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

December 31, 2001

2. In accordance with the provisions of the arrangement, the government of Ethiopia, in cooperation with staff of the IMF, has evaluated the implementation of the first annual program (October 2000–September 2001). The attached memorandum on economic and financial policies (MEFP) also presents the government's objectives and policies for the second annual program (October 2001-September 2002), in line with the MEFP for 2000/01-2002/03, dated January 29, 2001, and the letter of intent, dated May 29, 2001. The government intends to make the contents of this letter, and those of the attached MEFP and technical memorandum of understanding, available to the public and authorizes you to arrange for them to be posted on the IMF website, subsequent to Executive Board completion of the second review under the PRGF arrangement.

3. As you will appreciate, performance under the first annual program was broadly satisfactory, notwithstanding delays in the disbursement of external financial assistance, and continued deterioration of the terms of trade. Most quantitative and structural performance criteria and benchmarks through end-September 2001 were observed, except for the July 7, 2001 benchmarks for net foreign assets (NFA) and net domestic assets (NDA) of the National Bank of Ethiopia (NBE), which were missed because external assistance was delayed by a few days for technical reasons. Calculations indicate that both benchmarks would have been observed with large margins if these funds had been disbursed as originally anticipated. Also, the performance criterion on the NDA of the NBE for end-September 2001 was missed, and the government of Ethiopia requests a waiver for its nonobservance in view of the fact that the program remains on track, as outlined in the attached memorandum. The government is determined to meet all subsequent performance criteria and benchmarks. Following the completion of the second review under the PRGF arrangement by the Executive Board, the government requests the third disbursement of SDR 10.429 million under the arrangement.

4. The second annual program was formulated in the context of a difficult world economic environment characterized by continued deterioration of the terms of trade for Ethiopia, which is further adversely affected by the events of September 11, 2001. In the face of these developments, the government is determined to pursue a restrained fiscal stance and a cautious monetary policy. However, real GDP growth and foreign reserve targets had to be revised downward. To mitigate the impact of the recent events on the balance of payments, the government requests an increase in access under the PRGF arrangement of 10 percent of quota (about US$17 million), to be disbursed at the completion of the second review of the PRGF-supported program. The government also requested an increase in disbursement of balance of payments support from the World Bank of around US$20 million.

5. To monitor progress in economic policy implementation, financial and structural benchmarks through end-September 2002 and performance criteria for end-March 2002 under the second annual program are summarized in the tables annexed to the MEFP. The third review under the PRGF arrangement is scheduled to be completed by end-July 2002 and will, inter alia, consider the budgetary policy framework for 2002/03. At that time, the performance criteria for end-September 2002 will be established. A fourth review, which will assess progress in policy implementation, describe the third annual program, and set performance criteria and benchmarks for the third annual program, is scheduled to be completed by end-January 2003. The fifth and final review under the arrangement is scheduled to take place by end-July 2003. The government of Ethiopia will provide the Fund with such information as the Fund requests in connection with the country's progress in implementing the economic and financial policies and achieving the objectives of the program.

6. The government believes that the policies and measures set forth in the attached memorandum are adequate to achieve the objectives of the program. During the period of the arrangement, the government stands ready to take additional measures that may become appropriate for the achievement of the objectives of the program. We will consult with the Managing Director of the IMF on the adoption of any measures that may be appropriate, at the initiative of the government of Ethiopia or whenever the Managing Director requests such consultation. Moreover, after the period of the arrangement and while Ethiopia has outstanding financial obligations arising from loans under the arrangement, Ethiopia will consult the IMF from time to time at the initiative of the government of Ethiopia or whenever the Managing Director requests such consultation.

Sincerely yours,

Memorandum of Economic and Financial Policies for the Period
October 2001–September 2002

December 31, 2001¹

1. Following the end of the border conflict with Eritrea in 2000, the government of Ethiopia started to implement an ambitious adjustment and reform program, with a view to achieving sustainable economic growth, poverty reduction, and medium-term financial viability. The program is being supported by the IMF under a three-year Poverty Reduction and Growth Facility (PRGF) arrangement approved on March 22, 2001. This memorandum reviews performance under the first annual program (October 2000-September 2001) and outlines the government's objectives and policies for the second annual program (October 2001-September 2002), in line with the memorandum on economic and financial policies for 2000/01-2002/03, dated January 29, 2001, and the letter of intent, dated May 29, 2001.

I. Performance Under the First Annual Program

2. Considerable progress was made toward restoring peace between Ethiopia and Eritrea. On December 12, 2000, Ethiopia and Eritrea signed a peace agreement, and to date, Ethiopia has demobilized close to 100,000 soldiers, about 28 percent of the armed forces. On April 18, 2001, a 25-kilometer Temporary Security Zone was established between the two countries.

3. The first annual program under the PRGF arrangement was satisfactorily implemented, notwithstanding delays in the disbursement of external financial assistance and continued deterioration of the terms of trade. Real GDP growth in 2000/01 (fiscal year ending July 7) is estimated to have risen from 5.4 percent in 1999/2000 to 7.9 percent, slightly higher than program projection, as agricultural output rose by 13.2 percent. Inflation turned negative in 2000/01, reflecting a bumper cereal crop and large inflows of food aid; the negative inflation trend continued through September 2001. The external current account deficit (including official transfers) fell to 4.2 percent of GDP in 2000/01 from 5.2 percent in 1999/2000. Coffee exports (which accounted for 40 percent of merchandise exports in 2000/0l) were lower than expected, as both volume and prices fell in 2000/01 and the first quarter of 2001/02. With a slower-than-anticipated pace of project implementation, imports were also lower than expected.

4. Most quantitative performance criteria and benchmarks through October 2001 were observed (Table 1). However, the benchmarks on the floor on net foreign assets (NFA) and the ceiling on the net domestic assets (NDA) of the National Bank of Ethiopia (NBE) for July 7, 2001 were not met. These benchmarks were calculated on the assumption that a US$150 million balance of payments International Development Association (IDA) credit would be disbursed before end-June 2001. In the event, the external assistance was disbursed a few days later, and calculations indicate that the NFA floor and the NDA ceiling would have been observed with large margins if these funds had been disbursed as originally anticipated. The adjusted performance criteria for end-September 2001, relating to the NFA of the NBE and the net domestic financing of the general government, adjusted for the excess in disbursed nonproject external financial assistance, were observed. The adjusted performance criterion on the NDA of the NBE was missed.

