Dominica—Letter of Intent, Technical Memorandum of Understanding

Roseau, Dominica
August 13, 2002

The following item is a Letter of Intent of the government of Dominica, which describes the policies that Dominica intends to implement in the context of its request for financial support from the IMF. The document, which is the property of Dominica, is being made available on the IMF website by agreement with the member as a service to users of the IMF website.

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

Dear Mr. Köhler:

1. This letter describes the economic policies that the Government of Dominica intends to follow during FY 2002/03 (July 1, 2002 to June 30, 2003). Through prudent macroeconomic policies and a step-up in structural reforms, the Government aims at restoring order to the public finances, maintaining low inflation and reducing external vulnerability, while laying the basis for a sustained recovery in economic activity and employment and a reduction in poverty over the medium term. To further these objectives and in the context of the successful implementation of this economic program, the Government will work to develop over the next few months a medium-term program that could be supported by a three-year Poverty Reduction and Growth Facility arrangement from the IMF.

2. The Government of Dominica seeks support from the IMF for its economic program for FY 2002/03 and hereby requests a Stand-By Arrangement for the period August 28, 2002 through August 27, 2003 in a total amount of SDR 3.28 million (40 percent of quota). This support, together with financial and technical assistance from other international financial institutions and donor agencies, would assist the Government to finance its adjustment efforts and begin important structural reforms.

Background

3. The economy of Dominica is predominantly agricultural, although some degree of diversification has taken place in recent years toward tourism. The performance of the main agricultural activity, banana production and exports, has steadily deteriorated since the early 1990s owing to natural disasters, notably hurricanes, and, in more recent years, the changes in the marketing arrangements for bananas in the European Union in preparation for the phasing out of the preferential trading regime. The decline in the banana industry has adversely affected developments in other sectors. Also, external shocks associated with the slowdown in global economy activity in 2001 and the events of September 11 exacerbated the already weak economic situation, with tourism being particularly hard hit. Moreover, the productivity of public investment has generally been low. As a result of these developments, output and employment performance has deteriorated over the past several years—real GDP is estimated to have contracted by close to 1 percent on average during 1999-2001, and is projected to register a further decline in 2002.

4. The public finances have deteriorated sharply in recent years as Government saving and foreign grants have declined, while capital expenditure has increased. In FY 2001/02 (year ending June 30), Central Government dissaving is estimated to have increased to 6¾ percent of GDP from 4 percent in the previous year. As a result, and despite a substantial decline in capital spending, the overall deficit of the Central Government is estimated to have amounted to about 10½ percent of GDP, largely financed by an accumulation of domestic arrears. The deterioration in public saving reflects both stagnating revenue and increasing expenditure. Revenue has not increased owing to the lack of buoyancy of the tax system, resulting from substantial tax exemptions—including discretionary exemptions—and low tax receipts on petroleum products at times when international fuel prices were high (due to our practice of holding the domestic fuel prices constant by adjusting the tax rate). Current spending has increased, reflecting a rising wage bill and increasing debt service obligations.

5. The Government is conscious of the fact that, if the strains that have been building up in the public finances and the economy are left unchecked, there would likely be serious adverse economic consequences with accompanying widespread social dislocation, particularly rising levels of unemployment and poverty. The Government is resolved to preempt such developments by tackling the root causes of current economic difficulties, and by doing so in a way which protects critical investment in economic and social infrastructure and creates a solid foundation for economic and social progress into the future.

Macroeconomic program

6. The Government's strategy for FY 2002/03 is to lay the basis for renewed and sustainable growth over the medium term through the implementation of sound macroeconomic policies, and by putting in place structural reforms aimed at bolstering the economy's productive potential and competitiveness.

7. The fiscal program envisages an increase in tax revenue from 21½ percent of GDP in FY 2001/02 to 25 percent of GDP in FY 2002/03. This increase will result from revenue measures announced in the FY 2002/03 budget, including: (i) a stabilization levy of 4 percent on all payroll income; (ii) broadening the base for transactions-based taxes; (iii) curtailment of tax concessions and streamlining fiscal incentives; (iv) imposing the increased rate of sales tax on petroleum products and increasing the price of fuels at the pump consistent with generating annual revenues of 3 percent of GDP¹; and (v) collection of tax arrears. Enactment of a budget, which includes these revenue measures and is consistent with the Government's fiscal program, is a prior action for IMF Board consideration of our request for the Stand-By Arrangement.

