Zambia—Letter of Intent and Technical Memorandum of Understanding

Lusaka, November 8, 2002

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

Dear Mr. Köhler,

In this letter, we review progress in implementing our 2002 program, which is supported by a PRGF arrangement, and describe our key economic and financial policies for the remainder of the year. The letter summarizes the recent agreement with Anglo American plc (AA) which will allow the Konkola Copper Mines (KCM) to remain open, and outlines the government's response to the drought that has affected Zambia. The letter requests completion of the fifth review under the PRGF arrangement and the ninth disbursement under the arrangement. As the overall program remains broadly on track, the government is also requesting additional interim HIPC debt relief from the Fund for 2003 equivalent to SDR 117.2 million, which would cover 69.5 percent of principal obligations falling due to the Fund between January 2003 and December 2003. The attached tables report on developments and prospects with regard to performance criteria and benchmarks until end-September 2002, and propose performance criteria and benchmarks through end-December 2002.

I. Performance Under The Program and Recent Economic Developments

1. All of the program's quantitative performance criteria for end-June 2002 were met, as were the end-May and end-September structural performance criteria (Tables 1 and 2). In addition, all the benchmarks were met, except that regarding the phased reduction of domestic arrears.¹ The continuous structural performance criterion and benchmark were also observed. The government is finalizing a comprehensive database of domestic arrears (a benchmark for end-December 2002) and has taken actions to improve expenditure management (LOI, paragraphs 26-28).²

2. Economic developments are being adversely affected by the regional drought. The government estimates that the 2002 output of maize was about 25 percent below last year's output and about 40 percent below the normal crop year of 2000. In contrast, however, data for the first half of 2002 show that copper production increased by 14 percent, substantially above the 1.9 percent increase projected for 2002. The 12-month inflation rate through August rose to 23.7 percent, mainly because of the higher than anticipated food prices due to the drought. Between end-December 2001 and end-June 2002, the Kwacha depreciated by about 17 percent against the U.S. dollar, largely reflecting continuing uncertainties in the copper sector and the expectation of an increase in the demand for foreign exchange for food imports. However, the rate has remained broadly unchanged since end-June 2002.

3. Fiscal performance through end-June 2002 was broadly on track, but the composition of expenditure and the continuing accumulation of domestic arrears were worrisome. Furthermore, spending pressures are expected to mount in the second half of the year. The wage bill through end-June 2002 was higher than programmed, reflecting payments for arrears on a 2001 wage award to the defense and security forces, as well as lapses in financial controls. Recurrent departmental charges were also slightly higher than expected. These overruns were in part offset by lower spending on HIPC Initiative financed programs, owing to capacity constraints in the line ministries, and in retrenchment payments. Revenues were slightly higher than targeted.

4. Monetary data for the first half of 2002 indicates that broad money rose by over 13 percent compared with a program target of 5 percent. However, excluding the impact of the kwacha depreciation on commercial banks holdings of dollar denominated deposits, the increase in broad money was 6 percent, broadly in line with the program. Owing to the reduction in inflation since end-2000, the yield on 91-day treasury bills has declined from nearly 50 percent at end-December 2001 to around 30 percent at end-August 2002. The BoZ's authorization to allow banks to hold their cash reserve requirements on foreign currency deposits in foreign currency has reduced intermediation costs to banks, and the release of the domestic currency resources previously committed to serve as reserves on FCDs may also have helped increase demand for treasury bills. Unfortunately, commercial banks lending rates have not declined in line with the yields on treasury bills. As a result, the volume of new commercial banks credit to the private sector through end-June was lower than programmed.

5. Balance of payments developments for the first half of 2002 were better than expected. The volume of copper exports grew significantly faster than anticipated notwithstanding Anglo's announced withdrawal from the sector, while non-traditional exports grew in line with program estimates. Merchandise imports declined faster than expected as the metal and other sectors responded to the uncertainty created by the copper crisis. With the release of non-Fund interim debt relief under the Enhanced HIPC Initiative amounting to US$114 million, plus US$152 million of interim relief from the Fund, as well as World Bank disbursements of US$56 million, the BoZ was able to build up gross international reserves to US$166 million at end-June 2002 compared with an adjusted program target of US$159 million.

6. Regarding the copper sector, we have concluded an agreement with AA that will enable KCM to operate as a going commercial concern and to remain in the private sector. AA has agreed to leave in place its management team while an orderly transition is being arranged, and will continue to provide KCM with procurement and marketing arrangements until at least end-March 2003. AA has agreed a financing package estimated at US$105 million which covers virtually all of KCM's expected operating deficit for 2002-03. The financial package includes: (i) an exit fee of US$30 million; (ii) an advance from AA to KCM of US$18 million secured by KCM's insurance claim in respect of the Nchanga open pit cave-in; (iii) a loan of US$8.5 million from AA, which matches a loan of the same amount from the government; (iv) an acceleration of payments of US$20 million from KCM's key customers; and (v) a US$20 million bank overdraft collateralized by receivables. It is expected that KCM will become profitable beginning 2004, although the impact of the recent fall in copper prices on KCM's finances gives cause for concern and government is closely monitoring developments in this area.

7. Regarding structural reforms, the ZPA advertised the sale of 51 percent of ZNCB shares, and in September it appointed a team with authority to negotiate the sale of the bank. The government also implemented the oil sector reforms agreed with the World Bank, and the related disbursements from the World Bank of US$50 million were made in June 2002. Consistent with the program's objectives, in July 2002 the task force formed to review and streamline BoZ's mechanism for financing government operations prepared a proposal on modalities, including listing of all outstanding BoZ credits to GRZ and GRZ securities issued to the BoZ, all of the GRZ's dormant accounts at the BoZ, and the appropriate instruments to securitize the government's indebtedness to BoZ while ensuring an appropriate income stream to the BoZ. Based on this proposal, the government has already decided on a strategy which it intends to implement by end-December 2002.

