Cape Verde—Letter of Intent, Memorandum of Economic and Financial Policies, and Technical Memorandum of Understanding

March 11, 2002

Mr. Horst Köhler
Managing Director
International Monetary Fund
Washington, D.C. 20431

Dear Mr. Köhler:

The government of Cape Verde implemented during the period August-December 2001 a wide-ranging economic stabilization and adjustment program that was informally monitored by Fund staff. The staff-monitored program (SMP) helped stabilize the macroeconomic situation and facilitated our dialogue with other multilateral agencies and donors.

The attached memorandum of economic and financial policies reviews performance under the SMP and sets out the objectives the government of Cape Verde intends to pursue in the context of a new medium-term program covering the period January 1, 2002-December 31, 2004. To facilitate the achievement of these objectives and implementation of the necessary policies, the government requests a three-year arrangement under the Poverty Reduction and Growth Facility (PRGF) in an amount equivalent to SDR 8.64 million (90 percent of quota).

The government will make every effort to improve the coverage and timeliness of economic and financial statistics and provide the IMF with such information the Fund requests to monitor the program adequately. In this context, the government will consult regularly with the IMF staff and keep it informed of the progress in the implementation of economic and social policies.

The government believes that the policies and measures described in the attached memorandum are adequate to achieve its program objectives but will take any further measures that may prove necessary for this purpose. After the period of the new PRGF arrangement and for as long as Cape Verde has outstanding financial obligations to the Fund arising from the loans under the arrangement, the government will consult with the Fund from time to time, at the initiative of the government or whenever the Managing Director requests consultation, on Cape Verde's economic and financial policies.

The government of Cape Verde will conduct with the Fund two reviews of the first annual program supported by the new arrangement, the first not later than end-October 2002 and the second before end-April 2003.

Sincerely yours,

Cape Verde:
Memorandum of Economic and Financial Policies for 2002-04

I. Introduction

1. Following a period of strong economic growth and accelerated implementation of structural reforms, the macroeconomic situation deteriorated considerably and the reform agenda stalled in the run-up to the legislative and presidential elections in early 2001. Following national elections in January and February 2001, the new government that took office committed itself to a substantial tightening of financial policies during the second half of 2001, as well as an acceleration of structural reforms, in the context of a staff-monitored program (SMP) with the IMF. This memorandum reviews performance under the August-December 2001 SMP, presents the medium-term objectives of the government's program, and sets out the policies and measures the government of Cape Verde intends to pursue in the first year of the program.

2. To guide its policy framework, the government has prepared an interim poverty reduction strategy paper (I-PRSP) in a national consultative process with civil society. The government's full poverty reduction strategy will be developed in the coming year, focusing on a framework to achieve broad-based improvements in living standards in the context of a sustainable high-growth strategy, improved governance and transparency, and enhanced delivery of social services.

II. Performance Under the August-December 2001 SMP

3. Performance under the SMP was satisfactory, and all quantitative benchmarks were met. The central government during the second half of the year managed to reduce its indebtedness vis-à-vis the banking system by CVEsc 0.7 billion (1 percent of GDP), compared with a programmed increase in domestic bank financing of CVEsc 0.7 billion. Concomitantly, net domestic assets of the central bank decreased by CVEsc 0.7 billion over the same period, compared with a programmed increase of CVEsc 0.5 billion. In addition, the government regularized a good part of its stock of domestic arrears (through reschedulings and cancellations) without accruing new domestic arrears. There was also no new accumulation of external debt arrears by the central government or nonconcessional external borrowing during the program period.

4. An overall fiscal surplus (including grants) of CVEsc 1.2 billion was recorded in the second half of 2001, compared with a programmed deficit of CVEsc 0.4 billion. The sizable improvement in the fiscal position is explained in part by the strong increase in domestic revenue, which exceeded forecasts by CVEsc 2 billion, reflecting improved tax administration, the exceptional collection of tax and nontax revenue arrears, and unexpectedly large profit transfers from public enterprises. These higher domestic receipts were able to offset, to a large degree, smaller-than-programmed capital grants and the delayed disbursement of European Union budget support. ¹ At the same time, expenditures were contained well below program ceilings, aided by lower capital expenditure (primarily foreign financed), the large increase in domestic retail petroleum prices (which virtually eliminated the government's domestic petroleum subsidy to consumers), and the reduction in loans to university students abroad. These reductions, however, were in part offset by larger transfers to municipalities and public institutions. Nonetheless, the overall fiscal deficit in 2001 was limited to 3 percent of GDP, well below the deficit target of 5 percent.

5. In the wake of the fiscal consolidation observed in the third and fourth quarters, monetary aggregates continued to stabilize. Broad money expanded by 9½ percent in 2001, compared with an increase of 13 percent in the previous year. Money growth was constrained as the banking system's net claims on the central government fell by 0.4 percent, while credit to the private sector increased by 6.9 percent and net foreign assets of the banking system increased by 5.8 percent (as a share of beginning-of-period broad money). Gross international reserves of the Bank of Cape Verde (BCV) increased sharply, by € 17 million, during the third and fourth quarters. At the end of 2001, international reserves stood at € 47½ million (equivalent to US$42 million, or 1.6 months of imports). This sharp increase was due, in large part, to purchases from commercial banks reflecting sizable emigrants' deposits, the World Bank's end-December disbursement of US$7.5 million, and the BCV's one-off purchase of some US$8 million in foreign currency from commercial banks; the BCV's purchase, in turn, reflected customers' conversions of euro zone countries' currency notes into local currency in advance of the introduction of the euro.

