On behalf on my Saotomean authorities, I would like to express my deep appreciation to Management and Staff for their continued policy advice and support to São Tomé and Príncipe. Discussions held with Staff in Sao Tome in June and November 2006 have been very instrumental in strengthening policy design and implementation in the second part of the year. In a meeting with the Managing Director held last week in Libreville, Gabon, at the occasion of the inauguration of the Regional Technical Assistance Center, AFRITAC Center, my authorities reaffirmed their commitment to the achievement of the program objectives and their program ownership. They are determined to press ahead with their reform agenda, in order to create the conditions for low inflation and sustained growth, which is essential for poverty reduction. However, they also concur with the view that the successful implementation of the reforms will depend on the need to address the administrative and institutional capacity constraints facing the country. In this regard, they hope that they can continue to count on the support and technical assistance of the international community to help them advance towards the MDGs.

Under the program, five of the six structural benchmarks through September 2006 were met, and strong remedial actions were taken on the five quantitative performance criteria (PC) for end-June 2006 that were missed by small margins. My authorities regard the successful completion of the third review as merit for reaching the completion point under the HIPC Initiative and request the Board’s consideration in this regard. They consider—a view also shared by staff—that significant progress was made to implement all completion point triggers agreed upon at the decision point, including the implementation of the required health and education measures, the putting in place of institutional mechanisms to ensure efficient and transparent use of HIPC interim debt relief, the increase in transparency and accountability in the management of public resources, and the establishment of arbitration tribunals. They would also like to bring to the Board’s attention that they have maintained a constructive dialogue with all the country’s creditors and has contacted the Paris Club creditors with a view to concluding bilateral agreements under the September 2005 Paris Club terms of reference. They have also signed agreements with Germany and France, and the signature process with Spain is advanced. My authorities are resolved to ensure debt sustainability. To this effect, they are putting in place a debt recording and management system obtained from the Commonwealth Secretariat (CS-DRMS).

My authorities request waivers for the nonobservance of the end-June 2006 performance criteria for domestic primary balance, domestic primary spending, and net domestic financing of the government. These deviations are mainly due to higher spending related to the elections, and the Government has since then taken revenue and expenditure measures as well as monetary policy measures to broadly safeguard the financial targets for end-2006. The Government also requests waivers for the nonobservance of the end–June 2006 performance criteria on net international reserves and net domestic assets of the Central Bank of São Tomé and Príncipe which was mostly due to the delay in the receipt of oil signature bonuses.

Given that the higher inflation and election spending needs have required a revision of the government’s fiscal program for 2006, they request modification of the targets for four quantitative performance criteria for end-December 2006 and deletion of the performance criterion for domestic primary spending. Furthermore, the Government requests deletion of the structural performance criterion on the implementation of the public financial management system (SAFE) on the understanding that it will be established in due course as a structural performance criterion for end-December 2007. The original target of fully implementing the SAFE by end-2006 was not met because agreement with a key donor and technical preparation took longer than expected.

I. Recent Developments

Economic activity in 2006 has been buoyant thanks to higher foreign direct investments in the oil and tourism sectors. Growth is expected to reach 8 percent in 2006, well above the 5.5 percent projection made at the time of the second review under PRGF. However, inflation has been higher than projected on account of various factors, including temporary food shortages, higher oil product prices, large capital inflows and unforeseen election-related spending. It reached a peak of 26 percent in August before receding to 23 percent at end-November 2006, thanks to continued sound policy implementation in the second part of 2006.

Progress was also made towards strengthening democratic institutions essential for participative implementation of appropriate macroeconomic and structural reforms programs for poverty reduction. The country held successively parliamentary, presidential, and local elections from March to July 2006. These elections further strengthened democratic institutions and confirmed São Tomé and Príncipe’s well-known democratic culture. A new cabinet was appointed in April 2006 which reaffirmed its strong commitment to implement the Fund-supported program and reach the HIPC completion point. The improved economic performance at end-December 2006 demonstrates this commitment. It is worth indicating that although President Fradique de Menezes and his coalition—who won the three elections—has only a relative majority at the National Assembly, all political parties reiterated their strong support to the government’s development and poverty reduction program. The National Assembly’s passing of several laws is an evidence of this political consensus.

