Lusaka, March 10, 1999

Mr. Michel Camdessus
Managing Director
International Monetary Fund
Washington, D.C. 2043.

Dear Mr. Camdessus,

During the last few years, Zambia has continued to make progress in stabilizing the economy and implementing structural reforms, including the privatization of state enterprises, the reform of the public service, and the strengthening of the banking sector. The country has experienced a strong growth of economic activity in the nontraditional sectors since the start of our adjustment program, and the fight against inflation has born results. The recent progress on the privatization of the copper mines has been crucial in creating an enabling environment for economic growth in the coming years. Notwithstanding these encouraging developments, Zambia's economic recovery remains fragile, and we must continue with our macroeconomic stabilization and structural reform efforts in order to establish the conditions for sustained economic growth.

The attached Memorandum of Economic and Financial Policies of the government of Zambia describes the policy objectives for 1999. The government's medium-term macroeconomic and sectoral policy objectives are embodied in a policy framework paper (PFP) for the period 1999-2001. In support of the program for 1999-2001, the government hereby requests a three-year arrangement from the Fund under the Enhanced Structural Adjustment Facility in an amount equivalent to SDR 254.45 million (52 percent of quota).

We believe that the policies and measures set forth in the attached Memorandum are adequate to achieve the objectives of the program, but will, if necessary, take any additional measures deemed necessary for this purpose. During the period of the arrangement, we will consult with the Fund on the adoption of any such measures in accordance with the Fund's policies on such consultations. The government of Zambia will provide the Fund with any information that may be requested for the purpose of monitoring progress under the program.

1. This memorandum summarizes the government's medium-term adjustment strategy for the period 1999-200¹ The medium-term strategy is elaborated in the policy framework paper for 1999-2001. and presents its economic and financial program for 1999.
II. Medium-term adjustment strategy
2. Our main macroeconomic objectives for the period 1999-2001 are to achieve average economic growth of about 5 percent a year, further reduce inflation, and strengthen the external position. To that end, we will continue our stabilization efforts through prudent financial policies, complemented by structural reforms, specifically public service reform, privatization, a strengthening of the banking sector, an improved legal framework and the provision of growth-enabling infrastructure. These reforms will be essential for removing the bottlenecks that hamper the development of the private sector, which, in turn, will create the conditions for making a dent in the widespread poverty through job creation in the private sector.
3. The main sources of economic growth over the medium term are in mining, agriculture, tourism, and export-oriented manufacturing:
• We expect copper production to grow by some 10 percent a year during 1999-2001. In the wake of the recent economic crises in Asia, the copper price has weakened considerably and is projected at about US$1,600 per metric ton over the medium term.
• The government recognizes that sustained growth in agriculture, which contributed about one-fifth of GDP over the 1990-97 period, will require the elimination of bottlenecks on the supply side, notably through improved roads, increased access of farmers to new production and harvest technologies, and wider access to financing. The government will also emphasize and stimulate the role of the private sector in agriculture and refrain from intervening in the marketing of agricultural products and input supply, except in the context of officially declared emergencies and specifically targeted poverty reduction schemes. Agricultural production is projected to grow on average by some 7½ percent a year, driven importantly by the nontraditional sectors, including cotton, tobacco, horticulture, and floriculture. Past agricultural reforms, including the liberalization of prices and the privatization of support services, processing, and distribution, have encouraged new private sector initiatives.
• Several recent developments have affected tourism positively, including the establishment of a number of private airlines and the leasing to the private sector of government lodges.
• The restructuring of the manufacturing sector has been accelerated by trade and exchange reforms, as well as by progress in privatization and the removal of restrictions on private sector activities.
• The tariff reform of 1996 and the elimination of the import declaration fee in 1998 have been particularly beneficial in enhancing the attractiveness of producing for exports. A continuation of these policies should encourage further growth in these sectors.
4. The growth projections are predicated on normal weather conditions and a steady increase in investment to 21 percent of GDP in 2001 from 14½ percent in 1998, with the bulk of the increase originating from foreign investment in the mining sector. Improved macroeconomic conditions and a strengthened banking system should help raise the national savings rate by about 7 percentage points of GDP while reducing the savings-investment gap by about 1 percentage point between 1998 and 2001.
5. The medium-term fiscal strategy will aim at reducing the overall fiscal deficit to about 1 percent of GDP by 2001, which will require domestic fiscal surpluses of about 1 percent of GDP a year (excluding exceptional lending to the mining parastatal (ZCCM). In view of the limited scope for raising substantially the revenue- and expenditure-GDP ratios, the need for expanding investment in infrastructure and social services will require a significant reallocation of public outlays. The lowering of the combined wage and interest bill as a share of total expenditure over the medium term will create room for stepped-up expenditure in priority areas. As the scope for raising tax rates and introducing new taxes is limited, the revenue effort will need to come mainly from a further strengthening of tax administration, while avoiding new tax exemptions and special regimes. We also intend to undertake a study of the structure of corporate income tax rates, with a view to unifying these rates in a revenue-neutral manner.
6. The main objective of monetary policy is reducing inflation through an appropriately tight policy stance, notably by controlling the expansion of reserve money and maintaining positive real interest rates.
7. The privatization of state enterprises is key to the government's efforts to raise efficiency and bolster economic growth. In January 1999, the government and a foreign mining company reached firm understandings on the sale of the main asset packages of the ZCCM, which is expected to take place by end-March 1999. As regards the nonmining sector, we plan to do the following:
• offer for sale a minority shareholding and management rights in the telecommunications company (ZAMTEL);
  