6. The government made good progress on the structural front. The Council of Ministers approved the legislative framework for introducing a value-added tax (VAT) and the liberalization of the external tariff regime in September (a structural benchmark) and submitted it to the National Assembly for approval in December (also a structural benchmark). Submission to the National Assembly was delayed by two months, owing to the complex nature of the necessary technical support documents. The government drafted a revised central bank organic law, with assistance from Fund staff, which was approved by the Council of Ministers in February 2002 three months later than anticipated, as a consequence of the lengthy review of the technical issues involved by legal and banking experts. In addition, an international team of experts, with World Bank assistance, reviewed the administered price mechanism for domestic petroleum products and presented initial recommendations to the government in November for the introduction of an automatic and transparent pricing mechanism in 2002.

III. Program for 2002-04

A. The Poverty Reduction Framework for the Medium-Term Program

7. Cape Verde has a well-developed poverty reduction strategy based on the 1997-2000 National Development Program (NDP) and the National Poverty Alleviation Plan (NPAP). The NDP is a comprehensive framework with macroeconomic stability, private sector-led growth, and social and environmental sustainability as key objectives. The NPAP consciously targets rural poverty, while aiming at an improvement in the overall effectiveness of poverty reduction programs. The NPAP is based on three pillars: (i) labor-intensive public works financed largely by counterpart funds generated from donated food aid; (ii) economic integration of the poor; and (iii) a social emergency fund, geared to respond to disasters and epidemics. The new administration updated this vision in a document presented to parliament in November 2001 that describes the government's economic development and poverty objectives, as well as its policy priorities for the 2002-04 period. Known as the Grandes Opções do Plano, this paper outlines the government's sectoral objectives and priorities. The five priorities are (i) the promotion of good governance; (ii) support for private sector-led growth and the broadening of the productive base; (iii) the development of human capital; (iv) the promotion of a holistic approach to fighting poverty; and (v) a balanced development of infrastructure across the territory of Cape Verde.

8. To help design and implement the programs and policies that will achieve these objectives, in a way that is consistent with the overall macroeconomic framework, the government is developing a comprehensive poverty reduction strategy paper (PRSP), which it expects to complete in 2002-03. As a first step, the government prepared in January 2002 an interim PRSP (I-PRSP) that provides a framework for the development of the full strategy. The I-PRSP contains a diagnosis of the poverty situation, including an analysis of the socioeconomic composition of poverty and the quality and timeliness of poverty statistics. The I-PRSP presents the priority focus of the poverty strategy, including increasing income and productive employment opportunities across the country, enhancing the capacity of the public sector to implement policy reforms and program mandates, improving access to social services, and strengthening governance and human development. Consistent with this strategy, this memorandum presents the government's medium-term program for the period January 1, 2002-December 31, 2004 and the specific objectives and policies it will pursue during the first year of the program.

B. Medium-Term Program Objectives

9. Over the medium term, the government will focus on maintaining macroeconomic stabilization and a policy environment that encourages a broad-based increase in economic growth and poverty reduction. While economic growth decelerated somewhat in 2001, partially reflecting an uneven rainy season and the deteriorating global environment unfolding in the wake of the events of September 11, 2001, real GDP growth is expected to increase significantly over the medium term. This growth will be led by strong private sector investment and improvements in basic infrastructure, which will boost tourism and the nascent export sector, and by a continued strong performance in the construction and services sectors.

10. The key macroeconomic objectives of the program are to (i) increase the annual rate of economic growth from 3 percent in 2001 to 4½-5 percent by 2004; (ii) reduce the annual rate of inflation from 4 percent in 2001 to that of Cape Verde's major trading partners by 2004 (2-2½ percent); (iii) reduce the external current account deficit (including grants) from 10½ percent of GDP in 2001 to 5½ percent in 2004; and (iv) increase gross international reserves from 1.6 months of imports of goods and services in 2001 to 2.2 months in 2004. The improvement in growth would be supported by a rebound in domestic investment from 20 percent of GDP in 2001 to 22-22½ percent in 2004. The program also targets a broad-based reduction in poverty, including, in particular, a sustained reduction in infant mortality rates and an increase in life expectancy. ²

11. To achieve these objectives, the government will ensure a supportive macroeconomic framework, including (i) a stable macroeconomic environment, with an appropriately constrained fiscal and monetary policy stance, necessary to support the pegged exchange rate and encourage private investment; (ii) the elimination of domestic and external payments arrears and the timely payment of debt service; (iii) a more focused role for the public sector in the economy, including through divestiture, deregulation, and civil service reform; (iv) the acceleration of the domestic debt-reduction operation, with a view to reducing markedly the domestic debt-to-GDP ratio; and (v) the improved targeting of public expenditure to the social sectors, and the greater effectiveness of that expenditure, including improvements in the delivery of health and education services.

