1. In mid-1996, the government of Ethiopia adopted a medium-term adjustment program for the period 1996/97-1998/99,¹ which was supported by a three-year arrangement under the Fund's Enhanced Structural Adjustment Facility (ESAF), by the World Bank in the form of new sector investment loans, and by other multilateral and bilateral donors. However, the midterm review under the first annual ESAF arrangement could not be completed, and the arrangement was allowed to expire in October 1997. Ethiopia intends to deepen the reform process while strengthening macroeconomic performance (Table 1). The government has adopted a new medium-term adjustment program for the period 1998/99-2000/01 and, in this context, is requesting financial assistance from the Fund under the ESAF, from the World Bank, and from other multilateral and bilateral donors.

2. Performance of the economy in 1996/97 was in most instances better than envisaged in the initial ESAF program. Output grew by 5.6 percent, marginally below the expected rate of 6 percent, while inflation decelerated to a negative 6.4 percent (Table 2). Broad money increased by 3.4 percent against a targeted rate of 9.1 percent. The fiscal deficit including grants (1.3 percent of GDP) was smaller than targeted, owing to an unexpected rise in revenue that helped offset largely an unforeseen decline in foreign grants. The external current account deficit (excluding official transfers), estimated at just over 7 percent of GDP, was smaller than projected. Transfers were smaller than originally anticipated, but exports were higher owing to higher coffee volumes and prices.

3. Important liberalization and structural reform measures were undertaken in 1996/97. In the external area, these included opening foreign exchange bureaus within the banking system; increasing the frequency of the foreign exchange auction from biweekly to weekly; reducing the export proceeds surrender requirement; and allowing exporters and recipients of private remittances to open foreign currency deposit accounts. Other structural reforms implemented during the year included the establishment of a review process for adjusting domestic petroleum prices; the elimination of controls on retail prices of fertilizers; and a lowering of the maximum import tariff rate and a reduction in the number of tariff bands. Also, a national consumer price index was introduced, and the reporting lag in balance of payments data was reduced.

4. In 1997/98, the economy suffered from the adverse effects of El Niño on agriculture and transportation. GDP growth slowed to an estimated 0.5 percent. However, as the effect of crop shortfalls on food prices was mitigated by buffer stocks and extraordinary food imports, while nonfood inflation was subdued owing to prudent monetary policy, inflation was kept well within the initial program target of 3 percent. After the substantial deceleration of the previous year, broad money growth reached about 12 percent (somewhat higher than the targeted rate of 9 percent), led by a rapid expansion in credit to the private sector. The inflow of official foreign grants again fell below the initial estimate, while fiscal revenue was below expectations. However, the fiscal deficit in 1997/98 was smaller than expected, owing to an underexecution of investment outlays. The overall general government deficit (excluding grants) is estimated at 6.4 percent of GDP, compared with 7 percent in the budget and 4.9 percent in the previous fiscal year. The external current account deficit (excluding official transfers) widened somewhat to 7.6 percent of GDP-but at less than initially expected. Official transfers were smaller, while net capital inflows were larger. As a result of special expenditures toward the end of the fiscal year, gross official foreign reserves declined from the equivalent of 4.2 to 2.9 months of imports of goods and nonfactor services during 1997/98.

5. Despite the expiration of the first annual ESAF arrangement, the government continued to deepen the structural reform process. Interest rate liberalization, which was initially intended to await the emergence of a treasury bill rate that could be used as a reference rate, was accelerated by lifting the control over bank lending rates in January 1998 and setting the minimum deposit rate at a positive level in real terms. These measures, and the termination of government bank borrowing, paved the way for deregulating the treasury bill market. Moreover, banks were allowed to trade surplus funds in the interbank market. However, foreign exchange market liberalization, which would have entailed a phased relaxation of the foreign exchange surrender requirement and elimination of exchange controls on payments for services transactions (such as foreign travel and education abroad), stalled in light of the uncertainties surrounding the balance of payments support for the country. Weighted-average import tariffs (weighted by the number of items in each band) were reduced as scheduled from 24.5 percent to 21.5 percent. Finally, the investment code was liberalized, particularly to allow foreign investments in the telecommunications and power sectors.

6. The overriding objective of the government is to attain relatively fast, broad-based, and more equitable economic growth with macroeconomic stability. A rapid increase in agricultural output-sparked by productivity gains and rural development programs to upgrade infrastructure and social services-is expected to be the cornerstone of economic growth and poverty alleviation. At the same time, agricultural development will provide the springboard for higher export earnings of farm commodities and agro-industrial goods. An additional and equally important objective is to attain relative stability of prices to help protect the poor from the ills of inflation and encourage saving and long-term investment.

7. Closely related to the twin objectives of growth and price stability is the aim of the progressive integration of Ethiopia into the global economy. The focus of this integration effort is on the further liberalization of foreign trade in goods and services, which calls for a further reduction in import tariffs and removal of all restrictions on external current account transactions. Clearly, a strengthening of international competitiveness is essential for attaining a high growth rate of exports and moderating the growth in imports of goods and services, which are, in turn, key factors for both sustained economic growth and macroeconomic stability.

8. The objectives of growth, relative price stability, and global integration of the real economy provide a guiding framework for the formulation of a medium-term economic program for the period 1998/99-2000/01. The major macroeconomic objectives (on an average annual basis) under this program are a growth rate of real GDP of 7¾ percent; an inflation rate of about 4 percent; an external current account deficit (excluding official transfers) of 8-8½ percent of GDP, taking into account the weak prospects for international coffee prices and the large import requirements associated with the envisaged increase in domestic investment in priority sectors; and a rebuilding of international reserves to a more comfortable level. As noted earlier, economic growth would come from the expansion of agriculture, beginning with a recovery of output in 1998/99, but there would also be some acceleration of growth in the industrial sector (following the commencement of production of new factories and further increase in capacity utilization from firms established in recent years) and in services. Inflation is expected to be held in check through appropriate macroeconomic policies; also normal rainfall conditions would yield an appreciable expansion of crop output and keep food prices relatively stable. The exchange rate would remain market determined.

9. Gross domestic investment would reach an annual average of 21.7 percent of GDP in 1998/99-2000/01, following a significant increase in public investment. Total private investment, both domestic and foreign, also is likely to rise somewhat above the average of 11.1 percent of GDP in 1995/96-1997/98 to 11.8 percent in 1998/99-2000/01. This expansion would be promoted by a favorable climate and the acceleration of privatization. Government investment as a share of GDP would increase by about 2 percentage points above the average level of 1995/96-1997/98 to an annual average of about 9.9 percent over the period 1998/99-2000/01, mainly as a result of the expansion of sector investment programs. During the same period, the financing of the investment effort would rely on an increase in private saving, to an annual average of 3.2 percent of GDP from 0.5 percent in 1995/96-1997/98, and on the mobilization of foreign resources; government saving would average 6.4 percent of GDP per annum, about the same as the average of the past three years.

