December 1, 2000

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

Dear Mr. Köhler:

1.  The Executive Board of the Fund approved a three-year Poverty Reduction and Growth Facility (PRGF) arrangement for Mozambique on June 28, 1999. The purposes of this letter and attached memorandum of economic and financial policies are to inform you of the progress in implementing the first-year economic program; to set out the objectives and policies that the government of Mozambique intends to pursue during the program period; and to request that the third loan under the arrangement in an amount equivalent to SDR 8.4 million be disbursed following the completion of the second review under the arrangement.

2.  The government of Mozambique will provide such information as the Fund requests in connection with the progress made in implementing the economic and financial policies and achieving the objectives of the program.

3.  The government of Mozambique believes that the policies and measures set out in the attached memorandum are adequate to achieve the objectives of its program; it will take any further measures that may become appropriate for this purpose. During the remaining period of the three-year PRGF arrangement, Mozambique will continue to consult with the Managing Director on the adoption of any measures that may be appropriate, at the initiative of the government or whenever the Managing Director requests such a consultation. Moreover, after the period of the three-year PRGF arrangement and while Mozambique has outstanding financial obligations to the Fund arising from loans under the arrangement, the government will consult with the Fund from time to time, at the initiative of the government or whenever the Managing Director requests consultation on Mozambique's economic and financial policies.

4.  The government of Mozambique will conduct with the Fund the third review of the three-year PRGF arrangement not later than end-April 2001, based on quantitative and structural performance criteria for end-December 2000 and end-March 2001, respectively.

Sincerely yours,

Attachment

Memorandum of Economic and Financial Policies of the Government of Mozambique for 2000–01

1.   The government of Mozambique presents this memorandum in support of its request for the third loan disbursement under the Poverty Reduction and Growth Facility (PRGF) arrangement for Mozambique approved by the Executive Board of the Fund on June 28, 1999. The economic and financial policies and related structural reforms described in this memorandum are intended to secure the stable macroeconomic framework that is critical to the successful implementation of the government's poverty reduction strategy. This strategy is published in the government's interim poverty reduction strategy paper (PRSP) of March 2000, which incorporates in full the National Action Plan for the Reduction of Absolute Poverty (PARPA) developed in the course of 1999. The strategy is being further developed as part of the preparation of the full PRSP, expected to be completed by end-March 2001, in consultation with civil society and donors.

2.   Implementation of the first-year program under the current PRGF arrangement was marred by the devastating floods that hit Mozambique in early 2000. Although the resettlement of the displaced population is proceeding well, some critical flood-related bottlenecks persist, particularly in the transportation system, and reconstruction has only recently gathered speed. As a result, the government had to revise the expected rate of economic growth in 2000 from 6 percent in the immediate aftermath of the floods to less than 4 percent.

3.   Despite the large burden of flood reconstruction facing the country, the conditions of program implementation in the first half of 2000 remained such that all quantitative performance criteria and benchmarks under the program were observed. The two structural performance criteria relating to a review of the system of tax and customs exemptions and to the publication of quarterly budget execution reports were also observed. However, a rapid monetary expansion over the past year has required a reorientation of monetary policy. In addition, in response to problems in two commercial banks with minority government shareholding, the government has acted decisively to bring about their restructuring and recapitalization.

4.   The PRGF-supported program is part of Mozambique's medium-term development strategy, which is described in the Government Program for 2000–04, the interim PRSP, and a medium-term expenditure framework. The government's four medium-term objectives are (i) the reduction of absolute poverty; (ii) the attainment of high and sustainable growth through the creation of an enabling environment for the private sector; (iii) the reduction of regional inequalities; and (iv) the consolidation of peace, national unity, and democracy. Achievement of these objectives will be supported inter alia by the maintenance of a stable macroeconomic environment, public sector reform, and safeguards for freely functioning domestic financial markets. The medium-term strategy has been translated into an annual budget and report on the social and economic program, which is being debated in the National Assembly.