C. Program for 2002

12. The government's program for 2002 aims at ensuring macroeconomic stability and restoring internal and external viability; bringing the economy onto a sustainable growth path; and accelerating efforts to reduce poverty. Within this framework, the main macroeconomic objectives of the program are to (i) maintain annual economic growth in a range of 2½-3 percent; (ii) reduce end-period inflation to 3 percent; and (iii) increase gross international reserves by € 6 million (to 1.7 months of imports).

Fiscal policy

13. Following the significant improvement in fiscal performance in 2001, fiscal policy for 2002 is geared toward continuing the consolidation. In the context of a substantial reduction in domestic and external arrears and sizable retrenchment outlays associated with the liquidation of two public enterprises, the overall fiscal deficit (including grants) is targeted to remain at 3 percent of GDP (CVEsc 2.2 billion) in 2002, after falling from 19 percent of GDP in 2000; the primary current surplus is expected to increase from 3 percent to 3½ percent of GDP (CVEsc 2.6 billion) over the same period. This outcome will be achieved through spending restraints and targeted revenue measures. In order to ensure the government's ability to pay—in a timely manner—all authorized expenditures, the treasury will strengthen internal control mechanisms, prioritize spending, and ensure the availability of resources for committed expenditures. The government is committed to achieving the fiscal targets agreed under the program, which are based on lower domestic revenue projections and lower expenditures than included in the budget approved by the National Assembly. Lower domestic revenue estimates reflect, in large part, the estimated impact of the events of September 11, 2001 on tourism and remittances, the impact of slower world economic growth in 2002, and the nonreoccurrence of a number of one-off measures in 2001 (including the collection of tax and nontax revenue arrears). The lower domestic revenue projections under the program in 2002 will be partially offset by larger foreign grants. In addition, the government will meet the reduced expenditure targets under the program by using its statutory authority to limit transfers to institutions and capital expenditure.

14. As the government accelerates its efforts to reinforce tax administration and payment discipline and introduces several additional tax measures, domestic revenue (including domestic capital participation and net loan repayments) is projected to stabilize in the range of 22 percent of GDP in 2002 (CVEsc 16.4 billion), after increasing substantially in 2001. Revenue measures in 2002 include actions in six areas. First, an increase in the tax on certain unsubsidized petroleum products will cover the amortization costs associated with repaying the regularized domestic debt accumulated with the petroleum companies. (This increase will be introduced in concert with the new petroleum price mechanism by end-June 2002 and is expected to generate some CVEsc 140 million in 2002). Second, the customs user fee will be increased by 1 percentage point to 9 percent. Third, the temporary reduction in the preferential tax rate for commercial banks introduced in 2000 will be eliminated. Fourth, tax arrears will be collected through the formation of a special tax collection task force. Fifth, profit transfers will be increased as government reviews the audited accounts of selected public enterprises. Finally, the collection of debt service due to the government from public enterprises will be improved.

15. Structural reforms in the fiscal area aim at expanding the tax base and strengthening revenue collection. These reforms will center on the replacement of the consumption tax (levied on imported commodities) with a broad-based VAT at a uniform rate of 15 percent and the liberalization of the external tariff regime. The VAT and tariff reform proposals were approved by the Council of Ministers in September 2001 and submitted to the National Assembly in December 2001. The government will undertake considerable preparatory work, with the assistance of several bilateral and multilateral donors, during the remainder of 2002 to ensure the successful introduction of the VAT on January 1, 2003, including (i) restructuring the VAT committee and the National Tax Institute; (ii) providing training to the tax administration; (iii) installing the necessary information systems; and (iv) undertaking a nationwide publicity campaign during the remainder of 2002.

16. The government inherited a system of numerous custom and tax exemptions for a wide variety of sectors. While the government continues to support the exemption from taxes and duties of certain high-priority sectors and diplomatic missions, it intends to undertake a review of exemptions by end-September 2002, and to introduce measures to prioritize their application and reduce the level, in the context of the 2003 budget.

17. Following the dramatic reduction in expenditures in 2001, public spending will continue to be strictly limited. As a result, primary current expenditures, as a share of GDP, will fall from 19 percent in 2001 to 18 percent in 2002 (CVEsc 13.3 billion). The continued expenditure consolidation will be achieved through the implementation of the following measures:

• After having effectively eliminated petrol price subsidies in 2001 (through increases in the administered price), the government will introduce an automatic and transparent pricing mechanism for retail petroleum products by end-June 2002 to delink the budget from fluctuations in the world market price.

• The government will limit the increase in public sector salaries to 2.5 percent, in line with the wage negotiations concluded with the trade unions in November 2001. The overall wage bill will increase by 6 percent reflecting the salary increase, the hiring of some 200 additional teachers, and the increase in tax administration staff to meet a critical shortage.

• During 2002, and before a new financing mechanism is established for university-level student scholarships abroad, the government will continue to limit monthly subventions.

• The treasury will further strengthen its efforts to (i) prioritize expenditure; (ii) verify—prior to a spending authorization—that sufficient funds are available to pay for the corresponding goods and services in a timely manner; and (iii) identify and eliminate wasteful expenditure.

• The government will accelerate the divestiture program for public enterprises in order to reduce subventions and limit a further buildup in contingent liabilities of the central government.

18. The government is confident that these measures will be sufficient to ensure that the overall fiscal deficit target is met. However, it is prepared to institute further revenue-enhancing and expenditure-reducing measures, if necessary, to meet the performance benchmarks. In this regard, the government will undertake a formal review of budget performance at the end of each quarter and adjust expenditure in the subsequent quarter (focusing on transfers to institutions and capital expenditure) so as to meet the cumulative fiscal deficit benchmarks.

