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


July 22, 2003

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 staff of the IMF, has evaluated the implementation of the second annual program (October 2001-September 2002) and performance through March 2003. The attached memorandum on economic and financial policies (MEFP) also presents the government's objectives and policies for the third annual program (July 2003-June 2004), in line with the strategy presented in Ethiopia's Sustained Development and Poverty Reduction Program of August 2002. The government intends to make the contents of this letter, and those of the attached MEFP and technical memorandum of understanding, available to the public and authorizes you to arrange for them to be posted on the IMF website, subsequent to Executive Board completion of the fourth review under the PRGF arrangement.

2. As you will appreciate, performance under the second annual program was broadly satisfactory, notwithstanding a severe drought, and continued deterioration of the terms of trade. Most quantitative and structural performance criteria and benchmarks through end-March 2003 were observed (see paragraph 4 of MEFP). The government is determined to meet all subsequent performance criteria and benchmarks. Following the completion of the fourth review under the PRGF arrangement by the Executive Board, the government requests the fifth disbursement of SDR 10.429 million under the arrangement. In view of the delay of the completion point under the enhanced HIPC Initiative by a few months compared to the original schedule of July 2003, the government is requesting additional interim enhanced HIPC assistance of SDR 2.111 million for the period November 8, 2003-May 31, 2004.

3. To monitor progress in economic policy implementation, financial and structural benchmarks through end-December 2003 and performance criteria for end-September 2003 under the third annual program are summarized in the tables annexed to the MEFP. The fifth review under the PRGF arrangement is scheduled to be completed by end-December 2003. At that time, the performance criteria for end-March 2004 will be established. The sixth and final review under the arrangement is scheduled to take place by end-July 2004. In order to complete this review the government of Ethiopia requests the extension of the PRGF arrangement to end-July 2004. The government will provide the IMF with such information as the IMF requests in connection with the country's progress in implementing the economic and financial policies and achieving the objectives of the program.

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

Sincerely yours,

ETHIOPIA

Memorandum on Economic and Financial Policies for the Period

July 8, 2003 - July 7, 2004¹

July 22, 2003

I. BACKGROUND

1. The Government of Ethiopia reconfirmed its economic reform efforts and its commitment to poverty reduction within a framework of macroeconomic stability, as laid out in its interim Poverty Reduction Strategy Paper (IPRSP) of November 2000 and the Sustainable Development and Poverty Reduction Program (SDPRP) or full PRSP of August 2002. These reform efforts are supported by the International Monetary Fund under a three-year Poverty Reduction and Growth Facility (PRGF) arrangement, approved on March 22, 2001. This memorandum reviews performance under the second annual program (October 2001 - September 2002) and during the period through March 2003, outlines the government's updated medium-term objectives and policy framework for 2003/04 - 2005/06, and sets out the economic and financial policies for 2003/04, within the strategy outlined in the SDPRP.

II. PERFORMANCE UNDER THE SECOND ANNUAL PROGRAM AND THROUGH MARCH 2003

2. Performance under the second annual program and through March 2003 has been broadly satisfactory, despite the adverse impact of a severe drought and continued deterioration of the terms of trade. Recent economic developments have been severely affected by the drought—the worst since 1984/85, with cereal production declining by about 6 percent in 2001/02 and 26 percent in 2002/03. An estimated 12.6 million people are in need of food assistance, compared with about 5 million in a normal crop year. Real GDP growth in 2001/02 was consequently revised downwards to 1.2 percent from 5 percent, and is estimated to have declined by 3.8 percent in 2002/03, mainly as a result of a drop in agricultural production and continued weakness in the world price of coffee, Ethiopia's major export. Average annual inflation accelerated to 13.4 percent in the 10-month period ending in April 2003, up from -7.2 percent in 2001/02, mainly because of food shortages. Food assistance needs for 2003 have been estimated at 1.5 million metric tons of cereals. So far, 1.3 million metric tons have been secured and the government is seeking additional donor assistance to fill the gap. Timely arrival of pledged food aid is critical to ensure food security.

