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

Lusaka, November 30, 2004

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

Dear Mr. de Rato:

The Government of Zambia presents the attached Memorandum of Economic and Financial Policies (MEFP) in support of its request for the second disbursement under the Poverty Reduction and Growth Facility (PRGF) arrangement that was approved by the Executive Board of the IMF on June 16, 2004. The MEFP reviews the progress we have made in implementing the program supported under the PRGF and sets out the policies that the Government of Zambia will pursue in 2005.

The Government requests the IMF Executive Board to grant waivers for the nonobservance of three performance criteria. As described in the MEFP, payments of domestic arrears fell slightly short of the level envisaged under the corresponding performance criteria but government has subsequently corrected the shortfall. The signing of the contract for the supply and installation of the hardware and software to implement the integrated financial management and information system (IFMIS) was delayed. As a result it was not possible to initiate the pilot implementation of the IFMIS in September as called for under the structural performance criterion. The contract is expected to be signed shortly and the piloting of the IFMIS will commence thereafter. In November, we adopted actions plans for the resolution the National Savings and Credit Bank and the Development Bank of Zambia. However, after careful consideration, we concluded that further work, which is now underway, is needed to finalize plans to resolve the Zambia National Building Society (ZNBS). As a result, the end-October performance criterion on the adoption of action plans for all three of these nonbank financial institutions was not met. A final decision will be taken when the budget for 2005, which includes funds to meet the costs of resolving the ZNBS, has been approved.

Successful implementation of policies supported by the PRGF arrangement will be essential to allow Zambia to reach the Completion Point under the enhanced HIPC Initiative early in 2005. Attaining the Completion Point will be key to reducing Zambia's external debt to sustainable levels and will also lower debt service payments to manageable levels, so as to release resources to poverty-reducing expenditures.

The Government of Zambia believes that the policies set forth in the attached MEFP, which was approved by the Government on November 26, are adequate to achieve the objectives of its program, but it will take any further measures that may become appropriate for this purpose. Zambia will consult with the IMF on the adoption of these measures and in advance of revisions to policies contained in the MEFP, in accordance with the Fund's policies on such consultation.

The Government of Zambia authorizes the IMF to make this letter and attached memoranda available to the public, including through the placement of these documents on the IMF website, subject to the removal of market-sensitive information, following the IMF Executive Board conclusion of the review.

Yours sincerely,

Supplement to the Memorandum of Economic and Financial Policies

I. Performance Under the Program Supported by the PRGF Arrangement

1. All but one of the quantitative performance criteria and all of the benchmarks for end-September 2004 under the program supported by the Poverty Reduction and Growth Facility (PRGF) were met (Table 1). In particular, the targets for gross international reserves, net domestic assets of the Bank of Zambia, and net domestic financing of the government were met by wide margins. The wage bill was held within the program ceiling and transfers to the special account in the Bank of Zambia to fund priority poverty reducing projects were made as envisaged. However, government payments of domestic arrears fell slightly short of the target-resulting in the nonobservance of this performance criterion.

2. Most of the structural measures monitored under the PRGF were implemented, albeit with delays in some cases (Table 2). Negotiations for the settlement of domestic arrears identified in the multiyear plan were initiated in July. The government has maintained tight control over expenditures and refrained from paying amounts for which it was not legally liable and which were not included in the budget. Unforeseen spending was funded only to the limits of the contingency account or after cabinet approval including identification of spending savings elsewhere (see paragraph 5). Beginning with the report for the second quarter, quarterly budget execution reports have been published within 45 days from the end of the quarter and have incorporated the activity-based budgeting (ABB) classification. Also, after some delay, a contract for the supply and installation of the integrated financial management and information system (IFMIS) is expected to be signed shortly. Consequently, the initiation of the piloting of the IFMIS in three ministries—a performance criterion for end-September under the PRGF arrangement—was delayed. The cabinet is still discussing the policy for granting tax incentives, a structural benchmark for September 2004. In this context, the government has decided not to proceed with proposals to amend the Export Processing Zones Act, and will monitor the progress of a single export processing zone before granting further applications. With regard to financial sector reforms, the Government and the Bank of Zambia (BoZ) adopted in November action plans for the resolution of the National Savings and Credit Bank and the Development Bank of Zambia. A final decision on an action plan for the resolution of the Zambia National Building Society, however, will be made by April 2005, following parliamentary approval of any necessary budget allocations. Proposals for the repeal of sections of the three statutes covering these NBFIs, which are in conflict with the Banking and Financial Services Act (BFSA), and related revisions to the BFSA are being drafted with technical assistance from the Legal Department of the IMF and other cooperating partners; these revisions are now expected to be submitted to parliament early in 2005, after a required period of public comment.

II. Economic Developments and Prospects for 2004

3. Zambia's macroeconomic performance continued to strengthen in 2004. Real GDP growth is now expected to reach 4.6 percent in 2004, led by a strong expansion in the mining sector, continued growth in non-traditional exports, and a second consecutive year of strong food crop production. Per capita income will therefore increase in 2004, extending to a fifth year the longest period of sustained expansion in more than two decades. The 12 month rate of inflation has been held below 20 percent despite the sharp rise in fuel prices.

