Managua, Nicaragua
August 19, 1999

Mr. Michel Camdessus
Managing Director
International Monetary Fund
700 19th Street, N.W.
Washington, D.C. 20431

Dear Mr. Camdessus:

1.  Over the past several weeks, we have reviewed with the staff of the Fund the performance under the government's economic program and discussed the macroeconomic and structural policies to be implemented in the second half of 1999 and 2000-01. We believe that the government's policies will permit an expeditious and efficient execution of the program of reconstruction, following the devastating effects of Hurricane Mitch, and an expansion of social programs, while strengthening the macroeconomic conditions, and thus the basis to achieve high and sustainable growth.

2.  Implementation of the government's program will require broad domestic political support. To this end, the government recently has sponsored discussions between the leaders of the governing Liberal party and the opposition Sandinista party, together with their parliamentary allies, aimed at reaching a consensus to resolve important political and institutional issues. Such political consensus will be instrumental in facilitating the passage of legislation related to the macroeconomic and structural reform aspects of the program.

3.  The support of the international community also is crucial for the success of the government's program. The government is fully committed to its agreements with the World Bank and the IDB on structural and social lending programs. Following the Consultative Group Meeting for the Central American countries in Stockholm last May, the required external financing from multilateral and official bilateral sources, all on concessional terms, has been secured. Nicaragua's program will be further strengthened with the expected improvement in the external position resulting from a major reduction in the debt service burden, as Nicaragua becomes eligible and reaches an early decision point, under the HIPC Initiative.

4.  In our letter of January 27, 1999, at the time of the ESAF review, we presented the government's preliminary macroeconomic projections for 1999, following an initial assessment of the reconstruction needs arising from the natural disaster. The annexed memorandum of economic and financial policies reviews recent performance under the program and describes the policies and revised targets for 1999-01, in the framework of a new public investment program prepared with the help of the World Bank. The tables attached to the memorandum present performance criteria and benchmarks for the second half of 1999 and for 2000. The targets, policies, and financing requirements for 2000 would be reassessed at the first review of the second annual ESAF arrangement expected to take place prior to end-February 2000; a second review is expected to be conducted by end-August 2000.

5.  In support of these objectives and policies, the Government of Nicaragua hereby requests that the Fund approve the second annual ESAF arrangement for Nicaragua in an amount equivalent to SDR 33.635 million. During the period of the second annual arrangement, the Government of Nicaragua will consult with the Fund on the adoption of any measures that may be appropriate, in accordance with the Fund's policies on such consultations. Moreover, the Government of Nicaragua will provide the Fund with such information as the Fund requests on the progress made on policy implementation and the achievement of the program objectives.

6.  After the period of the second annual arrangement and while Nicaragua has outstanding financial obligations to the Fund arising from loans under the arrangement, the Government of Nicaragua will consult with the Fund from time to time, at the initiative of the Government or whenever the Managing Director requests consultations on Nicaragua's economic and financial policies.

1.  Beginning in 1997 and during 1998 under the ESAF-supported program, the government strengthened macroeconomic policies and the process of structural reform. The fiscal position improved more than envisaged in the program, credit policy was tightened, and important progress was made in strengthening the financial system by divesting inefficient state banks, advancing legislation for the privatization of public enterprises, and improving governance in the areas of property rights and management of public finances. As a result, private sector confidence strengthened, private investment and capital inflows increased, economic growth accelerated and inflation was kept in check, while unemployment continued to abate and social conditions improved. This strong performance contributed to improve substantially the government relations with the business community, labor organizations, and other social partners.

2.  Economic and social conditions suffered a setback in October 1998, with the devastation caused by Hurricane Mitch in terms of loss of life, displaced families, and destruction of infrastructure and agricultural production. Overall physical damage has been estimated at US$1.3 billion (61 percent of the 1998 GDP). In a short period of time, the administrative resources of the government were mobilized in an attempt to resolve the many demands of the society that resulted from this natural disaster. Together with the international community, the government was able to quickly implement emergency measures in all the affected areas of the country.