3. The external current account deficit (including official transfers) is estimated to have remained at around 6 percent of GDP in 2002/03 (excluding official transfers, the deficit rose from 13.2 percent to 15.2 percent). Total exports performed better than expected and are estimated to have increased by 8.6 percent, as the decline in coffee exports was more than offset by a robust growth of other exports. Coffee exports (which accounted for 37 percent of merchandise exports in 2001/02) have continued to decline largely because of a further drop in prices. Nonfactor service exports, however, grew strongly by over 14 percent. Large scale food aid imports, together with higher oil prices, resulted in an estimated increase of 16.5 percent in total imports in 2002/03. Non food, non fuel imports grew slightly faster than programmed reflecting progress with project implementation as well as higher prices.

4. All the quantitative performance criteria and benchmarks through December 2002 were observed (Table 1). The indicative quantitative targets for end-March 2003 were also met. The structural performance criterion related to the introduction of the value-added tax (VAT) was observed (Table 2), and a performance contract with the Commercial Bank of Ethiopia (CBE) was signed in June 2002 (structural benchmark). However, although progress was made with the help of the IMF technical assistance, the two structural benchmarks related to the improvement of public expenditure management have not yet been met, partly as a result of the ongoing decentralization of fiscal powers to woredas (districts). At end-September 2002, the nonperforming loans (NPLs) of the CBE (excluding cofinanced loans with the Development Bank of Ethiopia (DBE)) were only reduced to Birr 3.7 billion, compared to Birr 3.1 billion established as a structural benchmark.² Nonetheless, NPLs (including cofinanced loans) have fallen from their peak of Birr 5.8 billion at end-June 2002 to Birr 4.2 billion at end-March 2003 through write-off, the issuing of government bonds, foreclosure, rescheduling, and repayment. The audit of the CBE by an internationally reputable audit firm (KPMG), originally scheduled as a structural benchmark for January 2003, was eventually completed in early May 2003. During the same month a contract was signed with the Royal Bank of Scotland to begin providing management consulting services to the CBE for a two-year period, starting June 9, 2003 (prior action for the completion of the fourth PRGF review).

5. In the fiscal area, the overall deficit (including grants) is estimated to have decreased from 9.3 percent of GDP in 2001/02 to 8.5 percent in 2002/03, compared with 9.7 percent under the program. However, excluding grants, the deficit is estimated to have widened from 14 percent of GDP to 17.4 percent (compared to 14.5 percent under the program), reflecting emergency assistance equivalent to 5.4 percent of GDP received in the form of grants.

6. On the revenue side, the government implemented several tax measures, including the introduction of the VAT (performance criterion) and the reduction of the average external import tariff from 19½ percent to 17½ percent in January 2003. The maximum tariff has been reduced from 40 percent to 35 percent, and the number of bands from seven to six. Efforts have also continued to improve tax administration and collection, including the strengthening of the large taxpayer unit, which accounts for about 75 percent of federal tax revenues. As a result, total tax revenues increased from 15.3 percent of GDP in 2001/02 to an estimated 16 percent in 2002/03.

7. On the spending side, the government continued to follow a cautious expenditure management policy, while making every effort to increase poverty-reducing spending. The government adopted a supplementary budget for 2002/03 in May 2003, to take account of additional external assistance in the form of grants from a bilateral donor and some additional nontax revenue, leading to higher spending of around 1.1 percent of GDP, mainly on a project aimed at extending access to education through the use of satellite technology. Defense expenditure was curtailed to 5.3 percent of GDP. However, poverty-targeted outlays (health, education, agriculture, and roads) are estimated to have increased to 17.7 percent of GDP, though somewhat lower-than-programmed because of delayed disbursement of external assistance. Total expenditures (including special programs) amounted to an estimated 39 percent of GDP and were higher than the level programmed by 2.7 percentage points of GDP, reflecting the high food aid received and lower than projected nominal GDP. Expenditures on special programs are estimated to have fallen from 1.9 percent of GDP in 2001/02 to 1.5 percent in 2002/03.

8. Regarding monetary and exchange rate policies, the government sterilized some excess liquidity and moved towards allowing greater market determination of the exchange rate. However, the financial market remains dominated by the CBE. Broad money is estimated to have increased by 11.3 percent in 2002/03 (compared with 12.4 percent assumed under the program, and 12.3 percent in 2001/02). Reflecting weak economic activity and the decision of the CBE to stop lending to those with NPLs, total credit to the nongovernment sector is estimated to have increased by only 4.8 percent, less than the 13.7 percent increase under the program, but compared with a decline by 7.1 percent in 2001/02. Credit to the government is estimated to have increased by 3.1 percent, in line with the program. Despite increased sales of government securities to the banking system, the banks' excess reserves rose from 8.1 percent of deposits on July 7, 2002 to 12.3 percent by end-March 2003 largely because of weak credit demand.

