Ms. Anne O. Krueger
The Acting Managing Director
International Monetary Fund
Washington, D.C.

Dear Ms. Krueger,

The Government of Zambia requested the staff of the International Monetary Fund to monitor implementation of the government's program covering the second half of 2003. As described in the attached Memorandum of Economic and Financial Policies, the initial implementation of this program fell short of expectations as a result of a significant overrun in nonwage expenditures, which has added to the recent sharp rise in domestic borrowing. Moreover, the Government recognizes that some of the program's end-year targets can no longer be attained.

Therefore, to enable us to develop a track record of performance that would allow us to move to a PRGF arrangement, the Government requests that the period of the staff-monitored program (SMP) be extended through end-June 2004. We consider the policies set out in the attached memorandum for this period, which were endorsed by Cabinet in February 2004, to be sufficient to safeguard macroeconomic stability through a sharp reduction in domestic borrowing, supported by strong initial reforms of the tax system and government expenditures. At the same time, the SMP will continue the implementation of the reform agenda established in the PRSP.

We hope that, with sound implementation of this SMP, and passage of the budget for 2004, we will be in a position to request a new PRGF arrangement in the first half of 2004. Successful implementation of policies supported by a new PRGF arrangement will be essential to allow Zambia to reach the completion point under the enhanced HIPC Initiative during 2004. Not only will this be a key to reducing Zambia's external debt to sustainable levels, it will be crucial to reduce debt-service payments in 2004 and 2005 to manageable levels.

Yours faithfully,

Memorandum of Economic and Financial Policies
For the Period December 2003 Through June 2004

I. Performance Under the SMP And Recent Economic Developments

A. Performance Under the SMP, July-December 2003

1. The SMP went off track as a result of significant expenditure overruns in September and October, which resulted in net domestic financing exceeding the cumulative adjusted program ceiling by about 1.7 percent of GDP in December (Table 1). The programmed payment of domestic arrears was also not observed, and the continuous prohibition against the accumulation of external arrears was breached. In addition, the target was not met on the cumulative deposits into the HIPC Initiative account was not met. The targets that were met included the net domestic assets (NDA) of the Bank of Zambia (BoZ); gross international reserves (GIR); the ceilings on external debt, including for the Zambia Electricity Supply Corporation (ZESCO); and the cumulative wage bill. However, arrears were accumulated on the housing allowance whose cancellation was challenged in court by civil service unions.

2. Progress in implementing structural reforms was mixed (Table 2). The strengthened commitment control system, which has been implemented in most ministries, helped to limit the accumulation of arrears to just 0.1 percent of GDP in the second quarter, and the Government has continued to issue quarterly expenditure ceilings. However, cash releases did not conform to these ceilings, because expenditure policy decisions led to the execution of unbudgeted expenditures. Enforcement of the sanctions against over-commitment and virement of funds between budget subheads has been inadequate, despite the improved timeliness of the Monthly Expenditure Reports (MERs). At the same time, the government's commitment to refrain from paying any amounts for which it is not legally liable was not observed, because the Government found it necessary to take on liabilities of mine workers in Luanshya (see paragraph 6). Although a comprehensive database of domestic arrears was completed in June, and only the Office of the Accountant General (OAG) has initiated settlement of such arrears, the preparation of a multiyear plan for clearing domestic arrears has been delayed to 2004.

3. Progress has been made in containing the wage bill, but structural measures in this area have yet to be implemented. Between April and November 2003, a total of 2,498 employees in the central administration were retrenched and, by the end of the year, this total was expected to reach 3,500. In line with agreements reached with some trade unions, a circular was issued in September 2003 to reduce the rates of housing allowances payable in 2003.

4. The development of a Medium-Term Expenditure Framework (MTEF) for the 2004-06 period and the publication of the Green Paper, discussed with stakeholders and local communities, has been a major step in improving budget preparation. The MTEF consultations that have taken place with politicians, Sector Advisory Groups, the Provincial Development Coordinating Committees, and other stakeholders have enriched the budgeting process and should strengthen stakeholders' ownership of the budget. Government will continue to consult these stakeholders in the process of implementation, monitoring, and evaluation of the MTEF. A draft of a financial sector development plan (FSDP) has been posted on the BoZ website for further comments. At the same time, the Government has refrained from providing further budgetary support to nonbank financial institutions (NBFIs), pending finalization of the FSDP.

B. Recent Economic Developments

5. Real GDP growth is estimated at 4.2 percent in 2003, not 4.5 percent envisaged earlier, owing to a lower than anticipated growth in mining. The 12-month inflation rate of 17.2 percent at end-December was above the target of 13 percent in the SMP, reflecting some relaxation of financial policies and some firming of food prices. Zambia's external position through end-December was bolstered by higher copper prices and continued growth in nontraditional exports, which aided the BoZ in meeting the international reserves target.

Fiscal policy

6. Although revenue was in line with the program, the fiscal deficit for 2003 was about 1.4 percent of GDP larger than programmed as a result of higher expenditures. This overrun was concentrated in nonwage current and capital spending including recurrent departmental charges (RDCs). The overrun in RDCs included security-related spending, expenditures on travel, workshops for staff, by-elections, and higher spending on fertilizer price support. These excesses were partially offset by lower than programmed HIPC-financed expenditures, and by lower external debt-service payments. Additional expenditure overruns resulted from unbudgeted payments of K 167 billion (0.8 percent of GDP) to the Luanshya mine workers of the Roan Antelope Mining Company of Zambia (RAMCOZ) to meet accumulated wage arrears and retrenchment benefits, to facilitate the sale of the mine to a strategic investor in December. These payments were expected to yield K 20 billion in income tax withholding; K 10 billion in 2003, with the balance collected in 2004. Nevertheless, the overall cash deficit for 2003 is now estimated at 6.6 percent of GDP, thus exceeding the programmed deficit target by about 1.4 percent of GDP. As a result, by end-December net domestic financing exceeded the program target (adjusted for the shortfall in external debt service) by K 354 billion (1.7 percent of GDP).

