La Paz, Bolivia
April 8, 1999

Dear Mr. Camdessus:

1. The Bolivian Government has developed its economic program for 1999, which is explained in the attached Memorandum of Economic Policies. We would like to note that requesting bids for the privatization of the state petroleum company (YPFB) by February 1999 was a structural performance criterion under the first annual ESAF arrangement. We are requesting a waiver of this structural performance criterion because of delays related to the need to coordinate the sale of all remaining assets of YPFB.

2. We believe that the policies and measures set forth in this memorandum are adequate to achieve the objectives of our program, but will take any other measures necessary for this purpose. During the period of the arrangement, the government will consult with the Managing Director, on its own initiative or at the request of the Managing Director, concerning the adoption of appropriate measures.

3. On this basis, we are requesting the completion of the midterm review under the first annual ESAF arrangement and the second disbursement of SDR 16.8 million.

Attachment

1.  This memorandum provides a brief update of our economic policy memorandum of August 27, 1998 (which sets out Bolivia's economic program for 1998-2001) by reviewing economic developments in 1998 and explaining in more detail the government's economic program for 1999.

2.  The 1998 economic program aimed at reducing inflation to 6.5 percent following a sharp increase at end-1997 in excise taxes on domestic sales of petroleum products, achieving an economic growth rate of 4.5 to 5 percent, and holding net international reserves constant, with a view to keeping the international reserve cushion at six and a half months of imports. The program also envisaged that the external current account deficit would stay at somewhat over 8 percent of GDP in 1998, financed by a surge in foreign direct investment (FDI) that had been triggered by the reforms adopted since 1985. The combined public sector deficit was to rise from 3.3 percent of GDP in 1997 to 4.1 percent of GDP in 1998, even with a substantial increase in excise taxes, because the cost of structural reforms, particularly the 1996 pension reform, was projected to rise from 3 percent of GDP in 1997 to over 5 percent of GDP in 1998 (Table 1). Credit policy was to remain tight, while exchange rate policy would continue to preserve external competitiveness. Structural measures included making the preparations to bring the refineries of the state petroleum company (YPFB) to the point of sale, privatizing the state smelting company (Vinto), improving governance through judicial and customs reform, continuing the process of strengthening financial sector supervision and beginning a dialogue on labor market modernization.

3.  Economic policies remained strong in 1998, and all performance criteria for end-December 1998 were observed. The fiscal revenue effort improved considerably, owing in part to a successful program to collect back taxes on contraband vehicles. However, structural reform costs rose as expected and the fiscal deficit amounted to 4 percent of GDP. With regard to credit policy, net domestic assets contracted by significantly more than expected. In the area of structural reform, the government, with the assistance of the Fund's Fiscal Affairs Department, developed a plan for comprehensive customs reform to eliminate the widespread evasion of customs duties. As part of this effort, some senior staff of the customs administration were replaced, and a long term external advisor on customs reform was appointed. In other areas, an insurance law was approved by congress, most of the reserve requirement on financial institutions was converted into a liquid asset requirement, and a regulation was adopted that phased in a substantial increase in bank provisions over the next five years. The Law of Popular Credit and Property approved in June 1998 established a system of consolidated financial system supervision, reformed the administration of public utility cooperatives, expanded access to microcredit and set in motion the creation of a national identification system (RIN).

4.  The turmoil in international financial markets had little direct impact on domestic financial conditions, which remained broadly stable in 1998. Nonetheless, the effect of these difficulties is being felt through the terms of trade, as the world prices of Bolivia's exports have declined by over 20 percent since the onset of the crisis in Asia.

