Cape Verde and the IMF

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Cape Verde—Letter of Intent,
Memorandum of Economic and Financial Policies,
Technical Memorandum of Understanding

September 5, 2001

The following item is a Letter of Intent and a Memorandum of Economic Policies of the government of Cape Verde. It is being made available on the IMF website by agreement with the member as a service to users of the IMF website. This memorandum describes the policies that Cape Verde is implementing in the framework of a staff-monitored program. A members's staff-monitored program is an informal and flexible instrument for dialogue between the IMF staff and a member on its economic policies. A staff-monitored program is not supported by the use of the Fund's financial resources; nor is it subject to the endorsement of the Executive Board of the IMF.

Mr. Horst Köhler
Managing Director
International Monetary Fund
700 19th Street, N.W.
Washington, D.C. 20431

Dear Mr. Köhler:

Following a sizable deterioration in the macroeconomic situation in 2000 and early 2001, characterized by the substantial loosening of fiscal and monetary policies, the new government that came to power in February 2001 initiated a wide-ranging effort to stabilize the macroeconomic situation in the near term. The government is pleased to report that these efforts are beginning to bear fruit, with net international reserves of the Bank of Cape Verde stabilizing during the first six months of the year, after having fallen precipitously last year. In addition, we have successfully rescheduled our external debt with Portugal, our largest bilateral donor, and have secured a new line of credit with the Government of Portugal in support of the country's exchange rate peg.

To consolidate these gains and make further progress in stabilizing the macroeconomic situation, while promoting a solid economic recovery and the alleviation of poverty, the government of Cape Verde has developed a macroeconomic and financial policy framework for the remainder of 2001, and requests that the IMF staff monitor the program during the course of the year. The attached memorandum of economic and financial policies (MEFP) describes recent economic developments, the objectives of the staff-monitored program (SMP) for the August-December 2001 period, and the policies that will be pursued by the government to achieve them. In addition, we expect the program will facilitate the dialogue with other multilateral agencies and donors, helping pave the way for the resumption of financial support, and prepare the ground for subsequent discussions on a successor economic program which could be supported by a Poverty Reduction and Growth Facility (PRGF).

Our expectation is that monitoring of our program by the IMF staff will enhance its credibility and help build the government's implementation capacity. In this regard, we request the IMF to post this statement and the attached MEFP on the IMF website, and we will post it as well on the government's website.

My government is strongly committed to the reform effort described in the attached memorandum. At the core of these reforms are policies to restore the soundness of public finances and regularize relations with donors and creditors. The government will make every effort to improve the coverage and timeliness of economic statistics, and will provide the IMF staff with the information necessary to monitor the program adequately. In this context, the government will consult regularly with the IMF staff and keep it informed of the progress in the implementation of economic and social policies. Furthermore, we request that the IMF staff review developments under the program, including a mid-term review of program implementation scheduled for November 2001. Following this review, we request that the IMF post the Fund staff's assessment of policy implementation on its website and we will post it as well on the government's website.

The government believes that the policies and measures described in the attached memorandum are appropriate to achieve its program objectives but will take any additional measures that may prove necessary for this purpose. We look forward to a close and constructive dialogue with the IMF in support of our adjustment efforts in the period ahead.

Sincerely yours,

Carlos Augusto Duarte Burgo
Minister of Finance and Economic Planning


Memorandum of Economic and Financial Policies for the Period
August-December 2001

I. Introduction

1. In response to the deteriorating macroeconomic and financial environment in late 2000 and early 2001, the newly-elected government that assumed power in February 2001 launched a number of important reforms aimed at correcting the sizable internal and external imbalances it inherited. This memorandum reviews recent economic and financial developments and presents a comprehensive program the government intends to implement during the remainder of 2001 to substantially improve the macroeconomic situation in the near term and lay the foundation for strong economic growth and an important decline in poverty over the medium term.

2. The government has asked the IMF staff to informally monitor its economic and financial program in 2001. The staff-monitored program (SMP) discussed below, covering the period August 1-December 31, 2001, aims at providing a consistent macroeconomic and financial framework within which official creditors and donors could resume much-needed financial and technical assistance. In addition, it is expected that satisfactory performance under the SMP will help set the stage for subsequent discussions in the last quarter of this year on a medium-term program that could be supported by the IMF's Poverty Reduction and Growth Facility (PRGF). It is also expected that the government's medium-term program could be supported by the World Bank and other key multilateral and bilateral development partners.

II. Review of Recent Economic and Financial Developments

3. During 1998-99, real GDP grew at an annual rate of 8 percent, while inflation fell significantly, to about 4½ percent per year. The acceleration in real GDP growth was driven by developments in the tourism sector, significant foreign investment, and sustained and substantial inflows of workers' remittances, which stimulated construction activities. The government's comprehensive adjustment program, supported by the IMF's Stand-By Arrangement (February 1998-March 2000), created an environment that proved conducive to increased private sector activity. A comprehensive domestic debt-reduction operation, financed by donor contributions and foreign currency receipts stemming from the government's privatization program, represented a key pillar of the government's fiscal consolidation and structural reform program.

