Mr. Rodrigo de Rato
Managing Director
International Monetary Fund
Washington, D.C. 20431

Dear Mr. de Rato:

The Government of Bangladesh is committed to implementing the reform strategy set out in our Interim Poverty Reduction Strategy Paper (I-PRSP), endorsed by the IMF Executive Board together with the approval of the arrangement under the Poverty Reduction and Growth Facility (PRGF) in June 2003. This strategy is aimed at moving the economy onto a path of higher sustainable growth with job creation, and faster poverty reduction. It will be further defined in the Poverty Reduction Strategy Paper (PRSP) that is to be completed by end-2004.

Based on discussions for the second review under the PRGF arrangement with the Fund staff in February and May 2004, the attached Memorandum of Economic and Financial Policies (MEFP) assesses economic and policy performance through May 2004 under the arrangement, updates the macroeconomic framework, and discusses the financial policies and structural reform program through June 2005. It supersedes the MEFP dated June 4, 2003.

In view of newly available data, and drawing on a recent study by IMF staff on the potential impact of the impending expiry of the WTO Agreement on Textiles and Clothing at the end of 2004, the outlook for our balance of payments has considerably worsened entailing additional financing need. While the Government has strengthened policies to mitigate this adverse impact, additional financial assistance is still required and therefore, we hereby request the activation of the Fund's Trade Integration Mechanism (TIM) and an augmentation of access under the PRGF arrangement by 10 percent of quota or the equivalent of SDR 53.33 million, in accordance with the TIM. We would then, by the activation of the TIM, be able to request a further augmentation of access under the PRGF arrangement in accordance with the TIM, if the actual balance of payments effect is larger than anticipated under the revised baseline.

All quantitative performance criteria for end-March 2004 were observed. Although the structural performance criteria on the Central Intelligence Cell (CIC) and relating to bank-by-bank resolution strategies for the nationalized commercial banks (NCBs) were missed, corrective actions have now been taken. The CIU is now fully functioning, and bank resolution strategies are being adopted by the Government at the latest before the completion of the second review. On this basis, and in view of the policies set out in the attached memorandum, including the strengthening of tax administration and stepped up reform of the NCBs, the Government requests waivers for the nonobservance of these structural performance criteria and the completion of the second review.

The Government of Bangladesh will provide the Fund with such information as the Fund may request in connection with progress in implementing the economic and financial policies, and achieving the objectives of the program. The Government believes that the policies set out in the attached MEFP are adequate to achieve the objectives of the program, but it will take any further measures that may become appropriate for this purpose. The Government of Bangladesh 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.

Sincerely yours,

BANGLADESH

Memorandum of Economic and Financial Policies for Fiscal Year 2005

July 8, 2004

I. Introduction

1. The BNP-led government adopted in June 2003 a reform strategy to move Bangladesh to a higher growth path and faster poverty reduction, as spelled out in its Interim Poverty Reduction Strategy Paper (I-PRSP). This strategy is being supported by a three-year arrangement under the Poverty Reduction and Growth Facility (PRGF). This memorandum assesses economic performance under the first year of the arrangement, updates the medium-term policy framework, and lays out the objectives and policies that the government intends to pursue in FY05.

II. Performance Under the First-Year Program

2. The economic recovery that began in FY03 strengthened further in FY04, although inflation has picked up. Driven by both domestic and external demand, real GDP growth is likely to accelerate to 5.5 percent, from 5.3 percent in FY03 (MEFP Table 1). Activity in the industrial and services sectors and exports have all rebounded. However, due mainly to higher imported food prices, inflation rose in late 2003 but has leveled off more recently to about 6 percent; nonfood inflation remains moderate. The inflation target for the year has therefore been raised to 6 percent.

3. Macroeconomic management remains cautious and all quantitative targets for end-December and performance criteria for end-March were met (MEFP Table 2). On the fiscal side, in response to somewhat weaker-than-targeted revenue performance in the first half of FY04, we have stepped up efforts to meet the programmed revenue target, and have trimmed ADP spending relative to the budget. We have revised the FY04 budget to trim the overall deficit to 4.2 percent of GDP, from 4.8 percent programmed.