5.  In 1998, underlying economic growth is estimated at around 5.5 percent, as the reforms since 1985 have led to rapid growth in key sectors, although actual growth is estimated at 4.7 percent, owing to the one-time effects of El Niño. Consumer price inflation fell to 4.4 percent by December 1998, benefitting from transitory factors (the decline in world oil prices and moderate food price inflation) as well as the stance of demand policies; nonenergy nonfood inflation amounted to somewhat over 6 percent. The decline in world oil prices was able to feed through into consumer prices because of the introduction in December 1997 of an automatic link between domestic and world petroleum prices. The external current account deficit widened from 7 percent of GDP in 1997 to 7.9 percent of GDP in 1998. Exports fell somewhat, reflecting both lower prices as well as slow growth in volumes. Imports rose by 30 percent in the first half of the year, but then fell by 8 percent in the second half. With foreign direct investment--mainly into oil and gas exploration and telecommunication--rising to over 10 percent of GDP (US$870 million), net international reserves increased by about US$125 million, bringing gross international reserves to the equivalent to seven and a half months of imports and 130 percent of short-term liabilities of the central bank. Bolivia's external debt burden improved further, following the provision of debt relief under the HIPC Initiative of about US$700 million in net present value terms.

6.  The economic program for 1999 fits into the medium-term program, which seeks to achieve a substantial reduction in poverty by fostering economic growth of 5.5 to 6 percent a year by early next decade and taking steps to distribute the benefits of growth more equitably. The specific economic objectives for 1999 are to encourage economic growth of 4.5 to 5 percent and limit inflation to 5.5 percent. We will allow a moderate loss of net international reserves in line with the objective of maintaining an international reserve cushion of about six and a half months of imports and somewhat above 100 percent of short-term liabilities of the central bank.

7.  Fiscal policy will stay on the medium-term path to gradually offset the sharp rise in the cost of structural reforms since 1996 and to reduce the fiscal deficit to around 2 percent of GDP in 2002, a level that can be financed entirely by concessional external financing. This approach will gradually reduce the government's need to borrow from the private pension funds, and will leave these resources free to finance private activity. In the coming years, the government will analyze the structure of public revenues, drawing on the advice of the recent technical assistance mission on tax policy from the Fund's Fiscal Affairs Department.

8.  For 1999, the combined public sector deficit is targeted to decline to 3.9 percent of GDP (Tables 2 and 3). The nonpension balance will improve to a surplus of 0.3 percent of GDP (the level contemplated in the program), as net pension costs rise to 4.2 percent of GDP, instead of declining to 3.9 percent of GDP as expected.¹ Net concessional external financing will amount to 2.9 percent of GDP, with net domestic financing of 1 percent of GDP (compared with pension fund savings of 1.7 percent of GDP). Net domestic financing will be adjusted upwards to a maximum of 1.3 percent of GDP, in the event of a shortfall in external financing.

9.  Total revenues are projected to rise slightly in relation to GDP, reflecting several different factors. Tax revenues are expected to remain broadly stable in relation to GDP, as customs reform and the ongoing efforts to improve domestic tax administration offset most of the effect of the loss of the one-time collection of back taxes. In particular, the customs reform is expected to yield additional collections of customs duties, VAT on imports, and other taxes of 0.5 percent of GDP in 1999. The operating balance of public enterprises is still expected to improve by 0.7 percent of GDP, as severance payments will fall to virtually zero as the process of restructuring major public enterprises will be finished in mid-1999, and grants are expected to rise in relation to GDP. Both nontax revenues and operating profits of the central bank are projected to decline in relation to GDP.

10.  Our revenue projection currently assumes that net privatization proceeds are zero and that other capital revenues are 0.1 percent of GDP. If the government receives privatization proceeds from the sale of the residual of YPFB, Vinto or other public enterprises, the government will spend up to US$45 million of its capital revenue (which would include privatization proceeds) on public investment, particularly on roads, and capital revenues in excess of US$45 million will be used to reduce the fiscal deficit.

11.  Total nonpension spending is projected to fall by 0.5 percent of GDP, reflecting a similar decline in current spending in relation to GDP. The government has adopted a very prudent wage policy to help limit inflationary pressures. The general government's wage bill is expected to decline in relation to GDP, based on the recent agreement to grant an average wage increase of 4 percent (ranging from 6 percent for those earning below Bs 600 per month to no increase for those earning above Bs 3,000 per month and some additional increases for teachers). Interest payments will also fall owing to relief under the HIPC Initiative. Other current spending on reforms in health, education and other sectors will rise in relation to GDP, financed in part with resources coming from lower interest payments resulting from debt relief under the HIPC Initiative. This spending also includes the backpayment of all overdue tax rebates to exporters.

