Brazil—Letter of Intent, Memorandum of Economic Policies, and Technical Memorandum of Understanding

Brasília, August 29, 2002

Mr. Horst Köhler
Managing Director
International Monetary Fund
Washington, D.C. 20431
United States of America

Dear Mr. Köhler:

The attached Memorandum of Economic Policies (MEP) describes the economic policies and objectives of the Government of Brazil for the remainder of 2002 and for 2003, in support of which the government requests a Stand-By Arrangement (SBA) for a period of 15 months with the Fund, in the amount of SDR 22,821 million (equivalent to some US$30 billion, of which the equivalent of US$10 billion would be under the Supplemental Reserve Facility).

We request the cancellation of Brazil's existing 15-month Stand-By Arrangement that was approved by the Executive Board on September 14, 2001 and was scheduled to expire on December 13, 2002. Also attached is a Technical Memorandum of Understandings (TMU) that sets out specific targets (in the form of performance criteria, indicative targets, and structural benchmarks) that are to be observed under the SBA.

The program is meant to reduce uncertainty in the external front and to allay concerns about the stance of macroeconomic policies following the upcoming presidential election, and thus providing a bridge to the new administration starting in 2003. The core elements of the program have been explained to the leading candidates, and they have committed to support them. The attached MEP and TMU will be distributed to the leading presidential candidates as soon as possible.

The government believes that the policies described in the memorandum will promote sustainable and equitable long-term growth of output and employment with continued low inflation and external viability, despite the current difficult environment. In addition to the policies outlined in the attached MEP, the government stands ready to take additional policy measures as appropriate to ensure the attainment of these objectives.

During the period of the arrangement, the authorities of Brazil will maintain the usual close policy dialogue with the Fund.

Yours sincerely,

Brazil—Memorandum of Economic Policies

Financial market variables came under increasing pressure beginning in the second quarter of this year, as uncertainties about future economic policies were compounded by a generalized increase in global risk aversion and by sharp downturns in industrial countries' equity markets. In response, the government has strengthened policies, elaborated an enhanced set of structural measures, and requested a new Fund program through the end of 2003.

The objective of the program is to bring economic growth closer to its potential in the medium term, while maintaining low inflation and external sustainability, with the goal of increasing employment, reducing poverty and improving social conditions. By reducing uncertainties in the external front, the authorities expect to build a solid bridge to the new Administration starting in 2003, guaranteeing a stable environment for the new government to formulate its own policy strategy.

I. Recent Performance of the Brazilian Economy

1. Economic activity shows signs that the modest recovery that began late last year may have stalled. After growing 6.1 percent annually in April, industrial activity dropped 1.0 percent in May and increased 0.7 percent in June, bringing the cumulative decline over the first half of the year to 0.1 percent when compared to the same period last year. Retail sales fell by 0.9 percent over January-June versus the same period last year. Export and import volumes in the second quarter of 2002 declined by about 9.7 percent and 15.5 percent, respectively, from the levels observed in the second quarter of 2001, with the sharp fall in imports reflecting in large part continued efficient import substitution.

2. Labor market developments reflect the subdued economy. The unemployment rate averaged 7.2 percent in the second quarter on a seasonally adjusted basis, up from 6.8 percent in the first quarter of the year. No wage pressures are evident in the economy, with average real earnings in the year to May 2002 dropping 4.5 percent from the same period last year in the six metropolitan regions surveyed by IBGE.

3. Consumer price inflation is moderating. Monthly inflation measured by the IPCA reached 0.4 percent in June, below the monthly average for 2002, and trend core inflation has been declining, reflecting in part the appreciation of the real through March. The 12-month headline rate has fallen from 8 percent in April to 7.7 percent in June, still above the band for consultation with the Executive Board of Directors of the Fund under the Stand-By Arrangement. This consultation will be conducted in the context of Executive Board consideration of the request for a new arrangement. The current high 12-month inflation rates are in part a legacy of the high monthly rates experienced at the end of last year. This is particularly true for regulated prices (prices regulated by contracts or monitored), which despite representing 30 percent of the consumer price index account for 50 percent of the increase in prices over the last 12 months. The recent depreciation of the real will doubtless put upward pressure on prices during the remainder of the year, but the impact is likely to be reduced by the fact that the rate has clearly overshot, and thus firms are unlikely to pass all of the depreciation through to prices. Soft domestic demand conditions are also likely to limit the passthrough to prices. Taking into account recent developments, the central bank (BCB) projects 2002 inflation around 6½ percent, above the 5½ percent upper limit of the official target. According to market expectations, inflation in 2003 is forecasted to be slightly above 4 percent, which is the midpoint of the official target range.

