March 22, 1999

Mr. Michel Camdessus
Managing Director
International Monetary Fund
Washington, D.C. 20431

Dear Mr. Camdessus:

1. After a decade of declining per capita income and chronic economic and financial imbalances, São Tomé and Príncipe, in agreement with the staff of the International Monetary Fund, implemented in 1998 vigorous macroeconomic and structural adjustment policies aimed at eliminating the government's primary budget deficit, lowering inflation, and improving the prospects for medium-term economic growth. The governments' efforts were also supported by bilateral and multilateral donors. To consolidate the gains achieved and redouble its reform efforts, the government adopted a staff-monitored program for 1999, which it is determined to implement in order to pave the way for new discussions with the Fund in the context of an Enhanced Structural Adjustment Facility (ESAF)-supported program, possibly in the second half of 1999. The government also hopes to eventually benefit from the support of the World Bank and its multilateral and bilateral creditors under the HIPC Initiative.

2. The attached memorandum of economic and financial policy presents the government's objectives and economic policies for the period 1999-2002, as well as the specific objectives and measures envisaged for 1999. In support of these objectives and policies, the government requests that Fund staff monitor and follow up the execution of its program.

3. The government believes that the policies set forth in the attached memorandum will enable it to achieve its program objectives, but it is ready to adopt any additional measures that may prove necessary to this end. During the period of the staff-monitored program, the authorities will consult with the Managing Director of the Fund on the adoption of any measure deemed appropriate, at their own initiative or whenever the Managing Director requests such a consultation.

4. The government will communicate to the Fund all the information needed to monitor its progress in implementing its economic and financial policies and the measures required to achieve the program objectives. The authorities of São Tomé and Príncipe will review the staff-monitored program with Fund staff no later than end-June 1999.

Attachment: Memorandum of Economic and Financial Policy for 1999
 

SÃO TOMÉ AND PRÍNCIPE

Memorandum of Economic and Financial Policy for 1999

March 22, 1999

1. The discussions held recently in São Tomé with the International Monetary Fund mission provided an opportunity to take stock and evaluate the results of the macroeconomic policies and structural adjustment measures implemented by the government of São Tomé and Príncipe in 1998. These policies and measures were part of an economic policy framework agreed with Fund staff and were aimed at eliminating the government's primary budget deficit, reducing inflation, and improving the prospects for medium-term economic growth. Overall, the measures envisaged have been implemented, and the macroeconomic objectives have been achieved or even exceeded.

2. However, the authorities are aware that, despite the progress achieved, the country's economic and financial situation remains precarious and very difficult. São Tomé and Príncipe's economy depends largely on external assistance, the public debt burden is particularly heavy, and the country's external position is not viable, per capita income remains very low, and structural rigidities continue to hamper economic growth and private sector development.

3. The government would like to consolidate the progress achieved in 1998, intensify its reform efforts, and strengthen the credibility of its economic policy. In this context, it reached understandings with the Fund mission on a staff-monitored program, which it is determined to implement with a view to paving the way for new discussions with the Fund in the context of an Enhanced Structural Adjustment Facility (ESAF)-supported program. The government also hopes to benefit, eventually, from the support of the Fund, the World Bank, and the international financial community under the Initiative for Heavily Indebted Poor Country (HIPC Initiative).

4. This memorandum of economic and financial policy analyzes São Tomé and Príncipe's recent economic performance and describes the government's objectives and economic policies for 1999-2002, as well as the specific objectives and measures envisaged for 1999.

5. Following a long period of economic decline and chronic economic and financial imbalances, the government of São Tomé and Príncipe, in agreement with the staff of the Fund, implemented in 1998 vigorous adjustment measures, which made it possible to turn around the government's primary budget balance (excluding externally financed capital outlays) from a deficit of 2.2 percent of GDP in 1997 into a surplus of 0.7 percent of GDP in 1998; reduce the inflation rate (as measured by the consumer price index) from more than 80 percent in 1997 to about 21 percent in 1998, on a year-to-year basis; and narrow the spread between the official exchange rate of the dobra (Db) and the parallel market rate from 6.5 percent in 1996 to below 1 percent in 1998. Real GDP growth reached 2.5 percent (against 1.5 percent on average for 1995-97), while the external current account deficit (excluding official transfers) was reduced from 75 percent of GDP in 1997 to 53 percent of GDP in 1998 because of the low execution rate of the public investment program.

