## _wp0407

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---

### I. Introduction and purpose
- Following independence in 1993, Eritrea experienced a promising start until the war with Ethiopia during 1998-2000, which led to GDP decline, rising inflation, a worsened external current account, near depletion of international reserves, and severely compromised banking assets.
- The most significant change was a sharp deterioration of public finances and a rapid increase in domestic and external public debt due to war-related factors and policy decisions.
- Purpose: examine developments in Eritrea’s public finances with respect to their sustainability, identify endogenous responses to fiscal developments, and discuss policy adjustments to restore sustainability.

### II. Fiscal sustainability framework (key definitions)
- Fiscal sustainability: present value of the budget constraint (PVBC) is satisfied without a major and abrupt correction in the balance of income and expenditure.
- PVBC primary-balance view: today’s government debt must be matched by (or smaller than) the excess of future primary surpluses over deficits in present value terms.
- Key variables in sustainability equations: government revenue, primary expenditure, domestic/external debt stock, domestic/foreign nominal interest rates, nominal exchange rate, real GDP growth, and inflation.

### III. Key variables influencing sustainability (summary)
- Revenue (Z)
  - Z = T + ER + G, where T = tax and nontax revenue, ER = exceptional revenue (e.g., privatization receipts), and G = external grants.
  - Tax revenue T = T(t, TB) with TB depending on GDP; absent tax rate increases or admin improvements, GDP growth determines tax revenue.
  - Customs revenue and port fees are very important and depend on trade activities and relations; privatization dominates exceptional revenue; external grants depend on donors and diaspora and special factors.
- Primary expenditure (E)
  - E = C + I + SP where C = primary current expenditure, I = capital expenditure, SP = special program spending (ERP, demobilization, humanitarian assistance).
  - Defense spending linked to demobilization progress; capital expenditure dominated by reconstruction and donor-financed projects; SP largely donor financed.
- Debt accumulation and financing composition
  - Debt evolves with previous stock, interest payments, and primary deficits; affected by exchange rate and interest rate developments and by composition of financing (domestic vs external).
- Interest rates, exchange rate, growth, inflation
  - Domestic nominal interest rate administratively fixed (2.5 percent), real interest often negative due to high inflation.
  - Official exchange rate close to a conventional peg for official transactions; depreciation risk is substantial given large external deficits and low official reserves.
  - Real GDP growth critical for fiscal sustainability, depending on demobilization, reconstruction, structural reforms, foreign exchange availability, and macro stability.
  - Inflation can temporarily reduce debt ratios under nominal rigidities but at cost of growth.

### IV. Fiscal developments and trends (1993–2002) — key findings
- War impact and fiscal deterioration
  - The war with Ethiopia during 1998-2000 dominated fiscal developments: revenues declined, expenditure increased sharply, and fiscal deficits reached extreme proportions.
- Revenue developments
  - Total revenue (excluding grants) averaged some 35 percent of GDP until 1998, then plummeted to some 25 percent of GDP in 2000, driven by a sharp decline in nontax revenue (mainly port fees from Ethiopian transshipments).
  - Wartime surtax lift caused a revenue loss of some 5 percent of GDP after the war.
  - External grants for reconstruction and humanitarian purposes sharply increased following cessation of hostilities in 2000, keeping total revenue and grants at about previous levels.
- Expenditure developments
  - Total expenditure and net lending, incl. special programs (percent of GDP): 1993 = 63.2; 1994 = 61.5; 1995 = 71.9; 1996 = 61.4; 1997 = 52.1; 1998 = 77.9; 1999 = 93.8; 2000 = 85.5; 2001 = 78.1; 2002 = 67.9
  - Primary current expenditure rose markedly (e.g., current expenditure percent of GDP: 1993 = 35.0; 1999 = 53.7; 2000 = 54.3).
  - Overall deficit (excluding grants and special programs) widened to 58 percent of GDP in 1999 and remained well above prewar levels.
- Financing composition and consequences
  - Domestic financing reached 43 percent of GDP in 1999 and amounted to a cumulative total of 106 percent of GDP during 1998-2000.
  - In 1999, credit to the government accounted for more than 100 percent of the increase in domestic credit of the banking system, sharply reducing excess liquidity and crowding out private-sector credit demand.

### V. Exact fiscal indicators (selected series, percent of GDP unless noted)
- Total revenue and grants: 1993 = 56.8; 1994 = 50.1; 1995 = 48.4; 1996 = 42.1; 1997 = 46.9; 1998 = 42.6; 1999 = 41.5; 2000 = 44.8; 2001 = 42.6; 2002 = 37.9
- Revenue: 1993 = 36.2; 1994 = 31.1; 1995 = 36.1; 1996 = 31.3; 1997 = 41.1; 1998 = 33.3; 1999 = 33.3; 2000 = 25.3; 2001 = 24.9; 2002 = 25.5
- Nontax revenue: 1993 = 15.2; 1994 = 10.1; 1995 = 16.9; 1996 = 12.5; 1997 = 21.4; 1998 = 10.8; 1999 = 10.0; 2000 = 12.9; 2001 = 6.9; 2002 = 8.0
- Port fees and charges: 1993 = 9.9; 1994 = 4.6; 1995 = 6.3; 1996 = 6.4; 1997 = 8.9; 1998 = 1.8; 1999 = 1.8; 2000 = 1.0; 2001 = 1.3; 2002 = 1.6
- Grants: 1993 = 20.6; 1994 = 19.0; 1995 = 12.3; 1996 = 10.8; 1997 = 5.8; 1998 = 9.4; 1999 = 8.2; 2000 = 19.4; 2001 = 17.7; 2002 = 12.4
- Domestic balance: 1993 = -2.4; 1994 = -3.2; 1995 = -21.2; 1996 = -17.8; 1997 = -1.5; 1998 = -30.2; 1999 = -41.3; 2000 = -25.5; 2001 = -21.6; 2002 = -20.8
- Overall balance, excl. special programs and grants: 1993 = -17.2; 1994 = -11.9; 1995 = -30.1; 1996 = -25.3; 1997 = -10.4; 1998 = -43.0; 1999 = -58.1; 2000 = -41.4; 2001 = -33.6; 2002 = -31.8
- Primary balance, incl. special programs and excl. grants: 1993 = -27.0; 1994 = -30.3; 1995 = -35.4; 1996 = -29.2; 1997 = -10.0; 1998 = -43.5; 1999 = -58.6; 2000 = -57.4; 2001 = -49.7; 2002 = -38.5
- Financing (net overall, percent of GDP): 1993 = -0.4; 1994 = 10.5; 1995 = 19.3; 1996 = 17.9; 1997 = 7.7; 1998 = 34.5; 1999 = 51.6; 2000 = 41.2; 2001 = 32.9; 2002 = 30.2
- External (net) financing: 1993 = 0.1; 1994 = 4.7; 1995 = 1.2; 1996 = 1.2; 1997 = 4.1; 1998 = 3.7; 1999 = 8.7; 2000 = 8.6; 2001 = 13.5; 2002 = 10.2
- Domestic (net) financing: 1993 = -0.5; 1994 = 5.8; 1995 = 18.0; 1996 = 16.7; 1997 = 3.6; 1998 = 30.8; 1999 = 42.9; 2000 = 32.6; 2001 = 19.5; 2002 = 20.0