4. During the second half of 1999, sizable fiscal slippages emerged and led to pressures on the balance of payments and the exchange rate peg, mainly because extraordinary public expenditures were undertaken to cushion the impact of a serious drought that destroyed much of the 1998/99 harvest. The widening overall fiscal deficit was accommodated through higher-than-programmed credit from the banking system and unexpectedly high privatization receipts. Given the economy's high degree of openness and fixed exchange rate, the expansionary fiscal and credit policies resulted in higher imports and a widening of the external current account deficit. The macroeconomic consequences were, however, softened by concomitant inflows of significant foreign direct investments, mainly related to privatization, and large disbursements of bilateral and multilateral credits. These allowed the overall external balance to register a surplus in 1999, permitting an accumulation of official reserves.

5. Following an exceptionally good harvest in 1999/2000 and improved export conditions, real GDP increased by 7 percent in 2000. Consumer prices fell by 1 percent in 2000, on an end-period basis, primarily reflecting: (a) the fall in food prices associated with the bumper harvest; and (b) the previous government's decision to maintain domestic petroleum prices at artificially low levels, which postponed the consumer price impact of the rapid increase in world oil prices until 2001.

6. The fiscal deterioration that began in the second half of 1999 accelerated in 2000. The overall fiscal deficit (including grants) widened by 8 percentage points, to 19 percent of GDP in 2000, primarily reflecting: (a) unforeseen restructuring costs associated with the privatization of the state-owned commercial bank (equivalent to 7 percent of GDP); (b) an increase in petroleum price subsidies to consumers (4 percent of GDP), stemming from the maintenance of artificially low administered prices; and (c) the incorporation into the budget of new student loans formerly financed by state banks (1 percent of GDP). With donors and external creditors reducing their financial support to the government as the fiscal situation deteriorated, the fiscal deficit in 2000 was largely financed by domestic credit from the banking system (8 percent of GDP) and the accumulation of domestic and external arrears (7 percent of GDP).

7. The unsustainable fiscal situation revealed flaws in the independence of the central bank (BCV). With limited statutory independence, the central bank was not able to contain credit expansion adequately. The requirement contained in the Central Bank Law that the BCV's advances to the Treasury should not exceed 5 percent of the previous year's current receipts was not observed, as advances at times exceeded 20 percent of 1999 tax revenues. As a result, net domestic assets of the banking system increased by 16 percent and net credit to the general government expanded by 21 percent, both in terms of beginning-of-period broad money, while broad money grew at twice the rate of nominal GDP. The BCV began to tighten its monetary stance late in the year, raising the rediscount rate by 100 basis points to 9.5 percent in December 2000, and further to 11.5 percent in April 2001.

8. Expansionary fiscal and monetary policies in 2000, combined with the decline in donor inflows, led to substantial pressure on the exchange rate peg. Despite a modest reduction in the external current account deficit, lower privatization receipts and donor inflows led to an overall balance of payments deficit of 8½ percent of GDP in 2000, financed by a sizable draw down of official reserves (US$16 million) and the accumulation of external arrears (US$26 million). International reserves of the BCV fell to the equivalent of 1.1 months of imports. Despite the recent deterioration in the macroeconomic situation, international competitiveness has remained strong, with exports continuing to grow rapidly.

9. Little progress was made on the structural front in 2000, as preparations for the introduction of a value-added tax (VAT), the related tariff reform, and the reform of the budget management system, were delayed. Privatization efforts also slowed while the domestic debt-reduction-operation through the offshore Trust Fund stalled. Expected contributions to the Trust Fund did not materialize on account of shortfalls in both external assistance and foreign exchange receipts from privatizations.

10. Based on preliminary fiscal data and the balance sheets of the commercial and central banks, fiscal policy during the first six months of 2001 remained expansionary, despite the implementation of initial measures by the new government to improve the situation. An overall fiscal deficit (including grants) of CVEsc 3.2 billion (4.7 percent of full year GDP) was recorded during the January-June period, reflecting in part sizable election-related outlays. Domestic revenue collections of CVEsc 6.3 billion (9.3 percent of full year GDP) in the first half of the year were significantly lower than projected, largely as a consequence of: (a) the delayed passage of the 2001 budget (which delayed implementation of necessary revenue measures); (b) slower-than-anticipated economic activity which lowered the revenue base; and (c) start-up delays associated with the reform of the tax payment system initiated in January 2001, which utilizes commercial banks as revenue collection sites. While the new government attempted to hold expenditure within the envelope of revenue collections, unexpectedly large obligations to the petroleum companies to cover the remaining consumer subsidy on petroleum prices and delayed implementation of the reform of the student scholarship program, led to notable expenditure overruns during first half of the year. The overall fiscal deficit (including grants) was financed by an increase in net domestic credit to the government from the banking system of CVEsc 0.6 billion (0.9 percent of annual GDP), net foreign financing of CVEsc 2.7 billion (3.9 percent of annual GDP), the net accumulation of CVEsc 0.8 billion (1.2 percent of annual GDP) in new domestic payments arrears and the net reduction of CVEsc 1.3 billion (1.9 percent of annual GDP) in external debt service arrears.