II. The Program for the Remainder of 2002

A. Macroeconomic Policies

8. Reflecting mainly the impact of the drought, the macroeconomic objectives under the 2002 program have been revised as follows: (i) achieve real GDP growth of about 3.7 percent; (ii) reduce the 12-month inflation rate to 16 percent; and (iii) build up gross international reserves by US$112 million. Achieving these objectives will require continued implementation of appropriate fiscal and monetary policies, implementing key structural reforms, and improving public expenditure management and governance.

9. As noted earlier, Zambia faces a maize shortfall which is estimated at up to 600,000 metric tons during the 2002/03 crop season. Of this amount, the World Food Program (WFP) was expected to cover some 150,000 tons (to be distributed free to the most adversely affected Zambians). A further 300,000 tons was to be imported commercially by the private sector, leaving about 150,000 tons to be covered by the government, NGOs, and additional bilateral assistance. The government has committed to the private sector not to distort market prices. However, owing to the government's concerns regarding importing genetically modified (GM) maize and subsequent import ban, the WFP imports are likely to be sharply reduced. In the circumstances, the government has imported some 65,000 tons of non-GM maize, of which 40,000 tons will be for free distribution to the most adversely affected areas. The cost of these policies will exceed the amount provided in the budget by about K 80 billion or 0.5 percent of GDP, with additional costs, presently estimated at up to K 125 billion, to be incurred in 2003, if the donor assistance through WFP does not materialize. The government, through the Food Reserve Agency (FRA), intends to retain a modest stock of maize reserve in storage if sufficient financing is available.

B. Fiscal Policies, External Resources, HIPC, and PRSP

10. Revenues for 2002 are expected to be broadly in line with the program target. Direct taxes have been performing well, but the prospects for import VAT are weaker now than initially expected. This is largely due to the coming online of the Indeni refinery. To protect the revenue base and help maintain a transparent tax regime, the government will continue to abstain from introducing new tax reductions, exemptions and rebates.

11. Budgetary support from Zambia's cooperating partners during 2002 is projected to be some US$15 million lower than the program estimate of US$160 million. The EU has increased its commitment of support, but the World Bank disbursements of program loans are less than anticipated, as the Bank has not yet proceeded with a new adjustment credit. In response to our request for emergency assistance, the World Bank is expected to disburse US$50 million over a two-year period beginning in the fourth quarter of 2002, about half of which will be tied to new spending. External budgetary debt service is expected to remain broadly in line with the program estimate of 2.4 percent of GDP, after interim debt relief under the Enhanced HIPC Initiative of about US$114 million (excluding relief from the IMF). This amount is being used to support the government's plans to orient the budget toward poverty reduction.

12. In the absence of corrective measures, the program target for the domestic budget balance would be exceeded by about 1 percent of GDP (excluding the additional cost of 0.5 percent of GDP on account of the drought). This increase reflects mainly the impact of the large wage increase granted to the defense and security forces by the previous administration in the run-up to the December 2001 elections, as well as wage increases given to teachers as well as the hiring of additional teachers in 2002. The current administration is strongly committed to restraining the wage bill, and to offset the wage overruns has taken the following measures: (1) payroll processing for the Defense and Security forces, and the National Assembly has been transferred to the Ministry of Finance and National Planning (MoFNP), under the supervision of the Accountant General and the Centralized Computer Services Department, as is already the case with the rest of the civil service; (2) the recently announced housing allowance has been cancelled; (3) all payments in lieu of leave and all overtime payments have been suspended through end-December 2002; (4) a freeze on all civil service hiring will be implemented and strictly enforced effective end-August;³ (5) cuts in foreign travel, communications, and other RDCs will be instituted to save K 25 billion for the remainder of the year; (6) a reduction by K31 billion in non-HIPC financed payments to grant-aided institutions; (7) cuts in domestically financed non-HIPC capital expenditure to save K 44 billion;⁴ and (8) cuts in HIPC-financed capital expenditure amounting to K 31 billion of which K 9 billion is contingency expenditure. These measures will provide savings of K 173 billion and will close the corresponding financing gap. On this basis, the overall deficit in 2002 is projected to be 6.1 percent of GDP and the domestic balance would be 3.6 percent of GDP. Excluding the impact of the unanticipated expenditures on maize imports, the domestic balance is in line with the program. The overall deficit will largely be covered by external resources, and domestic financing will be higher than initially programmed by 0.9 percent of GDP, reflecting the shortfall in external budgetary support, and the additional financing for food imports.

13. On the basis of a passive projection, there would be a substantial financing gap in the 2003 budget. This reflects, in part, the cumulative impact of excessive wage increases over the past three years (which have raised the wage bill from 5.3 percent of GDP in 2000 to 8.6 percent projected for 2003), as well as the need to address the stock of domestic arrears, and the potential additional cost of maize imports. The government recognizes that in the absence of strong actions to reverse the trend, it will be difficult to have a meaningful increase in spending on the social sectors and for poverty reducing programs, without triggering renewed inflationary pressures that have undermined Zambia's economic development for many years. Thus, in order to address the fiscal situation and taking into account the very large increase in real public service wages over the past three years, the government is firmly committed to limiting the wage bill to 8 percent of GDP in 2003, slightly below the estimated outturn for 2002. To achieve this goal, the government is making strong efforts to reduce the size of the public service and to implement the recently adopted medium-term pay reform strategy. This will include, for 2003, a consolidation of all allowances into basic salary and undertaking a comprehensive audit of all payrolls, with a view to introducing a personal identification code and removing all "ghost workers" from the payrolls. Once the savings generated by implementing these and other measures materialize, the government will proceed to agree and fund performance-related pay enhancements. The government is fully committed to taking additional fiscal measures to ensure that the program's macroeconomic targets are achieved. It also intends to continue to pursue structural reforms in key areas.