Monetary policy

7. Broad money increased by 23.4 percent during 2003, compared with a target of 17 percent in the SMP. The larger than expected growth in broad money was largely because of the widening fiscal deficit, an easing of monetary policy in late October, when the BoZ lowered the cash legal reserve requirements from 17.5 percent to 14 percent and a larger than expected buildup of net foreign assets in the banking system. The lowering of the reserve requirement was intended to provide banks with additional liquidity for lending to the agricultural sector. Bank credit to the private sector rose by 31 percent in 2003, with the increase spread over a wide range of sectors including agriculture, manufacturing, transport, and communication.

8. After depreciating by about 12 percent in the first quarter of 2003, the kwacha strengthened against the U.S. dollar throughout the rest of the year, reducing the depreciation for the year to 7 percent. However, against the South African rand and the euro, the kwacha depreciated by 29 percent and 19 percent, respectively, through end- December. The introduction of the broad-based interbank foreign exchange market in July 2003 helped to strengthen confidence in the kwacha and was immediately followed by a significant appreciation of the currency. The interest rate on the 91-day treasury bill remained within a narrow band of 32-35 percent throughout most of the year, but declined to below 20 percent in mid-December, mainly as a result of excess bank liquidity, following the lowering of the cash legal reserve requirements.

External sector

9. Boosted by a 17 percent increase in copper prices since the beginning of 2003, and further strong growth in nontraditional exports, the overall balance of payments position through end-September 2003 was better than expected. Total exports grew by 17 percent for the first nine months compared with the same period in 2002, while total imports grew by about 11 percent. Thus, the BoZ was able to meet the adjusted end-December reserve target under the SMP by a margin of US$46 million through foreign exchange purchases from the market without putting undue pressure on the exchange rate. The current account and overall balance of payments are expected to record smaller deficits in 2003 than in 2002 and projected under the SMP for 2003.

II. The Revised Macroeconomic Framework for 2004

10. Following the large expenditure overrun and heavy recourse to domestic borrowing in 2003, a sharp fiscal adjustment is urgently needed in 2004 to address a growing threat to fiscal sustainability. Moreover, the Government recognized that the framework for the 2004 budget presented in the Green Paper for the MTEF needed to be revised. As a result of the increase in the stock of domestic debt in 2003 and higher interest rates, domestic debt service was expected to be about 1½ percent of GDP higher than projected in the Green Paper, at 3.7 percent of GDP. At the same time, Government recognizes that slippages in implementing the SMP may delay a move to a PRGF, raising uncertainty about the level of external financing available for the 2004 budget.

11. Government has therefore reformulated the macroeconomic framework for 2004. The revised framework is designed to break the spiral of rising domestic debt and interest payments that poses a major risk to macroeconomic stability and growth. In addition, the Government is determined that, through frontloaded reforms, it will set the stage for a sustainable fiscal adjustment and an early return to a PRGF arrangement. To this end, the 2004 budget presented to parliament in February 2004, is based on cautious assumptions for external budget support to mitigate the destabilizing costs of recourse to domestic borrowing should such external financing fail to materialize.

12. The revised macroeconomic framework for 2004 envisages (i) real GDP growth of 3.5 percent compared with 4.5 percent previously, (ii) a 12-month inflation rate of not more than 20 percent (instead of 13 percent); (iii) a build-up in GIR to about 1.5 months of import cover compared with 1.7 months previously. We recognize that achieving these objectives will require a more resolute adherence to the agreed fiscal and monetary framework, as well as the implementation of key structural reforms in public expenditure management, financial sector reforms and governance.

Fiscal policy

13. Fiscal policy will be geared to preserving macroeconomic stability, by containing domestic borrowing to reduce pressures on interest rates, prices and the exchange rate. On the basis of a passive projection drawn from the fiscal framework presented in the Green Paper, and with domestic financing reduced to 2 percent of GDP from 5.1 percent of GDP in 2003, there was a financing gap in the 2004 budget of over 2 percent of GDP (about K 500 billion). This reflected the impact of both higher interest payments and a projected shortfall in external budgetary support. The Government recognized that, in the absence of strong adjustment to cover the gap, use of further domestic financing would have led to a destabilizing spiral of higher debt and interest payments, and a sharp reduction in expenditures on all sectors, including poverty-reducing programs. Therefore, the Government is determined to take far reaching expenditure and revenue measures to ensure that the program's macroeconomic targets are achieved.

14. The wage bill will be reduced by 0.5 percent of GDP from the expected 2003 outturn. The nominal wage bill will be constrained by allowing only for a K 40 billion increase for the police, immigration and prison service personnel, who did not receive a raise in the last wage round, an allocation of K 38 billion to cover promotion increases or wage creep, and K 7.2 billion per month for the housing allowance. Aside from these changes, there will be no nominal increase in wages and the total headcount will not exceed the end-October 2003 level for the core civil service. As a result, the wage bill is expected to decline to 8.0 percent of GDP. The Government has begun to negotiate on this basis. With a view to implementing an orderly process of wage negotiations, the envelope available to cover wage increases has been announced and the Public Service Management Division (PSMD) has created a single team to negotiate with all unions, and no wage agreements will be concluded until these have been fully costed by the Ministry of Finance and National Planning (MoFNP) and their implications set out in a report to Cabinet. The Government will expand the campaign to remove ghost workers to noncore civil service areas, including teachers and health workers. The Government has already withdrawn and revised most of the circulars indicated in the Annex I to this letter, and expects to complete the process shortly.

