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

Kathmandu, October 31, 2003

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

His Majesty's Government of Nepal has adopted an economic program for 2003/04-2005/06 which aims to reduce poverty through private-sector led growth and social inclusion. Our economic program is detailed in the Poverty Reduction Strategy Paper (PRSP) and summarized in the attached Memorandum on Economic and Financial Policies (MEFP). The PRSP strategy focuses on creating the conditions for higher growth through a vibrant private sector and sound macroeconomic management. We believe that policy actions under this strategy will provide a basis for lasting peace. In support of this strategy and program of policy actions, we are requesting a three-year PRGF arrangement in the amount of SDR49.9 million (70 percent of quota). The first annual program under the PRGF will support policies to be implemented over the period July 16, 2003-July 15, 2004.

The Government believes that the policies set forth in the MEFP are adequate to achieve the objectives of its program, but it will take any further measures that may become appropriate for this purpose. Nepal will consult with the Fund on the adoption of these measures, and in advance of revisions to the policies contained in the MEFP, in accordance with the Fund's policies on such consultation.

The Government will provide the Fund with all the information in a timely manner as might be requested to monitor progress in implementing policies and achieving the objectives of the PRGF-supported program.

We assure you that His Majesty's Government of Nepal is determined to fully implement the program and we hope we can count on Fund support for our endeavors.

Sincerely yours,

 

	s				s
Dr. Prakash C. Lohani Minister of Finance				Dr. Tilak Rawal Governor Nepal Rastra Bank

Nepal—Memorandum on Economic and Financial Policies for 2003/04 Under The Three-Year PRGF Arrangement

I. Introduction and Background

1. Nepal needs to accelerate implementation of economic reforms to achieve and sustain high growth and reduce poverty. Our country remains among the poorest in the world—the high poverty incidence is attributed to insufficient growth and limited targeting of past poverty alleviation efforts. To address these issues, the government prepared its 10^th Five Year Plan—also its Poverty Reduction Strategy Paper (PRSP)—in July 2003, which aims to lower the poverty rate from 38 percent to 30 percent by the end of the plan period. Our strategy sets out a far-reaching agenda to deliver broad-based growth, improve social service delivery, promote social inclusion, and strengthen governance so as to improve economic performance and ensure that the poor benefit from growth. The donor community has indicated strong support for the PRSP, including a willingness to provide financial resources to assist with its implementation.

2. PRSP reforms would also help address the root cause of the seven-year old civil strife and break the vicious cycle of insurgency, low growth, and high poverty incidence. Pervasive poverty and perception of unfair distribution of economic opportunities breed support for the insurgency, while the conflict prevents Nepal from realizing its growth potential—low growth, in turn, impedes poverty reduction. The PRSP reforms are expected to end this vicious cycle by providing increased income opportunities and better social services to the poor. In January 2003, the government reached a ceasefire agreement with the insurgents and has since conducted three rounds of peace talks. However, the ceasefire came to an abrupt end in August 2003 when the insurgents temporarily withdrew from peace negotiations. We continue to make a determined effort to resume the negotiations and contain the fallout from the insurgency. Despite these developments, strong reform efforts are continuing. This reflects government's commitment and the fact that the PRSP was developed through an extensive consultative process, and these reforms have broad-based support across the political spectrum and civil society.

3. Macroeconomic stability has been maintained and substantial progress has been made in reforms over the past two years to prepare the ground for the PRGF. Major efforts are being made in addressing structural constraints to growth, improving social service delivery and in governance—along the lines of the PRSP. Key reforms that have been implemented in recent years are summarized in Section III.

4. This memorandum outlines the medium-term objectives and policy framework through 2003/04-2005/06, provides a brief summary of the current economic setting and progress in reform, and sets out the economic and financial policies of the program for 2003/04 for which we are seeking support under a PRGF arrangement from the IMF. Policies described in the memorandum are consistent with the objectives and strategy in the PRSP, the Medium-Term Expenditure Framework (MTEF), and the 2003/04 budget which was passed in July 2003.

II. Medium-Term Framework and Policies

5. The PRSP rests on four pillars that are critical for addressing poverty in Nepal. These are: (i) promoting higher broad-based and pro-poor growth; (ii) improving service delivery; (iii) promoting social inclusion and targeted programs; and (iv) improving governance.

• Higher and broad-based growth is essential to achieving the government's poverty reduction goals. Macroeconomic stability and peace are pre-requisites for such growth. The PRSP focuses on: (i) private sector led growth combined with a reduction of government ownership in the public sector and improvement in the efficiency of state-owned enterprises (SOEs); and (ii) agricultural productivity growth through implementation of the Agriculture Perspective Plan. We are also working to raise external competitiveness and promote export growth by addressing financial sector weaknesses, lowering transport costs, improving access to and reliability of power, and easing labor market regulations.