4. The original revenue target (an effort for the year of Tk 45 billion) has been underpinned by a more vigorous implementation of tax administration measures. We also recognize that revenue performance hinges on improved capacity in the NBR. Intensified efforts are being made to collect VAT in the retail sector, and to ensure steadfast functioning of the new Large Taxpayer Unit (LTU) for income tax; some 80 selected LTU cases have been audited and additional collection has begun. Furthermore, although the target for making the Central Intelligence Cell (CIC) fully operational (an end-December 2003 structural performance criterion) was missed, corrective actions have been taken. The organization chart has now been approved, budget allocation and staffing have been arranged, and the identification of potential evaders and monitoring of 35 large taxpayers has begun. In addition, a new information base has been set up to detect large taxpayers that have escaped the tax net for follow up enforcement.

5. On the expenditure side, current spending has been broadly in line with the budget, with lower interest payments offset by higher transfers to enhance school teacher compensation and social safety net. Given the slow pace of Annual Development Program (ADP) spending in the first half of the year, efforts have been stepped up following issuance of instructions to operationalize the procurement guidelines. At the same time, ADP spending in lower priority areas has been reduced by 0.4 percentage point of GDP relative to the program to safeguard the quality of spending.

6. Monetary policy remains prudent. Even though the uptick in inflation appears to have stemmed mainly from external factors, we believe a cautious monetary stance is warranted. Thus, following the staff advice in February, and in view of the slower-than-anticipated growth in private sector credit, for FY04 Bangladesh Bank (BB) has tightened policy relative to the program by reducing the June targets for broad money and private sector credit. The limit for banking system credit to the government has also been scaled back, in line with the lower revised budget deficit. With continued remittance inflow, BB's open-market operations have been active, keeping excess reserves and reserve money growth within the target range. Furthermore, the primary dealer system for government securities was launched in December and the functioning of the interbank market has been strengthened.

7. Meanwhile, the external sector is recovering, and external debt management has been cautious. Exports grew by 15½ percent during the first ten months of this fiscal year, led by ready-made garments (RMG) and frozen food. Import growth, mainly for the RMG sector, was also buoyant, while remittances remain strong. In addition, the contracting of new nonconcessional debt has been kept well below the program limits. Overall, as a result of slower-than-anticipated aid disbursements, especially some temporary delays in the disbursement of program loans from the World Bank, and the pickup in imports, the foreign exchange market has tightened in recent months, leading to a slowdown in the accumulation of reserves. Overall, the level of reserves reached $2.7 billion by end-June 2004 (2.7 months of import cover). Finally, external competitiveness has been boosted as the effective exchange rate has depreciated by 3 and 6 percent, respectively, in real and nominal terms since the taka was floated in May 2003.

8. Good headway has been made on the structural agenda, but slippages in some areas subject to the program's structural performance criteria and benchmarks have been unavoidable, in part due to capacity constraints (MEFP Table 3). On tax administration in particular, as noted above, both the newly expanded LTU for income tax and the CIC have been in operation after initial delays, although teething problems continue. The bonded warehouse system has been revamped, broadly as envisaged, although the bank guarantee requirements for imports for domestic consumption have been stayed by the High Court. In addition, progress has recently been made in expanding the audit program to cover 80 cases (a benchmark for March 2004), but because of capacity constraints, the original target of 1,000 new cases now appears highly unrealistic.

9. With respect to the Nationalized Commercial Banks (NCBs), their performance under Memoranda of Understanding (MOUs) with BB has been satisfactory. However, the final stages for strengthening bank management proved protracted. While the selection of a sales adviser for Rupali was broadly on track, the appointment of a new management team for Agrani (an end-January benchmark) was delayed. Similarly, the process for selecting management support teams for Sonali and Janata (an end-May benchmark) is going forward, albeit with some delays. Finally, adoption of bank-by-bank resolution strategies (a structural performance criterion for end-April) had been delayed.

10. Following substantial efforts last fiscal year, closure of state-owned enterprises (SOEs) in manufacturing has essentially stalled due to stiff opposition of vested interests and in spite of the availability of severance payments to affected workers. Nonetheless, loss-making SOEs have been encouraged to downsize. Moreover, kerosene price was raised by 17 percent in May, in response to higher world oil prices in line with the automatic pricing formula agreed with the World Bank and to bring it in line with diesel prices to curb adulteration of diesel. With this adjustment, losses of Bangladesh Petroleum Corporation (BPC) have been reduced, although they remain significant (0.3 percent of GDP for FY04) in view of the high world oil prices. However, for SOEs in the energy sector, their financial performance has been a concern, especially in the case of Dhaka Electricity Supply Authority (DESA)-its stock of arrears to other SOEs rose by 40 percent to 2 percent of GDP during the last 18 months.