8. During the program period, consistent with the projection for revenue and the fiscal deficit targets, Central Government expenditure as a ratio of GDP is targeted to remain at the same level as in the previous year, as a decline of 1 percent of GDP in the wage bill (reflecting a freeze on wages and salaries, a reduction in payments for overtime and in the number of contractual workers, and normal retirements) will be offset by an increase in spending on goods and services (reflecting the Government's intention to remain current in meeting its obligations to domestic suppliers). Hiring would only be allowed in the education and health sectors, and in areas critical to the management of the stabilization program, such as tax and customs administration.

9. The Government will clear its arrears to the Dominica Social Security and to the Dominica Water and Sewerage Company by end-December 2002, to Dominica Electricity Services and Cable and Wireless by end-March 2003, and to other domestic parties by end-June 2003 (performance criteria), largely by issuing long-term, interest-bearing debt, and where possible, with interest capitalization through at least FY 2004/05. Moreover, beginning October 2002, the Government will stay current in meeting its domestic obligations.

10. To reduce pressures on commercial banks' liquidity and make room for increased credit expansion for private sector investment, the fiscal program also includes a lowering of the Government's indebtedness to the banking system by 1 percent of GDP in FY 2002/03.

11. In line with available financing, the public sector investment program will be limited to fixed investment of 6 percent of GDP in FY 2002/03. Within this expenditure limit, capital spending will be restricted to projects largely financed by external grants or loans on concessional terms. Parliamentary approval will be sought for the funding of additional projects for which financing is available and where their implementation does not threaten the attainment of fiscal objectives.

12. As Dominica is a member of a currency union with a common central bank—the Eastern Caribbean Central Bank (ECCB)—there is little or no scope for independent monetary and exchange rate policies. In this context, the fiscal program is expected to create space for adequate credit expansion to finance productivity-enhancing private investment. At the same time, competitiveness will be strengthened through implementation of the structural reforms specified below.

13. With the help of the foregoing measures, real GDP is projected to grow by 1½ percent in 2003, while the 12-month rate of inflation is envisaged at 2 percent. The external current account deficit in 2003 is projected at around 13¼ percent of GDP, up from about 12½ percent of GDP projected for 2002.

14. The overall deficit of the Central Government is targeted to fall by about 4¾ percent of GDP in 2002/03, to around 5¾ percent of GDP. This level would be consistent with the projected availability of multilateral and bilateral funding and the repayment of Government domestic debt. The fiscal targets of the program will be monitored on a quarterly basis through ceilings on the Central Government overall balance and other variables, as set out in Table 1. The Government will stand ready to take additional measures that may be needed to ensure that the fiscal deficit targets are observed.

Structural reforms

15. The structural reform agenda for 2002/03 includes a comprehensive reform of the tax system, a public expenditure review, the initiation of civil service reform, banana sector restructuring, privatization, and the strengthening of financial system supervision, with the support of the World Bank, ECCB, CDB, EU, and CARTAC, as indicated in Table 2.

16. With the help of the CARTAC, we intend to conduct a comprehensive review of the tax system and its administration by end-December 2002 (a program benchmark), and to implement the recommendations of the review by end-June 2003 (a performance criterion). Our aim will be to improve the revenue system by broadening the tax base, increasing the efficiency of tax administration, and strengthening the legal framework for enhancing tax compliance. We expect that the review will examine in particular: (i) the feasibility of introducing a value-added tax; (ii) further rationalization of the corporate income tax;
(iii) the streamlining of tax incentives; (iv) replacement of the current mechanism for determining domestic fuel prices with one that would permit these prices to reflect import costs; and (v) the reform of the property tax.

17. With the support of the World Bank, we intend to conduct a public expenditure review by end-March 2003 (a program benchmark), with the aim of rationalizing and increasing the efficiency of public spending. We also intend to conduct a review of the public sector investment program (PSIP) by end-December 2002 (also a program benchmark), to improve the quality and focus of public investment expenditure in the medium term, and to ensure that only projects aimed at redressing the main impediments to growth, and supported by external financing on concessional terms, are included in the PSIP.