• Service delivery will be improved through decentralization, with increased involvement of local communities in primary school and basic health management. Measures to further improve access to drinking water services are also envisaged.

• Social inclusion will be fostered by policy and institutional changes that actively promote the access of marginalized groups, and women, to basic services and employment opportunities. In this regard, our strategy includes targeted programs in education, as well as affirmative action programs. The recently approved Poverty Alleviation Fund, supported by the World Bank and other donors, will help fund these programs.

• Improvements in governance are essential if the PRSP reforms are to be effective. The main policy actions include measures to increase the effectiveness of the civil service, strengthen anti-corruption institutions and take action against corrupt officials, and to improve financial management and procurement through greater transparency and accountability.

6. In line with PRSP objectives, our medium-term macroeconomic framework envisages:

• Real GDP growth reaching 5-6 percent by 2005/06. Under more favorable conditions such as a rapid improvement in security and recovery in the domestic economy, GDP growth rates could reach 6-7 percent.

• Reducing inflation from 6 percent at end-2002/03 to 4 percent by end-2005/06 through prudent monetary policy and the exchange rate peg to the Indian rupee.

• Reducing domestic budget financing to ½ percent of GDP in 2005/06.

• Maintaining international reserve cover at around six months of imports of goods and services.

III. The Current Economic Setting and Progress in Reform

7. The economy is beginning to recover following the contraction in 2001/02 and inflation is under control, but balance of payments vulnerabilities remain. The economy contracted by ½ percent of GDP in 2001/02 as the conflict intensified, the global economy slowed down and agriculture was affected by poor weather conditions. The ceasefire agreed in January 2003 helped restore some normality in agriculture, transport, and service sectors. GDP growth is estimated at 2⅓ percent in 2002/03. Inflation was 6 percent at end-2002/03 and is expected to moderate as the pass-through effect of administrative price adjustments and supply shortfalls of agricultural commodities fades. On the external front, weak export growth is expected to have contributed to a current account deficit (excluding official transfers). Although gross international reserves have remained adequate at over six months of imports of goods and services, this has been sustained by large remittance, aid, and other inflows, all of which are volatile.

8. Budgetary pressures have been increasing in recent years. The escalation of security related spending, declines in external financing, and shortfalls in revenue collection have increased the domestically financed deficit to over 2½ percent of GDP during 2000/01-2001/02. The fiscal situation has been contained by expenditure cuts, particularly in capital spending, and various tax policy and administration reforms during the latter half of the 1990s. Nevertheless, the public debt ratio has been increasing and there remain potentially large contingent liabilities from financial sector and SOE reforms.

9. Significant progress has been made in reforms in recent years:

• Fiscal reforms. A modern VAT was introduced in 1997 and tax administration has been strengthened by merger of the Inland Revenue and VAT Departments. A new Income Tax Act has been introduced and ASYCUDA has been implemented at some customs points. A public expenditure review was undertaken and expenditure management has improved with the introduction in 2002/03 of the MTEF which prioritizes projects and programs.

• Financial sector reforms. The new NRB Act, which increases the central bank's autonomy and strengthens its supervisory and regulatory functions, was enacted in early 2002. To further strengthen NRB oversight over the financial system, a new Banking and Financial Institutions (BFI) Ordinance has been introduced. This legislation replaces a number of separate laws and will cover all deposit-taking financial institutions. The debt recovery framework has been strengthened with the establishment of a Debt Recovery Tribunal (DRT). The tribunal provides for a time bound decision for debt recovery and is now considering a number of cases. In this regard, regulations clarifying action required prior to petition at the DRT have been issued. In addition, a new strengthened blacklisting directive was issued by the NRB in September 2003. To "reengineer" the NRB, a voluntary retirement scheme (VRS) has been implemented, all non-officer level vacancies eliminated, and salaries decompressed. To further strengthen monetary operations, the NRB has announced an issuance calendar for government securities and introduced one month and six months treasury bills. External management teams are working at the two largest, financially troubled commercial banks—Rastriya Banijya Bank (RBB) and Nepal Bank Limited (NBL)—and their financial performance is improving. To address overstaffing at these banks, VRSs have been announced.

• Public enterprise reforms. The government has divested its shareholding in a major power company. Privatization/liquidation of five public enterprises is well underway, with a further four enterprises identified for divestment. The government has been gradually increasing the state-owned enterprises being audited. Petroleum product prices have been adjusted to avoid losses at the Nepal Oil Corporation (NOC).

• Governance reforms. Several anti-corruption bills have been passed, a Special Court to tackle corruption cases was established, and the Commission for the Investigation of Abuse of Authority (CIAA) has initiated investigations against politicians and revenue officials. An anti-corruption strategy has been approved by the cabinet. Considerable work has also been done to improve public financial management and procurement, with World Bank support. Civil service reform is proceeding with the elimination of over 6,000 vacant posts, the introduction of a Personnel Information System (PIS), partial decompression of salaries, and implementation of the first phase of a VRS. On decentralization, the transfer of basic health and education services to local communities is underway.

