Managua, Nicaragua
December 13, 2000

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

Dear Mr. Köhler,

1.  This letter describes recent performance under the government's modified economic program for 2000, which was set out in the Memorandum of Economic and Social Policies (MESP) of August 30, 2000, relating to the second annual arrangement under the Poverty Reduction and Growth Facility (PRGF) that was approved on September 15, 1999. It also describes certain policies in the financial and macroeconomic areas that the government has started to implement in the wake of recent difficulties in the banking sector and while discussions are under way in early 2001 on a macroeconomic framework that could be supported by the third annual PRGF arrangement. In order to complete the discussions on a program that could be supported by the third annual arrangement, we request that the commitment period under the three year PRGF arrangement be extended until March 17, 2002.

2.   Since the MESP was prepared, and despite the adverse effects of recent banking difficulties (see below), progress has continued to be made in the macroeconomic, structural, and governance areas. Reflecting a tightening of fiscal and credit policies starting in the second quarter of 2000, as envisaged under the modified program, 12-month inflation fell to around 9 percent in October-November, from a peak of 15 percent in April. In the first nine months of 2000, the combined public sector deficit (after grants) was held to the equivalent of 4.3 percent of annual GDP, compared with 5.3 percent under the program, as externally financed capital outlays fell short of programmed levels. Credit to the private sector expanded by 23 percent in the year to August 2000, compared with over 40 percent during 1999. The benchmark on the net international reserve target for September could not be met, however, because of the serious difficulties experienced by two large banks beginning in August.

3.  In the structural area, the electricity distribution companies have been sold and a long-term lease of a port has been granted. The thermal electricity plants have not yet been divested, however, because potential investors are awaiting the outcome of a Supreme Court judgment on existing legal challenges, and the telecommunications company has not been privatized because a single bid that was received in October 2000 was below the reservation price. Legislation on the supervision of private pension funds was submitted in October to the National Assembly. In the governance area, the Treasury's cash management system has been completed and actions aimed at strengthening the Comptroller's Office have been undertaken. Also, new legislation modernizing the functions of public prosecutors has been passed and a new penal code is expected to be approved by the National Assembly shortly. In addition, the November municipal elections were carried out in a free and transparent manner.

4.  The government has made further important progress in preparing its strengthened poverty reduction strategy (SPRS). The SPRS is being consulted at the local level to seek grass roots reaction; comments from civil society and the donor community are being incorporated; and the costing of programs and projects has begun. The government is receiving substantial technical and financial support from the Inter-American Development Bank (IDB) and UNDP to strengthen the institutions involved in the preparation of Nicaragua's poverty alleviation strategy, as well as in the monitoring and evaluation of its implementation.

5.  Despite the progress being made in all these areas, Nicaragua's economic and financial situation was unsettled in August-November. Confidence in the banking system weakened, and banking system deposits fell sharply during that period, contributing to a cumulative loss of US$90 million in net official international reserves during January-November 27, 2000. The weakening of confidence reflected a marked deterioration in the quality of the portfolios of two commercial banks related to fraud and mismanagement. To deal with this situation, the government acted decisively by intervening these banks, providing liquidity assistance in the context of guaranteeing their deposits and, subsequently, by implementing resolution plans for these institutions. At the same time, open market operations were stepped up to sterilize part of the liquidity injection by the central bank. The resolution plans involve: (1) writing off the shares of the original owners; (2) recapitalization of the intervened banks (by exchanging their impaired assets for central bank paper) in preparation for their resale; (3) resale of the intervened banks to other domestic banks; and (4) implementation of asset recovery plans. Also, the government is pursuing legal action against those involved in fraudulent activities.

6.  As a result of these actions, the financial situation has now stabilized and the government is taking steps to rebuild the official international reserve cushion and further improve the health of the banking system.

