention in economic activity that had been built up prior to 1985. The anti-poverty effort was spearheaded by a substantial increase in social spending by the public sector in relation to GDP and improvements in the quality of social programs. Also a series of restructurings of external debt complemented these policies to ensure that the external sector would become viable again. Most recently, in September 1997 Bolivia was declared eligible for debt relief under the Highly Indebted Poor Countries Initiative (HIPC) that would lower the net present value of Bolivia's external public and publicly guaranteed external debt by about US$450 million in September 1998.

2. By 1997, Bolivia had achieved a considerable degree of macroeconomic stability. The structural reforms of the previous 12 years had removed most of the distortions that had affected the economy in the early 1980s. The annualized rate of inflation had fallen from its peak of 23,500 percent in September 1985 to 18 percent in 1990 and to less than 7 percent in 1997, and economic growth in 1997 amounted to 4.2 percent, around the average of this decade. The external debt burden-while still high-had eased substantially, and international reserves amounted to about 7 months of merchandise imports. The external current account deficit rose from about 5 percent of GDP in 1996 to about 8 percent of GDP in 1997, as the structural reforms led to a surge in foreign direct investment (including the construction of the gas pipeline to Brazil at a cost of about 2 percent of GDP per year in 1997 and 1998).

3. Our economic program for 1998 (which is supported by the third annual program under the current ESAF arrangement) is in line with this medium-term strategy. Economic policies seek to boost real output growth to 4½ to 5 percent by stimulating higher domestic investment and savings, limit inflation to 6½ percent, and hold net international reserves constant. The external current account deficit was projected to remain somewhat below 8 percent of GDP. The combined public sector deficit was to rise from 3.3 percent of GDP in 1997 to 4.1 percent of GDP, reflecting mainly the increase in the cost of structural reforms (especially the pension reform) from 3 percent of GDP in 1997 to about 5 percent of GDP in 1998 (Table 1). Key structural reforms included the privatization of the state smelting company (Vinto), and other public enterprises and bringing the refineries of YPFB to the point of sale; improved governance through judicial and customs reform; continued strengthening of financial sector supervision; efforts to develop domestic capital markets further; approval of the insurance law; and the beginning of a dialogue on labor market reform.

4. Economic policies in the first half of 1998 were implemented as expected. The combined public sector deficit amounted to an estimated 1.1 percent of GDP, compared with 2.1 percent of GDP in the program, although the smaller-than-expected deficit largely was explained by shortfalls in external disbursements. Net domestic assets of the central bank declined by Bs240 million, more than expected in the program. With regard to structural reforms, in March and April the central bank issued regulations to encourage greater use of microcredit. In May, the regulations on the new reserve and liquidity requirements, issued in December 1997 came into force. A plan for furthering customs reforms, based on the recommendations of the Fund's Fiscal Affairs Department, has been developed. Measures to improve tax administration and taxpayer controls in the three largest cities were introduced in May. In June, the hydrocarbons tax-monitoring unit was established, the insurance law was approved, and the new customs law was submitted to congress.

5. Economic activity rose by an estimated 4.7 percent in the first half of 1998, as very strong growth in telecommunications and construction more than offset the effects of El Niño on agricultural production. Consumer prices rose by 7.9 percent in the 12-months ended in June 1998, in line with the program. Net international reserves of the central bank rose by US$21 million, compared with no gain in the program.

6. The medium-term strategy pursued since 1985 has yielded significant gains on the inflation and external fronts, but economic growth in recent years and the decline in poverty have been slower than expected. The government believes that this growth performance results from gaps in the implementation of certain key reforms, most notably the lack of a national road network, limited progress in education and health reform, and continued difficulties with the judicial system and customs administration and delays that occurred in the privatization of key public enterprises. Also, the strategy needs to incorporate a comprehensive reform of the labor market, which is governed by antiquated and often contradictory laws and regulations. Against this background, in November 1997 the government launched a national action plan for the period 1998-2002 to reorient the focus of the medium-term strategy by placing renewed emphasis on key reforms, so that all Bolivians can enjoy a higher standard of living.