10. Consistent with the objectives and targets above, the macroeconomic policy package for the medium term focuses on continued pursuit of prudent fiscal and monetary policies, with virtually no net domestic borrowing by the public sector; a further reduction in import tariffs; full deregulation of external current account transactions; and development of a modern and sound financial system. Simultaneously, structural reforms will focus on export promotion and private sector development, particularly by streamlining and improving the legal, regulatory, and institutional framework; building capacity in the public and private sectors; liberalizing the investment code; and accelerating privatization. Moreover, the government will implement development programs in the key areas of agriculture, infrastructure, education, health, and population, and create an environment conducive to export diversification.

11. Improving Ethiopia's growth prospects will rely heavily on providing the proper incentives to smallholder farmers, domestic entrepreneurs, and direct foreign investors. First, agriculture-led growth is to be driven by productivity improvements in smallholder agriculture. Progress will depend critically upon the diffusion of technology, export promotion policies, and the availability of affordable credit as a result of the active promotion of rural banks.

12. Second, private sector-led growth rests on domestic entrepreneurship. Despite nearly two decades-until 1991-of a centrally planned command economy, recent times have witnessed a sharp acceleration in private sector development and a reduction in rent-seeking activity. The private sector will be supported by efficient and transparent modes of service delivery, including in the customs and inland tax administration, the judicial system, the public utilities, and the financial sector. In this connection, steps will need to be taken to develop markets for credit to small enterprises (even those unable to provide adequate collateral), loans for long-term investments, and urban land lease markets.

13. Third, foreign direct investment will play an increasingly critical role in Ethiopia's development, both in terms of financial resources and technological and managerial know-how. The strategy is to create a favorable and credible environment for investment while opening up foreign investment to all sectors except for those few to which participation would be explicitly prohibited in the immediate future. In that regard, the government has already permitted foreign entry in hitherto restricted areas, such as telecommunications and power generation. Ethiopia has achieved political stability, rapid economic growth, low inflation, relatively stable and market-determined conditions in the exchange market, and fiscal discipline, but there is room for making these achievements known better so as to help attract foreign investors.

14. Another arm of the economic development strategy concerns the maintenance of a stable macroeconomic environment, along with the implementation of further policy reforms in the financial sector and the foreign trade regime. Of key concern is the need to create the conditions for interest rate liberalization through the development of appropriate short-term money markets and longer-term securities markets, and to ensure neutrality of tariff reduction on government revenue. To develop an indirect monetary instrument, the emergence of a debt securities market will be encouraged (focusing on long-term bonds), and steps will be taken to foster the development of short-term money markets (see paragraph 22). By relying on corporations such as Ethiopian Air Lines, Ethiopian Electric Power Corporation, and the Development Bank of Ethiopia to issue bonds, yields would be realistically fixed, taking into account the rate of return of investments. This would provide an appropriate setting for effective market determination of interest rates in the long-term end of the yield curve. Revenue neutrality of further cuts in import tariffs becomes important because tariffs will have been lowered by December 1998 to an average of 19.5 percent, without enactment of any compensating tax revenue measures over several years. Subsequent gains from broadening the tax base will need to go toward fiscal strengthening rather than financing of tariff reform; this is all the more important in view of the need to make government finances less dependent on counterpart funds.

15. Lastly, the government's strategy will focus on promotion and diversification of exports, given the need to reduce the reliance on coffee receipts and sustain over the long term the rapid rate of export growth of recent years. Although the coffee sector will continue to be exposed to high price volatility and sluggish growth in world demand, it will probably remain the country's most valuable export for quite a while. Resilience to price fluctuations and competitiveness in the world market should be strengthened through further improvement that may be needed in the domestic coffee market structure and in the infrastructure for coffee exports, as well a through an increased share of washed coffee and further liberalization in the foreign exchange system. Meanwhile, export diversification will be sought in the areas of horticultural products, meat, semiprocessed and finished leather articles, and in the introduction of new items, such as textile garments.

Fiscal policy

16. The fiscal deficit is expected to rise somewhat over the program period before beginning to decline, owing to increased public investment under the sectoral investment programs (SIPs) developed with the assistance of the World Bank. The SIPs (see para- graph 18 below) are five- to ten-year programs in priority sectors that are mostly externally funded under the leadership of the World Bank. The government remains committed to avoiding domestic bank borrowing for the financing of budgetary deficits in order to minimize inflationary pressures. Thus, the bulk of financing will emerge from external concessional sources. The government will also utilize the primary domestic budget surplus (i.e., excluding interest payments and foreign-financed outlays) as a measure of fiscal adjustment under its own resources; this surplus is expected to improve from 0.1 percent of GDP in 1997/98 to 2.8 percent in 2000/01. Given Ethiopia's low per capita income and the need for infrastructure and social welfare improvement, the temporary rise in the public sector deficits mentioned above is deemed warranted, especially as it can be financed at highly concessional rates.

17. Revenue policies will aim at further broadening the tax base and gradually bolstering government savings as a share of GDP. New tax measures will be implemented over the next three years by an average of about 0.5 percent of GDP per annum to offset the envisaged decline in nontax revenue and any potential revenue losses from lower customs duties, as well as to provide resources for raising priority outlays. To achieve these goals in 1998/99, the government will review a number of options for raising revenue proposed by a technical assistance mission from the Fund's Fiscal Affairs Department in July 1998, with a view to fully compensating for expected revenue losses from the planned tariff reform in December 1998. New tax measures are expected to include (i) a unification of sales tax schedules for goods and services, with the application of the maximum rate of 12 percent to all goods and services (except food items, financial service, and construction contracts); (ii) an increase in excise taxes sufficient to offset fully the decrease in import duties from tariff reduction on excisable goods; and (iii) application of a simplified and uniform rate structure to all forms of income. The government will also continue to reform agricultural income and land taxation, broaden the use of presumptive taxation methods, and implement the new financial services tax. Tax administration will be strengthened by assigning and computerizing taxpayer identification numbers; expanding the tax fraud unit and assigning penalties and interest charges to late payments; completing the reform of the Customs Office and the Federal Inland Revenue Authority, including delegating enhanced authority to enforce and monitor existing regulations; and stepping up efforts to improve regional collection capacity. The government will undertake preparatory work before the end of 1998/99 for the introduction of a value-added tax (VAT) by the end of the program period. The composition of revenue is expected to change slightly (as nontax income declines and tax revenue rises), while tax collections would shift away from customs duties toward indirect taxes. Tax revenue would increase from an estimated 12.8 percent of GDP in 1996/97-1997/98 to 14.5 percent in 2000/01, while nontax revenue (including privatization receipts in the budget) would decline from 6 percent of GDP to 5 percent over the same period. The level of foreign grants, which averaged an estimated 3.3 percent of GDP during 1996/97-1997/98, will depend on the pace of SIP implementation. After an initial rise to 6.4 percent of GDP in 1998/99, government saving is expected to remain flat in spite of new revenue measures.