• Nepal concluded negotiations for WTO accession on September 12, 2003. Nepal has made history by being the one of two less-developed countries to join the WTO by accession.

IV. Macroeconomic Objectives and Policies for 2003/04

A. Macroeconomic Objectives

10. The recovery is expected to gain strength in 2003/04. Real GDP growth is projected to rise to 3½ percent, with downside risks if a resumption of the ceasefire takes time. The recovery could be broad-based, with a rise in agricultural productivity and a rebound in manufacturing, although the prospects for tourism have worsened. Inflation is expected to stay around 5 percent as the exchange peg would help keep prices in line with developments in India. The current account deficit (excluding official transfers) is projected to widen to 1¾ percent of GDP, as imports rise to fuel the recovery. However, higher foreign aid, remittances and other inflows, should help the NRB meet the targeted increase in its net foreign assets of US$60 million to over US$1¼ billion by end-2003/04.

B. Fiscal Policy

11. The government's principal fiscal policy objectives are to raise the revenue-to-GDP ratio, improve the efficiency of public spending and reduce domestic borrowing. In line with understandings reached with the IMF, the medium-term fiscal framework aims to raise the revenue-to-GDP ratio to 13½ percent of GDP by 2005/06. Over this period, expenditure is projected to rise to 18¼ percent of GDP. The bulk of the increase will be in capital expenditure, in line with the prioritization set out in the MTEF. Current expenditure is set to rise in 2003/04 but then fall as the special factors which raise spending in 2003/04 abate (see next paragraph). With higher aid inflows, net domestic financing of the budget would be reduced to ½ percent of GDP in 2005/06. This path of budget financing will help to stabilize, and then reduce, the public debt ratio and create room to meet contingent liabilities which will need to be borne under the ongoing banking sector and public enterprise reforms.

12. The 2003/04 budget takes the first step in achieving these objectives. The budget targets a stable revenue-to-GDP ratio of around 12½ percent of GDP, with a major revision of a wide range of charges, fees and excises. The increase in current spending reflects larger allocations for clearance of domestic arrears and to meet contingent liabilities of SOEs undergoing liquidation, integration of off-budget funds into the budget, a contingency allocation for elections, and wage allocation for additional security personnel. Capital spending is expected to increase from the depressed level of 2002/03 as implementation constraints at the local level are overcome. Social sector spending will rise, with higher health and education spending. With higher aid flows, the net domestic financing target of 1¾ percent of GDP is achievable, but the government will stand ready to take additional revenue measures or expenditure cuts to limit domestic budget financing. In this context, the government intends to conduct and publish a mid-year review of the budget.

13. The government is also determined to achieve the fiscal targets beyond 2003/04. In particular, the VAT rate would be raised and tax exemptions eliminated to mobilize additional tax revenues and the government will keep a tight control over current spending. However, after a three year freeze, pressures for a civil service wage increase are mounting. To address these pressures within the agreed fiscal framework, savings in other areas would be required, including through downsizing of the civil service in the context of the Public Sector Management Program and reduction in security outlays. These elements will be incorporated in the 2004/05 budget.

14. The 2003/04 budget incorporates several important tax policy and administration reforms. These reforms, based on the government's Fiscal Reform Task Force and IMF recommendations, include: (i) elimination of one half of the special duty on imports and integration of this into customs duties and excises; (ii) reduction in some import duties offset by increases in excises; (iii) removal of the export service fee and a reduction in export taxes; (iv) elimination of the VAT exemption for edible oils; and (v) an increase in the income tax threshold.

15. Further fiscal reforms are envisaged to improve tax administration, prioritize spending and enhance fiscal transparency. The government's Task Force has made recommendations, consistent with IMF technical assistance, to expand the audit operations of the current office in the Inland Revenue Department into a full-fledged Large Taxpayer Unit (LTU) which covers collection and service functions as well. The government intends to make this LTU operational by mid-January 2004, and has secured further technical assistance from the IMF and donors to help make it into an efficient unit. The government is also looking forward to IMF technical assistance to help implement its three-year customs administration reform program, especially to improve customs valuation. Understandings on specific actions in this area can be reached during the first review of the program and will be incorporated in the 2004/05 budget which will be prepared in consultation with the IMF. On the expenditure side, steps are being taken to weed out low-priority projects in the MTEF, improve costing and budget classification, and extend prioritization to regular expenditure. The government will also limit the operation of special funds outside the budget and will not create any additional funds to enhance fiscal transparency and flexibility.