5. All structural performance criteria and benchmarks through October 2001 were observed (Table 3), with the exception of the introduction of the interbank foreign exchange market (benchmark) set for October 1, 2001, the implementation of which was delayed until October 24 because provision of technical assistance was deferred as a result of the travel suspension related to the September 11, 2001 events.

6. In the fiscal area, the overall budget deficit (including grants and emergency programs) narrowed from 11.4 percent of GDP in 1999/2000 to 5.6 percent in 2000/01, much lower than the program target of 8.4 percent of GDP. Although overall fiscal performance was good, the government had to deal with a tight treasury situation, resulting from a small revenue shortfall and uncertainty on the disbursements of program aid, and difficulties in accelerating capital spending. The implementation of the emergency programs, projected at 1.9 percent of GDP in 2000/01, was slower than expected because of delays in disbursement of external assistance. During the first quarter of 2001/02, fiscal performance was better than programmed, with revenue exceeding projections and higher capital spending offset by lower current outlays.

7. On the revenue side, the government has embarked on comprehensive tax policy reforms and an overhaul of tax administration. In December 2000, the rate of the sales tax was increased from 12 percent to 15 percent and the 10 percent import duty surcharge was removed. In February 2001, new legislation on presumptive taxation and a 5 percent withholding tax on imports became effective. In March 2001, legislation was approved to introduce a taxpayer identification number (TIN) to reinforce the collection power of revenue agencies, and a tax reform implementation task force was established. In July 2001, a large-taxpayer unit was made operational, and in October 2001, draft value-added tax (VAT) legislation was submitted to parliament. Despite these efforts, total revenues in 2000/01 were 6 percent lower than programmed on account of lower domestic sales and excise tax receipts.

8. On the spending side, the government followed a cautious expenditure management policy because of uncertainty regarding the disbursement of program aid, and it slowed domestic defense expenditures, which amounted to 6.2 percent of GDP (lower than the programmed 7.3 percent of GDP). Poverty-targeted outlays (health, education, agriculture, and roads) reached 10.9 percent of GDP. The pace of capital spending was slower than expected. Total expenditure in 2000/01 was 17 percent lower than programmed.

9. In the monetary and exchange areas, the government has started sterilizing excess liquidity, and has taken steps to adopt indirect monetary management instruments and move toward market determination of interest and exchange rates. Reflecting lower-than-projected nonagricultural economic activity and inflation, broad money growth slowed from 14 percent in 1999/2000 to 9.5 percent in 2000/01 (compared with 12.5 percent under the program), and credit to the economy increased by 7.6 percent (compared with 18.4 percent in the program). Net central bank credit to the government declined by about 30 percent in 2000/01, much more rapidly than envisaged under the program, and the government relied more on borrowing from commercial banks. During the first quarter of 2001/02, broad money rose by 3.6 percent, lower than programmed.

10. In order to enhance the use of indirect monetary management and to reduce excess liquidity, the NBE introduced a two-year government bond in November 2000, and increased sales of government securities. As a result, commercial banks' excess reserves fell from 29.6 percent of deposits at end-September 2000 to 5.3 percent at end-July 2001, before rising to 9.7 percent at end-September 2001. To facilitate liquidity management, the NBE introduced a rediscount facility for eligible government papers in March 2001.

11. In the area of financial sector reforms, several measures were taken to improve the competitiveness of the financial sector and strengthen the Commercial Bank of Ethiopia (CBE), in line with recommendations made by IMF-World Bank technical assistance. Government guarantees for bank assets frozen in Eritrea were issued, and the CBE's board was reconstituted to increase private sector participation. Restrictions on the payment of interest on current account deposits were also lifted. However, delays occurred in finalizing a comprehensive study of the NBE's operational, organizational, and administrative setup. A management contract between CBE and a foreign bank was signed on June 29, 2001, and was expected to enter into effect after the Boards of the two institutions had resolved the only remaining issue relating to liabilities of the management and arbitration. In the absence of an agreement on this issue, the foreign bank withdrew from the contract in January 2002.

12. Trade restrictions and administrative controls on access to foreign exchange were lifted in December 2000, and the foreign exchange market started to operate more efficiently. At end-March 2001, the NBE issued directives that lifted the previously existing restrictions on the purchase of foreign exchange for holiday travel and education purposes. On October 24, 2001, the NBE discontinued its weekly wholesale foreign exchange auction and moved its foreign exchange operations to the interbank market. Over the program period, this auction has not lead to a spread of more than 2 percent between buying rates. The value of the birr against the dollar fell by about 2.9 percent in 2000/01, and by another 0.7 percent in the first quarter of 2001/02. At end-September 2001, net foreign assets of the NBE amounted to US$281 million (about 1.7 month of import cover) compared to the programmed US$313 million.

13. In other structural areas, progress was made, with World Bank assistance, in implementing reforms focused on public sector management, including civil service reform and public expenditure policy, and on private sector development. During 2000/01, the government also pursued its privatization program with the sale of seven public entities, for a total value of US$2.2 million, putting three entities under private management contract, and completing the preparation for privatization of 36 public entities.

II. Program for October 2001-September 2002

A. Medium-Term Strategy and Objectives of the Second Annual Program

14. Building on the progress made under the first annual program, the government is determined to continue implementing steadfastly its medium-term economic reform strategy, as outlined in the interim poverty reduction strategy paper and the January 29, 2001 policy memorandum. The strategy seeks to promote rapid, broad-based and equitable growth by emphasizing rural development and improvement in physical and human capital, and by addressing post-conflict reconstruction and reintegration needs. The key elements of the medium-term strategy continue to be (a) the reorientation of budgetary resources from defense toward poverty alleviation outlays; (b) tax reforms that lay the foundation for strong revenue performance; (c) improved monetary management and financial sector reform; and (d) capacity building and regulatory reforms to promote private sector development. The revised medium-term objectives for the next three years, taking into account recent developments, are (a) to achieve an annual real GDP growth of 6 percent, lower than the 6.5-7 percent projected in the original program; (b) to maintain inflation at a low rate of around 3 percent; and (c) to reduce the external current account to 4.6 percent of GDP by 2003/04, after a rise to 7.1 percent in 2001/02.