• concessioning of the railway system;
  
• privatize the Zambia National Commercial Bank (ZANACO);
  
• instruct the Zambia Privatization Agency (ZPA) to explore the options for divestiture of the electricity company (ZESCO), parastatals in the transport sector (the Njanji Commuter Company and ZAMPOST), and the National Savings and Credit Bank;
  
• ensure that the Zambian and Tanzanian privatization agencies will submit recommendations to their respective governments on options for private sector participation in the operations of the commonly owned TAZARA railway and TAZAMA pipeline.
8. The government adopted on September 1, 1997 a comprehensive public service reform program, with the twin objectives of reducing excess employment in the public sector and improving the delivery of public services by, inter alia, eventually offering a more competitive remuneration. Some 15,500 public workers were retrenched between December 1997 and end-1998 under this program. The original plan envisaged a reduction in the size of the public service to 80,000 employees by end-1999. However, an updated payroll analysis suggests that such a sharp reduction in the public service cannot be realized without reducing employment in education and health care. With the assistance of the World Bank, we are carrying out more detailed work to determine the optimal size of the civil service in the medium term. Nonetheless, for 1999, we are targeting a reduction in the number of civil servants to 112,500, which entails removing 7,000 civil servants from the payroll through retrenchment, natural attrition, and the hiving off of public institutions. Owing to delays in the retrenchment of pensionable civil servants in 1998, we envisage an extension of the timetable for the implementation of a revised program through 2001. A new civil service remuneration structure, which will address, inter alia, the significant compression in the pay scales, will be introduced after the substantial completion of the retrenchments, but with the understanding that the central government wage bill will not exceed 5 percent of GDP.
9. The liberalization of the trade regime has contributed importantly to the expansion of private sector activity. The government intends to complete this process by following up on its commitments under the Cross-Border Initiative, as well as by reducing import tariffs to a weighted average of close to 10 percent. To this end, we also intend to reduce the maximum import tariff rate from 25 percent to 20 percent by 2001.
10. During 1999-2001, we intend to make significant progress toward the attainment of external viability by
• fostering a stable macroeconomic environment;
  
• maintaining trade and exchange rate policies that are conducive to the further expansion of nontraditional exports;
  
• revitalizing the mining sector, led by the privatization of the ZCCM;
  
• raising national savings;
  
