Political Developments

2. Bolivia has faced difficult political circumstances. President Mesa resigned due to social unrest, and subsequently both presidents of the Senate and the Lower Chamber declined to take over. As a result, the President of the Supreme Court Eduardo Rodríguez was sworn in as President on June 9. Congress amended the constitution to allow general elections on December 4, and a political settlement was reached to hold a constitutional assembly and a referendum on regional autonomy in mid-2006. We highlight that the presidential succession and all other political arrangements were carried out within the legal framework.

Economic Performance under the SBA

3. Despite adverse social and political conditions, macroeconomic stability has been maintained and overall performance has been positive in 2005. Economic growth remained strong during the first half of the year, boosted by the hydrocarbons sector, and the balance of payments in the first semester has been substantially stronger than programmed.

4. The Bolivian authorities have shown a strong commitment to the economic program under the SBA. All the end-June quantitative performance criteria were observed. In particular, the fiscal deficit was smaller than programmed, and the target for the accumulation of net international reserves was met with a large margin. According to preliminary information, all end-September quantitative performance criteria were also met.

5. The authorities also made important progress in carrying out the structural reforms envisaged under the program. Congress passed new tax code procedures and a law enhancing the Financial Restructuring Fund and enhancing the autonomy of the banking superintendency and the central bank. Also, provisioning and reserve requirements were tightened. In addition, the authorities submitted three draft bills to Congress: the budget law for 2006, consistent with a reduction in the programmed fiscal deficit to 3 percent of GDP; the Budget Framework Law, aimed at enhancing the budget process at all levels of government; and a law introducing a partial-coverage deposit insurance scheme, with contributions from financial institutions.

Economic Performance in 2005

6. Real growth in 2005, underpinned by a significant increase in hydrocarbons output, is forecast at 4 percent, lower than envisaged under the program, but higher than in 2004 (3.6 percent). Twelve-month inflation would decrease to 4.2 percent, from a peak of 6.4 percent in June. The overrun of the program inflation target (3.8 percent) is associated mainly with temporary supply disruptions caused by road blockades and the depreciation of the Boliviano vis-à-vis regional currencies. The balance of payments will likely be substantially stronger than originally expected.

Fiscal Policy

7. The public sector recorded an overall surplus of 0.4 percent of GDP during the first seven months of the year, reflecting both higher revenues and lower spending. The increase in revenues reflected improvements in tax administration, strong gas exports, and the introduction of a new tax on hydrocarbons. Spending has been contained, due mainly to the slow implementation of public investment.

8. In view of the fiscal surplus recorded in the first seven months of the year, hydrocarbon revenues not contemplated in the program, and lower pension payments, the projected fiscal deficit for 2005 has been adjusted downward to 3.5 percent of GDP, 2 percentage points lower than the programmed deficit before grants. A recovery in public investment implementation is expected in the remainder of the year—especially in infrastructure and social projects—through the use of a share of revenue from the new tax on hydrocarbons and the upturn in project-financing external disbursements. In addition, current spending will also increase due to fuel subsidies and transfers to a housing program targeted to low-income families.

9. In order to improve control on wage and pension layouts and on sub-national debt, the authorities are creating registers for public sector employees and pensioners (they expect to cover 50 percent of the health and education sector employees by end-December 2005) and a register system for the debt of 9 regional governments and 17 municipalities, which has been presented to sub-national government.

10. A tax reform is contemplated under the SBA. However, given the interim nature of the current government and the need for such a reform to be fully owned by the next government, the submission and approval of a tax reform is not possible for the moment. Nevertheless, the authorities will prepare a draft tax reform law by end-December for consideration by the new government. The proposal will include, inter alia, a personal income tax, and will be anchored on the objectives of equity and efficiency.

Monetary and Exchange Rate Policies

11. Monetary and exchange rate policies have been consistent with low inflation and accumulation of foreign exchange reserves. During May and June, deposit withdrawals associated with the political crisis introduced pressures on the reserve position. In response, the central bank temporarily raised interest rates on liquidity loans. Once confidence was restored, financial system deposits recovered from the sharp drop in June, and liquidity assistance extended to banks was fully repaid. Moreover, the net liquid foreign assets of the financial system have increased significantly—including central bank reserves, which are now much higher than programmed. The monetary impact has been matched by renewed demand for local currency. At the same time, in order to prevent possible inflationary pressures, the central bank has increased its placements of local currency paper. It should be noted that local currency interest rates have declined, given the increased preference for local currency.

