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

Dear Mr. Köhler:

1. In accordance with the provisions of the three-year arrangement (approved on March 22, 2001) under the Poverty Reduction and Growth Facility (PRGF), the government of Ethiopia, in cooperation with the staff of the International Monetary Fund, has evaluated the implementation of the second annual economic and financial program adopted for the period October 2001-September 2002. ¹ We focused on the progress made in implementing the program during the first nine months of the fiscal year 2001/02 and on the prospects and policies to be pursued during the remainder of the program year, in light of the objectives set forth in the memorandum on economic and financial policies for 2001/02, dated December 31, 2001, and the letter dated February 27, 2002. The government intends to make the contents of this letter available to the public and authorizes you to arrange for it to be posted on the IMF website, subsequent to Executive Board completion of the third review under the PRGF arrangement.

2. As you will appreciate, performance under the second annual program has been good, notwithstanding continued deterioration of the terms of trade. All the quantitative performance criteria and benchmarks under the second annual program have been observed (Table 1). Structural performance criteria and benchmarks through March 2002 have also been observed, with the exception of the revised regulation for the provisioning by banks for nonperforming loans and other doubtful assets (benchmark), which has been adopted, but with regard to loan classification is not in line with international best practice as had been envisaged (Table 2). A revision of the directive is to be adopted by August 31, 2002 to bring it closer to international best practice. The government is also determined to meet the remaining performance criteria and benchmarks through September 2002 and the prior actions set in this letter (Table 3). Following the completion of the third review under the PRGF arrangement by the Executive Board, the government requests the fourth disbursement of SDR 10.429 million under the arrangement.

Progress made during the first nine months of 2001/02

4. Considerable progress continues to be made towards restoring peaceful conditions between Ethiopia and Eritrea. To date, Ethiopia has demobilized 140,000 soldiers. On April 13, 2002, an international boundary commission delivered its final and binding ruling on the border between Ethiopia and Eritrea, which was accepted by both countries.

5. As described in the December 2001 memorandum, the second annual PRGF-supported program has been designed in the context of an updated medium-term framework for 2001/02-2003/04 that continues to stress (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 medium-term objectives for 2001/02-2003/04 set in the December 2001 memorandum are (a) to achieve an annual real GDP growth of about 6 percent; (b) to maintain inflation at a low rate of about 3 percent; and (c) to reduce the external current account deficit (including official transfers) to 4.6 percent of GDP by 2003/04.

6. On the whole, economic developments during the first nine months of 2001/02 were satisfactory. Real GDP growth rate for 2001/02 is estimated at 5 percent, lower than the program projection of 5.8 percent. Following the 2000/01 bumper cereal crop, agricultural output is estimated to increase by 4.5 percent in 2001/02, lower than initially projected. Nonagricultural GDP however is still estimated to grow by about 5.5 percent. Coffee exports (which account for 40 percent of merchandise exports) for the first nine months of 2001/02 are estimated at 65,000 tons, compared to a level of 60,800 tons in the same period of 2000/01. However, coffee export prices fell further by 5.8 percent during that period. With the good performance of non-coffee exports, total exports are in line with projections. With much higher food imports than programmed, imports are somewhat higher than projected. A large food surplus led to a 16 percent drop in food prices, resulting in an average annual national consumer price inflation in the first nine months of 2001/02 of negative 9.2 percent as non-food consumer price inflation was 2.4 percent for the same period.

7. The government is greatly concerned by recent declines in producer prices of coffee and cereals. The decline in producer prices of cereals is due to oversupply following the bumper harvest in 2000/01, and large food aid and commercial imports. However, despite record levels of production and low food prices, Ethiopia will still require food aid in the foreseeable future to help the needy and regions facing shortfalls. In order to reverse the decline in food prices while meeting Ethiopia's food aid requirements, the government is urging donors to increase local purchases of food from food surplus regions. The decline in coffee export prices reflects developments in world markets. The government is taking a number of measures to prop up rural incomes in the medium term. These include measures to encourage crop diversification; to ensure that farmer's production decisions are market driven through better price transmissions; and to enhance rural transport. The authorities intend to conduct a study on the effects of, and ways to reverse or mitigate the impact of, the decline in coffee and cereal prices on producers.

