Lusaka, June 30, 2000

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

Dear Mr. Köhler:

1. In this letter, we assess the recent performance of the Zambian economy and describe the government’s key economic and financial policies for the remainder of 2000. The first review of the three-year PRGF arrangement was delayed mainly due to difficulties in the privatization of the copper parastatal ZCCM. During the second half of 1999, we revised our program for the remainder of the year to take into account the fundamental change in the macroeconomic outlook. During discussions with Fund staff in December 1999 and in January and March 2000, we agreed on an outline of the budget for 2000. This letter outlines our program for 2000. In view of the delay in completion of the first review, we are requesting a one year extension of the PRGF program period through March 2003.

I. Recent Economic Developments

2. During 1999, the economy continued to be hampered by the difficulties of ZCCM and the delays in its privatization. Despite a recovery of agricultural production, real GDP rose by only 2.4 percent. The twelve-month rate of inflation was 21 percent. While lower than the previous year, inflation was higher than programmed, reflecting high inflationary expectations, a rapid expansion of domestic credit, and higher import prices.

• Fiscal performance was undermined by an increase in the stock of payments arrears by line ministries of K122 billion, or 1.6 percent of GDP. The overall fiscal deficit (excluding grants) deteriorated by about 0.7 percent of GDP to 11.4 percent. Social sector spending, however, met the target of 36 percent of domestic discretionary expenditure.

• The 12 month growth of broad money accelerated to 29 percent, reflecting mainly rapid expansion in bank lending to parastatals, particularly ZCCM and the Zambia National Oil Company (ZNOC), including the Y2K problem. Weak export performance and a shortfall in donor support exerted pressure on gross international reserves which fell to US$45 million, equivalent to less than 3 weeks of imports.

• Continued delays in the privatization of ZCCM affected the economic outlook and market sentiment during the first quarter of 2000. At end-March, inflation reached 24 percent, and debt service payments combined with lack of donor support reduced free reserves to only $9 million. Following a 5 percent depreciation during the first two months of the year, the kwacha/dollar exchange rate has remained stable.

• At end-March the ZCCM privatization was finally completed, which contributed to improved market sentiment. This provides a window of opportunity for increased focus on program implementation leading to a revival in economic activity and addressing our development and social objectives.

II. Program Implementation

3. Most of the quantitative performance criteria for end-June 1999 were not observed, except for the domestic fiscal surplus, and the ceilings on nonconcessional borrowing (Table 1). The nonobservance of the performance criteria for net domestic assets, net claims on the government, and net international reserves was largely related to delays in disbursement of the World Bank’s adjustment credit. The end-June performance criterion on net external payments arrears was met in July 1999. The performance criterion on the size of the civil service was not observed because of problems with the identification of civil servants eligible for voluntary separation. As regards budget management, there was a further accumulation of domestic payments arrears.

4. The Government faced considerable challenges in meeting the structural performance criteria, (Table 2). In particular, the privatization of ZCCM was delayed until March 31, 2000, and left the government with gross debt obligations totaling some US$770 million. Moreover the government resolved to take further actions to strengthen the banking system, particularly regarding the state-owned Zambia National Commercial Bank (ZNCB) in order to safeguard financial stability and government finances.

III. The Program for 2000

5. The government’s medium-term macroeconomic framework and targets are outlined in our Interim Poverty Reduction Strategy Paper (PRSP). For 2000 our key objectives will be to restore economic growth and to further reduce inflation. We intend to step up our efforts to reduce poverty and reform the economy through, inter alia, strengthening expenditure controls, improving the delivery of social services, and continue privatizing state-owned enterprises. Real GDP is projected to grow by 4 percent in 2000, reflecting a strong recovery of mining and continued improvement in agricultural production. Improved economic conditions, coupled with tightened monetary policies, are expected to limit inflation to 19 percent by end-2000. Higher exports and an increase in donor inflows will allow us to strengthen gross reserves by at least US$100 million. To reduce our external debt service burden, implementation of the PRGF program will be strengthened to ensure that we reach the HIPC decision point by early 2001 and thus begin to benefit from bilateral and multilateral debt relief in 2001 and beyond.