11. Broad money expanded by 3.6 percent in the first six months of the year, in line with the estimated increase in nominal GDP, and was driven to a large degree by the 1.4 percent increase in net credit to the central government and 3.2 percent increase in credit to the private sector (as a share of beginning-of-period broad money). Net international reserves of the Bank of Cape Verde increased by €1 million (or US$0.9 million) during the first half of the year (to a level of € 30 million, or US$26 million), reflecting an important stabilization of reserves. The new government successfully concluded negotiations with the Portuguese government in July to refinance/reschedule the government's bilateral bridge loan arrears (€ 17 million, or US$15 million), the credit line (€ 15 million, or US$13.2 million), as well as other Portuguese external debt arrears and debt service obligations falling due in 2001. The concomitant reopening of the credit line, provided by the Portuguese government to support the peg and the bilateral convertibility agreement, substantially strengthened the exchange rate regime.

12. In recognition of the serious deterioration in the macroeconomic situation, the new government is committed to a substantial reduction in the overall fiscal deficit in the second half of 2001, proposing a comprehensive package of revenue-enhancing and expenditure-reducing measures in the budget, which was sent to the National Assembly in May. As a major first step, even before submitting the budget to the legislature, the authorities felt it was necessary to reduce consumer price subsidies on petroleum products, and, accordingly, increased petroleum prices at the pump by some 20-25 percent in early March. They also announced that, with World Bank technical assistance, they intended to introduce a mechanism for automatic and frequent adjustments based on world prices by the end of the year. The budget was subsequently passed by the National Assembly in July. However, a number of key tax revenue measures, projected to increase tax revenue by some CVEsc 300 million in 2001, were not approved by the legislature.1 As a result, the approved budget law required the government to take additional executive actions to increase revenues and/or limit expenditure during the remaining five months of the year. These measures are discussed in section III.

13. Over the last three years, external debt has been rising continuously as a share of GDP, from 44 percent at end-1998 to 52.5 percent at end-2000. Almost all of the additional external debt has been incurred vis-à-vis the World Bank and the African Development Bank, to which 56 percent of the total outstanding debt at end-2000 is owed. Bilateral debt represents 27 percent of total debt. At the same time, and more important for the current balance of payments difficulties, external debt service increased from 7 percent of exports of goods and nonfactor services and private transfers in 1998 to 17 percent in 2000.

III. Program for August-December 2001

14. The government's key priorities for the remainder of 2001 are to stabilize the macroeconomic situation and begin to put in place certain key economic reforms. Successful implementation of this short-term agenda will provide a solid basis for a more comprehensive program aimed at private sector-led growth and decreasing poverty over the medium term. The main macroeconomic objectives for the period immediately ahead are to: (a) maintain real economic growth in the range of 3-4 percent for the year as a whole; (b) limit inflation in 2001 to 5 percent; and (c) increase net international reserves of the Central Bank of Cape Verde (BCV) by some € 3 million (or US$2.6 million) by the end of 2001.

15. To achieve these objectives, the government is determined to tackle the current difficult public finance situation and to accelerate the implementation of key structural reforms. The government is committed, in this regard, to substantially reducing the excessively expansionary fiscal stance experienced in recent years through the adoption of a comprehensive package of revenue-enhancing and expenditure-reducing measures. This will be accomplished within the limited financing available from international donors and the banking system, without the accumulation of new external payments arrears, limiting the accumulation of domestic arrears to CVEsc 0.3 billion during the program period. Achievement of these objectives is expected to quickly improve the confidence of the private sector—particularly with the payment without delay of government financial obligations—and of international donors.

16. The government, at the same time, recognizes that the independence of the central bank is key to ensuring macroeconomic stability and the viability of the exchange rate peg and is committed to enhancing BCV's independence in the near term. To increase the productivity of the remaining public enterprises, as well as attract necessary foreign and domestic private investment, the government is also committed to accelerating the privatization program, with assistance from the World Bank and other donors.

A. Fiscal Policy

17. The government recognizes the need to address the unsustainable fiscal policies pursued over the past 24 months. The fiscal policy measures outlined below will reduce the overall fiscal deficit (including grants) from 12 percent of GDP last year (excluding bank restructuring costs) to about 5½ percent this year. This will be achieved through a combination of sizable—but realistic—reductions in expenditures and moderate increases in revenues, reflecting both the impact of the measures already approved by the National Assembly in July in the context of the 2001 budget and additional ones discussed below. In order to assure the government's ability to pay, in a timely manner, all authorized expenditures, the Treasury will prioritize spending and ensure the availability of resources prior to the making of expenditure commitments.

18. Domestic revenue is targeted to increase to CVEsc 13.4 billion in 2001 (19½ percent of GDP), reflecting considerable improvements in the collection of taxes during the program period. In particular, during the second half of 2001, the government forecasts total domestic revenue of some CVEsc 7.1 billion, representing an increase of 12½ percent over the first six months of the year, which in part reflects the seasonality of tax revenue. Since the National Assembly rejected the government's request to raise some targeted taxes on cars, tobacco, and alcoholic beverages, the government is instead implementing a package of nontax revenue measures in order to close the corresponding financing gap in the budget. These include (a) an increase in the customs users fee from 7 percent to 8 percent (generating about CVEsc 50 million in additional revenues during the program period); (b) an increase in the airport transit fee for international travel from US$10 to US$25 (additional yield of CVEsc 115 million); and (c) an increase in profit transfers from select public enterprises, representing the sales of remaining equity share holdings in certain public utilities. In addition, the government will be working closely with the commercial banks to improve the implementation of the new tax collection system which should allow for a sizable increase in direct tax revenues in the third and fourth quarters, particularly with regard to corporate taxes, which are largely paid in the third quarter. Furthermore, the government expects capital participation by the private sector in infrastructure projects to increase in the second half of the year, as the pace of projects accelerates. The government is also committed to implementing the remaining measures which will allow the provision of CVEsc 700 million in budget support from the European Union before the end of the year.