8. In the fiscal area, as a result of the accelerated implementation of fully-financed special programs and capital and poverty-targeted expenditure, the program allowed for an increase of the overall budget deficit (including grants and emergency programs) from 5.7 percent of GDP in 2000/01 to 9.1 percent in 2001/02. Overall fiscal performance during the first nine months of 2001/02 has been satisfactory. The government continued to implement its comprehensive tax policy reforms and overhaul its tax administration. A draft value-added tax (VAT) was submitted to Parliament in October 2001, and was ratified in early July 2002 after extensive consultation with the private sector. The large tax payer unit and tax reform implementation task force established in 2001 have been strengthened. During the first nine months of 2001/02, total revenues increased by 10.2 percent compared to 2000/01, and were only slightly lower than projected due to lower direct and indirect tax revenue.

9. On the spending side, the government continued to follow a cautious expenditure management policy. Total expenditure of the general government during the first nine months of 2001/02 was slightly lower than programmed. Capital spending accelerated substantially compared to previous years, in line with the program. The implementation of the emergency programs, projected at 2.2 percent of GDP in 2001/02, has been slightly slower than programmed because of delays in disbursement of external assistance. Defense outlays were also lower, but social spending was in line with the program. The quantitative performance criteria for end-March 2002 on the domestic financing of the government was met with a wide margin.

10. In the monetary area, reflecting lower-than-projected economic activity and negative inflation, broad money increased in the first nine months of the year by 5.3 percent, compared to 10.9 percent under the program, and total bank credit fell by 2.3 percent compared to a projected increase by 6.3 percent under the program, partly reflecting increased provisioning by the CBE. During the first nine months of the fiscal year, net claims on the government declined by 2.9 percent, more than programmed. Increased auctions of government securities reduced excess reserves of commercial banks to 3.4 percent of deposits in December 2001, down from 5.3 percent in July 2001. However, excess reserves rose again to 6.9 percent by March 2002. In response to lower economic activity and negative inflation, the NBE lowered the floor on deposit interest rates from 6 percent to 3 percent on March 4, 2002. All banks have adjusted their deposit and lending interest rates accordingly.

11. Several measures were taken to improve the soundness and competitiveness of the financial sector, including the issuance of government guarantees for assets held in Eritrea, the issuance of a letter to encourage public entities to do business with all banks, the establishment of a bankers' association, and the lifting of restrictions on the payment of interest on current account deposits. A comprehensive study of the National Bank of Ethiopia's (NBE) operational, organizational, and administrative set-up is being finalized. In line with recommendations under the recent Safeguards Assessment of the NBE, an unqualified audit of NBE's financial statements for the year ended June 30, 2001 was approved by the NBE's Board by end-March 2002. However, delays occurred in bringing to the point of sale the Construction and Business Bank, and in adopting a restructuring plan to address the weak financial condition of the Development Bank of Ethiopia. A workshop was held in Addis Ababa during April 3-4, 2002 to discuss the role of the financial sector in economic development and the issue of competition.

12. With respect to the CBE, which still has over 80 percent of bank deposits and about 70 percent of bank loans, the management contract for the CBE with a foreign bank did not enter into effect as the foreign bank withdrew from the contract in January 2002. At the same time, the Ethiopian anti-corruption commission arrested 28 past and 13 current CBE officials on charges of corruption. Against this background, in March 2002 a new management team that will operate CBE on a commercial basis was appointed. Lending by CBE to customers with loans past due by over one year has been suspended. CBE has also recently increased provisioning from Birr 1.4 billion to Birr 1.9 billion.

13. Significant progress has been made in eliminating most of the previously identified exchange restrictions, including the termination of the NBE's weekly wholesale foreign exchange auction and the move of all foreign exchange operations to the interbank market on October 24, 2001. Most trade restrictions and administrative controls on access to foreign exchange were lifted in December 2000. Restrictions on the purchase of foreign exchange for holiday travel and education purposes were eliminated in March 2001. At end-May 2002, the value of the Birr against the dollar had depreciated by 1.1 percent since the beginning of the fiscal year, and net foreign assets of the NBE at end-March 2002 were estimated at US$318.6 million (around 1.8 months of import cover) compared with the programmed US$282.2 million.