• increasing gross official reserves to the equivalent of about three months of imports.
11. Zambia's heavy external public debt burden will require continued reliance on debt relief and concessional balance of payments assistance for the foreseeable future. We intend to make a request for debt relief under existing mechanisms in early 1999. In addition, we hope to qualify for assistance under the Heavily Indebted Poor Countries (HIPC) Initiative, as it is not expected that the external debt burden can be reduced to sustainable levels without such supplementary debt relief. We recognize that consideration for participation in the HIPC Initiative will require a strong track record under Fund- and Bank-supported programs, improvements in our capacity to produce accurate debt and external sector statistics, and the maintenance of an accurate database on social sector outlays.
12. The widespread poverty in Zambia remains a key concern. The government has prepared a National Poverty Reduction Plan, which aims to reduce the overall incidence of poverty from the current 70 percent of the population to 50 percent by the year 2004. This is to be achieved through rural development, increased investment in infrastructure, the development of human resources, and targeted poverty reduction programs. In this regard, we intend to allocate at least 36 percent of domestic expenditure (excluding debt service) to the social sectors in 1999-2001. We also intend to promote the construction of dwellings and home ownership through the President's housing initiative, which is expected to gain momentum in 1999.
III. The program for 1999
13. The government's macroeconomic objectives for 1999 are to achieve real GDP growth of 4 percent; reduce inflation to 15 percent (end-of-year basis); and strengthen the external position by adding some US$120 million to gross international reserves. The principal structural reforms in 1999 relate to public service reform, privatization, and the strengthening of the banking sector.
A. The Budget for 1999
14. Our main fiscal policy objectives are to reduce inflation, to reconfigure the expenditure profile toward high-priority sectors, and to contribute to an increase in national savings. We will aim at limiting the overall fiscal deficit to K 250 billion (3.2 percent of GDP) and attach great importance to controlling firmly the government wage bill and implementing a restrained public service wage policy. As part of the budget process, we will in 1999 continue to operate a contingency reserve mechanism to cope better with unforeseen outlays and revenue shortfalls.
15. Domestic revenue is programmed to increase by 30 percent to K 1,460 billion in 1999, which takes into account the improvements in tax administration, notably in personal and company income taxes.² Also, we are continuing to step up our efforts to combat smuggling and customs fraud. In this regard, as part of the customs modernization project, antismuggling operations started in November 1997, and the collection of excise duties was tightened, including through the closure of major loopholes, during 1998. Furthermore, we expect positive effects on value-added tax (VAT) and customs revenue from the ongoing computerization of controls on removals in bond and transit and customs declarations, as well as from increased cooperation with customs officials in neighboring countries.
16. To achieve the targeted improvement in revenue performance, it will be crucial to maintain the integrity of the tax system. With a view to protecting the tax base, we have revoked import duty and import VAT exemptions granted in September-October 1998 to three companies,³ including ZESCO. We will ensure that the duty exemptions granted to the parliament⁴ will be limited to goods imported through the National Assembly for use by parliamentarians in performing their official duties. In practice, this exemption will apply only to the importation of one official car for each parliamentarian. In addition, we will refrain from introducing any tax reductions, new exemptions, rebates, or any other preferential tax treatment in 1999, except for the suspension of import duties on agricultural machinery and equipment, and the specific tax concessions that were made in the context of the privatization of the ZCCM.
17. Total domestic expenditures (excluding the contingency reserve) in 1999 will increase by 29 percent to K 1,333 billion. As regards current outlays, the wage bill will increase by 21 percent to K 395 billion (5 percent of GDP), which will be achieved by limiting the average per worker pay increase to 22 percent (including wage drift), retrenching public workers, and setting limits on employment levels in 1999 (see ¶26 below). Domestically financed capital expenditure will increase by 23 percent over the 1998 budget provision, to K 170 billion. More than 25 percent of this amount will be used to improve the road infrastructure, and about 10 percent of the funds will be spent on water and sanitation facilities. Foreign-financed capital expenditure is projected at K 666 billion, of which more than 30 percent will be spent in the social sectors, 36 percent on infrastructure, about 13 percent in the agricultural sector, and about 9 percent on private sector development. Exceptional charges in this year's budget consist of the retrenchment costs for 7,000 civil servants and the lending to the ZCCM of K 302 billion for the financing of the retrenchment of 7,500 workers and the settlement of arrears.
18. To strengthen the cash management of the budget, the government will establish a contingency reserve of K 147 billion in 1999, which will be utilized to offset unforeseen shortfalls in domestic revenue and external program assistance, and to cover unforeseen domestic arrears and interest payments up to the total amount allocated for each quarter. Any remaining amounts in the quarterly contingency reserve would then be allocated in the month following the quarter to projects that could not be funded in the original budget. The contingency reserve will also be used if a tightening of the fiscal stance is needed to counter unexpected macroeconomic developments.
19. The government is strengthening budgetary procedures, notably with respect to spending commitments, cash outlays, and domestic arrears. Two comprehensive audits of domestic arrears, completed in 1998, are being used to build a database for the monitoring and payment of arrears, as well as for the analysis of commitments. In addition, six principal budget management measures will be introduced in 1999:
• quarterly auditing of arrears and commitments by the Ministry of Finance;
  