19. Given the sizable expenditure overruns recorded in some areas in the first half of the year, largely related to the petroleum price subsidies and the student loans, the government intends to implement a number of expenditure reforms to contain spending during the program period. Taking into account the impact of these additional measures, primary current expenditure for the year as a whole, is expected to decline from 24½ percent of GDP in 2000 to 19 percent in 2001, with primary current expenditures during the second half of the year being limited to CVEsc 6.7 billion. This sizable consolidation will be achieved through the implementation of the following measures: (a) further price increases in selected administrative petrol prices (CVEsc 300 million) to reduce consumer subsidies;2 (b) the reduction in transfers to public institutes by 10 percent for the remainder of the year (CVEsc 25 million); (c) the reduction in the loans granted to students enrolled in Brazilian universities by 50 percent (CVEsc 80 million); (d) the freezing of nonessential government travel (CVEsc 10 million); and (e) constant nominal government salaries during 2001.3 At the same time, the government is committed to protecting expenditures associated with core social sector activities and will work with international donors to maintain social sector expenditures at levels recorded last year. In this regard, the government is committed to working with EMPA to accelerate the generation and payment of counterpart funds associated with the sale of donated food products for social and public investment projects.

20. Even with the sizable reduction in expenditures, an overall fiscal deficit (including grants) of some 5.4 percent of GDP is projected for 2001. Limiting the government's recourse to domestic bank financing to CVEsc 1.3 billion (equivalent to 1.9 percent of GDP), consistent with the monetary program, the government will finance the remaining gap through: (a) net donor disbursements of CVEsc 1.2 billion; (b) the sale of CVEsc 0.1 billion in Treasury bills to nonbank institutions; (c) domestic debt issuance vis-à-vis the private sector of about CVEsc 0.8 billion related to the regularization of 2001 domestic arrears; and (d) accumulation of domestic arrears of CVEsc 0.3 billion during the program period. While the government is committed to accelerating the privatization program (as discussed below), no net privatization receipts are currently anticipated in 2001.

21. The government will continue to support higher education in Cape Verde, but recognizes the unsustainable nature of the current system of funding student loans, the responsibility for which it assumed from the formerly public banks in July 2000. The government is in the process of fundamentally reforming the system, with the objective of: (a) ensuring qualified Cape Verdean students' ability to pursue a higher education; (b) ensuring the beneficiaries' commitment and ability to repay student loans in a timely manner; and (c) reducing the related obligations by the Treasury. To achieve these goals, the government intends to encourage the development of commercial bank financing mechanisms. Concomitantly, the government is seeking technical assistance to develop a self-financing autonomous higher education fund that would limit the Treasury's obligation to interest subsidies to poor and meritorious students.

22. The new government is committed to improving the productivity of public expenditure and its targeting to high priority social sector activities and infrastructure. As a first step, the government will undertake a comprehensive public expenditure review (PER), with support from the World Bank, which will analyze the composition and adequacy of expenditures, particularly focusing on the social sector. The authorities will use this information in the preparation of the medium term poverty reduction strategy. A draft PER is expected to be completed by mid-2002, depending on the availability and timing of donor financing.

23. The government will not accrue any new external payment arrears during the program period. It will limit the accumulation of domestic arrears to CVEsc 0.3 billion, and will eliminate the outstanding stock of domestic payment arrears through the restructuring of its arrears with the domestic oil companies into medium-term debt instruments at market interest rates. With respect to external debt service arrears, the government will eliminate one-half of the arrears that accumulated during the first half of the year with multilateral institutions (CVEsc 91 million). The remainder will be cleared in 2002.

24. Budget management and expenditure control remain a key concern. To better control day-to-day commitments by central government entities, the Ministry of Finance has prepared a monthly cashflow budget for the remainder of 2001, and will provide government ministries and other central government entities monthly expenditure allotments on the first day of each month, based on the previous month's revenue collections, within which the agencies will operate. The monthly cashflow will be updated at the end of each month based on current revenue flows and include all central government transactions. To improve expenditure management in the near term, the government has requested urgent technical assistance from the IMF and key bilateral donors. In this regard, the government approved in July a comprehensive budget management and monitoring law which will allow the Ministry of Finance to strengthen its budget operations, management and auditing, with full implementation targeted for January 2002. Implementing this new management and control system will require sizable technical assistance. In coordination with the BCV, the government will prepare monthly public finance statements consistent with monetary statistics and will transmit them to the IMF at the latest within two weeks after the end of the month concerned to help monitor fiscal developments.