6. In the fiscal area, the turnaround in the primary balance of the government's financial operations from a deficit in 1997 to a surplus in 1998 reflects increased efforts to both mobilize revenue and control expenditures. Government revenue rose to Db 54.5 billion in 1998 (19.4 percent of GDP), more than Db 9.5 billion above budget projections. Measures to improve the tax administration were introduced in 1997 and 1998, including strengthening the tax audit unit; these measures led to better performance in the areas of both direct and indirect domestic taxes. Furthermore, the partial privatization of the national petroleum distribution company (ENCO) resulted in improved collection of customs duties and specific taxes on gasoline and diesel oil. However, problems with customs administration, exemptions, fraud, and tax evasion resulted in large shortfalls in import duties (excluding petroleum products) and export taxes. Regarding primary expenditure, budget overruns of Db 7.6 billion were recorded in 1998, despite stronger controls; these overruns resulted from increases in locally financed investments, the wage bill (because of a general wage increase and the implementation of the special system for the remuneration of military personnel in 1998), and current spending on goods and services. However, thanks to the primary budget surplus, the government was able to eliminate all its domestic payments arrears in 1998 and remain current on its external debt service to international institutions; nevertheless, it was not able to settle all its external arrears and accumulated new arrears to its bilateral creditors.

7. On the financial side, the money supply increased by 16.3 percent in 1998, less than the nominal growth rate of GDP. The collection of proceeds from the partial privatization of ENCO and the sale of oil exploration concessions helped limit the increase in net bank credit to the government. In turn, net domestic assets of the banking system increased by only 8 percent of the beginning-of-the-year broad money, in spite of an increase in real terms in credit to the economy. In the circumstances, the net foreign assets of the banking system continued to improve in 1998. The reserve requirement ratio, which the monetary authorities had unified at 22 percent in November 1997, remained at this high level throughout 1998, and the government's counterpart funds were transferred to the central bank in March 1998, enhancing control over liquidity in the banking system. With the reduction in inflation, the central bank lowered its reference interest rate in November from 55 percent to 29.5 percent.

8. On the structural reform agenda, the monetary authorities eliminated the obligation to surrender export earnings to the central bank in September 1998, following a gradual reduction in the surrender requirement rate from 70 percent in 1997 to 30 percent in June 1998. In addition, the government eliminated most of the quantitative restrictions on imports, with the exception of the preferential foreign exchange allocation for imports of essential goods (basic foodstuffs, petroleum products, medicines, and agricultural products).¹It also liberalized prices, with the exception of the rates of goods and services produced by the utility companies, such as water and electricity. In 1997, the government introduced a mechanism to automatically adjust the retail prices of petroleum products in line with world prices and local distribution costs, and, in 1998, water, electricity, and telephone rates were adjusted several times. In the public sector, the authorities liquidated three public enterprises in 1997-98, including the national savings and loans institution (CNPC), for which a loan recovery mechanism was instituted; they also placed two hotels under private management (Miramar and Pousada Boa Vista), and privatized 49 percent of ENCO.²In addition, the government revised the general civil service regulations in December 1997. However, delays were encountered in preparing the administrative reform and civil service downsizing program.

9. The government is determined to consolidate the progress achieved in 1998 and strengthen the macroeconomic and structural adjustment policies, in order to resolve São Tomé and Príncipe's economic and social problems, improve the prospects for medium-term economic growth, and reduce poverty. It has decided to take additional measures in the context of a staff-monitored program covering 1999, in the framework of an adjustment strategy for the four-year period 1999-2002.