7. The two key aims of our plan are to raise economic growth from less than 5 percent in 1998, 5 to 5½ percent in 1999, and then to 5½ to 6 percent in 2000 and to achieve a significant reduction in poverty, as measured by improvements in extreme poverty indices, the poverty gap, child and maternal mortality, and child malnutrition. We intend to achieve these goals first by preserving macroeconomic stability, with inflation projected to decline steadily to 6 percent in 1999 and to 5.5 percent in 2000 and international reserves to remain at about 6½ months of imports. Fiscal policy would aim to boost public savings in the next several years to contribute to a strong growth in national savings to help finance the expected growth in investment and keep the external current account deficit on a sustainable path. In addition, the combined public sector deficit would be financed mostly with external concessional resources and declining amounts of bond financing from the private pension funds. By 2002, the deficit would return to 2 percent of GDP (its level prior to the pension reform), when the fiscal costs for the recent structural reforms would be fully absorbed, and the pension funds would be able to contribute fully to the development of the domestic capital market. The central bank will continue to control the expansion in its net domestic credit and maintain the current exchange rate policy so as to adjust the exchange rate in light of the evolution of inflation differentials with respect to its key trading partners.

8. A vigorous and well-targeted structural reform program will also help us boost growth and reduce poverty. We attach very high priority to strengthening education and health reform and the rural development program, with the support of the Inter-American Development Bank (IDB) and the World Bank. Other key structural reforms will include making fiscal decentralization as effective as possible, privatizing all remaining public enterprises, improving road construction and maintenance, carrying out another round of comprehensive financial sector reforms (including the establishment of deposit insurance), deepening of domestic capital markets, and reforming labor market legislation. It will also be essential to weed out corruption through ongoing judicial reform, a complete restructuring of customs, and steps to improve the transparency of government operations.

9. The combined public sector deficit in 1998 will amount to 4.1 percent of GDP, as originally planned, and then decline to 3.6 percent of GDP in 1999 and 3.2 percent of GDP in 2000. Public savings would rise from less than 2 percent of GDP in 1998 to about 4 percent of GDP in 2000, while public investment would rise by about 1 percent of GDP over this period.

10. In 1998, net pension costs are estimated to amount to 4 percent of GDP, compared with somewhat above 1 percent of GDP prior to the pension reform. The nonpension deficit is expected to fall from 0.8 percent of GDP in 1997 to 0.1 percent of GDP in 1998. Public sector revenues (including grants) are projected to rise slightly in relation to GDP, as the 25 percent increase in hydrocarbon prices in December 1997 and improved tax administration are offsetting the loss in revenue resulting from recent structural reforms. The operating balance of the public enterprises will shift from a moderate surplus in 1997 to a small deficit in 1998, due in part to the effect of lower international petroleum prices on the state petroleum company (YPFB) and higher severance payments. Official grants are expected to rise in relation to GDP between 1997 and 1998, while the sale of four small state enterprises will yield a moderate level of capital revenues.

11. Efforts to improve tax administration will continue in 1998. To better coordinate its efforts, the hydrocarbons' unit will draw up a formal work plan, to be approved by the minister of finance, and will produce monthly reports on revenue developments in the hydrocarbons sector. Additional technical staff needed for the operation of the unit will be hired by March 1999, and the proposed 1999 budget will include any necessary funding for this purpose. An improved system of tax collection and taxpayer control, designed with the support of the IDB, was put into operation in Cochabamba, La Paz, and Santa Cruz at end-May 1998, and will be implemented in the country as a whole by end-October 1998.

12. Nonpension current spending will remain stable in relation to GDP, reflecting in part about 0.4 percent of GDP in costs for disaster relief (El Niño and an earthquake in May 1998 that destroyed two small cities). Current spending on reforms in health, education and other sectors will amount to 0.6 percent of GDP, while the general government wage bill (including merit pay for some teachers) will hold steady in relation to GDP. The government will maintain very tight control over other current expenditures to ensure that the deficit target is reached.