3.  Because of the strong performance of nonagricultural sectors, the effect on total output was limited and real GDP growth slowed only to 4 percent in 1998, from 5 percent in 1997; however, temporary food supply problems contributed to an increase in the 12-month rate of inflation to 18.5 percent in December 1998, from 7 percent in December 1997. The external current account deficit (excluding interest obligations) widened by 4 percentage points of GDP to 23 percent in 1998 because of lower agricultural exports and the sharp increase in imports following the hurricane. This increase, however, was largely financed by emergency external aid, and net international reserves (NIR) remained unchanged from end-1997 to end-1998; at end-1998 the stock of NIR, adjusted for shortfalls in external financing, was in line with the program.

4.  Since early 1999 the economy has been recovering, with a partial rebound in agricultural output and a strong increase in domestic demand, driven by a surge in construction-related activities. At the same time, the 12-month inflation rate fell to 10 percent in July, compared with a projection of 12-14 percent for the year as a whole made at the time of the ESAF review in February 1999; core inflation (excluding food, fuel, and utilities) fell to 9.2 percent, from 11.2 percent in December 1998. The external current account deficit widened further in the first half of 1999, mostly because of a large increase in reconstruction-related imports, but it was financed by official aid disbursements and higher private capital inflows. During January-July 1999, NIR rose by US$78 million, in line with program projections.

5.  During the first semester of 1999, policies focused largely on the emergency rehabilitation program aimed at restoring the most basic infrastructure to facilitate economic recovery, while avoiding excessive domestic demand pressures. The combined public sector deficit during January-June was larger than had been projected at the time of the ESAF review in February 1999, as was its external financing, but domestic financing was slightly lower. While overall public sector revenue was in line with the program, there was a shortfall in central government revenue reflecting a delay until March in the approval of legislation that raised some excise taxes, as well as weak customs tax collections. Although customs revenue had been expected to decline because of reductions in import duties in mid-1998 and again in January 1999, the erosion turned out to be larger than anticipated because of an unexpected increase in the proportion of duty-exempted imports related to hurricane relief. The central government revenue shortfall, however, was offset by improvements in the revenue performance of social security and the public enterprises. On the side of expenditure, outlays on public works rose at a fast pace in the first semester, and more than offset delays in the execution of other new programs. Such delays contributed to raising public sector savings above the previous estimates for the first semester of 1999.

6.  Credit policy was broadly in line with the program in the first half of 1999, with a significant contraction in the central bank's net domestic assets (NDA). In March, legal reserve requirements were lowered by ¾ of 1 percentage point, which served to provide some liquidity to the banking system in the initial stage of the economic recovery. Real money demand rose significantly in this period, as the growth in banking system deposits accelerated while domestic inflation declined. Bank credit to the private sector also rose rapidly, in line with the acceleration in construction and commerce-related activities. Nicaragua's financial deepening is being sustained by continuing private capital inflows and a strong increase in remittances observed in recent months.

7.  In June 1999, the Superintendency of Banks intervened in a small commercial bank in the wake of irregular operations committed by its main shareholder. Prompt legal actions were taken by the authorities, and following bid offers from several domestic banks, the Superintendency of Banks approved a merger with a large commercial bank which took immediate control of assets and liabilities of the intervened bank; the central bank granted a period of six months to restore legal reserve requirements corresponding to the intervened bank's deposit liabilities. Losses of the intervened bank are estimated at US$9 million, which are expected to be recovered with embargoed personal assets of shareholders, but the government is prepared to cover part of the losses, if necessary, by issuing a central bank three-year U.S. dollar-indexed bond.