4. The stance of fiscal policy has been key to preserving macroeconomic stability in 2004. Following a surge in government's domestic borrowing to 5 percent of GDP in 2003, which brought Zambia to the verge of a destabilizing cycle of rising domestic debt and interest payments, improved implementation of the 2004 budget reduced net domestic financing (NDF) of the government to 1.2 percent of GDP in the first nine months of 2004. This sharp decline in borrowing has helped to reduce pressures on inflation and interest rates, while freeing resources for bank lending to the private sector.

5. The government recognizes that continued strict control of expenditures will be essential to ensure that the full-year ceiling on net domestic financing of 2.2 percent of GDP is observed. Tax and nontax revenues, which were 0.3 percent of GDP less than budgeted through September, are projected to fall short of the annual target by 0.4 percent of GDP. This projected outcome reflects weaker performance of corporate income tax collections, stemming from the impact of a sharp decline in interest rates on profits and dividends in the financial sector. In addition, timely payment of VAT refunds has reduced net VAT collections. Based on performance through September, most categories of spending are projected to be held at or below budgeted levels for the year as a whole, more than offsetting the shortfall in revenues. The wage bill and current poverty-reducing priority (PRP) expenditures are expected to remain as budgeted. Interest payments on domestic debt are projected to be 0.3 percent of GDP lower than assumed under the PRGF arrangement as a result of the fall in interest rates on Treasury bills and bonds in the first half of the year. Domestically financed capital expenditures, excluding capital spending on PRPs, are also expected to be less than budgeted (by 0.4 percent of GDP). However, Cabinet approved an increase in spending on recurrent departmental charges of K 120 billion (0.4 percent of GDP) including an additional allocation for defense of K 92 billion, which was expected to be accommodated by the fall in interest payments. Against this background, Government is exercising strict control over commitments to hold domestic financing within the budgeted level.

6. Lower recourse to domestic borrowing has supported the Bank of Zambia's efforts to rein in excess liquidity in the banking system. In the first 8 months of the year, the increase in reserve money was limited to 7.4 percent, compared with 16.8 percent in 2003, mainly reflecting a tightening in liquidity conditions during the third quarter of the year. This tightening led to an increase in Treasury bill interest rates in the third quarter, which reversed the "overshooting" that had occurred following the lowering of reserve requirements at the end of 2003. In September, the average yield on Treasury bills stood at 14.0 percent, compared with 6.6 percent in June and 20.8 percent at end-2003. Despite this tightening, broad money grew by 21.3 percent in the first 8 months of the year, compared with 12.9 envisaged under the program. Credit to the private sector rose by 36 percent during this period, driven by substantial demand for financing in the productive sectors of the economy, notably agriculture and manufacturing. It is expected that the growth of broad money will end the year at 25.6 percent compared with 18 percent envisaged in the program, and the BoZ will therefore continue its present policy of mopping-up excess liquidity.

7. External developments in 2004 have been favorable. Total merchandise exports are projected to increase by 51 percent in 2004, reflecting sharp increases in copper prices and volumes and in nontraditional export earnings. However, as a result of a surge in imports for the expansion and rehabilitation of the mining sector and higher oil imports, the external current account deficit (after grants) is projected to narrow only slightly, to just over 6 percent of GDP. Higher inflows of private capital have more than financed the current account deficit, allowing for an increase in international reserves. As of end-September, gross international reserves stood at 1.3 months of imports of goods and services. For most of 2004, the exchange rate of the kwacha has been relatively stable in nominal terms; as of end-October, the kwacha had depreciated by 5.6 percent against the U.S. dollar since end-2003. In real effective terms, the kwacha appreciated by 4.2 percent in the year through September.

8. The government has continued to advance its reform strategies in the four key areas of Public Expenditure Management and Financial Accountability, Private Sector Development, Financial Sector Development, and Public Service Rightsizing and Pay Reforms.

9. Progress has also been made in privatization and public enterprise reform during 2004. Negotiations for the sale of a 51 percent share in Konkola Copper Mine (KCM), were concluded in August and the transaction was completed in November. Proceeds from the equity sale, part of which will accrue to ZCCM Investment Holdings, in which government is a shareholder, are expected to be used to defray past accumulated losses. Protracted negotiations for the sale of a 49 percent share in Zambia National Commercial Bank (ZNCB), which have included discussions with both of the two preferred bidders, are continuing. The government remains committed to the successful sale of its equity stake in ZNCB. Implementation of the commercialization plan for Zambia Electricity Supply Corporation (ZESCO) has remained broadly on track.

III. The Medium-Term Reform Strategy

10. The government's PRSP and the Progress Report elaborate a medium term strategy focusing on promoting economic growth through diversification and improving the quality of public services, while addressing the cross-cutting issues of governance, HIV/AIDS, gender and the environment. Since poverty is concentrated in rural areas, agricultural development receives a high priority, while the development of the road infrastructure throughout the country is essential to facilitate growth and poverty reduction.

11. The central challenge for Zambia is to strengthen the recent momentum of economic growth that has reversed the prolonged decline in per capita incomes. The Government recognizes that long-term growth rates of over 8 percent would be needed to reduce poverty in line with the Millennium Development Goals. The Government is therefore striving to move the economy towards this higher growth path and reduce poverty by intensifying its efforts to remove obstacles to private and financial sector development and improving the delivery of basic health and education services.