15. Allocations on Ordinary RDCs have been reduced by 0.5 percent of GDP from the 2003 outturn of 2.8 percent of GDP. Savings will be achieved through re-organization of operations and aggressive cutting of discretionary spending. In this area, the Government recognizes that it is essential to demonstrate to the public, including public service unions, that the burden of adjustment is being shared. Thus, the Cabinet Office is preparing a plan for rationalizing government structures in order to reduce costs and government is installing its own internal telephone system to reduce the cost of telephone services with Zambia Telecommunication. In addition to strict enforcement of regulations on breaches of expenditure control (see below under public expenditure management) official travel and other discretionary spending will be reduced. The Government envisages these actions to be a precursor to the launch of a wide-ranging program of civil service reform which is now being discussed with civil society and the donor community, including the World Bank.

16. Despite this fiscal restraint, Government is committed to increase priority poverty-reducing expenditures financed with HIPC debt relief from 1 percent of GDP in 2003 to 2.1 percent of GDP in 2004. The Government will continue to make monthly payments into account 49 at the BoZ to cover these expenditures. However, the balances of line ministries' accounts in commercial banks for these expenditures will be monitored closely and funds will be disbursed to these accounts from account 49 only when existing balances are expected to be exhausted during the month. At the same time, execution of some nonpriority domestic capital projects will be rephased, so as to remain within the budget envelope without incurring arrears.

17. The budget submitted to parliament proposes that revenues in 2004 will be bolstered by reforms that focus on broadening the tax base and further improving the efficiency of the system. The original structure, coverage and efficiency of the VAT will be restored by exempting most nonexport goods that are currently zero-rated. This measure, which took effect on February 7, 2004, is expected to yield K 95 billion or 0.4 percent of GDP. Increased compliance with the VAT has been facilitated by doubling the turnover threshold for the VAT to K 200 million; at the same time, cancellation of voluntary registration below this threshold should result in savings of K 26.3 billion from VAT refunds. A 3 percent turnover tax, to be introduced by April 1, 2004, replaces income tax and VAT for companies below the VAT threshold, and should yield K 7.3 billion. In addition, the personal income tax has been reformed to alleviate poverty and provide additional resources to the budget. The reform, effective April 1, 2004, increases the threshold for exempting annual income to K 3.1 million (from less than K 2 million) and adds two income brackets (at tax rates of 35 and 40 percent) above the current top rate of 30 percent. These measures should yield K 23.8 billion; a 10 percent excise duty on cell phone airtime, introduced on February 7, 2004, should provide K 15.6 billion; and the removal of the preferential corporate tax rate for companies listed on the Lusaka Stock Exchange should yield K 17.4 billion. In combination, the tax policy measures are expected to raise revenues by 0.7 percent of GDP. Measures on nontax revenues (increase of fees and penalties) and exceptional revenues (reduction of subsidy on sales of fertilizer) should generate additional resources of 0.4 percent of GDP. Consequently, total revenue collection should reach 19 percent of GDP in 2004. Total grants are estimated at 6.0 percent of GDP and include program grants carried over from 2003 and the first disbursement under a new program from the European Union that would be contingent on approval of a new PRGF.

18. The Government will, in 2004, complete a review of the potential adverse impact of the Export Processing Zone Act on the revenue base and particularly in the area of direct taxation. The review will be completed in time for its conclusions to be addressed, if necessary, in the 2005 budget.

19. The Government is looking into the issue of tax and other incentives for investors, with the aim of developing a consistent and general policy for the granting of tax incentives to avoid ad hoc interventions. The Government intends to complete this exercise, in conjunction with the review of the EPZ Act, and put in place a new policy in this area in time for the preparation of the budget for 2005. In the meantime, the Government will consider only limited exceptions to the current policy of not granting any new tax reduction, exemptions, rebates or preferential treatment. Such tax incentives would be granted only in the case of new "green field" investments, or for the operation of the Luanshya mine or KCM following their sales to new investors. Moreover, the revenue implications of any such incentives would be assessed and offsetting measures taken to protect revenues.

20. The domestic primary balance is projected to move from a deficit of 0.7 percent of GDP in 2003 to a surplus of 2.4 percent in 2004 and the overall deficit after grants would similarly narrow to 4.0 percent of GDP. Net external financing, including small amounts carried over from 2003 and the first tranche of US$20 million under a new IDA structural adjustment operation, would amount to 2.0 percent of GDP. Recourse to domestic financing would therefore be limited to 2 percent of GDP, down from 5.1 percent of GDP in 2003.

Monetary and exchange rate policies

21. Monetary policy in 2004 will aim to achieve the program's inflation target while safeguarding the international reserve position. In line with these objectives, and taking into account a monetary overhang in the third quarter of 2003, the expansion of broad money will be limited to about 18 percent through BoZ's use of indirect monetary instruments. The proposed monetary framework provides sufficient room for a significant real increase in credit to the private sector in support of the program's growth objective, and is consistent with the fiscal framework. The BoZ will monitor monetary developments very closely and stands ready to take appropriate action, including, if necessary, raising the legal reserve requirement. The BoZ will continue to explore appropriate market-based avenues for increasing access to domestic credit by farmers and other small-scale enterprises.

