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

Dear Mr. de Rato:

The macroeconomic policies and structural reforms pursued by our government since taking office continue to bear fruit. Several macroeconomic indicators have improved during the first half of 2004 and the social and political situation has generally remained calm. The positive outcome on the July gas referendum shows that there is growing support for our policies and is an important step in implementing our medium-term hydrocarbons strategy.

All performance criteria and indicative targets for end-June were met, with the exception of net international reserves (NIR) and net domestic assets of the central bank (NDA). The latter were affected by delays in external disbursements and significant bank deposit withdrawals in the context of the introduction of the financial transactions tax and the run up to the referendum on gas exports. With the disbursements arriving in July and the situation in the financial sector having stabilized, both indicators are now back within program limits. Thus we are requesting waivers for the nonobservance of the end-June quantitative PCs on NIR and NDA.

In support of our policies described in the attached Memorandum of Economic and Financial Policies (MEFP), the Government of Bolivia requests the completion of the fourth review under the SBA. The Government believes that the policies set forth in the attached MEFP are adequate to achieve the objectives of its program, but it will take any further measures that may become appropriate for this purpose. Bolivia 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.

/s/ Javier Cuevas Minister of Finance

/s/ Juan Antonio Morales President Central Bank of Bolivia

Supplementary Memorandum of Economic and Financial Policies of the Government of Bolivia
Fourth Review of the Stand-By Arrangement

1. The positive outcome of the gas referendum was an important step forward in strengthening our democracy and broadening support for the government's political and economic agenda. We continue to implement a solid macroeconomic program, while gradually reducing social tensions. We expect to meet the quantitative targets for the remainder of 2004, which were set at the last review of the Stand-By agreement.

2. The program will continue to be guided by the macroeconomic and structural reform policies described in the Memorandum of March 21, 2003, and modified by the Supplementary Memoranda of June 20, 2003, September 24, 2003, and June 2, 2004.

3. The next review of the SBA will focus on assessing progress towards securing Congressional approval of a 2005 budget consistent with: (i) a deficit target after grants below 5½ percent of GDP, taking into account the expenditure limits and revenue projections in the budget bill, as well as the likely revenue yield from specific revenue measures to be agreed with the staff and incorporated into the MEFP for the fifth review; and (ii) the prospective availability of external concessional financing and grants, while limiting nonconcessional financing. If necessary, the budget and macro frameworks for 2005 would be revisited to ensure consistency with available external financing. The review will also assess the likely impact on prospects for gas exports from the Hydrocarbons Law that would be expected to have been approved by Congress.

A. Macroeconomic Framework

4. Solid export performance in the first half of the year owing to favorable international developments including commodity prices suggests that the real GDP growth would reach 3¾ percent in 2004, moderately higher than programmed. 12-month inflation rose to 4.8 percent by end-July, partly reflecting the impact of bad weather on agricultural production, but is expected to decline to 3½ percent by end-2004, in line with the program. The external current account surplus has widened significantly and is now expected to be almost 3 percent of GDP for 2004, reflecting strong growth in gas, minerals, and agricultural exports, partially offset by some recovery in imports.

B. Fiscal Policy

5. The fiscal deficit after grants through June 2004 was 0.7 percent of GDP below the program ceilings, reflecting mostly overperformance of tax revenues. Owing to strong hydrocarbons exports and economic activity in general, and strong results of the tax regularization program, tax revenues exceeded the program projections by almost one percent of GDP. This positive outturn allowed us to increase domestically financed investment mainly from local governments ( percent of GDP). Reflecting our austerity efforts and tight expenditure controls, current spending stayed in line with our program. As planned, we have allowed for partial payments to the so-called "sandwich generation" (contributors under the old system but not eligible under the new), and begun to gradually incorporate 23,000 eligible people into the pension system that had been postponed by previous administrations. With the latter, we will fully close access to the pay-as-you-go system.