12. Key medium-term macroeconomic objectives include: (i) increasing real GDP growth to at least 5 percent in 2005 and beyond; (ii) reducing the rate of inflation to around 10 percent in 2006 and to single digits thereafter; and (iii) increasing the gross international reserves of the BoZ to about 1.7 months of import cover by 2007. The strategy is also geared to restoring a sustainable external debt position by reaching the Completion Point under the HIPC Initiative and reducing the external current account deficit to a sustainable level. At the same time, fiscal policy aims to re-orient spending towards poverty-reducing expenditures, while reducing domestic debt to sustainable levels. Beginning with the 2005 budget, the government plans to use a new expanded definition of poverty-reducing expenditures consistent with the objectives of the PRSP. However, provided external donor support is forthcoming, we remain committed to increasing poverty reducing expenditures over the medium term by at least the amounts envisaged under the old definition of these expenditures that were included in the macroeconomic framework of our first PRSP progress report and in the PRGF arrangement approved in June 2004.

13. The medium term policy framework now envisages considerably higher spending in preparation for elections in 2006 and for the constitutional review. The authorities are working closely with the donor community and other stakeholders on a road map for the elections and the constitutional reform, and are committed to a transparent process that follows international best practices. In 2005, expenditures of 0.6 percent of GDP, mainly for a national census and voter registration, are expected to be accommodated with currently available resources. In 2006, Presidential, parliamentary, and local elections and a referendum on the reform of the constitution are estimated to cost 2 percent of GDP, while further spending of the 0.6 percent of GDP is envisaged in 2007 to cover legal procedures for adopting constitutional amendments, including the possible establishment of a constitutional assembly. The government expects that donors will provide grants to meet much of the costs in 2006 and 2007. However, at this time, no firm commitments have been made and further work is needed to refine the cost estimates for 2006 and 2007. The government recognizes that the resulting financing gaps in 2006 and 2007 will need to be filled through a combination of the addition grants and offsetting measures, possibly including some paring down of these initial cost estimates.

IV. The Program for 2005

14. Macroeconomic objectives for 2005 include real GDP growth of 5 percent and a reduction in the 12-month inflation rate to 15 percent. The growth objective for 2005 has been increased from the original target of 4.5 percent of GDP, on account of favorable developments in 2004, including accelerated investment in the mining sector, and continued diversification in agriculture and tourism. Major risks to growth include climatic and terms of trade shocks. In the short term, the adverse effects of high world oil prices (projected to average US$43 per barrel in 2005) on the balance of payments are expected to be largely offset by continued increases in metal and other exports. These projected movements in world oil prices are not expected to entail further significant upward pressure on petroleum prices in Zambia, which have been adjusted in response to rising world market prices.

A. Fiscal Policy

15. The budget for 2005 will be geared to enhancing macroeconomic stability, while directing more resources toward wealth creation and poverty reduction. After the sharp adjustment during 2004, the budget targets a more gradual reduction in government's domestic borrowing to 1.6 percent of GDP to make low interest rates sustainable. Despite this lower recourse to domestic borrowing, with the support of additional external assistance—principally in the form of grants—the overall deficit (before grants) is projected to increase to 8.7 percent of GDP. Excluding payments to settle arrears, real non-interest spending would rise by 7 percent, allowing a significant increase in the priority areas identified in the PRSP.

16. In addition to meeting PRSP priorities and limiting recourse to domestic borrowing, the budget seeks to address another legacy of the past, the large stock of domestic arrears. The consolidation and extension of the commitment control system has stemmed the accumulation of new arrears. But the existing arrears stock of 3 percent of GDP continues to be subject to high penalties and is increasingly an obstacle to the execution of government contracts, particularly for infrastructure construction, including priority projects. The budget therefore includes additional resources intended to facilitate the negotiation and settlement of debt agreements with the larger domestic contractors. The framework also includes a higher allocation to reduce the stock of pension arrears.

17. The budget for 2005 will target revenues of 18.3 percent of GDP, a marginal increase from the projected outcome in 2004. Tax revenues are projected to rise by 0.1 percent of GDP as a result of the impact of higher interest rates on financial sector profits. Revenue from import duties are projected to rise in 2005, as the suspension of the 5 percent import duty on petroleum products, which was implemented in October 2004 in an effort to alleviate upward pressure on fuel prices arising from the maintenance shutdown of the country's only refinery, expires at end-2004. The government will adjust upwards the nominal level of fines and fees to meet its target on nontax revenues (including exceptional revenue) of 0.7 percent of GDP.

18. The wage bill will be limited to 8 percent of GDP. Within this total, the budget for 2005 will provide for the recruitment of additional teachers and health care professionals, in addition to filling vacancies that fall due in these sectors (paragraph 36). The budget will also make provisions for termination benefits that must be paid before those leaving the service can be removed from the payroll and their positions filled. After meeting these provisions for recruitment and termination benefits, and allowing for promotion increments, the wage bill would accommodate a significant increase in average wages, within the framework of the MTEF.

19. Total recurrent departmental charges will be increased by 0.6 percent of GDP to accommodate special provisions for the constitutional review commission, to prepare for the elections in 2006 and to settle arrears (see paragraph 33), including a backlog of outstanding court claims. Excluding these elements, other RDCs will decline by 0.2 percent of GDP.

