January 29, 2001

Mr. Horst Köhler
Managing Director
International Monetary Fund
700 19th Street NW
Washington, D.C. 20431
U.S.A.

Dear Mr. Köhler:

1. On behalf of the government of Ethiopia, we have the honor of transmitting a memorandum on economic and financial policies that sets out the objectives and policies that the government of Ethiopia intends to pursue during 2000/01-2002/03. The focus of our development strategy remains the reduction of poverty, which we aim to achieve by promoting sustainable growth, through the implementation of further structural reforms in a context of macroeconomic stability. The second pillar of our strategy consists of policies that seek to improve the income earning capacity of the poor and to increase their protection against major hardship. In support of these objectives and policies, the government of Ethiopia requests a three-year arrangement under the PRGF in an amount equivalent to SDR 86.9 million (equal to 65 percent of quota). The government intends to make the contents of this letter, and those of the attached MEFP and Technical Memorandum of Understanding (TMU) available to the public and authorizes you to arrange for them to be posted on the IMF website, subsequent to Board approval.

2. The government of Ethiopia is in the process of preparing a poverty reduction strategy paper (PRSP) that will spell out in more detail our medium-term objectives and policies. We expect to complete it by end-2001, with the participation of the poor and in consultation with civil society, the private sector and development partners. An interim PRSP—setting out a timeline and process for preparing the full PRSP and preliminary objectives for promoting poverty reduction, including macroeconomic policies and structural reforms—has been prepared and sent to the Fund and the World Bank.

3. To monitor progress in economic policy implementation, financial and structural benchmarks and performance criteria under the first annual program of the PRGF are summarized in the tables annexed to the memorandum on economic and financial policies. Quantitative performance criteria for end-March and end-September 2001, and quantitative benchmarks for end-June 2001 apply to net foreign assets of the National Bank of Ethiopia, net domestic assets of the National Bank, net domestic financing of the government of Ethiopia, and avoidance of payments arrears and nonconcessional borrowing (Table 1). Structural performance criteria and benchmarks apply to key structural reforms (Table 2). A first program review will be completed by July 31, 2001 and will, inter alia, consider the budgetary policy framework for 2001/02. At that time, the performance criteria for end-September 2001 will be established. A second review, which will assess progress in policy implementation and describe the second annual program and set performance criteria and benchmarks for the 2001/02 program year, will be completed by December 20, 2001. Subsequent reviews under the arrangement are expected to take place approximately semiannually. The government of Ethiopia will provide the Fund with such information as the Fund requests in connection with the country's progress in implementing the economic and financial policies and achieving the objectives of the program.

4. The government believes that the policies and measures set forth in the attached memorandum are adequate to achieve the objectives of the program. During the period of the arrangement, the government stands ready to take additional measures that may become appropriate for the achievement of the objectives of the program. We will consult with the Managing Director of the Fund on the adoption of any measures that may be appropriate, at the initiative of the government of Ethiopia or whenever the Managing Director requests such consultation. Moreover, after the period of the arrangement and while Ethiopia has outstanding financial obligations arising from loans under the arrangement, Ethiopia will consult with the Fund from time to time at the initiative of the government or whenever the Managing Director requests consultation on Ethiopia 's economic and financial policies.

Ethiopia

Memorandum on Economic and Financial Policies for 2000/01-2002/03

I. Introduction

1. This memorandum reviews economic and financial developments in Ethiopia and progress under the government's recent reform program. It also outlines the government's medium-term program for 2000/01-2002/03, focusing particularly on the current financial year, in support of which the government of Ethiopia requests a new three-year arrangement under the Poverty Reduction and Growth Facility (PRGF). The government's program is formulated against the background of Ethiopia's emergence from the border conflict and the government's request for debt relief under the Heavily Indebted Poor Countries (HIPC) Initiative.

2. Ethiopia's reform and recovery efforts gained momentum soon after the establishment of the transitional government in 1991. Under the government's economic program of that time, the country made notable progress toward establishing a market economy, achieving macroeconomic stabilization, and removing barriers to competition. As a result, economic growth increased strongly and inflation declined to low single digits.

3. The government's reform program has been targeted at reducing poverty, through a long-term development strategy of Agricultural Development Led Industrialization (ADLI). Complementary reforms essential to reduce poverty were also pursued in the form of priority sector development programs in the areas of health, education and roads, with the support of international donors. The ADLI strategy was recently reconfirmed by government, following extensive consultations with the public, and will guide the National Development Program of the five years through 2004/05.

4. The government is preparing a poverty reduction strategy paper (PRSP), which will focus on developing further specific measures and programs aimed at improving the living standards of the poor. Standards are indicated by way of specific poverty reduction targets laid out in the interim poverty reduction strategy paper (I-PRSP). Essential to the effort of poverty reduction would be the policies and reforms necessary to safeguard macroeconomic stability and promote growth, basic objectives that also form the core of the National Development Program. In order to ensure broad-based support, the government intends to prepare the PRSP in consultation with local stakeholders, the donor community, and civil society. Considerations relating to the PRSP process are set out in the I-PRSP, which also includes a preliminary matrix of the macroeconomic and structural policies, and targeted poverty reduction programs.

II. Recent Economic Performance and Policy Implementation

5. During the ESAF arrangement period (1996/97-1998/99), the government's program largely achieved macroeconomic stability and put in place many of the structural reforms needed to raise economic growth. For most of the period, the government pursued cautious fiscal and monetary policies, notwithstanding adverse factors at times, including drought conditions, a deterioration of the terms of trade, and the impact of the recent border conflict. Modernization of the tax system strengthened government revenue. Confronted with declining external support and mounting security requirements, the government had to scale back spending, including for social services; nevertheless, by 1998/99 the overall fiscal deficit (including grants) had climbed to 8.5 percent of GDP, from 2.4 percent of GDP in 1996/97.