14. With respect to external debt, the Executive Boards of the IMF and IDA decided that Ethiopia was eligible for assistance and had reached the decision point under the enhanced Initiative for Heavily Indebted Poor Countries (HIPC). All pre-cutoff debt with Paris Club creditors was rescheduled on Cologne terms on April 18, 2002. The performance criteria on the noncontraction of new public or publicly guaranteed nonconcessional debt and on the nonaccumulation of external debt arrears were observed.

15. In other structural areas, progress was made, with World Bank assistance, in implementing reforms focused on public sector management, including capacity building, civil service reform and public expenditure policy, and on private sector development. Revised investment and urban land lease laws were adopted. However, the privatization program slowed down and only one public entity was sold in the first nine months of 2001/02 out of the 20 entities put up for sale.

Policies during the remainder of the second annual program

16. Building on the satisfactory results achieved during the first nine months of 2001/02, the government is determined to continue with the steadfast implementation of the program in order to achieve its objectives. A few revisions in the original macroeconomic projections have been made to take into account developments during the first nine months of 2001/02 and measures outlined in this letter. While growth of agricultural output after slowing down to 4.5 percent in 2001/02 would return to a more normal level of about 5 percent, nonagricultural economic activity is expected to continue to grow robustly at around 7 percent as capacity building, infrastructure expansion, the privatization of a number of public enterprises, and further progress in financial sector reform, create an environment conducive to private sector activity. Real GDP growth, estimated at 5 percent in 2001/02, could therefore reach the projected 6 percent in 2002/03. Consumer price inflation is expected to rise to 4.5 percent in 2002/03 on a yearly-average basis. While exports are in line with initial projections, imports are expected to be slightly higher than originally projected. Reflecting these developments, lower nominal GDP, ² and higher than projected official transfers, the current account deficit (including official transfers) is estimated to be at 6.6 percent of GDP in 2001/02. For 2002/03, the deficit is projected to rise slightly to 6.9 percent as official transfers would return to a more sustainable level.

17. In the fiscal area, the government has implemented the measures necessary to limit the overall budget deficit (including grants and emergency programs) in 2001/02 to within the original program target in absolute terms. However, with lower nominal GDP, the deficit for 2001/02 is estimated to reach 9.9 percent of GDP (compared to 9.1 percent under the original program). For 2002/03, the original target of 7.8 percent of GDP was revised upward to 9.7 percent to take into account lower nominal GDP, the identified initial cost of restructuring CBE, and higher-than-initially projected social spending. Based on an expected substantial net recourse to external financing (entirely on concessional terms), net borrowing by the government from the banking system will be limited to Birr 0.5 billion (0.9 percent of GDP). The additional spending to be financed by this bank borrowing includes spending on food security, education, health, and rural development. The government will continue with its cautious spending policy in 2002/03. The Council of Ministers has adopted in June 2002, a budget for fiscal year 2002/03 consistent with the revised fiscal framework presented in this letter. The budget was adopted by Parliament in early July 2002.

18. The government is determined to achieve an increase in tax revenue to 16.6 percent of GDP in 2002/03. To do so, revenue performance will benefit from the introduction of the VAT in January 2003, improved tax administration, especially through the recent strengthening of the large taxpayer unit, and tax arrears collection. The import tariff reform to be introduced by January 2003 is expected to be revenue neutral. The government has taken necessary steps in the preparation for the introduction of the VAT by January 2003, including the appointment of a program director and the identification of taxpayers. The taxpayer identification number project is to be completed by October 2002. The VAT and income tax laws were passed by Parliament in early July 2002. A poverty and social impact analysis of the VAT will be undertaken by mid-December 2002.