9. In the area of financial sector reforms, several measures were taken to strengthen the banking system and to improve the competitiveness of the financial sector, including the adoption of a directive for the provisioning by banks for NPLs and troubled debt in line with international best practices in August 2002 (to be fully implemented by January 2004), and the signing of a performance contract with the CBE to ensure that the CBE is operated effectively on a commercial basis. The Construction and Business Bank (CBB) was brought to the point of sale through the floatation of 100 percent of shares to the Ethiopian public, but due to lack of audited accounts, the offer was withdrawn.

10. Since the beginning of the 2002/03 fiscal year, the nominal value of the birr has depreciated by about 0.2 percent against the dollar to reach Birr 8.6 per US dollar at end-March 2003. At end-March 2003, net foreign assets of the National Bank of Ethiopia (NBE) stood at US$730 million (around 3.6 months of following-year imports of goods and services) compared with the programmed level of US$521 million. Gross foreign reserves were estimated at around 4.6 months of following-year imports.

11. The government has implemented several other structural measures with World Bank assistance. These include expansion of health and education services, public sector management, including civil service reform and public expenditure policy, and private sector development. Several small public entities were brought to the point of sale in 2002, but the sale of larger public entities has proved more difficult, and only Birr 13 million is expected to be realized by end-2002/03.

12. During December 7-8, 2002, the Ethiopian government organized its first Consultative Group meeting since 1996 under the heading "Partnership for Accelerated and Sustainable Development". At that meeting, Ethiopia's development partners pledged US$3.6 billion in support of the SDPRP over the three-year period 2002/03 - 2004/05. The government has also engaged the development partners in the harmonization of aid, including budget support, with the view to reducing the transaction costs related to aid delivery.

13. Ethiopia and Eritrea have exchanged prisoners of war (POWs) with Ethiopia releasing all Eritrean POWs in November 2002. The countries are currently discussing with the United Nations Mission to Eritrea and Ethiopia (UNMEE) the issue of the border demarcation between the two countries.

III. ALIGNING THE SDPRP AND THE PRGF AND MEDIUM-TERM STRATEGY

14. The third annual PRGF-supported program and the updated medium-term strategy were formulated in the context of the strategy outlined in the SDPRP (or full PRSP). The medium-term economic strategy focuses on promoting growth led by a strong performance of the agriculture and rural sectors, as well as by improving the environment for promoting exports and private sector growth. The strategy seeks to promote rapid, broad-based, and equitable growth by emphasizing rural development and improvement in physical and human capital in line with the SDPRP. In the context of this strategy, the PRGF-supported program focuses on six key policy components: (a) the reorientation of budgetary resources from defense toward poverty alleviation outlays; (b) improved public expenditure management in the context of an overall reform of the public service and a decentralization of fiscal powers to the woredas (districts); (c) tax reforms that lay the foundation for a strong revenue performance; (d) improved monetary management and financial sector reform; (e) capacity building and regulatory reforms to promote private sector development; and (f) agricultural and rural development to ensure food security.

15. Taking into account the development strategy outlined in the SDPRP and the impact of the recent drought, and assuming a more realistic real GDP growth, the updated medium-term objectives for 2003/04-2005/06 would be (i) to achieve an annual average real GDP growth rate of about 6 percent (a 7 percent annual real GDP growth was projected in the SDPRP); (ii) to maintain core inflation at about 3 percent; and (iii) to reduce the external current account deficit (including official transfers and excluding aircraft imports of Ethiopian Airlines—see below) to about 4.9 percent of GDP (9.3 percent, excluding official transfers) by 2005/06.