4. The performance of the balance of payments continued to strengthen in the first half of the year. The current account posted a deficit of US$8.3 billion in the first six months of 2002, well below the US$13.3 billion deficit recorded during the same period last year, mostly reflecting a US$2.7 billion turnaround in the trade balance, a marked improvement in nonfactor services and declining profit remittances and interest payments. The trade balance, in particular, posted a surplus of US$1.2 billion in July, and accumulated during January-July 2002 a US$3.8 billion surplus, compared with a surplus of just US$36 million in the same period of last year. The 12-month current account deficit reached US$18.1 billion in June, the lowest level since September 1996. Foreign direct investment reached US$9.6 billion in the first six months of the year, virtually identical to that recorded in the same period last year, and 12-month FDI continued to exceed the 12-month current account deficit by a healthy margin.

5. However, access to international capital markets, which had already become more constrained during the second quarter, worsened significantly in July. Rollover rates on medium- and long-term debt fell sharply, reflecting both heightened concerns about domestic politics and a substantial deterioration in the global economic environment. In addition, FDI dropped to about US$1.0 billion in July, well below the US$1.6 billion averaged monthly during the first half of the year, and the share of FDI coming from flows of new funds (rather than debt conversion) fell even more sharply. Although the rollover rate on interbank credits averaged 93 percent for the four weeks to August 16, this partly reflected the conversion of longer term trade credits into short term credit lines. Gross international reserves increased from US$35.9 billion at the end of 2001 to US$42.0 billion at end-June, reflecting in part net drawings from the Fund, but declined by US$3.0 billion by end-July. Net international reserves (NIR), as measured under the program, stood at US$23.6 billion at end-July, some US$8.6 billion above the floor established by the previous program at that date.

6. External debt is estimated to have declined by US$6.8 billion during April 2002 (the most recent available data) to US$204 billion (39.8 percent of GDP). Some US$179 billion of this amount was medium- and long-term debt and the rest short-term. About 46 percent of the external debt was owed by the nonfinancial public sector and the rest by the private sector and the public financial sector.

7. Brazil's fiscal performance improved markedly in the second quarter of 2002. The consolidated public sector posted an accumulated primary surplus of 4.7 percent of period GDP (R$28.9 billion) in the first half of 2002, nearly R$4 billion above the end-June performance criterion under the Fund program. As a result of this robust performance, the public sector borrowing requirement—measured on a harmonized basis that excludes the impact of exchange rate-induced changes in the valuation of the debt stock accrued but not actually paid during the reference period—fell by 0.8 percent of GDP relative to end-2001 to 2.8 percent of GDP (R$17.4 billion) at end-June. However, the real depreciated sharply in the period, and the net public debt rose to 58.6 percent of GDP at end-June from 53.3 percent of GDP at end-2001, and breached the indicative target ceiling for end-June under the Fund program.

8. The central and regional (state and municipal) governments have continued to post sizable primary surpluses. The central government recorded a primary surplus of 3.4 percent of period GDP in the first half of 2002, virtually unchanged from the same period of 2001, with the payment of outstanding income tax liabilities by the pension funds and other nonrecurrent collections compensating for revenue losses due to weak economic activity. The states and municipalities turned in a combined primary surplus of 1.1 percent of GDP, comparable to that achieved in the same period of 2001. Revenue performance remains in line with the program at the federal and regional levels of government, and expenditure control continues to be very strong. The performance of the public enterprises—which had been weak in the first quarter due to the impact of lower international oil prices on revenues of the state oil company, Petrobrás, as well as to one-off expenditures—improved markedly in the second quarter. The public enterprises posted a combined surplus of 0.2 percent of GDP in the first half of 2002, reversing the sizable deficits accumulated in the first quarter.

9. In light of the deterioration in the economic environment, the government announced in June an increase in the consolidated public sector primary surplus target by ¼ percent of GDP to 3¾ percent of GDP in 2002-03. Congress approved the extension of the bank debit tax (CPMF), scheduled to expire on June 17, 2002, exempting stock market transactions and revoking the requirement of a 90-day waiting period after approval of the tax for collections to resume, thus minimizing revenue losses to the Treasury. In accordance with the Fiscal Responsibility Law, a new budget execution decree was issued on July 23 effectively cutting R$4 billion of federal expenditures relative to the ceilings set in the budget execution decree issued on February 8. These expenditure cuts are aimed at compensating for an upward revision in other spending categories, including an increase in the projected deficit of the social security system by R$0.9 billion, in line with the impact of higher inflation on the average value of benefits, and a fall in revenues of nearly R$3.5 billion arising from the slower pace of economic recovery.