6. Monetary management was prudent, although the transition to indirect policy instruments was slower than desired. Commercial bank lending rates were decontrolled, regulations modified to improve the functioning of the treasury bill market, conditions were established for the introduction of the interbank money market and the foreign exchange market, and restrictions on payments for invisibles were removed (with the exception of limits on holiday travel and some education allowances). To improve financial intermediation, the government authorized private banks in 1994 and began to tackle the deficiencies of state-owned financial institutions. As a first step, the dominant state-owned Commercial Bank of Ethiopia (CBE), which holds 86 percent of the systems deposits, 78 percent of the credit, and 84 percent of assets of the banking system, underwent a comprehensive audit by an international firm. Also, a foreclosure law was made operational in 1998 to expedite collections on nonperforming loans and facilitate enforcement of contracts in general.

7. The pace of liberalization and deregulation began to pick up in 1998/99. Following the privatization or liquidation of 175 enterprises in the preceding two fiscal years, several large enterprises and state farms were brought to the point of sale, and preparations began for the privatization of the Construction and Business Bank (CBB). Limits were lifted on foreign investment in joint ventures in the telecommunication and power sectors. Administrative hurdles for exporters, concerning price verification and foreign commercial borrowing, were dismantled. The surrender requirement for exporters was replaced with a conversion requirement, permitting the use of foreign exchange proceeds for current account transactions within four weeks.

8. Economic growth during the ESAF period averaged 3.3 percent, but it was uneven owing mainly to volatile agricultural output. Consumer price inflation was contained at close to 4 percent, except for the drop of 6.4 percent in 1996/97 caused by bumper crop conditions. The external current account deficit, including grants, averaged 2.3 percent of GDP in 1996/97 and 1997/98, reflecting initially exceptionally low food imports and subsequently a strong improvement in the terms of trade as well as delays in the government's sector development programs (SDPs). In 1998/99, the external deficit widened to 7.9 percent of GDP, as prices and volumes of coffee exports dropped sharply and the fiscal deficit increased. Gross official reserves stood at 2.8 months of imports of goods and nonfactor services at end-1998/99, down from 4.4 months at end-1996/97.

9. Ethiopia's economic situation deteriorated in 1999/2000 because of severe drought conditions; a sharp decline in the terms of trade, reflecting a sharp drop of coffee export prices and the steep rise in petroleum import prices; and the impact of the border conflict which boosted the fiscal deficit to 11.6 percent of GDP and led to a reduction in donor support. Real GDP growth was estimated at 4.6 percent and inflation remained subdued, in part because upward pressure on food prices was dampened by the availability of large food aid supplies. Large food grants by donors and government purchases of grain in surplus areas were distributed to the drought stricken parts of Ethiopia. The external position deteriorated sharply, and official reserves declined to two months of import cover. To contain exchange market pressures, the government imposed temporary restrictive measures in the exchange and trade areas. At the end of the financial year, an agreement for the cessation of hostilities was signed with Eritrea, terminating the two-year border conflict. A peace agreement was reached on December 12, 2000.

III. Medium-Term Policy Framework

10. Notwithstanding the focus on poverty reduction and the economic progress of recent years, per capita income in Ethiopia is about US$100 and almost half of its population lives in absolute poverty. The government's primary development goal remains to achieve sustained poverty reduction, in line with internationally agreed targets for the year 2015, through increased economic growth, underpinned by key reforms in social areas, including well-targeted poverty reduction measures. The government's program for 2001/02-2002/03 aims at (i) increasing economic growth to around 7 percent, consistent with rising per capita GDP; (ii) reducing inflation to low single digits; and (iii) raising the import reserve cover to about four months.

11. Given the importance of rural development for broad-based, labor intensive growth and poverty reduction, the government's policies remain centered around the ADLI strategy. Rising rural incomes would serve as a stepping stone toward industrialization, with increased private savings and investment enabling a virtuous circle of growing employment and incomes. Increases in income rely on rising agriculture productivity and improved conditions for the nonfarming economy, which is to be achieved through agricultural input programs, improved access to credit and marketing facilities, and a broad range of policies to upgrade the human and physical infrastructure and remove impediments to private sector activity. Therefore, the ADLI strategy is complemented by (i) targeted improvements in public services through capacity building, judicial and civil service reform, and further fiscal decentralization; (ii) further steps to liberalize the exchange and trade system; and (iii) regulatory reforms. Infrastructure programs, focusing on education, health, road and water services, will retain priority in the government's medium-term expenditure program and continue to receive multi-donor support. These programs are deemed to have a large positive impact on the poor. The government is also emphasizing other poverty alleviating programs, in particular initiatives to increase food security and combat HIV/AIDS.

12. Given Ethiopia's resource constraints and very low level of income, the achievement of sustained high economic growth will require major external support (including relief under the Enhanced HIPC Initiative which the government is requesting), but also efficiency gains in the use of resources, and higher private savings and investment. In this regard, the development of a modern, competitive financial sector is a crucial step, while short-term measures will target greater efficiency in allocating financial resources and improving incentives for financial savings, including promotion of microcredit institutions. Within the macroeconomic framework, the monetary program will be geared toward low inflation and the rebuilding of international reserves.

13. The underlying fiscal strategy (excluding the post-conflict special programs) hinges on a major improvement in tax revenue, which is underpinned by a comprehensive medium-term reform of tax policy and administration. The overall expenditure strategy involves a decline in defense spending in relation to GDP (excluding demobilization costs), after a substantial cut in 2000/01, and relies on restraint in other nonsocial spending in order to accommodate higher outlays on health, education, water, infrastructure, and agricultural services. On this basis, the underlying general government deficit (including grants but excluding special programs) would decline from 11.6 percent of GDP in 1999/2000 to 6.4 percent in 2000/01 and to 5.1 percent in 2002/03.