15. Within this medium-term framework, the second annual program, straddling the two fiscal years 2001/02 and 2002/03, was formulated in the context of the difficult world economic environment characterized by continued deterioration of the terms of trade for Ethiopia, which is further adversely affected by the impact of the events of September 11, 2001. Export prices of coffee, Ethiopia's main export, are projected to fall further by 15 percent in 2001/02, before increasing moderately in 2002/03 and over the medium term. The slowdown of the world economy is also likely to result in lower worker remittances and private capital inflows, as well as lower demand for Ethiopian exports. The activities of Ethiopian Airlines have also been affected. In the face of these difficulties, the government is determined to pursue a restrained fiscal stance and a cautious monetary policy. Nonetheless, the macroeconomic objectives presented in the letter of intent of May 29, 2001, had to be revised. Although the authorities still expect real GDP growth of 6.5-7 percent in 2001/02, the program assumes that the rate would fall to 5.8 percent in 2001/02 and recover somewhat to 6 percent in 2002/03. These growth rates will still hinge on increasing government investment from 8.7 percent of GDP in 2000/01 to 11.2 percent in 2001/02 and 10.7 percent in 2002/03, and improving the environment for private investment through major capacity building and infrastructure expansion, the privatization of a large number of public enterprises, and further progress in financial sector reform. The second annual program also aims at limiting inflation to 3 percent in 2001/02 and in 2002/03, and containing the external current account deficit at 7.1 percent of GDP in 2001/02, and at 6.2 percent in 2002/03, while raising gross reserves from the equivalent of 2 months of following-year imports of goods and nonfactor services in 1999/2000 to about 2.9 months in 2001/02 and 3.8 months in 2002/03, lower than projected in the original program.

B. Macroeconomic Policies²

Fiscal policy

16. The overall fiscal deficit after grants is targeted at 9.1 percent of GDP (including special program expenditure equivalent to 2.2 percent of GDP) in 2001/02, and 7.8 percent of GDP (including special program expenditure equivalent to 1.9 percent of GDP) in 2002/03. The widening of the fiscal deficit by about 3.5 percentage points of GDP in 2001/02, reflects the accelerated implementation of special programs and capital expenditure, and additional poverty-targeted and capital outlays fully financed by concessional external assistance and enhanced Initiative for Heavily Indebted Poor Countries (HIPC Initiative) interim assistance that were not included in the budget adopted in July 2001.³ Consistent with the budget, the targeted fiscal deficit set in May 2001 in the context of the first review under the PRGF arrangement was Br 4,934 million (8.2 percent of GDP), assuming special program spending of 2.9 percent of GDP and HIPC assistance of 0.7 percent. To reflect these developments, the availability of new concessional external assistance and the need for budgetary appropriation to use the HIPC resources (Br 334 million), a revised supplementary budget⁴ will be adopted by the government and submitted to parliament limiting additional fully financed non-HIPC spending to Br 567 million (1 percent of GDP), largely for social and capital outlays. With lower than initially projected spending on special programs and projected delivery of HIPC assistance, the overall deficit in 2001/02 will be limited to Br 5,244 million (9.1 percent of GDP). Based on this, the government's domestic public debt to the banking system would decline by 0.7 percent of GDP in 2001/02 and 0.8 percent in 2002/03.

17. The government is determined to pursue its efforts to lay the foundation for strong revenue performance over the medium term. To achieve the revenue target of 14.7 percent of GDP in 2001/02 and 14.9 percent of GDP in 2002/03, revenue performance will benefit from the full-year impact of the measures implemented since early 2001, improved tax administration (especially the recent establishment of the large-taxpayer unit), and the planned introduction of the VAT by January 2003. Vigorous efforts will also need to be made to improve tax collection (including of arrears), and to combat fiscal fraud. A new Ministry of Revenues was established, and its functions and responsibilities and those of the Ministry of Finance and Economic Development have been delineated. In the period ahead, the government will accelerate the pace of the tax reform program. In particular, it will (a) further strengthen the large-taxpayer office through adequate staffing and training, particularly for its revenue collection, accounting, and audit functions (for this a new salary scale for tax officials will be adopted in December 2001); (b) submit to parliament by June 2002, a revised income tax law, which includes enhanced enforcement procedures and improved penalty regime, with a view to increasing the efficiency of income tax collection, and ensuring the recovery of income tax arrears; (c) implement the tax identification number in Addis Ababa and the regions; (d) develop and implement, by end-June 2002, the systems and programs required to administer the withholding tax on the hard-to-tax group of taxpayers; and (e) develop and implement an audit program to cover all taxes, including customs taxes. With respect to the preparations for the introduction of the VAT, the government will (a) complete the design and computerization of the taxpayer registration process by end-June 2002; (b) complete the operational development of taxpayer services activities, return process, and debt and audit activities by end-September 2002; (c) initiate a publicity campaign, and taxpayer education and advisory visits; and (d) start the computerization of revenue accounting by end-October 2002.