18. Also with the help of the World Bank, we intend to conduct a review of the civil service by end-March 2003 (a program benchmark), with the aim of designing a reform program to rationalize it and improve its efficiency in the provision of Government services. We will use the recommendations of the study to initiate the reform process by end-June 2003 (also a program benchmark).

19. As a step toward improving economic efficiency and increasing private sector participation in the economy, we intend to initiate a privatization program. The first privatization will be the Dominica Banana Marketing Corporation, which we propose to accomplish by end-September 2002 (a program benchmark). We will also study the feasibility of privatization of the two state-owned banks and the divestiture of the Government's shares in Cable and Wireless: we aim to discuss with the IMF concrete proposals regarding these privatizations and divestment at the time of the mid-term review of the program. To manage any proceeds from privatization, we will establish a special privatization fund by end-March 2003 (a program benchmark) that will hold the proceeds of all privatizations. Only the yield from this fund's investments would be used for budgetary support.

20. To strengthen financial system oversight, we will seek to place all nonbank financial institutions under the supervision of the Ministry of Finance and Planning (with support from the ECCB) by end-June 2003 (a program benchmark), as these institutions should be subject to periodic on-site inspections and surveillance, and should be regulated to meet capital adequacy ratios consistent with international standards. Dominica, along with other member countries of the ECCB, is committed to carrying out a financial sector assessment program under the auspices of the IMF, to commence in the latter half of 2003. As a first step, Government will request CARTAC assistance to undertake a comprehensive review of the sector by end-December 2002 (a program benchmark) with the aim of strengthening the legal and regulatory framework, establishing supervisory procedures, and training staff to carry out effective supervision of financial institutions.

21. With the support of the European Union, the Government intends to expedite the ongoing restructuring of the banana sector to help it become viable in an increasingly competitive international market. The restructuring program includes targeting efficient farms for EU-funded investment in irrigation and drainage and other infrastructure works to raise efficiency, quality, and labor productivity. A critical element of the program will be the implementation of parallel foreign-funded programs to help displaced farmers move into nontraditional agriculture and so minimize the adverse social impact from the restructuring of the industry.

22. As part of our drive to enhance economic efficiency, we will eliminate all remaining price controls (except on fuels and cement) by end-December 2002 (a program benchmark). Price controls on fuels and cement will be eliminated by end-June, 2003 (also a program benchmark). The Government will study, by end-December 2002, the feasibility of abolishing the Dominica Export Import Agency's (DEXIA's) monopoly on the importation of sugar and bulk rice, and the Agency's ability to continue to be self-financing in the absence of this monopoly. The Government will also examine by end-December 2002 the scope for transforming the National Development Corporation (NDC) into a self-financing agency so that budgetary transfers to it will be minimized. The completion dates for both studies are program benchmarks. At the time of the mid-term review of the program, we aim to discuss with the IMF strategies for restructuring DEXIA and the NDC.

23. The Government of Dominica believes that the policies described in this letter will achieve the objectives of the program. For the period of the arrangement, we will maintain the customary policy dialogue with the IMF, and will take appropriate action to promote the achievement of the Government's economic policy objectives in light of evolving circumstances. The mid-year review with the IMF, to be completed by end February 2003, will cover the implementation of the economic program described in this letter, including in particular an assessment of progress in: (i) formulation of a comprehensive tax reform package in line with the recommendations of the review of the tax system; (ii) implementation of the privatization program, including the creation of the privatization fund; (iii) placement of nonbank financial institutions under the supervision of the Ministry of Finance and Planning; (iv) restructuring of the banana sector; and (v) design of a civil service reform program.

24. As indicated in paragraph 1 above, the Government believes that its program constitutes a sound basis for a three-year Poverty Reduction and Growth Facility arrangement. Consequently, in parallel with the implementation of the program, the Government intends to initiate discussions with the IMF and other institutions, and with representatives of economic agents and civil society in Dominica, with a view to formulating an Interim Poverty Reduction Strategy Paper by end-March 2003.