14. In the next three years, the overall fiscal position would show transitory larger deficits, as the government begins to address immediate post-war demobilization, rehabilitation, and reconstruction needs. The government, with assistance from the World Bank, has developed a comprehensive emergency program of a maximum scale of US$725 million, equivalent to 10.6 percent of annual GDP, for which it will obtain World Bank financing of US$428 million within the three fiscal years ending in 2002/03. At this stage, the government has incorporated into its macroeconomic framework phased outlays associated with the emergency program of 6.4 percent of GDP (of which 1.9 percent in 2000/01), which are fully funded.

15. The demobilization component of the emergency program supports the phased reintegration of a substantial number of veterans into the civilian economy and provides care for disabled veterans, at a total cost of US$150 million in 2000/01-2001/02. The remainder of the program consists of rehabilitation, reconstruction, and de-mining components; the focus is on (i) restoring the infrastructure and income earning capacity of those households that were dislocated, suffered a war-related loss of assets, or lost their primary bread winner; (ii) the rehabilitation of social service infrastructure; (iii) the reconstruction of road infrastructure; and (iv) de-mining. Prior to the start of the next fiscal year, the government will reassess its overall macroeconomic framework in light of updated prospects for the implementation of the various components of its emergency program. On the basis of the current projections of emergency outlays, the overall fiscal deficit would increase from 8.4  percent of GDP in 2000/01 to 8.8 percent of GDP in 2001/02, and decline to 6.2 percent of GDP in 2002/03.

16. The envisaged policies, together with an assumed gradual recovery in Ethiopia's terms of trade starting in 2001/02, are expected to result in higher private and public domestic saving and contribute to a rise in investment from 12.3 percent of GDP in 1999/2000 to 19.2 percent of GDP in 2001/02, and to about 20.0 percent in 2002/03. Nevertheless, high—albeit declining—levels of foreign saving will be necessary to finance investment over the foreseeable future. The resource gap would be expected to decline from 17 percent of GDP in 1999/2000 to 15.9 percent of GDP in 2001/02, followed by a gradual reduction to around 15.0 percent of GDP in 2002/03.

IV. Economic Program for 2000/01-2001/02

17. The program assumes that post-war reconstruction, a pick-up in the execution of the government's sector development programs, agricultural sector recovery after three years of drought, and a resumption in private investment will sustain GDP growth of 7.8 percent in 2000/01 and 7 percent in 2001/02. Inflation is envisaged to increase modestly from 4.2 percent in 1999/2000 to 5.2 percent in 2000/01, before declining to 4.9 percent in 2001/02, primarily due to higher world oil prices and domestic tax increases. The external current account deficit (after grants) would narrow gradually, from 7.5 percent of GDP in 1999/2000 to about 6 percent of GDP in 2000/01 and 2001/02, notwithstanding lower military imports, as the sharp deterioration in the terms of trade since 1998/99 is expected to be only gradually reversed beginning in 2001/02 and the post-conflict programs come with relatively high import requirements. Given the projected increase in foreign funding (including the requested relief under the enhanced HIPC Initiative), gross foreign reserves should rise from 2 months of imports of goods and nonfactor services in 1999/2000 to 3½ months by end 2001/02.

A. Fiscal Policy

18. The underlying fiscal deficit after grants (excluding the post-conflict programs), is targeted to fall from 11.6 percent of GDP in 1999/2000 to 6.4 percent of GDP in 2000/01 and to 5.4 percent of GDP in 2001/02. Higher tax revenues, lower defense-related spending, and restraint on nonpriority current expenditure would strengthen the fiscal position while allowing substantial increases in capital and social spending. Given the expectation of higher project financing and resumed balance of payments support (including debt relief), the government's domestic public debt as a proportion of GDP would begin to decline from 2000/01.

19. Laying the foundation for a strong tax revenue performance over the medium term is a key objective of the fiscal program, given the need for increased public services and the likely decline in nontax revenue as a ratio to GDP. The decline would result from the depletion of the fuel stabilization fund and lower proceeds from other funds as government is disengaging from the marketing of agricultural commodities, such as sugar. In order to boost tax revenue by about 2½ percentage points during the three-year period ending 2002/03, the government is embarking on comprehensive tax policy reforms and an overhaul of tax administration, with Fund technical assistance. Tax policy reforms are geared to increasing efficiency and equity, and will proceed along three tracks, namely (i) income tax streamlining and closing of loopholes, (ii) improving the efficiency of the incentive system, and (iii) strengthening domestic indirect taxes by selective rate increases and the broadening of the base while relying less on border taxation.

20. Income tax reforms are to be implemented in two phases. New legislation on presumptive taxation and a 5 percent withholding tax on imports will become effective by February 1, 2001. The next phase comprises a new income tax code and legislation regarding standard assessments, to be effective at the start of 2001/02. The current incentive system will be modified by a more efficient and focused system by end-2001. Regarding indirect taxation, the government will take all necessary steps to introduce a value added tax (VAT) in January 2003, and publicly announced in November 2000 that the VAT is to become effective in 2002/03. Effective January 1, 2001 the government eliminated the 10 percent import surcharge on imports and increased the top sales tax rate to 15 percent. At the time of budget preparation for 2001/02, the government will consider tax revenue measures as necessary to ensure that the revenue targets under the program are met.

21. Tax administration will be strengthened through procedures that help to enforce collection and through institutional reforms. For 2000/01 the plan is to pass legislation by March for the introduction of a taxpayer identification number (TIN) and for enforced collection power of revenues agencies; the TIN, together with computerization, will become gradually available to all federal and regional revenue agencies over the next two years. To ensure that the challenging agenda of tax policy and administrative reforms is successfully implemented, a tax reform task force will take the leadership in overseeing the reform process. This task force will also work closely with a large-tax-payer unit that will become fully operational at end-2000/01. The unit is expected to help increase compliance of this group of taxpayers and lay the technical ground work for the introduction of the VAT.

