The Federal Democratic Republic of Ethiopia and the IMF

News Brief: IMF Completes Ethiopia's Review Under the PRGF and Approves US$22 Million Disbursement
August 2, 2001

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Ethiopia—Letter of Intent

May 29, 2001

The following item is a Letter of Intent of the government of Ethiopia, which describes the policies that Ethiopia intends to implement in the context of its request for financial support from the IMF. The document, which is the property of Ethiopia, is being made available on the IMF website by agreement with the member as a service to users of the IMF website.

Use the free Adobe Acrobat Reader to view the Tables (28 kb PDF file)

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

Dear Mr. Köhler:

1.  With Ethiopia's emergence from the border conflict with Eritrea, the government resumed its economic reform efforts and renewed its commitment to poverty reduction within a framework of macroeconomic stability, as laid out in its interim poverty reduction strategy paper (I-PRSP) of November 2000. These reform efforts are supported by the three-year arrangement (approved on March 22, 2001) under the Poverty Reduction and Growth Facility (PRGF). In accordance with the provisions of the arrangement, the government of Ethiopia, in cooperation with the staff of the International Monetary Fund, has evaluated the implementation of the first annual economic and financial program adopted for the period October 2000-September 2001.1 We focused on the progress made in implementing the program during the first nine months of the fiscal year 2000/01 and on the prospects and policies to be pursued during the remainder of the program year, in light of the objectives set forth in the memorandum on economic and financial policies for 2000/01-2002/03, dated January 29, 2001. The government intends to make the contents of this letter available to the public and authorizes you to arrange for it to be posted on the IMF website, subsequent to Executive Board approval.

2.  As you will appreciate, performance under the program was broadly satisfactory, notwithstanding delays in the disbursement of external financial assistance, and continued deterioration of the terms of trade. All the quantitative and structural performance criteria and benchmarks under the program through March 31, 2001 have been observed (Tables 1 and  2). The government is also determined to meet the remaining performance criteria and benchmarks through July 2001 and the prior actions set in this letter (Table 3). Following the completion of the first review under the PRGF arrangement by the Executive Board, the government requests the second disbursement of SDR 17.381 million under the arrangement.

3.  As envisaged in the memorandum of January 2001, understandings were reached on performance criteria for end-September 2001, in light of the updated budgetary policy framework for 2001/02. Quantitative benchmarks for end-December 2001, as well as indicative targets for March 2002, were also established. In addition, in the context of this first review, (i) the progress in implementing reforms in monetary and exchange markets and in the financial sector was assessed; (ii) the government has adopted a medium-term reform agenda for the financial sector; and (iii) an action plan for the reduction of trade protection during the remainder of the PRGF arrangement period was specified. The government remains committed to implementing all of the policies described in the memorandum of January 29, 2001, supplemented by this letter.

Progress made during the first nine months of 2000/01

4.  Considerable progress was made towards restoring peaceful conditions between Ethiopia and Eritrea. On December 12, 2000, Ethiopia and Eritrea signed a peace agreement, and to date, Ethiopia has demobilized close to 63,000 soldiers. On April 18, 2001, a 25-kilometer Temporary Security Zone was established between the two countries.

5.  As described in the January 2001 memorandum and the I-PRSP, the medium-term economic strategy seeks to promote rapid, broad-based and equitable growth by emphasizing rural development and improvement in physical and human capital, and addressing immediate post-conflict reconstruction and reintegration needs. In the context of this strategy, the PRGF-supported program for 2000/01-2002/03 focuses on four policy components: (a) the reorientation of budgetary resources from defense toward poverty alleviation outlays; (b) tax reforms that lay the foundation for strong revenue performance; (c) improved monetary management and financial sector reform; and (d) capacity building and regulatory reforms to promote private sector development. In the context of this strategy, the first annual program, straddling the two fiscal years 2000/01 and 2001/02, (a) assumes an acceleration of real GDP growth from 5.3 percent in 1999/2000 to 7-8 percent; (b) aims at maintaining consumer price inflation close to 5 percent, up from around 4 percent in 1999/2000; and (c) seeks to increase reserve cover from 2 months of the following year's imports of goods and nonfactor services as of July 2000 to 2½ months by July 2001, and further to 3½ months by July 2002.

