Praia, February 22, 2000

Dear Sir:

1.  On behalf of the government of Cape Verde, I have the honor to transmit to you the attached memorandum of economic and financial policies (MEFP). It describes the progress made in 1999 in executing Cape Verde's comprehensive economic adjustment program, supported by a Stand-By Arrangement from the International Monetary Fund, and outlines the government's economic and financial policies and objectives for 2000. The government intends to use the MEFP as a framework for its policies during 2000.

2.  As noted in the MEFP, one structural performance criterion for end-November 1999, concerning the privatization of port facilities and the national airline, and one for end-December 1999, concerning the minimum amount of domestic debt conversion, could not be met. In addition, the government temporarily reintroduced foreign exchange restrictions, breaching the continuous performance criterion regarding the nonimposition of restrictions on the making of payments and transfers on current international transactions. For these, for the reasons stated below, the government requests waivers for nonobservance of the performance criteria.

3.  Delays in privatization receipts--part of which accrue to the government on account of its claims on the privatized enterprises--in combination with a severe regional drought necessitating extraordinary poverty-averting measures, resulted in higher-than-programmed net credit to the central government in the third quarter. This, combined with delays in expected donor disbursements, led to a temporary reemergence of the foreign exchange queue, which was subsequently eliminated at end-December 1999. Privatization delays led to the nonobservance of the structural performance criterion relating to the adoption of legislation authorizing the privatization of ENAPOR, Cabmar/Cabnave, and TACV at end-November 1999. The government, in agreement with the World Bank, has redesigned its privatization strategy for these enterprises. In addition, the structural performance criterion relating to the minimum amount of domestic debt to be swapped for TCMFs at end-December 1999 was not met; however, this criterion was met with a three-week delay in January 2000.

4.  The government is convinced that the policies and measures described in the MEFP are sufficient to achieve the program's objectives. The government will continue to provide the Fund with any information necessary to monitor the implementation of the program.

Attachment: Memorandum of Economic and Financial Policies

I.  Developments in 1999 Under The Stand-by Arrangement

1.  During 1999, the government of Cape Verde continued to implement its comprehensive program of economic, structural, and social sector reforms. This program has received support from the International Monetary Fund under a Stand-By Arrangement, approved on February 20, 1998. On December 30, 1999, the Executive Board extended the program until March 15, 2000. Overall, the implementation of the program has been broadly successful; however, the government encountered some difficulties in the third quarter of 1999 that required immediate action, so as to achieve the overall objectives of the program for 1999 as a whole.

2.  Prudent macro-economic policies, together with privatization, trade liberalization, and other structural reforms, have created the conditions for sustained economic growth. As in 1998, real GDP is expected to have grown by 8 percent in 1999, driven by private and public infrastructure investment and a pickup in exports. At the same time, prices stabilized, with consumer prices declining from January to December by 0.7 percent.

3.  In 1999, the government's fiscal policies aimed at limiting the overall deficit of the central government, including grants, to CVEsc 3,599 million (6.0 percent of revised GDP), and the domestic fiscal deficit, excluding retrenchment costs, to CVEsc 389 million (0.7 percent of revised GDP); no central bank financing of the budget--other than cash advances within pre-determined levels--was envisaged. After a loosening in the first quarter, fiscal policy was tightened considerably in the second quarter, so that it was brought back on track by the end of June. Although delays in external grant disbursement occurred, these were offset by a seasonal increase in nontax revenue--tax revenues grew as planned--and by cuts in capital expenditures. The amount of extraordinary social expenditures reached CVEsc 905 million, within the program target (albeit not financed, as envisaged, by privatization receipts). The domestic fiscal balance at end-June 1999 recorded a deficit of CVEsc 930 million; the overall fiscal deficit, including grants, reached CVEsc 1,224 million. To finance the deficit, the authorities used the counterpart funds of the US$10 million drawings on the credit line facility with Portugal, whose objective was to support official foreign exchange reserves; thus, the bank financing of the fiscal deficit was contained within the program's target.