19. As outlined in the I-PRSP, the government will ensure adequate funding for priority social sectors, primarily health and education, protecting them from possible across-the-board expenditure cuts (should these become necessary). Current expenditure on health and education will be maintained at 6 percent of GDP in 2002. In addition, the government will broaden the pension scheme to encompass elderly and disabled FAIMO (public works) workers. In this context, the government will undertake a comprehensive public expenditure review (PER), with World Bank support, to analyze the adequacy and effectiveness of expenditures, especially those in the social sectors. This information will be an important input into the preparation of the full PRSP. A draft PER is expected to be completed by July 2002.

20. Particular emphasis will be placed on ensuring—in a sustainable manner—that qualified students in Cape Verde continue to have access to tertiary education. In July 2000, the government took over from the banking sector the responsibility for a system of de facto scholarships, adding to fiscal outlays the equivalent of more than 1 percent of GDP in that year. During 2001, as costs continued to accelerate, the government reduced the level of fiscal support for overseas scholarships. In 2002, with donor assistance, the government's reform efforts in this area will be based on the following key principles and goals: (i) qualified students in Cape Verde should have access to some form of financing; (ii) a socially responsible mechanism should be introduced, to ensure that beneficiaries, after graduation, repay student loans in a timely manner; and (iii) the treasury's net contribution to funding tertiary education should fall to a sustainable level. The government has encouraged the development of commercial bank financing mechanisms (although without financial support) to achieve these ends and commercial banks have begun providing unsubsidized finance.

21. Disbursements of capital expenditure are projected in the range of 8 percent of GDP in 2002, including a contribution by the government equivalent to 2 percent of GDP. To better leverage donor contributions, the government intends to strengthen public investment planning and programming. It will therefore institute, on a quarterly basis, meetings of locally represented donors and the Ministry of Finance and Economic Planning to review proposed disbursement schedules and actual disbursements. It is hoped that the meetings will also lead to improved discussion of project and sector priorities, as well as enhanced donor coordination and information sharing.

22. Expenditure management remains a key concern, and the government has sought technical assistance from donors to help it to improve its control over spending. An externally financed budget advisor is expected to begin work during the first quarter of 2002. The government will continue its current implementation of a two-tier liquidity buffer, by which 10 percent of proposed transfers to autonomous institutions and 15 percent of certain proposed transfers to nonautonomous institutions are withheld.

23. During the program period, the government intends to improve its oversight and accounting of counterpart funds generated by domestic market sales of donated food aid. As a first step, a program review of food aid sales and allocations of counterpart funds will be completed by end-June 2002. Based on this review, the government will institute transparent and detailed guidelines for the generation and use of counterpart funds, in consultation with relevant donors, by end-October 2002.

24. The outstanding stock of domestic arrears at end-2001 is estimated at CVEsc 3 billion. The government is committed to regularizing the stock of these arrears through a combination of cash payments and restructuring agreements and will complete negotiations by end-June 2002 with the remaining domestic creditors to regularize such arrears. In addition, the government will not accrue new domestic arrears during the program period.

25. Transparency and good governance in public finances are important objectives of the government. In this regard, the government will transmit the final 2001 budget accounts to the National Assembly by end-December 2002, after which an independent audit of the accounts for 2001 will be completed by the Tribunal de Contas.

Monetary and financial sector policies

26. Complementing the fiscal efforts, monetary policy during 2002 aims at stabilizing the macroeconomic situation and supporting the exchange rate peg, with gross international reserves of the BCV programmed to increase by € 6 million (to 1.7 months of imports). In the context of the further consolidation of the fiscal position, net domestic assets of the banking system are projected to rise by 5½ percent (as a share of beginning-of-period broad money) in 2002, while net credit to the central government would increase by 2 percent (also as a share of beginning-of-period broad money). The reduction in the growth of net credit to the central government should allow for an expansion in credit to the private sector in the range of 3½-4 percent (in terms of beginning-of-period broad money), while broad money is expected to expand by 6½ percent, in line with nominal GDP growth. The central bank is committed to actively utilizing the monetary instruments at its disposal (including discount rates, open market operations and its liquidity absorption facility) in order to control liquidity and achieve the monetary targets established under the program. The BCV will also continue to closely monitor the health of the banking system, including strengthening its supervision of commercial banks.

27. The government believes that a fully independent central bank is necessary to ensure macroeconomic stability and support the exchange rate regime, and it is committed to granting the BCV such independence. Consequently, a new central bank organic law which ensures the statutory independence of the central bank and international best practices will become effective by end-June 2002 (a structural performance criterion under the program). The new central bank law will, among other things, establish price stability as the overriding policy objective of the central bank, prohibit government borrowing from the central bank (with the exception of a temporary and limited overdraft account that must be cleared at the end of each year), limit central bank "lender-of-last-resort" financial support to commercial banks, and establish a transparent process for appointing the central bank governor and board members. The government and the BCV redrafted the central bank organic law, with technical assistance from the IMF, in late 2001, and it was approved by the Council of Ministers in February 2002.