C. Monetary and Exchange Rate Policies

16. A key monetary policy objective of the NRB is to support the exchange rate peg to the Indian rupee. To achieve this objective, reserve money growth will be limited to 10½ percent, given the projected GDP growth and a broadly unchanged multiplier. The corresponding increase in broad money growth would be sufficient to allow real private sector credit growth of 9-10 percent and to meet budget financing needs from the banking system. However, the NRB intends to keep the peg under review, in view of the potential impact on external competitiveness of WTO accession and phasing out of the Multi-Fiber Arrangement by 2005. The NRB is committed to not taking exchange rate actions which generate unacceptable cross rate differentials under the IMF's Articles of Agreement.

17. The NRB is taking steps to improve monetary management and foster market development. Reserve requirements for commercial bank deposits were unified and the separate vault cash requirement has been eliminated. The NRB is strengthening its liquidity forecasting capability to help support implementation of reserve money programming. A separate high-level monetary policy committee will be established at the NRB. To make its open market operations more transparent, longer-term government bonds will be auctioned from the second half of 2003/04.

18. The NRB will issue directives to ease limits on commercial banks' interest rate and foreign exchange rate spreads and phase out lending requirements. By mid-January 2004, the permissible spread limits on published lending rates and foreign exchange buy/sell will be eliminated. The priority sector lending requirement will be eliminated by end 2005/06.

D. Structural Reforms

19. The structural reform agenda for the 2003/04 program under the PRGF Arrangement will focus on:

Financial Sector Reform

• With the BFI Ordinance in place, the NRB will focus on ensuring adherence with the strengthened provisions, including capital adequacy, licensing, corporate governance, insolvency and compliance with International Accounting Standards (IAS). The BFI Ordinance will be revised, if needed, by mid-April 2004 to make it consistent with registration and incorporation provisions in the new Company Ordinance.

• The government and NRB are fully committed to addressing the problems of the non-performing assets of banks and of willful default by borrowers. We will continue to support DRT operations and implement the strengthened blacklisting mechanism. The government is also committed to removing impediments to the transfer of cases from district courts to the DRT. These debt recovery efforts will also be supported by the establishment of a Credit Information Bureau as a public limited company to disseminate blacklisting and repayment record information.

• Reengineering of the NRB will be taken forward. The NRB's supervision and regulation capacity is being strengthened, with World Bank support. To strengthen supervision capacity, the NRB will aim to recruit skilled personnel for the Supervision Department, limit the transfer of qualified supervisors, and adopt a strengthened off-site supervision manual. The NRB will inspect each commercial bank at least once every two years. A new organizational structure of the bank will in place by mid-January 2004. Further to the remuneration decompression, performance incentives will be improved by new policies on merit-based promotion, transfers, and training to be introduced by mid-July 2004. A number of support services will be outsourced and a targeted VRS will be implemented to reduce staffing. A hiring freeze at the non-officer level will be continued. Privatization of the payments system is also under consideration. During 2003/04, the NRB will introduce IAS-compliant accounting manuals and chart of accounts, and upgrade the auditing manual to strengthen internal controls.

• Reforms at RBB and NBL will continue under the external management teams. These teams have made considerable progress in loan recovery and these efforts will have the full support of the government and NRB. The government recognizes that given the reform agenda facing the teams, an extension to their tenure will be necessary. To reduce staffing, VRSs will be implemented at RBB and NBL. If the schemes are unable to generate the expected separations, consideration will be given to extending the schemes or other means sought to achieve appropriate staffing levels at the banks. The government is seeking external financing to help defray the costs of the schemes. At the same time, in consultation with the World Bank and the IMF, the government is actively considering key strategic decisions—such as privatization as separate or merged entities—on the future of these banks, with the eventual goal of privatization during the arrangement period. The banks will also prepare IAS-compliant audited accounts for 2002/03 by mid-January 2004.

• The government will approve external audit reports and restructuring plans for Agriculture Development Bank of Nepal (ADBN) and the Nepal Industrial Development Corporation (NIDC) by mid-January 2004. Restructuring options would include liquidation, if needed, and introduction of professional management, financial restructuring, a phased reduction in overstaffing, and eventual privatization/commercialization.

Public Sector Reform

• The privatization/liquidation of five SOEs is expected to be completed by mid-July 2004, of which two enterprises would be privatized/liquidated by mid-January 2004. Preparation for privatization/liquidation of four other SOEs will be continued. The 2003/04 budget also announced divestment plans for Nepal Telecommunications Corporation, Royal Nepal Airline Corporation, and the National Life Insurance Corporation. An internal unbundling of Nepal Electricity Authority is also planned during 2003/04.

• Petroleum product imports will be opened up to the private sector to generate competition and improve the efficiency of NOC. To ensure that NOC does not incur losses, petroleum product prices will be adjusted on at least a quarterly basis to reflect cost conditions. The government will introduce an automatic petroleum pricing formula during 2003/04 , which will be published. An IAS-compliant audit of NOC's 2002/03 accounts by an international auditor will be completed by mid-July 2004.

