Djibouti—Letter of Intent and Supplementary Memorandum on Economic and Financial Policies

Djibouti, October 25, 2004

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

Dear Managing Director:

1. The economy and the social situation in Djibouti remain fragile despite seven years of adjustment efforts under IMF-supported programs (a stand-by arrangement from 1996 to 1999, and a Poverty Reduction and Growth Facility (PRGF) arrangement from 1999 to 2002). The fiscal position has gradually been restored and progress has been made toward the reform of public finances.

2. These programs have made it possible to stabilize tax revenues, rationalize budgetary outlays, increase social spending, and reduce, since 2001, the sizeable domestic fiscal arrears. However, the structural reform program intended to remove obstacles to growth has not been completed, and as a result, economic growth has not been strong enough to foster job creation and reduce poverty. Consequently, the government believes it essential to continue its partnership with the IMF under a new staff-monitored program covering the period January-December 2004.

3. Last year, the government approached IMF staff to negotiate a second arrangement under the PRGF. However, staff concluded that because of substantial additional budgetary resources from military agreements with France and the United States, the Republic of Djibouti would not, for the time being, need an IMF program with drawings. Moreover, during its recent 2003 Article IV discussions, the Executive Board of the IMF expressed the wish that the authorities establish a strong track record of implementing their economic and financial policies before concluding such an arrangement. In particular, the Board hoped to see completion of the last program’s structural reform agenda to enhance growth, as well as the adoption of a budget for 2004 that would support growth and poverty reduction.

4. The main objectives of our economic program were set forth in the Memorandum on Economic and Financial Policies approved by the management of the IMF in May 2004. This document describes the government’s commitments for the period July 1–December 31, 2004.

5. The measures proposed in the Supplementary Memorandum reflect the authorities’ political commitment to pursuing reforms, while bearing in mind the importance of mobilizing additional external resources in support of the government’s poverty reduction strategy.

6. The government believes that the policies described in the attached Supplementary Memorandum clearly reflect the authorities’ commitment to economic reforms and lay a solid foundation for implementing their economic policy. The government therefore requests that IMF staff closely monitor execution of this program covering the period January 1–December 31, 2004, as is usually done under IMF-supported programs with drawings.

7. The government will also provide IMF staff with all necessary information to assess policy implementation and fulfillment of the program targets. The authorities intend to review progress under the program with IMF staff at regular, three-month intervals.

8. The government appreciates the help that the IMF has provided in preparing economic reform programs since 1996 and attaches great importance to continued collaboration with the IMF.

Supplementary Memorandum of Economic and Financial Policies
for the Second Half of 2004

I. Introduction

1. In order to return to a sound macroeconomic environment, the government adopted a Poverty Reduction and Growth Facility (PRGF) arrangement in 1999.

2. After three years of implementation (1999–2002), this program has made it possible to stabilize tax revenues, rationalize budgetary outlays, and increase social spending. Consequently, the government believes it essential to continue its partnership with the IMF under a staff-monitored program (SMP) covering the period January-December 2004.

3. The main objectives of our economic program were set forth in the Memorandum on Economic and Financial Policies attached to the Letter of Intent sent to the management of the IMF in February 2004. This memorandum describes the government’s commitments for the period July 1–December 31, 2004.

4. The measures proposed in the memorandum reflect the authorities’ political commitment to pursuing reforms, while bearing in mind the importance of mobilizing additional external resources in support of the government’s poverty reduction strategy.

II. National Economic Developments in the First Half of 2004

5. In the first six months of the year covered by the SMP, Djibouti’s economic results were moderate. The consumer price index (CPI) indicates an increase in prices of 1.5 percent since the beginning of the year.

6. The average annual inflation rate remained low (about 2.3 percent), albeit with a tendency to accelerate in the second quarter of 2004, owing to the higher prices of oil and food imports associated with the fall of the U.S. dollar on the international market.

7. Economic growth slowed in the first half of 2004, probably as the result of a slump in port activity, despite a sharp increase in private investment in projects such as the Doraleh oil facility.

8. Fiscal performance was generally on track throughout the first half of 2004. Indeed, budget execution over the period shows a degree of fiscal consolidation. Overall, the level of revenue at end-June 2004 exceeded the amount at the same time last year and was sufficient to cover current expenditure.

9. Although domestic revenue increased relative to the first half of 2003, thanks to the rise in direct taxes and the domestic consumption tax (TIC), certain categories of indirect taxes and fees decreased, owing in particular to: (i) a reduction in oil imports caused by the hike in world prices, (ii) the government’s desire to keep the retail prices of oil products affordable and not pass on the whole of the world price increase to consumers, and (iii) the smuggling of tobacco and alcohol from neighboring countries.