10. Increased market volatility in recent weeks has affected debt management. The average maturity of the securitized public debt has fallen somewhat to about 22 months at end-June, from about 25 months at end-2001, following a substantial lengthening in 2001, but duration has remained broadly stable at about 10½-11 months since end-2001. The share of short-term public debt, defined as the stock of debt maturing in less than 12 months, rose to about one-third of the securitized public debt stock from about one-quarter at end-2001, but remains low by historical standards. Stable at about 29½-30 percent on average in 2002 (about R$195 billion), the share of exchange rate-indexed securities in the total debt stock remains below the peak of 33 percent reached in October 2001. In addition, taking into account issuance of different modalities of foreign exchange swaps by the BCB (since the introduction at end-March of a new mechanism for stripping the foreign exchange insurance component of the debt from the underlying domestic currency-denominated bond), the central bank's net foreign exchange exposure stood at about R$21 billion at end-June.

11. In view of the persistence of high inflation in 2002, driven by a sequence of substantial negative economic and financial shocks over the last 18 months, and the resulting carry-over effects on 2003 inflation, the National Monetary Council (CMN) decided in June to raise the end-2003 inflation target by ½ percentage point to 4 percent. Recognizing the size and frequency of shocks affecting the Brazilian economy in the past years, the CMN also decided to widen the tolerance bands around the central target by ½ percentage point, to +/-2½ percentage points. Noting that unregulated price increases and aggregate demand pressures have remained subdued and that projected inflation was significantly below the midpoint of its inflation target for end-2003, the central bank lowered its main policy interest rate (the SELIC) by 50 basis points in July to 18.0 percent. The BCB maintained the SELIC at 18 percent with a downward bias in its August meeting.

12. The banking system remains very healthy, having been submitted to numerous real-world stress tests in recent years and done extremely well . In March, regulatory capital to risk-weighted assets of the banking system stood at 17.1 percent and, except for two very small banks, all institutions exceeded the minimum capital adequacy ratio of 11 percent. Profits, while lower than in 2001Q1, were nonetheless in line with average profits over the last three years. In June, average bank spreads narrowed 3.2 percentage points to 37.1 percent. Newly allocated bank credit grew 3.1 percent in June from the same period last year, reflecting the substitution of domestic credit for foreign credit by firms, due to the tighter capital account. The share of loans with payments overdue for more than 120 days decreased slightly to 6.0 percent at end-June from 6.7 percent at end-March. Nevertheless, total bank provisions reached R$25.6 billion at end-June, more than fully meeting minimum provisioning requirements. Bank profits are likely to be under pressure during the remainder of this year versus last year, given decreases in securities prices, a slowdown in credit growth and increased provisioning requirements. The central bank has taken further steps in its program to improve the transparency and effectiveness of its control, accounting, reporting, and auditing systems. It has moved towards adopting internationally-accepted accounting practices for its financial statements. The central bank is reviewing internal audit's staffing, training needs and planning methodology and manuals for audits conducted from a risk perspective. It will also complete the implementation of an enhanced internal audit of reserves management functions and systems by September 30, 2002.

II. Policies and Prospects For the Remainder of 2002 and 2003

13. Despite the maintenance of strong macroeconomic policies, uncertainty about the direction of policy following the elections this year and a worsening international environment have led to a significant deterioration in financial market variables, presenting challenges for government debt management and constricting the capital account of the balance of payments. These factors have in turn contributed to a slowdown in economic growth in the second quarter of this year. To address these developments, the government is committed to an additional strengthening of policies in 2002, further structural reforms to enhance the institutional framework, and a new Stand-By Arrangement with the IMF, to dispel concerns about the stance of macroeconomic policies following the presidential transition.

14. The macroeconomic framework for 2002 and 2003 is based on conservative assumptions of real GDP growth of 1.5 percent in 2002 and between 2.5 percent and 3.5 percent in 2003. The balance of payments projections are also conservative. The external trade surplus is projected to reach US$6.0 billion in 2002 and US$8.0 billion in 2003, due in part to the depreciation of the real that occurred in the second quarter of this year. Reflecting this higher trade surplus, the current account deficit is projected to narrow to about US$18.5 billion in 2002 (from US$23.2 billion in 2001) and to US$17 billion in 2003. FDI, conservatively projected, is sufficient to finance a substantial share of the current account deficit this and next year.

15. The government is continuing to strengthen the public finances by raising the consolidated public sector primary surplus target to close to 3.9 percent of GDP in 2002. The increase in the primary surplus target in 2002 will be made possible by expenditure control and the expected collection of nonrecurrent revenues in the second semester of the year. Also, for the period July 2002-June 2003, the primary surplus is projected to be around 3.9 percent of GDP. As a minimum, the 3¾ percent of GDP target for 2003 called for in the budget guidelines law for next year will be maintained. The 2003 Budget Law will confirm this target and be submitted to congress by August 31. The government also considers that primary surplus targets for 2004 and 2005 of no less than 3¾ percent of GDP are needed to ensure a declining path of the debt to GDP ratio under conservative assumptions and that these targets should be incorporated in the 2004 Budget Guidelines Law. The regional governments and the public enterprises are projected to contribute towards achievement of the consolidated primary surplus target, with the central government projecting a primary surplus of 2.25 percent of GDP in 2003. The central government remains committed to offset any slippages elsewhere in the public sector by increasing its own primary surplus. The strengthening of fiscal discipline in recent years, particularly with the enactment of the Fiscal Responsibility Law (FRL) and the continued observance of the debt restructuring agreements between the regional governments and the National Treasury, has contributed to extending the central government's fiscal consolidation efforts to all elements of the public sector.