III. Medium-Term Outlook

11. Notwithstanding the difficult political environment, the government remains committed to the reform strategy for a private sector-led growth and poverty reduction, as outlined in our I-PRSP. Preparations for a full PRSP have begun, and we aim to complete this by end-2004 on target. A National Steering Committee has been formed to lead this effort, and twelve interministerial working groups are to produce inputs for the PRSP by June. In addition, consultations at the regional and national levels and with donors have been held. We intend to strengthen the consultative process to ensure a genuine national ownership. In addition, attention will be given to costing and incorporating pro-poor policies into a medium-term expenditure framework.

12. We have updated the medium-term macroeconomic framework to factor in risks in the external outlook. Inflation risk has risen with the edging up of world commodity prices, but the key risk stems from the lifting of MFA quotas at end-2004. RMG exports have been buoyant due to strengthened competitiveness, especially in the duty-free EU market, and fresh investment has been made in the sector. However, Bangladesh is vulnerable due to its heavy dependence on RMG exports and on quota preferences. Without a decisive policy response, the possible adverse BOP impact of the lifting of MFA quotas on Bangladesh could be on the order of $1.4 billion during FY05-06 (or an average of 1 percent of GDP per year), in line with Fund staff estimates. To mitigate this impact, reform elements under the PRGF to reduce the cost of doing business and to enhance competitiveness will be critical, as described below. Of particular importance will be maintenance of a flexible exchange rate, significant reduction in anti-export bias through trade reform, concerted efforts to improve the investment climate, and prudent financial policies.

13. To complement this strategy and to strengthen the economy's competitiveness and resilience, a high-level National Coordination Council under the Prime Minister's office has now been set up to define an action plan for the export sector. In particular, we intend to reduce the cost of doing business by streamlining administrative procedures and licensing requirements, open up the RMG sector to foreign direct investment, further liberalize the import regime, and adopt other measures to assist the RMG sector in the post-MFA era. The latter measures include: (i) a skill development program for workers and managers in the RMG sector; (ii) retraining programs for displaced workers; and (iii) a capacity-building program for SMEs who are most at risk, especially in technology and marketing.

14. Particular care will be taken to avoid picking winners and to keep the cost to the budget to a very minimum. To support overall policy adjustment and to meet the impact of the MFA quota phase-out on the balance of payments and the budget, we are seeking additional external assistance, including through the Fund's Trade Integration Mechanism and complementary assistance from the World Bank and ADB in particular.

15. The original medium-term macroeconomic framework under the PRGF has been adjusted to incorporate the policy response to post-MFA challenges. Real growth has been revised to 5.5 percent in FY05 and to 6 percent in FY06, with inflation falling to 5 percent. The external current account deficit is projected to widen to 1.4 percent of GDP by FY06, and gross official reserves kept at close to three months of import cover.

A. Fiscal Policy and Reform

16. Our fiscal strategy remains to protect fiscal sustainability while supporting growth and poverty reduction. To this end, we are making strong revenue efforts by expanding the tax base, reducing and rationalizing trade taxes, and improving tax administration. Expenditure management is also being strengthened to ensure increased spending on high-quality projects for infrastructure and the priority social sectors. We intend to address the key structural fiscal problems, so as to contain public debt to under 60 percent of GDP, inclusive of the potential cost of SOE/NCB reforms, which is the key risk factor. This debt ratio is judged manageable as half of debt is external on highly concessional terms.

17. For FY05, the budget will be set consistent with this medium-term fiscal strategy. The overall deficit will be contained to 4.3 percent of GDP, and domestic financing capped at Tk 71 billion (1.9 percent of GDP). A further revenue effort of 0.5 percentage point of GDP is being targeted, and the implementation of ADP projects is to be stepped up. Measures to strengthen both tax administration and policy will be required. These measures will draw on the recommendations of FAD technical assistance, more recent work by the World Bank staff on a medium-term strategy to modernize the NBR, and DFID technical assistance under its RIRA project.