• the establishment of a coordination cell in the Budget Office for cash release and monitoring of ministry monthly returns on commitments, expenditures, and arrears;
  
• outstanding commitments of ministries at any time must not exceed 10 percent of their warrant limit without the specific agreement of the Permanent Secretary of Budget and Economic Affairs;⁵
  
• the rationalization of commercial bank accounts held by ministries, and, where appropriate, the transfer of these accounts to the central bank by end-June 1999;
  
• the completion, by June 30, 1999, of a comprehensive inventory of capital projects, complemented by a review of the management and control of ongoing capital projects; and
  
• the completion, by end-June 1999, of a feasibility study of a computer-based financial management information system.
B. Monetary and Credit Policy
20. The key to bringing down inflation is a firm control over the growth of money supply. Taking into account the programmed strengthening in 1999 of the net foreign assets position by almost 23 percent of beginning-of-year broad money, net domestic assets of the banking system will need to be reduced by about 2½ percent of beginning-of-year broad money. To provide sufficient credit to the private sector, which is projected to grow in line with nominal GDP, net bank claims on the government will need to contract by K 109 billion. The increase in treasury bill rates since mid-May 1998 has contributed to our objectives of stabilizing the kwacha and mobilizing financial savings. We will continue to maintain positive real interest rates.
21. With a view to keeping broad money growth within the program targets, the Bank of Zambia (BoZ) will carefully monitor the growth of reserve money. The targeted improvement in the net foreign assets position of the BoZ will require a decline in its net domestic assets of about 4 percent. On November 1, 1997, when the payments clearing house was transferred to commercial banks, the BoZ ended operation of its unsecured overdraft facilities to financial institutions. It will continue to refrain from providing unsecured overdrafts to commercial banks.
C. External Sector Outlook
22. Notwithstanding the projected recovery in metals production and robust growth of nontraditional exports, the current account deficit (including official transfers) is expected to widen from an estimated 8 percent of GDP in 1998 to almost 9 percent in 1999. The balance of payments projections assume an average copper price of US$1,507 per ton, copper export volume growth of about 16 percent, and import volume growth of about 13 percent. The growth of imports mainly reflects higher imports of capital goods by the mining sector. With adequate external support, the BoZ will be able to build up its official reserves without putting undue pressure on the exchange rate.
23. The exchange rate of the kwacha is market determined, and the BoZ will continue to refrain from interventions in the exchange market that go against underlying market trends. We will closely monitor conditions in the exchange market and price and exchange rate developments in other major countries in the region, and we will adjust policies if exchange rate developments jeopardize the inflation objective or Zambia's external competitiveness.
24. The external financing requirement before Paris Club debt relief is estimated at US$526 million in 1999 (excluding foreign-financed capital expenditure). Of this amount, US$175 million could be covered by World Bank program assistance,⁶ US$20 million by the African Development Fund, US$50 million by the European Union, US$50 million by the United Kingdom, and US$12 million by Germany. The remaining financing gap (US$219 million) could be filled by debt relief.
25. The government intends to remain current on all its external debt-service obligations and start discussions with the Paris Club in early 1999 on the rescheduling of debt-service obligations falling due during 1999-2001. We will also make efforts to reach an agreement with Russia on the rescheduling of outstanding debt, consistent with the 1996 Paris Club rescheduling agreement, and with non-Paris Club bilateral official creditors, both on terms at least as favorable as Naples terms. We will also settle in 1999 payments obligations dating from the era of exchange controls that give rise to exchange restrictions under Article VIII of the Fund's Articles of Agreement.
D. Structural Reforms