Sincerely yours,

Dominica: Technical Memorandum of Understanding

Dominica's performance under the Stand-By Arrangement supported program, described in the letter of the Government of Dominica dated August 13, 2002, will be assessed by the IMF on the basis of the observance of quarterly quantitative performance criteria as well as on compliance with structural performance criteria and benchmarks. This Technical Memorandum of Understanding (TMU) sets out and defines the performance criteria (and adjustors) and benchmarks, as well as the monitoring and reporting requirements. It also sets out and defines the prior actions.

I. Definitions of Concepts

1. The central government overall balance will be measured as (a) total revenue and grants of the central government, less (b) total expenditure of the central government, as reported by the Budget Division of the Ministry of Finance and Planning, supplemented with data on capital grants and fixed investment expenditure from the PSIP Unit in Planning.

2. The central government wage bill will be measured as the total expenditure of the central government on wages and salaries, including acting allowances, special duty allowances, responsibility allowances, subsistence allowances, and the employer contribution to Dominica Social Security, but not including retirement benefits.

3. The banking system is defined as the consolidation of the Eastern Caribbean Central Bank operations in Dominica, with the accounts of all banks licensed by the ECCB to do business in Dominica as commercial banks.

4. The nonfinancial public sector (NFPS) comprises the central government, Dominica Social Security, the National Development Corporation, local governments, the Dominica Banana Marketing Corporation, the Dominica Water and Sewerage Corporation, the Dominica Export and Import Agency, the Dominica Port Authority, and the Dominica Broadcasting Corporation.

5. Banking system net credit to central government and banking system net credit to the nonfinancial public sector will be defined as in the monetary survey compiled by the Eastern Caribbean Central Bank. The cumulative amounts that represent performance ceilings are defined as the change in stocks from June 30, 2002 up to the test date.

6. Central government arrears to Dominica Social Security are defined as the total stock of arrears of contributions and interest, as reported by Dominica Social Security and verified by the Accountant General's office.

7. Central government arrears to other parties are defined as the sum of all amounts pending payment by government for goods and services already purchased from these parties, as well as pending interest obligations. The measure used will be the total reported by the Accountant General as amounts overdue by more than thirty days.

8. Public and publicly guaranteed external debt is defined to include debt contracted or guaranteed by the public sector as defined in paragraph 4. The performance criterion on contracting external debt applies not only to debt as defined in point No. 9 of the Guidelines on Performance Criteria with Respect to Foreign Debt (Executive Board Decision approved on August 24, 2000), but also to commitments contracted or guaranteed for which value has not been received. The definition of debt set forth in point No. 9 of the Guidelines reads as follows: "(a) For the purpose of this Guideline, the term "debt" will be understood to mean a current, i.e., not contingent, liability, created under a contractual arrangement through the provision of value in the form of assets (including currency) or services, and which requires the obligor to make one or more payments in the form of assets (including currency) or services, at some future point(s) in time; these payments will discharge the principal and/or interest liabilities incurred under the contract. Debts can take a number of forms, the primary ones being as follows: (i) loans, i.e., advances of money to obligor by the lender made on the basis of an undertaking that the obligor will repay the funds in the future (including deposits, bonds, debentures, commercial loans, and buyers' credits) and temporary exchanges of assets that are equivalent to fully collateralized loans under which the obligor is required to repay the funds, and usually pay interest, by repurchasing the collateral from the buyer in the future (such as repurchase agreements and official swap arrangements); (ii) suppliers' credits, i.e., contracts where the supplier permits the obligor to defer payments until some time after the date on which the goods are delivered or services are provided; and (iii) leases, i.e., arrangements under which property is provided which the lessee has the right to use for one or more specified period(s) of time that are usually shorter than the total expected service life of the property, while the lesser retains the title to the property. For the purpose of the guideline, the debt is the present value (at the inception of the lease) of all lease payments expected to be made during the period of the agreement excluding those payments that cover the operation, repair or maintenance of the property. (b) Under the definition of debt set out in point No. 9(a) above, arrears, penalties, and judicially awarded damages arising from the failure to make payment under a contractual obligation that constitutes debt are debt. Failure to make payment on an obligation that is not considered debt under this definition (e.g., payment on delivery) will not give rise to debt."