• SOE reform efforts would aim to improve corporate governance, reduce the fiscal drain and manage contingent liabilities. In this regard, the boards of SOEs are being strengthened with the introduction of professional management. The cap on the aggregate employment in SOEs will be continued and lowered to reflect divestment that has been completed. Moreover, performance indicators and contracts will be established with the management of SOEs. A strong effort is also underway to update audits of all SOEs to international accounting standards.

• Civil service reform will continue to make the service more accountable and efficient. A further 4,000 vacant positions will be eliminated by mid-July 2004, and the freeze on recruitment for nongazetted positions will be maintained. The government is extending the PIS to teachers, connecting the PIS with the payroll, reducing transfers, outsourcing selected support activities to downsize lower level positions, and further decompressing salaries. Merit based wages will be introduced at selected government agencies during 2003/04. The civil service act will be amended in 2003/04 to strengthen provisions for merit based recruitment and promotion, performance appraisal, and VRS.

Governance Reforms

• Actions to improve accountability, financial management and transparency, and to tackle corruption feature strongly in the PRSP. During 2003/04, the anti-corruption strategy approved by cabinet in early 2003 will be developed further into a strategic action plan that includes priority actions, a timeframe for implementation, and indicators for monitoring progress. Resources for the CIAA will be increased and the government will also seek to enhance the capacity of the Special Court to ensure a more accelerated processing of cases.

• In the area of financial management and transparency, the government will implement the recommendations of the Country Financial Accountability Assessment and Country Procurement Assessment Reports prepared with World Bank support. A new procurement law based on international standards and procedures will be approved. The Fiscal Transparency Ordinance will be issued by mid-July 2004 which, among other things, would help make government procurement more transparent. New Financial Administration Regulations have also been prepared.

Private Sector Development

• Future trade reforms will focus on legal amendments to make the trade regime consistent with WTO accession. To increase transparency, the remaining security levy will be integrated into customs duties and excises. In addition, all import levies will be consolidated into a single customs duty with the highest rate of 35 percent. Export taxation will be phased out within two years by the 2004/05 budget.

• Corporate and financial governance reforms will be advanced by issuance of Secured Transactions Ordinance, Insolvency Ordinance and a new Company Ordinance in 2003/04.

• Draft amendments to relevant legislation to make labor employment more flexible will be finalized by mid July 2004.

E. Poverty and Social Impact Analysis and Monitoring

20. Further work on poverty and social impact analysis (PSIA) is envisaged. We expect the key reforms supported by the PRGF to have PSIA conducted with the support of the World Bank. The government is also committed to taking countervailing measures to protect the poor, such as through VRS schemes and provisions for retraining.

21. A monitoring framework for the PRSP is in place. A new poverty monitoring unit has been established in the National Planning Commission. The Nepal Living Standards Survey will be completed in 2003/04 and will provide the basis for monitoring MDG indicators. Strengthening the monitoring of public expenditures is a priority, and information on expenditures (and revenues) as well as physical performance of all high priority projects will be published each trimester. The first annual PRSP progress report will be produced by October 2004.

F. External Financing

22. We expect that the policy commitments elaborated in the PRSP and in this MEFP will help secure donor financing for the program. The financing gap for 2003/04 is estimated at US$90 million, of which US$70 million is expected from the World Bank's Poverty Reduction Support Credit. The remainder of the financing gap is to be filled by the PRGF arrangement.

G. Safeguards and Statistical Issues

23. The government is fully committed to the financial soundness of the NRB and to implementing the 2002 safeguards assessment report's recommendations. An external auditor with experience in auditing central banks is to finalize IAS-compliant 2002/03 NRB accounts by mid-February 2004.

24. The government recognizes the critical importance of producing timely and accurate statistics. During 2003/04, we will continue to implement IMF technical assistance recommendations.

H. Risks and Contingencies

25. There are risks to the program but we believe that these are manageable and that the reforms supported by the IMF and donors will help mitigate these risks:

• Progress in the peace talks is critical if growth and poverty reduction targets are to be met. Despite the recent setback in the peace process, we are making efforts to resume the negotiations. Furthermore, implementation of reforms that promote pro-poor spending and broad-based growth are expected to erode support for the insurgency.

• There are political uncertainties due to the impasse with the political parties. We are working to resolve this impasse. In the meantime, the risks of policy reversal from the impasse are limited as these parties have been consulted during the PRSP preparation process and the reform strategy has broad support among them.