Public service reform
26. The program for 1999 envisages that a further reduction in the size of the public service will take place in the context of the restructuring of ministries, the hiving off of government units,⁷ and the government's long-term strategy to develop the sustainable capacity needed in the public sector to deliver high-quality services. With the assistance of the World Bank, we have drawn up a detailed implementation plan for the retrenchment of 7,000 public sector employees in 1999 to be achieved through (i) the hiving off of three government institutions with a total of 3,754 employees; (ii) the elimination of 500 positions in restructured ministries; (iii) 645 voluntary separations; (iv) natural attrition of 355 employees (on a net basis); and (v) the compulsory separation of 1,746 contractual daily employees. To ensure that the total cost of retrenchment of pensionable civil servants in 1999 will not exceed K 80 billion, we will adjust the benefits that separated civil servants presently can claim under the Public Service Pensions Act. An actuarial review of civil service pensions, which will specifically correct the anomalies in the various pension options under the present plan, will be submitted to the President by end-April 1999.
27. The monitoring of the targeted reductions in the public service will require reliable payroll data and effective controls on the establishment register. At present, inconsistencies exist between the payroll data of the Ministry of Finance and the establishment register managed by the Cabinet Office. By end-April, 1999, we will submit recommendations on improving the quality of the payroll data and establishing controls. In the meantime, the size of the public service will be monitored on the basis of the payroll data of the Ministry of Finance.

Privatization

28. The government will continue to give high priority to the privatization of state-owned enterprises, including major utility companies, parastatals in the petroleum and transport sectors, and financial institutions. The following specific actions are envisaged in 1999:
• offering for sale minority shareholding and management rights in ZAMTEL before end-September 1999;
  
• requesting the ZPA before end-June to study options for the divestiture of ZESCO;
  
• offering for sale or closing the Zambia National Oil Company (ZNOC);
  
• before end-September 1999 putting out to tender the granting of concessions of the railway system;
  
• tendering management rights on the operations of the National Airports Corporation in Livingstone, Ndola, and Mfuwe;
  
• handing over ZAMPOST and the Njanji Commuter Company by end-June 1999 to the ZPA; and
  
• ensuring the preparation by ZPA of options for the privatization of the Zambia National Commercial Bank (ZANACO).

Commercial banks

29. Owing to the decline in economic activity, the financial position of the banking system remained weak in 1998. We are addressing this problem by pressing banks to step up their loan recovery efforts and, where appropriate, requiring changes in management in those banks. This policy has already led to a decline in the portfolio of nonperforming loans in recent months. In addition, the supervisory authorities will not hesitate to require new capital injections or the closure of banks that show capital deficiencies. In conjunction with these measures, prudential supervision of commercial banks will be further reinforced in 1999. The BoZ intends to strengthen off-site risk analysis through intensified training of staff and the use of an improved commercial bank database, which will be set up with Fund technical assistance. In addition, we have prepared an amendment to the Banking and Financial Services Act that, inter alia, would strengthen the supervisory powers of the BoZ and extend supervision to nonbank financial institutions. We intend to send a legislative proposal to parliament in early 1999.
30. We aim for the completion of the sales agreement on ZCCM's largest asset packages by end-March 1999. The net amount of short-term debt and suppliers' arrears (after deduction of the privatization receipts) to be repaid by the ZCCM holding company at the time of the transfer of the assets is projected at US$124 million, including US$110 million arrears to the electricity supplier (CEC). This financing gap will be covered in part as follows:
• rescheduling of ZCCM debt to the CEC beyond 1999, amounting to US$50 million; and
  