7.  In particular, the government is committed to increase public sector deposits at the central bank by US$36 million during November 28-December 31, 2000 (consistent with the underlying programmed flow of central bank net credit to the nonfinancial public sector, adjusted for certain delayed external flows) to rebuild official international reserves by around US$50 million in that period. Credit conditions also will be tightened through the implementation until end-January, 2001 of a marginal liquidity requirement on bank's deposits and through open market operations. The official reserve cushion would increase further in 2001, as the government will carry out pending reforms in the financial and electricity sectors that will secure the disbursement of US$60 million of delayed balance of payments support from the IDB. Also, in early 2001 the government will offer for sale the electricity generation facilities, sterilizing the net proceeds in the central bank.

8.  To support the international reserve build-up and reduce pressures on interest rates, the government will continue to undertake actions necessary to comply with the modified program's end-December benchmarks on public sector saving and net domestic financing, adjusted for delays in the disbursement of balance of payments support from the IDB and the fiscal cost of bank resolutions. In early 2001, the government will hold comprehensive discussions of fiscal policy options with IMF staff in the context of the formulation of a program that could be supported by a new PRGF arrangement. Until then, domestically financed spending by the nonfinancial public sector will be contained as necessary to avoid recourse to net domestic financing, before taking into account resources stemming from the privatization of the electricity generating plants (net of debt service payments connected with the privatization of the electricity company) and the disbursement of the delayed balance of payments support from the IDB. To that end, the government will continue to refrain from granting across-the-board wage increases and will limit wage increases to selective adjustments for teachers, health workers and police personnel.

9.  To improve the health of the banking system, in the next few months the government will review and modify, as necessary, the legal, regulatory and supervisory framework of the financial system. For that purpose, a specific action plan to be implemented with IMF, World Bank, and IDB technical support has been developed (Attachment I). As part of this plan, the government will enact by the end of this year a law on deposit insurance to provide appropriate guarantees to small depositors and limit the fiscal costs of bank restructuring. The government will consult with the IMF, the World Bank, and the IDB staffs any modifications that might be required to bring this legislation in line with international best practices and will submit the required modifications to the National Assembly by March 2001.

10.  The government is committed to implementing vigorously the actions described in this letter to support its economic program, which aim at reducing the country's high poverty levels. In particular, special care will be taken to monitor developments in the banking system to strengthen its situation through appropriate policy actions. The government reaffirms its intention to use HIPC Initiative assistance solely for poverty spending. The government feels that the implementation of the strategy laid out in this letter is essential to resolve the difficulties in the banking sector and ensure continued macroeconomic stability and economic growth. The government stands ready to take any further measures that might be required to deal with unexpected difficulties in complying with its economic program.

11.  The government appreciates the continuing support of the IMF, which is critical to maintaining confidence and improving Nicaragua's economic prospects.

