Public Information Notice No. 02/136

Public Information Notice: IMF Concludes 2002 Article IV Consultation with Nicaragua

December 12, 2002

On December 4, 2002, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Nicaragua.¹

Background

After a decade of economic decline, the peaceful transition to a democratic system and adoption of market-based reforms in the early 1990s generated a strong economic recovery. Real GDP grew at an annual average of about 5 percent during the second half of 1990s and inflation was brought under control, helped by a slowing crawl of the exchange rate. Substantial external assistance mitigated the adverse effect on growth caused by the 1998 Hurricane Mitch. Notwithstanding these improvements, this period also saw the emergence of new vulnerabilities, reflecting a difficult political environment and social tensions. Government spending remained high and became inflexible, and the domestic debt of the public sector increased substantially. Meanwhile, bank credit to the private sector was allowed to expand rapidly, under inadequate supervision.

In 2000-01, the economy deteriorated sharply as the vulnerabilities were compounded by external shocks (including a steep decline in the terms of trade) and a widening fiscal deficit. Efforts to arrest the economic deterioration under a staff-monitored program (SMP), covering the second half of 2001, were not successful. The combined public sector deficit (after grants) increased to over 14 percent of GDP in 2001, reflecting large expenditure overruns; governance concerns intensified; and a banking crisis stunted credit flows to the private sector. As a result, real GDP growth, after reaching over 7 percent in 1999 (boosted by Hurricane Mitch-related spending), slowed to an estimated 1 percent in 2002. Exchange rate policy continued to follow a "crawling peg" to the U.S. dollar, and trend inflation remained around 6 percent, reflecting the exchange rate crawl.

The financial position of the central bank deteriorated sharply in 2000-01. In addition to a large loss of reserves (with NIR declining by US$200 million over the two-year period), the central bank's dollar-indexed domestic debt jumped by US$520 million (21 percent of GDP) as it absorbed the cost of resolving four banks that failed in 2000-01. Gross official reserves at end-October 2002 stood at US$362 million (2.7 months of imports of goods and services); excluding reserve requirements on dollar deposits with domestic banks, gross reserves were US$166 million (one month of imports of goods and services).

The new government that took office in January 2002 has moved quickly to address economic imbalances. Government spending was reined in, first through administrative means and then (in July) by a reduction in the budget (by about 1.5 percent of GDP). The assembly also approved the first round of a major tax reform package, yielding about 2.1 percent of GDP. As a result, the combined public sector deficit after grants is projected to narrow significantly in 2002 (to 9.2 percent of GDP). Reflecting improved confidence, interest rates on central bank paper dropped significantly after the November 2001 presidential elections, to about 12 percent by mid-2002; since then, monetary policy has been tightened and interest rates have increased to about 15 percent by October. Despite the absence of balance of payments support, the net position of the central bank (NIR plus the central bank's domestic debt) has remained broadly stable during the first 10 months of the year. Prudential oversight of banks has been stepped up, and all banks have been required to comply with relevant provisioning and capital adequacy rules.

Nicaragua reached the decision point under the HIPC Initiative in December 2000, and it is expected to reach the completion point by end-2003 assuming relevant conditions are met. In 2001-02, Nicaragua received about US$110 million of interim assistance from various multilateral organizations, which has been used to finance poverty-reducing expenditures in the health, education, and social safety net programs. The debt service deferral granted by Paris Club creditors after Hurricane Mitch (1998) expired in March 2001, and since then Nicaragua has been servicing its post-cut-off debt. During 2000-02 Nicaragua negotiated debt reduction agreements with Brazil, Bulgaria, Finland, Guatemala, and Slovakia, in line with the enhanced HIPC Initiative. At end-2001, Holland cancelled its ODA claims on Nicaragua.

Executive Board Assessment

Executive Directors noted with concern that economic performance in Nicaragua had deteriorated significantly in recent years as domestic problems were compounded by external shocks. In particular, a deterioration of the external environment, combined with expansionary fiscal and monetary policies in the run-up to presidential elections and a banking crisis, had resulted in large increases in the fiscal deficit and domestic debt, and a significant decline in official international reserves.