• assumption by the government of ZCCM's debt-service obligations to the World Bank, amounting to US$23 million.
31. The net financing gap to be covered by the government is projected at US$51 million. Taken into account the uncertainties with regard to the financial position of the ZCCM, the program for 1999 includes a budgetary provision of K 151 billion (US$65 million) to cover the remaining liabilities emanating from the sale of the assets. If the debt settlement by the government is below this provision, the difference will go toward raising the targeted domestic fiscal surplus in the second quarter of 1999.

Energy pricing

32. Recognizing the importance of a reliable and efficient energy supply for the economy, the government remains committed to the market-based pricing of energy products. The privatization of public enterprises in the energy sector will contribute to this effort by ensuring an environment that fosters competition and efficiency. In support of this objective, regulations make it possible for the private sector to connect to the power grid and import petroleum products. However, given the existing monopolies in the energy sector, oversight of energy pricing will continue to be necessary. To this end, the Energy Regulatory Board (ERB) will henceforth adhere to a price adjustment policy that allows for the adjustment of wholesale and retail petroleum prices in order to reflect costs, including changes in exchange rates and world market prices. With respect to electricity tariffs, prices will be set to reflect underlying costs and a reasonable margin. Price adjustments in energy products will be subject only to ex-post reviews by the ERB on the basis of the aforementioned criteria.
E. Statistical Issues
33. In the recent period, considerable progress has been made in improving the quality of monetary and balance of payments data. The BoZ will attach the highest priority to the elimination of the remaining inconsistencies in the monetary survey and further improve the timeliness of balance of payments data by implementing the recommendations of the November 1997 STA technical assistance mission by, among other things, speeding up the collection of bills of entry forms from customs offices. The Central Statistical Office will eliminate inconsistencies between the revised national accounts data and production data on the agricultural and manufacturing sectors. The Ministry of Finance and the Bank of Zambia will strengthen data reporting on external debt service.
F. Monitoring
34. The progress in the implementation of the government's adjustment program will be monitored on the basis of quantitative and structural performance criteria and benchmarks, as shown in the attached Tables 1 and 2. These include ceilings on (i) increases in net domestic assets of the BoZ, (ii) increases in net bank claims on the government, (iii) the outstanding stock of domestic arrears of the government, (iv) the accumulation of external payments arrears, (v) the contracting of new medium- and long-term nonconcessional public or publicly guaranteed loans, (vi) the stock of short-term debt contracted or guaranteed by the central government and the BoZ, and (vii) the size of the public service. The quantitative performance criteria and benchmarks also include floors on the domestic fiscal balance (cash basis) of the government and the net international reserves of the BoZ. The structural performance criteria and benchmarks relate to (i) the offering for sale of a minority share and management rights in ZAMTEL; (ii) the submission of recommendations on the establishment of an actuarially sound civil service pension system; (iii) the maintenance of positive real interest rates on treasury bills; (iv) the abstention from new tax exemptions, waivers, or preferential tax treatment; and (v) the transfer of the major asset packages of the ZCCM.
35. The Fund will conduct with Zambia two reviews of the annual program based on performance through end-June 1999 and end-December 1999, respectively. The reviews will include an assessment of the macroeconomic framework, progress in public service reform, the implementation of measures to improve expenditure control, privatization, and the strengthening of prudential supervision of the banking sector.