Structural policies

28. A major component of the program is the liberalization of the external tariff regime, which will lower average rates, reduce the number of tariff bands, remove inconsistencies in the taxation of similar items, and eliminate customs fees and minor taxes. The new tariff structure will be streamlined into seven tariff bands ranging from zero to fifty percent, with the average unweighted tariff rate lowered from 23½ percent (including the 9 percent customs fee) in the present tariff regime to 12½ percent. The new tariff regime will be introduced on January 1, 2003, in conjunction with the VAT, with IMF and other donor technical assistance. The combined impact of the introduction of the VAT and the lowering of tariff rates is expected to be revenue neutral.

29. The government intends to accelerate, with the support of the World Bank, the public enterprise reform program, taking into account the changing market environment and financial position of the remaining parastatals. EMPA (the food import and distribution company) and TRANSCOR (an urban transport company active in Mindelo and Praia) are slated to be liquidated in 2002. Given the substantial retrenchment costs associated with liquidation, the government is seeking financial support from its key bilateral and multilateral partners, but it will nonetheless move ahead with the planned liquidations, given the rapid accrual of contingent liabilities. SALMAR (a cold storage company) and CERIS (the brewery) were sold in late 2001. During 2002, a second cold storage company (INTERBASE), the shipyards (CABMAR/CABNAV), and the national airline (TACV) will be made ready for privatization.

30. A study of the oil sector in Cape Verde was completed in November 2001, with the support of the World Bank. It clarified the pricing system for oil distillates distributed in Cape Verde and addressed key issues, including cost efficiency, equity, and an assessment of the distributors' past submissions to government for compensation of fuel sold at fixed domestic prices. On the basis of the study's findings, the government will regularize its arrears with the oil distributors by end-June 2002. In addition, the government will implement an automatic and transparent pricing mechanism for retail petroleum products, with the publication of such a mechanism in the official gazette and implementation of such mechanism by end-June 2002 (a performance criterion under the program). The new pricing mechanism will be approved by the Council of Ministers and published in the official gazette by end-June 2002. The mechanism will require automatic, transparent, and timely changes to domestic retail prices of petroleum products based on changes in world market prices. The oil pricing policy will ensure that the government will not incur any new liabilities related to domestic petroleum sales, while ensuring adequate distribution of oil to all islands. Any price subsidies proposed for specific products (in particular, butane) will be targeted specifically to the poor and transparently included in the budget.

31. The government is committed to improving the delivery of social services, including specific policies aimed at (i) increasing the poor's access to social services; (ii) containing the spread of HIV/AIDS; and (iii) strengthening food security programs. This will be accomplished, first, by undertaking an extensive review of current expenditure policies by July 2002 and developing a medium-term expenditure plan to protect these services. In addition, the government will analyze the poverty and social impact of key measures to be supported by the program, including the impact of the proposed changes to the petroleum price mechanism, in order to minimize their impact on the poor.

Domestic debt-reduction operation

32. To address Cape Verde's sizable and unsustainable domestic debt burden, the government is seeking donor support for the continuation and acceleration of the stalled domestic debt-reduction operation (DDRO) under the Trust Fund, which began in 1998. ³ The government will convene a donor roundtable in the first half of 2002 to discuss continuing the DDRO. The program will be based on the principles of sequenced disbursements, tied to further fiscal consolidation and an improvement in the quality of public expenditure, as well as continued burden sharing between the government and donors. In light of the increased stock of domestic debt (estimated at some CVEsc 17 billion at end-2001, or 24 percent of GDP), the government will consider expanding the scope of the original Trust Fund design to take into account the new debt situation. The government is targeting a reduction in the domestic debt-to-GDP ratio to some 20 percent by end-2004.

The PRSP process

33. The I-PRSP provides an outline of the process to be undertaken to complete the full PRSP, including the collection and analysis of poverty data, addressing institutional issues and involving civil society, as well as more operational issues. A nationwide participatory process is planned for developing the PRSP, with various consultative groups identified, including groups organized along thematic lines, such as education, health, the environment, private sector development, macroeconomic management, etc. These groups will provide advice on specific issues (technical, managerial, sectoral, etc.) as they arise. A separate, broad-based group will act as a steering committee for the PRSP. Its role will be to ensure that policies proposed under the PRSP are consistent with the macroeconomic framework, and that execution, reporting, and monitoring mechanisms are adequate to support the objectives of the PRSP.

External sector policies

34. A key objective of Cape Verde's external policy is to enhance external competitiveness and promote nontraditional exports in order to achieve external viability and strengthen growth prospects. In particular, opportunities presented as a result of the soon-to-be-granted duty-free access to the U.S. market will be vigorously pursued, including through the attraction of foreign private investment for light industry. To boost the potential return from these activities, the government intends to strengthen its foreign investment promotion center and relations with potential investors. The government is aware that the pursuit of prudent fiscal and credit policies, as well as the implementation of the envisaged structural reforms, will be key to strengthening Cape Verde's external position.

35. Given Cape Verde's openness and the particular importance of tourism, international transportation services, and workers' remittances, it is expected that the country's external position will be affected in 2002 by the deterioration in the global economic environment after September 11, 2001. In particular, tourism receipts are projected to remain at the levels seen in 2001, while workers' remittances—largely originating from the United States and Portugal--are expected to fall by some 3½ percent, reflecting the considerable deceleration of growth rates, and the rise in unemployment rates, in the countries of origin. As a result, Cape Verde's external current account deficit (excluding transfers) is expected to widen by 3 percentage points of GDP in 2002 (to 14 percent of GDP), with the overall balance deteriorating by 6 percentage points to -2 percent of GDP.