6.  On the whole, economic developments during the first nine months of 2000/01 were satisfactory. Reflecting a bumper cereal crop, agricultural output is estimated to increase by 13.2 percent in 2000/01. However, nonagricultural economic activity appears to have recovered more slowly than anticipated, and nonagricultural GDP would rise only by about 3 percent. As a result, total real GDP growth rate for 2000/01 is estimated at 7.5 percent, close to the program projection. Coffee exports (which account for 50 percent of merchandise exports) for the first nine months of 2000/01 are estimated at 62,600 tons, compared to a level of 75,100 tons in the same period of 1999/2000. Coffee export prices also fell by 17 percent during that period. As a result, total exports are lower than expected despite the strong performance of non-coffee exports. With a slower-than-anticipated pace of project implementation, imports are also lower than projected. The combined effects of large inflow of food aid, a bumper crop, and a less than expected depreciation of the local currency resulted in an average annual consumer price inflation in the first nine months of 2000/01 of negative 3 percent.

7.  In the fiscal area, the original program aims at reducing the overall budget deficit (including grants, but excluding the emergency programs) from 11.5 percent of GDP in 1999/2000 to 6.4 percent in 2000/01, and to 5.4 percent of GDP in 2001/02. Higher tax revenues, lower defense-related spending, and restraint on non-priority current expenditure would strengthen the fiscal position while allowing substantial increases in capital and social spending. Although overall fiscal performance during the first nine months of 2000/01 has been satisfactory, the government has had to deal with a tight treasury situation, resulting from revenue shortfalls, and uncertainty on the disbursements of program aid, as well as difficulties in accelerating capital spending. The implementation of the emergency programs, projected at 1.9 percent of GDP in 2000/01, has been slower than expected because of delays in disbursement of external assistance.

8.  The government has embarked on comprehensive tax policy reforms and an overhaul of tax administration. By December 2000, the rate of the sales tax was increased from 12 percent to 15 percent, and the 10 percent import duty surcharge was removed. By February 2001, new legislation on presumptive taxation and a 5 percent withholding tax on imports became effective. In March 2001, legislation was approved to introduce a taxpayer identification number (TIN) to reinforce the collection power of revenue agencies, and a tax reform implementation task force was established. Despite these efforts, during the first nine months of 2000/01, total revenues were 8 percent lower than programmed, mainly on account of lower domestic sales and excise tax receipts as well as lower non-tax revenue.

9.  On the spending side, the government followed a cautious expenditure management because of uncertainty in the disbursement of program aid, and made a deliberate attempt to slow down defense spending. In May 2001, birr 500 million was reallocated from defense to mostly social outlays. The pace of capital spending was slower than expected. Total expenditure of the general government during the first nine months of 2000/01 was 22 percent lower than programmed. The quantitative performance criteria for end-March 2001 on the domestic financing of the government was met with a wide margin.

10.  In the monetary and exchange areas, the government has started sterilizing excess liquidity, and has taken steps to modernize monetary management, by moving towards market determination of interest and exchange rates. Reflecting lower than projected economic activity and inflation, broad money increased in the first nine months of the year by 3.7 percent, less than half the programmed growth, and credit to the economy rose by 5.4 percent, compared to 14 percent under the program. During the first nine months of the fiscal year, central bank credit to the government declined by 22 percent, nearly twice the rate envisaged under the program, and government borrowing from commercial banks was lower than envisaged.

11.  In order to enhance the use of indirect monetary management and to mop up excess liquidity, the National Bank of Ethiopia (NBE) introduced a 2-year government bond in November 2000, and increased sales of government securities. As a result, commercial banks' excess reserves fell from 29.6 percent of deposits in September 2000 to 7.5 percent at end-March 2001. In response to these liquidity developments, the yield on short-term treasury bills has increased from 2.4 percent in July 2000 to 3.2 percent at end-March 2001. To facilitate liquidity management, the NBE introduced in March 2001 a rediscount facility for eligible government papers.