5.   The government recognizes the key role of good governance for the quality of public sector service delivery and the overall business and investment climate. Although the formulation of a strategic plan for the judicial system will be delayed, a comprehensive legal reform remains an important item on the government's medium-term agenda. Meanwhile, a number of concrete measures will be adopted over the next few months to strengthen controls and accountability in public administration. These steps include the renewal of the State Inspectorate's staff; the adoption of regulations to the Ethics Law, requiring, inter alia, the periodic disclosure of senior government officials' personal financial situation to the Supreme Court; and the dissemination of guides describing citizens' basic rights and rules in their dealings with public officials.

6.   The objective of the program for 2000-01 is to establish the conditions for a recovery of economic growth to levels achieved in the years prior to the floods and to make this growth more pro-poor. The program period marks the first full year in which debt relief is flowing under the original and the enhanced Initiative for Heavily Indebted Poor Countries (HIPC Initiative). The government welcomes the important debt relief granted under the HIPC Initiative and considers it to be essential for the successful implementation of the country's poverty reduction strategy. At the same time, the government faces the continuous challenge of improving its planning, budgeting, and reporting systems to facilitate the execution of specific expenditure programs.

7.   The government has recently set in motion important reforms in the tax system. A first set of measures in the area of tax incentives has been already implemented, based on the recommendations of two recent technical assistance studies charged with reviewing the system of tax and customs exemptions (one mission from the Fund in June 2000). The measures included the following: (i) establishment of a management unit in the tax directorate (DNIA) to analyze, coordinate, and follow up on the granting of all domestic tax incentives; (ii) adoption of procedures to require a technical opinion from the tax and customs directorates before granting exemptions for new investment projects; (iii) adoption of a decree limiting the special regime of industrial free zones to groups of enterprises or large projects in a demarcated geographical area, in order to better enforce customs control of the inflows and outflows of goods and services; (iv) adoption of a decree requiring the posting of a guarantee before granting tax incentives to rent-a-car activities; and (v) adoption of a decree setting up regulations and enforcement procedures allowing the tax and customs directorates to control and audit goods in domestic circulation. Beyond these administrative improvements, the government is proceeding with a rationalization of tax and customs exemptions that will include the preparation of a new code of fiscal incentives for investment, the renegotiation of permanent exemptions granted in the past to enterprises, and a reduction of miscellaneous other exemptions. After first adopting some basic principles for the new incentive system by the end of 2000, a new code of fiscal incentives for investment will be drafted by mid-May 2001. In addition to aiming at greater effectiveness, the changes in fiscal incentives under this new code are expected to result in a net revenue gain in 2002 of about 1 percent of GDP; overall, the intended rationalization of tax and customs exemptions is expected to yield a full-year net revenue by 2003 of 1.5 percent of GDP. Finally, the government is envisaging a comprehensive reform of direct taxes, including the streamlining of income and profits taxes, the effective establishment of a tax court (Tribunal Fiscal), and a review of the appeals procedures (contencioso tributário).

8.   In parallel with its efforts to reform tax policy, the government is also engaged in overhauling tax administration. In the area of the value-added tax (VAT), the government is simplifying refund procedures, intensifying the public information campaign, and strengthening audit capacities. In addition, the government is preparing to create a new career stream for tax administration and to set up a special section within the tax directorate to handle tax collection, audits, and control with respect to large taxpayers. Finally, in line with reforms of the tax and customs directorates, the government is taking steps to create a central revenue authority within the next three to five years that would integrate the tax and customs directorates into an autonomous entity.

9.   In line with its poverty reduction strategy and its reconstruction program, the government has budgeted increases in noninterest current expenditure from 11.9 percent of GDP in 1999 to 13.4 percent in 2000 and 14.5 percent in 2001, and in capital expenditure from 11.8 percent of GDP in 1999 to 13.4 percent in 2000 and 13.8 percent in 2001. About two-thirds of the cumulative expenditure increase will be channeled into education, health, infrastructure, agriculture, and social action. Expenditure will also increase as a result of the government's contribution to the recapitalization and restructuring of two commercial banks (paragraph 12); this contribution will likely amount to Mt 2,200 billion and will be mostly financed by issuing marketable public debt. To facilitate the restructuring of the cashew processing industry (paragraph 13), the government expects to transfer about Mt 100 billion to various companies to pay for accumulated liabilities to the labor force before the end of this year. A higher-than-expected increase of 16 percent in wages this year will not affect the primary deficit, as the effective date of the increase was deferred by three months from April to July 2000. In 2001, the wage bill will increase by 34 percent, reflecting in large part the hiring of new teachers, nurses, and police officers at more competitive salaries and the full-year effect of the wage increase granted in mid-2000.