19. On the expenditure side, overall outlays (excluding special programs) are budgeted at 34.6 percent of GDP in 2002/03. Defense outlays will be maintained at the nominal level of the previous year, but as a ratio to GDP will be further cut from 5.9 percent in 2001/02 to 5.3 percent in 2002/03. Poverty-targeted current and capital spending (including on health, education, and priority infrastructure) are to be raised to 18.4 percent of GDP (including 1.4 percent of GDP from HIPC relief) in 2002/03. Capital spending is to be increased, and the wage bill is to be budgeted at Birr 4.455 billion (7.8 percent of GDP). The government will assess by the time of the fourth review under the PRGF the sustainability of possible increased IDA disbursements under the World Bank's forthcoming Country Assistance Strategy. It will include any additional secured commitment from the World Bank and other donors for 2002/03 in a supplementary budget if it is assessed that it will be spent efficiently on poverty-related sectors, and will not jeopardize Ethiopia's external debt sustainability. The government will pursue its efforts to improve its control, tracking and reporting mechanisms of expenditures. In particular, it is determined to consolidate federal and regional budgets for both the past year and the current year, including all extrabudgetary funds and accounts, by end-September 2002. It will also improve the effectiveness, reporting and monitoring of local government expenditures before further decentralizing public spending.

20. In the monetary and exchange areas, monetary policy will remain geared toward containing inflation and achieving the international reserve targets. The monetary program for 2002/03 has been updated in light of the revised projections for nominal GDP growth, and with a view to providing room for an adequate increase in credit to the nongovernment sector. The latter will be helped by the government's plan to limit the resort to bank borrowing during the program period. Money supply growth is estimated at 10.9 percent in 2001/02 and is projected at 12.4 percent in 2002/03. With the move of all foreign exchange operations to the interbank foreign exchange market in October 2001, exchange rate policy will continue to be more market-determined.

21. In the financial sector area, the government will revise by August 31, 2002 the recently adopted regulation for the provisioning of nonperforming loans and other doubtful assets to bring it more in line with international best practices, by including five categories for the classification of nonperforming loans, and removing any temporary weakening of provisioning that may result from the phasing in of the new requirements that will be fully implemented by January 2004. With regard to the inclusion of borrowers' repayment capacity as a criterion for the classification of nonperforming loans, the authorities believe that in the absence of reliable and timely financial information on borrowers, it would not be advisable at this time to require banks to have an assessment of repayment capacity of their clients on a subjective basis. The authorities will nonetheless encourage banks to use available information to assess repayment capacity of borrowers. Once the quality and timeliness of financial information of clients improves, the authorities will revise the guidelines accordingly. The government will also (a) take steps to strengthen the NBE, following the completion of the ongoing comprehensive study of the NBE, including as necessary, revising the existing Banking Act to increase the NBE's autonomy by end-December 2002; (b) ensure that the Construction and Business Bank is brought to the point of sale after its balance sheet has been restructured on the basis of NBE's recommendations, by end-December 2002; and (c) adopt a restructuring plan to address the weak financial condition of the Development Bank of Ethiopia by end-September 2002.

22. With respect to the CBE, a performance contract was signed between the government and the new CBE management on June 28, 2002 to ensure that CBE is operated effectively on a commercial basis so as to achieve the necessary improvements in financial performance. At the same time, the credit approval and monitoring process was strengthened, lending authority was transferred from the Board of CBE to its management, and an audit committee was created at the Board to oversee financial performance. The new management will have autonomy in decision-making including on staffing, meeting performance targets, pursuing delinquent borrowers, as well as on taking steps to strengthen CBE's cost competitiveness and profitability. CBE will also (a) hire consultants from a reputable foreign financial institution by end-September 2002 to assist the new management; (b) strictly adhere to the reserve requirement, and fully implement the new provisioning directive; (c) reduce nonperforming loans (NPLs) by Birr 0.8 billion from Birr 3.9 billion at end-December 2001, including through write-offs, by end-September 2002; and (d) prepare a financial restructuring plan until end-March 2003, on the basis of a financial audit of the CBE to be conducted by an internationally reputable audit firm. The terms of reference for this audit was tendered on July 13, 2002, and the audit completed by end-January 2003. The restructuring plan will seek significant reduction of NPLs, including through write-offs, and the recapitalization of CBE on a timely basis. All options for the restructuring of CBE will be kept open. The investigation related to the arrest of CBE's managers on corruption charges is continuing.