22. The government's expenditure strategy is geared toward maintaining overall expenditure levels within a framework of macroeconomic stability, fostering a sustained economic expansion, and achieving a meaningful reduction in poverty levels. Against the backdrop of declining requirements for national security expenses, the government will resume executing its sectoral development programs (SDPs) at the faster pace that had been targeted prior to the outbreak of the conflict. This would result in substantial increases in social sector and priority infrastructure (roads and water) expenditures. Capital outlays would rise from 6.7 percent of GDP in 1999/2000 to 10.1 percent of GDP by 2001/02. Overall expenditure is expected to fall from 32.7 percent of GDP in 1999/2000 to 29.0 percent of GDP by 2001/02, which will require restraint on nonpriority recurrent expenditures.

23. Expenditure targeted at poverty reduction will focus on upgrading services that impact on human development (health and education), and on increasing the opportunities for and efficiency of income earning activities (agricultural inputs, improved marketing conditions through storage, credit access for agricultural production, and road infrastructure). Poverty targeted capital and recurrent expenditures, before the benefits of the enhanced HIPC Initiative, are projected to increase from 8.6 percent of GDP in 1999/2000 to 12.1 percent of GDP in 2000/01 and further to 12.3 percent in 2001/02. Savings in external debt relief derived from the enhanced HIPC Initiative would permit further increases in these and other poverty reducing expenditures, equivalent to a total of 1.7 percent of GDP over the second and third fiscal years under the program period.

24. These spending priorities imbedded in the medium-term budget strategy underpin the quantitative output or outcome targets for poverty reduction programs which the government has formulated in the I-PRSP. The targets refer to poverty inequality, food security, health, education, clean water supply, and roads. The main thrust of expenditures in the health sector is to improve primary and preventive health care by focusing on improvement of service delivery; and provision of drugs, and medical supplies. More generally, the health services will address the major diseases confronting Ethiopia by rolling back malaria and HIV/AIDS, in particular. With regard to education, raising the gross enrollment ratio and lowering grade repetition will call for additional teachers and schools; and better deployment of teachers, especially in the underserved areas. In the water sector, the goal is to raise service levels by expanding access to safe water and sanitation facilities and installing efficient management. Road construction or rehabilitation will give priority to underserviced rural areas.

25. The government intends to improve substantially its control, tracking and reporting mechanisms of expenditures at both the federal and regional level. It will apply the established monitoring procedures to avoid the emergence of domestic or external payments arrears. Steps have been taken toward the effective devolution of authority, responsibility, and resources to local governments. The process of rationalizing federal and local government taxes has started, with the aim of providing more revenues to local government authorities to match the expenditure responsibilities transferred to them. The local authorities will be held responsible for managing their finances and service delivery. At the general government level, expenditure execution in the priority sectors (including those in poverty-related spending) will be monitored by annual expenditure reviews. In addition, the government will improve, with technical assistance from the World Bank and other development partners, its system of monitoring budget allocations and executions, which will involve the strengthening of budgetary data and processes so as to arrive at a satisfactory medium-term tracking system.

B. Monetary Policy and Financial Sector Reform

26. Monetary policy will remain geared toward containing inflation and achieving the international reserve targets. The monetary program assumes that velocity remains stable, with broad money growing by 12.5 percent and 13.2 percent in 2000/01 and 2001/02, respectively. The net domestic assets of the central bank (NBE) will remain the key aggregate in steering monetary policy. The central bank has begun to monitor closely developments in reserve money and broad money. Progress in fiscal consolidation, supported by substantial disbursements of foreign aid, is expected to facilitate a rebuilding of net international reserves, while leaving scope for adequate growth in domestic credit to the private sector so as to set the stage for private-sector-led growth.

27. In November 2000, the NBE has begun to sterilize the excess liquidity of commercial banks by selling, on behalf of the government, increased amounts of treasury bills in the bi-weekly auctions and offering a longer-term government bond for auction. Excess reserves on the order of birr 3,300 million were absorbed in November, and the plan is to absorb an additional birr 500 million per month in treasury bill auctions for two months thereafter. In judging the liquidity position of banks, the NBE will take into account treasury bill yield and exchange market developments, and it will develop a forecasting framework for bank reserves. Steps will be taken to improve the treasury bill auction, including the removal of cut-off rate limits; the introduction of a longer-term treasury bill; and the introduction of a book entry system for treasury bills.

28. The NBE will also closely follow interbank money market developments, and define, in cooperation with banks, a code of conduct for money market participants. In this context, the desirability of lifting the collateral requirement for short-term inter-bank lending will be explored. To facilitate liquidity management, the NBE will introduce a re-discount facility for eligible government paper for banks at a penal price; and, for the longer run, it may move to a standing repo facility. The central bank's adoption of a more active stance in steering monetary policy with indirect instruments will be complemented by efforts at improving conditions for more efficient exchange market operations.

29. As a first step, the NBE eliminated by mid-December 2000 the temporary barriers to market access imposed in early 2000, i.e., both the 100 percent advance deposit required for authorization of import applications and the nonuniform ceilings across banks on their authority to approve import permits. To ensure that the weekly foreign exchange allocations are conducted under conditions of exchange rate flexibility, the foreign exchange open position limits on commercial banks will be applied only on the basis of prudential considerations. If necessary, a limit on any single bidder's share of auction allocation will be introduced. In the event of exchange market pressures, the NBE will tighten monetary conditions, and will refrain from rationing foreign exchange allocation in the auction or from sustained intervention in the interbank market. The NBE's position in the exchange market, i.e., in the weekly wholesale auction and in the interbank market, will be guided by the program's net foreign assets targets. The NBE has announced that it is also preparing institutionally the, so far little used, interbank foreign exchange market to replace the auction by October 2001 with a view toward achieving efficiency gains through broader-based foreign exchange operations. In this spirit, the open-position related requirement for surrender to the NBE will be replaced in June 2001 by a requirement for banks to square any excessive open position.

