Antananarivo, October 23, 2000

Mr. Horst Köhler
Managing Director
International Monetary Fund
Washington, D.C. 20431

Dear Mr. Köhler:

1. As provided under the second annual arrangement under the Poverty Reduction and Growth Facility, approved by the Board on July 23, 1999, the government of Madagascar and the Fund staff conducted the discussion for the second review under the arrangement during the period September 5–18, 2000. The discussions focused on economic and financial developments and the structural reforms undertaken in the first eight months of 2000, and the outlook for the remainder of the year. Also discussed were the main lines of the 2001 budget, which is under preparation, taking into account the priorities set forth in the poverty reduction strategy paper (PRSP) under preparation within a wide process of civil society participation.

Economic and financial developments in the first six months of 2000

2. Madagascar’s economy was seriously affected in the first few months of the year by three cyclones that devastated certain regions of the country, causing considerable loss of human life and destroying infrastructure, housing, and agricultural crops. To cope with these disasters, the government received extraordinary assistance from external donors and lenders, including the International Monetary Fund, and mobilized additional domestic financial resources for reconstruction programs, which were authorized in the supplementary budget approved by the National Assembly in July 2000. The prospects for economic growth had to be revised downward: preliminary estimates place the rate of real GDP growth in 2000 at approximately 4.8 percent, instead of the 5.3 percent initially projected. Moreover, the impact of the cyclones on export crops and on the demand for imported rice, raw materials, and equipment necessitated an upward revision of the external current account deficit, excluding grants, from 7.3 percent to 9.1 percent of GDP in 2000. The government would like to thank the international community for its quick response in mobilizing humanitarian aid, and in providing support for the reconstruction program (amounting to more than US$100 million over the course of 24 months) and the additional financial resources needed to cover the balance of payments financing requirement. These resources include the exceptional debt relief granted by Paris Club creditors for the period June-November 2000 (deferral of all remaining obligations on precutoff-date-debt) in the context of the extension of the 1997 Paris Club agreement from end-July to end-November 2000.

3. In the first seven months of the year, inflation slowed considerably as a result of the prudent financial policy implemented by the authorities and the increased agricultural production in certain regions not devastated by the cyclones. Consequently, in January-July 2000 the consumer price index (traditional index) rose by 1.9 percent, resulting in a year-on-year inflation rate of 10.2 percent at end-July, compared with 14.4 percent in 1999. In the first seven months of 2000, the Malagasy franc appreciated in response to a number of factors, including the accelerated repatriation of export revenue, longer contractual delays in paying for imported oil products, and an inflow of capital partly linked to investments and partly spurred by the interest rate differential. At end-June, the quantitative performance criteria for the program supported by the second annual arrangement were observed by a wide margin (net domestic and external assets of the central bank, domestic financing of the government, and tax revenue). The structural performance criterion constituted by the completion by end-May 2000 of the organizational, financial, and actuarial audits of the pension system for government workers (the Caisse de Retraites Civiles et Militaires, CRCM, and the Caisse de Prévoyance et Retraite, CPR) was also observed.

4. With regard to government finance, revenue in the first six months of 2000 was in line with program objectives. Indirect taxes and value-added tax (VAT) revenues performed well; customs revenue was up 11.4 percent from the same period last year, but remained short of the ambitious objective set in the program (a 30 percent increase), as imports grew more slowly than expected. A rebound in customs revenue is nevertheless projected for the final months of the year, as imports are expected to recover. As for expenditure, the pace of commitments for nonwage current expenditure was particularly slow in the first six months, owing to the late adoption of the budget law and the difficulties encountered by departmental appropriations managers in familiarizing themselves with new budget procedures, such as the new budgetary expenditure classification introduced at the beginning of the year and the monthly limits on commitments. The relevant ministerial staff has now received training that will enable it to speed up commitments in the second half of the year. Expenditure related to structural reforms (the judicial system, the performance-related bonuses in the civil service, and the costs of public enterprise privatization) also fell short of projections as a result of delays in reforming the civil service and finalizing the privatization of the petroleum company, SOLIMA, the major components of which were sold in June. At end-June, privatization receipts stood at only FMG 11 billion, compared with the program objective of FMG 366 billion. As for investment expenditure, commitments in the first six months were well below projections, but are expected to increase in the second half of the year. Consequently, at end-June, the domestic budgetary financing, defined to include privatization receipts, was a negative FMG 11 billion, in contrast to a programmed positive amount of FMG 169 billion.