20. The Government is committed to increasing priority poverty-reducing expenditures. Under the existing narrow definition, the increase in these expenditures to 2.2 percent of GDP is smaller than was earlier envisaged . However, it is expected that, under the new wider definition to be introduced in the 2005 budget, poverty reducing expenditures would also rise as a result of hiring in the health and education sectors. In addition the government's decision to accelerate the clearance of pension arrears is intended to alleviate the hardship caused by prolonged delays in pension payments. ABB will enable the tracking of all poverty-reducing spending and the results will be published in quarterly budget execution reports. The government remains committed to increase poverty-reducing expenditures under the revised definition by at least the amounts envisaged in our first PRSP progress report using the old definition, provided external donor support is forthcoming. However, comparisons with the outcome in 2004 will only be available in June when spending has been reclassified using the new wider definition of poverty-reducing programs.

B. Monetary and Exchange Rate Policies

21. Monetary and exchange rate policies in 2005 will be geared to achieving the program's inflation target while strengthening the international reserve position. In line with these objectives, the expansion of broad money will be limited to 19 percent through the BoZ's use of indirect monetary instruments. Reserve money would grow in line with broad money. The monetary framework provides sufficient room for a significant real expansion of credit to the private sector in support of the program's growth objective. Large increases in donor assistance to combat HIV/AIDS, which is mainly channeled through commercial banks, may complicate monetary policy; the BoZ will closely monitor these deposits as it manages the underlying liquidity in the banking system.

22. In early 2005 growth in the monetary aggregates would need to be restrained, to assure that the targeted reduction in inflation takes hold. As the year progresses, it would then be possible to ease the growth of base money in response to increased demand for real money balances. A strong fiscal performance will be key to maintaining credibility in the macroeconomic stabilization effort, and would make low interest rates sustainable.

23. The exchange rate will continue to be market-determined. BoZ intervention in the market will be aimed at meeting the program's gross international reserves target and smoothing short-term fluctuations. The import coverage of gross international reserves is expected to rise to 1.3 months by end-2005.

C. External Sector

24. The external current account deficit is projected to narrow further in 2005. While copper prices are expected to ease from their peaks of 2004, the volume of copper exports is projected to increase by 22 percent as new capacity, including the Kanshansi copper mine, comes on stream. A recovery in cobalt output is also expected. Total metal export receipts are projected to increase by 5 percent while non-traditional exports, mainly agricultural products, such as tobacco, are estimated to increase by 10 percent. Notwithstanding a projected substantial increase (almost 30 percent) in the oil import bill associated with the restoration of inventories and continued high prices, total merchandise imports are expected to decline somewhat (by almost 3 percent in dollar terms) as investment in the metal sector slows. On this basis, the current account deficit (after grants and debt relief on interest payments) is projected to decline to 4 percent of GDP.

25. On conservative assumptions, external program assistance, mostly in the form of grants, is expected to increase substantially in 2005. External program assistance is projected to increase from US$65.6 million in 2004 to US$122.9 million in 2005, of which US$87.9 million would be grants and US$35 million loans. Additional disbursements under the EU's PRBS for 2004-06 are assumed to be only a fraction of the maximum amounts available under variable tranches while the expectation of bilateral grants is based on the firm commitments of donors under the Wider Harmonization in Practice (WHIP) program. Moreover, the projected budget support loans consist of the second tranche of the World Bank's structural adjustment credit and a disbursement from the AfDB under its country support program well below the ceiling available. Zambia has a rescheduling agreement on Cologne terms with Paris Club creditors for the period leading up to the HIPC Initiative completion point, expected to be reached in early 2005. With the additional debt service relief expected after the achievement of the completion point, the program would be fully financed in 2005.

26. Zambia's trade regime remains open and supportive of export development and the diversification of the economy. The average nominal tariff on imports is 11.5 percent and Zambia does not have any non-tariff import barriers. The establishment of a common external tariff by the Common Market for Eastern and Southern Africa customs union is expected in 2005.

D. Structural Reforms, Public Expenditure Management, and Governance

27. In 2005, structural reforms will continue in the four key areas of Public Expenditure Management and Financial Accountability, Private Sector Development, Financial Sector Development, and Public Service Rightsizing and Pay Reforms. Significant progress has been made in elaboration of the reform agenda for private sector development. However, reforms in public expenditure management and financial sector development, on which plans are most advanced, will continue to be the immediate main priorities.

28. Following cabinet approval of the Public Expenditure Management and Financial Accountability (PEMFA) reform program in June 2004, attention has focused on developing modus operandi to support its implementation. Discussions with cooperating partners are expected to conclude with the signing at the end of 2004 of a memorandum of understanding covering these issues. At the same time, there is progress on the development of a work program, with monitorable milestones, for the first year of the implementation of the PEMFA, which is expected to be adopted by January 2005 (performance criterion). In the first year, implementation is expected to include further strengthening of the commitment control system, audit reforms, the MTEF, and adopting of indicators intended to measure the results of the reforms. At the same time, work will continue in the 12 areas covered by PEMFA.

29. The government remains fully committed to implementation of the Integrated Financial Management Information System (IFMIS), which is a key component of the PEMFA program. Following the signing of the contract for the supply of hardware and software for piloting of the IMFIS, the government will draw up a project plan with the contractor, laying out key milestones for the pilot program. The pilot for the IFMIS is now expected to commence before end-June in at least three ministries and a preliminary assessment of the pilot will be prepared by December 2005.