14. Regarding the PRSP priority expenditures designated "poverty reduction programs" and funded by HIPC Initiative resources, government intends to spend K 271 billion equivalent to 1.7 percent of GDP in 2002, compared with the program target of 2.2 percent of GDP. This shortfall, which had already taken place before end-June 2002, reflects mainly capacity constraints at the line ministries, an intensification of the process for monitoring HIPC Initiative financed expenditures, as well as the need to contain inflationary financing in the second half of the year. However, the government is committed to restore HIPC spending to the programmed level of 2.2 percent of GDP in 2003. The government also intends to adhere to its operational rules to ensure that cash releases are consistent with budget allocations in priority areas. The government will continue to improve its monitoring and tracking of HIPC Initiative resources, which could serve as a model for improved management and control of all PRSP expenditures in the future. To this end, the government is modifying its computer systems to enable analysis of cash release data on a functional basis. In the meantime, an annual report on the use of HIPC Initiative resources during 2001 has been prepared and published.

C. Monetary Policy

15. Monetary policy during the second half of 2002 will aim to achieve the program's targets on growth, inflation and international reserves. Broad money is expected to increase by 16 percent during 2002, broadly in line with the original program rate of 15 percent. Achieving the monetary target will be facilitated by continued use of indirect monetary instruments. The BoZ will continue to adhere to the Treasury bill auction guidelines in order to ensure the efficient functioning of the treasury bill market. Overall credit expansion to the private sector is expected to be in line with the program, although part of the increase reflects the impact of the kwacha depreciation on foreign currency denominated loans, as the demand for kwacha denominated loans was lower than projected mainly on account of the smaller than expected reduction in commercial bank lending rates. Meanwhile, credit to public enterprises, including the government bond issue of K 250 billion to ZNCB on behalf of ZNOC (paragraph 22), is projected to increase marginally reflecting largely the valuation impact of the higher-than-expected depreciation of the Kwacha, and somewhat higher than projected borrowing by ZESCO.

16. Although there has been a substantial reduction in yields on treasury bills, the government is concerned that commercial bank lending rates have not declined significantly and that their high level will continue to have a negative impact on economic performance and on the prospects for diversification. To address this concern, the government intends to maintain prudent financial policies to contain and, if possible, reduce the stock of domestic debt, and generally address persistent inflationary expectations. To further facilitate banks liquidity management, the BoZ will: (i) continue to increase the proportion of banks' cash reserve requirement for foreign currency deposits that can be held in foreign currency; (ii) review the current volume and price penalties put in place on rediscounting of treasury bills with a view to providing banks with greater flexibility in their cash management; (iii) continue to improve the effectiveness of tender and off-tender sales of government securities; (iv) review the current statutory cash reserve requirements policy to facilitate greater flexibility in cash management; and (v) widen the treasury bill market to encompass a larger segment of the population with a view to providing high yield savings instruments while reducing the overall cost of government borrowing. Finally, with respect to the pilot scheme to exempt the amount commercial banks lend to the agricultural sector from the calculation of their statutory reserve requirements, we delayed implementation while discussing ways to avoid distortions and to focus attention on productive lending. The scheme was introduced in September on a voluntary basis and we will carefully monitor its implementation.

17. A joint team from the IMF and the World Bank recently conducted a comprehensive assessment of the financial system under the Financial System Assessment Program (FSAP). The team's preliminary findings were that the quality of banking supervision is adequate, and with the exception of the state-owned ZNCB, the overall banking system was satisfactorily capitalized, liquid, profitable, and with moderate nonperforming loans. Although there is no immediate risk of insolvency of the banking sector, given the high capitalization, the mission found that banking profitability was susceptible to a reduction in interest rates and in foreign exchange-related revenue, which could become a source of systemic risk in the medium term. We agree with the report's conclusion that a number of state-owned financial institutions are insolvent and pose substantial risk to the financial system and to the budget on account of the contingent liabilities for the government. The BoZ is immediately enhancing its supervision and monitoring of these institutions. The report also found that banks provide services to only a small segment of the population supporting the claim that lack of access to finance and its high cost are major impediments to growth and diversification. As an initial step, the government is requesting technical assistance from the Fund and the Bank to design a medium-term financial sector development plan to address these issues.

18. The government has made significant progress towards streamlining the diverse range of instruments it uses to borrow from the BoZ with a view to improving monitoring and the transparency of the banking system's net credit to government. On the basis of a joint task force proposal prepared in July, government has decided on a strategy which will be implemented by end-December 2002. The streamlining will result in a simplified mechanism for financing government operations consisting of three elements: treasury bonds, treasury bills, and an overdraft account at the BoZ. All government debt instruments held by the BoZ, including the foreign exchange bridge loan account, will be consolidated into an interest bearing bond.

D. External Sector and Exchange Rate Policies

19. Zambia's external current account deficit (excluding grants) is projected to narrow to 18.6 percent of GDP in 2002, compared with 20.2 percent of GDP in 2001. The wider deficit compared with the program target of 17.2 percent, mainly reflects the substantial increase (6.8 percent) in merchandise imports during the second-half of 2002, on account of the higher food imports noted above. Total merchandise exports receipts are projected to increase by 6.9 percent, compared with a small programmed decline, mainly because of the higher-than-expected volume of copper exports so far this year, which has offset the lower-than-expected copper prices. The improved current account deficit is expected to offset the substantially lower net capital inflows and therefore result in a smaller-than-programmed overall balance of payments deficit. In July 2002, Zambia held a Consultative Group meeting where cooperating partners renewed and expanded their commitments to provide financial support. Thus, taking into account these commitments, external concessional loans, and interim HIPC debt relief, gross international reserves are projected to increase by US$112 million, broadly in line with the program target.