10. On the expense side, outlays on goods, services, and transfers rose slightly above program estimates. Indeed, transfer increased following the implementation of social programs, with more training for auxiliary healthcare workers, expanded enrollment capacity in the teacher training center, introduction of the service national adapté (youth training program), and pensions for disabled former combatants.

11. The surge in investment expenditure can be explained in part by domestically financed capital expenditure (in addition to outlays on equipment and infrastructure, three factories were started up in Ali-Sabieh in 2003) and by the growing counterpart funds granted by the government to externally financed investment projects.

12. The government honored all of its external debt commitments, but continued to accumulate external arrears toward Italy and Spain, with whom external debt rescheduling talks are in progress.

13. The small amounts of external payment arrears on nonreschedulable debt to bilateral and some multilateral lenders that had accumulated at end-March and end-June have since been paid.

14. At end-March 2004, all of the budgetary targets had been met, as had the end-June targets regarding the floor on fiscal revenue, the ceiling on the wage bill, and the net accumulation of domestic arrears.

15. The indicative monetary targets were not met. At end-June 2004, the three indicative monetary criteria had not been attained.

16. The floor on net international reserves was set at US$9.5 million, as opposed to US$10 million in the SMP.

17. In June, the government used its deposits with the Central Bank of Djibouti (BCD) to pay certain current expenses and external debt services resulted in nonobservance of the ceiling on net BCD credit to the government.

18. Advances granted to the government by commercial banks between December 2003 and June 2004 led to nonobservance of the ceiling on net commercial bank credit to the government. At the same time, government deposits in commercial banks grew by DF 22 million.

19. In the area of financial sector reforms, the central bank stepped up its capacity-building efforts in the first six months of 2004 with the resumption of the staff continuing training program, with support from the IMF (balance of payment statistics, anti-money laundering, portfolio investment, and macroeconomic management).

20. As in the four previous fiscal years, the 2003 external audit of the central bank was conducted in June 2004 by an international audit firm. Furthermore, the BCD financial statements (balance sheet and income statement) for 2002 were published in the Official Gazette of the Republic of Djibouti of August 31, 2004. Finally, in March 2004, the monetary authorities adopted a regulation governing the operations of savings and loan banks and authorized the IFAD to begin operations.¹

21. Implementation of the structural reform program was delayed. Certain prior actions fell behind schedule.

22. However, during the first half of the year, the government also promulgated the law creating free-trade zones, demobilized a total of 411 combatants instead of the 500 cited in the SMP, and drafted a detailed report on social spending. Nonetheless, the five structural measures planned for end-March and end-June were not implemented.

23. Moreover, the revised drafts of the banking law and the central bank charter have not yet been submitted to the Council of Ministers. Publication of the report of the Chambre des Comptes et de Discipline Budgétaire (audit and fiscal discipline office) has been postponed.

24. We were also able to adhere to the monthly cash-flow management plan and the data reporting requirement.

III. Economic and Fiscal Policies from July to December 2004

25. The government made a commitment under the SMP to further stabilize the major economic aggregates and implement significant structural reforms, with the objective of promoting sustainable economic growth and taking steps to reduce poverty. The actions taken should qualify the government to receive assistance from the international community. We will continue to pursue this objective in the second half of 2004.

26. The program for July-December 2004 is based on a macroeconomic framework in which real GDP growth is projected at 3.2 percent, and inflation is contained at 2.8 percent despite inflationary pressure from higher international prices. The 2004 supplementary budget is based on expenditure targeted under the SMP.

A. Fiscal Policy

27. The 2004 supplementary budget, to be presented to the National Assembly in October, projects a cash-basis deficit of DF 1,109 billion (0.9 percent of GDP). This supplementary budget, for which no budgetary support from the European Union and France (SAS) will be received, is nonetheless in line with the fiscal criteria of the SMP and provides for the use of domestic funds to settle domestic arrears amounting to DF 2.097 billion. To meet these criteria in the second half of 2004, it will be necessary, on the one hand, to mobilize more revenue and, on the other, to exercise greater control over operating costs, particularly outlays on goods, services, and transfers.

28. With regard to projected revenue, the 2004 supplementary budget estimates an increase of DF 102 million (0.09 percent of GDP), which will mean an increase of 2.3 percent in GDP from the first to the second half of 2004, as a result of: (i) a higher collection rate, (ii) more frequent inspections of imported goods, (iii) more rigorous border controls, and (iv) computerization of the tax administration will make it possible to achieve this objective.