Against this backdrop, Directors welcomed the new government's commitment to correct the economy's key vulnerabilities and create the basis for sustained growth and poverty reduction by addressing the structural rigidities confronting the economy. They were encouraged by the authorities' efforts to date to address the macroeconomic imbalances, strengthen prudential oversight in the banking sector, and undertake strong anti-corruption initiatives, but stressed that further decisive actions in these areas will be needed over the medium-term. Building on the government's strong ownership of the program, it will therefore be important that the authorities continue their efforts to widen ownership and support for reform across the political spectrum and among the population at large.

Directors agreed that sustained fiscal consolidation will be key to the authorities' medium-term strategy and, in particular, their objective of attaining public debt sustainability. Early passage and strict implementation of the 2003 budget, in line with the program, will be an important milestone in this regard. Following the helpful first stage of tax reform, which fell however short of initial objectives, Directors underscored the need for timely adoption of a second round of reforms to achieve the targeted increase in revenues while also making the tax system more equitable, efficient, and transparent. They stressed that eliminating tax exemptions and reducing the list of zero-rated VAT items will be critical to this end. They also looked forward to the planned comprehensive reform of tax administration and partial transfer of pension administration to the private sector, while encouraging careful monitoring of any budgetary implications of pension reform. On the expenditure side, Directors supported the authorities' plan to reduce non-priority primary spending while raising the quality and quantity of poverty-reducing spending. They highlighted, in this context, the importance of carrying on with the implementation of the new mechanism to track and monitor the use of poverty-reducing spending, and also looked forward to the forthcoming Poverty and Social Impact Analysis to help target social programs.

Directors supported the authorities' monetary policy strategy of strengthening international reserves while maintaining low inflation, noting that fiscal adjustment and implementation of the asset recovery plan will be key to helping achieve these objectives. The authorities were also encouraged to further strengthen the independence of the central bank. Directors noted that the crawling peg exchange regime has helped to keep inflation low, and that the current level of external competitiveness is broadly appropriate. While Directors saw no need to consider abandoning the crawling peg in the near future, many Directors considered that over the medium term greater flexibility would help reduce vulnerabilities and facilitate adjustment to shocks and structural change. These Directors, therefore, recommended that the authorities put in place the conditions for moving toward greater flexibility, including appropriate fiscal, monetary and financial sector policies, while carefully taking into account the high degree of dollarization of the economy.

Directors stressed the crucial importance of strengthening bank supervision and strict enforcement of prudential rules, especially on provisioning and minimum capital requirements. They urged the supervisory authorities to react promptly and forcefully to any weaknesses in financial institutions. Directors welcomed the recent selection of a firm to implement asset recoveries, and encouraged the authorities to allow speedy asset disposal without government interference—noting the importance of successful asset recovery for program financing, improving governance, and strengthening the credit culture. Directors commended the authorities' commitment to combat money laundering and the financing of terrorism, and encouraged them to continue their efforts in this area. They also looked forward to the implementation of the recommendations of the safeguard assessment.

Directors were encouraged by the steps taken by the authorities toward achieving public debt sustainability, including their efforts aimed at lowering the stock of nonconcessional domestic debt. They also stressed that long-term debt sustainability beyond debt relief will depend on continued prudent external borrowing based on highly-concessional financing.

Directors welcomed the high priority which the authorities are giving to structural reforms aimed at addressing economic vulnerabilities and removing long-standing barriers to growth. They looked forward to continued efforts to fight corruption and improve accountability in the public and private sectors, and urged the authorities to press ahead with their plans for reforming the judicial system, restructuring the public sector, and continuing the privatization program. Further trade liberalization and regional integration will also be important to underpin growth and external viability.

Directors supported the planned improvements in Nicaragua's economic statistics, including steps to bring monetary statistics and national accounts in line with international standards, and encouraged the authorities to follow up on their intention to join the General Data Dissemination System.