30. Despite delays in the implementation of the IFMIS, progress has been and will continue to be made on related reforms. The computer-based financial management system (FMS) initiated in 2002 has been extended across all government ministries and provinces. The incorporation of the commitment control system (CCS) in the FMS has considerably improved spending execution and reduced the accumulation of new domestic arrears. The new system will help ensure that control over monthly expenditure returns is appropriately and timely monitored, while improving transparency and the accountability of accounting officers.

31. The budget for 2005 will include a broader definition of poverty reducing expenditures which will be followed in the classification of spending at all stages of the budget process. However, the budgetary framework of the MTEF, which forms the basis of fiscal policy elaborated in this memorandum, was developed using the older narrower definition, which has been applied to HIPC-financed spending. When presented to parliament, the budget will include the new wider definition of spending; budget execution reports will similarly use the new definition and not the narrow definition.

32. The government is also taking steps to strengthen its control over defense expenditures. Following cabinet approval of additional allocations for the security services, the Government commenced an audit of the use of recurrent department charges by the Ministry of Defense, which is expected to be completed in December 2004. The results of this audit will be used in determining final budget allocations during 2005. The Government is also conducting an audit of the military payroll.

33. In July the MoFNP started negotiations with contractors for infrastructure projects accounting for the bulk of the audited stock of domestic arrears at end-2003. Making use of an increased allocation for this purpose, the Government will conclude these negotiations. To provide for an orderly and equitable process, the Government will define a framework for conducting these negotiations. Given the available resource envelope, it is envisaged that, in return for a significant down payment, settlements could include some reduction in the present value of claims, as well as a halt to penalty charges on these claims. The government recognizes that agreements reached must be affordable so that they can be honored.

34. The MoFNP will strongly enforce expenditure procedures. Unbudgeted 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 finding compensatory funding within the approved budget resources. In order to prevent the accumulation of new arrears and diversion of resources, the Budget Office in the MoFNP is strengthening the timeliness and reliability of quarterly and monthly expenditure ceilings issued to spending agencies. The Secretary to the Treasury is supervising strict enforcement of sanctions for noncompliance with the established spending procedures. The Accountant General is reporting on reductions of disbursements to line ministries, departments, and provinces responsible for over-commitments and diversion of funds between budget sub-heads without ex-ante written authorization by the Secretary to the Treasury, as well as failure to accurately report expenditures, as specified in the circulars issued in September 2002.

35. Initial implementation of the Financial Sector Development Plan (FSDP) will continue to focus on immediate priorities, including the resolution of the three state-owned nonbank financial institutions. As is recognized in the FSDP, a key step in this process is the harmonization of the acts under which these NBFIs operate with the Banking and Financial Services Act (BFSA) and thereby strengthen the BoZ's regulatory and supervisory powers over these institutions. The MoFNP will therefore, by end February 2005 submit to cabinet proposals to repeal sections of the Building Societies Act (BSA), the National Savings and Credit Bank Act, and the Development Bank of Zambia Amendment Act that conflict with the Banking and Financial Services Act (BFSA), and proposals for new legislation on the supervision of NBFIs. The Government and the Bank of Zambia has, in consultation with the staff of the IMF and the World Bank, reached decisions on action plans that will lead to the resolution of these NBFIs. The main elements of the action plans for these institutions are as follows.

• Government has accepted in principle a proposal under which the International Fund for Agricultural Development (IFAD) will contribute up to US$2.15 million to the National Savings and Credit Bank (NSCB) to facilitate the expansion of rural financial services. The BoZ has deemed acceptable the Rural Banking Strategic Plan under the Institutional Development Plan submitted by NSCB to the MoFNP. In November 2004, the BoZ has entered into a Memorandum of Understanding (MOU) with the NSCB setting out performance targets, including a time-bound plan to fully recapitalize NSCB. Government's financial contribution to the recapitalization of NSCB will be limited to K 5.3 billion through the cancellation of the NSCB's outstanding obligations to Government and K 5.8 billion in the form of a cash injection, which will be made only when IFAD has approved its own contribution to NSCB. The MOU also strengthens the BoZ's supervisory authority over the NSCB by stipulating that NSCB will adhere to the Banking and Financial Services Act until such time as the sections of the Savings and Credit Bank Act that are inconsistent with the BFSA have been repealed and new legislation is in place. To support the continued improvement in NSCB's financial performance in line with the targets for recapitalization established with the BoZ, and to assist in implementing the bank's Rural Banking Strategy Plan and Institutional Development Plan, the MoU also states that NSCB will utilize technical assistance offered by cooperating partners to further articulate a business plan.
  
  
• The Development Bank of Zambia will be recapitalized without the use of public money and, when it has been brought fully under the BFSA, 75 percent of its shares will be in private hands. The Ex-Im Bank of India has invested US$1.4 million in DBZ, as reflected in accounting transactions as of September 15, 2004, allowing for a quorum of three Class B directors and two Class A directors and enabling DBZ to make legally enforceable decisions. This capital injection gives Ex-Im Bank of India 34 percent of total paid up capital. In November 2004, the DBZ entered into a memorandum of understanding with BoZ and the Government stipulating that (i) the DBZ cannot accept deposits, there will be no government guarantee of loans made to or by the DBZ, and that there will be no use of government funds for lending; (ii) the DBZ will adhere to the Banking and Financial Services Act, giving the BoZ full supervisory authority over the DBZ until such time as the sections of the Development Bank of Zambia Act that are inconsistent with the BFSA have been repealed; (iii) pending full compliance with the BFSA, the DBZ's total lending will not exceed the equivalent of US$10 million; (iv) the DBZ will prepare a revised five year strategic plan, including performance targets to ensure the reduction of its operating costs, that is acceptable to the BoZ by December 31, 2004; and (v) if quarterly targets are not met the BoZ will take appropriate supervisory action.
  