12.  Public investment will rise somewhat to 6.5 percent of GDP, with an emphasis on public sanitation, and the ongoing reforms of the education, health and judicial systems. In addition, we will intensify our focus on improving the maintenance and construction of the road network, which has been badly damaged by recent heavy rains. A better road system will help lower transport costs, which will benefit exporters and other producers.

13.  Broad money is projected to grow at the same pace as in 1998 (13.5 percent), continuing to rise gradually in relation to economic activity, and the degree of dollarization of the financial system is expected to remain broadly the same as last year. The central bank will expand its net domestic assets no more than by the equivalent of 25 percent of outstanding currency issue at the beginning of the year, consistent with the targeted loss of US$50 million for net international reserves and a growth in currency issue slightly faster than the growth in nominal GDP (Tables 4 and 5). Net central bank credit to the public sector will not exceed minus Bs 70 million. This credit policy is expected to be consistent with an expansion in bank credit to the private sector of about 14 percent, compared with 24 percent in 1998.

14.  The external current account deficit is projected to decline to about 7 percent of GDP in 1999, as the construction phase of the gas pipeline to Brazil ends and the gas exports come on stream. Export prices, on an annual average basis, are expected to decline further this year, and then begin to recover gradually starting in 2000. We expect foreign direct investment in mining, energy, and other export products to remain strong in the coming years, although below the levels observed during the construction of the gas pipeline. As exports from the mining and other sectors come on stream, and as gas and oil exports rise further, the external current account deficit is projected to decline to less than 6 percent of GDP by early next decade. Because these deficits are expected to be financed mostly by foreign direct investment, the central bank will be able to maintain the international reserve cushion at about six and a half months of imports. To ensure that Bolivia's external debt remains manageable, we will continue to restrict new nonconcessional external borrowing by the public sector (Table 6). We will conclude agreements with Paris Club creditors under the HIPC Initiative by June 30, 1999 and will secure debt relief on comparable terms from non-Paris Club bilateral creditors. We will not incur external payments arrears during 1999.

15.  Bolivia's external sector remains vulnerable to adverse developments in the world economy, including the recent decline in export prices. The government will continue to adapt fiscal policy as necessary to keep the external current account deficit on a sustainable path. Bolivia's exchange rate policy has promoted a significant diversification of exports in the past decade, and it will continue to be directed at keeping the economy on a competitive footing.

16.  The government remains committed to the agenda of structural reforms described in our August 1998 economic policy memorandum (Table 7). In 1999, we place the highest priority on implementing the following reforms:

• The state petroleum company (YPFB): Bids to purchase the refineries are to be requested in April 1999. The refineries are expected to be privatized by August 1999, and we understand that this action will be a prior action for the next annual ESAF arrangement. The privatization of YPFB's natural gas network, jet fuel stations and natural gas bottling plants will also be completed by August 1999.

• The state smelting company (Vinto): We will attempt to privatize this enterprise by May 1999; if this effort does not succeed, we will liquidate Vinto by September 1999.² Either the privatization or liquidation of Vinto will be another prior action for the next annual ESAF arrangement.

• Financial sector: The government will present to congress in the coming months a financial sector reform law that will establish a system of deposit insurance and strengthen procedures to deal with problem banks.

• Fiscal decentralization: The government will strengthen the current system of decentralization to reduce the risk of losing fiscal control and to improve the quality of public investment. In 1998, the congress tightened the limits on the indebtedness of local governments, and the government introduced new bank regulations to require banks to observe such debt limits and established penalties for noncompliance of the new norms on budget and borrowing by local governments. From January 1999, those municipalities that have already breached the current debt limits have been barred from taking on additional debt until they come back into compliance with the limits.

• A medium-term plan will be put in place to implement the recommendations of the FAD mission on more fundamental changes to the budget and accounting frameworks of local governments (December 1999) and the reassignment of the expenditure responsibilities of local governments (mid-2000).

• Tax administration: Amendments to the tax code will be submitted to congress by June 1999 to make tax collection more efficient and to improve the enforcement of the tax laws.

• Customs reform: The most important aspect of this reform in 1999 will be the passage of the new customs law and the adoption of the related regulations by June 1999.