### VI. Fiscal sustainability indicators and debt (selected)
- Overall public debt-to-GDP ratio: less than 10 percent in 1994; 42 percent in 1997; 77 percent in 1998; some 200 percent of GDP in 2002.
- Public debt composition (percent of GDP): public debt: -3.7 (1993), 8.6 (1994), 26.9 (1995), 38.4 (1996), 41.5 (1997), 77.1 (1998), 134.2 (1999), 177.3 (2000), 180.7 (2001), 201.8 (2002)
  - Domestic debt: -4.2 (1993), 2.7 (1994), 20.3 (1995), 31.7 (1996), 30.5 (1997), 58.2 (1998), 96.7 (1999), 125.9 (2000), 119.9 (2001), 123.2 (2002)
  - External debt: 0.5 (1993), 5.9 (1994), 6.6 (1995), 6.7 (1996), 11.0 (1997), 18.8 (1998), 37.5 (1999), 51.4 (2000), 60.8 (2001), 78.6 (2002)
- Net present value of public external debt (NPVX, percent of GDP): 0.4 (1993), 2.6 (1994), 3.4 (1995), 3.7 (1996), 7.0 (1997), 11.8 (1998), 23.3 (1999), 31.9 (2000), 36.0 (2001), 43.9 (2002)
- Debt service pressures
  - Domestic debt service (percent of domestic revenue): -6 (1993), -16 (1994), 42 (1995), 163 (1996), 179 (1997), 299 (1998), 583 (1999), 876 (2000), 1,130 (2001), 1,080 (2002)
  - External debt service (percent of exports of goods and services): 0.0 (1993), 0.1 (1994), 0.2 (1995), 0.2 (1996), 0.3 (1997), 0.5 (1998), 3.0 (1999), 4.1 (2000), 7.6 (2001), 19.5 (2002)
- Gross foreign reserves (months of imports): 3.9 (1993), 5.0 (1994), 4.1 (1995), 3.8 (1996), 5.0 (1997), 1.4 (1998), 1.1 (1999), 0.9 (2000), 1.1 (2001), 0.7 (2002)

### VII. Government assets and liabilities (selected levels)
- Net assets (percent of GDP): 28.5 (1993), 29.6 (1994), 26.7 (1995), 31.1 (1996), 50.5 (1997), 35.9 (1998), 12.8 (1999), -33.4 (2000), -36.2 (2001), -51.7 (2002)
- Government assets (percent of GDP): 24.8 (1993), 38.1 (1994), 53.7 (1995), 69.5 (1996), 91.9 (1997), 113.0 (1998), 147.0 (1999), 143.9 (2000), 144.6 (2001), 150.1 (2002)
- Public liabilities (percent of GDP): -3.7 (1993), 8.6 (1994), 26.9 (1995), 38.4 (1996), 41.5 (1997), 77.1 (1998), 134.2 (1999), 177.3 (2000), 180.7 (2001), 201.8 (2002)
- Major finding: physical and human capital stock rose to 147 percent of GDP in 1999, but net assets turned negative by 2000 as borrowing outpaced asset accumulation and use shifted toward consumption and defense.

### VIII. Macroeconomic and monetary context (selected indicators)
- Growth and inflation
  - Average real GDP growth over 1993–2002: 5 percent (average).
  - Industry growth averaged 13 percent; industry share rose to 25 percent by 2002.
  - Inflation (consumer price index in Asmara; average): 4.6 (1993), 11.6 (1994), 10.7 (1995), 9.3 (1996), 3.7 (1997), 9.5 (1998), 8.4 (1999), 19.9 (2000), 14.6 (2001), 16.9 (2002)
- External performance
  - Current account, excl. official transfers (percent of GDP): -3.7 (1993), 3.4 (1994), -9.0 (1995), -18.7 (1996), -5.4 (1997), -31.5 (1998), -38.4 (1999), -32.0 (2000), -35.4 (2001), -28.1 (2002)
  - Gross foreign reserves (million U.S. dollars): 88.8 (1993), 168.5 (1994), 154.6 (1995), 179.0 (1996), 243.3 (1997), 69.0 (1998), 54.3 (1999), 36.6 (2000), 50.6 (2001), 33.1 (2002)
- Monetary sector and financial intermediation
  - Net claims on central government (percent of net domestic credit): -62.9 (1993), 13.4 (1994), 40.9 (1995), 47.5 (1996), 41.2 (1997), 51.2 (1998), 51.7 (1999), 67.2 (2000), 75.4 (2001), 74.0 (2002)
  - Credit to the economy (percent of net domestic credit): 112.6 (1993), 86.6 (1994), 59.1 (1995), 52.5 (1996), 58.8 (1997), 48.3 (1998), 32.8 (1999), 24.6 (2000), 26.0 (2001), 32.0 (2002)
  - Interest rate on government securities administratively fixed at 2.5 percent.

### IX. Exchange rate regime, competitiveness, and special factors
- Official nominal exchange rate of the nakfa essentially unchanged to limit fiscal costs of foreign payments and external debt service; this supported “nominal” sustainability but produced:
  - a dual exchange rate regime with a strong parallel market;
  - high rigidity undermining transparency, competitiveness, and private-sector growth.
- Droughts affected agriculture for six years out of the last ten years and, together with the war, materially influenced fiscal and external balances.

### X. Endogenous responses affecting sustainability
- Growth of GDP depends on capital, labor, and TFP; fiscal policy influences all three through public investment, demobilization, and openness to capital goods and know-how.
- Private sector initiative has been constrained by increased government intervention (finance, foreign exchange, utilities, petroleum, trade), reducing growth prospects.
- Financial sector stability undermined by large deficit financing and administratively low interest rates, threatening private saving and investment.
- Expectations and confidence have been undermined by large deficits and rising debt; diaspora financing and donor financing remain critical:
  - Bonds issued to the diaspora reached 3.1 percent of GDP in 1999.
  - Grants amounted to 3.2 percent of GDP in 2000.
  - Private transfers from the diaspora averaged 37 percent of GDP over the last ten years.
  - Total assistance from donors (net official loans and external grants) reached 31 percent of GDP in 2001 during intensified reconstruction/humanitarian support.