10. The main macroeconomic objectives for 1999-2002 are to (a) gradually reduce inflation to 3 percent by 2001; and (b) limit the external current account deficit (excluding official transfers) to 79 percent of GDP by 2002. The average annual growth rate of real GDP is projected at 4 percent for 2001-2002, allowing for a 1.7 percent annual increase in per capita income. The balance of payments should continue to recover, in spite of the stabilization of the production and export of cocoa, because of efforts to diversify the economy, particularly in the areas of agriculture, fishing, and tourism. Private investment should grow from 18.4 percent of GDP in 1998 to 45 percent of GDP in 2002, owing primarily to the initial investments in the oil sector, and gross national savings would increase from 21 percent of GDP in 1998 to 39.6 percent of GDP in 2002, reflecting mainly the resurgence in the mobilization of external official transfers, which declined considerably in 1998 because of delays in the execution of investment projects. To achieve the objectives of its medium-term adjustment strategy, the government will pursue a prudent fiscal policy aimed at increasing the government's primary budget surplus from 0.7 percent of GDP in 1998 to 5 percent of GDP in 2002 while raising budgetary allocations for education and health. The government will also pursue a prudent monetary policy aimed at reducing inflation and at increasing the central bank's international reserves, in the context of the flexible exchange rate regime now in place. It will also deepen the structural reforms, with a view to promoting economic diversification and private sector development while improving public sector efficiency.

11. In the context of the medium-term strategy, the main macroeconomic objectives of the staff-monitored program for 1999 are to (a) reduce the rate of inflation to 10 percent; and (b) limit the external current account deficit (excluding official transfers) to 63 percent of GDP. Real GDP growth is projected at 2.5 percent in 1999. In the fiscal area, the program is aimed at increasing the government's primary budget surplus to 2.8 percent of GDP. To achieve these objectives, a set of measures will be implemented in 1999 in the fiscal, money and exchange rate, external sector, and structural reform areas.

Fiscal policy

12. The government budget bill for 1999, which was submitted to the National Assembly in February 1999, is consistent with the objectives of the staff-monitored program. It includes a set of measures aimed at improving revenue collection and strengthening expenditure control. Also attached to it is a budget proposal for the Central Bank of São Tomé and Príncipe showing a surplus of 0.4 percent of GDP, as well as a budget proposal for the water and power distribution company (EMAE), that limits the deficit of the company to 0.6 percent of GDP in 1999.

13. In order to launch its program under the most favorable conditions, the new government constituted on January 5, 1999 has (a) limited the number of ministries to nine; (b) placed international cooperation and the responsibility for the government's financial commitment (including in the areas of grants, food aid, and loans) under the authority of the Minister of Planning and Finance; and brought together agriculture, fishing, industry, trade, and tourism into a large ministry in charge of the economy (the Ministry of the Economy). These actions will help strengthen government policy coordination and, in particular, restore the integrity of the government budget and ensure that fiscal policy is implemented effectively under the Minister of Planning and Finance.

14. On the revenue side, the authorities will strengthen the tax and customs administration and intensify collection efforts during 1999 in several ways. First, they will eliminate all ad hoc tax and customs duty exemptions, strictly control legal exemptions, and widen the tax base. Second, they will strengthen the tax inspection and audit units in the Finance Directorate and in the customs administration. Third, the authorities will prepare an action plan to restructure and strengthen the customs administration. Fourth they will make operational the computerized system (SYDONIA) for the assessment of the tax bases and calculation of customs duties. Fifth, they will give full authority to the customs administration and to the Minister of Finance to assess the tax bases, compute and collect customs duties, and impose penalties as needed by amending Article 180 of the 1944 law with a view to eliminating the requirement of prior clearance from the judiciary in the assessment of penalties. Sixth, the authorities will ensure that tax and customs legislation is fully enforced. Finally, they will tighten control over transfers from public enterprises and government agencies to the budget, particularly from the food aid management agency (GGA). Implementation of these measures should make it possible to increase government revenue from 19.4 percent of GDP in 1998 to 19.8 percent of GDP in 1999.