18. The government will continue to pursue a prudent expenditure policy, while further reorienting spending from defense to poverty-targeted outlays and capital expenditure. Total outlays (excluding special programs) are programmed to increase by 2 percent of GDP to 31 percent in 2001/02, but are projected to be reduced to 29.5 percent in 2002/03. Defense outlays will be cut by 1 percentage point of GDP to 5.2 percent in 2001/02, and the government intends to reduce them further in 2002/03. Poverty-targeted spending will increase by 4 percent of GDP to 14.9 percent (including 0.6 percent from HIPC Initiative interim assistance) in 2001/02, and would remain at that level (in terms of GDP ratio) in 2002/03 (including 1.5 percent of GDP from interim HIPC Initiative assistance). Expenditure targeted at poverty reduction will continue to focus on improving services delivery that have an impact on human development (health and education), and on increasing the opportunities for and efficiency of income earning activities (especially in agriculture and road infrastructure). The total wage bill will be limited to Br 4.2 billion (7.4 percent of GDP) in 2001/02. At the time of the first review under the PRGF arrangement, the authorities indicated their intention to assess at the time of the second review whether a modest general wage increase would be feasible and financeable within the budgeted envelope. With lower than budgeted military wage bill and slower filling of vacancies, it will be possible to provide a modest wage increase in January 2002 that will be limited to Br 280 million on an annual basis, representing an average wage increase of 7 percent; the impact over the last six months in 2001/02 will not exceed Br 140 million. No further increases will be provided until a comprehensive civil service reform strategy has been adopted and a review of wage policy carried out in the context of this reform. Capital outlays (excluding special programs) are projected to increase by 29 percent (to 11.3 percent of GDP) in 2001/02, as project implementation and external disbursement are accelerated and HIPC resources become available. A further increase of 6 percent is projected in 2002/03. The government will also ensure that prudent debt-management policies are implemented.

19. The government has adopted a medium-term action plan to improve substantially the planning, control, tracking and reporting of public expenditures, especially poverty-targeted spending, at the federal and regional levels. In particular, the government will (a) consolidate federal and regional budgets for both the past year and the budget year, including all extra-budgetary funds and accounts, starting with fiscal year 2002/03; and (b) reconcile monetary and fiscal accounts, starting with fiscal year 2001/02. Other actions include (a) enhancing the financial management system through the introduction of a budget classification system in accordance with international standards; (b) reviewing intergovernmental relationships at federal, regional, and woreda levels, including transfer mechanisms; (c) strengthening the budgetary preparation process through adherence to the financial calendar; (d) reviewing the impact of reporting procedure on the quality of fiscal data, at the federal and regional levels; (e) introducing an integrated computerized financial information management system, starting with pilot projects at the federal level; and (f) continuing to monitor expenditure execution in the priority sectors (including those in poverty-related spending) in annual expenditure reviews. Technical assistance is expected to be provided by donors to carry out most of these actions.

Monetary policy and financial sector reform

20. Monetary policy will remain geared toward containing inflation and achieving the international reserve targets. The monetary program assumes stable velocity with broad money growing by 11.1 percent in 2001/02 and 9.9 percent in 2002/03. The net domestic assets of the central bank will remain the key aggregate in steering monetary policy. The central bank will continue to closely monitor developments in reserve money and broad money. Progress in fiscal consolidation and the planned reduction in net claims on government, supported by disbursements of foreign aid, is expected to facilitate the continued rebuilding of international reserves while providing room for an adequate increase in credit to the nongovernmental sector, so as to contribute to private-sector-led growth.

21. The NBE will continue sterilizing the excess liquidity of commercial banks by selling treasury bills in the biweekly auctions. In judging the liquidity position of banks, the NBE will continue to take into account treasury bill yield and exchange market developments. The NBE will also encourage the use of the rediscount window by keeping the size of the rediscount penalty (now, the savings rate plus 1-3 percent) under review, so as not to dissuade banks from using this facility. The central bank will also prepare for the introduction of transactions in repurchases (repos), in consultation with banks. The NBE's position in the exchange market will be guided by the program's net foreign assets targets. The recent replacement of the foreign exchange auction by the foreign interbank exchange market is expected to achieve efficiency gains through broader-based foreign exchange operations.

22. On the basis of the study undertaken with joint technical assistance from the IMF and the World Bank, the government has reviewed its medium-term reform strategy for the financial sector, and will implement further reforms to strengthen the financial sector and improve its competitiveness. The objectives are to achieve a sound financial sector structure that would foster economic development and active competition in Ethiopia by offering an attractive range of financial savings instruments throughout the country and providing for an efficient allocation of financial resources to borrowers.

23. In the context of this strategy, the NBE will adopt by end-March 2002 regulations on the provisioning for nonperforming loans and other doubtful assets in line with international standard practices.⁵ The government will (a) take steps by end-March 2002 to strengthen the NBE, following the completion of the ongoing comprehensive study of the NBE, including as necessary, revision of the existing Banking Act to increase the autonomy of the NBE; (b) allow by end-December 2001 a bankers' association to be established formally; (c) ensure that the Construction and Business Bank is brought to the point of sale by end-March 2002, after its balance sheet has been restructured based on the NBE's recommendations; (d) start to implement a restructuring plan to address the weak financial condition of the Development Bank of Ethiopia, taking into account the NBE's supervision findings; (e) encourage public entities to do business with all banks by issuing before end-December 2001 a letter to these entities indicating that they are free to do business with the banks of their choice; and (f) allow private banks to enter into management contracts with foreign institutions. A workshop will be held with IMF and World Bank staffs to discuss the possible role of foreign banks in the Ethiopian economy.

24. With regard to the CBE, which still dominates the financial market with over 80 percent of bank deposits and about 60 percent of bank loans, as noted earlier, the management contract for the CBE with a foreign bank that was signed on June 29, 2001, did not enter into effect as the foreign bank withdrew from the contract in January 2002. At the same time, 28 past and 13 current managers from CBE, including the president and two vice-presidents, were arrested for corruption charges, which are under investigation. The CBE's financial situation also deteriorated in 2001, with non-performing loans increasing significantly. Against this background, a new management team for CBE will be appointed by February 28, 2002, with whom the government will sign a performance contract by end-June 2002, to ensure that CBE is operated effectively on a commercial basis so as to achieve the necessary improvements in financial performance. As had been contemplated in the management contract with the foreign bank, the performance contract will ensure that the new management has decision-making autonomy, including on staffing, meeting performance targets, and pursuing delinquent borrowers, as well as on taking steps to strengthen CBE's cost competitiveness and profit and loss situation. To assist the new management, CBE will be concluding a twinning arrangement with—or hire consultants from—reputable international financial institutions by end-September 2002. In the meantime, to improve its financial situation, CBE will fully implement the new provisioning directive to be adopted by end-March 2002. The reserve requirement will be strictly enforced and there will be no lending from the Central Bank to CBE. CBE will also reduce non-performing loans by Birr 0.8 billion by end-September 2002, including through write-offs. CBE will prepare a financial restructuring plan by end-December 2002. CBE will by end-June 2002 also transfer lending authority from the Board to management and create an audit committee of the Board to oversee financial performance of CBE, particularly measures to reduce nonperforming loans. Finally, CBE will prepare quarterly quantitative and qualitative monitoring reports for its Board, indicating progress in meeting the goals of the performance contract.