22. The Government continues to be concerned by the high level of commercial bank lending rates and their negative impact on private sector economic activities and on the prospects for diversification. The Government recognizes that in order to lower interest rates on a sustainable basis, domestic borrowing requirements need to be sharply curtailed with a view to providing credibility for the disinflation process. In addition, improving the efficiency of the banking sector, including the sale of 49 percent of the shares of the Zambia National Commercial Bank (ZNCB) to a strategic investor, should strengthen the overall banking system, promote competition, and contribute to a further easing of pressures on interest rates. In this context, the BoZ intends to continue to adhere to the treasury bill auction guidelines to ensure that interest rates reflect market conditions. The BoZ is continuing to review measures, including the current volume and price penalties for rediscounting treasury bills, to facilitate banks' liquidity management and reduce banks' intermediation costs.

23. The exchange rate will continue to be market determined with BoZ intervention in the interbank foreign exchange market aimed at smoothing short-term fluctuations and meeting the program's gross international reserves target, without putting undue pressure on the functioning of the interbank foreign exchange market. Given that the exchange rate is freely determined, that Zambia has an open trade and exchange regime, and that nontraditional exports have been growing at a rapid pace, the Government is of the view that the current level of the real exchange rate is broadly appropriate for promoting diversification and protecting Zambia's external competitiveness.

External sector policies

24. Zambia's external prospects are expected to improve further in 2004 due to strong gains in both nonmining and mining exports. Copper receipts are projected to rise about 20 percent because of stronger prices and increased production, while nonmining exports would increase by over 12 percent. Prospects in the copper sector could be bolstered by the sale of a majority stake in Konkola Copper Mines to a strategic equity partner. These export gains are expected to be offset by stronger imports, mostly because of large capital expenditures in the mining sector, including expenditures on the new Kansanshi copper mine due to start operations in 2005. As a result, the current account deficit (including grants and debt relief on interest payments) is projected to increase to 6.4 percent of GDP from 5.9 percent in 2003.

25. External program assistance in 2004, projected at US$70 million, is expected to come from the World Bank, the EU, and the AfDB, and mostly in the second half of the year, once a new PRGF arrangement is in place. Following the expiration of the last Paris Club rescheduling agreement, the Government has contacted the Paris Club requesting forbearance and to allow payments to continue under the same terms until a new PRGF arrangement is in place. The Government intends to reach the completion point under the HIPC Initiative by the end of 2004. The Government is mindful of the need to ensure adequate international gross reserves, which are projected to increase from US$196 million at end-2003 to US$239 million (1.5 months of imports) by end-2004. As a result, the financing gap in 2004 is projected to be about US$182 million. This could be filled by additional donor program support as well as by support under a PRGF arrangement.

III. Structural Reforms, Public Expenditure Management, and Governance

26. The Government is committed to implementing financial sector reforms, strengthening public expenditure management, and improving the transparency of its operations. With regard to the financial sector, negotiations for the sale of the ZNCB are at an advanced stage and the Government hopes to conclude the sale and to effect the handover during the first half of 2004. The costs of retrenchment will be paid out of the gross sales proceeds. As earlier envisaged, no interest on the bond to recapitalize ZNCB will be paid before the sale is concluded.

27. Although a draft of the FSDP was completed in December 2003, some further work is needed to draw up operational plans. Developing strategies to address insolvent NBFIs is a priority of the FSDP. In line with the draft FSDP, the BoZ has set a deadline of end-March 2004 for the Zambia National Building Society and the National Savings and Credit Bank to reach agreements with the BoZ on time-bound and credible restructuring programs to be monitored against quarterly targets (Table 4). No public monies will be used to recapitalize or restructure these two entities before an appropriate FSDP is completed and agreements have been reached in restructuring plans. Should the proposed restructurings not be considered feasible by the BoZ, appropriate supervisory action will be taken. The Government has made an allowance in the 2004 budget for the expected minimum costs of resolving these institutions. Restrictions have been placed on the Development Bank of Zambia, pending private sector contribution of 60 percent of its capital base. No public money will be used to recapitalize the bank.

28. As a key part of the FSDP, the BoZ has drafted regulations for the microfinance sector. Smaller microfinance institutions would be subject to nonprudential supervision, with the onus put on transparency to strengthen the governance of the sector. These regulations will take effect in 2004 and will facilitate the development of private microfinance institutions using banking services provided by a network of rural branches to enhance the delivery of rural financial services and support growth in the agriculture sector.

29. The Government recognizes the need to reinforce the budget's role in the definition and execution of spending policy. This is essential to support both public expenditure management and good governance. The Government will therefore avoid policy decisions that would entail expenditures in addition to budget allocations. Unforeseen expenditure requirements will be funded only to the limits of the contingency resources indicated in the budget or only after cabinet has approved any changes by making adjustments elsewhere in the budget.

30. To strengthen cash management, the Budget Office is issuing quarterly and monthly expenditure ceilings which will be revised monthly on the basis of updated projections of revenue, expenditure, and financing constraints. Monthly ceilings will be backed by corresponding cash releases, so as to provide Controlling Officers in line ministries, departments, and provinces with reliable limits for commitments.

31. The MoFNP will strictly enforce sanctions for noncompliance with established spending procedures. Specifically, on the basis of monthly reports prepared by the OAG, the Budget Department will reduce disbursements to line ministries, departments, and provinces responsible for over-commitment, virement of funds, and expenditures lacking ex-ante written authorization by the MoFNP, as well as failure to report expenditures, as specified in the circulars issued in September 2002. The existing penalties will also be rigorously applied on accounting officers responsible for such unauthorized spending.