Fiscal Sector

Fiscal-related reforms advanced significantly with the strengthening of the Inspectorate General of Finance and the submission to and the adoption by the National Assembly of several direct tax and customs reform draft laws aimed at improving incentives, reducing distortions, lowering rates and enlarging the tax base. The authorities made good progress in preparing the integrated public financial management system for budget execution (SAFE), with notably the submission to the National Assembly of the organic public finance law and the preparation of a new budget nomenclature. However, as indicated above, the implementation of the integrated public financial management system for budget execution (SAFE) is now expected for end-2007 instead of end-2006. Nevertheless, the 2007 budget recently adopted, which is consistent with the program, will be implemented with a pilot public financial management program (SAFINHO) using the new budget classification. The authorities are aware that propoor spending is still low. They are committed to containing wages and reducing nonwage nonessential spending in order to create the fiscal space for increased propoor spending.

Through June 2006, revenue collection was better than programmed thanks to more buoyant import and domestic indirect tax receipts. Nevertheless, fiscal performance deviated from the program path owing mainly to expenditure overruns related to the elections and the need to meet unforeseen needs beyond the authorities’ control, including advances by the treasury for projects, pending financing by donors. But during mid-year, several measures were executed to bring the program back on track. These involved expenditure and revenue measures, including the increase in the import reference prices and the increase in petroleum prices in May 2006. In addition, action plans to recover corporate, personal income and petroleum indirect tax arrears have been implemented. However, the receipts of oil bonuses for Block 2–4 did not materialize as expected in 2006, thus complicating the execution of the budget. As a result, domestic primary deficit is estimated to remain within the program target of 15 ½ percent of GDP, after deviating by 2 percent from the end-June program target.

Monetary Policy and Exchange Rate Policies

Developments in the real sector and fiscal sector translated in monetary aggregates—notably net international reserves (NIR), credit to the government and private foreign currency deposits- growing faster than programmed early in 2006 and higher inflation. Policy response from the Central Bank of São Tomé and Príncipe (BCSTP) consisted in successive increases of the reference interest rate from 17.2 percent at end-2005 to 28 percent in September 2006, in order to maintain a positive real interest rate. Minimum reserves requirement was also increased. However, these measures had a limited effect in mopping up excessive liquidity in the economy and reducing monetary aggregates. In December 2006, with a view to further absorbing liquidity and reducing inflation, the BCSTP decided to activate its instrument of certificates deposits (CDs). More recently, the BCSTP resumed its foreign exchange auction system while keeping direct sales to the abovementioned purposes. In addition, the National Assembly adopted the anti-money laundering law.

Structural Reforms

Reform implementation accelerated in the second semester to make up for the delays that occurred previously. In particular, the arbitration law has been promulgated and an arbitration center has been set up at the Chamber of Commerce in mid-December 2006. These two measures mark the observance of the last completion point structural trigger. In addition, a new investment code, which provides equal treatment for domestic and foreign investors and eliminates exchange restrictions on transfers of dividends abroad, has been recently adopted by the National Assembly. As regards public enterprises, studies on the electrical sector and the restructuring of the port and airport have been completed.

II. Financial Policies for 2007

São Tomé and Príncipe remains a low-income country, still facing daunting challenges, including restoring macroeconomic stability while addressing growing pressing social needs in anticipation of both the upcoming oil era, beginning hopefully from 2012. During the meeting with the Managing Director last week, my authorities reiterated their commitment to macroeconomic stability and economic reforms with a view to better preparing the country to oil era. To this end, the program for 2007 seeks to pursue policy stance adopted since May 2006 with fiscal consolidation and inflation reduction as primary objectives. My authorities are particularly aware of the need to use oil bonuses prudently, as the potential oil reserves in awarded oil blocks are yet to be ascertained.

