Manaugua, Nicaragua
January 27, 1999

Dear Mr. Camdessus:

1.  Over the past several weeks the government has been assessing the human and physical toll resulting from the devastating effects of Hurricane Mitch, as well as the short- and medium-term impacts on the economy. The authorities have discussed with the staff of the Fund the appropriate economic policies to begin addressing the problems of reconstruction and the effects on the fiscal and balance of payments positions.

2.  The hurricane and subsequent rain storms resulted in about 3,000 deaths and the displacement of more than 400,000 people (close to one tenth of the country's population). There have been significant losses of agricultural crops, as well as destructions of roads, bridges, schools and housing, and power and water facilities. It is estimated that the total destruction of infrastructure and agricultural and other sectors' output amount to some US$1½ billion, the equivalent of 65 percent of GDP.

3.  The government has reiterated its commitment to the policies and objectives of the economic program supported by the ESAF arrangement that was approved by the Fund on March 18, 1998. The government intends to address the problems of reconstruction expeditiously and efficiently, while safeguarding the main financial and structural elements of the ESAF supported program. Within this framework, the government has started to prepare a five-year program of reconstruction, in which the additional financing requirements are expected to be covered through concessional aid from multilateral and bilateral sources. Following the Consultative Group Meeting for the Central American countries in Washington, D.C. last December, the government has initiated discussions with the World Bank, the IDB and bilateral donors on additional financing over the next five years. In this context, the government would like to request an augmentation of resources committed under the three-year ESAF arrangement for Nicaragua in the amount of SDR 48.05 million.

4.  The attached Memorandum of Economic and Financial Policies reviews performance under the program in 1998 and outlines the policies to address the fiscal costs of reconstruction. At this time revised benchmarks are presented for the end 1998, and preliminary targets and benchmarks are presented for the first quarter and the end of 1999. The macroeconomic targets, policies, and financing requirements for 1999 would be reviewed and agreed with the staff during the discussions for the second annual ESAF arrangement.

1.  In 1998 the government has implemented economic policies in line with the ESAF supported program; the fiscal performance was somewhat better than anticipated and important progress was made on structural reforms. Before the hurricane, economic indicators had pointed to a GDP growth of 5.5 percent in 1998 and the government had projected 6.5 percent growth in 1999. Because of the loss of part of agricultural production and exports as a result of the rain storms, the 1998 GDP growth estimate has been scaled down to 4 percent. For 1999, a lower than previously expected growth of agriculture could largely be offset by rehabilitation and reconstruction activities, and their effects on other sectors, and overall output growth could still be about 6 percent. In the first nine months of 1998, the 12-month inflation rate was higher than targeted in the program (12 percent compared with 8 percent in the program), mainly as a result of a faster than programmed depreciation of the cordoba under the crawling peg system. Inflation rose to 18 percent in November and December, reflecting a temporary sharp rise in food prices in the wake of the hurricane. Inflation is expected to decline to pre-hurricane levels during the course of 1999 and the authorities have targeted a rate of 12 to 14 percent by year-end; subsequently, inflation should return to single digit levels, as envisaged in the ESAF-supported program.

2.  In the first three quarters of 1998 the fiscal outturn was better than programmed, with higher public sector saving and lower overall deficit, because of stronger than projected revenues and lower outlays. Credit policy was in line with the program, and the central bank's short-term exchange rate indexed liabilities (CENIS) were reduced as envisaged. However, a sizeable shortfall in disbursement of aid for balance of payments support had a negative impact on the net international reserves (NIR), the central bank's net domestic assets (NDA), and the domestic financing of the public sector. Most of the shortfall resulted from lower disbursements by the World Bank and the IDB, owing to delays in the approval of certain legislation, which in turn slowed some structural reforms. These problems are being corrected (part of the withheld aid in the first half of 1998 was disbursed in August and September) and the authorities have agreed with staff of the World Bank and the IDB a revised schedule of actions and disbursements. In the absence of the aid shortfalls, the performance criteria for June 1998 on NIR, NDA, and public sector domestic financing would have been met. Waivers are thus requested for the non-observance of these performance criteria.