13. Capital expenditure by the general government will fall to 6 percent of GDP, reflecting in part unforeseen delays in two key road projects, while investment by public enterprises will fall from 0.7 percent of GDP in 1997 to 0.3 percent of GDP in 1998, following the transfer of the capitalized units of YPFB to the private sector in May 1997.

14. The composition of financing of the deficit in 1998 will differ from the original program. Net external financing is now projected at 2.6 percent of GDP (3.4 percent of GDP in the program). Net domestic financing will not exceed 1.5 percent of GDP (0.7 percent of GDP in the program) to help cover the one-time disaster relief costs and compensate for part of the shortfall in net external financing. This level of net domestic financing is still somewhat below the resources the pension funds will accumulate in 1998.

15. For 1999, the target for the combined public sector deficit of 3.6 percent of GDP incorporates an improvement in the nonpension balance to a surplus of 0.3 percent of GDP, while net pension costs are projected to decline gradually to 3.9 percent of GDP. The decline in net pension costs will be less than had been expected earlier because more eligible persons are choosing to retire under the old social security system.1 In 1999, the combined public sector deficit will be financed mostly with net concessional external resources (2.8 percent of GDP), while net domestic financing (0.8 percent of GDP) will decline considerably, compared with 1998.

16. In 1999, current revenues are projected to rise by 1 percent of GDP. The operating balance of public enterprises is expected to improve by 0.7 percent of GDP, as severance payments will fall to virtually zero as the process of restructuring major public enterprises will finish by end-1998. Tax revenues will improve by 0.6 percent of GDP, as hydrocarbon royalties rise based on the new exports of gas to Brazil and tax administration, particularly the customs reform, improves the collection of trade taxes and of the VAT on imports. These revenue gains are expected to offset moderate declines in nontax revenue and central bank operating profits in relation to GDP, while official grants are projected to remain stable in relation to GDP. To further improve tax administration, the government will request technical assistance from the Fiscal Affairs Department, and will develop a plan based on this assistance by March 1999. A revised tax code will be submitted to congress by June 1999.

17. In 1999, total nonpension spending is projected to rise by 0.5 percent of GDP, reflecting stable current expenditures and an increase in public investment in relation to GDP. With regard to current spending, the general government wage bill will remain constant in relation to GDP, which will include a general wage increase of 6 percent, the inflation target for 1999, merit pay increases for teachers, and some additional increases related to civil service reform. Nonwage current spending on reforms in health, education and other sectors will rise to 1 percent of GDP, and this increase in reform spending will be financed by the decline in interest payments resulting from debt relief under the HIPC initiative. The government also intends to clear a backlog in the processing of tax rebates for exporters (0.3 percent of GDP), and to contribute to assistance for the victims of the May 1998 earthquake (0.2 percent of GDP). Other current spending will be trimmed to meet the deficit target.

18. Public investment will rise to 6.8 percent of GDP, with an emphasis on roads, and public sanitation, and the ongoing reforms of the education, health and judicial systems. The government will enhance the implementation of public investment by ensuring that adequate domestic counterpart funds are available for projects approved in the budget, based on a realistic appraisal of differing implementation capacities across ministries and institutions.

19. To further improve the efficiency of expenditure in 1999 and beyond, especially with respect to employment, the government will complete a public expenditure review, with the assistance of the World Bank, by June 1999, and initiate a civil service reform by December 1999.

20. In 2000, the program calls for a deficit of the combined public sector of 3.2 percent of GDP with the nonpension balance continuing to improve to a surplus of 0.5 percent of GDP while the net pension costs are expected to decline by an additional 0.2 percent of GDP. Consistent with the strategy to improve efficiency in government spending, the wage bill in 2000 (in percent of GDP) will be brought back to the level of 1998. General government investment, with an emphasis on social programs will rise by about ½ percentage point of GDP between 1999 and 2000.