6. Given the outcome during the first half of 2004, we expect to stay slightly below the program target for the year as a whole. In particular, with the FTT yielding slightly below programmed levels during its first two months of implementation, we expect tax revenues to exceed programmed levels by 0.8 percent of GDP. To this end, we intend to maintain tax collection efforts and an efficient implementation of the new tax code. The higher revenues will allow us to accelerate the implementation of important pro-growth projects, including infrastructure, leading to an overall increase in investment of about 0.6 percent of GDP compared with the program. Pro-poor spending is expected to increase by 0.6 percent of GDP in line with the program. Despite continuing spending pressures, we intend to contain current expenditures within the program ceilings. In an effort to maintain fiscal discipline, we have reminded local governments of their reporting obligations and will strictly enforce the legal sanctions for noncompliance.

7. We will closely follow fiscal revenues and expenditures of the combined public sector, and central bank financing to the NFPS. We are committed to taking prompt corrective actions, as necessary. In particular, should deviations occur with respect to the monthly ceilings (Table 1), we intend to further curtail spending by the central government and other public sector entities, including by strengthening reporting requirements of local governments.

8. Despite the shortfall in net external financing, the favorable fiscal performance allowed us to meet the end-June PCs on net domestic financing and central bank financing to the combined public sector. The outcome for both targets includes an accounting transaction consisting of a swap of assets and liabilities between the central bank and the treasury. Adjusting for this (there is no formal adjuster in the program), both the net domestic financing target and the central bank financing would have been met. The attached supplementary technical memorandum incorporates new adjusters to these program targets to ensure that the accounting impact of such operations does not affect the future measurement of performance under the program.

9. We intend to pursue efforts to prepare the stage for fiscal consolidation over the medium term. Regarding tax revenues:

• To safeguard the new tax code, the Upper House of Congress has already approved a law regulating the relevant administrative procedures (recurso de alzada y jerárquico), and the Lower House is expected to approve it before end-September (structural performance criterion (PC)).
  
  
• Despite a one-month interruption owing to social concerns, we resumed incremental domestic fuel prices increases in August and are committed to further adjust prices later in the year to offset the effects on revenues resulting from the high international oil prices. While our current fuel price mechanisms ensures that further increases in international prices would be absorbed by oil companies, we are committed to consider other measures, including additional price increases, if necessary, to protect tax collection. In this context, we will conduct poverty and social impact analyses (PSIAs) to evaluate the impact of some of the proposed measures on the poor and implement appropriate safety nets.
  
  
• With Fund technical assistance, we are preparing a comprehensive tax reform to both enhance revenue collection and the fairness of the taxation framework. We expect to have all relevant draft legislation ready before year-end, for Congressional consideration in 2005, and adoption in 2006 at the latest, in time to replace the FTT (expiring in mid-2006).
  
  
• A hydrocarbons framework bill has been submitted to Congress (see Section E below).

10. To support our medium-term fiscal consolidation while taking advantage of the higher-than-expected revenues, we are revising our spending priorities so as to further promote growth and poverty reduction. In particular, our strategy now includes additional projects critical for growth, and higher pro-poor spending, partially offset by cuts in other spending. To this end, we are taking the following actions:

• A commission of highly respected members of civil society appointed in June 2004 (benchmark) is preparing recommendations to improve the effectiveness and pro-poor orientation of public spending. In coordination with the ongoing national dialogue, the commission will make recommendations by end-September, in time to be incorporated into the 2005 budget (structural PC).
  
  
• The cabinet will shortly conduct a comprehensive review of public investment projects to allow a reorientation to reflect our new priorities. Taking into account the findings from the expenditure commission and the ongoing national dialogue, we will streamline investment, to allow the accommodation of projects in 2005 such as roads establishing links with Brazil and Paraguay, and YPFB funding, that would be within the program ceilings and would have noncollateralized financing. We will aim at ensuring concessional financing for these projects. Should this prove not possible, the financing will be included within program limits for nonconcessional (domestic and external) financing of the nonfinancial public sector, consistent with debt sustainability, which we expect to be below 2004 levels.
  
  
• With IDB support, we will continue to step up efforts to control pension payments, including by strengthening an independent agency (SENASIR) to audit and control pension outlays and detect fraud. Despite some delays, SENASIR's action plan has been revamped to ensure that implementation proceeds expeditiously.
  