25. The government is reviewing its strategy for the development of rural financing, including allowing banks to finance microfinance institutions. The NBE will strengthen the regulatory framework and supervision capacity for microfinance institutions.

C. External Sector and Financing Requirements

26. As noted earlier, the external current account deficit is projected to increase to 7.1 percent of GDP in 2001/02, up from 4.2 percent in 2000/01, mainly as a result of the drop in the terms of trade and the impact of the September 11, 2001 events, but it is projected to decline to 6.2 percent in 2002/03. The value of merchandise exports is projected to decrease by 9 percent in 2001/02, reflecting a fall in export prices and virtually stagnant volume. The value of merchandise imports is projected to increase moderately (by 2.6 percent) as a rise of 5.3 percent in volume in 2001/02 will be partly offset by lower prices. Worker remittances, nonfactor export services and net foreign direct investments are also expected to fall as a result of recent events. Some modest improvements are, however, projected in 2002/03.

27. It is expected that much of the demobilization, reconstruction, and sector development efforts will continue to be funded by multilateral and bilateral donors, leading to further improvement of the capital account in 2001/02. The balance of payments is also to benefit from the recent Paris Club rescheduling agreement and the approval of the enhanced HIPC Initiative decision point on November 8, 2001. Balance of payments projections are subject to substantial uncertainty because of Ethiopia's vulnerability to terms of trade shocks, particularly as regards coffee and oil prices, and drought. In view of recent development of world prices, the government will consult with Fund staff if balance of payments developments endanger the achievement of the program objectives.

28. The financing requirements for 2001/02, after the already secured bilateral debt relief and assistance, estimated at US$312 million (4.7 percent of GDP), will be covered by World Bank's balance of payments support lending (US$174 million), the AfDB (US$50 million), the European Union (US$49 million), and by interim assistance under the enhanced HIPC Initiative (US$39 million). The financing requirement for 2002/03 is estimated at US$267 million (equivalent to 3.7 percent of GDP) and is expected to also be fully covered from the same sources.

29. The government will rely on prudent macroeconomic policies and a market-determined flexible exchange rate to maintain the current account in line with the prospective availability of foreign grants, concessional loans, and debt relief. With regard to new borrowing, the government will neither contract nor guarantee any new external loans on nonconcessional terms. There will be no accumulation of arrears (excluding debt subject to rescheduling or a stock-of-debt operation).

30. The government will finalize bilateral agreements following the Paris Club meeting on April 5, 2001, and will complete the reconciliation of debt data with all bilateral and multilateral creditors by end-December 2001. It will request treatment of debt service to non-Paris Club creditors on at least comparable terms. The government will also strive to improve the debt-monitoring system and debt statistics by formulating and starting the implementation of a comprehensive debt-management strategy by March 2002, with the support of external technical assistance.

31. The government has decided to reduce, by January 2003, the average (nonweighted) import tariff from an existing level of 19½ percent to 17½ percent, lower the maximum tariff rate of 40 percent, and reduce the number of bands from 7 at present. A study of effective protection will be carried out by March 2002 to ensure that the new tariff structure is efficient for the Ethiopian economy.

32. During the program period, the government will not introduce or intensify any existing exchange restrictions, introduce or modify any multiple currency practices, conclude any bilateral payments agreements that are inconsistent with Article VIII of the Fund's Articles of Agreement, or introduce or intensify import restrictions for balance of payments purposes. The multiple currency practice that might have arisen from the NBE's weekly foreign exchange auction was lifted with the replacement of the auction by the interbank foreign exchange market on October 24, 2001. The authorities will ensure that a spread of more than 2 percent will not arise between the NBE's buying and selling rates and those of the commercial banks. The authorities will lift any remaining restrictions as recommended by the review by the IMF's Legal Department, with a view to accepting the obligations of Article VIII, Sections 2, 3, and 4 of the IMF's Articles of Agreement.

33. The government will continue implementing the recommendations of the recent safeguards assessment review of the NBE conducted by the IMF. In particular, by end-March 2002, the government will (a) submit to the NBE's Board an unqualified audit of NBE's financial statements carried out by the Audit Services Corporation for the year ended June 30, 2001; and (b) resolve all differences older than six months on the foreign correspondent bank account reconciliations and establish steps to ensure that NBE's accounting records properly reflect the balances held with foreign correspondents. The authorities will also take advantage of the standing authorization payments process offered by the IMF to ensure timely payments. By end-December 2002, and with technical assistance from the IMF, the authorities will (a) adopt an action plan for the implementation of external and internal audit recommendations; (b) adopt international accounting standards for the preparation of the NBE's financial statements; (c) ensure the finalization of audited financial statements and their publication with full explanatory notes; and (d) strengthen the independence of the internal audit department of the NBE.

D. Social Policies and Poverty Reduction Strategy Paper (PRSP)

34. The government intends to complete the preparation of a full PRSP by the first half of 2002, and will strive to produce a high-quality, fully participatory PRSP that prioritizes and costs initiatives, includes an analysis of the sources of growth and its links to poverty, and elaborates a full-fledged HIV/AIDS strategy. The PRSP will articulate clear medium-term strategies in areas central to poverty reduction, including health, education, road, and agriculture. It will include a social impact analysis of key reforms. The full PRSP will also outline an action plan for further improvement in the quality of the PRSP in the medium term. To date, an interministerial steering committee and a technical committee have been constituted, and an action plan for the preparation of the PRSP has been shared with donors. Wide-ranging consultations at the district, regional, and federal levels started in October 2001, and include civil society, representatives of nongovernmental organizations, the private sector, and the donor community. A report on household income and expenditure and welfare surveys, which addresses the social dimensions and changes in, and characteristics of, poverty, will be released in December 2001.