16. The third annual program has been rephased to July 8, 2003- July 7, 2004, thus aligning it with the government's budget cycle, a key objective under the SDPRP. The program projects real GDP growth of 6.7 percent after the 3.8 percent decline in 2002/03, spurred by a gradual agricultural recovery following a two-year decline caused by the prolonged drought. An environment conducive to private sector development is expected to contribute to an increase in private investment to 9.8 percent of GDP. Consumer price inflation is projected to decline from an average of 14 percent in 2002/03 to 5.5 percent in 2003/04, as food supply conditions return to a more normal level and pledged food aid assistance is delivered on time. The external current account deficit (including official transfers and excluding aircraft imports for Ethiopian Airline (EAL)³) is projected to increase slightly from 6.1 percent of GDP in 2002/03 to 6.7 percent in 2003/04. Including EAL aircraft imports, the deficit would rise to 8.3 percent of GDP. Exports are expected to grow by 9.8 percent reflecting higher coffee prices and a recovery in volume, as well as continued strong performance of other exports. Imports would also continue to grow in response to both volume and price increases. Both private and official transfers are projected to fall from their drought related peak in 2002/03. Continued external support will allow a further build up in foreign reserve cover to 4.5 months of following year imports of goods and services (including EAL imports).

A. Fiscal Policy

17. Fiscal policy will continue to focus on prudent public expenditure management and enhanced revenue mobilization. The Council of Ministers adopted on June 27, 2003 a budget for 2003/04 consistent with the fiscal framework presented in this MEFP. The overall fiscal deficit for 2003/04 (including grants, and special program expenditure equivalent to 1 percent of GDP) will be reduced from 8.5 percent of GDP in 2002/03 to 7.5 percent in 2003/04. The budget will be financed by net external financing (entirely on concessional terms) equivalent to 5.5 percent of GDP, as well as Birr 1 billion (1.6 percent of GDP) of domestic bank financing, Birr 162 million (0.3 percent of GDP) of non-bank finance, and projected receipts from privatization of about Birr 100 million (0.2 percent of GDP). In addition, the budget assumes grants equivalent to 8.5 percent of GDP to finance projects and emergency food aid.

18. The government is determined to pursue its tax reform efforts aimed at further improvement in revenue performance. To achieve the tax revenue target of 16.5 percent of GDP in 2003/04, revenue performance will benefit from the full-year impact of the VAT introduced in January 2003, and improved tax administration. The government will continue to implement the tax reform program, in particular the functioning of the large taxpayer unit, enhancing the activity of the tax reform task force, the computerization of the tax identification number (TIN) and of the VAT, while measures are also being put in place to collect tax arrears including strengthened enforcement powers and special units to deal with arrears. The Ministry of Revenue is also benefiting from IMF technical assistance in the area of customs administration.

19. The government will pursue a prudent expenditure policy, focusing on poverty-reduction activities identified in the SDPRP. Total outlays (including special programs and food emergency assistance) are targeted to decline to 36.7 percent of GDP in 2003/04. Food emergency assistance is projected at 1.4 percent of GDP. Defense outlays will be cut by 0.5 percentage points of GDP to 4.8 percent. Poverty-targeted spending will increase to 17.9 percent of GDP (including 1.3 percent from HIPC relief). The total wage bill is to be limited to 7.8 percent of GDP. Capital outlays are projected at 14.7 percent of GDP, taking into account only existing loan commitments from the World Bank and including planned spending on resettlement and water harvesting. Regarding future disbursements from the World Bank, in line with the Country Strategy Assistance (CAS), only grants shown in IDA's CAS for 2003/04, in addition to disbursements from already committed IDA loans, were included in the budget at this stage. At the time of the completion point, Ethiopia's debt sustainability will be reassessed and the amount of any additional debt relief will be determined. At that time, any additionally secured commitment of IDA loans will be added in a supplementary budget, provided that disbursements will be spent efficiently on poverty-related sectors and will not jeopardize macroeconomic stability or debt sustainability. Any additional HIPC assistance granted at the time of the completion point will also be included in the supplementary budget.