• Adverse external developments could curb the effectiveness of reforms and require revisions to the macroeconomic framework. The main risks include a slower global recovery that would affect both demand for a narrow export base and tourism receipts, the impact of unpredictable weather patterns on agriculture, higher oil prices, and volatility in remittances. The PRSP is partly insulated against these risks through the inclusion of alternative macroeconomic scenarios. Moreover, the impact of the phasing out of the MFA and our accession to the WTO presents a number of urgent challenges for improving competitiveness, diversifying exports, and improving the investment climate.

• Implementation capacity may be a concern. The extensive reform agenda being supported by the international community will stretch capacity, and it will be a challenge to implement the development budget and the envisaged reforms. Significant technical assistance will continue to be required from donors. But we believe the PRSP sets ambitious yet realistic implementation targets and the existence of a dedicated core of senior officials in key ministries combined with the gradual decentralization of service provision will mitigate this risk.

26. There are also risks to the budget. The revenue targets will require a sustained effort to improve administration. On the expenditure side, the pressure for the civil service wage increase would have to be managed within the broad parameters of the fiscal framework. Shortfalls or delays in external funding would also complicate fiscal management. At the time of the mid-term budget review, the government will also decide whether additional revenue and expenditure measures are needed to meet the domestic borrowing ceiling. The government stands ready to take compensatory fiscal measures to keep the deficit within the budget target, including raising the VAT rate or reducing lower priority spending in line with the MTEF.

V. Program Monitoring and Review

27. Understandings have been reached with the Fund staff on the conditions for monitoring policy implementation under the program. The program period supported by the PRGF arrangement will begin in July 2003. Prior actions, a set of quantitative performance criteria for mid-January 2004 and mid-July 2004 and structural performance criteria and benchmarks are detailed in Tables 1 and 2.

28. The government is aware that the first review under the PRGF arrangement is scheduled to be completed by end-April 2004, and will be conditional on the observance of mid-January 2004 performance criteria. This review will focus on progress in reforms in areas discussed in this memorandum, as well as progress in developing the next phase of policy measures in these areas. Performance criteria, indicative targets, and precise definitions of quantitative variables monitored under the program are set out in the attached Technical Memorandum of Understanding (TMU). The government will make available to IMF staff all core data, appropriately reconciled and on a timely basis, as specified in the TMU. The nonaccumulation of external payment arrears will constitute a continuous performance criterion, as will the standard injunctions against overdue financial obligations to the IMF, imposition or intensification of restrictions on current payments, multiple currency practices, conclusion of bilateral payments agreements inconsistent with Article VIII, and imposition or intensification of import restrictions for balance of payments purposes.

1. This memorandum sets out the framework for monitoring the PRGF-supported program for 2003/04. It specifies quantitative performance criteria and indicative targets and the content and frequency of the data to be provided for monitoring the financial program. All foreign currency nondollar denominated quantities under the program will be converted into U.S. dollars at program exchange rates specified in Table 1. A description of selected structural performance criteria and benchmarks is also provided.

I. Quantitative Performance Criteria and Indicative Targets

A. Net Foreign Assets of Nepal Rastra Bank

2. Net foreign assets (NFA) of the Nepal Rastra Bank (NRB) is defined as the difference between market value of gross foreign assets and liabilities, at program exchange rates. Gross foreign assets of the NRB consist of monetary gold, foreign currency balances at the NRB, foreign exchange balances held outside Nepal, foreign securities (valued at market prices), foreign bills purchased and discounted, IMF reserve position and SDR holdings. Excluded from gross foreign assets will be participation in international financial institutions and holdings of precious metals other than monetary gold. Gross foreign liabilities are all foreign currency denominated liabilities and use of Fund credit.

3. The NFA floor will be adjusted downward/upward by the shortfall/excess of the identified foreign program financing as set out in Table 2. Foreign program financing is defined to include adjustment loans from multilateral creditors other than the Fund, budget support from bilateral creditors, loans (if any) from private creditors (including commercial banks) and rescheduling of medium- and long-term public and publicly-guaranteed debt.

B. Net Domestic Assets of NRB

4. Net domestic assets (NDA) of the NRB is defined as the difference between reserve money and rupee value of NFA of the NRB, at program exchange rates. NFA of the NRB is defined above; reserve money is defined in Section C.

5. The NDA ceiling will be adjusted downward/upward by the excess/shortfall of the identified foreign program financing as set out in Table 2. External program financing received for financial and public sector reforms over the amounts identified in Table 2 would not lead to a downward adjustment of the NDA ceiling. The upward adjustment in the ceiling due to a shortfall in external program financing compared to Table 2 would be capped at Nrs 5 billion (around 1 percent of GDP).

C. Reserve Money of the NRB

6. Reserve Money (RM) of the NRB consists of currency in circulation outside the NRB, deposits of commercial banks at the NRB, and other deposits at NRB. As of mid-July 2003, RM defined in this manner stood at Nrs 81.0 billion.