29. The government has agreed to limit spending to 34.3 percent of GDP. However, all measures to increase social spending—particularly on education and health—will be maintained. Current expenditure will fall from 31 percent of GDP in 2003 to 28 percent in 2004. This represents an increase of 0.3 percent over the original budget, attributable for the most part to a significant increase in maintenance outlays in the wake of major repair work on public infrastructure in the first six months of 2004.

30. It should be noted, however, that there was a 0.6 percent drop in the wage bill resulting from: (i) the civil servant retirement program, (ii) the demobilization of 411 members of the National Security Force, and (iii) a freeze on certain hiring initiatives originally provided for in the 2004 budget. In addition, coercive measures to curb the growth of certain operating expenses (expenses for travel and missions abroad, energy bills, etc) were implemented at the highest levels of government.

B. Financial Sector Reforms

31. With regard to financial sector reforms, the monetary authorities have proposed amendments to the BCD Charter and the Banking Law, and the revised texts were submitted to the Council of Ministers in September 2004. The National Assembly is expected to adopt them by the end of 2004.

IV. Structural Reforms: Strengthening Competitiveness and Poverty Reduction

32. The government, aware that the expansion of private investment is the driving force behind economic growth, continued its efforts to improve the legal framework with the adoption in June 2004 of the law on the free trade zone, which provides incentives for investors seeking to participate in the development of the Doraleh project. Far from discriminating against activities in the rest of the country, this policy is aimed at export activities.

33. At the same time, the task of revising the investment code—although slightly behind schedule (June 2004)—will be completed and the new regulations will be adopted by December 31, 2004. This goal of this reform is to simplify and rationalize the system of tax exemptions.

34. Furthermore, to liberalize the labor market and promote job creation, the government reaffirms its commitment to adopt the draft labor code prepared and proposed by the Ministry of Labor and National Solidarity, before December 2004. The delay in this measure, originally scheduled for June 2004, afforded the opportunity to consider the conclusions and recommendations of the Discussion on Labor Policy.

35. The government will encourage private initiative by implementing a strategy and support mechanisms for SMEs and SMIs. The purpose of the approved management centers will be to facilitate and enhance the competitiveness of small- and medium-sized enterprises. The authorities will also promote the expansion of microfinance, in particular by preparing a national microfinance strategy.

36. The government will create the best possible conditions for private initiative by putting in place a plan to restructure the power and water sectors, in cooperation with the World Bank. The feasibility and environmental impact studies for a wind power project in Grand Bara were recently presented to the National Procurement Commission.

37. The technical committee responsible for drafting a commercial code for Djibouti based on the OHADA Uniform Acts has, with the help of a consultant, already collected a number of legislative and regulatory texts on commercial activities. The work will continue and the necessary resources will be mobilized.

38. Regarding public expenditure, the new provisions on budget preparation and the monitoring and control of expenditure have been in force since April 2004. In addition, a detailed report on the allocation of budgetary social expenditure was prepared by the Ministry of Finance and published on the website of the Ministry of Economy, Finance, and Planning, and the Ministry of Finance recently signed a contract with a consulting group in Benin to computerize the expenditure chain.

39. The publication of the report of the audit and fiscal discipline office on the 2002 budget, which is part of the fiscal consolidation effort, is scheduled for October 2004.

A. Program Monitoring

40. We have put in place a flexible mechanism to coordinate and monitor reforms in the Ministry of Finance, which has allowed us to collect and report data and information on program execution to IMF staff on a timely basis. In this connection, the government has confirmed its commitment to maintaining and strengthening the monitoring mechanism.

41. Program performance will be monitored through quarterly indicative targets, structural benchmarks, and quarterly progress assessments by IMF staff. The indicative targets for the period July-December 2004 are shown in Table 1. The structural benchmarks are listed in Table 2.

Djibouti: 2004 Supplementary Budget (As a Percentage of GDP)
	Jan. – June Executed	July – Dec. Projected	2004 Projected
Revenue and grants	16.4	18.7	35.1
Tax and nontax	10.8	11.2	22.0
Military revenue	3.1	2.5	5.6
Grants	2.5	5.0	7.5
Expenditure	16.6	17.7	34.3
Wages	6.8	6.7	13.4
Transfers and equipment	5.4	4.9	10.3
Investments	2.4	3.7	6.1
Deficit (payment order basis)	-0.2	1.1	0.8
Change in arrears	-0.8	-1.0	-1.8
Deficit (cash basis)	-1.0	0.0	-0.9
Memorandum item: Nominal GDP in DF millions			117,862