15. On the expenditure side, efforts are under way to effectively contain noninterest outlays by bringing the wage bill under control. To achieve this, the government will begin to implement its administrative reform and civil service downsizing program in 1999, and it will limit application of the special wage regimes to education and health staff . In view of the inflation target, and given the current size of the civil service and projected tax collection performance, the application of the special wage regimes to other staff has been postponed to 2000, and no other wage adjustment will be made in 1999. The implementation of this wage policy will reduce personnel expenditures from 6.7 percent of GDP in 1998 to 6.5 percent of GDP in 1999. Severance payments under the downsizing program will be assessed by end-June 1999 and will be included in the budget for 2000.

16. Other current expenditures on goods and services should be reduced from 6.3 percent of GDP in 1998 to 6 percent of GDP in 1999, while taking into account the priority given to improving nonwage expenditure for education, health, agriculture, and infrastructure maintenance. Transfer outlays will also be reduced from 3 percent of GDP in 1998 to 2.8 percent of GDP in 1999. The government will prepare sectoral development strategies with technical assistance from the World Bank and other donors. It has also consulted the World Bank on capital expenditures, with respect to both the total size and the composition of its public investment program (PIP) for 1999. In general, the government will hold quarterly meetings on public investment projects, with the participation of the major donors represented in São Tomé and Príncipe; the first such meeting should be held by end-March 1999. These meetings should help improve the selection and monitoring of PIP projects, which will comprise all public investments, including those financed by exceptional external assistance, counterpart funds, and extraordinary deposits generated by the proceeds from the partial privatization of ENCO and the oil exploration concessions. Only those projects that appear in the budget and the PIP will be implemented. The government will also endeavor to strengthen its public investment programming by end-December 1999, by broadening the PIP planning horizon to a three-year period.

17. The overall deficit for government financial operations, on a commitment basis, is projected at Db 85.7 billion in 1999, or 25.6 percent of GDP (compared with 30.5 percent in 1998). Taking into account amortization of the external public debt and the need to reduce net central bank credit to the treasury, the external financing requirement will amount to Db 137.9 billion, and it will be partially met by project grants and concessional loans (Db 70.2 billion) and exceptional financial assistance (Db 43.2 billion). A residual financing gap of some Db 24.5 billion will remain and, in the absence of a debt-rescheduling agreement, the government will continue to accumulate new arrears to bilateral creditors. However, the authorities will avoid accumulating new arrears to multilateral organizations, and will seek to reach an agreement on the treatment of arrears to the Arab Bank for Economic Development in Africa (BADE).

18. With technical assistance from external experts, the government will undertake a study of the Finance Directorate by end-December 1999, with a view to making recommendations for improving operations and preparing an action plan for staff training and technical assistance. Also, as part of the study, terms of reference will be drafted for setting up three autonomous administrations for domestic taxes, budget operations, and the treasury, as currently envisaged within the Ministry of Finance.

Monetary and exchange rate policy

19. The central bank will pursue a prudent monetary policy in 1999 aimed at reducing inflation and at increasing the net foreign assets of the banking system by 69 percent of the beginning-of-year broad money. The improvement in the fiscal situation should allow net bank credit to the government to fall by 55 percent of the beginning-of-year broad money, reflecting mainly the expected mobilization of a second tranche of a bilateral special grant in an amount of Db 43.2 billion (US$6 million). In turn, net domestic assets would decline by 50 percent of the beginning-of-year broad money (in spite of an increase in real terms of credit to the private sector, which still is relatively low). The money supply would rise by about 19 percent in 1999, in line with the growth rate of nominal GDP, and base money would increase by some 4 percent.

20. The monetary authorities have already fully liberalized deposit and lending interest rates. In 1999, they intend to keep the central bank reference interest rate at 5 or 6 points above the recorded inflation rate and the reserve requirement ratio constant at 22 percent. Moreover, the central bank will strengthen the use of indirect instruments in the conduct of monetary policy by mopping up banks' excess liquidity more effectively. In this regard, it will establish a money market, beginning in April 1999, with the introduction of central bank bills which could be bought and sold by banks and other economic operators at freely negotiated interest rates.