36. The government has developed a plan to eliminate the stock of external arrears (estimated at US$15 million at the end of-2001), based on understandings reached with each of its multilateral and bilateral creditors. Discussions with export credit agencies will be completed by end-June 2002. Based on these understandings, the outstanding stock of multilateral external payments arrears will be eliminated through cash payments and reschedulings by end-June 2002. Given the already high level of Cape Verde's external public debt (60 percent of GDP at end-2001), the government will refrain from contracting any new nonconcessional debt over the program period. ⁴

37. The Ministry of Finance is committed to improving its management of public sector external debt. Toward this end, it has begun to improve its database on debt and debt service. To further its efforts, the Ministry of Finance and Economic Planning has established a committee responsible for the management of public sector external debt. The committee, which meets monthly, including the Office of the Treasury (DGT), the Budget Office (DGO), the BCV, and the Office of International Cooperation at the Ministry of Foreign Affairs, is responsible for reviewing the government's rolling monthly cash-flow plan for the payment of external debt-service obligations falling due, verifying payments made, and eliminating the outstanding stock of external arrears through cash payments and rescheduling arrangements.

Capacity building and technical assistance

38. The implementation capacity of the government to implement the package of policies needed to achieve the overarching objectives of the program will be enhanced in 2002. First, a key ingredient in ensuring the success of the program will be the government's ability to adequately monitor performance. In this area, the government will improve the quality and timeliness of key economic and financial statistics during the program period, including the national income accounts, the consumer price index (CPI) and the balance of payments. In this regard, the National Statistics Institute (INE) expects to complete the compilation of the national accounts for 1998-2000 by end-September 2002 and to rebase the series to 2002. In addition, the INE will revise by end-2002 the market basket and weights used to calculate the CPI, based on the current household survey. In addition, the BCV, with the assistance of the IMF, will improve the coverage and quality of the balance of payments statistics during 2002.

39. The government has established a formal interagency program monitoring committee to implement its poverty reduction and growth program. The committee, chaired by the Ministry of Finance and Economic Planning, includes key ministries, the central bank, and the INE. The committee will review monthly macroeconomic developments as well as program implementation, and will prepare monthly reports to the Minister of Finance and Economic Planning on performance under the program, which will be forwarded to the IMF on a monthly basis.

40. To improve its capacity to implement the program, the government will receive assistance from the World Bank in strengthening its expenditure allocation and review process and from the other multilateral and bilateral donors in budget planning, expenditure control, treasury operations, and external debt management. Implementation of the program will be improved by the early provision of this important technical assistance.

D. Program Monitoring

41. Program implementation for the first year under the PRGF arrangement will be monitored according to performance criteria and benchmarks presented in Tables 1 and 2 (attached). Table 3 describes the government's broader economic reform objectives for 2002. The definitions of the variables monitored as quantitative performance criteria and benchmarks are contained in the technical memorandum of understanding (Attachment III). Program implementation and the economic results associated with the program will be subject to two reviews per annum, the first by end-October 2002 and the second by March 15, 2003. Indicative performance benchmarks for end-March and end-June 2003 and the performance criteria for end-December 2002 will be set at the time of the first review.

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Cape Verde:
Technical Memorandum of Understanding for the First Annual Program Under the PRGF Arrangement

1. This memorandum sets out the understandings between the Cape Verdean authorities and the IMF staff regarding the definition of the quantitative performance criteria and benchmarks and reporting requirements under the first annual program supported by the Poverty Reduction and Growth Facility (PRGF) arrangement.

I. Quantitative Performance Criteria And Benchmarks ^{5 6}

A. Government Finances

2. Total government revenue is defined as the sum of all tax and nontax revenues, domestic capital participation, and net lending, cumulative since the start of the calendar year, excluding privatization proceeds and external grants. Tax and nontax revenue are defined in accordance with the Government Finance Statistics Manual (GFS) 1986, section IV.A.1.

3. The floor on the primary current fiscal balance cumulative from the beginning of calendar year 2002 constitutes an indicative performance target. The primary current fiscal balance is defined as the difference between total government revenue (defined above in para. 1) and current primary expenditures on a commitment basis. Current primary expenditures equal total government expenditures on a commitment basis less interest obligations on external and domestic debt, capital expenditures, and retrenchment payments made as a part of the public enterprise privatization and liquidation reform.

4. For the purposed of this memorandum, privatization proceeds will be understood to mean all monies received by the government from the sale or concessioning of a public company, organization, or facility to a private company or companies, organization(s), or individual(s), as well as any proceeds generated from the liquidation of a public company, less restructuring costs.

Reporting requirements. Data on the implementation of the budget compiled by the Ministry of Finance and Economic Planning (DGT) will be provided on a monthly basis, to be submitted not later than five weeks after the end of each month, including (i) government revenue by category, including external budget support grants; (ii) government expenditure, including primary current expenditure, domestic and external interest payments, and capital expenditure, including domestic capital expenditure and estimates of externally financed capital expenditure; (iii) the gross payment and gross accumulation of domestic payment arrears; (iv) external loan receipts and principal payments; (v) external arrears payments and accumulation; (vi) bank and nonbank financing; (vii) privatization receipts; and (viii) any other revenue, expenditure, or financing not included above.

