Maputo, June 10, 1999

Dear Mr. Camdessus:

1.  The government of Mozambique has prepared a new program of economic and structural adjustment that it intends to implement during the next three years. The main elements of this program are described in a new policy framework paper, covering the period April 1999-March 2002, which has been prepared in collaboration with the staffs of the Fund and the World Bank. The attached memorandum on economic and financial policies sets forth in detail the objectives and policies that the government intends to pursue during the first year of the program.

2.  In support of its program, the government of Mozambique hereby requests a new three-year arrangement under the Enhanced Structural Adjustment Facility (ESAF), in an amount equivalent to SDR 58.8 million (52 percent of quota).

3.  The government of Mozambique believes that the policies and measures set forth in the attached memorandum on economic and financial policies (MEFP) are adequate to achieve the objectives of the program to be supported by the new ESAF arrangement, but it will take any further measures that may become necessary for this purpose. Moreover, the government will continue to consult with the Fund from time to time on its economic and financial policies, in accordance with the Fund's policies on such consultations, and to provide the Fund with such information as the Fund requires to assess the government's progress in implementing the economic and financial policies described in the MEFP.

4.  The government will conduct with the Fund by end-January 2000 a midterm review of the first-year program under the three-year ESAF arrangement, based on performance criteria for end-September 1999. A second review will take place at the end of the first-year program; it will be based on performance criteria for end-March 2000 and will specify the second-year program.

Sincerely yours,

Attachment: Memorandum on Economic and Financial Policies

Mr. Michel Camdessus
Managing Director
International Monetary Fund
700 19th Street, N.W.
Washington, D.C. 20431

1.  Introduction. This memorandum sets forth the government of Mozambique's economic objectives and policies for the period from April 1999 to March 2000, the first year of a program to be supported by a new three-year ESAF arrangement under the Enhanced Structural Adjustment Facility (ESAF). These objectives and policies are an integral part of the government's economic strategy for the medium term, which is described in the policy framework paper (PFP) supporting the request for the new ESAF arrangement.

2.  Economic objectives for 1999-2000. The first-year program seeks to (a) contain the 12-month rate of inflation to 5-6 percent; (b) maintain gross international reserves at five months of imports of goods and nonfactor services; and (c) establish the conditions for average annual real GDP growth of around 8 percent. In setting these macroeconomic objectives, the government can build on the record of growth with stability achieved in recent years. Preliminary estimates of GDP suggest that 1998 was the second consecutive year of double-digit real growth. The 12-month rate of inflation, which had fallen to 5.8 percent during 1997, continued to decline and was negative at end-1998. At the same time, Mozambique has accumulated gross international reserves (to 6.7 months of import cover at end-1998) and maintained a relatively stable average exchange rate, implying a significant appreciation against the South African rand. The latter development, together with falling world commodity prices helped to lower inflation. While the government will maintain its strong policy stance, it recognizes that the external environment may not remain so favorable. Inflation will likely rise with the combination of higher prices for South African goods and a possible turnaround in commodity prices, as has already been the case with oil prices. Domestically, the recent substantial increase in the minimum wage and the introduction of the value-added tax (VAT) will also exert some upward pressure on prices.

3.  Fiscal adjustment in 1999-2000. The domestic primary deficit, before grants, is projected to increase from 0.6 percent of GDP in 1998 to 2.6 percent in 1999, but to narrow to 1.7 percent in 2000 because of both higher revenue and reduced spending pressures. A number of recent fiscal reforms are expected to have an adverse budgetary impact in 1999, but they will likely improve the economic environment for the private sector and build a better-performing public administration. These reforms include the restructuring and reduction of personal and corporate tax rates in 1998, the reduction of the maximum import tariff in April 1999, a strengthening of customs administration, a further step in the decompression of civil service salaries, and increased employment of teachers and health care personnel. In addition, there are budgetary costs associated with the recent increase in the minimum wage and with the presidential and parliamentary elections due by October 1999, and the petroleum tax arrears collected in 1998 will not be repeated in 1999.

4.  Revenue mobilization. The government considers revenue mobilization to be the foundation of a sustainable fiscal platform. Therefore, measures have been or are being taken to increase revenue by about ½ of 1 percentage point of GDP a year in 1999 and 2000. These comprise the replacement of the turnover and consumption taxes (and of the tourism tax from 2000) by the VAT and selected excise taxes; a substantial increase in rents in January 1999; and improvements in customs administration. In 1999, these measures will at least offset the decline in revenue arising from the cuts in tax rates mentioned above; their full impact will be felt in 2000. Other actions (discussed below) will be taken to widen the revenue base and strengthen internal tax administration. The government does not propose to adjust tax rates further in 1999-2000, but it will take offsetting revenue measures in the event of a revenue shortfall.

5.  Tax base. To maximize revenue and increase the equity and efficiency of the tax system, the government will step up its efforts to widen the tax base. The recently introduced VAT is broadly based, with a single rate and few exemptions. A documentation of the legal basis, terms, and duration of all existing tax and customs exemptions has just been completed and will be used to begin paring down exemptions. The use of customs exemptions is already being carefully monitored by the customs department, and a recording system for monitoring exemptions on domestic taxes will be created shortly. In addition, the tax and tariff system itself will be reviewed by end-March 2000, and in this context, the government will decide on further rationalizing the exemptions regimes.