4.  However, the fiscal situation worsened in the third quarter of 1999, mainly owing to expenditure increases. Outlays almost doubled from the second to the third quarter, reaching a cumulative CVEsc 16,248 million by end-September. While some of the increase reflected increases in capital expenditure financed by external sources, additional spending occurred in current expenditures, mainly in social and security areas. To limit the impact of the drought on the poorest segments of the population, the government decided to spend more on extraordinary social expenditures than the program's limit of CVEsc 1,100 million; total actual spending amounted to CVEsc 1,495 million by end-September. The whole amount was financed by recourse to central bank credit and not by privatization receipts, as programmed. In addition, faced with demographic pressures, the government started to hire teachers for the new academic season in excess of what had been originally envisaged. Also, transfers to autonomous funds increased, reflecting spending on coast guards and security in the face of increased risks of international drug trafficking. Interest payments were also higher than budgeted, owing to delays in setting up the Trust Fund. As a result, in the period January-September, the domestic fiscal balance recorded a deficit of CVEsc 1,861 million; the overall fiscal deficit, including grants, reached CVEsc 5,414 million. To finance the larger-than-programmed deficit, the government availed itself of the counterparts of an additional US$5 million drawing on the credit line facility with Portugal; nevertheless, bank financing of the deficit exceeded the program's target.

5.  In the last quarter of 1999, fiscal policies were tightened, and receipts from privatization and external grants increased. Revenue collection was strengthened through efforts to reinforce tax discipline by introducing late payment penalties; moreover, there were no further appropriations for extraordinary social expenditures. In addition, a part of the delayed external grants were received from the Netherlands and Sweden in December. Finally, and most important, the government received US$34 million from privatization as settlement of its claims on privatized firms. The government used the above resources to repay in full its overdraft from the central bank and its US$15 million borrowing under the credit line facility with Portugal. Overall, for the year as a whole, the domestic fiscal deficit was limited to CVEsc 1,579 million, equivalent to 2.6 percent of GDP, exceeding, however, the above-mentioned program target. The overall fiscal deficit, including grants, reached an estimated CVEsc 5,079 million, equivalent to 8.5 percent of GDP.

6.  During 1999, privatization revenue accrued both in foreign exchange and in local currency. As regards the foreign exchange component, a total of US$49 million was received in late 1999, comprising receipts from the sales of Electra (the electricity and water company) and the Caixa Economica (commercial bank). Of this total, as indicated above, the government received the equivalent of US$34 million. The remainder, US$15 million, was transferred to the Trust Fund. Regarding local currency privatization proceeds (the equivalent of US$2.6 million in 1999), the government, in agreement with the World Bank, has set them aside in the existing privatization account in order to meet future retrenchment costs associated with privatization and other local liabilities of privatized enterprises (for example, INPS).

7.  The operations of the Trust Fund encountered delays. By end-June 1999, its resources reached US$36.5 million, compared with a program target of US$73 million, owing to delays in donor disbursement (privatization receipts were not expected in the first half of the year). The government swapped existing domestic debt into títulos consolidados de mobilização financiera (TCMFs) of CVEsc 3.4 billion by end-June; in addition, it converted the equivalent of US$50 million of domestic debt, held by the central bank, into obligations with terms analogous to those for the TCMFs. Some further conversions were made during the third quarter, raising the total converted amount--including the aforementioned conversion to the central bank--to CVEsc 9.3 billion at end-September. By end-December, the resources of the Trust Fund had reached the equivalent of US$66.4 million. The government executed an additional domestic debt conversion into TCMFs, bringing the total amount of debt converted to CVEsc 12.7 billion.

8.  Monetary policy loosened considerably in the first months of 1999, as net credit to government reached CVEsc 1,607 million by end-March, and the central bank reduced its rediscount rate from 10 percent to 8.5 percent in early April. To contain the resulting high liquidity, in May the central bank increased the required reserve ratio from 15 percent to 18 percent, and credit to government was reduced. However, excess liquidity put pressure on foreign exchange reserves, which resulted in the nonobservance of the program target of US$2 million increase in the banking system's international reserves. In the third quarter, an expansionary factor was the larger-than-programmed increase in net credit to the central government, leading to declines in net foreign reserves of both the central bank and commercial banks. Credit to the economy continued to grow by over 10 percent in annualized terms, in line with the program targets.

9.  Monetary policy was less expansionary in the fourth quarter. The stock of net credit to government, excluding project deposits, was reduced by CVEsc 91 million for the year as a whole. At the same time, the international reserves of the central bank increased substantially, so that the program target of an increase in the net external reserves of the banking system of US$6 million for the year was exceeded by US$9.9 million. In 1999 as a whole, credit to the economy increased by 17.7 percent, and broad money by 15.7 percent.