10.   The publication of quarterly budget execution reports begun this year constitutes a major step in improving public accountability, but the government recognizes that much remains to be done in this area. The recent fiscal transparency assessment carried out by the Fund and approved by the government underlined weaknesses in specific areas of public expenditure management. In this regard, the government has initiated a reform of the public expenditure management system that envisages: (i) submitting a new public accounting law to the National Assembly by end-March 2001 that regulates all stages of expenditure, including commitment and verification; (ii) including all extrabudgetary activities in the budget in order to comply with standard budget procedures; (iii) improving the public accounting system by recording and reporting on each major step in the spending process (allocation, commitment, verification, and payment); (iv) improving the budget classification system in order to track program-based expenditures; and (v) strengthening audit and reporting systems by staffing and training internal and external control units and expanding computing capabilities for budget execution. In the effort to implement such a reform, the government is seeking technical assistance from the Fund, as well as from the World Bank for a public expenditure review. Aware of the immediate need to track poverty-related expenditures, the government has decided to implement a simplified interim control system to monitor such spending. Based on current budget procedures, and with a specific expenditure classification, the interim system will report actual expenditures on programs specified in the PARPA in comparison with the respective budgetary allocation. Information on these programs will be included in the quarterly budget execution report, beginning with the first quarter of 2001.

11.   In the light of the recent rapid expansion in monetary aggregates and in order to avoid fueling inflationary expectations, the monetary program seeks to limit broad money growth to 34 percent in 2000 and 16 percent in 2001—an objective that is consistent with reducing the 12-month rate of inflation to about 7 percent by end-2001 and will still leave room for a healthy expansion of bank credit to the private sector. The Bank of Mozambique has moved toward a tighter monetary stance by intensifying the placement of treasury bills in the money market, strictly enforcing statutory reserve requirements, and setting interest rates on its liquidity support credits (facilidade permanente de cedência, FPC) above the treasury bill rate. Thus, over the past two months, the FPC rate was raised from 16 percent to 23 percent, and is now higher than the treasury bill rate. As a result of these actions, the interbank money market rate rose from 17 percent in August to 23 percent in mid-November. Open market operations will continue to gain significance as a tool for monetary management. In light of the need for tighter monetary control, the Bank of Mozambique intends to monitor closely the supply of reserve money as an important and early indicator of money and credit growth. The Bank of Mozambique intends to introduce a computerized clearing system by end-June 2001.

12.   The Bank of Mozambique has recently obtained greater clarity on the financial situation of the two commercial banks with minority government ownership that have continued to experience problems since their majority privatization in 1996–97. This diagnosis has revealed an urgent need for higher loan loss provisions and recapitalization. For its part, the government is prepared to recapitalize these banks in proportion to its shareholding. In the case of the Banco Comercial de Moçambique (BCM), the government recently obtained the commitment of the private shareholder to do likewise and to begin implementing a restructuring plan that will be tightly supervised by the Bank of Mozambique and that will include a strengthening of management. In the case of the Banco Austral (BA), the shareholders agreed in mid-October 2000 to (i) alleviate the immediate liquidity shortage through the extension of soft loans, (ii) commission a financial due diligence review by end-November 2000, and (iii) decide by mid-December 2000 on the amount and modalities of recapitalization and on a recovery strategy for the bank. The shareholders further directed the BA's management to provide all necessary information to the auditors undertaking the due diligence review. Meanwhile, the Bank of Mozambique has put into place a series of safeguard measures requiring the BA to (i) limit the granting of loans to the amount resulting from the recovery of loans already granted; (ii) report weekly to the central bank on the evolution of the bank's situation; (iii) report daily to the central bank on the bank's cash flow; and (iv) seek the Bank of Mozambique's consent for the disposal of any assets, the releasing of any collateral, the amending of any agreements with third parties, the extension of any guarantees, or the incurrence of any other contingent liabilities. The government expects the necessary capital injection to be paid up, in the case of the BCM, mainly in the fourth quarter of 2000, with the balance in the first quarter of 2001, and, in the case of the BA, in the first quarter of 2001. The share of the government will be paid pari passu with the private shareholders' part. Closure on the recapitalization operation for the BCM and BA will constitute a performance criterion for end-March 2001. To accompany this restructuring operation and safeguard the stability of the banking system, the Bank of Mozambique will strengthen its supervision department.