3.  Substantial progress is being made on the structural front. The banking system is being strengthened with the closing or privatization of financially weak state banks. In June 1998 the large state bank, Banco Nacional de Desarrollo (BANADES) was liquidated, and the National Assembly approved the law for the privatization of the another major state bank, Banco Nicaraguense de Industria y Comercio (BANIC). In November, private investors were invited to bid for ownership of 51 percent of BANIC's equity. In December, the shares of the second tier state-owned financial institution, the Fondo Nicaraguense de Inversion (FNI), were offered for sale, and the government submitted to the Assembly a bill that would permit the partial privatization of the last state bank, Banco de Credito Popular. In addition, the Assembly approved the laws for the sale of the state telephone company (ENITEL), for the restructuring of the power company (ENEL) and the leasing of its units of generation and distribution, for the private sector management of the water supply system, and for the opening of the oil sector to private investors. Finally, the Assembly also approved the law for the restructuring of the Executive Branch aimed at reducing the number of ministries and streamlining the government.

4.  However, the offer for sale of 40 percent of the shares of ENITEL—which was a structural performance criterion—was not announced in June as envisaged. As noted above, the National Assembly approved the law for the privatization of ENITEL in June but the authorities decided to take certain actions to improve the prospects for sale, including the implementation of a new tariff structure. In addition, the preparation of the sale with transparent procedures conducted by an international investment bank (Rothschild and Sons) required more time than had been envisaged. The sale process for ENITEL started in October 1998, and in December ENITEL's new tariff structure was approved and the pre-qualified potential investors were made public. Following two rounds of consultations with potential investors, final invitation to bid is expected in April 1999. On this basis, the government requests a waiver for the nonobservance of the performance criterion related to the sale of ENITEL.

5.  Over the past several weeks the government has concentrated its efforts on the delivery of emergency assistance to the regions and families affected by the hurricane, and has started to prepare a five-year program of reconstruction. Adjustments were made to the 1998 central government budget and, on a preliminary basis, to the 1999 budget to permit the initiation of rehabilitation and reconstruction. It is anticipated that a large part of the resulting fiscal costs would be financed by external grants, concessional loans, and additional debt relief, and the government is determined to increase its efforts at mobilizing domestic resources to help cover these costs.

6.  With the adjustments already made to the budget for November and December of 1998, it is estimated that the program's original targets for the saving position and the overall deficit of the combined public sector in 1998 still were met because of the margins of overperformance that had accumulated in the first ten months of the year. Furthermore, after taking account of the shortfalls in aid for balance of payments support, as mentioned above, the December benchmarks for NIR, NDA, and domestic financing of the public sector also were met.

7.  Over the next several weeks the government would finalize the preparations of its economic program for 1999. The program will include the first year of reconstruction and the expansion of special social projects initiated in late 1998 that are being financed by the newly created Supplementary Social Fund (SSF). The reconstruction and SSF programs (which are expected to be concentrated in the areas affected by Hurricane Mitch) are to be financed with concessional external aid. These programs will advance as expeditiously as possible, as appropriate external financing becomes available. The authorities estimate that the aggregate additional public sector expenditures related to reconstruction and SSF programs could reach about US$160 million (7 percent of GDP) in 1999. On this basis, and taking account of compensatory fiscal actions (as described in paragraph 10), it is projected that the combined public sector deficit would rise to 11 percent of GDP in 1999, compared with an original target of 5 percent of GDP in the ESAF program.

8.  Depending on the capacity of project execution, and provided that domestic price pressures are kept in check, projects amounting to an additional US$50 million could be added to the budget during the course of 1999, on the basis of a satisfactory evaluation by the World Bank and full concessional financing. The authorities have requested the World Bank to assess a revised public investment program for the 1999 budget, and for the period of the reconstruction program.

9.  The authorities are fully committed to achieving the macroeconomic objectives of the ESAF-supported program, and in this context the additions to the fiscal program described above would be made within a framework of price stability and improvement of the external position over the medium term. The authorities will be monitoring closely developments in domestic demand and would take appropriate fiscal and monetary measures, as needed, to prevent in particular the build up of pressures on domestic prices. To this end, if the 12-month increase in prices (excluding food, energy, and public utilities) were to exceed the threshold of 15 percent over two consecutive months, consultations with the Fund staff would be held on the need to adopt corrective fiscal and monetary measures.

10.  In an effort to mobilize domestic resources, the government has submitted to the Assembly a tax package, which includes an increase in excises on cigarettes, soft drinks, and liquor. On the side of expenditures, the government is in the process of identifying a number of projects from the public investment program that could be delayed or eliminated to make additional room for those associated with the program of reconstruction. Control on less priority outlays (non-social and non-hurricane related outlays) will be tightened, in particular the public sector wage bill. Following long overdue adjustments in the salaries of teachers, health personnel, and police in 1998–99, no other general or sectoral increases will be granted in the government wages and salaries during 1999.