32. The Government has introduced activity-based budgeting (ABB) for the preparation, implementation, and reporting starting with the 2004 budget. The 2004 budget also includes an annex identifying all poverty-reducing spending allocations. Line ministries, departments, and provinces will report on the execution of spending identified in this annex through a form attached to MERs. The OAG will transfer these forms, on a monthly basis, to the Department of Planning, so as to improve cash management in funding poverty-reducing programs and contribute to the implementation of the PRSP.

33. Comprehensive quarterly budget execution reports, including full coverage of poverty reducing spending will be published within 45 days of the end of the quarter, beginning with the report for the first quarter of 2004.

34. The MoFNP will finalize by March 2004 a multi-year plan for clearing the stock of domestic arrears as at end-December 2002. The plan will prioritize arrears payments by the penalty accruing, the interest rate applied, and exchange rate affecting overdue payments. On the basis of the plan, an inter-ministerial committee, chaired by a MoFNP senior officer, will negotiate with contractors discounts on the payments due. Within the quarterly expenditure ceilings issued by the Budget Department, the OAG will have the exclusive responsibility to settle the discounted amounts due.

35. The Government remains fully committed to implementing an IFMIS, a key condition for expenditure control and monitoring. Progress has been made toward implementing the IFMIS, although the procurement of hardware and software, which had been expected to be completed by end-December 2003, is now expected in the second quarter of 2004 because of delays arising from the World Bank's procurement procedures. The MoFNP revised the timeframe for introducing the system and is expected to sign a contract for the procurement of hardware and software by end-April 2004 and start piloting the IFMIS in three line ministries shortly thereafter.

36. The Government will strengthen the independence of the Office of the Auditor General. By end-June 2004, the Government intends to submit to Parliament draft legislation to grant autonomy to the Office of the Auditor General.

37. The Government is committed to bringing forward the budget cycle so that Parliament can approve the budget before the beginning of the fiscal year. However, since this requires a constitutional amendment, the Government will present a proposal to this effect to the Constitutional Review Commission (CRC).

38. The Government is also proceeding with the reform of the electricity utility, ZESCO. Following the review by Fund and World Bank staff, the commercialization of ZESCO has reached the "entry point" and we intend to expedite implementation of the measures needed to reach the interim point June 2004 and then embark on ZESCO's commercialization according to the agreed detailed framework. Following the signature of a preliminary agreement to settle government's and ZESCO's cross-debts, the Controller of Internal Audit will verify the extent of government indebtedness to ZESCO. The tax liability of ZESCO, as assessed by ZRA, and subject to any revision by the Revenue Appeals Tribunal, will be used to estimate the cross-debts between ZESCO and Government. This process will be finalized before the settlement of any cross-debts between ZESCO and the Government. We envisage requesting a revision to the trigger for the HIPC initiative completion point on ZESCO's privatization to incorporate the completion of measures specified at the end of the interim phase of commercialization. Such measures could include the passage of the proposal to amend the Electricity Act, as well as Cabinet approval of the Ministry of Energy and Water Development's proposals for separate legal acts for private and public partnership. As previously agreed, to provide ZESCO some breathing space to build a track record of credit worthiness, new concessional borrowing by ZESCO guaranteed by the Government will be permitted, subject to cumulative limits of US$20 million to the end of 2004 and US$40 million to June 2005. This limit would be subject to review, in consultation with Bank and Fund staff, in the event that additional concessional resources are required.

39. The Government remains committed to providing an enabling environment for private sector growth and diversification and recognizes the need to review key land, labor and investment regulations. To ensure greater access to land, there is need to improve the framework for land administration by finalizing the national land policy with broad stakeholder support. The Government is also seeking to revise labor legislation to reduce the frequency of strike actions and to decrease the high statutory costs of providing permanent employment. The Government will also firmly resist amendments that would require employers to provide housing or housing allowances for workers and that prevent employers from recruiting skilled foreign workers where such local skills are unavailable. The Government also proposes to revise the Investment Act with a view to strengthening the facilitatory role of the Zambia Investment Center.

IV. The PRSP Progress Report, HIPC Triggers, and the MTEF

40. The Government recognizes that Zambia's external debt overhang is a serious obstacle to more rapid growth and sustainable poverty reduction. Zambia has made substantial progress in implementing the measures for reaching the floating completion point under the enhanced HIPC Initiative. Specifically, measures have been implemented in the areas of: health and education; the privatization of ZNCB; agreement on the commercialization of ZESCO; the preparation and implementation of the MTEF; the preparation of the PRSP progress report; and the implementation of the IFMIS on a pilot basis (see above). The key outstanding area is the maintenance of a stable macroeconomic environment as evidenced by a satisfactory performance under a PRGF arrangement. Therefore, the Government is committed to implementing the revised SMP so that it can serve as a bridge to a new PRGF which would pave the way toward the HIPC Initiative completion point.

41. Preparation of the Government's first annual report on the implementation of the PRSP has been completed and will be formally handed over to co-operating partners in March 2004. The delay in its completion was partly due to the comprehensive consultative process embarked upon and the need to incorporate a baseline of indicators against which progress in the second annual report can be assessed. The PRSP progress report has been prepared in tandem with the MTEF for 2004-2006. The priorities identified and the lessons learnt as indicated in the progress report have significantly influenced the reprioritization of Poverty Reduction Programs in the 2004 Budget and has ensured consistency with the expenditure profile of the MTEF.

V. Program Monitoring

42. Progress in implementing the SMP will be monitored monthly under the program, based on the quantitative and structural measures indicated in Tables 3 and 4. These targets are defined in the attached Technical Memorandum of Understanding. To allow accurate monitoring of spending on the wage bill, the Government will implement all the actions indicated in Annex I to this letter.