13.   The government is making progress in addressing the problems of the cashew sector. Thus, the government has accepted in principle the liquidation of several nonviable processing plants. It has also decided that the export tax on raw cashew nuts remain at 18 percent for the coming crop year, and that acceptable modalities for the first-right-to-purchase—granted by the law to local processors—be worked out by the exporters and processors themselves under the auspices of the Cashew Institute. The government has also endorsed the Cashew Institute's recent master plan for the promotion of farm production of cashew nuts. Acting on the recommendations of a recent study by the Food and Agriculture Organization (FAO) for the sugar sector in Mozambique, the government has decided to maintain the level of import protection for sugar granted in September 1999, and it will review this policy annually based on domestic and international sugar market developments.

14.   The government ratified the Southern African Development Community (SADC) trade protocol in December 1999 and agreed with its partners on certain amendments to the protocol in August 2000; it has until end-February 2001 to deposit its implementation documents. The government is adhering to its stated intention to reduce the top tariff rate from 30 percent to 25 percent by January 2002.

15.   The Bank of Mozambique has taken steps to improve the functioning of the foreign exchange market and encourage interbank trading of foreign exchange. Specifically, to improve the signal effect of its published rate, the Bank has begun to publish daily the weighted-average buying and selling rates for the U.S. dollar calculated from all transactions of commercial banks and exchange houses with their clients. At the same time, the Bank has ceased to publish the average interbank rate and is itself trading foreign exchange with commercial banks at the market rate. Furthermore, the Bank of Mozambique has ceased to advertise the inflow of foreign donor assistance, which had been interpreted by the private sector as a sign of availability of foreign exchange from the central bank. It also has begun to publish regularly a set of monetary indicators to enhance confidence in the currency.

16.   Despite the very large financing requirements, including those caused by expenditures associated with the recent floods, the program for this year is fully financed through a balanced mix of grants, concessional borrowing, assistance under the HIPC Initiative, and the government's own resources. Recognizing the exceptional nature of the large amount of external financing made available by the international community to Mozambique, including in the form of external debt and flood relief, the government is firmly committed to saving any amount that should not find an early effective use. The Bank of Mozambique has transferred to the government all HIPC Initiative assistance delivered by the IMF and accrued since the beginning of 2000, and is now transferring this part of HIPC Initiative debt relief to the budget on a regular basis. The government is finalizing delivery agreements with the remaining multilateral creditors for actual delivery of assistance under the original HIPC Initiative, and is continuing to seek non-Paris Club creditors' participation in the original and enhanced HIPC Initiatives. A renewed request for such assistance was recently sent to all creditors.

17.   In order to prevent the recurrence of debt problems, the government is continuing to strengthen its debt-management capacity. It has recently updated its information technology system to manage the external debt database. In preparation for the completion point under the enhanced HIPC Initiative, the government will prepare detailed projections for debt service and HIPC Initiative assistance as a basis for budgetary and economic planning. In this context, the government will also conduct a comprehensive assessment of the private sector's external indebtedness aimed at identifying short- and medium-term vulnerabilities in the sector's external position.

18.   The government remains committed to fulfilling the conditions for the HIPC Initiative completion point, including the preparation of a full PRSP, by March 2001. A consultation strategy, monitoring strategy, and draft policy matrix have been prepared, and action plans have been drawn up to put these strategies into effect. A number of growth studies are under way and will be integrated into the policy matrix. Provincial governments are now developing decentralized, participatory poverty reduction strategies, and local development plans have been drawn up in some provinces. The government has organized some consultations on the PRSP at provincial and central levels, with civil society groups and donors. A consultation unit is shortly to be established to organize future activities set out in the consultation strategy. This unit will be attached to the PRSP technical working group, with representation from the government, donors, civil society groups, and the private sector. To date, progress with the preparation of PRSP costings and tracking of HIPC Initiative-related expenditure has been slower than originally intended, but the government recognizes the need for accountability to its citizens and the international community with respect to the use of HIPC Initiative debt relief.