D. Net Domestic Financing of the Central Government Budget

7. Net domestic financing (NDF) of the budget is defined as net credit to the government (NCG) by the banking system (NRB and deposit money banks (DMBs)) and net change in holdings of treasury bills and other government securities by the non-bank sector. The flow NDF of the budget would be the cumulative change in book value from mid-July 2003 in the sum of the following government debt instruments: (i) treasury bills; (ii) development bonds; (iii) national and citizen savings certificates; (iv) special bonds (including duty drawback bonds); and (iv) loans and advances from the NRB and deposit money banks (DMBs) minus government deposits with NRB and DMBs. This stock stood at Nrs 84.2 billion at mid-July 2003. Central government is defined here to include line ministries, departments and public institutions.

8. The ceiling on net domestic financing will be adjusted upward/downward by the shortfall/excess of rupee equivalent of foreign program financing as set out in Table 2. External program financing received for financial and public sector reforms over the amounts identified in Table 2 would not lead to a downward adjustment of the NDF ceiling. The upward adjustment in the ceiling due to a shortfall in external program financing compared to Table 2 would be capped at Nrs 5 billion (around 1 percent of GDP). The ceiling on net domestic financing will be adjusted upward/downwards by 50 percent of the amount of any shortfall/excess in privatization receipts beyond the programmed amounts (Table 3).

E. Central Government Revenue

9. Central government revenue is defined as reported in the treasury accounts (economic classification), excluding principal repayments to the budget by corporations and including privatization receipts. The floor on central government revenue is cumulative from the start of the fiscal year. The central government revenue benchmark will be adjusted upwards/downwards by 50 percent of the excess/shortfall in privatization receipts.

F. Contracting or Guaranteeing of New Nonconcessional External Debt

10. Contracting or guaranteeing of new medium- and long-term nonconcessional external debt is defined as contracting or guaranteeing new nonconcessional external debt by the central government and the NRB with an original maturity of more than one year (valued at program cross exchange rates as defined in Table 1). Nonconcessional debt is defined as borrowing containing a grant element of less than 35 percent on the basis of currency-specific discount rates based on the OECD commercial interest reference rates. For maturities of less than 15 years, the grant element would be calculated based on six-month CIRR averages, while for maturities longer than this, the grant element would be based on ten-year CIRR averages. This performance criterion applies not only to debt as defined in point No. 9 of the Guidelines on Performance Criteria with Respect to Foreign Debt (Decision No. 12274-(00/85), August 24, 2000) but also to commitments contracted or guaranteed for which value has not been received. Excluded from this performance criterion are credits extended by the IMF and financing from the World Bank and Asian Development Bank (AsDB), and government counter guarantees on project loans from both the World Bank and AsDB, as well as changes in indebtedness resulting from rescheduling operations or rollovers. Debt falling within the limit shall be valued in U.S. dollars at the exchange rate prevailing at the time the contract is entered into, or guarantee issued.

G. Contracting or Guaranteeing of Short-Term External Debt

11. Stock of short-term external debt outstanding is defined as debt with original maturity of up to one year owed or guaranteed by the NRB and central government (valued at programmed cross exchange rates as defined in Table 1). This debt will also include foreign currency denominated loans and bonds contracted with residents. The term debt is defined as set forth in point No. 9 of the Guidelines on Performance Criteria with Respect to Foreign Debt (Decision No. 12274-(00/85), August 24, 2000), but excludes normal import-related credits.

H. Accumulation of External Payment Arrears

12. The program's performance criterion on nonaccumulation of external payment arrears is continuous throughout the program period. External payments arrears are defined as overdue payments (interest and principal payments) on short-term debt in foreign currencies with an original maturity of up to and including one year (spot, money market, letters of credit) and medium- and long-term debt contracted or guaranteed by the government. As of mid-October, there were no reported external payment arrears.

II. Data Reporting Requirements

13. For the purpose of monitoring the performance under the program, data will be provided in the format shown in Tables 4-9. Nepal shall provide the Fund, through reports at intervals or dates requested by the Fund, with such information as the Fund requests in connection with the progress of Nepal in achieving the objectives and policies set forth in the letter. All the program monitoring data would be provided by the Ministry of Finance and the NRB. Data on gross foreign assets and gross foreign liabilities would be provided at market prices. All the data relating to the above programmed targets will be furnished within 8 weeks after the end of each test date.