12.  Trade restrictions and administrative controls on access to foreign exchange were lifted in December 2000, and the weekly foreign exchange auction is beginning to operate more efficiently. At end-March 2001, the value of the birr against the dollar had depreciated by 2.1 percent since the beginning of the fiscal year, despite excess demand for foreign exchange in almost each auction during the period. At end-March 2001, NBE gross foreign reserves were at 2 months of imports cover.

13.  In the area of financial sector reforms, a comprehensive study of the NBE's operational, organizational, and administrative set-up, was started in February and is expected to be concluded in August 2001. The NBE has continued its work on bringing banking prudential regulations generally in line with Basel standards. Against the backdrop of slower-than-anticipated progress in the restructuring of small private banks, the ratio of nonperforming loans to total loans remained between 13 percent and 19 percent at end-March 2001 for at least three of the private banks.

14.  With respect to external debt, all pre-cutoff debt with Paris Club creditors was rescheduled on Naples terms on April 5, 2001. As agreed with Russia on March 13, 2001, the first half of the late payment on the consolidated portion of the debt to Russia was paid in early April, while the second half will be paid in the first week of July. The performance criteria on the non-contraction of new public or publicly guaranteed non-concessional debt and on the non-accumulation of external debt arrears were observed.

15.  At end-March 2001, the NBE issued directives that lifted the previously existing restrictions on the purchase of foreign exchange for holiday travel and education purposes. The weekly wholesale auction conducted by the NBE will be removed on October 1, 2001, when the interbank foreign exchange market is introduced. Over the program period, this auction has not lead to a spread of more than 2 percent between buying rates. The government has requested that the Legal Department of the Fund examine whether the relevant legislation is in compliance with the obligations of Article VIII, Sections 2, 3, and 4 of the Fund's Articles of Agreement.

16.  The government will discuss with Fund staff, in mid-July 2001, the recommendations made in the recent Safeguards Assessment of the National Bank of Ethiopia, including on the improvement of financial data reporting.

17.  In other structural areas, the World Bank is extending technical assistance for a study to identify the main constraints for private sector development, especially regulatory constraints, and the measures needed to address them. The government has continued to work with World Bank staff on key reform areas, including capacity building, and civil service reform. The privatization program has been pursued with the sale of another 7 public entities, during the first nine months of 2000/01, for a total value of U.S. dollars 2.2 million, and putting three entities under private management contract.

Policies during the remainder of the first annual program

18.  Building on the satisfactory results achieved during the first nine months of 2000/01, the government is determined to continue with the steadfast implementation of the program in order to achieve its objectives for 2000/01 and 2001/02. A few revisions in the original macroeconomic projections have been made to take into account developments during the first nine months of 2000/01 and measures outlined in this letter. While growth of agricultural output would return to a more sustainable level, non-agricultural economic activity is expected to pick-up as major capacity building and infrastructure expansion, the privatization of a large number of public enterprises, and further progress in financial sector reform, will create an environment conducive to private sector activity. Real GDP growth, estimated at 7.5 percent in 2000/01, could reach 7 percent in 2001/02. Consumer price inflation is expected to remain low in the last quarter of 2000/01, and to reach negative 2.7 percent in 2000/01, before rising to 5 percent in 2001/02 on yearly-average basis. With both lower than originally projected exports and imports, the current account deficit (including official transfers) is estimated at 5.5 percent of GDP in 2000/01. For 2001/02 the growth in exports and imports should be close to initial projections and the current account deficit is forecast at 6.2 percent of GDP.