The budget for 2000

6. The main objectives of fiscal policy will be to contain inflation, raise national savings, promote sustainable growth, and support social sector expenditure. Despite efforts to strengthen the revenue effort and expenditure control, the domestic fiscal deficit on a cash basis is programmed to increase by 0.7 percent of GDP to 2.3 percent of GDP in 2000.¹ In view of the continued weaknesses in budget management, the budget includes a contingency reserve which will be utilized for the clearance of arrears, unanticipated statutory outlays that could not be forseen at the time of budget preparation ( such as domestic interest payments higher than budgeted), legally mandated unavoidable outlays, and the fiscal cost of droughts and other natural disasters.

7. The budget for 2000 reflects a difficult balance between the maintenance of basic government operations, already committed capital spending, including payment of ZCCM liabilities, and a recognized need to shift additional resources to social spending in support of poverty alleviation. In this regard, recently completed labor negotiations will limit the government wage bill to 5.2 percent of GDP while significantly raising the minimum wage, to K150,000 per month on April 1, 2000 and further to K175,000 on October 1. Over the medium term our policy is to reduce the share of the wage bill in domestic noninterest expenditures. Budgeted allocations for spending on the social sectors, along with improvements in the funding mechanism, will ensure that at least 36 percent of domestically financed discretionary expenditures go to these sectors. ² Given this, domestically-funded capital outlays will be limited to K172 billion. In addition we have decided to free additional resources for priority uses by introducing broad based cost-cutting measures, including spending on foreign missions.

8. Preliminary data on the first quarter fiscal outturn indicates an increase in the stock of domestic payments arrears by K5 billion to K152 billion, a level equivalent to 1.5 percent of GDP. In addition, at end-April there were parastatal tax arrears of K133 billion, of which K69 billion have accumulated during January-April 2000 mainly on account of ZESCO (K32 billion) and ZNOC (K19 billion). To achieve the budgetary targets, we will improve tax collections from parastatals, as noted below. In order to substantially reinforce efforts to improve expenditure controls and budgetary discipline, we have i) established a commitment monitoring unit in the Ministry of Finance, with technical assistance from the IMF, which is responsible for coordinating the monitoring and control of commitments and arrears; ii) issued instructions to put a freeze on new contracts by Ministry of Works and Supply (effective April 1, 2000); iii) enforced the regulation requiring controlling officers to inform the Ministry of Finance in writing when they receive a directive to commit resources which exceed budgetary provision or cash allocations (effective April 1); iv) written to all controlling officers setting out their responsibility for monitoring and controlling expenditure, and indicating the disciplinary steps that will be taken against controlling officers who continue to accumulate arrears; v) line ministries that violate the 10 percent rule³ or fail to report commitments will be sanctioned by withholding cash releases. In the longer term, a key part of the solution to the problems of budget management is the implementation of an integrated financial management information system (IFMIS). To this end we have prepared a draft feasibility study and secured donor funding for the appointment of a project manager to coordinate the implementation of an IFMIS. Moreover we will conduct a complete inventory of the arrears and formulate a plan to eliminate them which will be discussed and agreed with the Fund staff.

9. A related issue concerns the operation of the cash budget. While the adjustment of monthly cash allocations in line with actual monthly revenues has helped us to constrain fiscal deficits in recent years, a lack of transparency and predictability in the allocation and amount of cash releases, at the aggregate level and within line ministries, has severely impaired budget execution. Therefore, we intend to (i) provide controlling officers in Ministries at the beginning of each quarter, starting in July 2000, a projection of their monthly allocations during the quarter, and (ii) publish on a monthly basis the monthly allocations made to Ministries, beginning July 2000 (including for the period January-June, 2000).

10. Action to address the financial performance of the parastatals, particularly the state-owned electricity and oil companies, ZESCO and ZNOC, is fundamental to our reform efforts. In the medium term, these difficulties will be addressed through eliminating government majority ownership and control of existing state enterprises. In the interim, with regard to ZESCO, electricity prices were raised by 25 percent in April and measures to cut costs and improve efficiency, agreed with the World Bank, have been introduced. These measures, together with the resumption of full and prompt payments by the privatized mining companies, will enable ZESCO to meet fully its tax obligations from June 1, 2000 and to clear its outstanding tax arrears by the end of 2000. With regard to ZNOC, the price of petroleum products was raised by about 20 percent in December 1999 and a further 20 percent in April 2000. Moreover, imports of petroleum products have been fully liberalized, and review of prices by the Energy Regulation Board will henceforth be strictly on an ex-post basis in accordance with the law.⁴ In addition, I have directed the commissioner-general of the Zambia Revenue Authority (ZRA) that henceforth all taxes due on oil imports should be collected at the point of entry and that, if necessary, ZRA should collect tax payments due from ZNOC directly from the oil marketing companies. To reinforce the integrity of the tax system, we will refrain from introducing any tax reductions, new exemptions, rebates, or any other preferential tax treatment without consultation with the Fund staff during the remainder of 2000.