23. The government will continue its efforts to enhance efficiency and competition in the financial sector, to prepare the ground for the progressive integration of the Ethiopian financial sector into the global financial market. Efforts are being made to strengthen private and public banks through creating a favorable external environment for banking, strengthening the internal dynamics of banks, and fostering contestability of markets within the banking sector. Measures were taken in early July 2002 to enforce the foreclosure law effectively and expeditiously to allow banks to reduce nonperforming loans and deter delinquency in loan repayments. Banks will be encouraged to modernize and raise efficiency by adopting improved practices and building their capacities, through a rigorous application of the revised bank provisioning directive, and more autonomous bank management, that is made more accountable to its board of directors. To enhance competition, private banks will be encouraged to increase their scale of operation, and raise their capital base, including through mergers. The government will also foster the development of microfinancing institutions, by transforming them into rural banks, as has already began, and by facilitating the flow of funds from commercial banks to these institutions for purposes of onward lending.

24. In the external sector area, as noted earlier, the current account deficit (including official transfers) is projected at 6.9 percent of GDP in 2002/03. It is expected that much of the demobilization, reconstruction, and sector development efforts will continue to be fully funded by multilateral and bilateral donors. The balance of payments is also to benefit from recent Paris Club rescheduling agreement. The reserve cover is to increase from 3.9 months of imports at end-2001/02 to 4.3 at end-2002/03.

25. Following the Paris Club meetings on April 5, 2001 and April 12, 2002, the government will finalize bilateral agreements by end-October 2002, and seek at least comparable terms from its non-Paris Club creditors, by December 31, 2002.

26. The government will reduce, by January 2003, the average (non-weighted) import tariff from an existing level of 19½ percent to 17½ percent, by lowering the maximum tariff and reducing the number of bands, and eliminating most tax and duty exemptions, to minimize any negative impact of the trade reform on government revenues. The authorities are considering reducing the maximum tariff from 40 percent to 35 percent, and the number of bands from 7 to 5. There are no remaining nontariff barriers with the exception of bans on imports of opium, ethyl alcohol and other spirits denatured of any strength, worn clothing and worn textile articles, and rags.

27. The government will continue to implement the recommendations of the Safeguards Assessment by end-December 2002, with technical assistance from the Fund. All differences older than six months on the foreign correspondent bank accounts will be reconciled, and steps will be taken to ensure that NBE's accounting records properly reflect the balances held with foreign correspondent banks.

28. On other structural reforms, the government, in consultation with the World Bank, will continue to implement key structural measures needed for enhancing the economy's growth potential and reducing poverty. Understandings have been reached with the World Bank on an Economic Structural Adjustment Credit focusing on public sector management, including civil service reform, public expenditure policy, private sector development, and export competitiveness. The authorities are also strengthening the existing legal and regulatory framework and taking measures to accelerate the privatization program that aims at bringing to the point of sale another 38 public entities (including units of whole enterprises) in 2002/03. With the assistance of MIGA, the authorities are also working to settle expropriation claims in the near future. The government will finalize by end-July 2002 the full PRSP, and submit it to the Executive Boards of the IMF and IDA. Wide-ranging consultations at the district, regional, and federal levels were completed in March 2002.

29. Efforts to improve statistics will be intensified, particularly the reporting of data on a timely basis, including by fully staffing the fiscal policy, national accounts, and accounting departments of the Ministry of Finance and Economic Development. The authorities will reconcile monetary and fiscal accounts by end-December 2002; the initial date of September 2002 is no longer feasible in view of the needed technical assistance, which is being provided by the IMF. They will continue to implement the recommendations of recent missions from the IMF's Statistics Department, including the revision of monetary statistics and the coverage of international reserves. The authorities will continue to improve data on poverty and social indicators, with a view to monitoring the output and outcomes of poverty reduction programs. Ethiopia will also participate in the General Data Dissemination System (GDDS) in 2002/03 and towards this end it has appointed a national coordinator.

30. The government believes that the reforms and measures set forth in this letter and in the letter and memorandum on economic and financial policies of December 31, 2001, and the letter dated February 27, 2002 are adequate to achieve the revised objectives of the second annual program. As envisaged, a fourth review, to be completed by December 20, 2002, will assess progress in policy implementation and describe the third annual program for the period October 2002-September 2003, and set performance criteria and benchmarks through June 2003.

Sincerely yours,

/s/ Sufian Ahmed Minister of Finance and Economic Development

/s/ Teklewold Atnafu Governor of the National Bank of Ethiopia

Attachments (3)
Quantitative Benchmarks and Performance Criteria
Structural Benchmarks and Performance Criteria
Prior actions