10.  In the context of the exchange rate peg, the international reserves of the central bank came under pressure starting in July 1999, owing to the fiscal slippages; delays in external disbursements also added to a weaker-than-foreseen foreign exchange reserve position. The central bank reacted by rationing foreign exchange; thus the foreign exchange queue, which had almost disappeared by the end of April, reappeared and its volume reached US$10 million at end-November. In December, high privatization revenue, together with programmed foreign aid, made it possible to eliminate the foreign exchange queue and to repay the drawings on the short-term credit facility with Portugal. 

11.  In terms of performance criteria, at end-June 1999 all but one performance criteria were met (see attached Table 1). The increase in the net foreign assets of the banking system reached US$0.1 million, short of the program's target of US$2 million. About US$1.1 million of the slippage was due to an appreciation of the dollar against the euro, in which the central bank keeps sizable reserves. By contrast, at end-September, three performance criteria were not met: net credit to the government, excluding project deposits, reached CVEsc 2,666 million, compared with a program target of CVEsc 1,000 million; net foreign assets of the banking system declined by US$6.9 million, in contrast with a programmed increase of US$2 million; and domestic debt conversion reached CVEsc 9.3 billion, compared with the program's target of CVEsc 13.9 billion. At end-November, the structural performance criterion related to the adoption by the government of legislation authorizing the privatization of ENAPOR (port administration), Cabmar/Cabnave (shipyard company), and TACV (airline company) could not be met (as discussed below). Finally, at end-December, domestic debt conversion reached CVEsc 12.7 billion, short of the program target of CVEsc 13.9 billion, as the privatization of BCA (commercial bank) could not be finalized before mid-January 2000; also, some donor disbursement was delayed. However, at end-January 2000, domestic debt conversion is estimated to have reached CVEsc 15.1 billion.

12.  Concerning balance of payments developments, the coverage of the services account has markedly improved through more accurate surveys of economic agents and their transactions. As a result, the current account deficit for 1998, excluding official transfers, has been revised upward by 3.2 percent of GDP to 19.4 percent of GDP, offset by an improved recording of private capital inflows. In 1999, data for the first three quarters of the year confirm the expected strong growth in exports of goods and services, as key manufacturing factories expanded production capacity and tourist arrivals expanded by about 20 percent, with new hotels entering into operations. Overall, the growth rate of exports of goods and services is estimated to have reached 18.5 percent in 1999, against the program's projection of 14.5 percent. On the import side, imports of goods are estimated to have grown by 13.2 percent in value terms, close to the program's projection of 12 percent because, as expected, the new direct investment in manufacturing and tourism has a large import content. The estimated increase in imports of services of about 21 percent, however, exceeded markedly the program's projection of 5 percent. Workers' remittances are estimated to have grown in 1999 by about 13 percent, compared with a program projection of 8 percent. On the basis of these developments, the current account deficit, excluding official transfers, is now expected to have deteriorated from 19.4 percent of revised GDP in 1998 to 20.6 percent in 1999; the program envisaged a small decline in this deficit of about 0.3 percent of GDP from a lower base. Including current official transfers, as in 1998, the deficit is expected to have reached 17.9 percent of GDP, reflecting an increase of such transfers from 1.5 percent of GDP in 1998 to 2.7 percent of GDP in 1999.

13.  The surplus on the capital and financial accounts in 1999 was, at the same time, sizably larger than programmed because of higher-than-projected privatization revenue, excluding those channeled to the Trust Fund, was only partially offset by smaller-than-projected (by 3.6 percent of GDP) official capital transfers; foreign direct investment, excluding that related to privatization, is expected to have amounted to US$19 million, or 3.3 percent of GDP, close to program projections, and against 1.6 percent in 1998. As a result of the strong capital account, net foreign assets of the banking system increased during 1999 by US$15.9 million, exceeding the corresponding program target. At end-1999, official reserves amounted to the equivalent of 2.2 months of imports of goods and services, up from 1.4 months at end-1998.