16. Consistent with the increase in the primary surplus target, the net debt of the public sector is projected to stabilize at about 59 percent of GDP in 2002. Debt dynamics are sensitive to variations in macroeconomic variables, particularly the real exchange rate, the real interest rate, and the rate of real GDP growth. A significant and sustained depreciation of the real exchange rate, the maintenance of high real interest rates, or a much slower-than-projected economic recovery may require a higher primary surplus to stabilize the debt-to-GDP ratio in 2003 and put it on a downward trajectory over the medium term. As a result, the 2003 primary surplus target will be reassessed during each of the next four review discussions (November 2002, February 2003, May 2003, and August 2003) taking into account the debt to GDP ratio, the existing macroeconomic conditions, in particular, the real exchange rate, the real interest rates, and real GDP growth, and prospects over the medium term. Each of these reviews will be completed only if the government and the Fund reach an agreement on the path of the primary surplus targets for the remaining period of the program.

17. The recent increase in the public debt stock calls for continued caution in debt management, and the government will follow a three-pronged debt management strategy , market conditions permitting. The strategy consists of reducing progressively the shares in the debt stock of foreign exchange-indexed securities and floating-rate securities; lengthening the average maturity of new debt issuances to further reduce the level of short-term debt; and progressively limiting the foreign exchange exposure of the government (including the central bank).

18. The government is committed to make further progress on its legislative agenda during 2002. In the financial sector area, the government will seek approval of the amendment of Article 192 of the constitution. This would allow the next government to submit to congress a new law for BCB operational autonomy. In the fiscal area, the government will seek approval of legislation (i) creating complementary pension funds for civil servants and collecting social security contributions on retired civil servants, and (ii) defining the careers for which civil servants can be hired under the private-sector social security regime.

19. The government recognizes the need for reforming the federal tax system and is committed to work toward approval of legislation converting the PIS, a federal turnover tax, into a value-added tax (VAT). Successful implementation of this measure in a revenue neutral way will lay the foundations for subsequently replacing COFINS, a higher-yielding federal turnover tax, by a federal VAT later in 2003. Tax competition among the regional jurisdictions is acknowledged to have weakened the revenue productivity of the state VAT (ICMS) and the government expects to work with the states to harmonize the ICMS legislation. A proposed constitutional arrangement to that effect was already submitted to congress in mid-2001. In addition, the extension of the current arrangement (DRU) for withholding a share of federal revenues, beyond its end-2003 expiration date and an increase in the withholding rate from the current 20 percent, should be considered in the near future. As these revenues are not subject to earmarking, such a move would be a first step toward increasing the flexibility of the central government's budget.

20. The government proposes an adjustor to the primary surplus target, set out in the attached TMU. A different version of the adjustor had been introduced at the time of the Third Review under the Stand-By Arrangement with the IMF to reflect the fact that investment spending by public sector enterprises run on a commercial basis creates assets with financial value and therefore does not reduce the net worth of the public sector nor put in jeopardy the sustainability of the public sector finances over time. Reflecting the intention to use this flexibility solely to increase investment, the primary surplus target of the consolidated public sector will be reduced by the excess of Petrobrás's actual investment spending over the level assumed in the program. This adjuster will be effective from the beginning of 2003.

21. Monetary policy in Brazil will continue to be set in a forward looking manner to ensure that inflation converges to the preannounced inflation targets over an appropriate time horizon. In response to adverse supply or external shocks the BCB will continue to adjust its policies to bring inflation back to the target trajectory, within a time period consistent with the lags of monetary policy and the size and nature of the shocks. The reaction function of the BCB is symmetrical and takes into account the nature and persistence of the shocks affecting the economy. Whenever there is a demand shock monetary conditions will be adjusted to bring inflation back to its pre-shock trajectory, while whenever there is a negative supply shock the BCB would allow the initial increase in the price level, while fighting the second round effects, to ensure that shifts in relative prices remain in place.

22. Inflationary pressures have arisen from the depreciation of the real, which has translated into more frequent and higher-than-expected increases in regulated prices, in particular for petroleum products following the liberalization of the market for these goods earlier this year. The BCB now projects prices regulated by the government or subject to contracts to rise 8.4 percent in 2002, contributing a higher-than-expected 2.6 percentage points to 2002 inflation. Inflation prospects will continue to be analyzed during program reviews, and the central bank will maintain its regular exchange of views with the Fund staff about the evolution of monetary policy and explain to the staff the economic and technical basis of policy decisions. The central bank remains ready to respond to changes in projected inflation to help achieve convergence to the inflation targets over the appropriate time horizon.