43. The Government has revived the economic monitoring committee for Economic Ministries to monitor implementation of the Economic Program. The committee is chaired by President Mwanawasa, and meets once every two weeks. Further, the Government has strengthened the existing Economic Management Monitoring Committee at the MoFNP to ensure that this meets at least once a week and that steps are taken to avoid lapses in program implementation. The Fund's Resident Representative will be invited to attend meetings of the Economic Management Monitoring Committee as required.

Annex I: Actions to control the wage bill and related payments

In order to ensure support implementation of the envisaged wage policy, the Government will take the following steps

1. The PSMD will withdraw the circulars PSMD/53/11/1 n. B.9 (June 26, 2002), TS/7/2/20 SEC n. 2, n. 3, and n. 4 (April 16, 2003), and any other related circulars introducing housing allowance.

2. As soon as negotiations with unions are concluded, the PSMD will revise the circulars PSMD/7/2/20 SEC. n. B.8 (April 16, 2003) and TS/7/2/20 SEC. n. B. 4 and n. B. 13 (April 16, 2003) in order to eliminate the voluntary Medical Scheme.

3. In November 2003 the MoFNP issued an instruction introducing the tracking of all payments related to housing assistance (housing allowance and housing rental) for civil service employees. The tracking mechanism will allow reporting on all the payments related to housing assistance executed in 2002 and from January to November 2003. The same instruction will also allow tracking and classifying under PEs all the payments related to housing assistance from November 2003 onwards.

4. By end-December 2003, the MoFNP will set up a unit dedicated to monitoring and reporting on a monthly basis all payments to civil service employees as specified in the attached TMU (paragraph 23).

5. By end-December 2003, the Government will also approve a requirement that the Minister of Finance and National Planning should submit to the Cabinet an analysis of the short and medium-term budget costs of any agreement with government employees before it is finalized.

Use the free Adobe Acrobat Reader to view Tables (21 Kb pdf file).

Zambia: Technical Memorandum of Understanding for
The Staff-Monitored Program (SMP)

I. Introduction

1. This memorandum sets out the understandings between the Zambian authorities and the International Monetary Fund (IMF) regarding the definitions of the quantitative targets and the structural reforms for the Staff Monitored Program, as well as the related reporting requirements. The definitions are valid at the start of the program, but may need to be revisited to ensure that the memorandum continues to reflect best understanding of the Zambian and Fund staff to monitor the program.

II. Quantitative Targets: Definitions and Data Sources

A. Net Domestic Assets (NDA) of the Bank of Zambia (BoZ)

2. NDA of the BoZ are defined as the monthly-average (based on daily data) of the reserve money less net foreign assets calculated at end-December 2003 BoZ mid-exchange rates (program exchange rate).¹ Reserve money includes currency in circulation, required reserves on kwacha deposits, required reserves on foreign currency deposits (at the program exchange rate), positive current account balances of banks with the BoZ and deposits of non-central government institutions. Net foreign assets of the BoZ are defined as gross international reserves (defined below) plus any other foreign asset, including the US$25 million blocked reserves at the former Meridien Bank, minus foreign liabilities (defined below). The kwacha figures are derived from the U.S. dollar values using the program exchange rate of K 4,645 per U.S. dollar.

3. Foreign liabilities are defined as short-term (one year or less in original maturity) foreign currency-denominated liabilities of the BoZ to nonresidents and outstanding use of Fund credit.²

4. The ceilings on NDA will be adjusted upward by the amount of the shortfall of balance of payments support net of debt service as indicated in Table 3 of the Memorandum of Economic and Financial Policies, up to a maximum of US$16 million for the period end-December 2003 to end-June 2004. External disbursements that occur anytime during the month of the test date will be treated as if they were disbursed on the first day of the month.³ In the event of excess balance of payments support net of debt service, the ceiling on NDA will be adjusted downward by 100 percent of the additional excess support. However, if part of the excess support is used to reduce treasury-bills or bonds held by commercial banks and the non-bank sector, then the programmed NDA will be adjusted upward by that amount.⁴ The kwacha value of the cumulative shortfall/excess will be calculated at the program exchange rate.

5. The ceiling on NDA will be adjusted downward/upward to reflect decreases/increases in the legal reserve requirements. The adjustor will be calculated as the percent change in the reserve requirement multiplied by the actual amount of reserves (kwacha and foreign currency denominated) at the end of the previous calendar month.

6. The ceiling on NDA will also be adjusted upwards by the full extent of payments made in 2004 to settle wage arrears and retrenchment costs relating to Luanshya mine workers, for which the Government assumed responsibility in 2003.

B. Net Domestic Financing (NDF)

7. Net domestic financing (Appendix II, Table 1) is defined as the Central Government's net borrowing from the banking and nonbanking sectors. All government issued securities will be recorded at cost (face value less discount). Net domestic financing will be defined as:

(a) the net position of the Government with commercial banks, including: (i) treasury bills; (ii) government bonds; (iii) loans and advances; less (iv) support to Meridien Bank (MBZ); and less (v) Central Government deposits (defined to include account balances under the authority of controlling officers); plus

(b) BoZ holdings of: (i) treasury bills; (ii) government bonds; (iii) the Kwacha bridge loan (overdraft facility); less (iv) the Government's position at the BoZ; less (v) the donor suspense account; plus (vi) the long-term non-transferable security issued against Government's total indebtedness to BoZ as at end-2002.

(c) Nonbank holdings will include: treasury bills; and government bonds.

(d) In the event of ZNCB's privatization, the measurement of NDF will exclude the government bond issued to ZNCB in 2002 in the amount of K 249 billion.