21. The central bank will strengthen bank supervision, with a view to ensuring that commercial banks continue to comply with prudential ratios, and the government will pursue the collection of loans made by the CNPC, which is in receivership. Debtors not current on their obligations to the CNPC will be publicly identified; they will be denied access to bank loans¹ and taken to court. The central bank has also decided with Fund technical assistance to strengthen its inspection services and implement the necessary internal controls on its operations. It will also have its accounts audited every year by external auditors. In February 1999, the authorities uncovered an attempt to defraud the central bank through an elaborate scheme of issuance and trading of false treasury bills. The officers involved have already been removed from their positions and taken to court, following an initial investigation. The government will prepare a full report on this fraud by end-April 1999. In addition, the central bank will prepare a detailed report on the fraudulent transfer of foreign assets that occurred in 1994; impose the appropriate sanctions and corrections; and, with donor assistance, have its correspondents' accounts for 1994-1997 audited by an independent external auditor by end-April 1999. Under its 1999 operating budget, which has been attached to the government budget, the central bank has begun an organizational restructuring effort which will result, by end-June 1999, in a reduction of staff on the order of 32 percent. It will also implement a prudent spending policy, with a view to achieving a small operating surplus, taking into account the payment of the severance packages necessitated by the restructuring efforts.

22. In the area of exchange rates, the authorities will ensure that their flexible, market-based exchange rate will work effectively and that discipline will continue to be enforced regarding bank financing of the government. Under these circumstances, the central bank will not attempt to influence the rate offered by commercial banks and will limit its intervention in foreign exchange markets to achieving the international reserves target. Following this policy would help consolidate the gains of 1998 and maintain the spread between the official rate and the parallel market rate at below 1 percent.

23. The authorities adopted new foreign exchange legislation in February 1999 with an aim of fully liberalizing the external current account transactions in São Tomé and Príncipe. This law is intended to eliminate all nontariff import barriers, including the preferential allocation of foreign exchange for imports of essential goods (basic foodstuffs, petroleum products, medicines, and agricultural products) and the import prohibitions established by Decree (despacho) 37/93, dated November 9, 1993, as well as all restrictions on current transfers of invisibles. Under these conditions, the government will take all steps required with a view to accepting the obligations of Article VIII, Sections 2, 3, and 4 of the International Monetary Fund's Articles of Agreement by April 1999.

24. In the area of structural measures, the government since 1997 has abolished price controls and fully liberalized domestic trade, including the marketing of agricultural products. It intends to review the structure of production and distribution costs for water and electricity, with a view to increasing efficiency and, if appropriate, revising public utility rates at end-March 1999, in accordance with the automatic adjustment mechanism based on costs.

25. As indicated above, the government fully liberalized external trade and other current account transactions in February 1999. In 1998, it set up a committee to review customs operations and the customs tariff structure, including the use of exemptions; outline a plan for reducing export taxes; and assess the impact of these measures on government revenue. The government has now decided to prepare an in-depth reform of the customs tariff structure and to draft a plan for reducing export taxes, both to be implemented under the 2000 budget. The new customs tariff structure will reduce the number of import duty rates to three, with the maximum rate not to exceed 20 percent and the zero rate to be eliminated. The government will request technical assistance from its bilateral and multilateral partners for the preparation of the new customs tariff.

26. The government will introduce additional flexibility in the area of human resource management, and it will implement its administrative reform and civil service downsizing program. With technical assistance from the United Nations Development Program (UNDP) and the World Bank, it will prepare and adopt organizational and staffing plans for an initial group of four ministries by end-June 1999, and assess the civil service staff reduction expected to result from implementing these plans between July 1 and December 31, 1999.⁴

27. The government will also prepare and adopt organizational and staffing plans for a second group of six ministries by end-December 1999 and implement them starting in January 2000.⁵ The reduction in civil service staff expected from the implementation of the second group of organizational and staffing plans in the course of 2000 will be assessed by end-December 1999. The schedule for implementing the civil service reform in the various ministries will be adopted by the government before end-April 1999.