18. Public sector capital outlays are expected to increase faster than GDP, owing to the needs in the priority sectors of roads, education, and health, that are addressed under the SIPs. (Higher investment in the power and telecommunications sectors will also be undertaken by the state-owned enterprises, but it will be treated as private sector investment since these public utilities are financially autonomous and are run on a commercial basis.) The redirection of public sector capital spending toward urgently needed infrastructure will be strengthened and prioritized through the three-year rolling public investment program established in 1996/97. Public outlays are expected to rise by some 2 percentage points of GDP above the 1996/97 level over the program period, and they will be reviewed on the occasion of midterm reviews and the beginning of each annual ESAF-supported program, to take account of expected disbursements of foreign grants and concessional loans and the results of World Bank Public Expenditure Reviews (PERs). Any revisions would be consistent with three principles: first, recourse to additional foreign financing should be on concessional terms to ensure that the external debt burden remains manageable; second, higher capital spending should not lead to inflationary domestic bank financing; and third, the projected growth in revenue will need to be adequate to meet the increasing recurrent expenditure generated by any higher capital outlays. Additional financing from receipts from the sale of state-owned enterprises will be used to build and maintain the country's capital stock, consistent with the PERs.

19. Current expenditure is expected to increase slower than nominal GDP, depending, however, on the pace of implementation of the SIPs and the success of the civil service reform program. This would create space for the capital budget while providing for a redirection of the recurrent budget to priority areas, such as adequate infrastructure maintenance and improved health, education, and agricultural extension services. (This process will be facilitated in the transport sector by a separate road fund, not shown in the budget, which will be self-financing and responsible for road maintenance.) In addition, the ongoing reform of the civil service at both the federal and regional levels should ensure that the maintenance of adequate remunerations will be partly offset by a restructuring of personnel, so as to maintain wage and salary outlays under 6 percent of GDP. Defense expenditure would fall back to the range of 2-3 percent of GDP, following a sharp rise in 1997/98 owing to the border dispute with Eritrea. To strengthen financial management, all accounts maintained by line ministries and other spending agencies will be consolidated in a single treasury account.

20. The government will begin consolidating the financial statements of the major public enterprises to facilitate the conduct and monitoring of fiscal policy. Moreover, the government may also need to make in the next several years equity contributions to certain state-owned firms, including the Commercial Bank of Ethiopia, to put them on a sound financial footing. Such contributions, however, would be covered by noninflationary domestic resources or concessional foreign borrowing.

21. The control of the regions' fiscal operations will be enhanced by timely and systematic reporting of revenue and expenditure data from the regions to the federal government, and by the establishment of a centralized accounting system that consolidates all regions and includes the extent and use of donor funding. Criteria will be developed to determine appropriate revenue shares for the central and regional governments, improve the formula used to determine grants from the central government to the regions, and ensure that the allocation of expenditure at the regional levels is consistent with the government's development aims. Any borrowing by the regions will continue to be monitored closely to safeguard overall macroeconomic stability.

Monetary and exchange rate policies

22. Monetary and exchange rate policies during 1998/99-2000/01 will be geared toward achieving the inflation and external sector targets envisaged under the program. Exchange rate policy will be consistent with the envisaged liberalization of the external current account and the need to foster export diversification and rebuild net foreign assets to a more comfortable level. The differential between the parallel and the official, auction-determined exchange rates has been practically eliminated, as the exchange rates in the two markets have converged since January 1998. With only a small segmentation of the exchange market, the exchange rate is largely market based. The government's policy will be to allow the exchange rate to be determined by market forces, while the planned reforms in the exchange system are meant to eliminate the remaining restrictions on the making of payments for current international transactions and to establish an interbank market for foreign exchange (see below).

23. At the same time, in the wake of the financial sector reforms described in paragraphs 24-30, the monetary program will be premised on an increase in the demand for broad money that is consistent with the envisaged financial deepening. In addition, and to improve the efficiency of the financial system, the use of indirect monetary policy instruments, such as open market operations with public securities, will be stepped up, while less reliance will be placed on reserve requirements.

Financial sector reforms

24. The government has already taken a major step toward the liberalization of interest rates. In January 1998, it lifted the control over the lending rates of commercial banks and kept only a minimum floor on their deposit rate set by the National Bank of Ethiopia (NBE), while ensuring that it was made positive in real terms. Henceforth, the NBE will be maintaining the minimum deposit rate for banks at a positive level in real terms. From a regime in which both deposit and lending rates were fixed, liberalization commenced with the deregulation of the lending rate, which, in a way, is the more difficult side. As the excess liquidity in the banking system tapers off gradually, it will be possible and appropriate to remove the remaining control on the interest rate regime. This process will be expedited by the establishment of an interbank money market in the near future (see paragraph 26) as well as a securities market subsequently, which would help redirect the asset holdings of public entities' funds from bank deposits. The development of a securities market will therefore facilitate market determination of interest rates at real positive levels, contributing to resource mobilization and macroeconomic equilibrium. As noted earlier, the focus will be on bond issuance by nonbudgetary public entities, and, since the government will seek to minimize domestic borrowing, the market for treasury bills will complement the bond market. To facilitate this development, the government will securitize as necessary part of its overdraft position with the NBE.

25. The modalities of the treasury bill auctions will be modified so as to make them more competitive and allow wider participation. The interest rate on the treasury bills will be allowed to be market determined. In addition, the minimum denomination of the bills will be reduced to Br 5,000 to facilitate a broader participation in the auctions by the private sector. The NBE's open market operations will not be offset by central bank rediscounting and lending, and the NBE will be fully supported by the holding of all government deposits. Furthermore, public enterprises will freely hold their deposits in commercial banks of their choice, and all banks holding savings and time deposits of public enterprises will remunerate them at competitive, market-determined interest rates.

26. Recognizing that a substantial portion of the excess liquidity of the banking system is held by the state-owned Commercial Bank of Ethiopia (CBE), a number of steps have been already taken to foster the development of an interbank market in local currency: (i) the CBE has agreed to provide overnight lending to other banks to enable them to cover shortfalls in their reserve position with the NBE, and it is studying the feasibility of providing term loans to private banks; (ii) commercial banks have agreed to provide syndicated loans, and they are seeking to establish a pooled rating system to assess the creditworthiness of clients; and (iii) commercial banks are forming a bankers' association and have already drafted its by-laws. During the program period, the authorities will adopt additional measures to make the interbank market more functional. A vibrant money market will facilitate greater reliance on indirect instruments of monetary policy (such as open market operations with government paper) and-to a lesser extent-on reserve requirements to influence banking system liquidity and interest rates.

27. The NBE recently completed an update of its June 1997 examination report on the financial situation of the CBE, which accounts for some 90 percent of bank deposits. Based on the findings of the original report and its update, several steps will be taken to strengthen the CBE's financial situation. First, loan collection efforts will be intensified so that the CBE's net outstanding stock of nonperforming loans, which was reduced from 35.8 percent of total loans at end-November 1996 to an estimated 24 percent at end-February 1998, will be reduced further to 15.4 percent by end-June 1999. Second, the CBE will be required to provide adequate provisions for all nonperforming loans, and to write off all assets deemed worthless, unless such loans or assets have been collected in full in cash or brought current with respect to contractual repayment of principal and interest. Third, the CBE will be required to comply strictly with all prudential banking regulations, including the NBE's directive on the single borrower loan limit, and it will be required to bring all loan balances exceeding this prudential limit into compliance by September 1998 and to reassess all overdrafts since September 1997 and take appropriate actions. In addition, the CBE will develop, in consultation with the NBE's Banking Supervision Department, a comprehensive policy and procedure manual on the renewal/conversion into term-loans of expired overdrafts. Fourth, the CBE's capital and reserves will be strengthened to ensure that they are equivalent to not less than 9 percent of total risk-weighted assets, and not less than 7 percent of total assets.