18. Strengthening tax administration will remain a top priority. For FY05, we will give particular attention to ensuring continued effectiveness of those measures that have been introduced so far this fiscal year. In addition, we will ensure adequate preparations so as to put in place on schedule an expanded LTU system covering the VAT and withholding income tax (a performance criterion for end-September 2004). In particular, the LTU coverage of the VAT will be set at a minimum of 50 percent of total VAT collections by NBR, covering at least the 100 largest VAT filers. In addition, enforcement will be enhanced, including by setting up a commissioneriate for enforcement and by stiffening penalties for noncompliance. Furthermore, nationwide inspections in the retail sector to enforce compliance with VAT have been launched, and legislative amendments will be made to strengthen enforcement and self-assessment. We will seek further technical assistance in tax administration.

19. On tax policy, the key priorities are to expand the tax base, simplify the tax system, make it more efficient, and improve compliance. Most important, in the context of the FY05 budget, trade taxes have been rationalized and reduced (see ¶ 24 below). Such rationalization should strengthen compliance, reduce the scope for leakage, and improve collections. Nonetheless, we have taken steps to protect revenue by taking compensating measures. These include reducing the scope of tax holidays and bringing additional taxpayers into the tax net. In particular, the existing tax holiday facility will be allowed to lapse at end-June 2005 and will be replaced by a more rational system for investment incentives in consultation with the Fund in the context of the FY06 budget. Drawing on the recommendations of the Revenue Commission, the VAT net has been expanded to include more services and VAT enforcement for products at import and domestic level has been strengthened. We will refrain from inter-year changes in tax rates. Looking beyond FY05, we will seek assistance of an FAD tax policy mission to follow up on reform priorities in line with the medium-term tax policy strategy.

20. On the expenditure side, the budget will incorporate a further reordering of priorities to favor pro-growth and pro-poor spending. Accordingly, it will aim at obtaining a better balance between recurrent and capital spending, focusing on providing adequate maintenance spending for physical infrastructure and for the MDG-related social sectors. Subsidies relative to GDP will be contained at current levels, but pro-poor spending is estimated to increase further by 0.8 percentage point of GDP to reach 7.4 percent of GDP. Close tracking of priority spending will be continued. Nonetheless, ADP spending needs to be better managed so as to enhance its quality and poverty impact. In this regard, we will draw on the recommendations of the ROSC for Bangladesh in order to strengthen the management of foreign-financed projects, while fostering fiscal transparency and accountability, and will seek further FAD technical assistance on expenditure management.

21. We will make best effort to promote domestic nonbank financing, while aligning interest rates on National Savings Certificates (NSCs) with comparable market instruments. In particular, we will take steps to ensure ready availability of NSCs, and will seek MFD technical assistance to actively build the nonbank treasury bill market. Moreover, the recent reduction in NSC interest rates has been extended to postal savings certificates, and the next phase of rate reductions on all NSC instruments will be implemented effective July 16, 2004, prior to the completion of the second review. Finally, we are contemplating a special window for limited access by pensioners and widows to NSCs at above-market interest rates as a form of social safety net. This mechanism will be designed to minimize the scope for abuse, by requiring registration and proof of identity, and by providing for modest transaction limits and restricted sale outlets.

B. Monetary and External Sector Policies

22. The monetary stance will continue to be aimed at balancing the support for economic growth while containing inflation. For FY05, the monetary program is aimed at limiting growth in banking system credit and M2 to 12½ percent, while further building up reserves. With MFD technical assistance, further steps are envisaged to improve the functioning of the interbank and treasury bill markets to help reduce interest rate spreads and improve intermediation. In particular, the primary dealer system will be strengthened by rationalizing the tax treatment of interest income and improving the incentives for dealer participation in order to facilitate the development of a secondary market for treasury bills.

23. We are committed to the floating exchange rate regime, which will be the first line of defense against the potential shock from the lifting of MFA quotas. Interventions will be confined to countering disorderly conditions and building reserves to the programmed level. Following technical assistance from LEG and MFD, we have examined the possible removal of the remaining exchange restrictions subject to Fund jurisdiction (transfer of funds from nonresident taka accounts and restrictions on advance payments for imports). Regulatory safeguards are being developed to prevent illegal transactions and limit the scope for capital outflows. We intend to remove the restriction to the advance import payments by end-December 2004, and the restriction with respect to the nonresident taka account will be reviewed by end-June 2005.