More specifically, fiscal policy as reflected in the 2007 budget aims at reducing domestic primary deficit by 2.5 percent of GDP. Fiscal consolidation will be achieved essentially by containing non essential spending and the wage bill (relative to GDP) through a stricter application of administrative measures decided last year. At the same time, my authorities intend to increase pro-poor spending by approximately the same amount (2.7 percent of GDP) through a prudent use of prospective oil bonuses and debt relief resources, consistently with the PRSP, the Priority Actions Program (PAP) and the Oil Revenue Management Law (ORML). On the revenue side, the impact of the tax and customs reforms will be broadly neutral in 2007, reflecting the gradual adoption of the procedural codes.

As regard fiscal-related structural reforms, the public financial management will be further strengthened with the progressive implementation of SAFE which as indicated above will be fully operational by end-2007 for the execution of the 2008 budget. My authorities are particularly concerned about the growing informal sector and accordingly they will conduct a study on indirect taxation in order to review the current tax structure and expand the tax base, with the support of international partners. On oil-related issues, it is my authorities’ intention to seek further clarification from the Joint Ministerial Committee (JMC) on the use of its important contribution (US$ 3.6 million) to the Joint Development Authority (JDA). A revised structure of the petroleum prices with fewer exemptions will be introduced by mid- March 2007, with a moderate increase in pump prices if needed.

Monetary policy for 2007 seeks to reduce the 12-month inflation to the 10–15 percent range by the end of 2007 from a level of more than 20 percent in 2006. Although this objective may appear ambitious, my authorities believe that it could be achieved through a stricter adherence to the base money target and active use of monetary and foreign exchange instruments, consistent with the NIR target, while avoiding excessive fluctuations in exchange rate and taking into account the central bank’s liquidity position. The central bank will continue to strengthen its operations with a view to improving its liquidity position and increasing transparency. This will be complemented by a more active communication strategy on its operations. My authorities are particularly thankful to the Fund for the technical assistance in strengthening the central bank’s instruments and technical capacities towards the achievement of its monetary objectives.

In their efforts to strengthen the financial sector, the Saotomean monetary authorities intend to further enhance banking supervision, implement the anti-money laundering law, and improve the internal management at the central bank in line with the IMF’s safeguards assessment conducted in 2004. Also in line with the safeguards assessment, the central bank intends to publish the 2005 audited financial statements and adopt investment guidelines for international reserves by January 2007. In addition, it will issue new prudential regulations on credit classification, liquidity, transactions with related parties, and limits on net open foreign currency positions by end-June 2007. A regular system for reporting prudential ratios to IMF staff has now been established. Following the adoption by the National Assembly of the draft anti-money laundering law, the central bank intends to adopt regulations on the creation of a Central Risk Unit within the central bank.

Other structural reforms will focus on increasing transparency in the oil sector. The government will continue the implementation of the institutional framework for the oil revenue management, as provided for in the ORML. In addition, the authorities will proceed with the implementation of the requirements for the participation in the EITI as expressed at the third EITI conference in Oslo in October 2006. My authorities believe that structural reforms covering taxation, investment code, the energy sector and banking supervision are improving the business environment and hence should promote the development of the private sector.

Conclusion

As committed at the time of staff mission in June 2006, my authorities took strong corrective actions to bring the program back on track. They have demonstrated a strong resolve to advance structural reforms with a significant number of laws passed in the fiscal, financial and governance areas. Through these reforms, they are committed to create the conditions conducive to stronger and sustained growth. They are also determined to continue to work closely with their partners to achieve the goals of sustained growth and poverty alleviation and to strengthen capacity building. In light of these achievements, my authorities request Board approval of the completion of the third review under the PRGF, and reaching the HIPC completion point.