30. Against the backdrop of modernizing monetary management and the importance of strengthened banking supervision for efficient operations of an expanding financial sector, the government intends to restructure the NBE's operational, organizational, and administrative set-up. An international competitive bid has been tendered for undertaking a comprehensive study, and the award will be finalized in early 2001. Following the completion of the study, steps will be taken to strengthen the NBE, including revision of both the existing Banking Act to increase the autonomy of the NBE, as necessary, and financial relations with the government. For the interim, the government has reached an understanding with NBE that growth in NBE claims will be informed by monetary policy objectives and that government borrowing outside of the NBE will also be coordinated with monetary management.

31. The National Bank of Ethiopia continues its work on improving banking regulation and supervision, as capacity building in the bank's supervision department continues to be a high priority. An enhanced supervisory framework and supervisory capacity for microfinance institutions will be put in place within a year, in light of the expansion of the banking sector—there are now 8 commercial banks and 16 microfinance institutions, some of which are expected to become licensed commercial banks in the medium term. Progress continues on bringing prudential regulations generally in line with Basel standards, with some important issues, such as the adequacy of loans loss provisioning requirements and accounting standards for regulatory reporting, still to be addressed. Banks have begun to prepare for meeting the increased minimum capital requirements that will apply as of June 2002. The foreclosure law is now in operation, and the banks, with assistance from the national bank, aim to establish a credit information bureau in 2000/01. Among the other numerous measures to improve banking supervision, new directives on troubled-debt-restructuring and the adoption of a formal problem-bank directive by June 2001 will allow for increased expediency of the NBE in addressing bank problems.

32. With a longer-term view, the government plans to review its financial sector development strategy by mid-2001. Agreement with the Fund and the World Bank on the issues to be reviewed is to be reached in January 2001. In the first quarter of 2001, the government will undertake, with joint technical assistance from the Fund and the World Bank a study that examines the current financial sector strategy, and financial sector conditions, and formulates reform proposals. The objectives are to achieve a financial sector structure that would foster economic development and active competition in Ethiopia by offering an attractive range of financial savings instruments throughout the country and providing for an efficient allocation of financial resources to borrowers. In the interim, the government will put the Commercial Bank of Ethiopia (CBE) under a management contract with a reputable foreign institution. The tender for the contract will be issued in January 2001, and the management contract will be signed by June 2001. Given the pending reforms in the financial sector over the coming years, the management contract will indicate that the rehabilitation of the CBE is to proceed against the background of possible streamlining of CBE's functions or its institutional reorganization. The management team will be charged with (i) transforming the CBE into an economically viable entity, operated on commercial principles, and (ii) the training of a team of skilled Ethiopian bankers to assume management of the bank by the end of the contract, which would cover a minimum of two years. Within the next 1¾ years, the government will complete the financial restructuring of the CBE. Prior to the start of the management contract, the government will reconstitute the CBE Board so as to include qualified individuals from the private sector as directors.

33. Regarding the soundness of the smaller private banks, the NBE is developing and implementing formal corrective action programs for those banks that do not meet targets in their nonperforming-loan action plans, which were agreed in early 2000.

C. External Sector Policies and Financing Requirement

34. As noted earlier, the projected decline in the external current account deficit over the program period and the medium-term, will be gradual notwithstanding a rebound in export growth (led by the coffee, leather, chat and nontraditional-export sectors), because of the high import requirements related to a recovery of investment in equipment and physical infrastructure, and post-conflict reconstruction. Consistent with pre-conflict levels of foreign support, it is expected that much of the demobilization, reconstruction and sectoral development effort will be funded by multilateral and bilateral donors, leading to an improvement in the capital account. International reserves need to be rebuilt over the next few years, at a time when the military downsizing and the tax revenue capacity building will be ongoing. Therefore, the closing of the remaining financing gaps will require large, albeit declining, amounts of balance of payments support and debt relief for some time. Moreover, balance of payments projections are subject to substantial uncertainty in light of Ethiopia's vulnerability to terms-of-trade shocks, particularly as regards coffee and oil prices, and droughts. In view of the recent volatility of world oil prices, the government will seek consultations with Fund staff if world market prices of petroleum products increase by 30 percent above the baseline petroleum prices assumed in the program, or if the increase in prices of imported petroleum products endangers the achievement of the program objectives.

35. The authorities intended to seek Paris Club rescheduling of pre-cutoff date arrears and maturities falling due through end-December 2003, and request treatment of arrears and debt service to non-Paris Club creditors on at least comparable terms. The program also assumes the provision of interim debt relief under the HIPC Initiative from the Fund, the World Bank, and the African Development Bank (AfDB). It is envisaged that any interim relief provided by multilateral creditors in the context of the HIPC Initiative will allow the government to increase poverty-reducing expenditures.

36. The government will rely primarily on prudent macroeconomic policies and a market-determined, flexible exchange rate to maintain the current account in line with the prospective availability of foreign grants, concessional loans, and debt relief. With regard to new borrowing, the government will neither contract nor guarantee foreign loans on nonconcessional terms. There will be no net accumulation of new arrears (excluding debts subject to rescheduling or a stock-of-debt operation).

37. During the program period, the government will not introduce or intensify any exchange restriction, introduce or modify any multiple currency practices, conclude any bilateral payments agreements that are inconsistent with Article VIII of the Fund's Articles of Agreement, or introduce or intensify import restrictions for balance of payments purposes. The NBE will eliminate the remaining restrictions on current account transactions (namely, on the availability of foreign exchange for holiday travel and on payments for education abroad by foreign residents) by end-March 2001. The government has also requested that the Legal Department of the IMF examine by end-June 2001 whether the relevant legislation is in compliance with the obligations of Article VIII, Sections 2, 3, and 4 of the Fund's Articles of Agreement.