20. The government will continue to strengthen the budget management program and implement the action plan under the Country Financial Accountability Assessment (CFAA) aimed at further improvements in the country's accountability and transparency. In particular, the government will during 2003/04 (a) ensure that fiscal decentralization efforts go in parallel with budget planning by the Ministry of Finance and Economic Development; (b) develop a three-year rolling integrated plan for public expenditure management; (c) develop a road map and action plan for the introduction of a double entry modified cash system across the entire government; (d) introduce a suitable Integrated Financial Management System at the federal level; and (e) adopt capacity building initiatives at the regional and woreda level to support the devolution of budgetary and financial responsibility. The consolidation of federal and regional budgets for both the past year and the budget year—including all extrabudgetary funds and accounts—will be completed by end-November 2003 and efforts will be made to improve the effectiveness, reporting, and monitoring of local governments' expenditures, and address issues related to the decentralization of fiscal powers, particularly ensuring adequate fiscal reporting from woredas, identifying the cost of decentralization and of woredas' new employment structure, and ensuring clearly delineated and transparent responsibilities for capital spending within regions.

B. Monetary and Financial Sector Reform

21. Monetary policy will remain geared at achieving the inflation and international reserve targets under the program. To help achieve these targets while providing room for an adequate increase in credit to the nongovernment sector, the government will limit recourse to borrowing from the banking sector to Birr 1 billion to finance food security and drought-related spending in 2003/04. Money supply is projected to rise by about 13.4 percent in 2003/04. The government will continue sterilizing the excess reserves held by commercial banks. Interest rate policy will remain under review. All rates are market-determined, with the exception of saving deposit rate set at 3 percent. With core inflation at about 3 percent, interest rates presently in the range of 3-12 percent remain adequate. The exchange rate will continue to be market determined and the effectiveness of the interbank foreign exchange market will be strengthened.

22. The government attaches strong importance to reforms aimed at strengthening the financial sector and improving its competitiveness. Measures during 2003/04 will include (a) full provisioning by banks for NPLs and other doubtful assets in line with international best practices by January 2004; (b) finalizing the financial restructuring of the DBE by end-2003; and (c) taking 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 NBE's autonomy by end-2003. The issue related to the unaudited accounts of the CBB will be resolved and shares of that bank will be re-offered for sale to the Ethiopian public by end-September 2003.

23. With respect to the CBE, an independent audit, carried out according to International Accounting Standards by KPMG, was finalized in May 2003. The audit found that (i) NPLs amounted to Birr 5.8 billion (59 percent of total loans) at end-June 2002; and that (ii) the losses of CBE, after a one-off adjustment by the auditors (including for impaired-interest income), amounted to Birr 471 million in 2001/02, but the bank was very liquid. However, the audit also found that (i) the capital adequacy ratio was at 8.3 percent, higher than the minimum required level of 8 percent; and that (ii) the recommended level of loan loss provisions against the advances portfolio was Birr 2.4 billion, representing an increase in the provisions held by the bank at end-June 2002 of Birr 273 million. Finally, the audit recommended that the NPLs issue be addressed, actions taken to restore the profitability of CBE, and that credit risk and portfolio management be significantly strengthened. As noted earlier, at end-March 2003 NPLs were reduced to Birr 4.2 billion (49 percent of total loans as per unaudited accounts), and provisions were raised to Birr 2.4 billion, higher than what is required by the NBE provisions directives.

24. The authorities will finalize, adopt, and commence implementing by end-November 2003 a detailed financial restructuring plan to restore CBE's profitability. The objective of this plan is to ensure that CBE becomes a sound and profitable bank. The plan will be based on the KPMG audit. Measures are being taken to minimize the risk of new NPLs emerging. The measures that have been implemented include (a) ceasing all lending to borrowers with NPLs; (b) strengthening the credit approval and monitoring process for all new loans; (c) transferring lending authority from the board of CBE to its management; (d) giving autonomy to management in decision making; (e) creating an audit committee at the board to oversee financial performance; and (f) implementing the revised foreclosure law to speed up its application and improve its effectiveness. Moreover, as part of the restructuring plan of CBE, credit risk and portfolio management will be significantly strengthened. The key elements of the plan will include (i) ensuring that CBE complies fully with the NBE provisioning directives by January 2004; (ii) a time-bound plan for reducing NPLs to 20 percent of total loans; and (iii) ensuring that the capital adequacy ratio will not fall below the minimum required ratio of 8 percent, and promptly recapitalizing the bank should the ratio fall below 8 percent. In addition, as part of the restructuring plan, the modalities and timetable for resolving NPLs will be set out clearly, no annual dividends will be paid out by the CBE until the capital adequacy ratio reaches at least 10 percent, and a business plan will be prepared to achieve this target by June 2004. The key actions that CBE will carry out in the period ahead will include (i) starting the preparation of the detailed restructuring plan, which would also address the advisability and modalities of establishing an asset management company; and (ii) completing an annual audit for the financial statement as at end-June 2003. The draft detailed restructuring plan of CBE will be submitted to the Monetary and Financial Systems Department (MFD) of the IMF for comments before it is finalized. To this end, an MFD mission, or preferably a joint MFD/World Bank mission, will go to Ethiopia to discuss such plan when it is ready, including how to reduce large loan exposures. An assessment of the fiscal impact of the restructuring plan, if any, will be carried out at that time.