### XI. Sustainability gap indicators and implications
- Gap indicators are negative in most years, indicating primary balances insufficient to stabilize debt-to-GDP ratios.
- Peak year 1999:
  - Gap indicators reached -52 percent of GDP when grants and special programs are excluded.
  - Gap indicators reached -46 percent of GDP including grants and special programs.
  - To stabilize 1999 debt ratios: total revenue and grants would have had to be raised to 88 percent of GDP (actual 42 percent); total primary expenditure would have had to be cut to 46 percent of GDP (actual 92 percent).
- Three factors that imply these gap estimates likely understate required adjustments:
  1. Debt-to-GDP ratio climbed above 200 percent of GDP in 2002; stabilization alone is insufficient.
  2. Administratively fixed domestic interest rate understates real interest costs and the true gap.
  3. Fixing an overvalued official exchange rate understates external debt and debt-service burden.

### XII. Dependence of adjustment needs on GDP growth and interest rates (2002 baseline)
- Baseline 2002 statistics:
  - Public debt in 2002: 201.8
  - Domestic debt in 2002: 123.2
  - External debt in 2002: 78.6
  - Primary balance in 2002: -26.1
  - Foreign inflation rate (in percent) 1/: 1.2
  - Annual depreciation of nakfa (in percent): 6.7
  - Domestic inflation rate (in percent) 2/: 9.0
  - Foreign inflation rate (in percent) 3/: 2.2
  - Domestic nominal interest rate used in baseline analyses: 2.5 percent
- If domestic nominal interest rate remains fixed at 2.5 percent and average annual GDP growth = 3.5 percent (baseline), the primary deficit needed for stability is 14.7 percent of GDP; observed primary deficit in 2002 was 26.1 percent of GDP → adjustment needed = 11.5 percent of GDP.
- With average GDP growth = 6 percent, primary deficit needed for stabilization would be 19.1 percent of GDP under unchanged interest rate, implying an adjustment need of 7 percent of GDP.
- Any increase in interest rates (to strengthen savings and bank balance sheets) lowers the equilibrium primary deficit and requires stronger fiscal adjustment.

### XIII. Scenario sensitivities and summary of quantitative findings
- Target: debt-to-GDP ratio of 70 percent by 2020 (achieved in accelerating fashion).
- High-growth scenario: average annual primary deficit could be 4.5 percent of GDP during 2003-20, versus zero needed under low-growth scenario.
- High-rate (market-oriented) interest-rate scenario: average primary balance of -0.8 percent of GDP, compared with average deficit of 2.3 percent of GDP under baseline.
- Moving official exchange rate to parallel market levels (implying a 30 percent depreciation in 2003) would require smaller average primary deficits of 1.2 percent of GDP during 2003-20, compared with 3.3 percent of GDP under a smaller adjustment scenario.

### XIV. Policy implications and recommended measures to restore sustainability
- Revenue-side measures
  - Streamline the tax system to make it more efficient.
  - Broaden tax bases.
  - Improve revenue administration and collections.
  - Consider raising selected excises and taxes, such as those on petroleum products.
- Expenditure-side measures
  - Swift and full demobilization of combatants and transition toward a peacetime economy to reduce recurrent defense and special-program-related expenditure.
  - Improve budget management and expenditure control.
  - Continue investments in physical and human capital to increase potential growth.
- Complementary and supporting measures
  - Combine fiscal measures with policies that foster economic growth, especially private sector development and measures affecting export potential and foreign-exchange earning capacity.
  - Attract external investments and generous donor assistance because the foreign exchange constraint is the most binding on development.
  - Emphasize soundness and transparency of economic policies, accountability, and good governance to secure investments and donor support.
  - Manage composition of deficit financing to avoid excessive domestic credit that crowds out private credit and pressures inflation/exchange rates.
  - Address exchange rate vulnerabilities to prevent swelling of foreign-currency-denominated debt.

*Source: Ministry of Finance; Bank of Eritrea; National Statistics Evaluation Office; and IMF staff estimates.*

### 1. Fiscal Policies and the Sustainability of Public Finances ............................................18

### 1. Fiscal Policies and the Sustainability of Public Finances

### I. Introduction
- Following independence in 1993, Eritrea experienced a promising start until the war with Ethiopia during 1998-2000, which led to: GDP decline, rising inflation, a worsened external current account, near depletion of international reserves, and severely compromised banking assets.
- The most significant change was a sharp deterioration of public finances and a rapid increase in domestic and external public debt due to war-related factors and policy decisions.
- Purpose: examine developments in Eritrea’s public finances with respect to their sustainability, including identification of endogenous responses to fiscal developments and discussion of policy adjustments to restore sustainability.

### II. Definition and Framework of Fiscal Sustainability
- Fiscal sustainability exists when the present value of the budget constraint (PVBC) is satisfied without a major and abrupt correction in the balance of income and expenditure to avoid solvency and liquidity problems.
- Solvency condition (general form): present value of current and future primary expenditure not greater than present value of current and future income net of initial indebtedness; formal representation given in equation (1).
- PVBC in primary-balance form: value of today’s government debt must be matched by (or smaller than) the excess of future primary surpluses over deficits in present value terms; formal representation given in equation (2) and ratio-to-GDP form in equation (2a).
- Domestic and external debt explicitly incorporated in equation (3) and ratio-to-GDP form in equation (3a): key variables include government revenue, primary expenditure, domestic/external debt stock, domestic/foreign nominal interest rates, nominal exchange rate, real GDP growth, and inflation.

### III. Key Variables Influencing Sustainability (Discussion)
- Revenue (Z)
  - Total revenue Z comprises tax and nontax revenue T, exceptional revenue ER (e.g., privatization receipts), and external grants G: Z = T + ER + G. (Equation (4))
  - Tax revenue function: T = T(t, TB) where TB (tax base) is a function of GDP. (Equation (5))
  - Implication: Unless tax rates rise or tax administration improves, GDP growth determines tax revenue; policies to enhance growth are therefore critical for fiscal sustainability.
  - Customs revenue and port fees are very important in Eritrea and depend on trade activities and relations; privatization progress dominates exceptional revenues; external grants depend on relationship with donors and diaspora and on special factors (development programs, drought, calamities).
- Primary expenditure (E)
  - Decomposed into primary current expenditure C (excluding interest), capital expenditure I, and special program spending SP: E = C + I + SP. (Equation (6))
  - In Eritrea, primary current expenditure is mainly wages and materials and services (defense and nondefense), plus government grants/contributions (e.g., ex-soldiers, food assistance).
  - Defense spending depends significantly on the progress with demobilization.
  - Capital expenditure dominated by reconstruction and donor-financed projects (the latter do not influence fiscal balance directly unless debt-financed).
  - Special program spending (ERP, demobilization, humanitarian assistance) is entirely donor financed, including by grants.
- Domestic/external debt stock
  - Debt accumulation identity (equation (7)): debt stock evolves with previous stock, interest payments, and primary deficits; affected by exchange rate and interest rate developments as well as primary balance financing composition.
- Nominal interest rate
  - Sustainability critically dependent on domestic and foreign interest rates on public debt.
  - Domestic interest rate on government securities is administratively fixed in Eritrea; no functioning market mechanism for government borrowings; real interest rate often negative due to high inflation.
  - Domestic interest rate currently clearly below equilibrium; freeing it would raise debt-service cost but may yield efficiency gains.
  - External interest rate largely concessionally fixed donor rate; borrowings from non-Paris club members and the diaspora show different, more market-reflective profiles.
- Nominal exchange rate
  - Critical for external debt and debt-service burden via direct effect on size and indirect effect on competitiveness and growth.
  - Current system close to a conventional peg for official transactions; arrangement bears substantial depreciation risk given large external deficits and low official reserves; depreciation would swell foreign-currency-denominated debt unless debt relief secured.
  - Market-determined exchange rate could strengthen exports and growth.
- Real GDP growth
  - Affects ratios to GDP and constituent variables (tax revenue, inflation, exchange rate); behavior of GDP is critical for fiscal sustainability.
  - Current growth depends on pace of demobilization, reconstruction efforts, structural reforms for private sector growth, foreign exchange and financial sector developments, and macroeconomic stability.
- Inflation
  - If markets function properly (nominal interest rate and exchange rate reflect inflation), inflation has no real impact; however, inflation affects fiscal sustainability positively in the short term if nominal rigidities prevail by reducing debt ratios when nominal interest rate and exchange rate are administratively fixed—but such rigidities impair economic growth.