Table 4. Net Foreign Assets of Nepal Rastra Bank

Table 5. Balance Sheet of Nepal Rastra Bank

Table 6. Net Domestic Financing of Central Government Budget

Table 7. Central Government Revenue

Table 8. Contracting or guaranteeing of new medium and long-term nonconcessional external debt by the central government and NRB

Table 9. Contracting or guaranteeing of short-term external debt by the central government and NRB

III. Structural Performance Criteria and Benchmarks

1. Take actions towards establishment of a large taxpayer unit (LTU) in the Inland Revenue Department (IRD)

The following actions would constitute observance of the performance criterion.

i. Cabinet approval of the organizational structure and staffing of the LTU;

ii. MOF approval of financial allocation for the LTU to fund its development, implementation and operation in 2003/04 and 2004/05;

iii. IRD selection of taxpayer files to be managed by the LTU and transfer of relevant accounts, records and files to the new unit;

iv. IRD identification, appointment and transfer to the LTU at least 50 percent of the total staff approved for full operation of the unit; and

v. IRD identification, acquisition and possession of accommodation for the LTU.

2. Implement voluntary retirement schemes (VRS) at Nepal Rastra Bank, Nepal Bank Limited and Rastriya Banijya Bank

Definition of actions

Implementation of the VRS comprises all of the following:

i. announcement of the scheme, including benefits, eligible staff, and an application deadline;

ii. receipt of applications from employees; and

iii. notification to accepted applicants, including terms of severance.

If, in any entity implementing the VRS, the number of applications received is less than the expected reductions in staff, the entity's scheme would be revisited at the time of the first review. A decision would be made to extend the scheme, change its coverage, or other means of staff reduction will be identified. In this context, the performance criteria for the second review will be set.

Schedule of actions

Nepal Rastra Bank

By March 15, 2004. Implement a VRS targeted at non-officer levels. The expected reduction in non-officer staff is 400.

Nepal Bank Limited

The NBL announced a VRS on September 17, 2003. The application deadline is November 7, 2003. Employees with longer than 20 years of service are eligible. The expected staff reduction under the scheme is 1,000.

By January 15, 2004. Implement the VRS scheme.

Rastriya Banijya Bank

The RBB announced a VRS on September 15, 2003. The application deadline is November 16, 2003. RBB intends to implement the scheme in two phases. Phase I is targeted at employees with service above 20 years; Phase II would be applicable to service periods of 15-19 years and to specific functions that are overstaffed. The expected reduction under Phase I is 800; the expected reduction under Phase II is 1,000.

By January 15, 2004. Implement Phase I of the VRS scheme.

By March 15, 2004. Implement Phase II of the VRS scheme.

2. Liquidation/privatization of state-owned enterprises (SOEs)

SOEs under consideration

Bhaktpur Brick Factory; Cottage and Handicrafts Emporium; Nepal Coal Limited; Nepal Transport Corporation; Hetauda Textile Factory; Birgunj Sugar Factory; Agriculture Tools Factory; Nepal Rosin and Turpentine Limited; and Himal Cement Company

Definition of actions

Liquidation. Settlement of all liabilities. Commencement of liquidation means appointment of a liquidator and initiation of settlement of liabilities.

Cabinet approval of privatization. Cabinet approval of sale and purchase agreement (SPA). The SPA must include the chosen buyer, final price and other financial and technical understandings between the government authority and the private buyer. The SPA would have been previously endorsed by the Privatization Committee. Commencement of privatization means endorsement of the SPA by the Privatization Committee.

Schedule of actions

By January 15, 2004. Cabinet approval of privatization or liquidation of two SOEs.

By July 15, 2004. Cabinet approval of privatization or liquidation of five SOEs. Commence privatization or liquidation of remaining four SOEs

3. Strengthening Nepal Rastra Bank

Re-organization of the NRB

The NRB's corporate reorganization will be completed by January 15, 2004. This reorganization will be based on a proposal of the NRB's internal Reengineering Committee, issued on March 1, 2002. The new corporate structure will maintain the Committee's recommendation to classify the NRB's functional activities into four groups (monetary policy, banking operations, supervision, and administration) in addition to offices/departments directly supervised by NRB Governor including in the areas of internal audit and corporate planning.

Human Resource Policies

The NRB Board will approve new polices on human resource management. These policies will be issued by July 15, 2004. The following points will be included:

Performance appraisal, recruitment and promotion. Performance appraisal, especially of department heads and other senior officers, will be conducted at least once a year. The NRB will move towards ensuring that all new openings at higher levels are announced both internally and externally to attract qualified people. Provisions will be made for merit-based recruitment and promotion. It is expected that less preference will be given to seniority in internal promotion decisions. A new code of staff conduct, including provisions on staff rules on taking external assignments, will be developed.

Transfers. Specialist positions and career paths in the NRB will be clearly identified to maintain functional continuity and build expertise. Tenure requirements in these positions will also be clearly identified. Assurances will be provided that satisfaction of the tenure requirements, subject to satisfactory performance, will not adversely affect the staff member's promotions and compensation prospects.

Training. Candidates for internal and external training would be selected based on relevance of training for the candidates' current or announced future assignments. Following training, the candidates would remain in the originating department for at least two years to utilize and disseminate acquired expertise.