8. The NDF ceiling will be adjusted upward by the amount of the shortfall in balance of payments support net of debt service as indicated in Table 3 of the Memorandum of Economic and Financial Policies, up to a maximum of US$16 million for the period end-December 2003 to end-June 2004. In the event of excess balance of payments support net of debt service, the ceiling on NDF will be adjusted downward by 100 percent of the additional excess support. The kwacha value of the cumulative shortfall/excess will be converted at the program exchange rate. The ceiling on NDF will also be adjusted upwards by the full extent of payments made in 2004 to settle wage arrears and retrenchment costs relating to Luanshya mine workers, for which the Government assumed responsibility in 2003.

9. The data source for the above will be the "Net Domestic Financing" Table produced by the BoZ Economics Department, submitted on a weekly basis, and reconciled with the monthly monetary survey.

C. Gross International Reserves of the BOZ

10. Unless otherwise noted here, gross international reserves of the BoZ will be defined as reserve assets of the Bank of Zambia (Appendix II, Table 2). Reserve assets are defined in the IMF BOP manual (5th edition) and elaborated in the reserve template of the Fund's special data dissemination standards (SDDS). They exclude, for example, foreign assets not readily available to or controlled by the monetary authorities, and foreign currency claims on Zambian residents.

11. Gross international reserves consist of (i) monetary gold; (ii) foreign currency in cash; (iii) unencumbered foreign currency deposits at non-resident banks; (iv) foreign securities and deposits; (v) SDR holdings and Zambia's reserve position with the Fund; and (vi) balances in the BIS account related to debt service to Paris Club creditors. Gross reserves will exclude non-convertible currencies, pledged, swapped, or any encumbered reserve assets including but not limited to reserve assets used as collateral or guarantees for third party external liabilities, commercial banks reserve requirements in foreign currency, and will exclude the US$25 million deposit in Meridien Bank which is under liquidation.

12. The floor on gross international reserves will be adjusted: (i) downward by the amount in U.S. dollars of the shortfall in balance of payments support net of debt service as indicated in Table 3 of the Memorandum of Economic and Financial Policies, up to a maximum of US$16 million for the period end-December 2003 to end-June 2004; (ii) upward by 100 percent of the cumulative excess balance of payments support net of debt service. However, if part of the excess support is used to reduce treasury bills or bonds held by commercial banks or the nonbank sector, then the programmed reserves buildup will be adjusted downward by that amount;⁵ (iii) downward/upward for any shortfall/excess in the U.S. dollar value of disbursements from the IMF under the PRGF arrangement; and (iv) downward for any increase in BoZ short-term foreign currency denominated debt (to resident and nonresidents), using the definition of short-term debt below.

13. For the purpose of this target, as well as those for external debt and arrears, valuation will be in U.S. dollars using the program exchange rate.

14. Data on gross international reserves including its components will be reported by the BoZ on a weekly and end-month basis.

D. Official Medium- and Long-Term Concessional External Debt

15. This is defined as all forms of official debt with original maturity of more than one year contracted or guaranteed by the central Government and BoZ having a grant element of more than 40 percent, but excludes debts subject to rescheduling. The grant element is to be calculated by using currency-specific commercial interest reference rates (CIRRs) reported by the OECD; for maturities of less than 15 years, the grant element will be calculated based on six-month averages of CIRRs, and for maturities longer than 15 years, the grant element will be calculated based on 10-year averages. Adjustment lending from the IMF will be excluded.

16. This target applies not only to debt as defined in Point 9 of the Guidelines on Performance Criteria with Respect to Foreign Debt (Decision No. 12274-(00/85) August 24, 2000) (see Annex), but also to commitments contracted or guaranteed for which value has not been received.

17. Detailed data on all new concessional and non-concessional debt contracted or guaranteed will be provided by MoFNP on a monthly basis.

E. Official External Short-Term Nonconcessional External Debt

18. This is defined as the outstanding stock of external debt with original maturity of less than one year owed or guaranteed by the central Government or the BoZ. For this purpose short-term debt will include forward commodity sales but will exclude normal trade credit for imports. There will be no new official external short-term debt during the program period. The term "debt" has the meaning 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).

19. The data will be reported by the MoFNP and BoZ on a monthly basis.

F. Collateralizing/Guaranteeing of Loans to ZESCO

20. The Government and the Bank of Zambia shall not extend or guarantee any new commercial debts to ZESCO, including in the form of loans, suppliers credits and leases. New concessional borrowing, as defined above (Paragraph 16), will be subject to a cumulative limit of US$20 million in 2004. The limit on new concessional borrowing will be subject to review, in consultation with Fund and World Bank staff, in the event that additional concessional resources are required.

G. Domestic Arrears of Government

21. Domestic arrears are defined as: (i) any bill that has been received by a spending Ministry from a supplier for goods and services delivered (and verified) and for which payment has not been made within 30 days after the due date of payments; (ii) Wage, salary and any payment to government employees, including any direct or indirect scheme of housing assistance, that were due to be paid in a given month but remained unpaid on the 15th of the following month; and (iii) interest or principal obligations which remain unpaid 30 days after the due date of payment. This definition of domestic arrears excludes changes in the stock on account of interest, penalties and valuation changes.

22. The information is to be compiled through audits of the accounts of spending Ministries and agencies, conducted by the Internal Audit division of the MoFNP. The audits will be completed and data submitted to Fund staff by the Accountant General within 6 weeks of the end of each quarter.