14.  The government's comprehensive privatization program is expected to raise a total of at least US$80 million, and additional local currency revenue will be accumulated by selling remaining government shares to the domestic public. The program's implementation encountered delays in 1998 and the first half of 1999 but was accelerated in the fourth quarter of 1999. The government privatized Electra and CECV (a commercial bank), generating, as described above, foreign exchange revenue for the Trust Fund and the budget (for the latter on account of debt owed by these firms to the government). The privatization of EMPA (procurement and food distribution company) was accelerated, and the corresponding legislation was published in November 1999. However, delays occurred in completing the legislation by end-November 1999 for the privatization of the port and shipyard sector because the authorities decided, in consultation with the World Bank, to broaden the strategy, taking into account the role the country intends to play as a transshipment and service center. Also, the legislation for the privatization of the airline company could not be adopted by end-November because of the need to link the privatization of the company to the broadened transport development strategy; the legislation is now expected to be completed by July 2000. As a result, the corresponding performance criterion for end-November was not met. As a prior action, the government launched the call for bids for EMPA in late January 2000 but postponed the adoption of a revamped action plan for the privatization of ENAPOR and Cabmar/Cabnave (see attached Table 2).

15.  The comprehensive trade sector reform continued in early 1999. The remaining import quotas (concerning meat, yogurt, tomatoes, onions, bread, beer, paint, soap, detergents, and furniture) were eliminated and replaced by customs tariffs. These changes resulted in a simple average tariff rate of about 26 percent, with a maximum tariff rate--with the exception of a 250 percent tax imposed on used cars for ecological reasons--of 50 percent. The tariff increases provided the budget with sizable revenues. In addition, the import monopoly of EMPA on sugar, oil, maize, and rice was removed. Efforts to strengthen the budgetary expenditure-monitoring system, including a new treasury accounting plan and budgetary nomenclature, with technical assistance from the Fund, progressed more slowly than expected because of remaining organizational weaknesses which the government is addressing (see below).

II.  Policies for 2000

16.  The economy is projected to continue to grow by a healthy 8 percent in 2000 (or by almost 6 percent in per capita terms), spearheaded by private and public investment, and continued strong export growth. The average annual inflation will be limited to 2 percent, close to the euro zone average.

17.  The budget for 2000, approved by parliament in December 1999, aims at achieving a surplus on the domestic fiscal balance, excluding retrenchment costs, of CVEsc 1,030 million, equivalent to 1.6 percent of GDP, as compared to a deficit of 2.6 percent of GDP in 1999; there will be no extraordinary social expenditures provided from the central budget. Social programs will be conducted on a decentralized basis with the involvement of the municipalities and non-government agencies, and with the support of donors; the associated transfers from the central budget to these agencies will be fully recorded in the budget. The overall fiscal deficit, including grants, will be reduced to CVEsc 4,258 million, equivalent to 6.5 percent of GDP. There will be no recourse to bank financing by the government in 2000. The government will make efforts to finance its short-term cash advance needs through the year by issuing short-term intra-year treasury bills to the non-bank sector; in any event, the statutory limit on cash advances from the central bank of 5 percent of last year's revenues will be strictly enforced.

18.  Total revenues, including external grants, are budgeted to increase from 29.5 percent of GDP in 1999 to 30.6 percent of GDP in 2000. The increase is projected to come from rise in external grants, reflecting the receipt of grants already expected for 1999. Total domestic revenues are targeted to reach CVEsc 14.3 billion, or 21.7 percent of GDP. Tax revenues as a share of GDP will decline somewhat, in part because the unified income tax rate of the financial sector has been reduced from the general rate of 35 percent to 20 percent, so as to provide incentives for the expansion of this sector; dividends from public enterprises will also decline in the wake of privatization.

19.  On the expenditure side, total expenditures in 2000 are budgeted to decline slightly as a share of GDP to 37.1 percent. The government has decided to focus on the most pressing social needs of the population in three priority areas: education, health, and security, including coast guards. Accordingly, the number of teachers will be increased by 7 percent; there will also be increases in the hiring of coast guards and in other current expenditures associated with security. The average wage increase in the civil service will be limited to 3 percent (in the framework of agreements with the social partners), and the wage bill, as a share of GDP, will be reduced from 13.5 percent of GDP in 1999 to 13 percent of GDP in 2000. As mentioned above, no extraordinary social expenditures are budgeted for 2000. Domestic interest payments will be reduced further to 0.8 percent of GDP--a 0.8 percent decline from 1999, with the further conversion of government debt into TCMFs at end-1999 and during 2000. Retrenchment costs associated with privatization will be covered by the local currency receipts from the sale of a number of enterprises, which will be presented to parliament in a supplementary budget.