B. Net Domestic Assets of the Central Bank

5. The ceiling on the cumulative change, from the beginning of calendar-year 2002, in net domestic assets of the Banco de Cabo Verde constitutes a performance criterion. Net domestic assets (NDA) of the Banco de Cabo Verde (BCV) are defined as reserve money minus net foreign assets of the BCV, evaluated at the program exchange rates presented below. The program ceilings for NDA will be adjusted upward (downward) by the cumulative downward (upward) deviations from program assumptions about nonproject disbursements from the World Bank, African Development Bank, European Union adjustment grants, and the Portuguese credit facility. The maximum cumulative adjustment will not exceed 75 percent of the planned disbursements. Reserve money comprises bank reserves and deposits of the monetary institutions and private sector with the central bank, as well as cash in circulation.

Reporting requirements. The preliminary monthly balance sheets of the BCV and the consolidated commercial banks will be transmitted on a monthly basis, with a maximum delay of five weeks. The definitive version of the monthly balance sheet of the BCV will be provided as soon as available.

C. Net Bank Credit to the Central Government

6. Net credit to the central government from the banking system is defined as the overall position of the main central government institutions vis-à-vis the banking system—that is, the stock of all outstanding claims on the central government (loans, advances, and all other government debt instruments, such as long-term government securities) held by the central bank and by commercial banks, less all deposits held by the central government with the central bank and with commercial banks, as they are reported monthly by the BCV to the IMF. The INPS (the social security agency) is not included in central government accounts. Net bank credit to the central government excludes claims on the Trust Fund (TCMFs).

7. Claims on the central government held by the central bank comprise the following items: (i) crédito conta corrente OGE; (ii) Tesouro público protocolo; (iii) títulos governo central—obrigações nova serie; (iv) créditos a regularizar m/n e m/e; (v) outros créditos ao governo; and (vi) any other claims, or claims on the central government to be regularized, held by the central bank.

8. Deposits held by the central government with the central bank comprise the following items: (i) depósitos do governo central—depósitos a ordem m/n; (ii) depósitos do governo central—depósitos a ordem m/e; (iii) outros passivos com o T.P.; and (iv) depósitos em administração—retroceso de linhas de crédito.

9. Claims on the central government held by the commercial banks comprise the following items: (i) Obrigações do Tesouro; (ii) bilhetes do Tesouro; (iii) protocolos; (iv) emprestimos; (v) outros créditos; and (vi) any other claims, or claims on the central government to be regularized, held by the commercial banks. Item (v) is understood to include claims resulting from the privatization of the Caixa Económica de Cabo Verde, amounting to CVEsc 795.5 million.

10. Deposits held by the central government with the commercial banks comprise the following items: (i) dep. governo central em m/n—D.G.T.; (ii) dep. governo central em m/n—serviços autónomos; (iii) dep. governo central em m/n—fundos autónomos; (iv ) dep. governo central em m/n—projectos de investimentos; (v) dep. governo central em m/n—fundos de contrapartida; (vi) dep. governo central em m/n—institutos c/autonomia administ. e financeira excepto INPS; (vii) dep. governo central em m/e, and (viii) outros passivos com o governo.

Reporting requirements. The preliminary monthly balance sheets of the BCV and the consolidated commercial banks will be transmitted on a monthly basis, with a maximum delay of five weeks. The definitive version of the monthly balance sheet of the BCV will be provided as soon as available.

D. Ceiling on Nonconcessional External Debt Contracted or Guaranteed by the Central Government

11. Under the program, ceilings on medium- and long-term, as well as on short-term, nonconcessional external debt constitute performance criteria. Nonconcessional external debt is defined as debt contracted or guaranteed by the central government with a grant element of less than 35 percent, calculated using currency-specific commercial interest reference rates (CIRRs) published by the Development Assistance Committee of the Organization for Economic Cooperation and Development (OECD). Debt rescheduling and debt reorganization are excluded from the limits on nonconcessional external debt. There will be no new nonconcessional external debt contracted or guaranteed by the central government (excluding borrowing from the Fund) in 2002. The definition of short-term nonconcessional external debt excludes normal short-term (less than one year) import-related financing. The Portuguese government precautionary credit line in support of the exchange rate peg is also excluded from the definition of nonconcessional external debt. In addition, the central government will not guarantee any external debt contracted by state enterprises and will maintain the policy of not guaranteeing private sector external debt. The performance criterion on medium- and long-term nonconcessional external indebtedness applies not only to debt as defined in point No. 9 of the Guidelines on Performance Criteria with Respect to Foreign Debt (Decision No. 12274-(00/85) August 24, 2000) but also to commitments contracted or guaranteed for which value has not been received. With respect to the performance criterion on short-term nonconcessional external indebtedness, the term "debt" has the meaning set forth in point No. 9 of the Guidelines on Performance Criteria with Respect to Foreign Debt (Decision No. 12274-(00/85) August 24, 2000).

Reporting requirements. The government of Cape Verde will consult with Fund staff before assuming any liabilities in circumstances where they are uncertain whether the instrument in question falls under the performance criterion. Details of all new external debt, including government guarantees, indicating terms of debt and creditors, will be provided on a monthly basis within four weeks of the end of each month.