### IV. Links between Fiscal and External Debt Sustainability
- Any primary deficit must be financed domestically or externally; when one source is insufficient, the other must expand.
- External borrowing reduces external sustainability directly; domestic credit expansion increases imports and reduces available foreign exchange, may raise inflation and pressure for exchange rate depreciation—thus domestic financing is not a panacea for external sustainability problems.
- For Eritrea, the external budget constraint is more likely binding than the domestic financing constraint because the country does not issue a convertible currency and access to foreign lending is limited.
- External debt sustainability condition (equation (8)): today’s external debt must be matched by present value of future primary current account surpluses; Eritrea’s large and chronic current account deficit suggests a violation of external debt sustainability and the need for major and abrupt import corrections absent large and stable official and private transfers.
- National income identity linking current account to public and private saving-investment balances: CA = PB + (Private saving - Private investment). (Equation (9)) — this clarifies the link between fiscal sustainability and external sustainability.

### V. Public Finances: Developments and Trends — Key Findings (1993–2002)
- War impact and fiscal deterioration
  - The war with Ethiopia during 1998-2000 dominated fiscal developments: revenues declined, expenditure increased sharply, and fiscal deficits reached extreme proportions.
- Revenue developments
  - Total revenue (excluding grants) averaged some 35 percent of GDP until 1998, then plummeted to some 25 percent of GDP in 2000, driven entirely by a sharp decline in nontax revenue (mainly port fees from Ethiopian transshipments).
  - After the war, total revenue did not recover because the wartime surtax was gradually lifted, causing a revenue loss of some 5 percent of GDP.
  - External grants for reconstruction and humanitarian purposes sharply increased following cessation of hostilities in 2000, keeping total revenue and grants at about previous levels.
- Expenditure developments
  - Total expenditure fluctuated between 43 percent of GDP in 1994 and 66 percent in 1995, and exceeded 90 percent of GDP in 1999 during the height of the war.
  - Primary current expenditure increased from 30 percent of GDP to more than 50 percent.
  - Overall deficit (excluding grants and special programs) widened to 58 percent of GDP in 1999 and remained above prewar levels of 12-30 percent of GDP.
  - Primary balance (major determinant of fiscal sustainability) showed the same severe deterioration.
- Financing composition and consequences
  - Deficit financing heavily relied on domestic credit and diaspora financing during the war, and on substantial external assistance for reconstruction thereafter.
  - Domestic financing reached 43 percent of GDP in 1999 and amounted to a cumulative total of 106 percent of GDP during 1998-2000.
  - In 1999, credit to the government accounted for more than 100 percent of the increase in domestic credit of the banking system, sharply reducing excess liquidity and crowding out private sector credit demand, impairing private sector growth and development.
- Selected exact indicators from Table 1 (percent of GDP unless otherwise indicated)
  - Total revenue and grants: 1993 = 56.8; 1994 = 50.1; 1995 = 48.4; 1996 = 42.1; 1997 = 46.9; 1998 = 42.6; 1999 = 41.5; 2000 = 44.8; 2001 = 42.6; 2002 = 37.9
  - Revenue: 1993 = 36.2; 1994 = 31.1; 1995 = 36.1; 1996 = 31.3; 1997 = 41.1; 1998 = 33.3; 1999 = 33.3; 2000 = 25.3; 2001 = 24.9; 2002 = 25.5
  - Nontax revenue: 1993 = 15.2; 1994 = 10.1; 1995 = 16.9; 1996 = 12.5; 1997 = 21.4; 1998 = 10.8; 1999 = 10.0; 2000 = 12.9; 2001 = 6.9; 2002 = 8.0
  - Port fees and charges: 1993 = 9.9; 1994 = 4.6; 1995 = 6.3; 1996 = 6.4; 1997 = 8.9; 1998 = 1.8; 1999 = 1.8; 2000 = 1.0; 2001 = 1.3; 2002 = 1.6
  - Grants: 1993 = 20.6; 1994 = 19.0; 1995 = 12.3; 1996 = 10.8; 1997 = 5.8; 1998 = 9.4; 1999 = 8.2; 2000 = 19.4; 2001 = 17.7; 2002 = 12.4
  - Total expenditure and net lending, incl. special programs: 1993 = 63.2; 1994 = 61.5; 1995 = 71.9; 1996 = 61.4; 1997 = 52.1; 1998 = 77.9; 1999 = 93.8; 2000 = 85.5; 2001 = 78.1; 2002 = 67.9
  - Current expenditure: 1993 = 35.0; 1994 = 29.3; 1995 = 51.5; 1996 = 37.7; 1997 = 28.4; 1998 = 50.3; 1999 = 53.7; 2000 = 54.3; 2001 = 42.3; 2002 = 40.5
  - Capital expenditure: 1993 = 18.5; 1994 = 13.8; 1995 = 15.6; 1996 = 19.6; 1997 = 23.1; 1998 = 26.0; 1999 = 37.5; 2000 = 11.7; 2001 = 17.5; 2002 = 16.9
  - Special programs: 1993 = 9.8; 1994 = 18.5; 1995 = 5.7; 1996 = 4.7; 1997 = 0.7; 1998 = 1.6; 1999 = 2.4; 2000 = 18.8; 2001 = 19.6; 2002 = 10.6
  - Domestic balance: 1993 = -2.4; 1994 = -3.2; 1995 = -21.2; 1996 = -17.8; 1997 = -1.5; 1998 = -30.2; 1999 = -41.3; 2000 = -25.5; 2001 = -21.6; 2002 = -20.8
  - Overall balance, excl. special programs and grants: 1993 = -17.2; 1994 = -11.9; 1995 = -30.1; 1996 = -25.3; 1997 = -10.4; 1998 = -43.0; 1999 = -58.1; 2000 = -41.4; 2001 = -33.6; 2002 = -31.8
  - Primary balance, incl. special programs and excl. grants: 1993 = -27.0; 1994 = -30.3; 1995 = -35.4; 1996 = -29.2; 1997 = -10.0; 1998 = -43.5; 1999 = -58.6; 2000 = -57.4; 2001 = -49.7; 2002 = -38.5
  - Financing (net overall, percent of GDP): 1993 = -0.4; 1994 = 10.5; 1995 = 19.3; 1996 = 17.9; 1997 = 7.7; 1998 = 34.5; 1999 = 51.6; 2000 = 41.2; 2001 = 32.9; 2002 = 30.2
  - External (net) financing: 1993 = 0.1; 1994 = 4.7; 1995 = 1.2; 1996 = 1.2; 1997 = 4.1; 1998 = 3.7; 1999 = 8.7; 2000 = 8.6; 2001 = 13.5; 2002 = 10.2
  - Domestic (net) financing: 1993 = -0.5; 1994 = 5.8; 1995 = 18.0; 1996 = 16.7; 1997 = 3.6; 1998 = 30.8; 1999 = 42.9; 2000 = 32.6; 2001 = 19.5; 2002 = 20.0
  - Memorandum items:
    - Domestic borrowing of government (in percent of total loans of the banking system): 1993 = -7.5; 1994 = 39.1; 1995 = 56.0; 1996 = 58.5; 1997 = 21.2; 1998 = 68.2; 1999 = 107.3; 2000 = 109.9; 2001 = 43.7; 2002 = 76.5
    - Excess reserves of the banking system (in percent of net domestic credit): 1993 = -51.0; 1994 = 37.3; 1995 = 39.0; 1996 = 59.6; 1997 = 93.0; 1998 = 19.9; 1999 = 18.7; 2000 = 14.3; 2001 = 3.6; 2002 = 2.5
    - Port fees and charges (in percent of total revenue): 1993 = 27.4; 1994 = 14.9; 1995 = 17.4; 1996 = 20.3; 1997 = 21.7; 1998 = 5.4; 1999 = 5.4; 2000 = 3.8; 2001 = 5.3; 2002 = 6.4
    - Grants (in percent of total revenue and grants): 1993 = 36.2; 1994 = 37.9; 1995 = 25.4; 1996 = 25.6; 1997 = 12.4; 1998 = 22.0; 1999 = 19.7; 2000 = 43.4; 2001 = 41.5; 2002 = 32.7
    - Wages (in percent of total expenditure, excluding special programs): 1993 = 17.7; 1994 = 32.5; 1995 = 26.4; 1996 = 31.8; 1997 = 27.6; 1998 = 20.3; 1999 = 18.0; 2000 = 31.6; 2001 = 25.7; 2002 = 28.4
    - Interest (in percent of total expenditure, excluding special programs): 1993 = 0.1; 1994 = 0.2; 1995 = 0.7; 1996 = 1.4; 1997 = 1.9; 1998 = 1.6; 1999 = 2.1; 2000 = 4.2; 2001 = 5.9; 2002 = 6.7
    - Capital expenditure (in percent of total expenditure, excluding special programs): 1993 = 34.6; 1994 = 32.0; 1995 = 23.6; 1996 = 34.6; 1997 = 44.9; 1998 = 34.1; 1999 = 41.1; 2000 = 17.6; 2001 = 29.8; 2002 = 29.5
    - Defense expenditure (in percent of total expenditure, excluding special programs): 1998 = 21.1; 1999 = 12.7; 2000 = 35.0; 2001 = 37.2; 2002 = 35.8; 2003 = 24.2; 2004 = 23.3 (table notes indicate series of defense shares across years)