24. More concerted efforts are being taken to reform the trade system in order to improve competitiveness and reduce anti-export bias. Starting in FY05, tariff incidence will be reduced by 3½ percentage points, from an estimated 24.5 percent in FY04, through a significant reduction in the level and dispersion of customs and supplementary duties. For customs duties, the FY05 budget has provided for a three-tier structure, with a maximum rate of 25 percent. For supplementary duties, the number of rates has been reduced from seven to three, and the maximum rate reduced to 30 percent; higher rates will be maintained for luxuries and special items (automobiles, and arms and ammunition). With effect from April 2004, we have significantly reduced the number of products subject to quantitative restrictions from 122 to 63. We intend to further phase out quantitative restrictions for reasons other than environmental, security, religious, except for poultry, fishing net, and salt, and replace them with appropriate tariff duties. At the same time, import licensing requirements will be streamlined to improve the investment climate. In order to make the RMG sector resilient, we intend to significantly reduce restrictions to the import of textiles outside of the back-to-back LC regime.

C. Reforming the Nationalized Commercial Banks

25. The NCB reform strategy is aimed at containing the core macroeconomic risks and is two-pronged: stemming the flow of nonperforming loans through a strengthening of bank management, and developing and implementing bank-by-bank strategies to resolve the longstanding problems of these banks. Accordingly, MOUs have been signed that restrict net lending, prohibit large unsyndicated loans, and oblige the banks to expedite loan recoveries.

26. We are taking steps to advance the process of strengthening bank management to redress the slippages so far. In particular, the sales adviser for Rupali has now been appointed and the final contract signed, and the retendering for the management support team for Janata is proceeding on course. Moreover, the contract for management support for Sonali has been signed, and the contract for the new management team for Agrani is expected to be signed by end-July. Furthermore, the MOUs have been extended to end-2004 and strengthened to include explicit targets for cash recoveries from the 20 largest defaulters of each NCB, targets on reductions of operating expenses, and implementation of Bangladesh Bank's core risk management guidelines by end-June 2004.

27. Bank-by-bank resolution strategies have been finalized in consultation with Bank and Fund staff (attachment), and have been adopted by the Government. Under these strategies, three NCBs (Rupali, Agrani, and Janata, for a combined market share of 25 percent) will be brought to the point of divestment in full or in part in sequence over the period 2004-06. Safeguarding the integrity of the divestment process is an overriding concern given the governance issues in the NCBs.

28. On Sonali, the largest NCB (17 percent market share), a restructuring strategy is being pursued, aimed at putting this bank on a commercial footing and on a path to partial divestment over the medium term. We believe an early partial divestment is not advisable given Sonali's central role in the provision of Treasury functions and essential banking services for the rural sector. The strategy for Sonali is thus designed to effectively contain its problems through strengthening management, revamping the board of directors, and, in the context of an enhanced MOU, further containing its commercial lending operations and stepping up NPL recoveries.

29. BB's supervision of banks, both state-owned and privately owned, will be strengthened. Off-site inspections are being intensified to ensure compliance with prudential regulations. We are also moving toward adopting international standards on loan classification and restructuring and the treatment of contingent liabilities and accrued interest, in line with recommendations made by the FSAP.

D. SOE Reform

30. We recognize the need to regain the momentum for reforming SOEs in manufacturing as soon as practicable. Accordingly, we are in the process of closing an additional five SOEs and we aim to significantly downsize loss-making SOEs. Budgetary support to them will not be extended nor will new bank credit for capital spending. Retrenched workers will receive severance packages, and to prevent the "revolving door" problem, no new hiring will be allowed. In addition, lending from NCBs to loss-making SOEs will be tracked more closely by requiring MOF approval of all new loans and regular reporting to BB.

31. In consultation with the World Bank, domestic prices for petroleum products, in particular diesel, will be kept under very close review and adjusted in July 2004, taking account of international oil prices and the need to reduce the losses of BPC. In addition, an Energy Regulatory Commission is expected to be created to provide a framework for reforming the energy sector SOEs. We intend to define a reform plan with assistance from the World Bank, to address the serious infrastructure bottlenecks and to stem arrears in this sector. For DESA, effective measures to reduce system losses, improve bill collection, and resolution of its arrears will be the key components of the agenda.