25. The 2001 budget gives priority to resources earmarked for the education and health sectors and to other poverty-reducing spending. In this context, efforts will be made to ensure that budget allocations for these sectors are protected from any across-the-board cuts, so as to maintain adequate levels of intervention. The government intends to approach its development partners, with a view to obtaining additional financial support for these sectors.

26. The government inherited a generous system of custom and tax exemptions for a wide variety of sectors. While the government continues to support the exemption from taxes and duties for certain high-priority sectors that are important to increasing Cape Verde's growth potential, it intends to review and rationalize the practice in the context of preparing the new external tariff regime (discussed below).

27. Structural measures in the fiscal area aim at broadening the tax base and strengthening revenue collection. With the technical assistance of the IMF and support from the World Bank, the government is preparing the introduction of a value-added tax (VAT) in conjunction with a streamlining of the external tariff regime. The revenue impact of the proposed changes will be incorporated in the 2002 budget. Envisaging the new tax and tariff rates to be effective as of July 1, 2002, the organic VAT and external tariff laws will be approved by the Council of Ministers in September and submitted to the National Assembly in October 2001. At the same time, the government will reorganize its revenue administration within the Ministry of Finance to include a new VAT office and begin training staff in the fourth quarter of this year, with the assistance of the IMF, the World Bank and other donors. In addition, the government intends to mount a country-wide sensitization program to inform the public of the benefits of an indirect tax system, the lowering of average import duty rates and a simplified external tariff system.

B. Monetary and Financial Sector Policy

28. Complimenting the fiscal efforts, monetary policy during August-December 2001 aims at stabilizing the macroeconomic situation and supporting the exchange rate peg. In the context of the sizable consolidation of the fiscal position programmed for the remainder of the year, net domestic assets of the banking system are projected to rise by 5.6 percent (as a share of beginning-of-period broad money) in 2001, while net credit to the central government is programmed to increase by 3.1 percent (also as a share of beginning-of-period broad money). The reduction in the growth of net credit to the central government should allow for an expansion in credit to the private sector in the range of 4 percent (in terms of beginning-of-period broad money), while broad money—assuming unchanged income velocity—is expected to expand by 6.3 percent, in line with nominal GDP growth. The central bank is committed to actively utilizing the monetary instruments at its disposal (discount rates, open market operations and the newly-created liquidity absorption facility) to control liquidity and achieve the monetary targets established under the program. Net domestic assets of the BCV are programmed to increase by CVEsc 0.4 billion from end-June to end-September 2001 and by a further CVEsc 0.1 billion from end-September to end-December 2001. Net domestic credit to the central government is programmed to increase by CVEsc 0.5 billion from end-June to end-September 2001 and by a further CVEsc 0.2 billion from end-September to end-December 2001. On an indicative basis, net international reserves of the BCV are projected to increase by €1 million (US$0.9 million) from end-June to end-September 2001 and by a further €1 million by end-December 2001.

29. The government believes that a fully independent central bank is necessary to ensure macroeconomic stability and support the exchange rate regime and is committed to granting the BCV such independence in the near term. The government and BCV are currently reviewing the central bank organic law, with technical assistance from the IMF, as well as other relevant legislation. A revised central bank law, as well as any additional legislative changes necessary to ensure the BCV's independence, is scheduled to be approved by the Council of Ministers in November and submitted to the National Assembly in December 2001.

C. Structural Policies

30. The government will complete, with the support of the World Bank, a study on the retail pricing of petroleum products by end-November 2001, with the objective of implementing a market-based pricing mechanism which allows for frequent price changes. The study will: (a) document the cost structure of petroleum product importation and distribution in Cape Verde; (b) analyze the social equity and economic efficiency of the current oil pricing mechanism; and (c) make recommendations on improvements in the timely and transparent adjustments in domestic prices to world market prices. A market-based oil price mechanism based on these recommendations will be introduced within 3 months after the report is completed (February 2002), eliminating any remaining subsidies.

31. The government is firmly committed to restarting the comprehensive privatization program which stalled last year.4 It is committed to accelerating the divestiture of the following enterprises in the second half of 2001: the food import and distribution company (EMPA), the municipal transport operator (TRANSCOR), the national airline (TACV), the ship repair facility (CABNAVE/CABMAR), the inter-island shipping company (ARCA Verde), and two fishing service firms (INTERBASE and SALMAR). The government expects to bring TACV and TRANSCOR to a satisfactory stage for divestiture before the end of the year. Given the substantial restructuring costs associated with these enterprises, the government is seeking financial support from its key bilateral and multilateral partners, but will nonetheless move forward with divestment in light of the rapid accrual of contingent liabilities associated with these entities. The government will prepare a letter of commitment regarding its plans for EMPA by end-September 2001.

32. The government will accelerate its efforts to complete the donor-supported domestic debt-reduction operation initiated in 1998. Given the sizable remaining financing requirements, and the setbacks experienced last year when the macroeconomic program went off-track, the government intends to host a donor round table during the fourth quarter of this year to discuss a realistic medium-term strategy and timetable for completing the much-needed debt reduction operation. The government will use any net foreign exchange proceeds from the sales of public enterprises to reduce domestic debt through the Trust Fund. In addition, as the fiscal situation allows, the government will reduce the new stock of domestic debt built up since the initiation of the debt reduction operation.