25. 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. Banks are being 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 are being encouraged to increase their scale of operation and raise their capital base, including through mergers. The authorities will continue to foster the development of microfinance institutions by transforming them into rural banks and by facilitating the flow of funds from commercial banks to those institutions for the purposes of on-lending.

C. External Sector and Financing Requirements

26. The government projects an increase in the external current account deficit (including official transfers and excluding aircraft imports by EAL) to 6.7 percent of GDP in 2003/04. This will be fully covered by project loan disbursements, balance of payment support from the AfDB (US$26 million), World Bank balance of payments support grant (US$150 million), reconstruction and demobilization programs (US$74 million), and by assistance under the enhanced HIPC Initiative (US$91 million). Such external financial assistance should allow further accumulation of international reserves to the equivalent of 4.7 months of following year imports. Over the medium term, the current account deficit (including transfers and excluding aircraft imports by EAL) is projected to decline to 4.9 percent of GDP (6.3 percent including EAL imports) by 2005/06, as a result of continued growth of nontraditional and traditional exports and nonfactor services. At the same time, total import growth is expected to decline, reflecting lower food aid requirements. Sustained concessional lending together with debt relief under the HIPC Initiative will allow maintenance of foreign exchange reserves at around 4.6 months of imports.

27. The government remains committed to trade liberalization in the context of the frameworks of the Common Market for Eastern and Southern Africa (COMESA), which has been chaired by Ethiopia in the past year. A new Investment Code was passed in April 2003 to promote foreign investment. Under the new code, the sole operation by government has been reduced to the transmission and distribution of electricity in main national lines, postal services excluding fast postal service, and aircraft that transport over 20 passengers. In addition, Ethiopia is conducting a Diagnostic Trade Integration Study (DTIS) as a preliminary step in the Integrated Framework for Trade Development in the Least Developed Countries. In this regard a National Steering Committee for the DTIS chaired by the Minister of Trade and Industry and including a few bilateral partners as well as IMF and World Bank representatives has been constituted. The purpose of the DTIS is to identify key constraints to the country's integration into the multilateral trade system and the global economy.

28. Following the Paris Club meetings on April 5, 2001 and April 12, 2002, the government has signed bilateral agreements with all but two Paris Club creditors, and the last two agreements are being finalized. It is also seeking rescheduling of debt owed to non-Paris Club creditors on terms at least comparable to those given by the Paris Club, and consistent with assumptions under the HIPC Initiative. Additional debt relief provided beyond that assumed under the Initiative has also financed additional poverty-targeted expenditure. Due to practical difficulties in implementing the mechanism agreed at the HIPC decision point for disbursing and tracking payments from the HIPC account at the NBE, the government will agree with creditors on a simplified method for disbursement that ensures that such resources continue to be spent in a timely manner on poverty-related activities, and which is consistent with the government's monitoring systems, including the Public Expenditure Review.

29. External debt sustainability analysis will be updated later in the year at the time of the completion point. Preliminary estimates indicate, however, that the NPV of debt-to-export ratio has risen sharply since the HIPC decision point in November 2001, largely due to exogenous factors. Application of updated exchange rates, discount rates, and export prices to the debt stock assumptions at the decision point increases the NPV debt-to-export ratio in 2003/04 from 174 percent to well over 200 percent. In this regard, the government intends to continue following sound debt management policies by restricting new borrowing to concessional credits, while simultaneously exploring with development partners the possibility of increasing the grant element in external assistance. In addition, the government will closely monitor new concessional borrowing and ensure that foreign loans are used effectively to enhance growth, particularly of exports.