11.  The authorities are committed to the financial strengthening of the state-owned enterprises. In the case of the power company (ENEL) and the water and sewerage company (ENACAL) the government is stepping up the efforts to improve revenue collection and to speed up the rehabilitation of damaged plant and equipment. Regarding revenue, ENEL and ENACAL will continue to adjust their rates to cover long-term marginal costs and to phase out cross subsidies. Because of lower international oil prices, the thermal factor in power rates that was put into effect at the end of 1997 lapsed at the end of December 1998. However, ENEL will continue to activate the thermal factor in power rates to compensate for increases in fuel costs and purchases of energy above its programmed levels. To strengthen collection procedures the government will seek approval by the Assembly of legislation typifying the theft of public utilities' output as an action subject to penalties. On expenditure, the government will seek to ensure that the additional investment needs of the enterprises are financed largely with multilateral and bilateral external aid flows and that additional efforts are made at restraining current outlays, including the wage bill.

12.  The central bank will continue to maintain a cautious credit policy, particularly in view of the anticipated expansion of government expenditures. Thus, the 1999 monetary program is being designed with an expansion of monetary aggregates and a contraction in the central bank's NDA consistent with the inflation target and an increase of US$120 million in NIR. Gross international reserves are expected to rise to 2.7 months of imports, which is similar to the level originally envisaged in the ESAF program for 1999. The tightness of credit policy will be monitored closely during the course of 1999 together with the pace of the public sector expenditures. In case reconstruction related expenditures were to advance at slower pace than envisaged, and provided that domestic price pressures are contained, the central bank may resume the net redemption of its short-term exchange rate indexed liabilities (CENIS). In addition to helping to reduce a source of debt vulnerability, such redemptions could provide some additional liquidity to the banking system, if needed, to support the recovery of private sector activity. On exchange rate policy, the authorities have decided to continue in 1999 the crawling exchange rate depreciation vis-à-vis the U.S. dollar at the current rate of 12 percent per annum, given the weakened external position of the country at the present time; however, the option for a more flexible rate of crawl will be kept open, and this rate might be reduced depending on developments in domestic inflation and the external sector.

13.  Continuing progress is being made in the structural front. On public employment reduction, some 970 positions were eliminated by the end of December 1998, compared with a revised target of 1,200. With an acceleration of the early retirement program it is expected that implementation of the program would be completed by end-March 1999. The social security reform is being prepared with the help of international advisors, and the authorities will proceed with the separation of the pension and health accounts no later than February 1999. On privatization, the government plans to divest or grant long-term concessions of ENEL's activities in the areas of distribution and generation; in preparation for this, ENEL's assets and activities will be separated into distribution, transmission and generation before mid-1999, and an international invitation for the pre-qualification of investors will be made by September 1999. Also, the state oil company, PETRONIC, will be offered for a long-term lease and private management is expected to take over by the end of June 1999.

14.  The government plans to accelerate other structural reforms to facilitate a rapid economic recovery in 1999. The acceleration of reforms also would facilitate the consideration by the Fund and the World Bank for an early decision point under the HIPC Initiative. In this context, the authorities have discussed with the staff of the Fund and the World Bank the following reforms : (i) the strengthening of the financial system, with new legislation to be adopted in 1999 for the Superintendency of Banks (to strengthen bank oversight), the banking system (to improve efficiency and bank soundness), and changes in the central bank charter; (ii) the reform of social security, with the approval of new legislation to restore its viability and with a new system of private sector management of individually funded accounts; (iii) the strengthening of governance with the passage of a new law on procurement to improve transparency in public finances, and with the acceleration of progress on property rights and the reform of the judicial system; and (iv) implementation of reforms of the education and health sectors, aiming at substantially increasing the coverage of primary education and basic and preventive health care services. It is anticipated that legislation for the Superintendency of Banks, for the banking system and for the procurement of the public sector would be approved by mid-1999. Draft legislation for the social security reform is expected to be submitted to the National Assembly by July 1999 and approved by the end of the year.

15.  The attached table presents indicative benchmarks for December 1998 and March 1999 on the saving and overall deficit of the public sector, the central bank's NIR floors and NDA ceilings and the ceilings on public sector indebtness on commercial terms.