8.  Further progress was made in implementing the structural reform program in the first half of 1999. In the area of public sector reform, the government payroll was reduced by an additional 700 positions for a total of 1,200 programmed for 1999 (following a reduction of 3,300 in 1997-98), and the health and pension accounts of the social security institute were separated in preparation of the planned social security reform; management of the state oil distribution company (PETRONIC) was transferred to an international trading company under a ten-year contract, and the electricity enterprise (ENEL) was broken down into distribution, generation, and transmission units, in preparation for the divestment of the first two units. In the financial sector area, the sale of the second largest state bank (BANIC) to a foreign financial institution was completed; an increase in the capital adequacy requirement of commercial banks, in line with improved prudential norms issued by the Superintendency of Banks, is being implemented; and agreement was reached with the staffs of the Fund, the World Bank, and the IDB on draft legislation related to modifications to the central bank charter and to laws governing the banking system and the Superintendency of Banks. In the trade policy area, the ceiling on the great majority of import tariffs was reduced to 20 percent in mid-1998, and further to 15 percent in January 1999, together with the phase out of most duties on imports originating in other Central American countries.

9.  The privatization process of the telephone company (ENITEL), however, suffered a setback early this year, with the withdrawal of the prequalified potential investors following disclosure of a weaker-than-expected financial and external debt position of the enterprise. To address this problem, the government has completed a detailed review of the situation of ENITEL, and with the advice of the World Bank is implementing an action plan to substantially strengthen the enterprise's financial position. ENITEL cancelled a previously contracted, but not disbursed, large external loan on nonconcessional terms and has started to implement tariff adjustments and cost reduction measures.

10.  The government's policies for the remainder of 1999 and 2000-01 have been framed in a medium-term context that would permit an expeditious and efficient implementation of the reconstruction program and the expansion of social and poverty reduction programs, while consolidating macroeconomic stability and thus enhancing the basis for high and sustainable growth. The program's main macroeconomic objectives include the strengthening of the external position (with an increase in NIR by US$118 million in 1999, US$45 million in 2000, and US$25 million in 2001), and reducing the 12-month rate of inflation to 10 percent by end-1999, 8 percent by end-2000, and 7 percent by end-2001. Annual real GDP growth is projected at 6.3 percent in 1999 and at 6.5 percent in 2000-01, on the basis of a continuing strong recovery of agricultural output and agricultural exports and the sustained strong pace of reconstruction activities.

11.  The government is confident that the policies described below are consistent with achievement of the program's objectives. However, in view of the ongoing significant increase in public sector investment, the authorities will be closely monitoring developments in domestic demand and will take appropriate fiscal and monetary measures, as needed, to prevent a weakening in the external position and the build up of domestic price pressures. To this end, the financing needs of the fiscal program are being fully covered with external grants and concessional loans. Price pressures are being measured by the 12-month core inflation index; if this index were to exceed 13 percent in two consecutive months, consultations with the Fund staff will be held on the needed corrective fiscal and monetary actions. These actions could include the slowdown in the pace of public sector outlays and the intensification of open-market placements.

12.  The fiscal program seeks to limit the combined public sector deficit to 13.6 percent of GDP in 1999; and to reduce it to 10.2 percent in 2000 and to 8.2 percent in 2001, as steps in the medium-term path toward fiscal consolidation. Public sector saving (excluding interest obligations) is projected to remain slightly above 10 percent of GDP in 1999, and to rise to about 11 percent of GDP in 2000-01. The public investment program would peak in 1999, followed by a gradual decline in 2000-01.

13.  Public sector revenue is being adversely affected in 1999 by the scheduled reduction in import duties; customs revenue would decline significantly this year, but would stabilize toward the end of 2000 with the completion of the import duty reductions. The authorities are aware of the need to maintain a strong level of government revenue, particularly in the face of rising social spending. However, they have decided not to raise domestic taxes at this time to compensate for the lower custom revenue, given the need to help consolidate the economic recovery. Thus, in the remainder of 1999, fiscal policies will focus on further improving tax administration and limiting the growth of expenditure. Tax revenue already is benefiting from the package approved by the Assembly last March, which raised excises on cigarettes, beer and liquor, and overall revenue may well turn out to be higher than estimated, particularly with the help of tighter tax administration. Collection of internal taxes has strengthened significantly since 1998 through improved management and enforcement. A program to improve customs tax administration, which has been lagging, is to be implemented with the technical assistance of the IDB before the end of 1999.