19.  In the fiscal area, the government is implementing the measures necessary to limit the overall budget deficit (including grants and excluding the emergency programs) to 4.9 percent of GDP in 2000/01 and to 5.4 percent of GDP in 2001/02. Emergency outlays are now projected at 1.6 percent of GDP in 2000/01 and 2.9 percent in 2001/02, bringing the overall deficit to 6.5 percent and 8.2 percent, respectively, both lower than the original program. The government will continue with its cautious spending policy in the remainder of 2000/01. The Council of Ministers will adopt, by end-June 2001, a budget for fiscal year 2001/02, consistent with the revised fiscal framework presented in this letter. The government is determined to achieve a tax revenue increase of about 0.6 percent of GDP (to 14.4 percent) in 2001/02. To do so, revenue performance will benefit from the full year impact of the measures adopted since January 2001. The government will pursue, with Fund technical assistance, its reform of tax administration with the establishment of a fully operational large taxpayer unit by July 1, 2001, and the submission to Parliament of the new VAT legislation by October 1, 2001. At the time of the second review, the government will consider tax revenue measures as necessary to ensure that the revenue targets under the program are met.

20.  On the expenditure side, the government will pursue its efforts to improve substantially its control, tracking and reporting mechanisms of expenditures at both the federal and regional level. Overall outlays will be budgeted at 32 percent of GDP in 2001/02. Defense outlays will be further cut from 6.9 percent of GDP in 2000/01 to 5.5 percent in 2001/02. Poverty-targeted current and capital spending (including on health, education, and priority infrastructure) are to increase by 20 percent, to 13.5 percent of GDP (from 12.4 percent in 2000/01). Savings in external debt relief derived from the enhanced HIPC Initiative would contribute to this increase. Capital spending is to be accelerated, and the wage bill is to be budgeted at birr 4.2 billion (7 percent of GDP). Within this envelope, the government will assess by the time of the second review under the PRGF arrangement whether a modest general wage increase would be feasible and financeable.

21.  In the monetary and exchange areas, monetary policy will remain geared toward containing inflation and achieving the international reserve targets. The monetary program for 2001/02 has been updated, in light of the revised projections for nominal GDP growth, and with a view to providing room for an adequate increase in credit to the non-government sector. To make market-based monetary instruments more effective, banks' excess liquidity will be further curbed, while the newly established rediscount window will facilitate liquidity management by banks. To increase the foreign exchange markets' efficiency, the NBE will terminate the wholesale foreign exchange auction and move foreign exchange operations to the interbank market by October 1, 2001.

22.  On the basis of a study undertaken with joint technical assistance from the Fund and the World Bank, the government has reviewed its medium-term financial sector reform strategy, aimed at fostering economic development in Ethiopia by offering an attractive range of financial savings instruments throughout the country and providing for an efficient allocation of financial resources to borrowers through active competition. The medium-term reform strategy aims at (i) strengthening the regulatory and supervisory framework; (ii) improving bank soundness; (iii) strengthening private banks' management; (iv) improving the Commercial Bank of Ethiopia's (CBE) management and financial position; (v) further strengthening of market-based money and exchange management arrangements; and (vi) increasing competition in the financial sector. The strategy also envisages reforms in the insurance industry and the promotion of specialized financial services, especially rural financial services.

23.   In the shorter-run, the government intends to (i) take steps to strengthen the NBE, following the ongoing comprehensive study of the NBE, including revision of both the existing Banking Act to increase the autonomy of the NBE, as necessary, and financial relations with the government; (ii) improve bank soundness through the issuance of new provisioning directive by the NBE, the strengthening of the NBE's supervision department to allow it to take regulatory enforcement actions, and an increase in logistic support to the department; (iii) allow a bankers' association to be formally established; (iv) ensure that, with the financial restructuring carried out recently, the Construction and Business Bank (CBB) is brought to the point of sale by December 2001; and (v) on the basis of NBE's supervision findings, develop, as necessary, by November 2001, a restructuring plan to address the weak financial condition of the Development Bank of Ethiopia (DBE). In addition, the NBE intends to remove, by July 15, 2001, the prohibition of payment of interest on current account deposits.