5. In the January-June 2000 period, the money supply expanded by only 0.2 percent, and credit to the economy fell slightly as a result of the seasonal reimbursements of crop credits; these results are in line with program projections. The decrease in net lending to the government was smaller than anticipated in the program (0.2 percent of beginning-period money supply, as against a programmed reduction of 1.4 percent) as a result of the increase in the stock of treasury bills held by commercial banks. The net external assets of the central bank rose significantly in July and August, following disbursements from the World Bank under the second structural adjustment credit (SAC II) and from the European Union in the context of structural adjustment support; at end-June, after adjusting for shortfalls in expected external aid disbursements, the central bank’s net external assets had exceeded the program objective by a large margin.

Economic outlook and structural reforms in progress for the remainder of 2000

6. In the fiscal area, the government intends to achieve the annual revenue objective and quicken the pace of nonwage operating and investment expenditure commitments over the remainder of the year. The ratio of tax revenue to GDP is expected to reach the original program target of 12.2 percent, and the budgetary deficit—on a commitment basis, excluding grants, and excluding net expenditure on structural reforms—is projected at 5.5 percent of GDP. Non-project-related external financing is projected at SDR 75 billion, compared with a program estimate of SDR 88 million. This gap is explained by the nonrelease of the second tranche of the World Bank SAC II, linked to the privatization of Air Madagascar, now scheduled for 2001. Privatization receipts, which were expected initially to total FMG 595 billion (US$82 million) in 2000, are now projected to reach only FMG 182 billion (US$25.5 million, or 0.7 percent of GDP) as a result of the postponement to 2001 of the sale of certain SOLIMA service stations and of petroleum storage facilities, as well as of the significant discounts granted to the buyers of the SOLIMA components when the sales contracts were finalized. Moreover, it is expected that the proceeds from the sale of Air Madagascar will be received in early 2001, owing to some delays in the privatization process. Disbursements for restructuring expenditures are also expected to fall short of program projections (FMG 590 billion, according to the updated estimates, in contrast to the FMG 760 billion initially projected). Consequently, the recourse to domestic financing from banks, nonbanks, and privatizations in the year 2000 is now projected at FMG 127 billion, or 0.5 percent of GDP (against the FMG 204 billion programmed), while net bank credit to the government is expected to decrease by less than anticipated in the program (by FMG 154 billion, or 0.6 percent of GDP instead of FMG 382 billion).

7. In the last part of 2000, the government will continue its efforts to strengthen customs tax administration and will quicken the pace of expenditure commitments. These efforts will be accompanied by greater discipline in expenditure execution and the improvement of control mechanisms. With regard to customs data, implementation of the new ASYCUDA software (Version 3 Plus Plus) will lead to more rigorous tax administration, thanks to the computerization of certain key procedures, such as the inputting of shipping documentation. The number of computerized custom offices will increase significantly in 2000 and 2001, with the addition of three in 2001. The authorities will step up their efforts to minimize fraudulent practices, while the preshipment inspection procedures will be revised to prevent delays that could hamper import operations.

8. In the area of domestic taxation, efforts will continue to focus on strengthening taxpayers’ field audits and their follow-up. Additional administrative resources will, therefore, need to be allocated for decentralized offices, the pursuit of delinquent taxpayers, and the reduction of fraud in the form of sales without bills of lading. The systems for cross-checking information between the tax and customs authorities will be further improved. The VAT reimbursement procedures for free trade area enterprises have been revised, with a view to shortening the delay for reimbursement to a maximum of 45 days, particularly for the best-complying companies. The reimbursement of VAT credits owed by the government to public works contractors under the public investment program will also be accelerated; to that end, substantial appropriations will be made in the 2001 Budget Law to reduce the existing delay, and a review will be undertaken, with a view to introducing faster reimbursement procedures.

9. To boost fiscal revenue, the authorities will step up their efforts to collect mining and forestry royalties. Moreover, the rates of the mining royalties will be reexamined in the context of preparing the 2001 Budget Law. To ensure that the unified tax for small taxpayers (impôt synthétique) is more efficiently managed, the government will explore the possibility of including the local authorities in the assessment and collection process.