20. Between end-December 2001 and end-August 2002, the Kwacha depreciated by 17 percent in nominal terms against the U.S. dollar and by about 9 percent in real terms. At the same time, the spread between the BoZ and the average bureau exchange rate has narrowed sharply. The major underlying cause for the depreciation has been the uncertainties in the foreign exchange market arising from developments in the mining sector and expectations of increased maize imports. We believe that with the conclusion of the agreement with AA, the uncertainty will be progressively reduced. We also believe that the current level of the real exchange rate is broadly appropriate to maintain Zambia's competitiveness and to encourage diversification. The BoZ is committed to allow the rate to continue to be market-determined with intervention limited to meeting the international reserves target and to smoothing short-term fluctuations. The government continues to be committed to an open trade regime and to strengthening the regional trading arrangements. However, on account of the adverse impact of regional developments on Zambia, we have enacted a temporary ban on 14 imports from a neighboring country. We intend to review this ban with a view to make it consistent with our commitments under the WTO and COMESA.

21. To increase the efficiency of the foreign exchange market, the government intends to introduce a unified inter-bank foreign exchange market during 2003 and in September 2002 received technical assistance from the Fund for this purpose. This reform will eliminate the existing auction system run by the BoZ and will preclude the potential of a continuation of the multiple currency practice. This will, however, require additional technical assistance from the Fund, in order to work out a detailed timetable for implementation including the necessary market infrastructure, the ability of the small banks to access foreign exchange in the new system, and in specifying the role of the BoZ. Given the current low level of international reserves and the uncertainty in the copper sector, and to avoid possible volatility in the exchange rate, we would prefer the transition to the inter-bank market to coincide with additional balance of payments support.

E. Structural Reforms, Public Expenditure Management, and Governance

Structural Reforms

22. The sale of the government's majority controlling interest in the ZNCB is a key element of our privatization and financial sector reform program and is intended to improve the investment climate and management of public finances. In response to ZPA's advertisement of the sale of 51 percent of ZNCB, several international banks have expressed interest in buying ZNCB. In September, the ZPA Board appointed a negotiating team with authority to negotiate the contract for sale of the bank. The Banking Supervision Department of the BoZ will conduct `fit and proper' screening of potential buyers before bids are evaluated. It is expected that the ZPA Board will conclude the evaluation of bids and approve negotiations with preferred bidders by end-November 2002, which will be monitored as a program benchmark. In addition, it is expected that negotiations and a final sales contract with the successful bidder will be completed by end-December 2002 which would enable the privatization process to be completed shortly thereafter. To facilitate the privatization process, the government has cleaned up the balance sheet of the bank and issued a bond valued at K 250 billion to recapitalize the bank consistent with regulatory requirement. Interest on the bond will become payable only at the time of privatization. The bond is to cover the liabilities to ZNCB of ZNOC and Roan Antelope Mining Company of Zambia (RAMCOZ).⁵ The contingent liabilities of a legal action by some ex-employees of ZNCB will also be covered by government. However, the government will not meet any of ZNOC's liabilities for which it is not legally liable. In addition, the buyer of ZNCB will not be required to maintain any non-viable rural branch for more than two years.

23. As discussed above, the government, jointly with the staffs of the World Bank and the IMF, plans to develop a strategic plan on financial market development that will consider the future of the rural branches and design an appropriate institutional structure for providing rural service. Technical and financial assistance from donors, including the World Bank, will be sought for this purpose. Given the need to encourage private sector investments, a key element for sustained medium-term growth and poverty reduction, the government will maintain a liberal environment for investment and will consult fully with all key stakeholders including our development partners before making any changes to the Investment Act. Also, to improve the business environment, the government will review existing labor laws with a view to identifying needed reforms.

24. The management of ZNCB is cooperating fully in preparing the bank for privatization and will agree on a plan with the BoZ to reduce costs and to halt further deterioration in the financial position of the bank. The ZNCB is complying with directives issued by the BoZ, including stopping the recognition of unrealized exchange gains, and continuing to strictly limit new lending. In addition, the BoZ has also undertaken measures to improve the supervision of financial institutions, including creating a special unit to deal with distressed banks and improving reporting requirement for non-bank financial institutions. In further efforts aimed at strengthening the overall financial system, in July the operations of United Bank of Zambia were suspended because of its failure to recapitalize and to bring in new shareholders as agreed earlier. With regard to anti-money laundering, the Zambian Parliament passed an Act on Prohibition of Money Laundering in November 2001 and guidelines are being prepared to implement the Act.

25. Regarding the oil sector, as indicated earlier, substantial progress in completing the reform program has been made, consistent with our commitments under the World Bank's Fiscal Sustainability Credit. Retail prices of petroleum products have been liberalized, and all oil marketing companies are free to import petroleum products directly. ZNOC, which has been responsible for huge losses and high energy costs in the country, has been put under liquidation. The remaining steps in this area will be implemented in consultation with the World Bank staff. In line with our previous commitments, and as the Indeni refinery has now become operational, the government is in the process of reducing the import tariff on petroleum products to 5 percent. This will limit monopoly pricing, and increase efficiency in the oil sector and, more broadly in the economy. Regarding ZESCO, in March 2002, ZPA received expression of interest from consulting firms to provide transactions advisory services for concessioning of ZESCO and prepared terms of reference for the advisors. It is expected that the ZPA will complete evaluation of technical proposals for the hiring of consultants by end-December 2002. We intend to proceed expeditiously with the concessioning of ZESCO, which is a trigger for reaching the HIPC completion point.