### VI. Implications for Sustainability and Policy Orientation (from text)
- Given the centrality of GDP growth and the composition of financing in the sustainability equations, policies should focus on:
  - Restoring and sustaining growth (impacting tax base and tax revenue).
  - Improving tax administration or adjusting tax rates if feasible.
  - Managing the composition of deficit financing to avoid excessive domestic credit that crowds out private credit and pressures inflation/exchange rates.
  - Addressing exchange rate vulnerabilities and external financing needs to prevent a swelling of foreign-currency-denominated debt.
  - Pursuing demobilization and structural reforms to lower recurrent defense and special-program-related expenditure and support private-sector-led growth.
  - Seeking stable and concessional external assistance and possible debt relief to alleviate immediate external sustainability pressures.

*IMF staff working paper chapter: "1. Fiscal Policies and the Sustainability of Public Finances" (pages excerpted).*

### 23.      On balance, then, fiscal indicators deteriorated substantially as a result of the war.

### _wp0407 - 23.      On balance, then, fiscal indicators deteriorated substantially as a result of the war.

### Indicators of fiscal sustainability
- Broad conclusions from Table 2:
  - Debt indicators worsened significantly since 1998.
  - Overall public debt-to-GDP ratio:
    - less than 10 percent in 1994
    - 42 percent in 1997
    - 77 percent in 1998
    - some 200 percent of GDP in 2002
  - Increase in debt driven mainly by accumulation of domestic debt; external debt and debt-service ratios also increased sharply.
  - Net present value (NPV) of external public debt rose sharply in 1999 and 2000 in terms of both exports of goods and services and domestic revenue, largely owing to new external borrowings and declines in exports and domestic revenue.
  - Because of the largely concessional nature of loans to Eritrea:
    - NPV amounted to only 44 percent of GDP in 2002
    - external debt stood at 79 percent of GDP in 2002
- Selected fiscal balances (percent of GDP), overall balance, excl. grants and special programs:
  - Overall balance: -17.2 (1993), -11.9 (1994), -30.1 (1995), -25.3 (1996), -10.4 (1997), -43.0 (1998), -58.1 (1999), -41.4 (2000), -33.6 (2001), -31.8 (2002)
  - Primary balance: -17.2 (1993), -11.8 (1994), -29.7 (1995), -24.5 (1996), -9.4 (1997), -41.8 (1998), -56.2 (1999), -38.6 (2000), -30.1 (2001), -27.9 (2002)
- Public debt composition (percent of GDP):
  - Public debt: -3.7 (1993), 8.6 (1994), 26.9 (1995), 38.4 (1996), 41.5 (1997), 77.1 (1998), 134.2 (1999), 177.3 (2000), 180.7 (2001), 201.8 (2002)
  - Domestic debt: -4.2 (1993), 2.7 (1994), 20.3 (1995), 31.7 (1996), 30.5 (1997), 58.2 (1998), 96.7 (1999), 125.9 (2000), 119.9 (2001), 123.2 (2002)
  - External debt: 0.5 (1993), 5.9 (1994), 6.6 (1995), 6.7 (1996), 11.0 (1997), 18.8 (1998), 37.5 (1999), 51.4 (2000), 60.8 (2001), 78.6 (2002)
- Net present value of public external debt (NPVX) (percent of GDP):
  - 0.4 (1993), 2.6 (1994), 3.4 (1995), 3.7 (1996), 7.0 (1997), 11.8 (1998), 23.3 (1999), 31.9 (2000), 36.0 (2001), 43.9 (2002)
- Debt service pressures:
  - Domestic debt service (in percent of domestic revenue): -6 (1993), -16 (1994), 42 (1995), 163 (1996), 179 (1997), 299 (1998), 583 (1999), 876 (2000), 1,130 (2001), 1,080 (2002)
  - External debt service (in percent of exports of goods and services): 0.0 (1993), 0.1 (1994), 0.2 (1995), 0.2 (1996), 0.3 (1997), 0.5 (1998), 3.0 (1999), 4.1 (2000), 7.6 (2001), 19.5 (2002)
- Gross foreign reserves and months of imports:
  - Gross foreign reserves (months of imports of goods and services): 3.9 (1993), 5.0 (1994), 4.1 (1995), 3.8 (1996), 5.0 (1997), 1.4 (1998), 1.1 (1999), 0.9 (2000), 1.1 (2001), 0.7 (2002)