30. The government will rely on prudent macroeconomic policies and a market-determined flexible exchange rate to maintain the current account in line with the prospective availability of foreign grants, concessional loans, and debt relief. With regard to new borrowing, the public sector will neither contract nor guarantee any new external loans on nonconcessional terms. New external debt incurred by Ethiopian Airlines will be excluded from these limitations. There will be no accumulation of external arrears at any time.

31. During the program period, the government will not introduce or intensify any existing exchange restrictions, introduce or modify any multiple currency practices, conclude any bilateral payments agreements that are inconsistent with Article VIII of the Fund's Articles of Agreement, or introduce or modify import restrictions for balance of payments purposes. Furthermore, the authorities intend to eliminate the few remaining exchange restrictions that existed prior to the PRGF arrangement, and accept the obligations of Article VIII, Sections 2, 3, and 4 of the Articles of Agreement. In addition, following the completion of the study of the NBE the authorities will speed up the implementation of the recommendations made in the recent Safeguards Assessment of the NBE.

D. Social Policies, PRSP, and HIPC

32. The government will continue to implement the SDPRP and prepare a progress report on the first year of implementation of the program by the time of the next PRGF review. The progress report will include (i) a further articulated strategy for promoting private sector development, including agriculture; (ii) alternative macroeconomic scenarios, as well as an examination of the linkages among macroeconomic policies, structural reforms, and poverty; (iii) a refinement of costing of PRSP programs, and (iv) an evaluation of the early experience with fiscal decentralization. Following some delay in the preparation of the terms of reference for the poverty and social impact analysis of the introduction of the VAT, the study has commenced and its findings as well as those from a separate study on the impact of the decline in coffee prices will be incorporated in the progress report. With regard to meeting the remaining enhanced HIPC Initiative completion point triggers, the reconciliation of fiscal and monetary accounts will be completed by end-December 2003 with further Fund technical assistance. Difficulties encountered in the consolidation of federal and regional budgets are largely resolved and the consolidated budgets for 2002/03 and 2003/04 will also be prepared by end-November 2003. The government expects to achieve all the triggers for the HIPC Initiative Completion Point by end-2003.

E. Other Structural Reforms

33. With the assistance of the World Bank and bilateral donors the government will continue to implement structural reforms that are conducive to growth and poverty reduction, including agricultural reform, food security, capacity building, export promotion, strengthening of the existing legal and regulatory framework, and supporting private sector development. In the area of export promotion, the government will continue to support the textile, horticulture, and leather subsectors with land, credit, and other facilities. To maintain export proceeds in the face of declining international prices, the government will make strong efforts to market organic and gourmet coffee while ensuring that the removal by the NBE of the floor on coffee exports prices benefits the producer. The government will continue to support the already established public-private sector consultation which is facilitated by the Ministry of Trade and Industry with the establishment of additional sectoral and sub-sectoral partnerships. Moreover, the privatization program will be enhanced. In April 2003, the government adopted an industrial development strategy document, and a white paper was issued.

F. Statistical Issues

34. With the support of technical assistance from AFRITAC, an action plan will be adopted to improve the compilation of real sector and balance of payments data. With regard to the revision of monetary statistics and the coverage of international reserves, comments on draft formats and manuals have been received from commercial banks and implementation will commence in July 2003. The meta data for Ethiopia under the GDDS has been updated and posted on the IMF Bulletin board since November 2002.

G. PRGF Monitoring

35. The program will be monitored on the basis of (a) quantitative quarterly performance criteria and benchmarks, which are set out in Table 3, and described fully in the attached technical memorandum of understanding; and (b) structural performance criteria and benchmarks, as specified in Table 4. The Macroeconomic Technical Committee will continue to meet regularly, with the IMF's resident representative in attendance, and report monthly to the Minister of Finance and Economic Development on progress made in the implementation of the program.

36. As indicated in the cover letter of intent addressed to the Managing Director of the IMF, two reviews are envisaged under the program; the fifth review will be based on economic performance at end-September 2003, to be completed by December 2003, and the sixth review will take place six months thereafter.