23. The experience of the current and past years confirms the importance of the floating exchange rate regime in helping the economy respond to shocks. Nevertheless, the size and scope of the shocks experienced recently required the central bank to alleviate some of the pressure on the exchange rate by intervening in the foreign exchange market. In the case of intervention reaching an accumulated amount of U$3.0 billion, on a rolling 30-day basis, a general discussion of monetary and intervention policies will be initiated with the staff. In this event, the BCB has indicated that it will not loosen monetary conditions.

24. The BCB and Treasury will not increase their net foreign exchange exposure (either by raising the stock of foreign exchange-indexed debt, raising the foreign exchange swap exposure of the BCB, or entering into other derivative contracts), except in extraordinary circumstances. As market conditions allow, the public sector will seek to reduce its foreign exchange exposure by rolling over less than 100 percent of these instruments as they mature.

25. The strengthening of the banking sector achieved in recent years has served the country well, helping to cushion some of the effects of domestic and external shocks. This process has included the revitalization of the major federal banks, which are now subject to prudential rules required of private banks. The continuing budgetary transparency in the treatment of subsidized lending through federal banks will remain a centerpiece to preserving the gains obtained in recent years. The government will continue to work on an improved bankruptcy law—a cornerstone to achieve lower lending spreads, and some additional prudential regulations (e.g., on provision for country risks, limits on tax credits and intangibles, and increased provisioning and establishment of a solvency margin for insurance companies) to strengthen the evolution of capital adequacy in the financial system. The program contains several structural benchmarks regarding ongoing efforts to strengthen bank supervision and financial sector prudential regulation.

26. In summary, despite continued strong economic fundamentals, a combination of a worsening external environment and increased uncertainty among investors about the future course of economic policies has led to a deterioration in financial market variables in recent months. The tightening of fiscal policies, continuation of disciplined monetary policies, and strengthened structural reform agenda laid out in this MEP, along with a new Stand-By Arrangement with the Fund, are designed to safeguard economic stability, and provide a framework for the continuity of core macroeconomic policies next year. In addition to the measures outlined in this MEP, the government stands ready to adjust policies as needed to ensure the achievement of the objectives of its economic program, and looks forward to a continued close and constructive dialogue with the Fund.

Brazil—Technical Memorandum of Understanding

1. This Technical Memorandum of Understanding (TMU) sets out the specific performance criteria (PCs), indicative targets (ITs), structural benchmarks (SBs) and assumptions that will be applied under the Stand-By Arrangement during 2002 and 2003.

I. Phasing of Purchases and Reviews

2. The general phasing of purchases and reviews for the remainder of 2002 and in 2003 is shown in Table 1 below.

Table 1. Brazil: Phasing of Purchases and Reviews
Amounts Available (In millions of SDRs) and Sources	Earliest Availability Dates	Conditions and Remarks
1,141.056 from CT 1,141.056 from SRF	September 6, 2002	Approval of the Stand-By Arrangement
1,141.056 from CT 1,141.056 from SRF	December 6, 2002	Completion of the first review, and observance of the relevant PCs under the arrangement (end-September, 2002).
1,520.913 from CT 1,520.913 from SRF	March 7, 2003	Completion of the second review and observance of the relevant PCs under the arrangement (end-December, 2002).
4,265.514 from CT 2,285.258 from SRF	June 6, 2003	Completion of the third review and observance of the relevant PCs under the arrangement (end-March, 2003).
1,521.408 from CT 1,521.408 from SRF	August 8, 2003	Completion of the fourth review and observance of the relevant PCs under the arrangement (end-June, 2003).
5,621.482 from CT	November 7, 2003	Completion of the fifth review and observance of the relevant PCs under the arrangement (end-September, 2003).

II. Quantitative Targets

A. Fiscal Targets

(i) Performance criterion for the primary balance of the consolidated public sector1
	Floor2 (In billions of R$)
Cumulative fiscal year primary balance of the consolidated public sector
January 1, 2002-June 30, 2002 (actual data)1	28.9
January 1, 2002-September 30, 2002 (performance criterion)	41.0
January 1, 2002-December 31, 2002 (performance criterion)	50.3
January 1, 2003-March 31, 2003 (performance criterion)3	13.8
January 1, 2003-June 30, 2003 (performance criterion)3	31.4
January 1, 2003-September 30, 2003 (indicative)3,4	41.9
1As defined below. Given that debt dynamics are sensitive to variations in the macroeconomic framework, particularly to changes in the real exchange rate, in the real interest rate and in real GDP growth, the primary balance target will be reconsidered at each review and reaching understandings on the appropriate level of the primary balance for 2003 is a condition for completion of each of the first four reviews envisaged under the arrangement. 2Minimum cumulative primary surplus of the consolidated public sector. 3For March 31, June 30 and September 30 of 2003 the floor will be decreased by the amount of capital investment of the state oil company Petrobrás that exceeds the programmed level of investment as specified in Table 2. 4Performance criteria to be set at the time of the second review under the arrangement.