28. Other structural reforms of the financial sector will focus on improving the environment within which banks operate. A foreclosure law has already been enacted; mechanisms for sharing information on borrowers and arrangements for undertaking credit rating of clients (such as the setting up of an information bureau on borrowers among the banks) will be developed; and steps will be taken to upgrade the training program for bankers and encourage banks to introduce modern banking organization, technology, and practices. These measures will enhance the efficiency of financial intermediation and assist in tackling the problem of nonperforming loans. In the case of the CBE, an external financial and managerial audit will be carried out by an independent, internationally reputed firm, with a view to providing recommendations for improving the operations of the bank. This audit will be launched shortly by issuing invitations to bid, and a firm will be selected to conduct the audit by December 1998. Taking the audit's recommendations into account, it is envisaged that the CBE will enter into a management contract with a reputed international institution to help increase its efficiency. At the same time, to boost the competitiveness of the banking system, additional banks will be allowed to begin operations; the Construction and Business Bank (the second-largest commercial bank) will be privatized; and the capital requirement of banks will be raised from the present level of Br 10 million. To ensure the soundness of the new entrants without however, unduly discouraging new entry; the existing banks will be allowed time to adjust their capital levels.

29. At present, the financial sector is not adequately equipped to provide medium- and long-term loans, credit to small and microenterprises, or venture capital. To address these shortages, the Development Bank of Ethiopia will be strengthened both in terms of management and finance, while rural banks will be encouraged to expand. Regarding the creation of venture capital, it is envisaged that the International Finance Corporation (IFC) will provide support in establishing a suitable financial institution.

30. As an integral part of the expansion and development of the financial sector, the capacity of the NBE to supervise and regulate financial intermediaries will be improved. In particular, the legal and regulatory framework to govern all financial institutions will be updated; the NBE's Banking Supervision Department will be strengthened, as will prudential guidelines; and a standardized reporting system will be put in place for all commercial banks to permit the consolidation of their accounts in the monetary survey. With regard to strengthening the capacity for banking supervision, in particular, the staffing and training facilities of the NBE will be improved, and the framework for banking supervision and prudential regulation will be extended to cover all financial institutions. To this end, the NBE will draw on technical assistance provided by the Fund and bilateral donors. A satisfactory bank supervision system will be put in place over the next three years, after which the government will consider allowing foreign banks to enter the banking system.

Trade and exchange system reforms and debt management

31. Substantial liberalization of the exchange and trade system has already been undertaken, driven by the aim of integrating Ethiopia into the global markets for goods and services. In pursuit of this objective, import tariffs have been progressively reduced, and the payments and exchange regulations for foreign trade in goods and services have been increasingly liberalized. In the medium term, further progress will be made in tariff reduction, and the current account will be fully deregulated. Currently, the tariff structure consists of a maximum rate of 50 percent, seven tariff bands excluding the zero-duty rate, an average rate of 21.5 percent, and no discretionary duty exemptions. While there is room for further reduction, fiscal considerations need to be taken into account. During 1998/99, the maximum tariff will be reduced to 40 percent, the tariff bands excluding the zero-duty band to six, and the average rate to 19.5 percent. In the following two years the average rate will be lowered by 2 percentage points to 17.5 percent, and a further reduction to 15 percent will be studied. In this area, the government will benefit from the technical assistance recommendations provided by the Fund. To encourage exports, the duty drawback scheme will be operated on a deferred payments basis-allowing exporters to import inputs at world prices up front. Initially, the deferred payments system will apply to a few selected commodities, and it will be expanded subsequently along with the strengthening of the capacity of the Customs Office to operate such a system.

32. In the exchange system, the envisaged reforms are intended to eliminate the remaining restrictions on the making of payments for current international transactions relating to education, travel allowances, and remittances, and to establish an interbank market for foreign exchange. The external current account will be fully deregulated during 1998/99 in accordance with the timetable of measures set out in the attached policy matrix. Foreigners residing in Ethiopia will be allowed to buy foreign exchange for remittances, with only ex post verification. Thus, the exchange restriction arising from limitations imposed upon the transferability of balances maintained in the nonconvertible birr accounts of nonresidents will be eliminated. The envisaged deregulation of the external current account transactions will be communicated in a public announcement.

33. Another measure of exchange market liberalization consists of the elimination of the foreign exchange surrender requirement in August 1998. Exporters will be able to sell their foreign exchange receipts to any bank or foreign exchange bureau at freely negotiated rates over an extended conversion period of four weeks, and they will be able to retain the remaining 10 percent in a foreign currency deposit account indefinitely. In addition, they will be free to use the foreign exchange repatriated to the country for bona fide imports of goods and services within the conversion period. Although the existing conversion period of three weeks provides ample time for market participants to effect sales of foreign exchange, it will be extended by an additional week to give extra time to exporters. Inward private remittances will be allowed to be held in foreign currency deposits accounts, subject to retention and conversion requirements similar to those that apply to exporters. The exchange restriction arising from the unremunerated bid bond requirement imposed upon the purchase of foreign exchange in the auctions will be eliminated. Additionally, investors with large import requirements-over US$500,000 at a time-will continue to be allowed to buy foreign exchange directly from the weekly wholesale auction of the NBE. Finally, following the public announcement of the above exchange liberalization measures, the commercial banks will be responsible for ascertaining that their clients, when purchasing or selling foreign exchange, are in full compliance with the existing import and export licensing and foreign exchange regulations. Hence, the NBE will no longer check ex ante traders' compliance with trade and exchange regulations. It may, however, conduct ex post checks of transactions on a sample basis to forestall underinvoicing and overinvoicing.

34. An interbank market for foreign exchange will be established to replace in stepwise fashion the present auction system of retail trading of foreign exchange for imports. As a first step, at the end of each week, the excess holding of foreign exchange-determined in relation to the foreign exchange exposure of the banks and bureaus and their capital-will be resold to the NBE at the marginal exchange rate of the auction held at the beginning of that week. During the week, the exchange rate will be market determined in an interbank market, which will entail the buying and selling of foreign exchange freely between banks, foreign exchange bureaus, and clients, and between banks themselves. Thus, there will be a wholesale auction trade of foreign exchange at the beginning of each week, in which banks and foreign exchange bureaus buy foreign exchange from the NBE, and a settlement of the excess holding at the end of the week. Consideration will also be given to increasing the frequency of the auctions. Finally, with the progressive development of the interbank foreign exchange market, the NBE will be expected to become a participant in that market-buying and selling foreign exchange in the interbank market while taking due care to secure the target level of net official foreign assets. For purchases and sales of foreign exchange outside the auctions, the NBE's buying (selling) rate on any given day will be the average buying (selling) rate prevailing in the interbank market on the preceding business day. As the NBE shifts an increasing volume of its net foreign exchange sales from the auctions to the interbank market, the auction market would eventually be phased out.