21. An important aspect of Bolivia's capitalization program was the transfer of 50 percent of the shares in the capitalized enterprises to all Bolivians at least 21 years old at end-1995. The previous plan to pass these benefits to the population (the supplementary payments to Bolivians at least 65 years of age known as the BONOSOL) was seriously underfunded in1997, forcing the private pension funds to borrow US$50 million to meet all the payments. After it became clear that they could not finance these payments in 1998 without further borrowing, the pension funds suspended the BONOSOL to preserve their financial integrity.

22. After careful study, the government adopted a new two-pronged program. First, to provide a supplementary payment to elderly Bolivians, an annual pension (BOLIVIDA) will be paid to all eligible elderly citizens (those 50 years of age or older on December 31, 1995) when they reach 65 years of age. The BOLIVIDA will be financed entirely from a Solidarity Fund endowed with 30 percent of the shares held in the Collective Capitalization Fund (FCC).

23. Second, to foster an expansion of microcredit and to deepen the local capital market, younger eligible Bolivians (those between 21 years or older but less than 50 at December 31, 1995) will receive an individual account (Cuenta de Acciones Populares) which they may use as a collateral to obtain credit, sell in the financial market or convert into an annuity when they reach 65 years of age. This program will be financed by the remaining 70 percent of the shares held by the FCC which will be transferred to a mutual fund called the Popular Share Fund (CAP). Shares in the Solidarity Fund and the CAP may be donated to a Social Action Fund (FAS) to be administered by the Catholic Church and other nonprofit organizations for the purpose of financing social work projects such as homeless shelters or to a treasury account designated for road construction. Both the Solidarity Fund and the CAP will be managed by the pension fund administrators.

24. The new scheme will become operational, after the government sets up a new national identification system (RIN) to eliminate fraudulent claims, which were prevalent under the BONOSOL, and the RIN is expected to be in place by May 2000. The government will also establish further safeguards to ensure that the new plan is consistent with the macroeconomic program. In 2000, the government will set the BOLIVIDA at a prudent level. After that, the pension funds will determine the amount of the BOLIVIDA based on the available proceeds from dividends or on the sale of the shares in the Solidarity Fund. The BOLIVIDA may not be financed with borrowing in any year. The shares held by younger Bolivians may serve as collateral only for loans for productive uses or to help purchase or improve a home, and the government will set an annual global ceiling for the amount of shares that can be sold or used as collateral to prevent an excessive expansion of credit. When a market for the shares in the CAP is fully developed, younger Bolivians will be able to sell their shares. Another important safeguard is our plan to develop strong supervision of nonbank financial institutions.

25. Credit policy in the period 1998-2000 will remain prudent. In 1998 net domestic assets will rise in line with the expansion in currency issue, which is projected to grow slightly faster than nominal GDP, and net international reserves will stay constant, as originally programmed. For 1999 and 2000, the growth in net domestic assets will be somewhat less than the expansion in currency issue (which is projected to grow at the same rate as in 1998) to secure a moderate gain in net international reserves to keep gross reserves at about 6½ months of imports. The growth in the demand for broad money is projected to slow from 17 percent in 1997 to about 14½ this year (16 percent in the program) and then to 12 percent in 1999 and 2000. Deposits in bolivianos are expected to grow faster than the U.S. dollar deposits, but the latter will continue to account for about 90 percent of total bank deposits by end-1998. The expansion in bank credit to the private sector is projected to slow from 21 percent at end-1997 to above 14 percent by end-1998 (in line with the program), as some banks prepare to meet the required increase in capital-asset ratios by end-year. For 1999-2000, credit to the private sector is projected to grow in line with nominal GDP. As indicated in our memorandum of economic policies of January 20, 1998, the monetary program in 1998 will be subject to adjustments explained in the technical memorandum to capture the effects of the new reserve requirements and the refining of the central bank's gold.