3. The cumulative primary balance of the consolidated public sector is defined as the sum of the cumulative primary balances of the various entities that make up the public sector. The public sector is defined to comprise the central government, state and municipal governments, and the public enterprises (including federal, state and municipal enterprises); the central government includes the federal government, the social security system, and the Central Bank of Brazil (BCB).

4. For any given month, the primary balance of the consolidated public sector is measured, in Brazilian reais (R$), as the total net interest (i.e., net interest paid on the consolidated net domestic debt of the public sector, plus the net interest due (competência contratual) on the net external debt of the public sector) minus the borrowing requirement of the consolidated public sector, where the public sector is defined as above. For foreign-exchange indexed government securities, the accrued interest rate is the accumulated rate of change of the U.S. dollar vis-à-vis the R$, plus the fixed coupon rate. The fixed coupon rate applies to the nominal value of the security revalued by the rate of change of the U.S. dollar vis-à-vis the R$ from the issuance date to the relevant date. For any given month, the borrowing requirement of the consolidated public sector-measured on a harmonized basis is defined as the change in the nominal outstanding net domestic debt plus the change in the net external debt, converted into R$ at the actual period average R$/US$ exchange rate,¹ minus the impact of exchange rate-induced changes in the valuation of the net debt stock accrued but not actually paid during the reference period.² The proceeds from privatization during that period are added to these results; amounts representing the recognition of unregistered liabilities during that period are subtracted from these results. The cumulative primary balance from January 1 of a given year to the relevant date of the same year is the sum of the monthly primary balances of the consolidated public sector for that period.

(ii) Indicative target on the net debt of the consolidated public sector1
	Ceiling2 (In billions of R$)
Total net debt outstanding of the consolidated public sector
End-June, 2002 (actual data)	750
End-September, 2002 (indicative target)	810
End-December 2002 (indicative target)	830
End-March 2003 (indicative target)3	835
End-June 2003 (indicative target)3	850
End-September 2003 (indicative target)3	860
1The public sector is defined as above; the net debt includes the monetary base. 2Maximum stock outstanding of total net debt of the consolidated public sector. 3For March 2003, June 2003 and September 2003, the indicative ceiling will be increased by the amount of capital investment of the state oil company Petrobrás that exceeds the programmed level of investment as specified in Table 2.

5. Total net debt outstanding of the consolidated public sector (dívida líquida total) equals the public sector's gross debt (including the monetary base), net of its financial assets; it is defined as the sum of the registered net domestic and net external debt (all valued in R$), of the central government, state and municipal governments, and the public enterprises (including federal, state and municipal enterprises); the central government is defined as above.

6. Total net debt outstanding of the consolidated public sector is measured on an accrual basis (including accrued interest) for the domestic debt component, and on an interest-due basis (competência contratual) for the external debt component. The stock of external debt and of foreign-exchange indexed domestic debt is valued at the actual R$/US$ exchange rate prevailing at the end of each period.

7. The central government will continue to incorporate into its registered debt unregistered liabilities that are currently outstanding. The above ceilings for the total net debt outstanding of the consolidated public sector are predicated on the paths for privatization receipts (defined here to exclude concession revenue) and the recognition of unregistered liabilities that are shown in Table 2 below. These ceilings will be adjusted downward (adjusted upward) to the extent that privatization receipts exceed (fall short of) the amounts implied by Table 2 below; they will be adjusted upward (adjusted downward) to the extent that the recognition of unregistered liabilities exceeds (falls short of) the amounts implied by Table 2 below.

B. External Sector Targets

(i) Performance criterion on external debt of the nonfinancial public sector1
	Ceiling (In billions of US$)
Stock of total external debt of the nonfinancial public sector at
End-June 2002 (actual data)	90.5
End-September 2002 (performance criterion)	97.6
End-December 2002 (performance criterion)	96.5
End-March 2003 (performance criterion)	95.6
End-June 2003 (performance criterion)	95.2
End-September 2003 (indicative target)2	94.9
1The data in this table apply to all external debt of the nonfinancial public sector that is disbursed and outstanding. The nonfinancial public sector includes the federal, state, and municipal governments, the public enterprises, and the social security system. Excluded from measured debt stocks are any liabilities vis-à-vis the Fund. 2Performance criteria to be set at the time of the second review under the arrangement.

8. For any given quarter, the stock of debt³ disbursed and outstanding is defined as the stock of debt disbursed and outstanding at the end of the previous quarter, plus gross disbursements that take place during the quarter in question, less the gross amortization payments made during the quarter in question.