E. Net International Reserves of the Central Bank

12. The floor on the cumulative change, from the beginning of calendar-year 2002, in net international reserves (NIR) of the Banco de Cabo Verde (BCV) constitutes a performance criterion under the program. Net international reserves (NIR) of the BCV are defined as gross international reserves of the BCV net of its short-term external liabilities, calculated at the program exchange rate described below. Gross reserves of the BCV are those that are readily available (i.e., liquid and marketable and free of any pledges or encumberments), controlled by the BCV, and held for the purposes of meeting balance of payments needs and intervening in foreign exchange markets. They include gold, holdings of SDRs, the reserve position at the IMF, holdings of foreign exchange and traveler's checks, demand and short-term deposits at foreign banks abroad, fixed-term deposits abroad that can be liquidated without penalty, and any holdings of investment grade securities. External liabilities of the BCV comprise liabilities to nonresidents contracted by the BCV with an original maturity of less than a year, any net off-balance-sheet position of the BCV (futures, forwards, swaps, or options) with either resident and nonresidents, any arrears on principal and interest to external creditors and suppliers, and purchases from the IMF. The program floors for NIR will be adjusted downward (upward) by the cumulative downward (upward) deviations from program assumptions about nonproject disbursements from the World Bank, European Union adjustment grants, African Development Bank, and the Portuguese credit facility. The maximum cumulative adjustment will not exceed 75 percent of the planned disbursements.

Reporting requirements. A table on NIR prepared by the BCV, including an account-by-account listing of gross foreign assets and gross foreign liabilities of the BCV, will be transmitted on a monthly basis, with a maximum delay of five weeks. The table will include the value of each asset/liability denominated in the currency it is held, as well as the value in Cape Verde escudos and the conversion exchange rate used.

F. Nonaccumulation of New Domestic Payment Arrears

13. As part of the program, the government will not accumulate any new domestic payment arrears. This will be monitored through the monthly execution of the cash-flow plan and the corresponding release of budget appropriations. For programming purposes, a domestic payment obligation to suppliers is deemed to be in arrears if it has not been paid within the normal grace period of 60 days (30 days for government salaries and debt service) or such other period as has been contractually agreed with the supplier after the verified delivery of the concerned goods and services, unless the amount or the timing of the payment is subject to good faith negotiations between the government and the creditor. The outstanding stock of domestic payment arrears at end-December 2001 is estimated at CVEsc 3.2 billion.

Reporting requirements. The Ministry of Finance and Economic Planning, through the DGT, will submit on a quarterly basis a detailed table of the stock of domestic payments arrears, including the accumulation, payment, rescheduling and write-off of domestic payments arrears during the quarter. The data are to be provided within four weeks after the end of the quarter.

G. Nonaccumulation of External Arrears

14. As part of the program, the government will not accumulate any new external payments arrears on a continuous basis. This will be monitored through the monthly execution of the cash-flow plan and the corresponding release of budget appropriations.

15. External arrears are defined as total external debt-service obligations of the government that have not been paid by the time they are due, unless the definition of an arrear has been defined contractually between the government and creditor. External arrears exclude arrears on external debt, pending the conclusion of debt-rescheduling agreements. The outstanding stock of external arrears at end-December 2001 amounted to US$15.3 million.

Reporting requirements. Data on (i) debt service payments and (ii) external arrears accumulation and payments will be transmitted on a quarterly basis by the Ministry of Finance and Economic Planning, DGT, within four weeks of the end of each quarter. In addition, the government will inform the Fund staff immediately of any accumulation of external arrears.

H. Program Exchange Rates and Nonproject Budgetary Support

16. Performance under the program will be assessed based on program exchange rates. The program exchange rates for this purpose are: CVEsc 110.3 = € 1; CVEsc 122.5 = US$1; CVEsc 0.55 = Esc 1 (Portuguese escudos); and US$1.28 = SDR 1.

17. The 2002 program assumes (i) € 12 million in nonproject budget support will be provided by the European Union, comprising € 7 million in the first quarter and € 5 million in the third quarter; (ii) US$7.5 million in nonproject budget support from the World Bank in the third quarter; (iii) SDR 4 million in nonproject budget support from the African Development Bank in the second quarter; and (iv) 1 billion Esc drawn from the Portuguese credit facility in the first quarter and repaid in the fourth quarter.

II. Other Data Requirements for Program-Monitoring Purposes

18. Data on exports and imports, including volume and prices, and compiled by the Director of Customs and the BCV, will be transmitted on a quarterly basis within four weeks after the end of each quarter. A preliminary quarterly balance of payments, compiled by the BCV, will be forwarded within four weeks after the end of each quarter.

19. The monthly disaggregated consumer price index for Cape Verde, compiled by the National Statistics Institute (INE), will be transmitted monthly, within four weeks after the end of each quarter.

20. Quarterly data on imports and sales of petroleum products, including values, volume, and estimated subsidy/surplus per liter (and for total sales) for each product, will be submitted quarterly, within four weeks after the end of each quarter, by the Ministry of Finance.

21. Documentation of all measures taken by the government to meet performance benchmarks or criteria under the program will be transmitted to the Fund staff within one week after the day of implementation.