D. External Sector Prospects

26. The external current account deficit is projected to remain somewhat above 8 percent of GDP in 1998, reflecting a significant weakening of export prices caused partly by the effects of the financial crisis in Asia and continued high imports associated with several large foreign direct investment projects (including the gas pipeline to Brazil). Over the medium-term, the current account deficit is projected to decline to slightly more than 7 percent of GDP in 1999, with private investment expected to fall by about 1 percent of GDP as the construction of the gas pipeline ends and the new export of gas begins. The current account deficit would then fall gradually to 4 percent of GDP by 2002 and stay at that level through 2005. This profile for the external current account deficit reflects an expected slow recovery in export prices and a gradual decline in foreign direct investment from the extremely high level of 9 percent of GDP in 1998 to 7 percent of GDP in 1999 and then to 4 percent of GDP by 2005. With this financing of the current account deficit, the central bank will be able to maintain the international reserve cushion at 6½ months of imports.

27. We view this medium-term outlook for foreign direct investment as a signal that Bolivia's reforms are finally beginning to yield significant gains. The investment projects are in export sectors, such as oil and gas exploration, electric energy and mining, and will contribute to a vigorous growth in exports and economic activity over the medium term. Nonetheless, this outlook is not without risk, particularly if the pace of investment is stronger than expected (or savings rise by less than expected) and bottlenecks begin to emerge in the economy. To guard against these risks, we have developed a contingency mechanism to adjust the target for the combined public sector deficit in 1999 if the current account deficit in 1998 turns out differently than expected. In any event, nonwage spending on key education and health reforms (including PAN) will be protected from expenditure cuts.

28. The government would like to express its gratitude to Bolivia's official creditors for declaring Bolivia eligible for relief under the HIPC Initiative, which is scheduled to be delivered starting in September 1998. This assistance would reduce the external debt burden to a manageable level, provide a final exit from further debt restructurings, and help cover the fiscal costs of recent structural reforms. Based on the final consistency check of the external debt data, the net present value of the external debt-to-exports ratio stood at 252 percent at end-1997, while the debt-service ratio for 1998 is estimated at 25 percent. The Bolivian government will continue to improve the structure of its external debt in order to maximize the benefits that would accrue to it under the HIPC Initiative. In this respect, nonconcessional external public debt will decline by at least US$10 million in 1998, as originally programmed and will continue to fall in 1999 and 2000. In addition, the Central Bank of Bolivia is undertaking a comprehensive analysis of its foreign debt and asset management. Bolivia does not have any external payments arrears, and will not incur any new external payments arrears at any time during the arrangement. This will be a performance criterion.

29. The program of social policies will be carried out in accordance with the strategy described in paragraphs 4 to 14 of the Policy Framework Paper (PFP), and which maintains the targets monitored under the HIPC Initiative.

30. With regard to public sector reform, a plan for further reform on fiscal decentralization, aided by a technical assistance mission of the Fund's Fiscal Affairs Department, will be formulated in accordance with the timetable described in paragraph 15 of the PFP. The privatization of the remaining state-owned enterprises will be implemented as described in paragraph 16 of the PFP. Under the effort to improve governance, the government is carrying out a comprehensive customs reform described in paragraph 19 of the PFP.

31. The government will take steps to improve existing mechanisms for managing, rehabilitating and expanding the national transportation network in accordance with the policies and measures described in paragraph 22 of the PFP. The government will also promote dialogue between the private and labor sectors aiming at the preparation of a new labor legislation.

32. In the financial sector, the strengthening of financial supervision including the establishment of a deposit insurance system will be implemented in accordance with the plan and timetable presented in paragraphs 24 and 25 of the PFP. Also, security market regulations and norms to be applied uniformly to all financial intermediaries will be issued in accordance with the timetable presented in paragraph 26 of the PFP.

33. The key policy actions to carry out these reforms are presented in Table 6 of this Memorandum.

Table 1. Bolivia: Annual Fiscal Cost of Structural Reforms

Table 2. Bolivia: Limits on the Deficit of the Combined Public Sector and Domestic Financing of the Combined Public Sector

Table 3. Bolivia: Limits on the Changes in Net Domestic Assets of the Central Bank of Bolivia

Table 4. Bolivia: Minimum Gain of Net International Reserves of the Central Bank of Bolivia

Table 5. Bolivia: Limits on the Increase of Public and Publicly Guaranted External Debt

Table 6. Bolivia: Benchmarks and Performance Criteria for the Implementation of Selected Structural Policy Measures