December 13, 2000
Mr. Horst Köhler
International Monetary Fund
Washington, D.C. 20431
Dear Mr. Köhler,
1. This letter describes recent performance under the government's modified
economic program for 2000, which was set out in the Memorandum of Economic and Social
Policies (MESP) of August 30, 2000, relating to the second annual arrangement under the
Poverty Reduction and Growth Facility (PRGF) that was approved on September 15,
1999. It also describes certain policies in the financial and macroeconomic areas that the
government has started to implement in the wake of recent difficulties in the banking sector and
while discussions are under way in early 2001 on a macroeconomic framework that could be
supported by the third annual PRGF arrangement. In order to complete the discussions on a
program that could be supported by the third annual arrangement, we request that the
commitment period under the three year PRGF arrangement be extended until March 17,
2. Since the MESP was prepared, and despite the adverse effects of recent
banking difficulties (see below), progress has continued to be made in the macroeconomic,
structural, and governance areas. Reflecting a tightening of fiscal and credit policies starting in
the second quarter of 2000, as envisaged under the modified program, 12-month inflation fell to
around 9 percent in October-November, from a peak of 15 percent in April. In the
first nine months of 2000, the combined public sector deficit (after grants) was held to the
equivalent of 4.3 percent of annual GDP, compared with 5.3 percent under the
program, as externally financed capital outlays fell short of programmed levels. Credit to the
private sector expanded by 23 percent in the year to August 2000, compared with over
40 percent during 1999. The benchmark on the net international reserve target for
September could not be met, however, because of the serious difficulties experienced by two
large banks beginning in August.
3. In the structural area, the electricity distribution companies have been sold
and a long-term lease of a port has been granted. The thermal electricity plants have not yet been
divested, however, because potential investors are awaiting the outcome of a Supreme Court
judgment on existing legal challenges, and the telecommunications company has not been
privatized because a single bid that was received in October 2000 was below the reservation
price. Legislation on the supervision of private pension funds was submitted in October to the
National Assembly. In the governance area, the Treasury's cash management system has been
completed and actions aimed at strengthening the Comptroller's Office have been undertaken.
Also, new legislation modernizing the functions of public prosecutors has been passed and a new
penal code is expected to be approved by the National Assembly shortly. In addition, the
November municipal elections were carried out in a free and transparent manner.
4. The government has made further important progress in preparing its
strengthened poverty reduction strategy (SPRS). The SPRS is being consulted at the local level to
seek grass roots reaction; comments from civil society and the donor community are being
incorporated; and the costing of programs and projects has begun. The government is receiving
substantial technical and financial support from the Inter-American Development Bank (IDB)
and UNDP to strengthen the institutions involved in the preparation of Nicaragua's poverty
alleviation strategy, as well as in the monitoring and evaluation of its implementation.
5. Despite the progress being made in all these areas, Nicaragua's economic
and financial situation was unsettled in August-November. Confidence in the banking system
weakened, and banking system deposits fell sharply during that period, contributing to a
cumulative loss of US$90 million in net official international reserves during
January-November 27, 2000. The weakening of confidence reflected a marked
deterioration in the quality of the portfolios of two commercial banks related to fraud and
mismanagement. To deal with this situation, the government acted decisively by intervening
these banks, providing liquidity assistance in the context of guaranteeing their deposits and,
subsequently, by implementing resolution plans for these institutions. At the same time, open
market operations were stepped up to sterilize part of the liquidity injection by the central bank.
The resolution plans involve: (1) writing off the shares of the original owners;
(2) recapitalization of the intervened banks (by exchanging their impaired assets for
central bank paper) in preparation for their resale; (3) resale of the intervened banks to
other domestic banks; and (4) implementation of asset recovery plans. Also, the
government is pursuing legal action against those involved in fraudulent activities.
6. As a result of these actions, the financial situation has now stabilized and the
government is taking steps to rebuild the official international reserve cushion and further
improve the health of the banking system.