D. Poverty Reduction Strategy

33. The government is currently undertaking a strategic exercise to help focus its program in the fight against poverty, which had been embodied in the National Development Plan 1997-2000. It is currently developing an action plan, with technical assistance from UNDP, to organize the work program that will substantiate their poverty reduction strategy. The action plan, titled "The Grand Options for Cape Verde," will be completed by October 1, 2001 and serve as the basis for the government's Interim Poverty Reduction Strategy Paper (I-PRSP). The I-PRSP will be completed by end-November 2001. The full poverty reduction strategy will be developed in consultation with key stakeholders in Cape Verdean society: the poor, business, government, NGOs, donors, and other representative groups. It will focus on the social sectors (education, health, the environment, social security, etc.), the private sector, the macroeconomic framework, and other specific issues of relevance, such as donor resource mobilization and coordination. The PRSP will be an extension of the 1998 National Poverty Alleviation Plan (NPAP), and will benefit from preliminary results of the updated national Household Expenditure Survey that is expected to be completed in 2002. The government will ensure that the strategy and policies proposed in the PRSP are consistent with the medium-term macroeconomic policy framework and potential financing commitments.

E. External Sector Policies

34. A key objective of Cape Verde's external policy is to enhance external competitiveness and promote non-traditional exports in order to achieve external viability and strengthen growth prospects. In particular, opportunities presented as a result of the recent granting of duty-free access to the U.S. market for African countries will be vigorously pursued, including through the attraction of foreign private investment for light industry, particularly in the area of textiles. The current external account deficit (excluding official transfers) is expected to narrow from 12 percent of GDP in 2000 to 8 percent of GDP in 2001, mainly on account of strong growth in exports of goods and tourism, and a modest increase in imports (in terms of the euro). The government is aware that the pursuit of prudent fiscal and credit policies, as well as the implementation of the envisaged structural reforms, will be key to achieving the strengthening of Cape Verde's external position.

35. The authorities will seek to normalize relations with external creditors and, toward this end, will remain current on all external debt service obligations over the program period, while eliminating one half of the multilateral arrears accrued in January-June 2001 by the end of the year. The government has initiated discussions with bilateral donors to reschedule the outstanding stock of external payment arrears and current obligations falling due this year and expects to conclude negotiations with several agencies before the end of the year. In this regard, in addition to the recent bilateral rescheduling agreement concluded with Portugal, Cape Verde's outstanding stock of public external debt with China has recently been forgiven (estimated at US$13½ million). The government intends to eliminate remaining external payments arrears in 2002 in the context of a program which could include rescheduling arrangements as well as cash payments. In addition, given the already high level of Cape Verde's external public debt, the government will refrain from contracting any nonconcessional debt over the program period. The Ministry of Finance is committed to improving its management of public sector external debt, and in the first instance will work to improve its database on debt and debt service. The Ministry of Finance will also begin collecting data in preparation for a comprehensive debt sustainability analysis which will be completed, with IMF technical assistance, by end-November 2001.

36. The government intends to streamline its external tariff regime in 2002, with lower average rates. The new tariff structure will be streamlined into 7 tariff bands ranging from zero to fifty percent, with a lower average rate.5 This new tariff regime will be introduced in conjunction with the VAT, with IMF and other donor technical assistance, in 2002. The introduction of the VAT and lowering of tariff rates will be revenue neutral.

IV. Medium-Term Outlook

37. A comprehensive medium-term macroeconomic framework will be developed in the context of the government's strategic action plan discussed above. The framework will serve as a key input into the I-PRSP and the government's medium-term program and will be discussed in detail with IMF staff during the review of the SMP. Given the unsustainable fiscal position, including the public debt overhang, the macroeconomic framework will necessarily focus on the fiscal aspects, including a sizable—but realistic—reduction in the overall fiscal deficit. Potential measures to increase significantly domestic revenue will include introduction of the VAT and subsequent expansion of its coverage, as well as measures to improve tax administration and reduce tax exemptions. Grant budget support could also increase markedly. The fiscal framework will include a road map to reduce expenditure markedly, with the elimination of the petroleum price subsidy, a reduction in the wage bill (through civil service reform), and reduced interest obligations. Alternate scenarios for the medium-term fiscal framework will be developed based on assumptions regarding the degree of concessional financing available. The 2002 budget will be prepared in October and November 2001, in the context of this medium-term macroeconomic framework, and discussed with the Fund staff at the time of the first review of the SMP.

38. While economic activity is expected to slow somewhat in 2001, partially reflecting the return to more normal crop production following the bumper crop experienced in 1999/2000, real GDP growth over the medium-term could increase to an average annual rate of some 5 percent, reflecting strong private sector investment and improvements in basic infrastructure which will boost tourism and the nascent export sector. With more moderate fiscal and monetary policies, inflation could be reduced to that of the euro zone over the medium term. At the same time, increased net exports and strong foreign private investment, combined with continued strong donor support, should bring about a strong recovery in gross international reserves over the 2001-2004 period.