H. The Central Government's Wage Bill

23. For the purposes of the wage bill, the definition of Central Government includes all heads covered in the 2004 Yellow Book. The Central Government's total wage bill will include payments on wages, salaries, allowances, and all other items specified as personal emoluments in the Yellow Book, and any direct or indirect payments of housing assistance to employees (Appendix II, Table 3). The Government will provide, on a monthly basis and by budget head, the following data: (i) the number of all employees in the Central Government for each budget head; (ii) the basic salary, the allowances and any other personal emoluments released during the month; (iii) the arrears incurred during the month on the basic salary, on the allowances, and on any other personal emoluments; (iv) the number of employees retrenched and the corresponding retrenchment costs; and (v) the number of ghost workers removed from the payroll and the corresponding monthly savings on the wage bill.

24. All the data will be submitted to the Fund staff by the MoFNP within three weeks of the end of each month.

III. Structural Reforms

A. 2004 Budget and Public Expenditure Management

Submission of the Government Budget for 2004

25. Submit to Parliament the 2004 central government budget by end-February, 2004, consistent with the SMP, including the wage bill ceiling and all the tax measures described in paragraph 17 of the MEFP. The 2004 budget will also contain an annex identifying allocations on all poverty-reducing spending programs, in case the Activity Based Budgeting (ABB) is not in place.

Preparation of a Multi-Year Plan for Clearing the Stock of Domestic Arrears

26. The Office of the Accountant General, in cooperation with the Budget Office and the Department of Debt management, will finalize by March 2004 a multi-year plan for clearing the stock of domestic arrears as at end-December 2002. On the basis of the information contained in the database of audited domestic arrears as at end-December 2002, the plan will prioritize arrears payments by the penalty accruing, the interest rate applied, and exchange rate affecting overdue payments. On the basis of the plan, an inter-ministerial committee, chaired by a MoFNP senior officer, will negotiate with contractors discounts on the payments due. Within the quarterly expenditure ceilings issued by the Budget Office, the Office of the Accountant General will have the exclusive responsibility to settle the discounted amounts due. Line ministries, Departments, and Provinces will not settle any arrears.

Government Liabilities

27. The Government will refrain from making payments for which it is not legally liable, including ZNOC liabilities on liquidation. It will also guide the liquidation process of public enterprises, such as ZNOC, to minimize Government's liabilities consistent with the law.

Publication of Quarterly Budgetary Execution Reports

28. Within 45 days from the end of each quarter, the Office of the Accountant General will publish, in at least two leading newspapers, quarterly reports on budget execution of revenues and expenditures. The reports will detail expenditure execution under RDCs and on the poverty-reducing programs identified in the annex to the 2004 central government budget (see paragraph 26).

Strengthening the Independence of the Office of the Auditor General (OAG)

29. To strengthen the independence of the Office of the Auditor General, the Government will submit to Parliament, by end-June 2004, draft legislation to grant full - autonomy to the OAG.

Procurement of Hardware and Software for IFMIS

30. The Government will award a contract for the procurement of software and hardware of IFMIS by April 2004.

B. Strengthen the Financial Sector and Public Enterprises

31. The Government and the BoZ will take the final decision and adopt an action plan for addressing the weaknesses of the state-owned nonbank financial institutions (NBFIs), including the Development Bank of Zambia (DBZ); the National Savings and Credit Bank (NSCB); the Zambia National Building Society (ZNBS); and the Zambia State Insurance Company (ZSIC); and (ii) designing institutional structures to support the development of financial services to rural areas and other related issues. The Government will collaborate with the IMF and the World Bank in preparing the strategic plan and seek necessary technical assistance.

32. The Government will not provide any budgetary support to the state-owned financial institutions until the comprehensive strategic plan for the financial sector is finalized. Moreover, Government will also refrain from taking over liabilities and/or providing guarantees on loans secured by the NBFIs.

C. Program Monitoring

Program Monitoring Group (PMG)

33. The benchmark will be met when the MoFNP sends written confirmation to Fund Staff of the creation of the PMG, indicating the composition of the group and the scheduled frequency of its meetings.

ANNEX

Guidelines on Performance Criteria with Respect to Foreign Debt

Excerpt from Executive Board Decision No. 6230-(79/140), as revised on August 24, 2000

9. (a) For the purpose of this guideline, the term "debt" will be understood to mean a current, i.e., not contingent, liability, created under a contractual arrangement through the provision of value in the form of assets (including currency) or services, and which requires the obligor to make one or more payments in the form of assets (including currency) or services, at some future point(s) in time; these payments will discharge the principal and/or interest liabilities incurred under the contract. Debts can take a number of forms, the primary ones being as follows:

(i) loans, i.e., advances of money to the obligor by the lender made on the basis of an undertaking that the obligor will repay the funds in the future (including deposits, bonds, debentures, commercial loans and buyers' credits) and temporary exchanges of assets that are equivalent to fully collateralized loans under which the obligor is required to repay the funds, and usually pay interest, by repurchasing the collateral from the buyer in the future (such as repurchase agreements and official swap arrangements);

(ii) suppliers' credits, i.e., contracts where the supplier permits the obligor to defer payments until some time after the date on which the goods are delivered or services are provided; and

(iii) leases, i.e., arrangements under which property is provided which the lessee has the right to use for one or more specified period(s) of time that are usually shorter than the total expected service life of the property, while the lessor retains the title to the property. For the purpose of the guideline, the debt is the present value (at the inception of the lease) of all lease payments expected to be made during the period of the agreement excluding those payments that cover the operation, repair or maintenance of the property.

(b) Under the definition of debt set out in point 9 (a) above, arrears, penalties, and judicially awarded damages arising from the failure to make payment under a contractual obligation that constitutes debt are debt. Failure to make payment on an obligation that is not considered debt under this definition (e.g., payment on delivery) will not give rise to debt.