14.  Nevertheless, the government will closely monitor revenue performance during the second half of 1999 and will stand ready to take corrective actions, as needed. In case revenue is weaker than projected, and the targets on savings and/or the deficit are not observed, the government will introduce revenue-increasing legislation to become effective in the first quarter of 2000. In this connection, the government is studying options for revenue actions and will request technical assistance from the Fund. If however, revenue turns out to be stronger than projected, the authorities will consult with the Fund staff regarding the use of the excess, whether to improve the fiscal position above program targets and/or to cover well-defined additional reconstruction/social outlays within the saving and deficit targets of the fiscal program.

15.  The government will follow a cautious policy on expenditure, continuing to aim at reducing unproductive outlays. In particular, consumption, transfers, and the wage bill will be tightly controlled. Following exceptional salary adjustments to teachers, health personnel, and police, granted in two steps in 1998 and 1999, no other general or sectoral salary increases are to be granted in the second half of 1999. Subsequently, the increase in the wage bill of the central government-including the effects carried over from the above-mentioned adjustments-is not to exceed 9.5 percent in 2000, and 6 percent in 2001. To this effect, the existing system of civil service reduction will continue through 2001. In addition, the government plans to further reduce military personnel (by some 2,000 positions) and to use the resulting savings to strengthen the civil police. All in all, noninterest current outlays of the combined public sector will be targeted to decline by 4 percentage points of GDP over the three-year period through 2001.

16.  The program will limit reconstruction outlays, including projects financed by the Supplementary Social Fund (SSF), to US$190 million in 1999 and 2000 (8.3 percent and 7.6 percent of GDP, respectively). This amount is US$30 million higher than previous estimates, corresponding to additional projects which have been incorporated in the program following an assessment by the World Bank and donors' commitments of full concessional financing. For 2001, the program provides for reconstruction spending of US$160 million, but this amount also may need to be increased by US$30 million, as in the case of 1999-00; any such increase will be decided in consultation with the staffs of the Fund and the World Bank in mid-2000, at the time of the preparation of the 2001 budget, on the basis of available concessional financing, project assessment, and macroeconomic conditions.

17.  With the completion of the emergency rehabilitation program implemented in the first months of 1999, the government has tightened control on reconstruction outlays, ensuring that in the execution of projects all line ministries strictly conform with the priorities established in the public investment program. In addition, the practice of direct awards of contracts, which was needed during the emergency period, has been discontinued, and currently all contracts are being awarded through the proper public bidding process to ensure the full transparency and maximum efficiency in the use of public funds. After a slow start in the first half of 1999, social spending is programmed to accelerate in the second half, including for the construction of schools and primary health care centers in rural areas. Overall social spending (including current and capital outlays), through the SSF and the regular government budget, is estimated to increase by some 3½ percentage points of GDP to about 14½ percent in 1999, and to more than 15 percent of GDP in 2000-01. Any additional spending in the social sectors financed by proceeds from ENITEL's privatization in accordance with the law, will be compensated with reductions in other sectors, so as to maintain total expenditures unchanged.

18.  The government is committed to the financial strengthening of the electricity enterprise (ENEL) and the water and sewerage company (ENACAL). These public enterprises have worked diligently in the rehabilitation of plant and equipment damaged during the hurricane and are stepping up their efforts to improve revenue performance. ENEL and ENACAL will continue to adjust their rates to cover long-term marginal costs, and ENEL has been authorized to activate, as necessary, the fuel factor in power rates; both of these enterprises plan to continue their scheduled phase out of cross subsidies in rates. On expenditure, the government will seek to ensure that additional efforts are made at restraining current outlays of these enterprises, including the wage bill, and that the additional investment needs are financed with multilateral and bilateral concessional aid.