Public Expenditure Management

26. The government is making progress in strengthening public expenditure management to enhance efficiency and to avoid a further accumulation of domestic payments arrears. In this context, the Accountant General (AG) and Controller of Internal Audit, are finalizing a comprehensive database of individual arrears as of end-March 2002. In addition, we will provide on a regular basis in the quarterly audit verification of domestic arrears, an analysis distinguishing between additional arrears generated by overdue payments on pre-2002 commitments and additional arrears due to current year commitments. By end-March 2003, we will also draw up a three-year plan for clearing these arrears. Starting in January 2003, line ministries will be required to document which arrears in the database were paid with any funds released by MoFNP for arrears clearance. At the same time, in order to prevent the accumulation of new arrears, the government has established an Expenditure Monitoring Unit (EMU) in MoFNP, introduced quarterly expenditure ceilings, and made progress toward establishing a Commitment Control System (CCS) in line ministries. Specifically, the government issued a treasury circular requiring each line ministry to appoint a Commitment Control Officer responsible for limiting commitments to the quarterly expenditure ceilings and cash releases provided by the Budget Office. The CCS will be introduced in the MoFNP, Judiciary, Ministry of Local Government and Housing, and Ministry of Works and Supply with effect from November 2002 and in the other line ministries from January 2003. The CCS will be enhanced by a new computerized ledger and reporting system (see below). The EMU will verify the consistency between arrears documented in the monthly expenditure reports (MERs) and arrears audited by the Controller of Internal Audit (see below).

27. The government will strengthen its efforts to receive MERs (within 15 days from the end of each month) from all budget units, documenting commitments, expenditures, and arrears. The MERs will be used as the basis for arrears monitoring, and regular quarterly audits by the Controller of Internal Audit. The new computer-based ledger and reporting system, the Financial Management System (FMS), was developed internally by the Centralized Computer Services Department in liaison with the AG's office, and is being piloted in 4 ministries and will gradually be rolled out to the entire government. The system will feed directly into the planned IFMIS.

28. The government has taken steps to improve the cash release and cash management processes. In September, the government issued a treasury circular detailing the following points to Controlling Officers in the line ministries: (1) commitments are to be kept within quarterly expenditure ceilings allocated for each budget line, even if this is smaller than the pro rata budget appropriation; (2) virement between budget subheads requires ex ante, written, approval from the Secretary to the Treasury (ST) and in the event that ex-ante Treasury authority is not sought, expenditures will be regarded as unauthorized and further funds will not be released; (3) requests for "special funding" above appropriations will not be entertained (except in cases of national emergencies); and (4) strict sanctions, including refusal to disburse future cash, will be imposed on Controlling Officers who fail to comply with the monthly reporting requirements, or with their financial responsibilities. Cash releases are being published in the Macroeconomic Indicators. A mid-term budget review was performed by end-August 2002. Line ministries are now being required to submit cash flow projections to MoFNP, to permit rephasing of expenditures in light of revenue forecasts and, thereby, minimize costly borrowing. With these reforms, and tightened approval procedures at the Zambia National Tender Board (whose tender committee is chaired by the ST), we believe that public expenditure management will improve and the trend of arrears accumulation reversed.

29. With regard to the longer-term introduction of an IFMIS to improve government financial control, a short-term consultant has been working with government officials since February 2002. The government has issued the Request For Proposal for the main consulting firm (expected to be hired by December 2002) to help design and pilot the IFMIS project, including hardware and software requirements. Procurement is expected to start by December 2002, and a pilot program should be launched in at least three ministries during the 2003 budget year, a condition for reaching the completion point under the HIPC Initiative.

30. Government is developing a Medium-Term Expenditure Framework (MTEF) that will guide annual budgets from 2004 onward, to serve as a bridge between the broad policy priorities outlined in the PRSP and the annual detailed budgeting exercise. In the meantime the budget framework paper will be submitted to the cabinet for approval by the end of October 2002. Moreover, the government will improve transparency in the presentation of the annual budget by henceforth employing the standard international presentation of GFS. The government has taken steps to improve its capacity to plan, to coordinate and to monitor its programs through the newly established Planning and Economic Management Department. This Department is responsible for macro-economic planning, the development of the MTEF, and coordination of monitoring PRSP implementation.

31. Zambia's PRSP, which was endorsed by the Fund and Bank in May 2002, was commended for the wide consultation process that was undertaken. The government has already incorporated part of the PRSP priority expenditure in the 2002 budget under "poverty reduction programs". The monitoring of the PRSP and of the HIPC Initiative financed programs is being coordinated by MoFNP who have appointed a HIPC Monitoring and Tracking Team. In addition, civil society groups have organized themselves to monitor HIPC and PRSP Initiatives. The government has made progress in implementing the triggers for reaching the HIPC completion point in 2003. In particular, progress has been made in implementing macroeconomic and structural reforms as well as social sector programs. The government is now focusing on areas which require additional efforts for timely implementation, namely privatization/concessioning of ZESCO, preparation and implementation of an MTEF, implementation of an IFMIS on a pilot basis and remaining measures to complete the agreed education, health and HIV/AIDS and poverty monitoring programs.