### Government assets and liabilities
- Rationale: debt and debt-service ratios alone are incomplete; sustainability depends on how financing was used (consumption vs. investment) and on government assets (physical capital, human capital, government deposits).
- Method: government assets assumed to consist of physical capital, human capital, and government deposits; physical and human capital stock calculated from annual investment flows net of depreciation and war damage. Calculations are indicative due to lack of market valuations and start from an assumed zero net worth at independence.
- Major findings (from Table 3):
  - Following independence in 1993, physical and human capital stock increased dramatically, reaching a cumulative level of 147 percent of GDP in 1999 despite increasing war damage, thereby substantially increasing growth potential and strengthening fiscal and external sustainability.
  - Following hostilities with Ethiopia in 1998, net assets of government declined substantially because new borrowing largely surpassed the increase in assets, resulting in a negative net worth of government by 2000.
  - The shift in use of borrowings from investment to consumption, notably defense spending, contributed materially to deterioration; defense spending reached 20 percent of GDP in 2000.
- Selected asset and liability levels (millions of nakfa and percent of GDP):
  - Net assets (millions of nakfa): 702 (1993), 975 (1994), 996 (1995), 1,379 (1996), 2,510 (1997), 1,987 (1998), 768 (1999), -2,069 (2000), -2,812 (2001), -4,670 (2002)
  - Government assets (millions of nakfa): 610 (1993), 1,258 (1994), 1,999 (1995), 3,083 (1996), 4,574 (1997), 6,248 (1998), 8,795 (1999), 8,922 (2000), 11,233 (2001), 13,556 (2002)
  - Public liabilities (millions of nakfa): -912 (1993), 831 (1994), 1,003 (1995), 1,704 (1996), 2,063 (1997), 4,261 (1998), 8,028 (1999), 10,991 (2000), 14,046 (2001), 18,226 (2002)
  - Net assets (percent of GDP): 28.5 (1993), 29.6 (1994), 26.7 (1995), 31.1 (1996), 50.5 (1997), 35.9 (1998), 12.8 (1999), -33.4 (2000), -36.2 (2001), -51.7 (2002)
  - Government assets (percent of GDP): 24.8 (1993), 38.1 (1994), 53.7 (1995), 69.5 (1996), 91.9 (1997), 113.0 (1998), 147.0 (1999), 143.9 (2000), 144.6 (2001), 150.1 (2002)
  - Public liabilities (percent of GDP): -3.7 (1993), 8.6 (1994), 26.9 (1995), 38.4 (1996), 41.5 (1997), 77.1 (1998), 134.2 (1999), 177.3 (2000), 180.7 (2001), 201.8 (2002)
- Capital spending and borrowing (selected flows and percent of GDP):
  - Physical capital expenditure (millions of nakfa): 455 (1993), 454 (1994), 582 (1995), 869 (1996), 1,148 (1997), 1,437 (1998), 2,246 (1999), 925 (2000), 2,005 (2001), 1,991 (2002)
  - Human capital expenditure (millions of nakfa): 65 (1993), 100 (1994), 173 (1995), 127 (1996), 220 (1997), 259 (1998), 272 (1999), 263 (2000), 280 (2001), 294 (2002)
  - Borrowing for consumption (flow, millions of nakfa): -530 (1993), -208 (1994), -37 (1995), -201 (1996), -985 (1997), 202 (1998), 382 (1999), 1,218 (2000), 192 (2001), 196 (2002)
  - Borrowing for consumption (cumulative, millions of nakfa): -530 (1993), -738 (1994), -775 (1995), -976 (1996), -1,961 (1997), -1,759 (1998), -1,376 (1999), -158 (2000), 342 (2001), 30 (2002)
  - Total borrowing (millions of nakfa): -113 (1993), 467 (1994), 187 (1995), 953 (1996), 841 (1997), 1,898 (1998), 2,900 (1999), 2,406 (2000), 2,477 (2001), 2,481 (2002)

### Key macroeconomic developments and policies
- Growth and inflation:
  - Average real GDP growth over 1993–2002: 5 percent (average) driven by expansion in nonagricultural sectors.
  - Industry growth averaged 13 percent and its share in GDP rose to 25 percent by 2002.
  - Agriculture growth fluctuated significantly; overall food security did not improve.
  - GDP per capita in U.S. dollars remained basically unchanged over the last ten years at a very low level by international standards.
  - Inflation (consumer price index in Asmara; average):
    - 4.6 (1993), 11.6 (1994), 10.7 (1995), 9.3 (1996), 3.7 (1997), 9.5 (1998), 8.4 (1999), 19.9 (2000), 14.6 (2001), 16.9 (2002)
  - Inflation drivers since 1998: the war, drought conditions, monetary expansion for deficit financing, and the depreciation of the nakfa.
- External performance:
  - Current account, excl. official transfers (millions of U.S. dollars): -17.3 (1993), 18.0 (1994), -53.2 (1995), -130.7 (1996), -37.0 (1997), -235.9 (1998), -282.1 (1999), -206.8 (2000), -252.6 (2001), -181.6 (2002)
  - Current account, excl. official transfers (percent of GDP): -3.7 (1993), 3.4 (1994), -9.0 (1995), -18.7 (1996), -5.4 (1997), -31.5 (1998), -38.4 (1999), -32.0 (2000), -35.4 (2001), -28.1 (2002)
  - Current account, incl. official transfers (millions of U.S. dollars): 52.2 (1993), 97.7 (1994), 17.8 (1995), -48.9 (1996), 14.4 (1997), -177.1 (1998), -204.7 (1999), -104.5 (2000), -131.9 (2001), -101.4 (2002)
  - Current account, incl. official transfers (percent of GDP): 11.1 (1993), 18.2 (1994), 3.0 (1995), -7.0 (1996), 2.1 (1997), -23.6 (1998), -27.9 (1999), -16.2 (2000), -18.5 (2001), -15.7 (2002)
  - Gross foreign reserves (in millions of U.S. dollars): 88.8 (1993), 168.5 (1994), 154.6 (1995), 179.0 (1996), 243.3 (1997), 69.0 (1998), 54.3 (1999), 36.6 (2000), 50.6 (2001), 33.1 (2002)
  - Gross foreign reserves (months of imports): 3.9 (1993), 5.0 (1994), 4.1 (1995), 3.8 (1996), 5.0 (1997), 1.4 (1998), 1.1 (1999), 0.9 (2000), 1.1 (2001), 0.7 (2002)
  - External sustainability implication: external sustainability cannot be achieved without major donor support and improvement in economic growth and export performance.