19.  The central bank will continue to adhere to a cautious credit policy. The monetary program in the second half of 1999 and in 2000 will aim at a contraction in the central bank's NDA consistent with the targeted increase in NIR. Over 1999-01, NIR will rise to cover nearly 80 percent of the projected monetary base, while gross international reserves will increase to the equivalent of 200 percent of short-term public debt and 3.5 months of imports. The central bank continues to monitor closely developments in domestic demand. Provided price pressures remain in check, the central bank will resume the net redemption of its U.S. dollar-indexed liabilities, CENIS, to further reduce this source of vulnerability. The large net reduction of CENIS in 1998 and the substitution of this paper with one carrying longer maturities has contributed to significantly reduce the prospective quasi-fiscal losses of the central bank. On exchange rate policy, the government has decided to slow the crawling exchange rate depreciation vis-à-vis the U.S. dollar and introduce an exchange rate band. This would help sustain the reduction in inflation and provide a first step toward a more flexible market determined exchange rate system. Beginning in July 1999, the crawl was reduced from a rate of 12 percent per year to 9 percent, and the central bank plans to reduce it further in early 2000 following a joint assessment by the authorities and the Fund staff.

20.  The government is committed to continue the process of trade liberalization by phasing out remaining nontariff restrictions and reducing import duties. For the great majority of import items, the maximum tariff was reduced to 10 percent in July 1999, and currently most tariff rates are in three groups of 10, 5, and 0 percent. However, a number of import duties remain above the general ceiling of 10 percent, and these will continue to be reduced gradually under an established schedule. To mitigate the effect on poor farmers of the recent large decline of world prices of corn, rice, and soybean oil, the government recently introduced limited price bands on these products through variable import levies. These levies, up to a maximum of 15 percent, will be set with reference to a moving average of world prices. The price bands and levies will be phased out over a 12-month period.

21.  In order to advance toward external viability, the government's debt management policy is to rely solely on securing grants and highly concessional loans to cover its external financing requirements, while continuing to actively pursue agreement with bilateral official creditors on debt and debt service reduction on terms at least as favorable to those granted by Paris Club creditors. The public sector will not contract, guarantee, or borrow any new loans on nonconcessional terms. The public sector will also ensure, on a continuous basis, that no external arrears are incurred during the period of the program, except for obligations which are eligible for rescheduling. In order to enhance the effectiveness of debt management, the ministry of finance will coordinate with the central bank all external debt operations of the public sector, including agencies and public enterprises. To this effect, any loan contracted or guaranteed by the public sector would require a prior authorization by the minister of finance and the president of the central bank. The authorities will consult with the Fund staff prior to signing any external loan contract as regard to the level of its concessionality.

22.  The government is implementing an ambitious structural reform agenda in the public sector, the financial system, social security, and governance, while carrying out an expansion and strengthening of its social and poverty reduction programs. Among public sector reforms, the program to divest the distribution and generation units of the state power company (ENEL) is on schedule under a plan proposed by the advisory international investment bank. The regulatory agency, INE, is expected to issue tariff regulations before the issue of final bidding documents in December 1999. Regarding the telephone company, ENITEL, as noted earlier, the government is taking actions to strengthen the enterprise's financial position in the context of a program agreed with the World Bank, which provides, inter alia, for raising average tariffs by 10 percent and reducing operating expenditures by 20 percent. With the technical assistance of an international investment advisory bank, ENITEL's privatization process is being reactivated, and through a new international tender, the government plans to bring the company to the point of sale in January 2000. Progress is being made with the implementation of the law on Organization, Functions, and Procedures of the Executive approved in 1998, aimed at streamlining central government activities and reducing civil service personnel in a process to be completed in early 2001.