38. The government is making efforts at further trade liberalization, and will define by July 2001 a time-bound plan for reducing the number and level of import duty rates so that the unweighted average tariff would decline from about 19½ percent to 17½ percent by January 2003. Remaining trade restrictions, in the form of nontariff barriers, will apply only to enforce national security, environmental, health, and safety regulations.

D. Other Structural Reforms

39. Besides the structural reforms in the financial and external sectors, enumerated above, the government will implement key structural measures needed for enhancing the economy's growth potential and reducing poverty. In particular, the government will implement judicial and civil service reforms, enhance capacity building and institutional development, and improve governance to make public and private organizations effective and efficient. Efforts will also continue to be made to facilitate private sector development as an essential prerequisite for sustainable socio-economic development. These reforms will give rise to modern institutions, strengthen key state functions (such as enforcement of contracts and property rights), and improve delivery of services that are important for the development of the private sector.

40. Civil service reform is geared toward building an efficient public workforce and strengthen the overall performance of the public sector. The first phase of the civil service reform program started in 1994/95. The reform program has five major components: (i) expenditure management and control, which includes reform of procurement, auditing, and internal controls; (ii) human resource management, which is aimed at improving the competence and attitude of the public service, increasing remuneration of the civil service, and improving supervision and performance management; (iii) service delivery; (iv) top management systems, which is designed to establish transparent systems and procedures in the selection of senior government officials; and (v) ethics of the civil service, which is targeted at enhancing ethics through the introduction of a code of conduct and prevention of corruption. The ongoing civil service reform will make a substantial improvement in governance, transparency, and accountability within the public sector.

41. The government has initiated and implemented a capacity building program since December 1998. The program comprises the development of human resources, the building and strengthening of institutions, and establishing effective working practices. In the public sector, capacity building will augment the government's judicial and civil service reforms. In particular, government will give high priority to building the capacity of revenue departments—by introducing computer-based systems, establishing a large-taxpayer unit, and improving the skills and remuneration of officials—so as to raise government tax receipts. Other sectors that will receive priority include education to increase trained manpower, and upgrade the civil service. The training needs of regional and district administrations will also receive special attention. In relation to smallholder agriculture, the program focuses on training of farmers, improving the performance of supporting microfinance institutions, and strengthening public and private sector organizations involved in the development of agriculture, including extension services and delivery of inputs. The private sector will stand to benefit significantly from capacity building such as establishing industrial training institutes, strengthening the financial sector, and supporting the development of private sector associations.

42. Considerable efforts have been made in recent years to ease regulatory constraints on the private sector, but eliminating such impediments remains an important area for future reform. The next step in this process is to complete a comprehensive study, with World Bank technical assistance, to identify the key regulatory constraints and the measures needed to address them. The government recognizes that the task of fostering private sector development would be greatly facilitated by establishing broad-based fora for regular consultations between itself and the private sector, along the lines of the "Export Promotion Council." Within private sector economic activity, export development will receive much attention in policy formulation; in particular, measures in favor of export activity will need to improve the access of exporters to finance and land. In support of private sector development, government will accelerate the pace of the privatization of large industrial enterprises. Progress has been made with the privatization of smaller enterprises, especially in trade and other service sectors, which account for the bulk of the enterprises privatized to date. Over the next two years, the government will bring to the point of sale at least 80 industrial enterprises. Participation of foreign investment in the Ethiopian Telecommunication Corporation is envisaged in the near future, and for this purpose a foreign consulting firm has been hired and has started work in August 2000 to undertake a study and prepare a bid document. The restructuring of the telecommunications and electricity utilities will be finished, regulatory frameworks put in place, and decisive progress made with private participation in these activities in 2001/02.

E. Statistical Issues

43. The government has taken a number of actions to improve the statistical database, but more needs to be done to enhance the timeliness and reliability of key statistics. Government has improved the reliability of price indices and made progress with regard to shortening the reporting lags. It will continue to improve the timeliness, quality, and coverage of economic statistics, particularly those related to national income accounts, money, and general government operations. The consistency of the monetary and fiscal accounts is also under review, including the implementation of recommendations of a Ministry of Finance/NBE committee dealing with discrepancies between the monetary and fiscal accounts. Government also plans to upgrade the balance of payments data, with technical support of the Fund, and to work on improving data on poverty and social indicators, with World Bank assistance.

F. Monitoring of the Program

44. Program implementation will be monitored with reference to (i) the quantitative performance criteria and benchmarks, which are set out in Table 1 and described fully in the attached technical memorandum of understanding; and (ii) the structural performance criteria and benchmarks, which are presented in Table 2. As noted in the cover letter addressed to the Managing Director of the Fund, the PRGF arrangement will include a first review of the first annual program. The second disbursement will be subject to end-March 2001 performance criteria and to the first review which will be completed by end-July 2001. At the time of this review, performance criteria for end-September 2001 will be established in light of an updated budgetary policy framework for 2001/02. In addition, in the context of the first review (i) progress in implementing reforms in monetary and exchange market management and in the financial sector will be assessed; (ii) the government will formulate reform proposals based on a review of its financial sector development strategy; and (iii) an action plan for the reduction in trade protection during the remainder of the PRGF arrangement period will be specified. A second review, which is expected to be completed by December 20, 2001, will assess progress in policy implementation, in particular in the area of tax administration reform and preparation of the VAT, as well as performance with respect to the end-September 2001 performance criteria. In addition, at that time, performance criteria for the second annual program will be established.