  
• We plan to take further steps to strengthen our debt management in order to reduce vulnerabilities, by improving the maturity and currency profile of our domestic debt through increased placements of bonds at longer maturities, including 2-4 years, and in local currency.

11. We plan to submit to Congress the 2005 budget bill before end-October (benchmark). The budget will be consistent with a deficit target of 8½ percent of GDP (before grants) for the combined public sector. Assuming the same level of grants as in 2004, this would result in a deficit below 5½ percent of GDP (after grants). The budget will include all existing extra budgetary funds, and take into account expenditure limits and revenue projections in line with the program. We expect increased revenues from the full year impact of the FTT, the hydrocarbons bill (still in Congress), and higher gas exports to Brazil and Argentina. In addition, we expect to exercise restraint on current spending including wages. We intend to identify by October specific measures of around 1¼ percent of GDP from a combination of revenue and expenditure adjustment efforts. This effort is consistent with our aim to achieve sustained fiscal consolidation by taking into account available external concessional financing and grants while limiting the use of nonconcessional financing.

12. The exceptional support from the international community both in the form of highly concessional loans and grants has been instrumental in the implementation of our program. To further enhance coordination with donors, we have set up five working groups on key areas and have agreed on a framework for multi-annual multi-donor budget support, for which six cooperation agencies have already subscribed. For our medium-term program, and in preparation for a Consultative Group (CG) meeting, we expect to conduct a donor coordination meeting by end-October, aimed at agreeing on detailed plans to strengthen public financial management, and to gather indications of potential budgetary support for 2005. We would aim to obtain appropriate financial assurances for the 2005 fiscal program, and we remain committed to implement additional fiscal measures, as necessary.

C. Monetary and Exchange Rate Policies

13. Apprehension associated with the FTT implementation and the run-up to gas referendum led to significant deposit withdrawals (about US$200 million between mid-June to July 1). These have since been partially recovered (close to US$70 million). During that period, the Central Bank of Bolivia (BCB) provided liquidity to the system, with adequate collateral, and continues to stand ready to do so. Interest rates sharply increased in late June, with repo rates in U.S. dollars rising from 7½ at end-May to 10¾ percent in early July, but have since been gradually reduced to 7½ percent. However, we remain committed to allowing prompt increases in rates as necessary to reflect changes in liquidity conditions.

14. Monetary policy will continue to aim at strengthening BCB's international reserves in the context of the crawling peg, while containing inflationary pressures. Reflecting the sharp deposit withdrawals at end-June, and internal administrative procedures which delayed a US$25 million disbursement from the World Bank, the end-June NIR and NDA targets were missed by US$31 and US$33 million, respectively. However, NIR have since recovered by US$65 million and are back on track. Disposable reserve coverage of banks' dollar deposits stood at about 37½ percent on August 23 and is expected to rise to 39 percent by end-2004.

15. The currency appreciation in neighboring countries has contributed in placing our real effective exchange rate at one of its most competitive levels in the last decade. A joint BCB and Fund staff study, to be released in October, shows that concerns over exchange rate competitiveness relate more to institutional weaknesses and the limited flexibility given by the crawling peg arrangement to deal with shocks, rather than to the exchange rate level. In this connection, we have recently concluded a study on options to allow more flexibility to the exchange rate. To this end, we are also in the process of gathering additional information on the interbank foreign exchange market, and are considering to introduce weekly auctions where the BCB would buy foreign exchange to complement the existing sale auctions. Moreover, with Fund technical assistance we plan to complete a study to recommend measures to promote the use of domestic currency by October 31, 2004 (benchmark).

D. Bank and Corporate Sector

16. Although the liquidity strains in the financial system have now eased somewhat, the Superintendency of Banks (SBEF) and the BCB have intensified their joint efforts in closely monitoring banks' liquidity position and deposit taking institutions. To protect and strengthen the financial soundness of the banking and corporate sectors, we have taken the following actions:

• On-site supervision of financial institutions has been intensified. In the case of a financial institution, this has led its management to call a shareholders' meeting to consider possible recapitalization plans, including capitalization and/or maturity extension of subordinated debt.
  