9. Contracting or guaranteeing of nonconcessional external public debt with maturity of at least one year will be monitored by the Accountant General's office on a monthly basis. For purposes of this ceiling, nonconcessional is defined as debt having a grant element (in net present value relative to face value) of less than 35 percent, based on the currency- and maturity-specific Commercial Reference Rates (CIRR), published monthly by the OECD. The limit excludes the use of Fund resources, and refinancing operations. This ceiling will be monitored on a continuous basis. The ceiling must not be exceeded at any time during the arrangement.

10. Contracting or guaranteeing of short-term external public debt with maturity of less than one year will be monitored by the Accountant General's office. This debt is defined as any external debt with original maturity of less than one year, excluding short-term import related debts.

11. External payments arrears of the public sector will be monitored by the Accountant General's office, together with the Debt Unit in the Ministry of Finance and Planning. Arrears are defined in relation to Dominica's external public and publicly guaranteed debt as all amounts of principal and interest that are due but not yet paid. As such, the arrears do not include subscriptions arrears to regional and international organizations.

II. Adjustors to Quantitative Performance Criteria

12. The limits on the central government overall balance will be adjusted downward (lower deficit) to the extent that there are shortfalls in programmed project financing. The same limits will be adjusted upward (larger deficit) to the extent that project financing exceeds programmed amounts. These upward adjustments will not exceed a cumulative US$1.3 million by end-September 2002; US$2.6 million by end-December 2002; US$3.9 million by end-March 2003; and US$5.2 million by end-June 2003. Programmed project financing is defined as the receipt of grants and loan proceeds to finance the central government's portion of the PSIP. The cumulative programmed amounts are as follows: US$3.5 million by end-September 2002; US$7.0 million by end-December 2002; US$9.7 million by end-March 2003; and US$12.9 million by end-June 2003.

13. The limits on the central government overall balance will be adjusted upward (larger deficit) by a cumulative amount of up to EC$10 million to accommodate redundancy payments associated with civil service reform.

14. The limits on banking system net credit to the central government, and banking system net credit to the nonfinancial public sector will be adjusted upward to the extent that there are shortfalls in net external nonproject financing that are outside the control of the authorities. The upward adjustments will not exceed a cumulative US$1.3 million by end-September 2002; US$2.6 million by end-December 2002; US$3.9 million by end-March 2003; and US$5.2 million by end-June 2003. The same limits will be adjusted downward to the extent that net external nonproject financing exceeds programmed amounts.

15. The maximum amount of arrears outstanding by end-September 2002, by end-December 2002, by end-March 2003; and by end-June 2003, will be adjusted downward by the amount that the stock of arrears outstanding as of 30 September 2002 falls short of programmed amounts. The maximum amount of arrears outstanding by end-September 2002, will be adjusted upward by the amount that the stock of arrears outstanding as of 30 September 2002 exceeds programmed amounts.

16. The limits on disbursement of nonconcessional external debt to the NFPS with maturity of at least one year will be adjusted downward to the extent that there are shortfalls in programmed project financing. The same limits will be adjusted upward to the extent that project financing exceeds programmed amounts. These upward adjustments will not exceed a cumulative US$1.3 million by end-September 2002; US$2.6 million by end-December 2002; US$3.9 million by end-March 2003; and US$5.2 million by end-June 2003.

III. Periodic Reporting

17. Regular reporting on a monthly basis will include the following:

• Data for monitoring the program's quarterly performance criteria.
  
  
• Fiscal sector
  
  

(i) Central government budgetary accounts.

(ii) Capital expenditure and source of financing.

(iii) Dominica Social Security Balance Sheet, showing amounts receivable from central government for contributions and interest.

(iv) Stock of all other arrears outstanding.

(v) Central government domestic debt data.

• Financial sector
  
  
(i) Monetary survey for Dominica as prepared by the Eastern Caribbean Central Bank.


• External and real sectors
  
  

(i) Imports and exports data by product.

(ii) Detailed (loan-by-loan) external debt report from the Debt Unit in the Ministry of Finance and Planning, and showing fiscal year-to-date disbursements, amortization, interest payments, and outstanding stocks, classified by borrower.

(iii) Copies of all loan agreements for any new loans contracted, including financing involving the issue of government paper.

(iv) Consumer price index.

18. Reporting on an annual basis will include the following:

• External and real sectors
  
  

(i) GDP and its components.

(ii) Balance of payments accounts.

19. Other reporting will include:

• Reports of legislative changes pertaining to economic matters.

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