Ethiopia: Technical Memorandum of Understanding

I. Introduction

1. This memorandum sets out the understandings between the Ethiopian authorities and staff of the International Monetary Fund regarding the definitions of quantitative and structural performance criteria and benchmarks, as well as indicative targets, for the three-year arrangement under the Poverty Reduction and Growth Facility (PRGF), as well as the mechanisms to monitor the program and related reporting requirements. To monitor the evolution of the economy during the program period, the Ethiopian authorities will provide the data listed in each section below to the African Department of the Fund, in accordance with the indicated timing. The financial criteria will be monitored on the basis of the methodological classification of monetary and financial data that exists as of October 1, 2000. For program purposes, the public sector consists of the general government (comprising the federal and regional governments) and the National Bank of Ethiopia. The quantitative targets on July 7, 2001 are benchmarks, and those at end-March 2001 constitute performance criteria. The indicative benchmarks for end-September 2001 will be established as performance criteria in the context of the first review to be completed by July 2001.

II. Quantitative Criteria: Definitions and Reporting Standards

A. Floor for Net Foreign Assets (NFA) of the NBE

2. Definition. NFA are defined as the difference between gross international reserves and all foreign liabilities of the NBE, including debts to the IMF and other long- and short-term liabilities to nonresidents of the NBE. Foreign liabilities also include foreign-currency-denominated domestic liabilities of the NBE. For calculating the criteria, foreign assets and liabilities shall be valued at the U.S. exchange rates prevailing on September 30, 2000. Gold holdings will be valued at the U.S. dollar market price of September 30, 2000. Finally, the net foreign assets shall be converted into local currency at the exchange rate of September 30, 2000 (8.255 birr per U.S. dollar).¹ Performance relative to an indicative floor on the net foreign liquid reserves of the NBE will also be monitored.²

3. Reporting. Data on gross international reserves and foreign liabilities of the NBE will be transmitted to the African Department of the Fund through the Fund Resident Mission on a weekly basis within 10 days of the end of each week. The NBE will also report the breakdown between liquid and unencumbered gross international reserves and those reserve assets that are pledged, swapped, or encumbered.

B. Ceiling on Net Domestic Assets (NDA) of the NBE

4. Definition. The NBE's NDA are defined to include net credit to the government, credit to enterprises and individuals, claims on banks, and other items net, but exclude foreign currency valuation adjustments.

5. Reporting. The monthly balance sheets of the NBE will be transmitted within six weeks of the end of each month.

C. Limit on the Net Domestic Financing of the General Government (GG)

6. Definition. The net domestic financing requirement of the general government is defined as the sum of (i) the change in the stock of general government domestic (bank and nonbank) debt; (ii) domestic and foreign receipts from divestiture operations, net of related expenditures; (iii) any pending overdue bills,³ and (iv) the floating debt.⁴ Net bank claims on general government consist of NBE and commercial bank claims on the government, including treasury bills and other government liabilities, net of general government deposits with the NBE and commercial banks, nonbank claims comprise treasury bills, bonds, and other general government paper placed with nonbank institutions or with the public.

7. Reporting. Data on domestic financing (bank and nonbank) of the general government (including treasury bills and government bonds held by the nonbank public) will be transmitted on a monthly basis, within six weeks of the end of each month, except for the data on regional governments, which will be furnished within 12 weeks after the end of each month. Net divestiture receipts, with gross receipts broken down into domestic and foreign currency, will be reported on a monthly basis, within six weeks of the end of each month. Reporting on domestic and external arrears (i.e., overdue bills) will be monthly, within six weeks of the end of each month.

D. Ceiling on External Debt-Service Arrears

8. Definition. External debt-service arrears are defined as overdue debt service arising in respect of obligations incurred directly or guaranteed by the public sector, except on debt subject to rescheduling or restructuring. The program requires that no new external arrears be accumulated at any time under the arrangement.

9. Reporting. The accounting of nonreschedulable external arrears by creditor (if any), with detailed explanations, will be transmitted on a monthly basis within four weeks of the end of each month. This accounting would include, separately, arrears owed by the federal government and other public sector entities; arrears owed by Ethiopian Airlines; and arrears owed to Paris Club creditors, non-Paris Club creditors, and other creditors. Data on other arrears, which are reschedulable, will be provided separately.

E. Ceiling on Nonconcessional External Debt

10. Definition. External debt limits apply to the contracting or guaranteeing of nonconcessional external debt by the public sector or any other agencies on behalf of the public sector.⁵ External debt includes all current liabilities, which are created under a contractual arrangement through the provision of value in the form of assets (including currency) or services, and which require the obligor to make one or more payments in the form of assets (including currency) or services, at some future point(s) in time to discharge the principal and/or interest liabilities incurred under the contract. This definition includes loans, suppliers' credits, and leases (operational and financial leases). Concessionality will be based on a currency-specific discount rate based on the 10-year average of the OECD's commercial interest reference rates (CIRR) for loans or leases with maturities greater than 15 years and on the six-month average CIRR for loans or leases maturing in less than 15 years. Under this definition of concessionality, only debt with a grant element equivalent to 35 percent or more will be excluded from the debt limits.

11. Reporting. A loan-by-loan accounting of all new concessional and nonconcessional loans contracted or guaranteed by the public sector, including detailed information on the amounts, currencies, and terms and conditions, as well as relevant supporting materials, will be transmitted on a quarterly basis within four weeks of the end of each quarter.

III. Adjusters

A. Excess in Disbursed External Financial Assistance

12. In case of an excess external financing beyond the programmed amounts shown in Table 1 of this annex, the floor on net international reserves of the national bank will be adjusted upward, with one exception, by the amount of disbursed external financing in excess of the programmed amounts (comprising nonproject-related loans and grants, including "special programs") at the end of each quarter (Table 1), valued at the average exchange rate of the quarter. The exception applies in the case that the overall excess funding stems from higher than programmed financing of the special programs. For end-March, July 7, and end-September 2001 an amount of up to US$50 million in excess of programmed overall external financing can be spent on special programs. Accordingly, within this limit, the floor on net international reserves, and the ceilings on net domestic assets of NBE and domestic financing of the general government will not be adjusted.