Governance

32. In line with government priorities spelled out in the PRSP, government is fully committed to improving economic governance, and has stated a zero tolerance policy towards corruption. Measures have been taken to strengthen the Anti-Corruption Commission, the Office of the Auditor General (OAG), and other relevant government institutions. In his July 2002 speech to the Parliament, President Mwanawasa highlighted a number of high profile corruption cases involving high ranking officials, and political and business leaders, and indicated government's resolve to prosecute these and other cases. All the officials involved were removed from their positions. In addition, as a sign of our commitment to improve governance, we intend to publish the final report on ZCCM cobalt sales shortly, and refer it to the appropriate legal authorities for further action. The government is strongly committed to making efforts to recover funds and assets acquired through corrupt and unlawful practices and will seek assistance from cooperating partners in this regard. Steps are also being taken to enhance transparency and accountability in the management of public resources, and as such, government is complying strictly with Zambian law that the Accountant General submits government accounts of the preceding year to the OAG by end-September and that the annual audited government accounts be submitted to Parliament by end-year. Moreover, given the need for public officials to be held accountable to the Zambian public for their actions and the large loss in the operations of ZNOC, we intend to seek donor financing to initiate a forensic audit of the purchase and sale of oil and of ZNOC's operations.

III. Technical Assistance and Data Issues

33. Zambia continues to require technical assistance (TA) in the areas of public expenditure management, monetary operations and liquidity management, restructuring of state-owned financial institutions, and in setting up a broad based inter-bank foreign exchange market. Considerable delays continue to be experienced in producing monetary statistics, particularly the monetary survey, despite BoZ's best efforts to resolve the problem. The report of the recent TA mission indicated that the quality of basic source data for national accounts estimates has been eroding in recent years, in addition to not keeping up with major structural changes that have occurred in the economy. We recognize that weaknesses in basic survey data and methodology, the use of outdated weights, long delays in compiling actual data, and frequent revision in the estimates undermine government's ability to monitor economic developments and formulate policies on a timely basis. The government will follow through with the recommendations of the TA mission and provide more resources to the Economic Statistics Division of the Central Statistics Office (CSO) to perform their tasks more effectively as a matter of high priority. The government intends to request additional follow-up TA in these areas in the context of the General Data Dissemination Standard (GDDS). Meanwhile, we have completed preparation of the metadata to comply with the requirements for participating in the GDDS. Further assistance to introduce the IFMIS on a pilot basis in a number of ministries will be required.

IV. Program Monitoring

34. For end-December 2002, the implementation of the program will be monitored on the basis of the quantitative and structural performance criteria and benchmarks indicated in Tables 1 and 2. These are defined in the attached revised Technical Memorandum of Understanding. The sixth and final review under the PRGF arrangement, to be completed no later than end-March 2003, will be a condition for the eleventh disbursement and will be conducted based on performance through end-December 2002. It will include understandings on an appropriate macroeconomic and financial framework for 2003.

Yours faithfully,

Zambia: Technical Memorandum of Understanding

I. Introduction

1. This memorandum sets out the understandings between the Zambian authorities and the International Monetary Fund regarding the definitions of the quantitative and structural performance criteria and benchmarks for the program supported by the PRGF arrangement, as well as the related reporting requirements. The definitions are valid at the start of the program, but may need to be revisited during the program reviews to ensure that the memorandum continues to reflect best understanding of the Zambian and Fund staff to monitor the program.

II. Quantitative Performance Criteria and benchmarks: Definitions and Data Sources

A. Net Domestic Assets of the Bank of Zambia (BoZ)

2. NDA of BoZ is defined as the monthly-average (based on daily data), during the month of the test dates, of the reserve money less net foreign assets calculated at end-December, 2001 BoZ mid-exchange rates (program exchange rates).¹ Reserve money includes currency in circulation, required reserves on kwacha deposits, required reserves on foreign currency deposits, positive current account balances of banks with the BoZ and deposits of non-central government institutions. Net foreign assets of the BoZ are defined as gross international reserves (defined below) plus any other foreign asset, including the IMF interim assistance and the US$25 million blocked reserves at the former Meridien Bank, minus foreign liabilities (defined below). The kwacha figures are derived from the U.S. dollar values using the program exchange rate of K 3,830 per U.S. dollar.

3. Foreign liabilities are defined as short-term (one year or less in original maturity) foreign currency-denominated liabilities of the BoZ to nonresidents and outstanding use of Fund credit.²

4. The ceilings on NDA will be adjusted upward by the amount of the shortfall of balance of payments support net of debt service as indicated in Table 1 of the letter of intent, up to a maximum of US$45 million for the program year. External disbursements that occur any time during the month of the test date will be treated as if they were disbursed on the first day of the month.³ In the event of excess balance of payments support net of debt service, the ceiling on NDA will be adjusted downward by 100 percent of the additional excess support. However, if part of the excess support is used to reduce treasury-bills held by commercial banks and the non-bank sector, then the programmed NDA will be adjusted upward by that amount. The kwacha value of the cumulative shortfall/excess will be calculated at the program exchange rate.

5. The ceiling on NDA will be adjusted downward/upward to reflect decreases/increases in the legal reserve requirements. The adjustor will be calculated as the percent change in the reserve requirement multiplied by the actual amount of reserves (kwacha and foreign currency denominated) at the end of the previous calendar month.

6. The ceiling on NDA will also be adjusted upward by a maximum of K 80 billion to reflect the government's cash cost arising from the privatization of ZNCB.