6.  Customs administration. The ongoing customs reform is a key element of the government's efforts to improve tax administration. The contract with the foreign company that has been managing customs since May 1997 ends in December 1999, at which time control of customs is expected to be passed back to Mozambican hands. The government will continue to provide the necessary financial and other support to customs to ensure that the management company completes its scheduled work by end-1999. In particular, the government will see to it that the computerization of at least ten customs clearance points is completed by end-September 1999, and that 500 redundant customs personnel are redeployed by the end of 1999. If necessary, the government will consider retaining the private company as a consultant for a period of time after 1999 to provide post-contract support. The government intends to submit to the National Assembly by end-December 1999 revised customs legislation, comprising a consolidated customs act, the customs code, and a new law establishing customs tribunals. The updated legislation will provide for an integrated customs department, the criminalization of customs offences, and authority for the customs department to prosecute customs offenders. The VAT refund mechanism for exporters has been made fully operational, with the establishment of the relevant forms, control procedures, and payment arrangements.

7.  Internal tax administration. Efforts to strengthen internal tax administration have been undertaken as part of the preparation for the introduction of the VAT. These efforts will soon be broadened to cover direct taxes. The taxpayer identification number--newly introduced for the VAT and domestic excises--will be applied to personal and corporate income taxes and customs duties, and work will begin on extending the VAT and customs computerized databases to include direct taxes. The auditing capacity of the internal tax office will be boosted with the recruitment of at least ten additional audit officers and the organization of at least two training courses. Finally, consideration will be given to the creation of a central revenue authority.

8.  Expenditure policy. The recent increase in the minimum wage, the decompression of civil service salaries, election-related costs, and an increase in income transfers to the poor, together, are expected to raise current government spending by almost 1¼ percentage points of GDP during 1999. In view of this, the government will keep other current expenditures in 1999 at their 1998 level in relation to GDP, and the phasedown of the private management contract with customs and the non-recurrence of election costs will reduce spending pressures in 2000. Thus, notwithstanding a relative increase in the wage bill, current expenditure is expected to decline by about ½ of 1 percentage point of GDP in 2000. In line with the expectations under the Initiative for Heavily Indebted Poor Countries (HIPC Initiative), the government has budgeted increases in real current spending on education and health of 15.8 percent and 16.4 percent, respectively, over the period 1999-2000.

9.  Expenditure management and budget reform. To increase the efficiency and transparency of the budgetary process, improve expenditure management, and guarantee the sustainability of public expenditure programs, the government has been implementing an expenditure management reform program. From 1999, the government will formally close the budget accounts for the previous year in December and submit the audited accounts to parliament. The government has begun to identify and will progressively remove any institutional and legal impediments to the inclusion in the budget of previously off-budget revenue and expenditure flows. Coverage of foreign aid flows in the budget has already been broadened with the inception of the present program. A medium-term expenditure framework will be prepared and linked to the annual budget so as to match sectoral expenditure priorities with resource availability and thereby enhance the sustainability of programs. Also, a new system of public accounting is expected to be approved by end-September 1999. To clarify the government's domestic claims and liabilities for use in the upcoming budget, the government has recently established inventories of its outstanding claims on public and private entities, and of its liabilities stemming from the privatization and restructuring of large enterprises and banks.

10.  Social security system. Because of payments to demobilized soldiers under the terms of the 1992 peace agreement, government pension payments in 1998 substantially exceeded contributions by workers. The government has therefore decided to assess the long term viability of the public sector pension system as well as the pension system administered by the National Social Security Institute. It will commission actuarial studies of both schemes in 1999.

11.  Monetary policy. The monetary program seeks to limit broad money growth to 17 percent in 1999 and 13 percent in 2000, on the assumption of a continued gradual slowdown in velocity in connection with the development of the financial sector. Given a projected substantial increase in government deposits in 1999 stemming from foreign aid disbursements, there will be room for both an increase in net foreign assets and a healthy expansion of bank credit to the private sector. In 2000, however, government deposits and the central bank's net foreign assets are projected to decline, while credit to the private sector will continue to grow.

12.  Targets and instruments of monetary policy. Currently, monetary policy targets the net domestic assets of the banking system, and the target is achieved primarily through limits on the net domestic assets of individual banks. For some time now, the central bank has been preparing the ground for the use of indirect instruments of monetary policy, and considerable progress has been achieved along this route. Most recently, minimum reserve requirements were extended to time deposits of more than one year maturity. With the ultimate objective of influencing liquidity conditions primarily through operations in treasury bills, the central bank will seek to phase out operations in its own bills, as it acquires authority and experience in issuing treasury bills for monetary control purposes. In recognition of the difficulties of projecting accurately the demand for money, and to permit a flexible response to unforeseen capital inflows, the monetary performance criterion under the program will target the net domestic assets of the central bank. At the same time, the central bank will monitor closely changes in the supply of reserve money as an important and early indicator of the expansion of broad money in the system.