  
• In the absence of agreement on a viable business plan for the Zambia National Building Society (ZNBS), the BoZ has put in place supervisory actions to protect depositors' funds and to limit the ZNBS's operations and is monitoring the institution's performance and assuring reduction of its operating costs. Government and the BoZ have considered different options to resolve the ZNBS and to foster the development of private financing for mortgages in Zambia. The budget framework also provides funds for the resolution of the ZNBS under these options and the Government intends to take a final decision and adopt an action plan for the resolution of the ZNBS by April 2004, after the passage of the budget for 2005. In the meantime, no public money will be used to recapitalize the bank.

36. Work is continuing on public service rightsizing and pay reform. A comprehensive strategy, which aims to achieve a public service of optimal size and raise the efficiency and quality of services, is being developed with technical assistance provided by the UK DfID. At the same time, important progress made in 2004 will continue:

• With the support of the World Bank, the Government was able to retrench 519 civil servants in 2004. The budget for 2005 will include an allocation of K 65.7 billion to cover the unpaid retrenchment costs for 1733 employees whose positions will be eliminated. Savings arising from retrenchments will be allocated to priority sectors. The government has lifted the hiring freeze that it imposed in 2003 and, in 2004, authorized the recruitment of 1294 teachers and 285 health workers.
  
  
• In the health sector, the Government has decided to abolish the Central Board of Health and bring all health sector employees under the Ministry of Health. It is envisaged that this will, inter alia, facilitate improved control over pay and benefits and allow hiring to be focused on front line medical staff.
  
  
• In education, a grant from the Government of the Netherlands is expected to facilitate the payment of terminal benefits and the removal from the payroll of about 7,000 teachers in 2004. The Government is expected to hire an equivalent number of new teachers in 2005, to replace those who have been removed from the payroll.
  
  
• Following the agreement reached with the Zambia police and the prison service and immigration and fire-fighting personnel to restructure salary scales and consolidate 15 allowances in the basic salary, the pay reform will continue to be extended to other sectors.
  
  
• The Public Service Management Division (PSMD) anticipates completing the implementation of the computerized payroll management and establishment control (PMEC) system by June 2005. This system, currently covering the records of 83,000 employees, will enable the PSMD to monitor and report—with a minimal time lag—actual hiring and salary developments, including in the education and the health sectors.

37. In consultation with business representatives, the donor community, and other stakeholders, government has elaborated an action plan for the implementation of the Private Sector Development Initiative. Most recently, in October 2004, the Zambia International Business Advisory Council endorsed the PSD action plan. The government recognizes the urgent need to remove administrative obstacles to business licensing, streamline regulations and move forward with legislative proposals.

38. The Government remains fully committed to enhancing the quality of governance and the transparency of public sector operations. As indicated in the PRSP, the Government has elaborated and is implementing a policy of zero tolerance for corruption. To improve transparency, the Government is strictly adhering to budgetary procedures. In line with last year's timely submission, the audited accounts for 2003 will be submitted to Parliament by end-2004. The Government is also committed to strengthening the independence of the Office of the Auditor General. However, since this will require a constitutional amendment, the Government has presented a proposal to this effect to the Constitutional Review Commission.

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

39. The government is finalizing its second PRSP Implementation Progress Report, covering the period July 2003-June 2004. The report was prepared with the participation of a wide range of stakeholders and highlights poverty reducing outcomes in the areas of health, education, and small-scale agriculture. It also points out a number of areas where program implementation has been strengthened. Notably, the execution of the PRPs during the first half of 2004 improved substantially over the same period the year before. The report includes the updated medium-term macroeconomic framework, which forms the basis for the 2005-2007 MTEF. A preliminary report on PRSP implementation in the second half of 2004 will be included in the 2005 budget speech or the Annual Economic Report.

40. The removal of the debt overhang at the HIPC Completion Point is a key element in eliminating potential obstacles to investment, growth, and poverty reduction. The Government is continuing the commercialization of ZESCO, as envisaged under the plan supported by the World Bank. The second MTEF, covering 2005-07, was approved by cabinet in October 2004. Despite the delays in implementing the IFMIS pilot project, significant advances have been made, including the installation of a local area network in the MoFNP, in the preparation for the installation of IFMIS. Moreover, as noted above, there have been substantial improvements to current public expenditure management systems, such as extending the coverage of the FMS and strengthening the CCS. The Government is continuing with its efforts in the execution of programs in the education, health and HIV/AIDS areas, including poverty monitoring programs. In addition to intensifying reform efforts to meet the triggers, the Government is working on reconciling its debt with all external creditors. A new debt sustainability analysis (DSA) will be prepared in collaboration with the staffs of the Fund and the World Bank during the next few months.