B. Net Bank Claims on Government (NCG)

7. NCG refers to the net banking system's claims on Central government and is defined as:

(i) the net position of the government with commercial banks, including: (i) treasury bills; (ii) bonds issued by the Government of the Republic of Zambia (GRZ); (iii) loans and advances; less (iv) support to Meridien Bank (MBZ); and less (v) Central government deposits (defined to include account balances under the authority of controlling officers); plus

(ii) BoZ holdings of: GRZ statutory bonds; ordinary GRZ bonds; bonds in respect of loans to former parastatals; treasury bills on the trading portfolio of BoZ; treasury bills issued for interest on the BoZ foreign exchange bridging loan to GRZ; other government stock; and the BoZ Kwacha bridging loan to GRZ (including the GRZ's revolving fund under the Fiscal Sustainability Credit), less government deposits at the BoZ; plus

(iii) The BoZ foreign exchange bridging (forex) loan to the GRZ less donor suspense account balances. This will be calculated by taking the beginning period stock of the forex loan expressed in kwacha and then adding net external balance of payments support valued at current exchange rates.

8. The ceiling on the increase in NCG will be adjusted upward by the amount of the shortfall in balance of payments support net of debt service as indicated in Table 1 of the letter of intent, up to a maximum of US$45 million for the program year. In the event of excess balance of payments support net of debt service, the ceiling on NCG will be adjusted downward by 100 percent of the additional excess support. However, if part of the excess support is used to reduce treasury-bills held by the non-bank sector, then the NCG would be adjusted upward by that amount. The kwacha value of the cumulative shortfall/excess will be converted at the program exchange rate.

9. The ceiling on NCG will also be adjusted upward by a maximum of K 80 billion to reflect the government's cash cost arising from the privatization of ZNCB. Any bond issue in the context of ZNCB privatization will be excluded from NCG.

10. The data source for the above will be the "Net Claims on Government Table" produced by BoZ Economics Department, submitted on a weekly basis, and reconciled with the monetary survey.

C. Gross International Reserves of the BOZ

11. Unless otherwise noted here, gross international reserves of the BoZ will be defined as reserve assets of the Bank of Zambia (Appendix II, Table 2). Reserve assets are defined in the IMF BOP manual (5^th edition) and elaborated in the reserve template of the Fund's special data dissemination standards (SDDS). They exclude, for example, foreign assets not readily available to or controlled by the monetary authorities, and foreign currency claims on Zambia residents.

12. Gross international reserves consist of (i) monetary gold; (ii) foreign currency in cash; (iii) Unencumbered foreign currency deposits at non-resident banks; (iv) foreign securities and deposits; (v) SDR holdings and Zambia's reserve position with the Fund; and (vi) balances in the BIS account related to debt service to Paris Club creditors. Gross reserves will exclude non-convertible currencies, pledged, swapped, or any encumbered reserves assets including but not limited to reserve assets used as collateral or guarantees for third party external liabilities, commercial banks reserve requirements in foreign currency, and will exclude the US$25 million deposit in Meridien Bank which is under liquidation, and the IMF's interim assistance.

13. The floor on gross international reserves will be adjusted: (i) downward by the amount in U.S. dollars of the shortfall in balance of payments support net of debt service as indicated in Table 1 of the letter of intent, up to a maximum of US$45 million for the program year; (ii) upward by 100 percent of the cumulative excess balance of payments support net of debt service (iii) downward/upward for any shortfall/excess in the U.S. dollar value of disbursements from the IMF under the PRGF arrangement; and (iv) downward for any increase in BoZ short-term foreign currency denominated debt (to resident and nonresidents), using the definition of short-term debt below.

14. The floor on reserves will be adjusted downward by a maximum of US$21 million to reflect the government's cash cost arising from the privatization of ZNCB.

15. For the purpose of this performance criterion, as well as those for external debt and arrears, valuation will be in U.S. dollars using the program exchange rates.

16. Data on gross international reserves including its components will be reported by the BoZ on a weekly and end-month basis.

D. External Payment Arrears

17. Official external payment arrears are defined as the stock of external arrears on debt repayments by the central government and BoZ, except on debts subject to rescheduling.

18. Data on arrears are compiled jointly by the MoFNP and BoZ and will be reported by MoFNP on a quarterly basis.

E. Official Medium- and Long-Term Concessional Debt

19. This is defined as all forms of official debt contracted or guaranteed by the central government and BoZ having a grant element of more than 40 percent, but excludes debts subject to rescheduling. This includes loans, supplier's credits and leases, that constitute current, i.e. not contingent liabilities, which are created under a contractual arrangement or guarantee through the provision of value in the form of assets (including currency) or services, and which require the government or BoZ to make one or more payment in the form of assets (including currency) or services, at some future point(s) in time; these payments discharge the principal and/or interest liabilities incurred under the contract. Under this definition, such debt includes arrears, penalties, and judiciary awarded damages arising from the failure to make payments under a contractual obligation that constitutes debt as specified above. The grant element is to be calculated by using currency-specific commercial interest reference rates (CIRRs) reported by the OECD); for maturities of less than 15 years, the grant element will be calculated based on six-month averages of CIRRs, and for maturities longer than 15 years, the grant element will be calculated based on 10-year averages. Adjustment lending from the World Bank and IMF will be excluded.

20. The definition of debt, for the purposes of the limit, is set out in Executive Board Decision No. 6230-(79/140), Point 9, as revised on August 24, 2000 (see Annex below). This performance criterion applies not only to debt as defined in Point 9 of the Executive Board decision, but also to commitments contracted or guaranteed for which value has not been received.

21. Detailed data on all new concessional and non-concessional debt contracted or guaranteed will be provided by MoFNP on a quarterly basis.

F. Official External Short-Term Debt

22. This is defined as the outstanding stock of external debt (as defined above) with a maturity of less than one year contracted or guaranteed by the central government, and BoZ. For this purpose short term debt will include forward commodity sales but will exclude normal trade credit for imports. There will be no new official external short-term debt during the program period.

