June 18, 2003

On behalf of our Nicaraguan authorities, we would like to thank the Staff and the Management of the International Monetary Fund (IMF) for all the advice and work done toward the making of the report on the country’s economic situation and for their broad set of recommendations. Also, they want to recognize the technical assistance received from the Fund and look forward to continue with this helpful relationship.

At this time our authorities request the Fund’s support for the completion of the first and second review under the PRGF arrangement, the review of the performance criteria for June 2003 and September 2003, and for a grant waiver for the nonobservance in due time of two performance criteria: the structural performance criteria related to the approval of the 2003 budget and the quantitative performance criteria for net domestic financing of the consolidated public sector. Both conditions have already been fulfilled, in addition to the prior conditions for this review that are fully described in Table II, Attachment II of the staff paper.

Background

Early this year during the Board visit to Central America, the visiting directors had a close view of the Nicaraguan political environment, and the difficulties that this government is facing in promoting a broad economic and structural reform agenda (See Box 1of the staff paper). The still young Nicaraguan democracy requires a lot of lobbying and dialog among the different actors in order to execute the planned reform agenda and the government has relied heavily upon the discussions promoted in the CONPES (Commission for Economic and Social Planning) where there is representation of almost all the member of the civil society. Our authorities remain grateful for the role that the Directors played during this visit, contributing a great deal to open new channels of dialogue and communication among the government, the different political parties and rest of the groups of the civil society toward attaining the necessary consensus for the approval of envisaged program reforms. Once again, the Nicaraguan Government would like to thank Directors, not only for their interest in enhancing their knowledge of the country, but also for their support to the program showed during their visit.

Amid this complex political environment, the strong commitment of our authorities has persevered, resulting in macroeconomic performance for 2002 well in line with the program, real GDP growth as envisaged at 1 percent, inflation drop to 4 percent below the targeted 6 percent and the external sector strengthened.

Fiscal Policy

Fiscal policy is one of the basic pillars of the program. For this reason our authorities have taken bold measures to protect its foundations, such as the Presidential partial veto to the 2003 budget that was modified unilaterally by Congress, incorporating additional expenditures that were above the program target. Before taking this decision, the President of Nicaragua addressed the nation explaining that even as this addition to the budget would sound right on the surface (municipality transfers and salary rises to policemen, health workers and teachers), it was a serious threat to the country since the completion point and donors’ assistance were at risk of being lost if the program went out of track, and for the good of each and every one of the Nicaraguan people he was vetoing the budget. Following the veto and in search of the necessary consensus for the approval of a sustainable budget, a higher spending equivalent to 0.3 percent of GDP¹ was allowed, yet at this time the compensatory revenue measures were incorporated in the form of taxes on luxury cars, cigarettes and commercial banks², in addition to some spending cuts, among them a 20 percent reduction in the salaries of the President and all his cabinet ministers, deputy ministers and secretary generals.

It is important to emphasize that at no time has the poverty reduction spending been compromised—as a matter of fact part of the above additional spending (0.2 percent) has been devoted to this purpose. Moreover, for this year the authorities have budgeted funds in a higher amount than originally planned. To have more transparency and better management of the public spending—especially those oriented toward poverty reduction and growth—the Government is establishing a high-level commission that will lend advice to the authorities in this matter. This is one of the agreed benchmarks.

Other bold measure taken prior to this review was the second stage of the tax reform initiated in 2002. This reform that aims to increase efficiency, equity and fairness in the tax system will generate additional revenues on an annual basis of about 1.7 percent of GDP—this surpasses the 1 percent that originally was envisaged under the program. The additional revenues will be used to attend extra expenditures that were agreed on with the legislative power.

Now that a reasonable tax burden has been reached, our authorities will focus their attention on improving customs and tax administration—they expect that once these measures are in place they will improve tax collection by about 0.6 percent of GDP at the end of the program. The government is requiring the Fund’stechnical assistance for the inception of these measures. Our authorities are fully committed to achieve this benchmark that is scheduled for the third review of the program. ‘

Monetary and Exchange Rate Policies

The Central Bank’s law mandates price and exchange rate stability as well as the protection of the economy’s payment system as the main objectives of the institution. With these in mind, our authorities are conducting a monetary policy that aims at strengthening the financial position of the central bank, in the context of low-inflation and a crawling peg exchange rate system.