### Monetary policies and aggregates
- Role of monetary policy:
  - Monetary policy influences fiscal sustainability directly via credit to government and indirectly via credit to the private sector and financial stability.
- Central bank stance and constraints:
  - Since introduction of the national currency in 1997, the Bank of Eritrea has subordinated its objectives to fiscal policy objectives and cannot independently pursue its statutory objectives.
  - Large share of credit to government in total credit (Table 4) evidences this subordination.
  - Rate of interest on government securities is administratively fixed at 2.5 percent.
  - These rigidities hamper effective monetary policy and prevent financial sectors from playing an intermediation role; monetary policy has not been able to contribute to economic growth and sustainability.
- Selected monetary aggregates and indicators (percent of net domestic credit where indicated):
  - Net claims on the central government (percent of net domestic credit): -62.9 (1993), 13.4 (1994), 40.9 (1995), 47.5 (1996), 41.2 (1997), 51.2 (1998), 51.7 (1999), 67.2 (2000), 75.4 (2001), 74.0 (2002)
  - Credit to the economy (percent of net domestic credit): 112.6 (1993), 86.6 (1994), 59.1 (1995), 52.5 (1996), 58.8 (1997), 48.3 (1998), 32.8 (1999), 24.6 (2000), 26.0 (2001), 32.0 (2002)
  - Excess reserves (percent of net domestic credit): -51.0 (1993), 37.3 (1994), 39.0 (1995), 59.0 (1996), 59.6 (1997), 6.7 (1998), 20.8 (1999), 19.8 (2000), 14.8 (2001), 3.6 (2002)
  - Velocity: 1.4 (1993), 1.3 (1994), 1.2 (1995), 1.2 (1996), 1.1 (1997), 1.0 (1998), 0.8 (1999), 0.7 (2000), 0.8 (2001), 0.7 (2002)
  - Money multiplier: 6.5 (1993), 3.6 (1994), 2.3 (1995), 1.5 (1996), 1.0 (1997), 1.9 (1998), 1.9 (1999), 2.0 (2000), 2.6 (2001), 2.8 (2002)

*Source: Ministry of Finance; Bank of Eritrea; National Statistics Evaluation Office; and IMF staff estimates.*

### 31.      As discussed above, exchange rate movements exercise a very important influence on

### _wp0407 - 31.      As discussed above, exchange rate movements exercise a very important influence on

### Exchange rate regime, competitiveness, and sustainability
- The choice of an exchange rate regime is important for fiscal and external sustainability and has a critical effect on external competitiveness and growth.
- Eritrea’s authorities have kept the official nominal exchange rate of the nakfa essentially unchanged mainly to limit fiscal costs of foreign payments, including external debt service; this has supported “nominal” sustainability.
- The present exchange rate system and its management have resulted in:
  - a dual exchange rate regime with a strong parallel market;
  - a high degree of rigidity that undermines transparency and competitiveness and hampers domestic growth.
- For assessing exchange rate policy effects on fiscal sustainability, it is important to examine:
  - functioning of foreign exchange markets;
  - influence on private sector activity.

### Influence of special factors
- Droughts and war have had a significant influence on economic performance and fiscal and external balances.
- Drought conditions:
  - Affected Eritrea for six years out of the last ten years.
  - Mainly caused large swings in agricultural production, with limited effects on other sectors and macroeconomic balances.
- War (1998-2000):
  - Reflected in every key variable: growth declined, inflation rose, public expenditure increased, the current account deficit widened, and foreign reserves were nearly depleted.

### Responses to fiscal policy and management — overview
- Fiscal policy in Eritrea has comprehensive and profound influence across the economy by affecting financial impacts of revenue and expenditure measures and by influencing incentives and expectations.
- For evaluating sustainability in Eritrea, key variables include:
  - GDP growth;
  - private initiative;
  - financial sector stability;
  - confidence in government policies;
  - diaspora and donor financing.
- The discussion extends to endogenous responses to nominal rigidities in interest rates, exchange rates, and prices.

### A. Key response variables and their effect on sustainability

Growth of GDP
- Growth depends on capital, labor, and total factor productivity (TFP).
- Fiscal policy influences:
  - capital formation via public investment in economic and social infrastructure and through tax and transfer policies affecting private saving and investment;
  - labor quantity and productivity: demobilization policies dominate availability of labor; mobilization of combatants during the war severely impaired private activity and public administration and reduced rural labor for agriculture; demobilization has been slow since 2000 and acceleration would increase economic activity and improve public finances;
  - TFP: primarily influenced by imports of capital goods and know-how; an open trade regime and adequate private sector access to foreign exchange are critical.
- Despite progress in trade liberalization and tariff reduction, the precipitous decline in foreign reserves and selective use of reserves have severely undermined private sector growth and reduced fiscal and external sustainability.

Private sector initiative and development
- Private sector is the key driver of employment and development in successful economies; effective when environment is open and liberal.
- Eritrea introduced many of these conditions after independence but has recently rolled back in areas such as finance, foreign exchange, utility services, petroleum products, and trade.
- Authorities’ dissatisfaction with the private sector has increased government intervention in the economy, a practice that may stifle private initiatives and endanger fiscal sustainability by lowering growth prospects.

Financial sector stability and development
- Fiscal policies affect financial sector stability mainly through the volume and terms of domestic deficit financing.
- Private saving (source of private investment) is strongly influenced by interest rate policies and expectations about financial sector stability.
- In Eritrea, the large increase in deficit financing and the setting of interest rates at hugely negative levels in real terms carry risks of reducing private savings and undermining financial sector stability, thereby constraining private investment and reducing prospects for fiscal sustainability.

Expectations and confidence
- Large fiscal deficits and increases in government debt have raised doubts about sustainability and prompted domestic and foreign investors to take protective measures.
- If not corrected, a vicious circle of self-fulfilling expectations could further undermine fiscal sustainability.

Diaspora financing
- Diaspora financing has been a substantial source of foreign exchange, guided by family ties and patriotism and increasingly viewed as investment.
- The soundness of government policies and economic performance conditions diaspora willingness to provide savings.
- Key figures:
  - Bonds issued to the diaspora reached 3.1 percent of GDP in 1999.
  - Grants amounted to 3.2 percent of GDP in 2000.
  - Private transfers from the diaspora averaged 37 percent of GDP over the last ten years.
- Continued diaspora support is critical for both fiscal and external sustainability.