11. The numerous government accounts in commercial banks has given rise to additional problems in expenditure control and monitoring of the financial position of the government, and thus financial management. It also raises the questions of prudent and transparent financial management. We have conducted an audit of the accounts and reduced the number significantly. At end-May the bank accounts (excluding donor controlled accounts) operated by each controlling officer were merged into one account in each commercial bank. The next step, which will be completed by end-December, will involve the consolidation of each controlling officer’s accounts into a single account in a single commercial bank. As a final step, and subject to the recommendations of a study we have commissioned with assistance from the EU to work out the modalities, all government balances held in commercial bank accounts will be transferred to the Bank of Zambia (BoZ) and appropriate “mirror accounts” (zero balance transit accounts)⁵ in the commercial banks will be established.

12. Consistent with the inflation objective, the growth of broad money during 2000 will be limited to about 25 percent compared with a 31 percent increase in nominal GDP. In meeting its broad money objectives, the BoZ will target reserve money through the use of open market operations. To enhance the effectiveness of these operations, the BoZ will improve the functioning of the market for treasury bills, notably by setting up a repurchase agreement and by improving the auction system.

13. To further strengthen the banking system and oversight role of the BoZ over financial institutions, a proposal that has already been approved by the Cabinet will be submitted to Parliament to amend the Banking and Financial Services Act, 1994. In particular, this amendment will enhance the legal authority of the BoZ in licensing and liquidating banks. Meanwhile, the BoZ has already placed one bank in curatorship, and proceeding with the privatization of the state-owned ZNCB. Consistent with existing law and cabinet directives already issued, the Zambia Privatization Agency (ZPA) will be instructed to prepare a study of the options for privatizing the bank through eliminating the government’s majority share ownership and control. ZPA will submit the study by end-December 2000, for the Cabinet’s consideration. Pending completion of the privatization, the BoZ will increase its direction of ZNCB’s specific activities to halt further deterioration of the bank, consistent with the provisions of the Banking and Financial Services Act, 1994. This direction will be in the form of a written directive from the BoZ to ZNCB outlining specific activities or prohibitions. This should aid in halting further deterioration of the condition of the bank. The directive will include the following key elements:

a) place ZNOC and all other non-performing loans on a non-accrual accounting basis, retroactive to December 31, 1999, and establish loan loss provisions consistent with BoZ guidelines;

b) no new funds (including capitalization of interest) to any non-performing credits or loans classified by the BoZ Financial System Supervision Department;

c) limit the growth of ZNCB’s assets, and its deposit and borrowing growth;

d) prohibit loans in excess of K500 million.

The BoZ will provide liquidity support only on a fully secured basis. Any bank that is unable to repay its liquidity advance or requests an increase in liquidity advances will be subject to immediate on-site examination to confirm that it is solvent. The BoZ will exercise its full legal authority to deal with any bank found to be insolvent. Moreover, the BoZ will not guarantee any loans to ZNCB from other institutions.

14. The exchange rate will continue to be determined by market forces, with the BoZ limiting its intervention to smoothing short-term fluctuations and without trying to influence the underlying trend. To meet the program target for net international reserves, the BoZ will undertake such measures as are necessary, and will refrain from entering into foreign exchange arrangements that will expose it to undue risk.

15. Zambia’s current account deficit is expected to decline from 15.8 percent of GDP in 1999 to 13.5 percent of GDP in 2000, partly reflecting a strong recovery of exports. Zambia’s external financing gap is expected to be covered by the concessional assistance from donors. Zambia will strive to maintain a sustainable debt service ratio by strictly adhering to a moratorium on new nonconcessional borrowing. On that basis, the external debt service, after rescheduling, is projected to remain at about 16 percent of exports in 2000. For the purpose of timely honoring of Zambia’s payments to the Fund, we request that disbursements under the PRGF arrangement be made to the SDR account of Zambia, which is an integral part of our gross reserves. Zambia does not intend to convert the SDR amounts into foreign currencies for other purposes.