23. The data will be reported by the MoFNP and BoZ on a quarterly basis.

G. Collateralizing/Guaranteeing of Loans to ZESCO and ZNOC

24. The government and the Bank of Zambia shall not extend or guarantee any new debts to ZESCO or ZNOC, including in the form of loans, suppliers credits and loans.

H. Domestic Arrears of Government

25. Domestic arrears are defined as: (i) any bill that has been received by a spending Ministry from a supplier for goods and services delivered (and verified) and for which payment has not been made within 30 days; (ii) wage and salary arrears that were due to be paid in a given month but remained unpaid on the 15^th of the following month; and (iii) interest or principal obligations which remain unpaid 30 days after the due date of payment.

26. The information is to be compiled through audits of the accounts of spending Ministries and agencies, conducted by the Internal Audit division of MoFNP. The audits will be completed and data submitted to Fund staff by the Commitments Monitoring Unit within 6 weeks of the end of each quarter.

III. Structural Performance Criteria and Benchmarks

A. Monthly Revenue and Expenditure Reports

27. The Central Computer Services Department (CCSD) shall process monthly FMS reports from the line ministries, so as to enable the Accountant General to submit a consolidated summary of monthly government expenditure, along with revenue collections, to the Secretary to the Treasury (ST) as a management tool. This report should show expenditure by subhead for each spending agency, and should also include a summary for government as a whole. The report should be published, along with data on cash releases, with a lag of less than two months, either on the government's website or in Macroeconomic Indicators. As the quality of the Monthly Expenditure Returns improve—or, alternatively, as the FMS reports are modified to include more information—additional data on commitments and arrears shall be included in the report.

B. Database on Domestic Arrears

28. The Controller, Internal Audit shall, using the results of quarterly audits of arrears at spending agencies, construct a database containing records for each individual unpaid bill owed by government. Once constructed, this database will allow the Ministry of Finance to hold line ministries accountable for their requests for funds for arrears clearance. Such requests must identify the particular arrears to be cleared, and the corresponding records in the database will be deleted upon verification from the line ministry.

C. Submission of Audited Government Accounts

29. "Accounts for 2001" are defined as the 2001 annual financial statements, as prescribed in the Finance Act and Regulations thereunder. "Timely preparation of final audited accounts as required by law" is taken to mean that the Auditor General will audit the accounts for 2001 in sufficient time to allow the Minister of Finance to present the Financial Report to Parliament within twelve months of the end of the year, i.e., by December 2002.

D. Procurement of Hardware and Software for IFMIS

30. Once the long-term IFMIS consulting firm is in place, it will help design the hardware and software requirements for the process. Procurement of hardware and software should commence—i.e., tender documents should be issued—by December 2002.

E. HIPC Reporting

31. The benchmark on publishing an annual report on the use of HIPC debt savings during 2001 and allocations for 2002, will be met following the publication of a report detailing: (i) debt relief received during 2001 and the amounts credited to the MoFNP account 49 at the BoZ; (ii) programs to which HIPC resources were allocated in the budget during 2001, together with the amounts allocated from the non-HIPC budget to these programs; (iii) cash releases to line ministries and expenditures for these programs; (iv) progress with public monitoring of HIPC resources, and any other related activities (e.g. training workshops, dissemination); and (v) the list of programs to receive HIPC resources for 2002.

F. Privatization of Zambia National Commercial Bank (ZNCB)

32. The performance criteria on the privatization of the ZNCB will be met on the day the Zambia Privatization Agency (or other designated agency): advertises the sale of at least 51 percent of ZNCB along with the relevant terms and conditions in national and international newspapers/newsweeklies.

33. The benchmark on the appointment of the negotiating team will be met on the day the ZPA Board appoints a negotiating team with full authority to negotiate a contract for sale and related matters consistent with existing rules and practices.

34. The benchmark on the evaluation of bids and approval of negotiations and final sale contract will be met on the day the ZPA Board formally concludes the evaluation of bids and approves negotiations and final sales contract with the successful bidder.

G. Consolidation of BoZ's Existing Mechanisms for Financing Government

35. The benchmark and performance criteria on streamlining and consolidating the BoZ's existing mechanisms for financing government operations to comprise three elements: an overdraft facility with the BoZ; treasury bills and treasury bonds, will be met once the following three steps are completed:

(i) The joint task force comprising MoFNP and BoZ staff submits its proposals on the modalities and timetable for streamlining and consolidating government accounts (along the lines indicated above) to the authorities in MoFNP and the BoZ.

(ii) The MoFNP and the BoZ authorities formally decide on a strategy (mode and timing of streamlining and consolidating the accounts) and a decision is communicated in writing to all concerned officials.

(iii) The revised system becomes operational and the BoZ issues the first weekly/monthly report indicating the position of all government accounts in the BoZ under the new system.

H. Abstention from Tax Reductions and Other Measures

36. The government shall refrain from introducing any additional tax exemptions beyond those already included in the 2002 budget and all expiring tax exemptions will be allowed to lapse. The zero-rating for VAT for hotel accommodation in the Livingstone area is carried over until end-2002.

37. The benchmark will be met when a hiring freeze is implemented throughout the government sector (including the Ministry of Defense and other payrolls recently moved to MoFNP), so that the headcount in each grade stays at or below the end-August 2002 level. Thus new hiring will only be permitted to offset reductions due to other reasons. Hiring teachers, doctors, and nurses will not be covered by the benchmark.

Guidelines on Performance Criteria with Respect to Foreign Debt

Excerpt from Executive Board Decision No. 6230-(79/140), as revised on August 24, 2000

9. (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 the 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 lessor 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 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.