28. The government will adopt a new privatization program in connection with public enterprise reform by end-June 1999. In the agricultural sector, the government has already turned all its large agricultural estates over to private operators under long-term operating leases and redistributed about 30,000 hectares of cultivated land to 5,000 families of small-and medium-scale farmers. By end-December 1999, it will finalize, with assistance from the World Bank, its strategy for privatizing large government agricultural estates and rationalizing the land tenure system in order to increase production and reinforce investment incentives.

29. As regards the prospects for oil exploration, the government will ensure transparency in the conduct of future operations and formally set up, with technical assistance from donors, an administrative unit responsible for the implementation of government's policy in the oil sector by end-March 1999. It will consult the Fund and the World Bank with respect to negotiations for oil concession contracts and the drafting of oil legislation.

30. Achieving sustainable growth in per capita income will help reduce poverty in São Tomé and Príncipe. Specifically, the distribution of arable land to small farmers and the rationalization of the land tenure system should improve appreciably the standard of living of rural populations, as should a reduction in export taxes on agricultural products. However, structural adjustment measures, including the civil service reform, are likely to affect the quality of life of wage-earning city dwellers. With support from the World Bank, the African Development Bank (AfDB), and the UNDP, the government will prepare by end-December 1999, an action plan against poverty, to be implemented during the period 2000-2002. The plan should include carefully targeted measures for further raising the school enrollment and literacy rates, improving primary health care, increasing women's participation in development activities, curbing the rural exodus, and bringing population growth under control. The action plan should be reflected in the budget by sufficient appropriations for education and health.

31. The government will intensify its efforts to improve the quality of its statistical data. It will supply the Fund with the basic data required in the context of Article IV consultations and strengthen program control and monitoring. In the area of monetary statistics, the authorities will speed up data dissemination and ensure that the monthly monetary survey is available within six weeks of the end of the month.

32. In the external sector, the government will pursue its objective of containing the external current account deficit by applying the macroeconomic and structural adjustment policies described in this memorandum, without placing restrictions on current transactions.

33. With a net present value equivalent to 12 times the value of exports of goods and services in 1998, the external public debt of São Tomé and Príncipe is excessively large, and it will remain unsustainable for many years to come. In these circumstances, the government will continue to seek grants and highly concessional loans only to cover its financing requirements. Accordingly, it will neither contract nor guarantee new nonconcessional external loans having maturities in excess of one year (and with grant components of less than 50 percent). Moreover, the government will neither contract nor guarantee external loans having an initial maturity of less than one year. With a view to normalizing its relations with its major foreign creditors and donors, São Tomé and Príncipe will remain current on its debt-service obligations to multilateral financial institutions. It will seek an agreement on the settlement of its arrears vis-à-vis the BADE and will avoid accumulating new external arrears to international institutions during the program period.

34. To monitor progress in the implementation of the program, the government has set quantitative benchmarks for end-March, end-June, end-September, and end-December 1999 (Table 1) as well as structural benchmarks (Table 2). The government will also provide the Fund with the statistical data and information listed in the attached Table 3 on a monthly basis, as well as any information it may deem necessary or which Fund staff may request for purposes of monitoring the program.

35. A review of the staff-monitored program will be conducted, at end-June 1999 and in cooperation with Fund staff, in order to assess the progress to date. On that occasion, the authorities would request discussions on a program that could be supported by a three-year ESAF arrangement.

36. An Economic Council, chaired by the Prime Minister and composed of the Minister of Planning, Finance, and Cooperation, the Minister of Economy, the Minister of Natural Resources and the Environment, and the Governor of the Central Bank, will coordinate the staff-monitored program. This council will be advised by a technical committee responsible for monitoring program execution. Each week, the technical committee will report on program execution to the Economic Council, and the Minister of Planning, Finance, and Cooperation will report to the Council of Ministers.