ETHIOPIA

Technical Memorandum of Understanding

July 22, 2003

I. Introduction

1. This memorandum sets out the understandings between the Ethiopian authorities and staff of the International Monetary Fund (IMF) regarding the definitions of quantitative and structural performance criteria and benchmarks, as well as indicative targets, for the third annual program under the three-year arrangement supported by the Poverty Reduction and Growth Facility (PRGF), as well as the mechanisms to monitor the program and related reporting requirements. To monitor the evolution of the economy during the program period, the Ethiopian authorities will provide the data listed in each section below to the African Department of the IMF, in accordance with the indicated timing. The financial criteria will be monitored on the basis of the methodological classification of monetary and financial data that exists as of end-May 2003. For program purposes, the public sector consists of the general government (comprising the federal and regional governments) and the National Bank of Ethiopia (NBE). The quantitative targets for end-September 2003 constitute performance criteria, and those at end-December, 2003 are benchmarks. The indicative benchmarks for end-March 2004 will be established as performance criteria in the context of the fifth review to be completed by end-December 2003.

II. QUANTITATIVE PERFORMANCE CRITERIA AND BENCHMARKS: DEFINITIONS AND REPORTING STANDARDS

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

2. Definition. The NFA of the NBE are defined as the difference between gross international reserves and all foreign liabilities of the NBE, including debts to the IMF and other long- and short-term liabilities to nonresidents of the NBE. Foreign liabilities also include foreign-currency-denominated domestic liabilities of the NBE. For calculating the criteria, foreign assets and liabilities shall be valued at the U.S. exchange rates prevailing at end-May 2003. Gold holdings will be valued at the U.S. dollar market price at end-May 2003. Finally, the net foreign assets shall be converted into local currency at the exchange rate at end-May 2003 (8.5937 birr per U.S. dollar).¹ Performance relative to an indicative floor on the net foreign liquid reserves of the NBE will also be monitored.²

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

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

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

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

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

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

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

D. Ceiling on External Payment Arrears

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

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

E. Ceiling on Nonconcessional External Debt

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

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

III. ADJUSTERS

A. Excess in Disbursed External Financial Assistance

12. In case of an excess external financing beyond the programmed amounts shown in Table 3 annexed to the memorandum on economic and financial policies (MEFP) for the period July 8, 2003-July 7, 2004, the floor on net foreign assets of the NBE will be adjusted upward (with two exceptions), by the amount of disbursed external financing in excess of the programmed amounts (comprising non-project-related loans and grants, including special programs, but excluding interim debt relief under the enhanced HIPC Initiative) at the end of each quarter (Table 3 annexed to MEFP), valued at the average exchange rate of the quarter. The two exceptions are (i) an amount of up to US$50 million in excess of programmed overall external financing can be spent on special programs in the case that the overall excess funding stems from higher than programmed financing of the special programs; and (ii) an amount of up to US$50 million in excess of programmed overall external financing can be spent on poverty-targeted outlays if the excess stems from higher than programmed other non-project financing. Accordingly, within this limit, the floor on net foreign assets, and the ceilings on net domestic assets of the NBE, and domestic financing of the general government will not be adjusted.

13. The ceiling on net domestic assets of the NBE will be adjusted downward (with the two above-mentioned exceptions) by the amount of disbursed external financing in excess of the programmed amounts (comprising non-project-related loans and grants, including special programs, but excluding interim debt relief under the enhanced HIPC Initiative) at the end of each quarter (Table 3 annexed to MEFP), converted into birr at the average exchange rate of the quarter.

14. The ceiling on domestic financing of the general government will be adjusted downward (with the two above-mentioned exceptions) by the amount of external financing disbursed to the budget in excess of the programmed amounts (comprising non-project-related loans and grants, including special programs, but excluding interim debt relief under the enhanced HIPC Initiative) at the end of each quarter (Table 3 annexed to MEFP), converted into birr at the average exchange rate of the quarter.

B. Shortfall in External Financial Assistance

15. In case of a shortfall in external financing below the programmed amounts, (comprising non-project-related loans and grants, including special programs, but excluding interim debt relief under the enhanced HIPC Initiative) shown in Table 3 annexed to the MEFP:

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

IV. OTHER REPORTING REQUIREMENTS FOR PROGRAM MONITORING

A. Macroeconomic Monitoring Committee

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

B. Developments on Structural Performance Criteria and Benchmarks

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

C. Data Reporting

Production and prices

18. The following data shall be transmitted:

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

Public finance

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

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

Monetary sector data

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

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

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

External sector data

22. The following data will be transmitted as follows:

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