35. With regard to foreign exchange bureaus, their scope of operation will be widened by allowing them to conduct all approved spot/cash (current account) transactions within the specified limits without prior authorization by the Exchange Control Department of the NBE. Moreover, consideration will be given to allowing bureaus to operate outside the banking system after the implementation of the present ESAF arrangements, as part of the measures to liberalize the capital account.

36. As a low-income, heavily indebted country, the government of Ethiopia will neither borrow nor guarantee debt on nonconcessional terms. Ethiopia will continue to seek debt relief from Paris Club creditors on concessional terms even after the end in October 1999 of the consolidation period under the 1997 Paris Club agreement. Concurrently, it will continue to seek debt relief on at least comparable terms from all other bilateral and commercial creditors. Under the present Naples terms flow rescheduling, entailing a 67 percent reduction in net present value (NPV) terms of debt service on eligible debt, the debt relief provided by these creditors would reduce the average debt-service ratio over the 1996/97-1998/99 period from 46 percent of exports (before rescheduling) to below 15 percent (after rescheduling). While this reduction is significant, the remaining nonreschedulable debt service will remain relatively large. For the future, the government plans to continue to pursue a prudent debt-management policy, borrowing only on concessional terms. The government will aim at eliminating all outstanding external payments arrears through debt relief from Paris Club and other bilateral creditors, and it will not incur new arrears on debt that is not expected to be subject to rescheduling. Furthermore, the government will strengthen its capacities for management and monitoring of foreign aid and external debt to ensure, among other things, the timely disbursement of external aid.

37. Ethiopia has achieved economic stability and progressed successfully toward a market-based economy. Commodity prices are virtually all decontrolled; macroeconomic prices, such as the exchange rate, will be fully decontrolled in 1998/99, along with the liberalization of external current account transactions in goods and services; and steps have been taken toward deregulating the interest rate. The challenge is to deepen these gains, actual and foreseen, by enabling the supply responses of economic agents to be realized satisfactorily. In particular, the central objective of rapid, broad-based and sustainable growth with concomitant poverty reduction requires both the maintenance of macroeconomic stability as well as implementation of a set of structural measures for consolidating or further strengthening reforms pertaining to (i) agricultural and rural development; (ii) the nexus of exports and private and financial sector development; (iii) poverty alleviation and social sectors; (iv) infrastructure and the environment; and (v) capacity building, including reform of the civil service.

38. Many of the policies already described have an important bearing on these areas. Additional measures with a more "sectoral" flavor are outlined below. First, however, it is worth emphasizing a central tenet of economic strategy in Ethiopia, namely, widespread sharing of growth is to be achieved through an emphasis on agricultural and rural development in the context of the existing egalitarian distribution of land.

39. This emphasis on rural development and poverty reduction runs through not only the provision of education, health and other social services, but also that of infrastructure, notably roads. Because Ethiopia's road density is the lowest in Africa, the difficulty of access to markets and social and infrastructural facilities is a major contributor to the severity of poverty and the isolation and vulnerability of the poor, as manifested most tragically in the famines of the 1970s and the 1980s. The commitment to improve the living standards of the rural population as the primary focus of development strategy is reflected in calling the strategy Agricultural-Development-Led Industrialization (ADLI). As such, this is also an industrialization strategy, the impetus for which is provided by agricultural growth, notably by an expansion in demand for industrial goods. The growth of agriculture, in turn, will be facilitated by tapping the demand for its products in overseas markets. Similarly, considerations of economies of scale and employment dictate that industry must also look for sources of external demand. ADLI then can be said to visualize an integration of the domestic economy with the global economy, leading to rapid export growth, both for agriculture and industry.

Export development

40. Exports have been receiving much attention in policy formulation and thinking. An array of additional measures are under consideration for the further encouragement of exports. One important set pertains to improving the access of exporters to finance, land, and free trade status.

41. As regards finance, the measures comprise (i) removing restrictions on foreign suppliers'/partners' credit and on importing inputs without payment from foreign collaborators, as well as on other implicit forms of credit not involving formal loan agreements; (ii) allowing all exporters of manufactures (including of agro-processed products) to obtain foreign commercial borrowing; (iii) easing the constraints on debt-equity ratios for exporters by allowing the NBE to authorize exporters to exceed the limit of 60/40 that currently obtains; and (iv) allowing banks to open usance import letters of credit for exporters with confirmed letters.

42. With respect to land, the authorities, recognizing the difficulties of acquiring land quickly in Addis Ababa and that the full implementation of the lease system will take some time, are to ease the constraints faced by exporters on an urgent basis by making at least ten sites with electric power available to exporters for immediate occupancy, along with underutilized land on the Nefas silk estate.

43. Regarding the strengthening of free trade status for exporters, the measures include eliminating price and quality preferences for domestic input suppliers and further improving the duty drawback and exemption schemes, with the aim, inter alia, of having a transparent, automatic, and computerized administrative mechanism with pretabulated input-output coefficients.

44. Other actions to promote exports that are under implementation or are to be implemented during the course of 1998/99 are as follows: (i) elimination of price verification for all nonagricultural exports and those agricultural exports for which verifiable international prices are not readily available; (ii) for other agricultural exports, except coffee, the replacement of ex ante price verification with ex post audit, and, for coffee, the replacement of the verification of a single point price with the verification of a range of prices for each variety; (iii) the further strengthening of the important initiative of the recently established Export Promotion Council (chaired by the Prime Minister) for private sector consultations by the more frequent scheduling of meetings; (iv) the simplification of procedures for nonequity collaboration with foreign firms, including extending all services provided to equity investors by the Ethiopian Investment Agency (EIA) to other partners; (v) the provision of any certification required from the Bureau of Standards within three days, failing which it will be deemed to have been automatically provided; and (vi) the clearing of customs for exports in no more than three days.

45. In addition to the above-mentioned array of measures to be implemented during 1998/99, the government is examining a range of other actions, with technical assistance from the World Bank. The aim is to formulate a package of additional export promotion reforms during the current fiscal year. The measures under consideration require further examination of details, costs, design, and feasibility, especially to minimize demands on scarce administrative capacity. They include the following: (i) a set of measures pertaining to finance (i.e., collateral agreements, domestic usance finance, an import finance revolving fund, export finance guarantees, and investment finance and leasing); (ii) other actions to fortify free trade status for exporters, such as a scheme for bonded manufacturing warehouses; and (iii) a set of sundry measures proposed in a World Bank study to further facilitate entry into exporting activities, coffee and mining exports, and air freight.

Private sector development and foreign investment

46. The reforms on exports outlined above have an obvious and important bearing on private sector development more generally, including foreign investment. The government also envisages several other measures to promote private sector development with a less immediate and direct export dimension.

47. One highly significant set of measures aims to both encourage foreign investment and a greater role for the private sector in the provision of infrastructure. These measures comprise the implementation of the recent decisions to allow foreign participation in the telecommunications and power sectors.