Donor financing
- Generous donor financing is indispensable for Eritrea’s development and the sustainability of public finances and external deficits.
- Following the conflict with Ethiopia, total assistance from donors, including net official loans and external grants, reached 31 percent of GDP in 2001 during intensified reconstruction and humanitarian support.
- Disputes over political governance and concerns about fiscal and other economic policies have caused donors to hold back new commitments except for demobilization and humanitarian assistance.
- Resumption of budgetary and balance of payments support will be needed for sustainable development and requires normalization of relationships with donors.
- Example of conditional reengagement: part of the EU’s demobilization assistance (€17 million out of €42 million) was unblocked, while disbursements of budgetary and balance of payments assistance remain conditional on satisfactory progress on governance issues and a sound macroeconomic framework.

### B. Influence of nominal rigidities and policies taken to minimize endogenous effects
- Authorities have taken actions (to keep budgetary costs low) that prevent market mechanisms from playing out; these have temporarily avoided undesired consequences for public finances, external accounts, and exchange rate.
- Such measures are likely to induce compensatory actions by economic agents that are costly and undermine economic responsiveness and development.
- Policies of concern include measures on:
  - interest rates;
  - exchange rates and foreign exchange allocation;
  - price controls.
- It is important to review the need for these policies and determine their long-term effects on incentives and growth.

### V. Restoring sustainability — A. Sustainability gap indicators
- Sustainability indicators show fiscal policies over the last ten years have significantly moved away from sustainability; large adjustments in government revenue and expenditure are necessary to stabilize public finances.
- Gap indicators (Table 5) are summarized as negative numbers indicating how far away each indicator is from the balance needed for stabilization and sustainability.
- The indicators are all negative except for 2001, indicating that the debt-to-GDP ratios could not be stabilized with the primary balance in the respective years because revenue was too low or expenditure too high.
- Peak year 1999:
  - Gap indicators reached -52 percent of GDP when grants and special programs are excluded.
  - Gap indicators reached -46 percent of GDP including grants and special programs.
- Implications for 1999 (to stabilize debt ratios at the 1999 level):
  - Total revenue and grants would have had to be raised to 88 percent of GDP, against the actual 42 percent.
  - Total primary expenditure, including special programs, would have had to be cut to 46 percent of GDP, against the actual 92 percent.
- Three factors suggest these adjustments underestimate the correction needed:
  1. The debt-to-GDP ratio climbed above 200 percent of GDP in 2002; merely maintaining this level is insufficient and debt reduction targets must be more ambitious.
  2. An administratively fixed domestic interest rate for public debt underestimates the real cost of interest payments and thereby underreports the intrinsic size of gap indicators. Under an administratively fixed interest rate, inflation improves the gap indicators because nominal GDP growth, t_n, goes up while t_r stays the same in the gap indicator formula.
  3. Fixing the official exchange rate at an overvalued rate underestimates the underlying size of the external debt stock and debt-service burden, thereby underreporting sustainability gaps.

*Source: _wp0407 - 31.      As discussed above, exchange rate movements exercise a very important influence on (PDF chapter/section).*

### 46.      To illustrate the dependence of changes in the sustainability gap and the need for

### _wp0407 - 46.      To illustrate the dependence of changes in the sustainability gap and the need for

### Dependence of sustainability gap and adjustment on GDP growth and interest rates
- A matrix based on GDP growth and the domestic nominal interest rate was calculated for the situation observed in 2002 (Table 6).
- If the domestic nominal interest rate on government debt remains fixed at 2.5 percent, and using the average annual GDP growth rate of 3.5 percent projected for the baseline scenario, the primary deficit needed for stability of the debt-to-GDP ratio is 14.7 percent of GDP.
- This 14.7 percent of GDP requirement is compared with the level of 26.1 percent of GDP actually observed in 2002, implying an adjustment needed for stability of 11.5 percent of GDP.
- In the more optimistic scenario with average GDP growth projected at 6 percent, the primary deficit needed for stabilization would be 19.1 percent of GDP under an unchanged interest rate on domestic public debt, implying an adjustment need of 7 percent of GDP.
- Any increase in the interest rate (to strengthen savings and banks’ balance sheets) would lower the “equilibrium primary deficit” and require stronger adjustment from government revenue and/or expenditure.

### Key statistics and baseline fiscal position (2002)
- Public debt in 2002: 201.8
- Domestic debt in 2002: 123.2
- External debt in 2002: 78.6
- Primary balance in 2002: -26.1
- Foreign inflation rate (in percent) 1/: 1.2
- Annual depreciation of nakfa (in percent): 6.7
- Domestic inflation rate (in percent) 2/: 9.0
- Foreign inflation rate (in percent) 3/: 2.2
- Domestic nominal interest rate used in baseline analyses: 2.5 percent

### Scenarios and sensitivity analysis (summary of findings)
- A target debt-to-GDP ratio of 70 percent by 2020 was set for scenario calculations, with the target reached in an accelerating fashion (manageable initial reduction followed by increasing adjustments).
- Sensitivity assessments highlight significant influence of GDP growth, interest rates, and the exchange rate on fiscal adjustment needs.
- For the high GDP growth scenario, the average annual primary deficit could be 4.5 percent of GDP during 2003-20, against a zero balance needed under the low-growth scenario.
- A more market-oriented interest rate (high-rate scenario) would require an average primary balance of -0.8 percent of GDP, compared with an average deficit of 2.3 percent of GDP under the baseline scenario.
- Moving the official exchange rate to the levels observed in the parallel market (implying a 30 percent depreciation in 2003) would require smaller average primary deficits of 1.2 percent of GDP during 2003-20, compared with average deficits of 3.3 percent of GDP under the smaller adjustment scenario, because of the heavier external debt and debt-service burden in domestic currency.

### Policy implications and key measures to restore sustainability
- Fiscal policy measures should concentrate first on variables that directly influence the primary fiscal deficit.
- On the revenue side:
  - Streamline the tax system to make it more efficient.
  - Broaden tax bases.
  - Improve revenue administration and collections.
  - Consider raising selected excises and taxes, such as those on petroleum products.
- On the expenditure side:
  - Largest gains could arise from a swift and full demobilization of combatants and a general move toward a peacetime economy.
  - Improve budget management and expenditure control.
  - Investments in physical and human capital will be required to increase potential growth.
- Complementary measures:
  - Combine fiscal measures with policies that foster economic growth, especially private sector development and measures affecting export potential and foreign-exchange earning capacity.
  - Attract external investments and generous donor assistance, given that the foreign exchange constraint is the most binding constraint on economic development.
  - Emphasize soundness and transparency of economic policies, accountability, and good governance to secure investments and donor support.

*Sources: Ministry of Finance; Bank of Eritrea; and IMF staff estimates (material extracted from the supplied content).*

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