19.   During the period of the PRGF-supported program, the government will not impose or intensify restrictions on payments and transfers for current international transactions; will not introduce multiple currency practices; will not conclude bilateral payments agreements that are inconsistent with Article VIII of the Fund's Articles of Agreement; and will not impose or intensify import restrictions for balance of payments reasons. Furthermore, the government will not incur any new external payments arrears, except on payments that are subject to debt-rescheduling negotiations.

20.   The quantitative performance criteria and benchmarks that will be used to evaluate the implementation of the financial program, as well as the test dates on which such evaluation will take place, are shown in Table 1 of this memorandum, with further definitions and explanations contained in a technical memorandum of understanding annexed to this memorandum. The first five quantitative targets represent key financial objectives of the program, the next two will help to maintain a sustainable external debt position, and the last one is intended to protect Mozambique's external creditworthiness. A number of structural performance criteria and benchmarks, drawn from this memorandum, are shown in Table 2. The government understands that its ability to request disbursement of the fourth loan under the three-year PRGF arrangement will be contingent upon the observance of the quantitative performance criteria for end-December 2000 set out in Table 1 and the structural performance criteria set out in Table 2, and the completion of the third review of the program, which is expected to take place by the end of April 2001.

Technical Memorandum of Understanding On Selected Concepts and Definitions Used in the Monitoring of the Second-Year PRGF Program

The purpose of this technical memorandum of understanding (TMU) is to describe concepts and definitions that are being used in the monitoring of the second year of the Poverty Reduction and Growth Facility (PRGF)-supported program, including:

• Central government domestic primary deficit;

• Central government revenue;

• Net domestic assets, net international reserves, and reserve money of the Bank of Mozambique;

• New nonconcessional borrowing contracted or guaranteed by the government or the Bank of Mozambique with a maturity of more than one year;

• Short-term external public debt outstanding;

• External payments arrears;

• Foreign program assistance

This memorandum also describes the adjusters that will be applied to certain quantitative targets of the program.

Central government domestic primary deficit

The central government domestic primary deficit is defined as central government revenue, less noninterest current expenditure, less locally financed capital expenditure, less locally financed net lending. The latter is derived as gross lending to enterprises through acordos de retrocessão (excluding acordos de retrocessão that were required by donors), plus food aid disbursed, but not collected in the period, minus repayments by enterprises of loans obtained through acordos de retrocessão and through refinancing agreements with the Bank of Mozambique, minus food aid collected, but not disbursed, in the period, plus the cost of bank recapitalization/restructuring.

The central government encompasses all institutions, whose revenue and expenditure are included in the state budget (orçamento do Estado): central government ministries, agencies, and the administration of eleven provinces. Although local governments (33 municipalities, autarquias) are not included because they are independent, the bulk of their revenue is registered in the state budget as transfers to local government.

Central government revenue, expenditure, and financing

Revenue is defined to include all receipts of the National Directorate of Taxes and Audit (Direcção Nacional de Impostos e Auditoría, DNIA), the National Directorate of Customs (Direcção Nacional de Alfândegas, DNA), and the net receipts from privatization received by the National Directorate of State Assets (Direcção Nacional do Património do Estado).

For the purposes of program monitoring, revenue is considered as collected at the time when revenue is received by the DNIA from private agents or other government collecting agencies in cash, check, or through transfer into a DNIA bank account.

Expenditure is defined as government outlays transferred from Treasury accounts to other government accounts or private sector accounts and includes spending reported to the National Directorate of Public Accounting (despesas liquidadas) and any further Treasury advances (operações de Tesuoraría) that have been transferred out of Treasury accounts but whose use is not yet reported to the National Directorate of Public Accounting. Any expenditure arrears will be treated like expenditure for the purpose of monitoring the ceiling on the domestic primary deficit.

For program monitoring purposes, expenditure carried out in the current budget year but accounted for as expenditure under the previous budget (período complementar) is treated as spending during the current budget year.