48. A further revision of the investment code is envisaged. This will remove for foreign investors in the engineering, metallurgical, pharmaceutical, chemical, and fertilizer industries the requirements for a minimum size of investment in joint ventures and for an upper limit in sole ventures.

49. Notwithstanding the considerable efforts that have been made in recent years to ease regulatory constraints, they remain an important area for future reform. The next step in this process is the demanding one of undertaking a comprehensive study, with technical assistance, to identify systematically the regulatory constraints and the measures needed to address them, in particular by classifying the remaining regulations into the following categories: (i) those to be removed; (ii) those to be modified; and (iii) those to be retained.

50. The task of fostering more private sector development is likely to be greatly facilitated by establishing a broad-based forum for regular consultations between the private sector and the government, along the lines of the Export Promotion Council.

Privatization

51. While considerable progress has been made with the privatization of smaller enterprises, especially in trade and other service sectors, which account for the bulk of the 175 enterprises privatized to date, the more complex divestiture of larger industrial firms and state farms has lagged behind. To accelerate the pace of privatization, the government sought the assistance of the World Bank, particularly in financing a study by Price Waterhouse to identify ways of doing so. The large, multivolume study has just been completed.

52. Among other things, the study suggests different modalities of privatization for each of the 114 enterprises to be divested. These proposals, along with ways to strengthen the Privatization Agency, are to be examined with technical assistance from Germany, which is expected to commence in November 1998. During 1998/99, the government aims to develop a Privatization Action Plan to accelerate the speed of privatization.

53. The aim is to complete the process of privatization over the 1998/99-2000/01 period. Whether that will be achieved will depend, of course, on the response of the private sector, but also on the capacity of the Privatization Agency, the timing and extent of external technical assistance, and the passage by parliament of a set of amendments to privatization-related laws. The government expects to be able to formulate these amendments by December 1998.

54. In light of the constraints noted above, it would not be prudent to set a firm target date for completing the privatization of all 114 enterprises. The government is committed to doing so at the earliest feasible date, subject to these constraints, as well as to the objective of establishing a transparent, corruption-free process that obtains reasonable prices for public assets. Notwithstanding the uncertainties with regard to the pace of the program and pending the completion of the action plan, at this stage it is considered feasible to set a firm target of bringing at least 80 enterprises to the point of sale by June 2001. The action plan would examine how this target could be made more ambitious. In any event, by December 1998, ten state farms and two large enterprises (a brewery and a cement plant) are to be brought to the point of sale.

Capacity building and reform of the civil service

55. "Regionalization" refers to the devolution of powers from the federal government to the regional governments. A primary goal of the regionalization program is promoting inter-regional equity and reversing the neglect of rural areas relative to urban areas. The implementation of a wide range of developmental programs and projects is now left to the regions. Their capacity to deliver effective and efficient development interventions varies widely, as does their capacity for revenue collection. Problems of staffing and communication across regions remain. The government's strategy for addressing these issues centers around the Civil Service Reform (CSR), supported by a number of donors.

56. The CSR covers a much broader agenda than traditional civil service reform programs. It covers judicial, legal, and financial management reform designed to improve the functioning of the public sector and to deal with the ongoing decentralization program by creating the framework and strengthening the institutions needed to exercise the powers and responsibilities of the regional administrations.

57. There are five major components of the CSR: (i) the economic management and control component includes the reform of procurement, auditing, and internal controls and the provision of training for relevant staff, including those from the regions; (ii) the human resource management component seeks to reform performance appraisals and job classifications, and improve the incentive system; (iii) the service delivery component is designed to improve the quality of services provided by public sector employees, including the establishment of a complaint-handling mechanism; (iv) the top management systems component aims to improve the selection and performance of senior government officials; and (v) the ethics and judicial reform components are designed to overhaul the legislative framework to reflect the 1994 constitution and strengthen the judiciary.

58. Given the scope of the CSR, it is unlikely that all its goals will be achieved by the announced completion date of June 2000; however, important progress has been made in the first three components listed above, and continued progress is essential to the decentralization program. The CSR will be important in improving the environment for the strengthening of social capital by increasing the efficiency, transparency, and accountability of public administration.

Rural development

59. As noted above, agricultural and rural development is the highest priority of the government. In the reforms undertaken by the present regime since its inception in 1991, improvement of the living standards of the rural population has been an abiding concern. In this endeavor, the liberalization of agricultural prices and marketing, and the hefty depreciation of the exchange rate-coupled with measures to strengthen rural institutions (notably the provision of extension services, seeds, fertilizers, and credit, the improved functioning of markets, and enhanced security of land tenure)-have had a major impact.

60. The next phase of rural reform is less amenable to quick actions and results. It comprises the interrelated nexus of the further strengthening of rural institutions (especially for provision of credit) and measures to increase yields per hectare (particularly through increased fertilizer use), reduce the vulnerability to weather-related risks (which is exceptionally high in Ethiopia), and improve the provision of infrastructure (especially roads) and social services.

61. In recent years, the increase in yields per hectare of the land already under cultivation has been offset by lower yields in new, less productive land brought under cultivation, so that the average yield has stagnated. Raising agricultural yields involves many factors, including improving extension and agricultural research (which is being assisted by a World Bank project), and increasing the effective demand for, and availability of, improved seeds and fertilizers, as well as irrigation. The quickest impact is likely to come from a greater application of fertilizers.

62. In this context, it should be borne in mind that the use of fertilizers in Ethiopia, at 7 kilograms of nutrients per hectare, is about half of the sub-Saharan Africa average of 13 kilograms; meanwhile the world average is 97 kilograms of nutrients per hectare. Moreover, there has recently been a sharp reduction in the farmers' benefit-cost ratio (the addition to net total revenue due to a unit increase in expenditures on fertilizers). Given the relatively high ratio that rational, risk-averting Ethiopian peasants are believed to require to invest in fertilizer-partly because of the high variability of yields- this matter deserves serious consideration. The less controversial part of the solution is to exploit the potential for reducing fertilizer costs through improved marketing and credit distribution. A more difficult task-pending the improvement in infrastructure-is to design and implement a scheme for risk sharing in fertilizer use. Whether and what type of a scheme that is administratively simple and affordable (without involving subsidies) can be devised is to be examined.

63. Another set of measures involves improving the incentives for peasants to invest in low-cost, labor-intensive land improvement. In addition, to facilitate access to land held by smallholders for commercial farming, adoption of the recent measure enacted in the Oromiya region to increase the allowable lease period to 15 years should be encouraged throughout the country. Furthermore, procedures for leasing agricultural land (such as those pertaining to duration and marketability of lease, and environmental protection) should be reformed.

64. The above-mentioned areas-along with measures to strengthen institutional capacity in the regions for assisting land improvement and rural investment-are to be examined. So are actions to promote rural nonfarm activities (such as the provision of finance and related services), and a pilot project, to be implemented by nongovernmental organizations (NGOs), to organize rural handicrafts for exports. The actual implementation of these measures is expected to commence mostly during the next fiscal year, 1999/2000.