E. Other Issues

32. Further progress will be made in addressing the critical recommendations under the Fund's safeguards assessment. In particular, BB's financial statements for FY04 will reflect additional progress in implementing international financial reporting standards, and will be audited in accordance with international auditing standards by a local firm affiliated with an international firm and signed off by the latter. We will publish the 2004 and all future audit opinions together with the corresponding financial statements. Monetary data reported to the Fund will also be reconciled against BB's audited financial statements and reviewed by the external auditors as part of this annual audit. Furthermore, as part of its medium-term effort to build capacity and with MFD technical assistance, BB will strengthen its foreign reserves management control framework, adopt and implement a plan for strengthening internal audit functions, upgrade accounting skills and standards, and establish appropriate reporting lines.

33. Faster progress with economic governance is crucial for improving the investment climate. Reform measures in NCBs and tax administration, in particular, bear directly on governance and when firmly implemented they should have a lasting impact. Beyond these, actions to reform the energy sector and the police will be important. Furthermore, the Anti-Corruption Commission (IACC) Act was passed by parliament in February and the chairman has been appointed. We are developing an anti-corruption strategy and we plan to soon draw up an action plan to make the IACC functional and effective. Technical assistance in this area is being provided by the World Bank, the Asian Development Bank, and USAID.

34. With regard to program monitoring, quantitative performance criteria have been set for end-September 2004, targets for end-December 2004, and indicative targets for the remainder of FY05. Key benchmarks and structural performance criteria for the remainder of FY05 center on fiscal and NCB reforms, are in MEFP Table 3 and prior actions are in MEFP Table 4. The third and fourth PRGF reviews are proposed to be completed by December 2004 and June 2005. Quarterly visits by the staff will continue. In addition, technical assistance, coordinated closely with the World Bank, will remain essential to help build capacity, especially in tax administration and NCB reform.

NCB Resolution Strategies

1. End-game strategies

The government is committed to divesting in whole or in part all four Nationalized Commercial Banks (NCBs) over the medium term. Accordingly, we intend to implement the following end-game strategies:

(i) Rupali: Financial advisor (FA) to be appointed and the bank is to be brought to the point of divestment by end-2004 based on the options recommended by the FA by end-2004.

(ii) Agrani: Corporatize and by end-2005 bring it to the point of divestment where it can attract a strategic partner to bid for substantial shareholding with full management control.

(iii) Janata: Corporatize and by end-2006 bring it to the point of divestment where it can attract a strategic partner to bid for substantial shareholding with full management control.

(iv) Sonali: Corporatize and bring it to the point where a minority shareholding can be divested over the medium term, the extent and pace of which will be worked out by the government with the help of the management advisor and is acceptable to IDA and the Fund.

2. Containing flow problems and improving bank financial performance

In the interim, the government intends to contain the problems of the NCBs and improve bank financial performance, by strict monitoring of the following key measures:

Strengthening bank management

Rupali: The sales advisor has been in place since June 24, 2004.

Agrani: The new management team has been selected through an international tender process to manage the bank. The final contract for the new team is expected to be signed by end-July 2004, and the new team, led by a Bangladeshi CEO approved by government, will be in place by end-August.

Janata: The retendering of a management support contract is under way, with the support team expected to be in place by mid-November. The pre-bid conference for short-listed firms for the management support contract was held on June 19, 2004.

Sonali: IBTC has been selected to field the management support team. The final management contract was signed on July 8, 2004, and the team in place by mid-August.

Revamping the boards of directors

The boards of directors of all the NCBs will be reconstituted to comprise only directors qualified as "fit and proper" under Bangladesh Bank (BB) guidelines. In the reconstitution process, Ministry of Finance (MOF) and BB will ensure that at least two board members have recognized financial/bank experience.

Extending and enhancing Memoranda of Understanding

To facilitate the rehabilitation of the NCBs, the government in 2002 signed Memoranda of Understanding (MOUs) with all four banks, which among other things, capped net credit growth to 5 percent, barred the sanctioning of loans to saturated sectors, as well as loans to a single client or group that were more than 5 percent of the bank's paid up capital. BB has extended the MOUs until end-2004, and stands ready if necessary to extend them beyond that date. The MOUs will be expanded to include:

• Targets for cash recoveries from the top 20 defaulters of each bank;
  
  
• Targets on reduction of operation expenses; and
  
  
• Implementation of BB's core risk management guidelines by end-June 2004.