V. Program Monitoring and Technical Assistance

39. A key ingredient in ensuring the success of the program will be the government's ability to adequately monitor performance. In this regard the government will work to improve the quality and timeliness of key economic and financial statistics, including national accounts and the CPI. The government has established an inter-agency program monitoring committee, including the central bank, to review monthly fiscal and monetary developments and to prepare monthly reports to the Minister of Finance on performance under the SMP. To improve its capacity to implement the program, the government will seek required capacity building technical assistance in the areas of macroeconomic policy development, budget management and expenditure control, tax policy and administration and economic and financial data collection from key multilateral and bilateral technical assistance agencies. Implementation of the program will be improved by the early provision of this important technical assistance.

40. To help monitor performance under the program, the government has established quantitative benchmarks for end-September and end-December 2001 (see Table 1 attached), including (a) a ceiling on net domestic assets of the central bank; (b) a ceiling on net credit to the central government from the banking system; (c) a zero ceiling on new public and publicly-guaranteed nonconcessional external borrowing; (d) a zero ceiling on the accumulation of external payments arrears; and (e) a ceiling on accumulation of domestic payments arrears, as specified in Table 1. In addition, the program includes an indicative target on quarterly floors on net international reserves of the central bank. Structural benchmarks have been established for (a) the approval of VAT legislation by the Council of Ministers by end-September 2001; (b) the submission of VAT legislation to the National Assembly by end-October 2001; and (c) the approval by the Council of Ministers by end-November 2001 of the revised central bank organic law, and other necessary legislation, to increase the independence of the central bank. The government will also complete a study by end-November 2001, with World Bank support, on retail pricing of petroleum products, including an action plan to introduce a mechanism for frequent changes in retail pricing of petroleum products based on world-market prices. The mid-term review under the SMP will be completed by end-November 2001.

41. The government will keep the Fund informed of the progress in the implementation of the SMP. The government undertakes to provide the IMF staff at the end of each month the budget cash-flow tables, the monetary survey, a report on revenue payments, external debt data, and all of the customary data on economic and financial developments. The data will be transmitted to the Fund no later than 45 days after the end of each month. Details of all new external borrowing, including central government guarantees indicating terms of loans and creditors, domestic and external payments arrears, and on the status of all structural reform measures undertaken by the government will be provided on a monthly basis no later than 45 days after the end of each month. The Technical Memorandum of Understanding describing in more detail the performance benchmarks under the program is attached as Annex I.

1Tax increases require a two-thirds majority in the National Assembly.
2The government will increase the price for "non-taxed" diesel-which is used, among other things, for the production of electricity-by 43 percent, for "taxed" diesel by 20 percent and for gasoline by 11 percent.
3This policy stance is in line with an agreement reached with the labor unions, according to which government salaries are increased by the expected inflation rate (5 percent) adjusted by the forecast error made in the previous period (- 5 percent).
4The privatization program was initiated in 1997 with World Bank support.
5Under the current regime, the current maximum and average tariff rates are 250 percent and 25 percent, respectively, including multiple import duty rates. These are complemented by a consumption tax (3-10 percent) and a customs fee of 7 percent.

Table 1. Cape Verde: Quantitative and Structural Benchmarks Under the Staff-Monitored Program1,2

Dec. Act.
Culmulative flows
from end-Dec. 2000

Jun. Est.
  Culmulative flows
from end-June 2000

  Sep.   Dec.
Program Benchmarks

    (In billions of Cape Verde escudos)
I.  Quantitative Benchmarks                
1.  Ceiling on net domestic credit to the central
     government from the banking system3
  11.6    0.6   0.5   0.7
2.  Ceiling on net domestic assets of the
     central bank3
    9.5   -0.1   0.4   0.5
3.  Ceiling on the accumulation of domestic
     payments arrears by the central government4
    1.5    0.8   0.2   0.3
4.  Ceiling on the accumulation of new external
     debt arrears by the central government4
    3.0    0.4   0.0   0.0
5.  Ceiling on new public and publicly-guaranteed
     nonconcessional external borrowing
     (excluding normal trade credits)
    0.0    0.0   0.0   0.0
(In millions of euros)
Memorandum item:  
Floor on net international reserves of the Bank of
   Cape Verde (BCV)5
  29.2    0.9   0.9   1.9
        Test Date
II.  Structural Benchmarks        
1.  Approval of VAT legislation by the Council of
        end-September 2001
2.  Submission of VAT legislation to
     National Assembly
        end-October 2001
3.  Approval by the Council of Ministers of
     revised central bank organic law, and other
     necessary legislation, to increase the
     independence of the central bank.
        end-November 2001

Sources: Cape Verde authorities; and staff estimates and projections.
1Quantitative performance criteria are described in the Technical Memorandum of Understanding (Annex I).
2Program exchange rates are CVEsc 110.3 = EUR 1 and CVEsc 125 = US$1.
3The ceiling will be adjusted upward (downward) by the cumulative downward (upward) deviations from program assumptions about non-project disbursements from World Bank (EUR 0 million), European Union adjustment grants (EUR 7 million in Q4), and the Portuguese credit facility (EUR 5 million in Q3). Maximum cumulative adjustment not to exceed EUR 3.5 million.
4For 2001 program, cumulative benchmarks from end-July 2001 (instead of end-June 2001).
5The indicative floor on net international reserves of the BCV will be adjusted downward (upward) by the cumulative downward (upward) deviationsfrom program assumptions about non-project disbursements from World Bank (EUR 0 million), European Union adjustment grants (EUR 7 million in Q4), and the Portuguese credit facility (EUR 5 million in Q3). Maximum cumulative adjustment not to exceed EUR 3.5 million.