  
• In a bank for which subordinated debt to the government was converted into equity, shareholders' equity was formally written down in June 2004 in line with the results of a due diligence completed by international auditors. A new Board of Directors and management have been appointed and a business plan is expected to be finalized by end-September (benchmark), including steps to return the bank to the private sector as soon as possible, and no later than December 2005. To this end, a sales plan will be completed by end-September that safeguards the state's financial interest without setting a minimum price.
  
  
• With World Bank support, we will issue later this year the operational manual of the public fund for bank restructuring. The manual will reflect the guidelines already set in the decree establishing the fund aimed at preventing the bail-out of shareholders of unviable institutions.
  
  
• With CAF support, we have issued implementing regulations for the corporate restructuring fund. Although delayed, six enterprises have now been identified to undergo a pilot study and the administrative process of debt workout has been started. We remain committed to improving the provisions of the voluntary restructuring law, to encourage agreements between debtors and their creditors while we await lessons drawn from the pilot sample of firms. This will allow us to conduct an evaluation of the overall bankruptcy legislation and submit legislative changes by November 2004 (benchmark).

17. With Fund technical assistance, we intend to further strengthen the prudential framework of the financial system, including the adoption by end-October of norms and procedures to ensure the effective supervision of financial conglomerates, and strengthen early warning indicators and prompt corrective actions (benchmark). In this context, the SBEF will: (i) enhance its offsite supervision of liquidity; (ii) include in its manual specific actions for banks with extensive or protracted use of BCB liquidity; and (iii) issue norms aimed at strengthening banks' liquidity risk management by end-November. In addition, the SBEF will provide a diagnostic to increase provisions and develop a related action plan (benchmark).

18. In order to facilitate the banking resolution framework, with the aim of introducing a fully-fledged deposit insurance over the medium-term, we will amend the law on banks and financial institutions by end-November. This will ensure that the Financial Restructuring Fund (FRF) is established as a legal entity and to permit its contributions to the bank resolution process to be complemented by contributions of the central bank in this context, for 2005 only. By end-December 2004, we will also submit to Congress anti-money laundering legislation after receiving MFD TA slated for September.

19. While the operational and budgetary independence of the SBEF and the BCB was strengthened through a June decree, we intend to elevate to law the SBEF's regulatory autonomy by submitting a bill to Congress for approval by end-2004.

20. An informal working group was recently formed to provide nonbinding advice to the superintendency in its efforts to strengthen the financial system. The working group will be headed by the Superintendent of Banks, and will include representatives from the Ministries of Economic Development, Finance, the BCB, banks and other financial institutions.

E. Hydrocarbons Sector

21. The government has repeatedly emphasized that the efficient exploitation of Bolivia's large hydrocarbon resources is critical for enhancing its medium-term growth prospects. In this connection:

• We have submitted to Congress a hydrocarbons framework bill in September, reflecting the mandate we received from the gas referendum. We will shortly appoint a "commission of notables" of highly respected experts to provide impartial technical advice to: (i) facilitate and enrich the discussion; and (ii) help us to draft the regulations which will subsequently be included in an implementing bill to be submitted to Congress soon after the approval of the framework bill. Despite initial difficulties in the discussions with Congress, we expect the approval of the framework bill in October 2004. On this basis we intend to adopt a strategy on gas exports by end-October 2004 (benchmark), which will incorporate progress made in our negotiations on large gas export projects.
  
  
• The framework bill introduces a new complementary tax based on volumes and international oil prices, which would increase with the size of field. Corporate income tax can be offset against the new tax, while the existing surtax is eliminated. The idea behind these changes is to increase the tax take from the hydrocarbons sector, while maintaining an environment conducive to hydrocarbons investment.
  