23.  The government attaches utmost importance to maintaining a sound financial system. To promote this process, prudential norms and bank supervision are being strengthened, together with the legal framework of the banking system. The Superintendency of Banks is supervising the implementation of the new capital adequacy ratios, which calls for an increase of the banks' capital from 8 percent to 10 percent of risk-adjusted assets over the 12-month period ending July 2000. In addition, draft laws on the central bank, the banking system, and the Superintendency of Banks will be submitted shortly to the national assembly and are expected to be approved by end-October. The new laws would increase autonomy of the central bank, strengthen the legal base for regulation of banks and other financial institutions, and strengthen the functions and responsibilities of the Superintendency of Banks and its regulatory council.

24.  The social security system is programmed to undertake a major reform with the main objectives of strengthening its financial position, eliminating existing inefficiencies and inequities, and introducing a fully-funded system based on individual and privately managed capitalized accounts. The expectation is that this reform will raise in time the level of pension benefits. The reform draft law (prepared with technical assistance of the World Bank and the IDB, and reviewed by the Fund staff) will soon be submitted to the national assembly, and should be approved by end-1999. Changes in the contribution rates, retirement age, longer minimum contribution period, and other parameters of the new system will be introduced in January 2000 after passage of the law. Following the necessary institutional preparations, the new system of privately managed accounts would start to be implemented in the second half of 2000.

25.  As regards governance, important strides are being made in improving accountability and transparency in the use of public funds. Actions in this area include: (i) a major improvement in the coverage of the previously extrabudgetary revenues and expenditures of central government ministries and agencies, starting with the 1999 budget; and (ii) the preparation of comprehensive new legislation on public sector procurement, regulating public sector acquisition and disposal of assets, goods and services. The procurement bill (prepared with the assistance of the World Bank and reviewed by the Fund staff) has been submitted to the Assembly. In addition, property rights are being strengthened through the acceleration of land titling and the resolution of remaining property rights claims, and by a comprehensive modernization reform of the judiciary. Additional details on these reforms are provided in the policy framework paper.

26.  The government has pursued poverty reduction and improvement in social conditions through a program of investment in human capital and the establishment of social safety nets, within a framework of sound macroeconomic policy. The main pillars of the social programs are the reforms of the public health and education systems which-supported by sectoral programs with the World Bank and the IDB-aim primarily at improving coverage, quality, and efficiency of preventive and primary health care and primary education. Implementation of these reforms is being accelerated with specially earmarked additional donor support through the Supplementary Social Fund (SSF) and Social Investment Fund (FISE). The SSF covers mostly current expenditures on specific programs related to provision of school materials and medical supplies, teachers' incentive scheme for autonomous schools, and primary health care, particularly in rural communities, while FISE focuses on investment related to reconstruction and expansion of schools, health centers, and water and sewerage facilities in poverty-stricken communities. In the coming months, the government will evaluate its social and poverty reduction programs in light of the results of the recently completed Living Standards Measurement Survey (LSMS) for Nicaragua carried out with the support of the World Bank. A revised social program, to be completed in the first quarter of 2000, will include an assessment of the appropriate level of social expenditures in 2000-01 taking into account the possible assistance under the HIPC Initiative. The program will be discussed with the staffs of the Fund, the World Bank, and the IDB, other creditors and donors, and the civil society.

27.  The attached tables present benchmarks and performance criteria for September and December 1999, and for March and June 2000, and indicative benchmarks for September and December 2000, on the net domestic financing of the nonfinancial public sector and savings of the combined public sector; the central bank's NIR and NDA; public sector indebtedness on nonconcessional terms; and indicative ceilings on the overall deficit of the combined public sector and the total expenditure of the central government. In addition, benchmarks and performance criteria for the structural policies are presented.