Sincerely yours,

Nicaragua: Financial Sector Reforms¹

Objective	Action	Date of Implementation
I. Strengthen the institutional framework for banking crisis resolution.	a. Create appropriate institutional arrangements to coordinate all institutions involved in the banking crisis resolution process (CBN, Ministry of Finance, SBIF), and assign clear responsibility.	End-January 2001
II. Establish the legal basis for bank restructuring.	a. Ensure that the deposit insurance law that will be enacted shortly is consistent with international best practices, containing flexible provisions for prompt bank resolution. The law should contain provisions to prevent undue suspension of bank resolution procedures due to legal claims, legal protection, and conflict of interest clauses for all staff and contractors involved in the bank resolution process. Changes necessary to the law, in order to bring it into line with the above considerations, will be submitted to the National Assembly after consultation with the IMF, IDB, and World Bank.	Approve deposit insurance law according to international best practices by end-March 2001.
	b. Modify the financial legislation to enhance superintendency's capabilities for bank resolution and to adapt deadlines for intervention and recapitalization according to international best practices. Include legal protection and conflict of interest clauses for the superintendent of banks, the president of the CBN, and staff of the superintendency of banks and CBN.	End-March 2001
	c. Modify the criminal code to update the definition of financial crimes.	End-June 2001
	d. Review of the legal and institutional framework for establishing, registering and enforcing property rights, including catastral and collateral registration systems, and develop a time-bound action plan to address any deficiency found.	End-December 2001
III. Strengthen solvency of banks.	a. Finalize current cycle of on-site assisted inspections and officially communicate required adjustments	End-March 2001
	b. Complete a second cycle of on-site assisted inspections including a review of all remaining categories of assets, liabilities and capital accounts not included in the first cycle. Also, a full diagnosis of contingent accounts would be performed and adequate samples of small credits would be taken and the results extrapolated to the remaining small credits portfolio. Revised rules as described in III.c and VI.a will be applied.	End-September 2001
	c. Design and implement strengthening programs for banks where capital weaknesses have been found during the assisted inspections.	Start implementation by end-January 2001
IV. Strengthen banks' liquidity management.	a. Design and implement a repo facility at the CBN.	End-March 2001
	b. Develop and implement a plan to improve the CBN's ability to place bonds at market terms, including strengthening the financial profile (debt sustainability) of the CBN.	Develop the plan by end-February 2001 Implementation by end-May 2001
	c. Reserve requirements (RR) will not be increased. The recently introduced liquidity requirement (LR) (that banks whose deposits increased between August 5 and December 5, 2000 invest 65 percent of this increase in BOMEX) will be rescinded.	As regard the RR, continuous As regards the LR, end-January 2001
V. Resolve intervened banks. Manage and recover impaired assets of Interbank and Bancafe.	a. Formally write off the value of the shares of Interbank's shareholders. For banks falling below 2.5 percent CAR and failing to recapitalize the bank within the legal timeframe of intervention, the intervention board should be constituted as general shareholders' meeting and formally write off the value of the shares of the bank.	Immediately
	b. Prepare an inventory of all assets of both intervened banks, which have not been transferred to other institutions, including valuation.	End-March 2001
	c. Establish a time-bound program for the disposal of the assets which will include an asset management strategy covering institutional arrangements, information and transparency, and private sector outsourcing.	End-April 2001
	d. Prepare a litigation strategy after assessing all possible legal actions to pursue in the courts those allegedly involved in criminal activities and misconduct in intervened banks.	End-January 2001
VI. Strengthen prudential regulations.	a. Tighten the rules for classification and provisioning of restructured loans and review classification criteria for all loans.	End-February 2001
	b. Review current norms to make sure they are still adequate given Nicaragua's needs. Among others, banks should be required to publish audited accounts, and sanctions should be introduced to punish the publication of erroneous information.	Norms reviewed by end-April 2001 Changes approved by end-May 2001
	c. Conduct a diagnostic of the operating procedures of the central de riesgos and implement a time-bound action plan to correct any deficiencies found.	Diagnostic completed by end-June 2001. Action plan implemented by end-December 2001
	d. Approve and strengthen fit and proper regulations for main shareholders and managers of banks, including restrictions on former owners and managers of failed banks that have caused losses to the State to subsequently own or manage banks.	End-January 2001
	e. Amend accounting standards to bring them into conformity with GAAP (Generally Accepted Accounting Principles), including with respect to proper asset valuation (mark-to-market valuation of securities-except held to maturity-and real estate assets) and accounting of restructured loans.	End-December 2001
	f. Complete satisfactory review of supervisory practices and undertake, with the assistance of the IFIs and foreign supervisors, compliance assessments of the Basle Core Principles.	End-January 2002
	g. Develop time-specific action plan to address any deficiencies found in (f).	End-March 2002
VII. Strengthen prudential supervision.	a. Implement the strengthening strategy and the integrated support program for the superintendency of banks, as established in the technical assistance matrix of the World Bank, and implement the training actions to be determined in the IDB program.	Beginning January 2001. Shall be completed by end-June 2002.
	b. Introduce a ladder of intensified supervisory action and penalties for noncompliance with regulatory norms. The Superintendency of Banks will apply penalties and disciplinary measures on a uniform and nondiscretional basis. The authorities will review the level and uniformity of penalties and of supervisory actions.	End-March 2001
	c. Strictly enforce fit and proper, conflict of interest, and related party lending regulations. Create public registries of main shareholders and managers of banks and related party databases.	End-December 2001
1All measures contained in this matrix will be implemented in manners satisfactory to the Fund and World Bank staffs.