10. Regarding the monitoring of budget execution and budgetary controls, particular attention will be given to the observance of commitment, settlement, and payment order procedures, with additional training for appropriations managers and an enhanced role for the Directorate of Expenditure Commitment Control (CDE). The use of requisitions regularized ex post will be strictly limited. The procedures for monitoring the execution of expenditures by the social sector ministries will be reinforced. As part for the institutional development effort to strengthen the procedures for the preparation, execution, and monitoring of the state budget—with the goal of improving transparency and good governance—additional resources will be made available to the State Inspectorate-General (IGE). The role of the Audit Court (Chambre des Comptes) will also be expanded.

11. Updated monetary and credit projections for 2000 indicate that credit to the economy will expand by less than initially projected in the program, that is, by about 13.8 percent instead of the 26 percent programmed. Net credit to the government is expected to decrease by the equivalent of 3 percent of the beginning-period money supply, as against a program reduction of about 7.5 percent. In the second half of the year, as a result of higher international oil prices, lower privatization receipts than expected (only partially offset by larger inflows of private capital), and less external financing than programmed, the net official reserves of the central bank could increase by less than originally programmed; thus, over the whole year, they are projected to increase by SDR 29 million, instead of the projected SDR 46.5 million. Reflecting these developments, the money supply is projected to expand by 5 percent, versus the 10 percent programmed.

12. As a result of the sizable decline in inflation during the first seven months of the year and the significant inflow of private capital, the monetary authorities have decided to lower the central bank’s key interest rate from 15 percent to 12 percent, effective October 13. A corresponding decrease in the rates of treasury bills and bank lending and deposit rates is also expected. Effective October 15, the reserve requirement on sight deposit has been cut from 25 to 24 percent, and that on time deposits, from 5 to 3 percent.

13. The companies in charge of collecting the nonperforming loans formerly in the portfolio of privatized banks will redouble their efforts, and will ensure that all amounts recovered are swiftly transferred to the treasury. The list of defaulting debtors of the former agricultural bank of Madagascar (BTM), for which the recovery agency is the Management and Collection Company (SGR), will be published at the latest by end-December.

14. The central bank will strengthen the resources allocated for the monitoring and compilation of balance of payments, especially with respect to flows of private capital, services, and transfers. To that end, it will continue its close consultation with Fund technical staff.

15. The new civil service statute will be submitted to the next regular session of the National Assembly; the statute reduces the number of special employment categories and introduces the principle of merit-based pay; the statute will also include a code of ethics and discipline.

16. The provincial council elections will be held in the six autonomous provinces on December 3, 2000. The organic law establishing the framework for management of the affairs of the autonomous provinces was promulgated August 29, 2000. This law defines, inter alia, the powers of the governor and the procedures for determining the constitutionality and legality of actions taken by the autonomous provinces. Financial responsibilities and resources will be gradually transferred to the provinces in the coming years, on the basis of bilateral agreements to be concluded between the central government and the new provinces. All transfers from the central government will be recorded in the general state budget. Provincial budgets will be prepared and executed in accordance with existing government accounting rules and principles.

Preparation of the Poverty Reduction Strategy Paper

17. The government is committed to strengthening its poverty reduction program by preparing—in the context of an expanded process of civil society participation—a PRSP that will define action programs aimed at boosting the incomes of the poor and improving key social indicators. The preparation of this document relies on the work of six special commissions, including representatives of civil society, covering the following areas: (i) output, investment, and trade; (ii) health and nutrition; (iii) education and culture; (iv) infrastructure; (v) rural development and the environment; and (vi) institutional development and decentralization. An interim PRSP will be submitted shortly to the Executive Boards of the World Bank and IMF. It will outline the costs of the medium-term priority programs that the government envisages financing with resources that could become available under the Initiative for Heavily Indebted Poor Countries (HIPC Initiative), for which it hopes to qualify by year’s end. The participatory process will continue up to the preparation of the final document, which is scheduled to be completed in the first half of 2001.

18. In support of its poverty reduction strategy, the government intends to request a new three-year arrangement with the Fund under the Poverty Reduction and Growth Facility, upon expiration of the current arrangement at end-November 2000.