20.  Developments in the course of 1999 highlighted the budget's--and the foreign reserves'--vulnerability to unexpected shocks. The 2000 budget, while appropriately targeting social needs, remains vulnerable to shocks, such as shortfalls in revenue or in foreign financing. The government therefore has decided to set aside an amount equivalent to one month's worth of expenditures, excluding wages and other contractual obligations (equivalent to about 0.2 percent of GDP), and to unblock it after October 1, 2000--but only if revenues and foreign financing have been broadly in line with the budget until that date.

21.  The Trust Fund is targeted to become fully operational by end-2000. An exchange rate gain related to the appreciation of the U.S. dollar reduced the total resources required from the originally estimated US$180 million to US$165 million in early 2000. Donor disbursements and commitments by end-2000 amount to US$81.2 million. The government originally committed to contribute US$80 million; of this amount, as mentioned, it had paid US$15 million by end-December. In January 2000, it paid an additional US$22.6 million from the sales of major financial institutions (see paragraph 26). The remaining US$42.4 million is expected to be paid from net privatization receipts from the sales of a number of companies, including the national airline, as described below. However, a gap of US$3.9 million still remains. The government is making efforts to cover it through additional privatization receipts or donor support. This would allow the conversion of all domestic debt into TCMFs by end-2000, reducing net domestic public debt (i.e., claims on the government in the form of TCMFs, minus government assets in foreign exchange earmarked to back these TCMFs) to zero. Following the full establishment of the Trust Fund, the government will consider giving priority to the retirement of the TCMFs in the portfolio of the central bank, thus strengthening its official reserves.

22.  Monetary policy will be geared toward strengthening the foreign exchange reserves of the central bank by about US$13 million, bringing the reserve coverage of imports of goods and nonfactor services from 2.2 months in 1999 to 2.5 months in 2000. There will be no bank financing of the budget, thereby making room for a growth in credit to the private sector of 12 percent. Money income velocity is expected to remain unchanged, so that broad money would grow by about 10 percent. The central bank will continue to develop indirect monetary instruments, such as central bank notes.

23.  The favorable performance of exports of goods and services is expected to continue in 2000, based on a further expansion in export-oriented manufacturing and hotel services, sustained by buoyant foreign direct investment. With export growth (of goods and services) projected to reach 17 percent and import growth projected to moderate to about 10 percent, the external current account deficit, excluding official grants, is now projected to decline by 1.9 percentage points of GDP in 1999 to 18.7 percent of GDP in 2000. On the capital account, privatization revenues, net of retrenchment costs and any liability to the government, are expected to be fully channeled to the offshore Trust Fund, but other foreign direct investment should increase substantially. Despite these overall favorable prospects, the balance of payments remains vulnerable to external shocks, such as adverse climatic conditions that may require higher food imports. It will thus be essential to continue to benefit from sizable external assistance, in particular to finance the execution of the public investment budget and to support poverty reduction initiatives.

24.  The government of Cape Verde aims at accepting the obligations under Article VIII before mid-2000. It will refrain from reintroducing restrictions on current international transactions.

25.  Negotiations concerning the settlement of external arrears with Spain are continuing; the government has sent a new proposal to the Spanish authorities. Concerning Russia, the government of Cape Verde sent a letter to the Russian government in February 1999 with a proposal. Until the final settlement, the government of Cape Verde continues to contribute to the cost of functioning of the Russian embassy in Praia, to be counted in the amount of the final settlement.

26.  The government will bring its comprehensive privatization program close to completion by end-2000. In January 2000, it privatized BCA, Promotora (venture capital firm), and Garantia (insurance company). In addition, it will sell Enapor, Cabmar/Cabnave, TACV, CERIS (brewery), the remaining shares of CVTELECOM (communications) and ENACOL (petroleum distribution), Electra, INTERBASE (storage facility), and EMPA.

27.  The tariff reform contributed to the government's broader program of trade liberalization, which has been accompanied by the liberalization of current payments. The government is committed to further trade liberalization by reducing the maximum tariff rate and the number of brackets and exemptions. The reduction of the average tariff rate will need to be synchronized with the introduction of the value-added tax (VAT)--now planned for January 1, 2002--because of its revenue implication. The government established a commission in November 1999 to study and make recommendations, with assistance from FAD, for the reform package. The government will make an effort to accelerate the timetable of this reform package, with a view to introducing it during the first half of 2001.

28.  In the area of expenditure monitoring, the government will accelerate its work on the introduction of the new accounting and budgetary nomenclature, with a view to have it fully operational by end-2000.

29.  Financial and structural performance criteria are presented in Table 1, and prior actions in Table 2.