  
• As mandated by the gas referendum, a portion of the additional revenues will be used to reduce poverty and social fragmentation. To this end, the framework bill includes revenue-sharing arrangements with regions and earmarking of resources for social spending and security. The earmarked revenue will be channeled through the budget. The implementing regulations of the law will: (i) set specific limits on fiscal deficit and debt levels, consistent with debt sustainability, above which no earmarking can take place; (ii) define clear standards of accountability necessary to receive earmarked transfers; and (iii) incorporate safeguards on the use of revenue sharing arrangement and earmarked revenues—avoiding the creation of extrabudgetary funds.
  
  
• The role of the state oil company (YPFB) will be strengthened. It will be split into a regulatory agency (Petrobolivia) and a company with direct participation in the sector (YPFB). YPFB's operations and financial management will be fully transparent and guided by principles of efficiency and cost minimization. Moreover, initially it will participate only in low risk downstream operations and jointly in operations with private companies. The inclusion of YPFB in transactions between private companies will not be mandatory. Any transfer of resources or borrowing to fund YPFB and Petrobolivia, including spending financed from the proposed sharing mechanism of gas royalties in the hydrocarbons law, will be incorporated in the budget and be subject to program ceilings. We intend to use minority shareholdings in privatized oil companies to capitalize YPFB. Budgetary resources will not be used to fund Bonosol payments.

F. Medium-Term Outlook and Progress Toward a PRGF Arrangement

22. Building on the current economic recovery, the government's overarching objective is to achieve sustained growth of 4½-5 percent (about 2 percent per capita), making a significant dent in poverty levels over the medium term. Our macroeconomic framework assumes a large increase in gas exports, which we consider conservative given that it could materialize through several alternatives, including through regional projects only. We will continue to make efforts to foster a stable social and economic environment, including by creating conditions for private sector-led growth. In this context, we intend to pursue further fiscal consolidation to increase the availability of financing to the private sector, while boosting and better targeting pro-poor spending. We also plan to remove structural and institutional barriers to growth, including by improving transparency and governance, and advancing negotiations on free-trade agreements with our main trading partners.

23. Through a participatory process with civil society, the national dialogue has made progress and our goal is to conclude it by November 2004, to provide input for a new PRSP. In particular, we will ensure that the PRSP encompasses a broad-based consensus on fiscal issues, by agreeing on sustainable sources of fiscal revenue, well-targeted social safety nets, and clear priorities for national spending. On this basis, we plan to request Fund support for our policies formulated in the PRSP through a new three-year Fund arrangement to succeed the current SBA expiring at end-2004. We also intend to hold a follow-up Consultative Group meeting, by January 2005. We hope that our initiatives to enhance budget transparency, pro-poor orientation of fiscal policies, governance, and donor coordination and harmonization, would be supported by concessional financing to ensure debt sustainability while increasing pro-poor spending.

Supplementary Technical Memorandum of Understanding

1. This technical memorandum supplements the technical memorandum of understanding of March 21, 2003, and the supplementary technical memorandum of understanding of June 2, 2004. It defines adjusters to the existing quantitative targets (performance criteria for September and indicative targets for December) for the net domestic financing of the combined public sector and central bank net credit to the nonfinancial public sector

2. Adjusters to the net domestic financing of the combined public sector.

• New adjuster. The limits on the net domestic financing of the combined public sector will be adjusted downward by (1) any medium- and long-term liabilities transferred from the Banco Central de Bolivia (BCB) to the treasury in 2004; and (2) any liabilities transferred from other financial public sector institutions to the treasury in 2004. The adjustment will include the World Bank loan of US$99.3 million, which was transferred from the BCB on June 30, 2004.
  
  
• Existing adjuster. For the calculation of the existing adjuster for shortfalls in external financing, actual net external financing of the nonfinancial public sector will be calculated excluding any medium- and long-term liabilities transferred from the BCB to the treasury in 2004 and any liabilities transferred from other financial public sector institutions.

3. Adjuster to the central bank net credit to the nonfinancial public sector. The limits on the central bank net credit to the nonfinancial public sector will be adjusted downward by any transfer of cash from the BCB to the treasury associated with the transfers of medium- and long-term liabilities in 2004 (including cash transfers used to repay outstanding central bank liquidity credits). In particular, the limits will be adjusted for the cash payment of US$36.2 million, which was transferred on June 30, 2004.