E. Other Structural and Governance-Related Reforms

35. Besides the structural reforms in the financial, fiscal, and external areas, the government will continue to implement, with the assistance of the World Bank, wide-ranging structural reforms that are conducive to growth and poverty reduction. Measures outlined for the period covered by the second annual program include (a) civil service reform, with the planned adoption of the civil service proclamation, the submission of a code of conduct to parliament, and the implementation of a medium-term wage policy; (b) capacity building, particularly in the Ministry of Revenues and the Ministry of Finance and Economic Development, in the judicial system, at the regional and district levels, and through the establishment of industrial training institutions and private sector associations; (c) agricultural reform, particularly the adoption and implementation of an action plan to improve the efficiency of the agricultural input market, the review, in cooperation with the regions, of the rural land proclamation to ensure an efficient lease policy, and an ambitious training program for farmers; (d) legal and regulatory reforms, including the adoption of a revised competition law, and a review of the implementation of the urban land lease policy to ensure efficient land allocation; (e) the restructuring of the telecommunications and electric utilities, including through private participation and the introduction of regulatory frameworks; and (f) the continuation of the privatization program of parastatals, with 40 enterprises to be brought to the point of sale in 2001/02-2002/03.

36. The government will also during the program period (a) review, and reform if necessary, the institutional and legal framework for public expenditure control, and internal and external audit; (b) make the Auditor General independent and accountable to the parliament; (c) review procurement procedures; and (d) present audited closed government accounts to the parliament for 1998/99, 1999/2000, and 2000/01.

F. Statistics Issues

37. The government will intensify its efforts to improve the timeliness, quality, and coverage of statistics. With technical assistance from the IMF, it will reconcile the monetary and fiscal accounts by September 2002, and improve the compilation methodology for fiscal data, the balance of payments, and national accounts. With regard to the latter, the national accounts unit of the Ministry of Finance and Economic Development will be strengthened through enhancement of staffing, training, and computer resources. With technical assistance from the World Bank, the authorities will strengthen their welfare-monitoring system, with a view to producing high-quality poverty and social indicators on a timely and regular basis, so as to monitor the output and outcomes of the poverty reduction strategy.

G. Monitoring of the Program

38. Program implementation will be monitored with reference to (a) quantitative quarterly performance criteria and benchmarks, which are set out in Table 2 and described fully in the attached technical memorandum of understanding; and (b) structural performance criteria and benchmarks, as specified in Table 3. In view of the uncertainties about delivery of external debt relief and external financial assistance, the program contains contingency mechanisms for the adjustment of the quantitative performance criteria and benchmarks; the modalities of these mechanisms are outlined in the attached technical memorandum of understanding. To ensure adequate monitoring of the program a technical committee has been established and will meet regularly and report monthly to the Minister of Finance and Economic Development on the progress made in the implementation of the program. The IMF's Resident Representative will attend the meetings of this committee.

39. As noted in the cover letter of intent addressed to the Managing Director, the third review under the PRGF arrangement is expected to be completed by end-July 2002. Disbursement of the fourth loan under the PRGF arrangement will be subject to observance of end-March 2002 performance criteria and the completion of the third review. At the time of the third review, performance criteria for end-September 2002 will be established in light of an updated budgetary policy framework for 2002/03. In addition, in the context of the third review, progress in policy implementation in the financial sector area, and for the preparation of the VAT, will be assessed. The fourth review, which is expected to be completed by end-January 2003, will assess progress in policy implementation, in particular in the areas of public expenditure management, tax and financial sector reforms, as well as performance with respect to the end-September 2002 performance criteria. In addition, at that time, performance criteria and benchmarks for the third annual program will be established.

Use the free Adobe Acrobat Reader to view Tables 1 and 2 (398 Kb PDF file)

Ethiopia

Technical Memorandum of Understanding

December 31, 2001

I. Introduction

1. This memorandum sets out the understandings between the Ethiopian authorities and staff of the International Monetary Fund (IMF) regarding the definitions of quantitative and structural performance criteria and benchmarks, as well as indicative targets, for the second annual program under the three-year arrangement supported by the Poverty Reduction and Growth Facility (PRGF), as well as the mechanisms to monitor the program and related reporting requirements. To monitor the evolution of the economy during the program period, the Ethiopian authorities will provide the data listed in each section below to the African Department of the IMF, in accordance with the indicated timing. The financial criteria will be monitored on the basis of the methodological classification of monetary and financial data that exists as of October 1, 2001. For program purposes, the public sector consists of the general government (comprising the federal and regional governments) and the National Bank of Ethiopia (NBE). The quantitative targets for end-December 2001 and July 7, 2002 are benchmarks, and those at end-March 2002 constitute performance criteria. The indicative benchmarks for end-September 2002 will be established as performance criteria in the context of the third review to be completed by end-July 2002.

II. Quantitative Performance Criteria and Benchmarks: Definitions and Reporting Standards

A. Floor for Net Foreign Assets (NFA) of the NBE

2. Definition. The NFA of the NBE are defined as the difference between gross international reserves and all foreign liabilities of the NBE, including debts to the IMF and other long- and short-term liabilities to nonresidents of the NBE. Foreign liabilities also include foreign-currency-denominated domestic liabilities of the NBE. For calculating the criteria, foreign assets and liabilities shall be valued at the U.S. exchange rates prevailing at end-September 2001. Gold holdings will be valued at the U.S. dollar market price at end-September 2001. Finally, the net foreign assets shall be converted into local currency at the exchange rate at end-September 2001 (8.524 birr per U.S. dollar).¹ Performance relative to an indicative floor on the net foreign liquid reserves of the NBE will also be monitored.²

3. Reporting. Data on gross international reserves and foreign liabilities of the NBE will be transmitted to the African Department of the IMF through the Fund Resident Mission on a weekly basis within ten days of the end of each week. The NBE will also report the breakdown between liquid and unencumbered gross international reserves and those reserve assets that are pledged, swapped, or encumbered.