7. In particular, the government is committed to increase public sector deposits
at the central bank by US$36 million during November 28-December 31, 2000 (consistent
with the underlying programmed flow of central bank net credit to the nonfinancial public sector,
adjusted for certain delayed external flows) to rebuild official international reserves by around
US$50 million in that period. Credit conditions also will be tightened through the
implementation until end-January, 2001 of a marginal liquidity requirement on bank's deposits
and through open market operations. The official reserve cushion would increase further in 2001,
as the government will carry out pending reforms in the financial and electricity sectors that will
secure the disbursement of US$60 million of delayed balance of payments support from
the IDB. Also, in early 2001 the government will offer for sale the electricity generation
facilities, sterilizing the net proceeds in the central bank.
8. To support the international reserve build-up and reduce pressures on
interest rates, the government will continue to undertake actions necessary to comply with the
modified program's end-December benchmarks on public sector saving and net domestic
financing, adjusted for delays in the disbursement of balance of payments support from the IDB
and the fiscal cost of bank resolutions. In early 2001, the government will hold comprehensive
discussions of fiscal policy options with IMF staff in the context of the formulation of a program
that could be supported by a new PRGF arrangement. Until then, domestically financed spending
by the nonfinancial public sector will be contained as necessary to avoid recourse to net domestic
financing, before taking into account resources stemming from the privatization of the electricity
generating plants (net of debt service payments connected with the privatization of the electricity
company) and the disbursement of the delayed balance of payments support from the IDB. To
that end, the government will continue to refrain from granting across-the-board wage increases
and will limit wage increases to selective adjustments for teachers, health workers and police
9. To improve the health of the banking system, in the next few months the
government will review and modify, as necessary, the legal, regulatory and supervisory
framework of the financial system. For that purpose, a specific action plan to be implemented
with IMF, World Bank, and IDB technical support has been developed (Attachment I). As
part of this plan, the government will enact by the end of this year a law on deposit insurance to
provide appropriate guarantees to small depositors and limit the fiscal costs of bank restructuring.
The government will consult with the IMF, the World Bank, and the IDB staffs any
modifications that might be required to bring this legislation in line with international best
practices and will submit the required modifications to the National Assembly by March
10. The government is committed to implementing vigorously the actions
described in this letter to support its economic program, which aim at reducing the country's high
poverty levels. In particular, special care will be taken to monitor developments in the banking
system to strengthen its situation through appropriate policy actions. The government reaffirms
its intention to use HIPC Initiative assistance solely for poverty spending. The government feels
that the implementation of the strategy laid out in this letter is essential to resolve the difficulties
in the banking sector and ensure continued macroeconomic stability and economic growth. The
government stands ready to take any further measures that might be required to deal with
unexpected difficulties in complying with its economic program.
11. The government appreciates the continuing support of the IMF, which is
critical to maintaining confidence and improving Nicaragua's economic prospects.
Noel Ramírez Sánchez
President of the Central Bank
Esteban Duque Estrada
Minister of Finance
Nicaragua: Financial Sector
|I. Strengthen the institutional
framework for banking
||a. Create appropriate institutional
arrangements to coordinate
all institutions involved in the banking crisis resolution process (CBN, Ministry
of Finance, SBIF), and assign clear responsibility.
|II. Establish the legal
basis for bank restructuring.
||a. Ensure that the deposit insurance law
that will be enacted
shortly is consistent with international best practices, containing flexible
provisions for prompt bank resolution. The law should contain provisions to
prevent undue suspension of bank resolution procedures due to legal claims,
legal protection, and conflict of interest clauses for all staff and contractors
involved in the bank resolution process. Changes necessary to the law, in
order to bring it into line with the above considerations, will be submitted
to the National Assembly after consultation with the IMF, IDB, and World
||Approve deposit insurance law according
best practices by end-March 2001.
|b. Modify the financial legislation to
capabilities for bank resolution and to adapt deadlines for intervention and
recapitalization according to international best practices. Include legal
protection and conflict of interest clauses for the superintendent of banks,
the president of the CBN, and staff of the superintendency of banks and CBN.