VI. Technical Assistance

41. The government has requested technical assistance to strengthen capacity and support program implementation. In the financial sector, the BoZ is receiving assistance from the Monetary and Financial Systems Department (MFD) in the resolution of the three NBFIs and will request further assistance from the Legal Department in this area. The BoZ is also requesting technical assistance to support further development of monetary operations. Zambia is a participant in the General Data Dissemination System (GDDS) and is receiving technical assistance in the area of macroeconomic statistics, including BOP, national accounts and government finance statistics, under the project for Anglophone African countries, which is sponsored by DfID. Finally, a data ROSC was completed in 2004 and will provide the basis for an action plan to further improve the quality of statistical information.

VII. Program Monitoring

42. Progress in implementing the PRGF-supported program will be monitored quarterly, based on the quantitative and structural measures indicated in Tables 3 and 4. These targets are defined in the attached Technical Memorandum of Understanding. The Fund will conduct the second and third reviews of the PRGF-supported program based on performance through end-December 2004 and end-June 2005 respectively.

43. The Government is strengthening the effectiveness of the Economic Management Monitoring Committee at the MoFNP to provide timely reconciled financing and budgetary data and ensure that preemptive measures are taken to avoid lapses in program implementation.

Technical Memorandum of Understanding

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 and structural performance criteria, benchmarks, and indicative targets for the program supported by the PRGF arrangement, 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 the best understanding of the Zambian authorities and IMF staff to monitor the program.

II. Prior Action

2. The prior action described below should be carried out and reported at least five working days before the IMF's Executive Board discussion. The implementation of the prior action shall be conveyed through a written communication from the Minister of Finance and National Planning indicating that the prior action has been observed, using the language of the prior action itself.

A. Nonbank Financial Institutions (NBFIs)

3. The prior action on the nonbank financial institutions (NBFIs) will be met following the adoption by Government and the Bank of Zambia (BoZ) of action plans for the resolution of the National Savings and Credit Bank (NSCB) and the Development Bank of Zambia (DBZ). The Government will collaborate with the IMF and the World Bank in preparing the action plans and seek necessary technical assistance.

III. Quantitative Performance Criteria and Benchmarks: Definitions and Data Sources

A. Net Domestic Assets (NDA) of the BoZ

4. Net domestic assets (NDA) of the BoZ are defined as the monthly average (based on daily data) of reserve money less net foreign assets calculated at Kwacha 5,167 per U.S. dollar (program exchange rate).¹ Reserve money consists of currency issued, 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 in the BoZ of non-central government institutions. Net foreign assets of the BoZ are defined as gross international reserves (defined below) plus any other foreign assets, including the US$25 million blocked reserves at the former Meridien Bank (MBZ), minus foreign liabilities (defined below). The Kwacha values are derived from the U.S. dollar values using the program exchange rate.

5. Foreign reserve 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 IMF credit.²

6. 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 (item 10) of the Memorandum of Economic and Financial Policies (MEFP), up to a maximum of US$20 million for the period end-December 2004 to end-December 2005. 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 the stock of Treasury bills or bonds held by commercial banks and the non-bank sector, then the programmed NDA will be adjusted upward by that amount. The Kwacha value of the cumulative shortfall/excess will be calculated at the program exchange rate.

7. The ceiling on NDA will be adjusted downward/upward to reflect decreases/increases in the legal reserve requirements on deposits in commercial banks. 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.

B. Net Domestic Financing (NDF)

8. Net domestic financing is defined as the Central Government's net borrowing from the banking and nonbanking sectors (Table 1). All government-issued securities will be recorded at cost (face value less discount). NDF 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 MBZ; and (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; and (v) the donor suspense account; plus (vi) the long-term non-transferable security issued against the 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 the privatization of the Zambia National Commercial Bank (ZNCB), the measurement of NDF will exclude the government bond issued to ZNCB in 2002 in the amount of K 249 billion.

9. 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 (item 10) of the MEFP, up to a maximum of US$20 million for the period end-December 2004 to end-December 2005. 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 corresponding monthly average of the BoZ mid rate.

10. 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

11. Unless otherwise noted here, gross international reserves of the BoZ will be defined as reserve assets of the BoZ (Table 2). Reserve assets are defined in the IMF BOP manual (5th edition) and elaborated in the reserve template of the IMF'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.

12. 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 IMF; and (vi) balances in the BIS account related to debt service to Paris Club creditors. Gross reserves 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 bank reserve requirements in foreign currency, and the US$25 million deposit in MBZ, which is under liquidation.

13. 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 (item 10) of the MEFP, up to a maximum of US$20 million for the period end-December 2004 to end-December 2005; (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 the stock of Treasury bills or bonds held by commercial banks or the nonbank sector, then the programmed reserves buildup will be adjusted downward by that amount; (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 residents and nonresidents), using the definition of short-term debt below.

14. 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.

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

D. External Payment Arrears

16. The performance criterion on the non-accumulation of new external arrears is continuous. Official external payment arrears are defined as unpaid debt service by the Central Government and BoZ, beyond the due date and/or the grace period, if any. This definition excludes arrears subject to rescheduling. It also excludes the accumulation of external arrears that arise from the transfer to non-residents of foreign currency denominated obligations owed by the Government of Zambia to resident creditors.

17. Data on arrears are compiled jointly by the Ministry of Finance and National Planning (MoFNP) and BoZ and will be reported by the MoFNP on a quarterly basis.