13.  Open market operations. The new approach to monetary targeting will require that the central bank deal primarily and actively in treasury bills, and continued efforts will be made to develop the market for such bills. Specifically, by the end of 1999, the Bank of Mozambique will be authorized to hold regular auctions of treasury bills; it will determine the amounts of the auctions on the basis of cash-flow forecasts shared with the Ministry of Planning and Finance, as needed for monetary control purposes. Meanwhile, the treasury's capacity to forecast and manage its cash flow will be enhanced through technical assistance, the source and terms of reference of which have already been identified.

14.  Bank supervision. The rapid development of the financial sector in recent years underscores the need for effective bank supervision. The central bank will monitor closely the restructuring of the two banks that were privatized in 1996-97 to ensure that capital adequacy and prudential requirements are observed, and it will actively enforce the Core Principles for effective bank supervision of the Basle Committee. In this context, the limits on the foreign exchange exposure of commercial banks will be monitored closely. The Bank of Mozambique's capacity for on- and off-site inspection of banks has been strengthened, and annual on-site inspections of all banks will continue. By the end of 1999, the recently drafted new chart of accounts for commercial banks will be adopted for application starting in the year 2000.

15.  Other structural reforms. Major reforms are being undertaken to improve public administration and encourage private sector development. These include the ongoing revision of career streams, pay scales, and compensation structure in the civil service; the preparation of new civil service regulations that include performance standards and incentive mechanisms; the development of a strategy for a major public sector reform including a functional review of ministries; the improvement of the judicial system; the revision of the commercial code; the continued reduction of bureaucratic obstacles to investment and trade; and the adoption of regulations to define and protect urban land-use rights. The earlier program of privatizing selected large enterprises was completed in September 1998, with the exception of the national airline, which--in the absence of acceptable bids--was converted into a limited liability company with the intention of selling the government's shares on the future stock exchange. The program of privatizing and restructuring small and medium-sized enterprises will be completed in June 1999. By end-March 2000, the government will prepare a policy statement regarding the future of the remaining public enterprises and of companies with majority state ownership. Details of these and other structural reforms are provided in the government's policy framework paper supporting the request for a new three-year ESAF arrangement.

16.  Exchange rate policy. The program envisages that an accumulation of net international reserves of about US$100 million in 1999 will be followed by a drawdown of about the same amount in 2000, reflecting mainly the expected disbursement pattern of foreign aid. Subject to meeting its reserves target, the Bank of Mozambique will intervene in the foreign exchange market primarily to smooth out fluctuations in the exchange rate. Where it is necessary to exceed the target in order to prevent an excessive appreciation of the currency, appropriate monetary sterilization will be considered.

17.  Trade policy. Mozambique's trade regime is relatively open. The government will continue to participate actively in negotiations on regional integration in the Southern African Development Community (SADC), while avoiding the introduction of measures that run counter to a progressive multilateral trade liberalization. In this context, the government will further reduce the level and dispersion of import tariffs during the period of the new three-year ESAF arrangement. Following the recent reduction in the top import tariff rate from 35 percent to 30 percent, a further reduction to 25 percent is envisaged to take effect in January 2002. In addition, the justification for the existing surcharges on imports of cement, steel plates and tubes, and sugar will be reassessed in the near future. The government will not adopt new or increase existing general import surcharges or export taxes and restrictions.

18.  External debt and the HIPC Initiative. Once Mozambique's request for a new three-year ESAF arrangement has been approved, a further key condition required for reaching the completion point under the HIPC Initiative will have been met. Mozambique expects to fulfill all other conditions at the same time and looks forward to receiving assistance under the Initiative and achieving debt sustainability. In this context, the government is committed to a sound management of its internal and external debt and will continue to avoid any external borrowing on nonconcessional terms.

19.  Exchange restrictions. During the period of the ESAF program, the government will not impose or intensify restrictions on payments and transfers for current international transactions; will not introduce multiple currency practices; will not conclude bilateral payments agreements that are inconsistent with Article VIII of the Fund's Articles of Agreement; and will not impose or intensify import restrictions for balance of payments reasons. Furthermore, the government will not incur any new external payments arrears, except arrears on payments that are subject to debt rescheduling negotiations. Mozambique intends to accept the obligations of Article VIII, Sections 2, 3, and 4 of the Fund's Articles of Agreement in July 1999.

20.  Performance criteria and benchmarks. The quantitative performance criteria and benchmarks that will be used to evaluate the government's progress in implementing the first-year financial program, as well as the test dates on which such evaluation will take place, are shown in Table 1 attached to this memorandum. The first four represent key financial objectives of the program, the next two will help to maintain a sustainable external debt position, and the last one is intended to protect Mozambique's external creditworthiness. The structural performance criteria and benchmarks are shown in the attached Table 2. These comprise specific actions that are important for the success of critical reforms in the various areas indicated. The government understands that its ability to request disbursement of the second loan under the three-year ESAF arrangement will be contingent upon the observance of the performance criteria set out in Tables 1 and 2, and the completion of the first review of the program, scheduled to take place by the end of January 2000.