|c. Modify the criminal code to update the
definition of financial
|d. Review of the legal and institutional
framework for establishing,
registering and enforcing property rights, including catastral and collateral
registration systems, and develop a time-bound action plan to address any
|III. Strengthen solvency
||a. Finalize current cycle of on-site
and officially communicate required adjustments
|b. Complete a second cycle of on-site
including a review of all remaining categories of assets, liabilities and
capital accounts not included in the first cycle. Also, a full diagnosis of
contingent accounts would be performed and adequate samples of small credits
would be taken and the results extrapolated to the remaining small credits
portfolio. Revised rules as described in III.c and VI.a will be applied.
|c. Design and implement strengthening
programs for banks
where capital weaknesses have been found during the assisted inspections.
||Start implementation by end-January
|IV. Strengthen banks'
||a. Design and implement a repo facility at
|b. Develop and implement a plan to
improve the CBN's ability
to place bonds at market terms, including strengthening the financial profile
(debt sustainability) of the CBN.
||Develop the plan by end-February
Implementation by end-May 2001
|c. Reserve requirements (RR) will not be
increased. The recently
introduced liquidity requirement (LR) (that banks whose deposits increased
between August 5 and December 5, 2000 invest 65 percent of this increase in
BOMEX) will be rescinded.
||As regard the RR, continuous |
As regards the LR, end-January 2001
|V. Resolve intervened
banks. Manage and recover impaired
assets of Interbank and Bancafe.
||a. Formally write off the value of the
shares of Interbank's
shareholders. For banks falling below 2.5 percent CAR and failing to
recapitalize the bank within the legal timeframe of intervention, the intervention
board should be constituted as general shareholders' meeting and formally
write off the value of the shares of the bank.
|b. Prepare an inventory of all assets of
banks, which have not been transferred to other institutions, including valuation.
|c. Establish a time-bound program for the
disposal of the
assets which will include an asset management strategy covering institutional
arrangements, information and transparency, and private sector outsourcing.
|d. Prepare a litigation strategy after
assessing all possible
legal actions to pursue in the courts those allegedly involved in criminal
activities and misconduct in intervened banks.
||a. Tighten the rules for classification and
of restructured loans and review classification criteria for all loans.
|b. Review current norms to make sure
they are still adequate
given Nicaragua's needs. Among others, banks should be required to publish
audited accounts, and sanctions should be introduced to punish the publication
of erroneous information.
||Norms reviewed by end-April 2001
Changes approved by end-May 2001
|c. Conduct a diagnostic of the operating
procedures of the
central de riesgos and implement a time-bound action plan to correct
any deficiencies found.
||Diagnostic completed by end-June 2001.
Action plan implemented
by end-December 2001
|d. Approve and strengthen fit and proper
main shareholders and managers of banks, including restrictions on former
owners and managers of failed banks that have caused losses to the State to
subsequently own or manage banks.
|e. Amend accounting standards to bring
them into conformity
with GAAP (Generally Accepted Accounting Principles), including with respect
to proper asset valuation (mark-to-market valuation of securities-except held
to maturity-and real estate assets) and accounting of restructured loans.
|f. Complete satisfactory review of
and undertake, with the assistance of the IFIs and foreign supervisors, compliance
assessments of the Basle Core Principles.
|g. Develop time-specific action plan to
address any deficiencies
found in (f).
||a. Implement the strengthening strategy
and the integrated
support program for the superintendency of banks, as established in the technical
assistance matrix of the World Bank, and implement the training actions to
be determined in the IDB program.
||Beginning January 2001. Shall be
completed by end-June 2002.
|b. Introduce a ladder of intensified
supervisory action and
penalties for noncompliance with regulatory norms. The Superintendency of
Banks will apply penalties and disciplinary measures on a uniform and nondiscretional
basis. The authorities will review the level and uniformity of penalties and
of supervisory actions.
|c. Strictly enforce fit and proper, conflict
and related party lending regulations. Create public registries of main shareholders
and managers of banks and related party databases.
1All measures contained in this matrix will be implemented in manners satisfactory
to the Fund and World Bank staffs.|