13. The ceiling on net domestic assets of the national bank will be adjusted downward by the amount of disbursed external financing in excess of the programmed amounts (comprising nonproject-related loans and grants, including "special programs") at the end of each quarter (Table 1), converted into birr at the average exchange rate of the quarter.

14. The ceiling on domestic financing of the general government will be adjusted downward by the amount of external financing disbursed to the budget in excess of the programmed amounts (comprising nonproject-related loans and grants, including "special programs") at the end of each quarter (Table 1), converted into birr at the average exchange rate of the quarter.

B. Shortfall in External Financial Assistance (Against Programmed Amount)

15. In case of a shortfall in external financing below the programmed amounts, (comprising nonproject-related loans and grants, including "special programs") shown in Table 1:

• The floor on the national bank's NFA will be adjusted downward by a maximum of 50 percent of the amount of the shortfall below the programmed amount, but by no more than US$20 million. The adjustment will be converted at the average exchange rate of the quarter.

• The ceiling on the national bank's NDA will be adjusted upward by a maximum of 50 percent of the amount of the shortfall, but by no more than US$20 million. The adjustment will be converted into birr at the average exchange rate of the quarter.

• The ceiling on general government net domestic financing will be adjusted upward by a maximum of 50 percent of the amount of shortfall in external financial assistance disbursed to the budget, but by no more than US$20 million. The adjustment will be converted into birr at the average exchange rate of the quarter.

IV. Other Reporting Requirements for Program Monitoring

A. Macroeconomic Monitoring Committee

16. The macroeconomic monitoring committee, composed of senior officials from the Ministry of Finance, Ministry of Economic Development and Cooperation, the NBE, and other relevant agencies, shall be responsible for monitoring the performance of the program, recommending policy responses, informing the Fund regularly about the progress of the program, and transmitting the supporting materials necessary for the evaluation of performance criteria and benchmarks. The committee shall provide the Fund with a progress report on the program on a monthly basis within four weeks of the end of each month, using the latest available data.

B. Developments on Structural Performance Criteria and Benchmarks

17. The authorities will notify the African Department of the Fund of developments on structural performance criteria and benchmarks as soon as they occur. The authorities will provide the documentation, according to the dates in Table 2, elaborating on policy implementation.

C. Data Reporting

Production and prices

18. The following data shall be transmitted:

• The monthly disaggregated Addis Ababa consumer price index will be transmitted within four weeks of the end of each month.

• The national consumer price index and its urban and rural components will be transmitted within eight weeks of the end of each month.

• Any revisions to the national accounts data will be transmitted within three weeks of the date of the revision.

Public finance

19. Monthly data on public finance will require a consolidated budget report of the federal and regional governments comprising:

• the revenue data by each major item, including that collected by the Federal Inland Revenue Authority, the Customs Office, and the regional governments;

• details of the recurrent and capital expenditure of the federal and regional governments; and

• details of budget financing, domestic, and external data will be transmitted within six weeks of the end of each month and data of the regional governments within 12 weeks of the end of the month.

Monetary sector data

20. The following data will be transmitted on a weekly/biweekly basis within five working days of the end of each week:

• treasury bill auction details (rates, amounts, and holders); and

• interbank foreign exchange rates and transactions.

21. The balance sheet of the NBE and the consolidated balance sheets of the commercial banks will be transmitted on a monthly basis within six weeks of the end of each month. The stocks of government securities, detailed information on interbank money market transactions (terms, duration, and participating institutions), and interest rate developments will be transmitted on a monthly basis within two weeks of the end of each month.

External sector data

22. The following data will be transmitted as follows:

• The interbank market exchange rate, as the simple average of the daily-weighted average buying and selling rates, will be transmitted on a weekly basis within five business days of the end of the week.

• The results of foreign exchange auctions (on a weekly or more frequent basis) will be transmitted on a weekly basis within five business days of the end of each week.

• Exports, imports, and other balance of payments data on services, private transfers, and capital account transactions will be transmitted on a quarterly basis within six weeks of the end of each quarter.

• The Ethiopian authorities will provide Fund staff regularly with detailed monthly data on the volume and prices of imported petroleum products.

Executive Board Decision No. 6230-(79/140) (Guidelines on Performance Criteria with Respect to Foreign Debt) adopted August 3, 1979, as amended by Executive Board Decision No. 11096-(95/100) adopted October 25, 1995, and as amended on August 24, 2000

Point No. 9

(a) For the purpose of this guideline, the term "debt" will be understood to mean a current, i.e., not contingent, liability, created under a contractual arrangement through the provision of value in the form of assets (including currency) or services, and which requires the obligor to make one or more payments in the form of assets (including currency) or services, at some future point(s) in time; these payments will discharge the principal and/or interest liabilities incurred under the contract. Debts can take a number of forms, the primary ones being as follows:

(i) loans, i.e., advances of money to the obligor by the lender made on the basis of an undertaking that the obligor will repay the funds in the future (including deposits, bonds, debentures, commercial loans and buyers' credits) and temporary exchanges of assets that are equivalent to fully collateralized loans under which the obligor is required to repay the funds, and usually pay interest, by repurchasing the collateral from the buyer in the future (such as repurchase agreements and official swap arrangements);

(ii) suppliers' credits, i.e., contracts where the supplier permits the obligor to defer payments until some time after the date on which the goods are delivered or services are provided; and

(iii) leases, i.e., arrangements under which property is provided which the lessee has the right to use for one or more specified period(s) of time that are usually shorter than the total expected service life of the property, while the lessor retains the title to the property. For the purpose of the guideline, the debt is the present value (at the inception of the lease) of all lease payments expected to be made during the period of the agreement excluding those payments that cover the operation, repair or maintenance of the property.

(b) Under the definition of debt set out in point 9 (a) above, arrears, penalties, and judicially awarded damages arising from the failure to make payment under a contractual obligation that constitutes debt are debt. However, arrears arising from the failure to make payment at the time of delivery of assets or services are not debt.