With the purpose of improving the financial position of the Central Bank, our authorities are taking the following measures:

• о Early buybacks of the bank’s domestic debt to help dilute the high concentration debt service that falls due in 2004.

• о A proposal to commercial banks to exchange on a voluntary basis their bond holdings for new instruments bearing a lower interest rate and longer maturity, but as indicated in the staff paper, with better financial characteristics that will make these instruments more negotiable. It is important to mention that the commercial banks understand the significance of this measure and have indicated their willingness to cooperate with the Central Bank to make this swap possible.

• о They concluded an auction of the assets that the Central Bank had received from intervened banks. To guarantee the transparency of the process, it was conducted by a well known international firm.

Regarding exchange rate policy, our authorities consider that the crawling peg exchange rate regime has served Nicaragua well and will continue using it as an anchor to control inflation. Nonetheless, they have taken notice of the staff’s concern about the risk and vulnerabilities associated with a peg, and as indicated in the staff paper, they will conduct a study of their actual exchange rate system to be discussed with the Fund staff.

Financial Sector

As indicated in paragraph 11 of the Supplementary Memorandum of the Economic and Financial Policies, the strengthening of the financial sector is a high priority in the government’s agenda. To this end, they have tightened banking supervision and are strictly enforcing the existing regulatory and prudential framework. As the staff point out, the supervisory authority will conduct on-site inspections of all banks and will take the necessary actions to correct any anomaly discovered during these visits.

Once again, our authorities would like to confirm their resolution to obtain the approval of the National Assembly (Not latter than September 2003) of the required reforms of the financial laws that will allow to establish a new set of prudential norms limiting liquidity risk and a regulatory framework in line with Basel Core Principles. Additionally, and with the assistance of the World Bank, they are working in establishing a unit responsible for the management and liquidation of assets resulting from possible bank failures. This unit will be a component of the recently created deposit insurance system (FOGADE).

To identify the strengths and vulnerabilities of the Nicaraguan financial system, and to determine the system’s developmental and technical assistance needs, as well as to help prioritize policy responses, the government is requesting the inclusion of the country in the Financial Assessment Program (FSAP).

External Debt

At the outset, our authorities would like to recognize the assistance given to Nicaragua by the International community during the 2002 Paris Club meeting, where most of the donors offered full debt forgiveness. The government would also like to reaffirm their commitment to only obtain concessional loans and carry no arrears, and they are doing their best efforts to obtain comparable HIPC debt relief from all non-Paris Club creditors.

The Nicaraguan Government has indicated their determination to comply with all the necessary conditions to reach the HIPC completion point by the end of 2003, In search of this objective, substantial progress has been made not only in macroeconomic aspects but in the areas of structural reforms and governance as well. On top of this, there is a well designed PRSP that is in its second year of implementation.

External Sector

Nicaragua is a relatively open economy that will be strengthened by a free trade agreement between the Central American countries and the USA. As indicated in the staff report, this agreement will be an essential source of medium-term growth, that will add to the benefits of the free-trade agreements with Mexico, Chile, Panama, Dominican Republic (these last three agreements are in the process of ratification by the National Assembly), and to those of the agreement with Canada that is being negotiated at this present.

Another important action toward trade liberalization was the recent elimination of a tax surcharge imposed on the imports coming from Honduras. This action makes trade within the Central American countries almost free.

To further facilitate trade, our authorities are in the process of revising their custom methodology and database. As indicated in the staff paper, they will seek the Fund’s technical assistance for this important task.

To conclude, our authorities remain confident that they will be able to gather the necessary political support to continue with the pace of reform, especially now that the main challenges (the budget and the tax reforms) of the program have been accomplished. We sincerely believe that underneath the political disputes there is clear understanding among the different political parties of the serious implications if the program goes out of track, and it can be expected that none of them will risk their political capital by going against the program.

Our authorities would like to reiterate their commitment with regard to the fight against corruption and to the improvement of governance and transparency in all governmental activities.