3. Guiding principles for bank reform and divestment

The government will be guided by the following principles:

No restrictions on human resource policies will be imposed: To ensure that the government realizes maximum benefit from the reform program it is essential that the NCBs are given greater autonomy in the area of human resource policy. To achieve this, policies on branch rationalization and HR policies relating to hiring, promotion, firing, staff compensation, and instituting voluntary retirement schemes (VRS) will need to be reviewed and maximum decision making autonomy will have to be allowed to the NCBs.

Quality, rather than price alone, should be the key selection factor: Fit and proper criteria will be used to determine the new private owners of these banks. The strategic investor will need to have significant banking expertise, management capabilities, a credible track record, and is prepared to put forward a significant amount of its own capital as a condition of sale. Government will not entertain any bid that requires regulatory forbearance for minimum capital adequacy.

Recapitalization by government up to zero level and only at signature of the final sales contract: This critical safeguard will preserve the integrity of the divestment process. NPLs from SOEs with government guarantees will be settled only by the government at that point.

Share offering to strategic investors and required holding period: Strategic investors will be preferred to investors in the form of equity funds and will be required to hold their shares for a specified minimum period.

Restrictions on foreign ownership would be eased: The government intends to permit qualified foreign investors to own shares in a privatized bank in excess of the statutory ceiling of 10 percent on a case by case basis to encourage foreign participation in the competitive bidding process.

Public relations exercise: The government will initiate intensive measures to inform the public about the need for banking reforms, focusing on the importance of a sound and healthy financial sector for overall economic development in the country.

4. Containing and strengthening Sonali's operations

The government is cognizant of the need to contain ongoing problems at Sonali. To achieve this, the following measures, in addition to those described above for the other NCBs, will be taken:

• Starting with MOUs from end-June 2004, Sonali's lending growth will be restricted to 5 percent, inclusive of loan write-offs, so as to reduce its market share.
  
  
• A new CEO meeting the fit and proper test with a proven track record in banking will be appointed by end-July 2004. Continued management support team will be ensured as long as necessary.
  
  
• The board of directors will be reconstituted by end-September 2004 to meet BB's fit and proper test for board membership.
  
  
• To level the playing field and introduce competition, the government will ensure free entry into areas where Sonali has a dominant position.

ANNEX II

Addendum to the Technical Memorandum of Understanding

The Technical Memorandum of Understanding dated June 4, 2003 (EBS/03/76) will be modified as follows:

• Para. 1, page 80 will be replaced by:

1. For program purposes, any foreign asset, liability, or cash flow denominated in a currency other than the U.S. dollar shall be converted into U.S. dollars by applying the appropriate end-of-period exchange rate for March 31, 2004, as published in the Fund's International Financial Statistics (Table 1).

Table 1. Selected End-of-Period Exchange Rates
Taka per U.S. dollar	58.9791	Indian rupee per U.S. dollar	43.3900
SDR per U.S. dollar	1.4805	Pakistani rupee per U.S. dollar	57.5110
Australian dollar per U.S. dollar	1.3177	Swedish kroner per U.S. dollar	7.5737
British pound per U.S. dollar	0.5451	Japanese yen per U.S. dollar	104.3000
Canadian dollar per U.S. dollar	1.3105	Gold price in U.S. dollars per troy ounce (London PM fixed)	428.3000
Euro per U.S. dollar	0.8181

Source: Fund's International Financial Statistics.

• The following additional paragraphs will be added at the end of page 81:

2. The end-November 2004 structural performance criterion with respect to the action plan to operationalize bank-by-bank resolution strategies for the NCBs will include:

• Targets and timetables for cash recoveries from the top 20 defaulters of each bank;
  
  
• Timelines for necessary legal changes to eliminate restrictions over human resource policies and limits on foreign ownership in the banking sector;
  
  
• Timelines to bring the banks to the point of divestment;
  
  
• Remedial actions that will be taken if any of the banks breach their respective MOUs.

3. A bridge financing of Tk 16 billion will be required by June 2004 to cover delay of the World Bank's DSCII and educational loans ($300 million) into the first six weeks of FY05. This will be unwound following receipt of such loans.