9. The above limits will be adjusted upward to accommodate new external borrowing that is made in order to undertake a voluntary early or advance repurchase to the Fund.

(ii) Performance criterion on publicly guaranteed external debt of the private sector1
	Ceiling2 (In billions of US$)
Stock of publicly guaranteed external debt outstanding
End-June 2002 (actual)	0.4
End-September 2002 (performance criterion)	1.6
End-December 2002 (performance criterion)	1.6
End-March 2003 (performance criterion)	1.6
End-June 2003 (performance criterion)	1.6
End-September 2003 (indicative target)3	1.6
1The limit applies to all private external debt guaranteed by the public sector. The public sector includes the nonfinancial public sector (as defined above), the BCB and the financial public sector. 2These ceilings will be adjusted upward for publicly guaranteed external debt that is actually transferred to or assumed by the private sector in the context of the privatization of public enterprises. 3Indicative target to be set at the time of the second review under the arrangement.

10. For any given quarter, the stock of external debt guaranteed by the public sector is defined as the stock of external debt guaranteed by the public sector that is outstanding at the end of the previous quarter, plus the net addition to external debt guaranteed by the public sector during the quarter in question.

11. Short-term debt⁴ is defined as all debt with an original maturity of strictly less than one year. For any given quarter, the stock of short-term external debt (disbursed and outstanding) is defined as the stock of short-term external debt (disbursed and outstanding) at the end of the previous quarter, plus the net flows associated with the disbursements and amortizations of short-term debt that take place during the quarter in question.

12. The above limits will be adjusted upward to accommodate new external borrowing that is made in order to undertake a voluntary early or advance repurchase from the Fund.

13. The NIR in the BCB are equal to the balance-of-payments concept of net international reserves in the BCB (reservas internacionais líquidas ajustadas) and include gross official reserves minus gross official liabilities. Any increases in foreign currency-denominated claims (both spot and forward) by the BCB against residents, or against foreign branches or subsidiaries of Brazilian institutions from the levels existing on September 14, 2001 do not count toward NIR in the BCB.

14. Gross official reserves are defined as liquid foreign currency denominated claims in the BCB. Gross official reserves include (i) monetary claims, (ii) free gold, (iii) holdings of SDRs, (iv) the reserve position in the IMF, and (v) holdings of fixed income instruments. Items (i) through (iv) will be valued at the end-period prices shown in Table 3 below. Item (v) will be valued marked to market. Gross official reserves will exclude participation in international financial institutions, the holdings of nonconvertible currencies, and the holdings of precious metals other than gold.

15. Gross official liabilities in foreign currencies include (i) foreign currency liabilities with original maturity of one year or less, (ii) the use of Fund resources, and (iii) any forward foreign exchange (FX) liabilities on a net basis—defined as the short position (posição vendida) minus the long position (posição comprada)—directly undertaken by the BCB or by other financial institutions on behalf of the BCB. Items (i) through (iii), will be valued at the prices shown in Table 3 below.

(v) Performance criterion on the BCB's and the Treasury's exposure in derivative markets

16. The BCB and the Treasury will continue to refrain from entering into futures, forwards and other derivative contracts (involving the Brazilian real, vis-à-vis a foreign currency) that would increase the exposure in foreign exchange and is not reflected in the NIR, either directly or through any institution they use as their financial agent. This constitutes a continuous performance criterion under the arrangement. This limitation does not apply to futures, forwards contracts or foreign exchange swaps and other derivative contracts (subject to prior consultation with the staff) issued by the BCB or the Treasury, either directly or through any institution they use as their financial agent, for transactions associated with the rollover of existing foreign exchange-indexed debt instruments and foreign exchange swaps since end-March 2002.

C. Monetary Targets

(i) Consultation mechanism on the 12-month rate of inflation

The quarterly consultation bands for the 12-month rate of inflation in consumer prices (as measured by the Índice nacional de preços ao consumidor amplo (IPCA)) are specified as follows:

Consultation bands for the 12-month rate of change of the IPCA (in percent)
					September 2002	December 2002	March 2003	June 2003	September 2003
		Outer band (upper limit)			10.5	9.0	8.5	8.0	7.5
			Inner band (upper limit)		9.0	7.5	7.0	6.5	6.0
				Central point	8.0	6.5	6.0	5.5	5.0
			Inner band (lower limit)		7.0	5.5	5.0	4.5	4.0
		Outer band (lower limit)			5.5	4.0	3.5	3.0	2.5

17. Inflation prospects will be an important part of each review under the arrangement. In addition, the BCB will discuss with the Fund staff the appropriate policy response should the 12-month rate of IPCA inflation exceed the upper limit of the inner band specified in the table above. Should the 12-month rate of IPCA inflation exceed the upper limit of the outer band specified above, the authorities will complete a consultation with the Executive Board of the IMF (henceforth the Board) on their proposed policy response before requesting further purchases under the program.