12. The crawling peg regime has contributed to keeping a highly competitive real effective exchange rate, given the appreciation of the region’s main currencies. In mid-July, the monetary authorities marginally appreciated the Boliviano against the U.S. dollar and widened the bid-offer spread, thus prompting increased activity in the interbank foreign exchange market. A small additional appreciation was introduced in mid-September.

13. Favorable market conditions have allowed the authorities to improve the currency composition and the maturity structure of domestic debt. The share of local-currency Treasury paper in open market operations has increased by over 20 percentage points since the end of 2004, and the average maturity of new issuances has tripled to over three years. Furthermore, the introduction of a new electronic auction system has improved transparency and information-sharing. The authorities have stated their intention to persist in their efforts to improve the currency composition and maturity of domestic debt.

14. The strength of international reserves has contributed significantly to limiting vulnerabilities, including those associated with political uncertainties. Given this positive performance, the projected increase in net international reserves has been revised upwards to US$230 million in 2005, compared with US$40 million, as originally programmed. However, in light of the risk of deposit withdrawals during the electoral period, the proposed target for end-December has been set at US$135 million. In addition, the authorities will take action to reduce 12-month growth in currency issuance, from 30 percent in June to 26 percent by December 2005, and will keep developments in the foreign exchange market under close review.

15. By end-December, the authorities will submit draft legislation to Congress aimed at expediting corporate restructuring and bankruptcy procedures. By the end of the year, they plan to sell the remainder of the state’s assets in a bank where the public sector holds a majority ownership.

Prospects and Vulnerabilities

16. The authorities project a real GDP growth rate in the range of 4-4½ percent in 2006, lower inflation, and a further reduction of financial sector vulnerabilities. The growth objective is underpinned by an acceleration of activity in the mining and construction sectors, and by higher capacity utilization in the hydrocarbons sector. With respect to this sector, the current administration is implementing and regulating the new law approved by Congress in May. Given the significant energy price distortions and the fact that discussions with oil companies on implementation issues are still ongoing, the impact of the new law is yet to be fully assessed. Hence, no further legislative adjustments are contemplated at this stage, and any review of the hydrocarbons policy would be conducted by the next government.

17. Inflation control will be eased by prudent management of hydrocarbon revenues, some of which will be saved to reduce the fiscal deficit and avoid creating expenditure rigidities in the medium term. The fiscal stance and competitive exchange rate, together with high prices for hydrocarbons and metals, will contribute to maintaining current account and overall balance of payments surpluses. Hence, a further increase in international reserves is expected.

18. The strength of international reserves and the reduction of the fiscal deficit from almost 9 percent of GDP in 2002 to 3.5 percent in 2005 have placed the economy in a better position. Medium-term fiscal prospects are expected to improve, and the decline in the fiscal deficit—due mainly to the increase in hydrocarbon revenues—would result in a lower debt ratio. Nevertheless, the Bolivian economy faces vulnerabilities that may jeopardize these prospects. In this regard, the authorities and the staff concur that the financial system is still highly dollarized and is very sensitive to political crises; that the current distribution of revenues and spending responsibilities between the central and sub-national governments is inadequate, with some regions calling for more fiscal decentralization and autonomy; and that subsidies on fuel are rising hazardously.

19. The authorities acknowledge the challenge to design an adequate fiscal decentralization policy and to modify the current distribution of revenues and spending to ensure fiscal sustainability. In addition, a flexible price-setting mechanism for fuel is needed, but not politically feasible in the current circumstances. It is expected that consultations during the final review will provide an opportunity for the new authorities to outline their medium-term economic policies and future arrangements with the Fund.

20. Given Bolivia’s improved performance and progress to date, we look forward to favorable consideration by the Executive Board of the authorities’ request for (i) the conclusion of the sixth review; (ii) waivers of nonobservance and applicability, and modification of performance criteria, and (iii) rephasing and reduction of access under the SBA, and precautionary treatment henceforth.