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

18. Official medium- and long-term concessional external debt 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.

19. 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. This excludes non-concessional loans stemming from the rescheduling of external arrears.

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

F. Official External Short-Term Non-concessional External Debt

21. Official external short-term non-concessional external debt 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; see Annex).

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

G. Collateralizing/Guaranteeing of Loans to the Zambia Electricity Supply Corporation (ZESCO)

23. The Government and the BoZ shall not extend or guarantee any new commercial debts of the Zambia Electricity Supply Corporation (ZESCO), including in the form of loans, suppliers credits and leases. New concessional borrowing, as defined above (Paragraph 19), will be subject to a cumulative limit of US$20 million in 2005. The limit on new concessional borrowing will be subject to review, in consultation with IMF and World Bank staff, in the event that additional concessional resources are required.

H. Domestic Arrears of Government

24. 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 all forms of housing allowances, 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.

25. Information regarding domestic arrears 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 IMF staff by the Secretary of the Treasury within six weeks of the end of each quarter.

I. The Central Government's Wage Bill

26. For the purposes of the wage bill, the definition of Central Government includes all heads covered in the 2005 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 allowances to employees. 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.

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

IV. Structural Performance Criteria and Benchmarks

A. Public Expenditure Management

28. The Government will refrain from making payments for which it is not legally liable. It will also guide the liquidation and receivership process of public enterprises to minimize the Government's liabilities consistent with the law.

29. The MoFNP will publish quarterly budget execution reports using the classification system of activity-based budgeting within 45 days of the end of each quarter.

30. The MoFNP, in consultation with its cooperating partners involved in the public expenditure management reform process, will develop and adopt a work program for the first year of implementation of the Public Expenditure Management and Financial Accountability (PEMFA) reform program. The work program will detail the milestones of the program, indicators, monitoring mechanisms, and reporting requirements. The milestones will mark the further strengthening of the commitment control system, reform of the audit system, and improvements to the MTEF process. The MoFNP will provide the adopted work plan to IMF staff by February 15, 2005.

31. In line with the revised definition in the PRSP, the MoFNP will use the activity-based budgeting classification introduced in 2004 to identify all poverty-reducing spending programs in the central government operations. The budget for 2005 will account for allocations on poverty-reducing programs on the basis of the new wider definition indicated above.

32. The Government will initiate the piloting of the IFMIS in at least three ministries as a key step to introduce an effective system in all ministries and province.

33. The Government will report the findings of a preliminary review of the piloting of the IFMIS in at least three ministries. This preliminary review will lead to the completion of a mid-term review of the pilot program as envisaged in the Enhanced HIPC Initiative completion point document.

B. Financial Sector Reform

34. Cabinet approval of a proposal to repeal sections of the Building Societies Act, the NSCB Act, and the DBZ Amendment Act, so that these institutions can be incorporated under the Company's Act, to remove inconsistencies with the Banking and Financial Services Act, and to strengthen the BoZ's supervisory powers over NBFIs. The proposal will be prepared with the aid of technical assistance from the Legal Department of the IMF.

35. Adoption by Government and the BoZ of an action plan, finalized in consultation with the World Bank and the IMF staff, for the resolution of the Zambia National Building Society.

C. Governance and Transparency

36. Unbudgeted expenditure requirements will be funded only to the limits of the contingency resources indicated in the budget or only after the Cabinet has approved any changes by finding compensatory funding within the approved budget resources.

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 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.

Table 2. Zambia: Gross International Reserves1 (In thousands of U.S. dollars)
	2005 March, June, September, December
	Amount	Current Each rate or price	U.S. dollars	End-Sept. 2004 Each rate or price	U.S. dollars
Official reserve assets2
Foreign Currency Reserves
Securities
In U.S. dollars
In U.K. pounds
In Euro
Other currencies
Deposits3
In U.S. dollars
In U.K. pounds
In Euro
In South African Rand
Other currencies
IMF reserve position
SDR (excludes IMF interim assistance    under the HIPC Initiative)
Monetary gold
Other reserve assets
Memo: Other foreign currency assets4
Predetermined short-term net drains5
Liabilities to IMF
Other foreign currency loans    and securities
In U.S. dollars
In U.K. pounds
In other currencies
Aggregate short and long positions    in forwards, futures and swaps
Other
Contingent short-term net drains
Contingent liabilities
Securities with embedded options
Undrawn, unconditional credit lines
Aggregate short & long term    positions of options
Memorandum items:
Short-term domestic currency debt    indexed to the exchange rate
Financial instruments denominated    in foreign currency settled by    other means
Pledged assets
of which: Balance of IMF interim       HIPC assistance
Securities lent and on repo
Financial derivatives (net, marked    to market)
Derivatives w/ residual maturity > 1    year, subject to margin calls
1As defined in the TMU or IMF, "Data Template on Int'l Reserves and Foreign Currency Liquidity: Operational Guidelines." 2Corresponds to gross international reserves for program monitoring 3Excludes deposits at resident banks, unless assets held abroad by the bank are explicitly connected to the foreign exchange deposits of the BoZ and are totally and effectively controlled by BoZ and are available for balance of payment needs. 4Includes foreign currency deposits at resident banks. 5The performance criteria on gross international reserves will be adjusted as described in the TMU.