III. Structural and Statistical Benchmarks

A. Structural Performance Criteria

By end-December 2002

• Enactment of the legislation to convert the social contribution for the Programa de Integração Social (PIS) into a value-added tax (VAT), as a first step towards converting, after an observation period of operation of the new system of approximately 12 months, the COFINS into a VAT.

By end-September 2002

• Develop a streamlined set of indicators from the financial data currently reported to the Off-Site Banking Supervision Department of the central bank to assess the economic and financial soundness of banks.
  
  
• Implement a systematic assessment of credit risk level of the largest borrowers in the financial system.
  
  
• Develop a monitoring system to report significant changes in key accounting data such as credit levels and composition, credit portfolio stress risks, and risk diversification.
  
  
• Completion by the central bank of an audit of its international reserves management function and systems.

• Submission to congress of enabling legislation to create complementary pension funds for federal civil servants after the approval of the relevant legislation.
  
  
• Further progress in the auctioning of the four remaining federalized state banks.
  
  
• Completion of a review of differences between Brazilian and internationally-accepted practices for the use of independent external bank auditors, in order to evaluate the appropriateness of implementing such international practices.
  
  
• Completion of the updating of existing regulations regarding licensing of financial institutions, including the adoption of a multistage approach to the licensing process; the introduction of a requirement that firms present detailed operating plans before licensing, including information on corporate organization and structure, internal controls, and corporate governance; and the requirement that the licensing process include consideration of the impact of the proposed new financial institution on market concentration and competition.
  
  
• Develop a streamlined set of indicators from the financial data currently reported to the Off-Site Banking Supervision Department of the central bank to assess the economic and financial soundness of nonbanking financial institutions.
  
  
• Develop a monitoring system to verify the quality of the accounting data provided to the Financial System Information Management Department of the central bank in terms of data consistency and accuracy.

• Submission to congress of the legislation to reduce the degree of earmarking of federal revenues (net of transfers to states and municipalities).
  
  
• Submission to congress of the legislation to prevent a revenue shortfall arising from the expected reduction in the rate of the bank debit tax (CPMF) scheduled for 2004, that is not offset by other measures.

IV. Disclosure of Specific Information

18. Specific data to continue to be provided by the authorities to the Fund staff include the following:

• Composition of gross international reserves under the cash concept (posição de caixa) and the liquidity concept (posição liquidez internacional);
  
  
• The levels of gross international reserves and of net international reserves as defined under the NIR concept;
  
  
• The BCB's position in FX futures, involving the Brazilian real, including notional amounts of open-interest contracts, both bought and sold, in each contract for the next four months (daily, the next business day if this position should exceed zero);
  
  
• Outstanding stocks of US$-indexed federal debt by instrument, showing auction values (preço de lastro) and updated nominal values (valor nominal atualizado), as well as information on rollovers of these instruments, showing the face value of the amounts falling due, and new placements of this debt . The BCB will provide details on the face value of amounts of US$-indexed debt falling due, new placements of the underlying domestic currency-denominated debt, FX swaps falling due entered into, and the total stock of such swaps.
  
  
• The BCB's asset (posição comprada) and liability (posição vendida) positions in FX swaps;
  
  
• The BCB will provide data on external credit lines of financial institutions, and of external medium- and long-term bank claims on Brazilian nonbank debtors.
  
  
• Petrobrás' commercial and financial indicators (quarterly): average ex-refinery domestic prices (gasoline and diesel); average rate of return (operating profit/capital); earnings per share (common and preferred shares, and ADSs, in reais); subsidies and transfers from the Treasury (if any); equity injections and loans from the Treasury (if any); stock of publicly-guaranteed debt; stock of tax arrears (if any).
  
  
• Certified quarterly cash flow statement of Petrobrás, including information on the current primary balance and investment expenditure of the company (on a cash basis).

The following Tables 2 and 3 set out program assumptions for selected variables.

Table 2. Brazil: Baseline Assumptions for Selected Variables (in millions of R$)
	2002		2003
	Sept.	Dec.	March	June	Sept.
Privatization receipts (cumulative/year)1	4,076	6,076	0	79	882
Recognition of previous liabilities and PROES (cumulative/year)	16,668	22,146	2,965	5,544	8,847
Programmed investment of Petrobrás			2,647	5,398	7,926
1Excluding concession revenues

Table 3. Brazil: Assumption on Accounting Exchange Rates and Gold Prices1
	Program Assumptions Third Quarter 2002
SDR (US$/SDR, end-period)	1,315
Gold price (US$/ounce, end-period)	US$308
1Currencies not shown here will first be converted using the official rate used by the Fund's Treasury Department as of August 29, 2002.