16. In the course of the privatization of ZCCM, it came to the government’s attention that there was a significant discrepancy between the world market price and the realized export price of ZCCM cobalt sales. An initial ZCCM internal study suggested that forward transactions and sales of lower grade cobalt concentrate account for the discrepancy. However, we believe that other measures are necessary to fully resolve the issue. We have thus submitted terms of reference for further action which will be initiated shortly with financial assistance from the EU.

Structural reform and poverty reduction strategy

17. The government will deepen structural reforms to restore confidence and promote investment, building on the momentum gained by the privatization of ZCCM. The structural reform program will include actions to improve budget management, to accelerate privatization and deregulation of the economy, and to strengthen the banking system.

18. Privatization is fundamental to Zambia’s adjustment program. In addition to measures proposed on ZNCB, we regard the elimination of government majority ownership and control of ZESCO and the oil sector as critical objectives. For ZESCO, a study of the modalities of privatization has already been initiated with technical assistance from USAID. This will be followed by a review by ZPA and submission by end-December 2000 of a proposal regarding the privatization options for Cabinet’s consideration. The government will select the preferred option and refer the privatization back to ZPA for implementation. Regarding the oil sector, the government will implement a program of action in the context of the policies envisaged in the World Bank’s Fiscal Sustainability Credit. This involves effectively privatizing the sector, with government retaining responsibility for maintaining storage facilities and a strategic petroleum reserve.

19. The structural performance criteria and benchmarks of the program are shown in Table 4. In addition to the actions above which have already been taken, by July 1 we will implement the following actions: (i)follow up action on cobalt sales; (ii) each controlling officer’s accounts in each commercial bank will be merged into a single account. The accountant general will provide a list of such accounts with balances to Fund staff; (iii) issuance of a directive to the Commissioner-General of the ZRA to collect the full amount of excise, customs duty, import VAT, and road levy from all oil importers, including ZNOC, at the point of entry, and instruction to ERB to review prices only on an ex-post basis; (iv) issuance of instructions to ZNCB to place ZNOC on a non-accrual accounting basis retroactive to December 31, 1999, and to re-file the December 1999 and March 2000 prudential returns. Furthermore, in view of the insolvency of the Public Service Pension Fund, the government will commission a study to establish the modalities for moving to a “pay as you go” system consistent with the recommendations of the World Bank, and with reference to the recent actuarial study of the pension fund. It is intended that draft legislation will be submitted to Parliament by end-2000.

20. In May 1998, the government adopted a Poverty Reduction Strategy Framework (PRSF) as the umbrella for its sector investment programs (SIPS) and other poverty reduction policies. Building on this framework, the government of Zambia has started preparation of a PRSP, which will be developed in a participatory and open consultative process involving civil society in Zambia. The poverty reduction strategy will aim to integrate our macroeconomic, structural, and social policies, as well as setting clear and monitorable goals for poverty reduction. Consistent with the long-term goal, the Government has also prepared a draft of its interim PRSP and held discussions on this issue with the IMF and World Bank staff. The interim PRSP includes an outline of our poverty reduction strategy, a work plan to prepare a full PRSP, an outline of the institutional framework to conduct a broad consultative process with civil society and other shareholders, and a three year macroeconomic framework and policy matrix, including objectives and intermediate targets.

IV. Program Monitoring

21. The program supported by the second annual PRGF arrangement will be monitored on the basis of the following quantitative performance criteria and benchmarks for 2000 (Table 3): (i) net domestic assets of the BoZ; (ii) net bank claims on the government; (iii) the domestic fiscal balance of the government; (iv) domestic payment arrears of the government; (v) net international reserves of the BoZ; (vi) the stock of external short-term debt of the government, BoZ and the public enterprises; (vii) external payment arrears; (viii) new nonconcessional external medium- and long-term loans; (ix) ceilings on loans collateralized or guaranteed by the government or BoZ for ZESCO and ZNOC; (x) the accumulation of new tax arrears by ZESCO and ZNOC. The second review of the PRGF will be conducted based on performance through end-December 2000, which will include an assessment of progress in structural reform and a macro-economic framework for 2001.