The financing of the budget deficit is measured as transfers into treasury accounts and from these accounts to accounts of the institutions included in the central government, as defined above, and private sector accounts. All treasury accounts held at the central bank are being monitored for purposes of measuring the financing of the budget deficit. There are no treasury accounts outside the central bank.

Any discrepancy between the overall deficit (revenue less expenditure, as defined above) and its financing will be included as "unallocated revenue/expenditure" in the budget balance.

Net domestic assets

Net domestic assets of the Bank of Mozambique are defined as reserve money minus net foreign assets of the Bank of Mozambique. The foreign currency component of reserve money and the net foreign assets are valued at program exchange rates; net foreign assets are defined to exclude the effect of any stock adjustments in medium- and long-term liabilities.

The central bank's foreign currency-denominated assets and liabilities are converted in its balance sheet to meticais at actual exchange rates. For purposes of program monitoring, these amounts are converted into U.S. dollars at the agreed program exchange rate.

Stock adjustments in the central bank's medium- and long-term liabilities are understood to mean any changes that are not the result of foreign exchange flows, such as write-offs, interest capitalization, etc.

Net international reserves

Net international reserves are defined as reserve assets minus reserve liabilities. The BM's reserve assets include: (i) monetary gold; (ii) holdings of SDRs; (iii) reserve position at the IMF; (iv) holdings of foreign exchange; and (v) claims on non-residents, such as deposits abroad. Reserve assets exclude assets pledged or otherwise encumbered, including but not limited to assets used as collateral or guarantee for a third party external liability (assets not readily available). The BM's reserve liabilities include: (i) all short-term foreign exchange liabilities to non-residents with original maturity of up to and including one year; and (ii) all liabilities to the IMF.

New nonconcessional debt contracted or guaranteed by the government or the Bank of Mozambique with maturity of more than one year

The term "debt" will have the meaning set forth in Point 9 of the Guidelines on Performance Criteria with Respect to Foreign Debt adopted on August 24, 2000. Government debt is outstanding debt owed or guaranteed by the Republic of Mozambique or the Bank of Mozambique (but does not include debt of any political subdivision or government-owned entity with separate legal personality that is not otherwise owed or guaranteed by the Republic of Mozambique).

The government will not contract or guarantee external debt with original maturity of one year or more with a grant element of less than 35 percent, calculated using a discount rate based on Organziation for Economic Cooperation and Development (OECD) commercial interest rates. This performance criterion applies not only to debt as defined in Point 9 of the Guidelines on Performance Criteria with Respect to Foreign Debt adopted on August 24, 2000, but also to commitments contracted or guaranteed for which value has not been received.

Stock of short-term external public debt outstanding

The government will not contract or guarantee external debt with original maturity of less than one year. This performance criterion applies not only to debt as defined in Point 9 of the Guidelines on Performance Criteria with Respect to Foreign Debt adopted on August 24, 2000, but also to commitments contracted or guaranteed for which value has not been received. Excluded from this performance criterion are short-term import-related trade credits.

External payments arrears

The government undertakes not to accumulate payment arrears on external government debt with original maturity of one year or more owed or guaranteed by the government, with the exception of external payments arrears arising from government debt in the process of being renegotiated with creditors, including Paris Club creditors.

Foreign program assistance

Foreign program assistance is defined as grants and loans received by the Ministry of Planning and Finance through BM accounts.

Adjustors

The quantitative targets (floors) for the central bank's net international reserves will be adjusted upward (downward) for any excess (shortfall) of foreign program assistance.

The quantitative targets (ceilings) for the central bank's net domestic assets will be adjusted upward (downward) for any shortfall (excess) of foreign program assistance.

The quantitative targets (ceilings) for the central bank's net domestic assets will be adjusted downward to the extent that eligible bank reserves fall short of 7.95 percent of resident deposits in commercial banks, excluding government-earmarked funds (fundos consignados), at the end of each quarter.

The ceiling on the central government's domestic primary deficit for end-December 2000 will be adjusted downward to the extent that the locally financed cost of bank recapitalization/restructuring in 2000 is lower than Mt. 1,351 billion.