B. Ceiling on Net Domestic Assets (NDA) of the NBE

4. Definition. The NDA of the NBE are defined to include net credit to the government, credit to enterprises and individuals, claims on banks, and other items net, but exclude foreign currency valuation adjustments.

5. Reporting. The monthly balance sheets of the NBE will be transmitted within six weeks of the end of each month.

C. Limit on the Net Domestic Financing of the General Government

6. Definition. The net domestic financing requirement of the general government is defined as the sum of (i) the change in the stock of general government domestic (bank and nonbank) debt; (ii) domestic and foreign receipts from divestiture operations, net of related expenditures; (iii) any pending overdue bills;³ and (iv) the floating debt.⁴ Net bank claims on general government consist of NBE and commercial bank claims on the government, including treasury bills and other government liabilities, net of general government deposits with the NBE and commercial banks. Nonbank claims comprise treasury bills, bonds, and other general government paper placed with nonbank institutions or with the public.

7. Reporting. Data on domestic financing (bank and nonbank) of the general government (including treasury bills and government bonds held by the nonbank public) will be transmitted on a monthly basis, within six weeks of the end of each month, except for the data on regional governments, which will be furnished within eight weeks after the end of each month. Net divestiture receipts, with gross receipts broken down into domestic and foreign currency, will be reported on a monthly basis, within six weeks of the end of each month. Reporting on domestic and external arrears (i.e., overdue bills) will be monthly, within six weeks of the end of each month.

D. Ceiling on External Payment Arrears

8. Definition. External payment arrears are defined as overdue debt service arising in respect of obligations incurred directly or guaranteed by the public sector, except on debt subject to rescheduling or restructuring. The program requires that no new external arrears be accumulated at any time under the arrangement.

9. Reporting. The accounting of nonreschedulable external arrears by creditor (if any), with detailed explanations, will be transmitted on a monthly basis within four weeks of the end of each month. This accounting would include, separately, arrears owed by the federal government and other public sector entities; arrears owed by Ethiopian Airlines; and arrears owed to Paris Club creditors, non-Paris Club creditors, and other creditors. Data on other arrears, which are reschedulable, will be provided separately.

E. Ceiling on Nonconcessional External Debt

10. Definition. External debt limits apply to the contracting or guaranteeing of nonconcessional external debt by the public sector or any other agencies on behalf of the public sector.⁵ External debt includes all current liabilities, which are created under a contractual arrangement through the provision of value in the form of assets (including currency) or services, and which require the obligor to make one or more payments in the form of assets (including currency) or services, at some future point(s) in time to discharge the principal and/or interest liabilities incurred under the contract. This definition includes loans, suppliers' credits, and leases (operational and financial leases). Concessionality will be based on a currency-specific discount rate based on the ten-year average of the OECD's commercial interest reference rates (CIRR) for loans or leases with maturities greater than 15 years and on the six-month average CIRR for loans or leases maturing in less than 15 years. Under this definition of concessionality, only debt with a grant element equivalent to 35 percent or more will be excluded from the debt limits.

11. Reporting. A loan-by-loan accounting of all new concessional and nonconcessional loans contracted or guaranteed by the public sector, including detailed information on the amounts, currencies, and terms and conditions, as well as relevant supporting materials, will be transmitted on a quarterly basis within four weeks of the end of each quarter.

III. Adjusters

A. Excess in Disbursed External Financial Assistance

12. In case of an excess external financing beyond the programmed amounts shown in Table 2 annexed to the memorandum on economic and financial policies (MEFP) for the period October 2001-September 2002, the floor on net foreign assets of the NBE will be adjusted upward (with two exceptions), by the amount of disbursed external financing in excess of the programmed amounts (comprising non-project-related loans and grants, including special programs, but excluding interim debt relief under the enhanced HIPC Initiative) at the end of each quarter (Table 2 annexed to MEFP), valued at the average exchange rate of the quarter. The two exceptions are (i) an amount of up to US$50 million in excess of programmed overall external financing can be spent on special programs in the case that the overall excess funding stems from higher than programmed financing of the special programs; and (ii) an amount of up to US$50 million in excess of programmed overall external financing can be spent on poverty-targeted outlays if the excess stems from higher than programmed other non-project financing. Accordingly, within this limit, the floor on net foreign assets, and the ceilings on net domestic assets of the NBE, and domestic financing of the general government will not be adjusted. The interim debt relief under the enhanced HIPC Initiative will be spent in accordance with the principles in the enhanced HIPC Initiative decision point document (EBS/01/174; paragraphs 61 and 62).

13. The ceiling on net domestic assets of the NBE will be adjusted downward (with the two above-mentioned exceptions) by the amount of disbursed external financing in excess of the programmed amounts (comprising non-project-related loans and grants, including special programs, but excluding interim debt relief under the enhanced HIPC Initiative) at the end of each quarter (Table 2 annexed to MEFP), converted into birr at the average exchange rate of the quarter.

14. The ceiling on domestic financing of the general government will be adjusted downward (with the two above-mentioned exceptions) by the amount of external financing disbursed to the budget in excess of the programmed amounts (comprising non-project-related loans and grants, including special programs, but excluding interim debt relief under the enhanced HIPC Initiative) at the end of each quarter (Table 2 annexed to MEFP), converted into birr at the average exchange rate of the quarter.

B. Shortfall in External Financial Assistance

15. In case of a shortfall in external financing below the programmed amounts, (comprising non-project-related loans and grants, including special programs, but excluding interim debt relief under the enhanced HIPC Initiative) shown in Table 2 annexed to the MEFP:

• The floor on the NFA of the NBE will be adjusted downward by a maximum of 50 percent of the amount of the shortfall below the programmed amount, but by no more than US$50 million. The adjustment will be converted at the average exchange rate of the quarter.
• The ceiling on the NDA of the NBE will be adjusted upward by a maximum of 50 percent of the amount of the shortfall, but by no more than US$50 million. The adjustment will be converted into birr at the average exchange rate of the quarter.
• The ceiling on general government net domestic financing will be adjusted upward by a maximum of 50 percent of the amount of shortfall in external financial assistance disbursed to the budget, but by no more than US$50 million. The adjustment will be converted into birr at the average exchange rate of the quarter.