Technical Memorandum of Understanding
for the August-December 2001 Staff Monitored Program

This memorandum sets out the understandings between the Cape Verdean authorities and the IMF staff regarding the definition of the quantitative and structural performance benchmarks under the August-December 2001 staff-monitored program (SMP).


A. Net Domestic Assets of the Central Bank

1. Net Domestic Assets (NDA) of the Banco de Cabo Verde (BCV) are defined as reserve money minus net foreign assets of the BCV, adjusted for valuation changes arising from the difference between the program and the actual exchange rates. The program ceilings for NDA will be adjusted upward (downward) by the cumulative downward (upward) deviations from program assumptions about nonproject disbursements from the World Bank, European Union adjustment grants and the Portuguese credit facility. The maximum cumulative adjustment will not exceed €3.5 million.

B. Net Bank Credit to the Central Government

2. Net bank credit to the central government is defined as the overall position of the main central government institutions vis-à-vis the banking system, i.e. the stock of all outstanding claims on the central government (loans, advances, and all other government debt instruments such as long term government securities) held by the banking system less all deposits held by the central government with the banking system. The INPS (the social security agency) is not included in central government accounts. Net bank credit to the central government excludes claims on the Trust Fund (TCMFs). The program ceilings for net bank credit to the government will be adjusted upward (downward) by the cumulative downward (upward) deviations from program assumptions about nonproject disbursements from the World Bank, European Union adjustment grants, and the Portuguese credit facility. The maximum cumulative adjustment will not exceed €3.5 million.

C. Ceiling on Nonconcessional External Debt Contracted or Guaranteed
by the Central Government

3. Nonconcessional external borrowing (including lease-purchase agreements) is defined as loans with a grant element of less than 35 percent, calculated using currency-specific commercial interest reference rates. Debt rescheduling and debt reorganization are excluded from the limits on nonconcessional external borrowing. Nonconcessional external borrowing will be zero throughout 2001. Public sector is defined to include the Government of Cape Verde, the Banco de Cabo Verde, publicly-owned enterprises, or any other agency acting on behalf of the government. The definition of nonconcessional external borrowing excludes normal trade financing and the Portuguese Government precautionary credit line in support of the exchange rate peg.

D. Net International Reserves of the Central Bank
(not a performance benchmark)

4. Net international reserves (NIR) of the Banco de Cabo Verde (BCV) are defined as gross international reserves of the BCV net of its short-term external liabilities. Gross reserves of the BCV are those that are readily available (i.e., liquid and marketable and free of any pledges or encumberments), controlled by the BCV, and held for the purposes of meeting balance of payments needs and intervening in foreign exchange markets. They include gold, holdings of SDRs, the reserve position at the IMF, holdings of foreign exchange and traveler's checks, demand and short-term deposits at foreign banks abroad, fixed-term deposits abroad that can be liquidated without penalty, and any holdings of investment grade securities. External liabilities of the BCV comprise liabilities to nonresidents contracted by the BCV with an original maturity of less than a year, any net off-balance-sheet position of the BCV (futures, forwards, swaps, or options) with either resident and nonresidents, and any arrears on principal and interest to external creditors and suppliers. The program floors for net international reserves will be adjusted downward (upward) by the cumulative downward (upward) deviations from program assumptions about nonproject disbursements from the World Bank, European Union adjustment grants, and the Portuguese credit facility. The maximum cumulative adjustment will not exceed €3.5 million.

E. Accumulation of New Domestic Payment Arrears

5. The government will limit the accumulation of new domestic payment arrears to CVEsc 0.3 billion during the program period. This will be monitored through the monthly execution of the cash-flow plan and the corresponding release of budget appropriation. For programming purposes, a domestic payment obligation is considered an arrear if it has not been paid within 60 days of the receipt of the goods and services, and 30 days for government salaries and debt services.

F. Nonaccumulation of External Debt-Service Arrears

6. As part of the program, the government will not accumulate any new external payment arrears, on a continuous basis. This will be monitored through the monthly execution of the cash-flow plan and the corresponding release of budget appropriation.

G. Program Exchange Rates and Nonproject Budgetary Support

7. Performance under the program will be assessed based on program exchange rates. The program exchange rates for this purpose are: CVEsc 110.3 = €1 and CVEsc 125 = US$1.

8. The program assumes €7 million in nonproject budget support will be provided by the European Union during the fourth quarter of 2001 and €5 million will be drawn from the Portuguese credit facility in September 2001. No nonproject disbursements by the World Bank are assumed during the program period.

1See Table 1 of the Memorandum of Economic and Financial policies (MEFP).
2The data source used to evaluate the monetary and net international reserve benchmarks will be the Cabo Verde—Panorama Bancario tables prepared monthly by the BCV Statistics and Research Department and forwarded electronically to the IMF Statistics Department.