65. Another set of measures whose implementation is to go into full swing in the current fiscal year pertains to the provision of roads, education, and health in the context of the SIPs, supported by several donors. The Road Sector Development Program (RSDP), whose implementation is just getting under way, aims to reduce the proportion of farms that are more than half a day's walk from the nearest all-weather road from the current 75 percent to 50 percent over five years, and to 25 percent over ten years. The targets for improved rural coverage of education and health services are discussed elsewhere.

Infrastructure

66. Development of the road network is a critical part of the government's strategy to integrate the rural population into the economy. Ethiopia's current road network of 23,812 kilometers translates into one of the lowest road densities in Africa, and, as mentioned in the preceding paragraph, 75 percent of farms are more than half a day's walk from the nearest all-weather road. The RSDP plans to expand the road network by 80 percent by 2007, at a cost of US$3.9 billion. A number of donors have pledged support, including the World Bank, which, in January 1998, approved a loan for US$309 million, the first of three loans planned.

67. Reforms undertaken in support of the RSDP include giving autonomy to the Ethiopian Roads Authority, implementing a road fund for sustainable road maintenance, increasing the involvement of the private sector, liberalizing transport charges, and privatizing parastatal freight transport enterprises and relief fleets.

68. The recent closing of the border with Eritrea means that the main port for Ethiopia has shifted from Assab to Djibouti, which has comparable capacity. Efforts are under way to improve the capacity of the Djibouti port, and several steps have been taken to ease restrictions on its use, including the ending of the parastatal monopoly on customs clearing and forwarding services, and the easing of restrictions on commercial road transport on the Djibouti corridor, and of customs, visa, and passport requirements for truck drivers.

69. Ethiopia has one of the lowest levels of energy consumption in the world-only 5 percent of the population has access to electricity. Private sector participation will clearly be needed if this is to change in the near future, and the government accordingly has recently decided to remove restrictions on private sector participation in electricity generation (see section on private sector development), and also to privatize the Calub Gas Company. Parallel reforms include the elimination of all subsidies to, and commercialization of, the public utility, and the enactment of a new regulatory framework.

70. The very limited access to telephone services should improve with the recent decision to seek a strategic private partner for the Ethiopian Telecommunications Corporation (ETC). This will be done in a way that seeks to ensure that the rural population is not left out as the telecommunications sector develops.

71. Four critical steps should follow. First, the new policy for the sector, which foresees private participation, should be formulated in a telecommunications policy statement; the statement would set out the objectives, the options it proposes to achieve those objectives, and exactly how it plans to allow private participation and to amend the legal framework to allow private sector participation. Second, labor issues, appropriate levels of capital expenditure in the run-up to privatization, the level of the ETC's debt, and the rebalancing of tariffs in preparation for private participation in ETC should be examined. Third, how sector policy and structure can be set up in such a way as to attract as much private participation in providing service in rural areas should be analyzed, as well as what form of public-private partnership will be needed for this purpose. Finally, appropriate advisors for the sale itself-usually high-quality international investment bankers and lawyers-should be recruited.

72. The water sector faces a critical deficiency of physical infrastructure. Only 27 percent of the population has access to potable water, and only 7 percent has access to sanitation facilities. Water supply and sanitation operations were decentralized to the regional governments in 1993, but the regional bureaus have a relatively low capacity for managing operations and regulating functions. In addition to the need to strengthen the regional bureaus (which is being undertaken with support from a World Bank project), the Ministry of Water Resources aims to develop the capacity to handle water resource policy, which would also enable Ethiopia to participate in the Nile Basin management initiatives more effectively.

Environment

73. The three most urgent areas of environmental concern are as follows: (i) the considerable land degradation, including loss of nutrients owing to removal of animal manure and crop residues for use as fuel and cattle feed; (ii) the low quality and availability of water, as a result of which only about one-fifth of the population has access to safe water; and (iii) the rapidly growing urban environmental problems, including lack of sanitary facilities, inadequate refuse collection, and low standards of housing.

74. The government has had a comprehensive National Conservation Strategy (NCS) in place since 1994. Grant funds are being used to fund implementation. An Environmental Protection Agency has been established, and basic environmental legislation has been prepared. Continued and strengthened implementation of the NCS will be important for the protection of Ethiopia's environment.

Poverty

75. Ethiopia's per capita GNP of US$110 is one-fourth the average for sub-Saharan Africa and just about the lowest in the world. Pervasive poverty is manifested, inter alia, in the highest incidence of malnutrition and the lowest primary school enrollment ratio in the world. Severe infrastructural shortcomings, notably the lowest road density in sub-Saharan Africa, contribute to the isolation and vulnerability of the poor, particularly in drought years.

76. The low level of average income severely limits the scope for transfers, subsidies, and social safety nets (although such limited safety nets as exist exhibit a low level of leakages, according to a United States Agency for International Development review). As noted above, the pervasiveness and severity of poverty makes redressing it an integral and central part of the overall development strategy.

77. There is evidence of a significant decline in poverty during the recent years of rapid economic growth and good harvests. The widespread sharing of the benefits of growth, particularly through the emphasis on agricultural and rural development in the context of an egalitarian distribution of land, has been stressed above.

78. Measures to reduce the high variability of incomes, as indicated in earlier sections, are likely to have a particularly beneficial effect on the poor, who lack a consumption-smoothing mechanism.

79. In addition to broad-based growth, the government has acted promptly and decisively to make food available from stocks, exceptional imports, and surpluses areas to food-deficit areas in bad agricultural years. It has thereby succeeded in avoiding the famines that have unfortunately occurred in recent decades. The government will continue to exhibit this vigilance to avert future threats of famines. At the same time, a systematic program to alleviate food insecurity is to be finalized during 1998/99. This strategy needs to take account not only of drought-related insecurity but also of the more regular seasonal insecurity.

80. In this regard, the authorities' road sector program is of special significance, not only because it will bring markets and imports within reach of families, particularly in isolated areas, but also because it will facilitate getting food into food-deficit areas in the lean season.

81. The other two sector investment programs, for education and health, also have a significant bearing on the alleviation of poverty. These are discussed below.

Social sectors

82. The very high priority given by the government to the social sectors is seen in the development of comprehensive sector development programs for health and education. Both programs are being supported by almost all the donors active in these areas in Ethiopia, reflecting the consensus reached on objectives, strategies, policies, and implementation arrangements.

83. The Health Sector Development Program (HSDP) addresses all health service activities of the central and regional governments from basic services to specialized and referral services. It is expected to bring significant improvement to the entire health system, and, in particular, to long-neglected rural areas and to especially vulnerable groups (such as mothers and children) that would benefit from the expansion of health services.

84. The focus will be on the health conditions that contribute most significantly to the burden of disease in Ethiopia: reproductive health care, treatment and control of basic infectious diseases (upper respiratory tract infection and tuberculosis, in particular), control of epidemic diseases (especially malaria), immunization, and control of sexually transmitted diseases (particularly AIDS). All health institutions will incorporate in their services preventive and promotive aspects of health, as well as education on health and nutrition and on environmental health and safety. The HSDP aims, by 2002, to improve primary health coverage from 40 percent to 55 percent, contraceptive use from 9.8 percent to 20 percent, and immunization coverage from 67 percent to 80 percent.