IV. Other Reporting Requirements for Program Monitoring

A. Macroeconomic Monitoring Committee

16. The macroeconomic monitoring committee, composed of senior officials from the Ministry of Finance and Economic Development, the NBE, and other relevant agencies, shall meet regularly and be responsible for monitoring the performance of the program, recommending policy responses, informing the IMF regularly about the progress of the program, and transmitting the supporting materials necessary for the evaluation of performance criteria and benchmarks. The committee shall provide the IMF with a progress report on the program on a monthly basis within four weeks of the end of each month, using the latest available data.

B. Developments on Structural Performance Criteria and Benchmarks

17. The authorities will notify the African Department of the IMF of developments on structural performance criteria and benchmarks as soon as they occur. The authorities will provide the documentation, according to the dates in Table 3 annexed to the MEFP, elaborating on policy implementation.

C. Data Reporting

Production and prices

18. The following data shall be transmitted:

• The monthly disaggregated Addis Ababa consumer price index will be transmitted within four weeks of the end of each month.
• The national consumer price index and its regional components will be transmitted within eight weeks of the end of each month.
• Any revisions to the national accounts data will be transmitted within three weeks of the date of the revision.

Public finance

19. Monthly data on public finance will require a consolidated budget report of the federal and regional governments comprising:

• the revenue data by each major item, including that collected by the Federal Inland Revenue Authority, the Customs Office, and the regional governments;
• details of the recurrent and capital expenditure of the federal and regional governments; and
• details of budget financing, domestic, and external data will be transmitted within six weeks of the end of each month and data of the regional governments within eight weeks of the end of the month.

Monetary sector data

20. The following data will be transmitted on a daily/weekly/biweekly basis within one/five working days of the end of each day/week:

• treasury bill auction details (rates, amounts, and holders); and
• interbank foreign exchange rates and transactions.

21. The balance sheet of the NBE and the consolidated balance sheets of the commercial banks will be transmitted on a monthly basis within six weeks of the end of each month. The stocks of government securities, detailed information on interbank money market transactions (terms, duration, and participating institutions), and interest rate developments will be transmitted on a monthly basis within two weeks of the end of each month.

External sector data

22. The following data will be transmitted as follows:

• The interbank market exchange rate, as the simple average of the daily-weighted average buying and selling rates, will be transmitted on a weekly basis within five business days of the end of the week.
• Exports, imports, and other balance of payments data on services, private transfers, and capital account transactions will be transmitted on a quarterly basis within six weeks of the end of each quarter.
• The Ethiopian authorities will provide IMF staff regularly with detailed monthly data on the volume and prices of imported petroleum products and exports of coffee.
• The Ethiopian authorities will consult with IMF staff if balance of payments developments endanger the achievement of program objectives.

February 27, 2002

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

Dear Mr. Köhler:

Further to our letter dated December 31, 2001, on the second review and the second annual program under the three-year Poverty Reduction and Growth Facility (PRGF) arrangement approved on March 22, 2001, this is to inform you that we could not meet the prior action on the entering into effect of the management contract for the Commercial Bank of Ethiopia with a foreign bank, as the State Bank of India withdrew from the contract.

After discussion with a visiting IMF staff team, we agreed to replace paragraphs 11 and 24 relating to the Commercial Bank of Ethiopia in the memorandum on economic and financial policies attached to our letter dated December 31, 2001, by the following text:

New paragraph 11:

"In the area of financial sector reforms, several measures were taken to improve the competitiveness of the financial sector and strengthen the Commercial Bank of Ethiopia (CBE), in line with recommendations made by IMF-World Bank technical assistance. Government guarantees for bank assets frozen in Eritrea were issued, and the CBE's board was reconstituted to increase private sector participation. Restrictions on the payment of interest on current account deposits were also lifted. However, delays occurred in finalizing a comprehensive study of the NBE's operational, organizational, and administrative setup. A management contract between CBE and a foreign bank was signed on June 29, 2001, and was expected to enter into effect after the Boards of the two institutions had resolved the only remaining issue relating to liabilities of the management and arbitration. In the absence of an agreement on this issue, the foreign bank withdrew from the contract in January 2002."

New paragraph 24:

"With regard to the CBE, which still dominates the financial market with over 80 percent of bank deposits and about 60 percent of bank loans, as noted earlier, the management contract for the CBE with a foreign bank that was signed on June 29, 2001, did not enter into effect as the foreign bank withdrew from the contract in January 2002. At the same time, 28 past and 13 current managers from CBE, including the president and two vice-presidents, were arrested for corruption charges, which are under investigation. The CBE's financial situation also deteriorated in 2001, with non-performing loans increasing significantly. Against this background, a new qualified management team for CBE will be appointed by February 28, 2002, with whom the government will sign a performance contract by end-June 2002, to ensure that CBE is operated effectively on a commercial basis so as to achieve the necessary improvements in financial performance. As had been contemplated in the management contract with the foreign bank, the performance contract will ensure that the new management has decision-making autonomy, including on staffing, meeting performance targets, and pursuing delinquent borrowers, as well as on taking steps to strengthen CBE's cost competitiveness and profit and loss situation. To assist the new management, CBE will be concluding a twinning arrangement with—or hire consultants from—reputable international financial institutions by end-September 2002. In the meantime, to improve its financial situation, CBE will fully implement the new provisioning directive to be adopted by end-March 2002. The reserve requirement will be strictly enforced and there will be no lending from the Central Bank to CBE. CBE will also reduce non-performing loans by Birr 0.8 billion by end-September 2002, including through write-offs. CBE will prepare a financial restructuring plan by end-December 2002. CBE will by end-June 2002 also transfer lending authority from the Board to management and create an audit committee of the Board to oversee financial performance of CBE, particularly measures to reduce nonperforming loans. Finally, CBE will prepare quarterly quantitative and qualitative monitoring reports for its Board, indicating progress in meeting the goals of the performance contract."

Table 3 on the structural benchmarks and performance criteria attached to the memorandum on economic and financial policies has been revised to reflect the above changes.

Sincerely yours,