24.  With regard to the CBE, the government issued a tender for a management contract with a reputable foreign institution in January 2001 and is in the process of evaluating the one submission with a view to awarding a management contract by end-June 2001. The terms of the contract to be negotiated would include sufficient commercial autonomy to the management team to take decisions to enable it to transform CBE into an economically viable entity, operated on commercial principles. Ahead of this, the government will, by June 30, 2001, reconstitute the CBE Board to put 3 qualified individuals from the private sector as directors and increase the number of directors from 7 to 10. The government will also issue, by June 30, 2001, government guarantees for the net claims owed by the Commercial Bank of Eritrea to the CBE, and for commercial banks' losses arising from imported goods stranded in Eritrea. In addition, the government will, by October 31, 2001, prepare as necessary a restructuring plan for the CBE that will include (i) adequate loan loss provisioning in accordance with NBE's new provisioning regulations, and (ii) calculation of additional capital to be provided by the government in cash or as an interest-bearing bond, in order to bring the capital ratio of the CBE to the 8 percent minimum capital ratio. Any cost to the budget resulting from restructuring CBE will be assessed at the time of the second review under the PRGF arrangement. To reduce the CBE's market share in loans and deposits, public entities will be encouraged to do business with all banks.

25.  In the external sector area, as noted earlier, the current account deficit (including official transfers) is projected at 6.2 percent of GDP in 2001/02. It is expected that much of the demobilization, reconstruction, and sectoral development effort will continue to be funded by multilateral and bilateral donors, leading to further improvement of the capital account. The balance of payments is also to benefit from recent Paris Club rescheduling agreement. As envisaged under the original program, by July 2002, reserve cover is to increase to 3½ months of imports.

26.  In light of Ethiopia's recently reconfirmed eligibility under the Enhanced HIPC Initiative, the government will revise the debt sustainability analysis by October 2001 in collaboration with Fund and World Bank staff, on the basis of reconciled stock-of-debt at July 7, 2001. The government will also finalize bilateral agreements following the Paris Club meeting on April 5, 2001, and seek at least comparable terms from its non-Paris Club creditors, by December 31, 2001.

27.  The government has decided to reduce, by January 2003, the average (non-weighted) import tariff from an existing level of 19½ percent to 17½ percent, and lower the maximum tariff rate and reduce the number of bands from 7 at present. A study of effective protection will be carried out by March 2002 to ensure that the new tariff structure is the most efficient for the Ethiopian economy.

28.  On other structural reforms, the government, in consultation with the World Bank, will continue to implement key structural measures needed for enhancing the economy's growth potential and reducing poverty. Understandings have been reached with the World Bank on an Economic Rehabilitation Support Credit focusing on public sector management, including civil service reform, public expenditure policy, private sector development, and export competitiveness. The authorities are also strengthening the existing legal and regulatory framework and carrying out a privatization program that aims at bringing to the point of sale 114 public entities (including units of whole enterprises) during the period 2001-2003. The government is determined to ensure good governance and to fight corruption. On May 24, 2001, Parliament passed a bill providing for the establishment of the Federal Ethics and Anti-Corruption Commission to investigate, prosecute, and prevent corruption.

29.  The government intends to complete the preparation of a full PRSP by the first half of 2002, and will strive to produce a quality full PRSP that prioritizes initiatives, includes an analysis of growth and its links to poverty, and elaborates a full-fledged HIV/AIDS strategy. The preparatory process of the PRSP will involve the full participation of local civil society and international development partners. An interministerial steering committee and a secretariat for the preparation of the PRSP have been established in May 2001.

30.  Finally, efforts to improve statistics will be intensified, particularly the reporting of data on a timely basis. The authorities will implement the recommendations of the recent mission from the Fund's Statistical Department, and reconcile the monetary and fiscal accounts. The authorities will continue to improve data on poverty and social indicators, with a view to monitoring the output and outcomes of the poverty reduction programs.

31.  The government believes that the reforms and measures set forth in this letter and in the letter and memorandum on economic and financial policies of January 29, 2001 are adequate to achieve the revised objectives of the first annual program. As envisaged, a second review, to be completed by December 20, 2001, will assess progress in policy implementation and describe the second annual program for the period October 2001-September 2002, and set performance criteria and benchmarks through June 2002.

Sincerely yours,

Sufian Ahmed
Ministry of Finance
Teklewold Atnafu
Governor of the National Bank of Ethiopia

1 The fiscal year ends on July 7.