85. The Education Sector Development Program (ESDP) seeks to raise enrollment rates, especially in underserved rural areas, and improve the quality, equity, and relevance of education. Target populations will include girls, who will benefit from gender-sensitive curricula and books, and more female teachers, and children out of school and dropouts, who will have access to nonformal education. The ESDP aims to raise the primary school enrollment ratio from 30 percent to 50 percent, reduce the student-to-book ratio from 5:1 to 1:1 in core subjects, and facilitate private sector involvement in education.

86. The strategy focuses on four areas: (i) a restructuring of the education system into kindergarten for children aged 4-6, primary school from grades 1 to 8, secondary school from grades 9 to 12, and higher and vocational education; (ii) a curriculum change in line with the new education objective and to increase the relevance of education; (iii) an improvement in the quality of education throughout the system; and (iv) the expansion of primary and vocational education to meet the demand, and to improve equity and sustainability of the education system.

87. Both sector programs will primarily be implemented and managed by regional, zonal, and "woreda"-level officials, coordinated by steering committees established at the central and regional levels. An annual review will be undertaken jointly by the government and donors to reexamine the objectives, priorities, and targets, and a work program and budget will be agreed to for the following year. The government aims to increase the share of the budget allocated to health and education every year to the extent consistent with macroeconomic stability.

88. Over the program period 1998/99-2000/01, real export growth is projected at an average annual rate of 9 percent. Coffee export volumes are projected to grow by 3 percent per annum and international coffee prices to decline by more than 25 percent over the program period. With the envisaged increase in the share of washed coffee, Ethiopia's coffee will command premium prices. Noncoffee exports are expected to grow by 15 percent a year, sparked in part by the start-up of operations of the recently privatized gold mine. Import volumes are projected to grow at about 4.5 percent annually during the program period, reflecting the import requirements of the SIPs financed by the World Bank and other donors. The projected deterioration in the terms of trade and additional import requirements for the SIPs would result in a widening of the trade deficit from 14 percent to 15 percent of GDP during the program period. Accordingly, after taking into account projected increases in private transfers and service receipts, the current account deficit (excluding official transfers) would stay in the range of 8-8½ percent of GDP during the period 1998/99-2000/01.

89. Over the same period, the total external financing requirement is projected at US$8.6 billion, taking into account the projected current account deficits, the targeted reserve accumulation, and the need to clear all external payments arrears (Table 3).² Disbursements from existing grant and loan commitments are estimated at US$0.44 billion, while disbursements from expected but not-yet-pledged new commitments are projected at US$1.56 billion. Total disbursements are projected at US$2 billion, of which about US$780 million would be from IDA and US$275 million from the African Development Bank. The initial financing gap of US$6.59 billion could be covered by debt relief from Paris Club and other bilateral creditors, as well as prospective drawings under the Fund's ESAF.

90. For 1998/99 the total external financing requirement is projected at US$6.35 billion, reflecting a current account deficit (excluding official transfers) of US$0.54 billion, scheduled debt amortization of US$0.52 billion, a targeted reserve accumulation of US$0.1 billion, and a planned reduction of arrears of US$5.20 billion. These requirements are expected to be covered by disbursements from existing commitments of grants (US$0.10 billion) and concessional medium- and long-term loans (US$0.15 billion); disbursements from commitments to be mobilized of grants (US$0.15 billion) and concessional medium- and long-term loans and other capital (US$0.23 billion); concessional debt relief (US$5.68 billion); and ESAF disbursements (US$40 million).

91. At the end of June 1998, Ethiopia's external public debt was estimated at US$10.0 billion, or about 160 percent of GDP. Of this amount, US$5.2 billion represented arrears to Russia, non-Paris Club creditors, and commercial creditors. About 60 percent of the outstanding principal of US$4.8 billion was owed to multilateral creditors, with most of the remainder owed to official bilateral creditors. In NPV terms, the debt including arrears at end-1997/98 represented 855 percent of exports of goods and nonfactor services (Table 4). It is projected that after the full use of existing mechanisms for bilateral debt relief, Ethiopia's NPV of debt-to-exports ratio would fall to 265 percent at end-2000/01, while the debt-service ratio would decline from 45 percent in 1997/98 to 16 2/3 percent in 2000/01.

92. The NPV of debt-to-exports ratio would remain over 250 percent until 2002/03. To attain long-term external debt sustainability, Ethiopia will request assistance under the Initiative for Heavily Indebted Poor Countries (HIPC Initiative), contingent on a successful track record of implementation of reforms under the program. Given the large external financing needs, it would also continue to require substantial inflows of official grants. In addition, the external sector would remain vulnerable to fluctuations in coffee export prices and supply shocks that customarily affect the country every few years; moreover, in the event of a slower-than-anticipated export diversification, external prospects would be considerably weaker than in the baseline scenario. Policies aimed at facilitating further export diversification and efficiency gains are consequently essential to attaining external viability.

93. Significant improvements have been made over the past few years in the timeliness and coverage of data, but a number of important weaknesses in the national accounts, fiscal, monetary, and balance of payments area remain to be addressed as a high priority, since they hamper macroeconomic and financial monitoring and policymaking. More specifically, the timeliness and reliability of price and external trade indicators will be improved, the range of real sector statistics will be broadened, and, the monetary accounts will be revised and the new system of compilation adopted as soon as possible, building on the findings and recommendations of recent technical assistance provided by the Fund on banking and monetary statistics. In addition, following the termination of the use of the birr as a legal tender in Eritrea, the redemption of old birr notes in Eritrea and the settlement of outstanding balances between the two central banks will be completed. Finally, strong efforts will be made to reconcile the fiscal accounts with those of the government's position at the NBE, and to move to a consolidated presentation of nonfinancial public sector operations.

94. The government will seek technical assistance as needed to bolster the effectiveness of its economic and structural reform program. Priority areas for assistance include foreign exchange markets, banking supervision, and tax policy and administration. Support for critical technical assistance needs, including resident experts, will be sought from appropriate donors. In the meantime, progress will be made, building upon the findings and recommendations of the extensive technical assistance provided in a number of areas in recent years.

Addis Ababa, September 24, 1998

1. On behalf of the government of Ethiopia, we are pleased to forward to you a copy of our medium-term policy framework paper, prepared in close collaboration with the staffs of the International Monetary Fund and the World Bank, which describes the government's basic economic objectives for the three-year period 1998/99-2000/01, and the macroeconomic and structural adjustment policies designed to achieve these objectives. We are also forwarding this document today to the President of the World Bank.

2. To facilitate a wide dissemination of the policy framework paper, the government of Ethiopia authorizes the Fund to publish it, including on the IMF Internet site.

3. The government of Ethiopia will remain in close contact with the staffs of the Fund and the World Bank in monitoring developments and progress in implementing the policies described in the attached policy framework paper, which will be updated each year as the program is executed.

Sincerely yours,