This supplement reports on the implementation of the prior actions since the Staff Report was issued on May 3, 2016. While two prior actions have not been met, staff supports Tunisia’s request for the extended arrangement under the Extended Fund Facility (EFF), given the substantial progress made toward meeting them alongside the authorities’ commitment, as outlined in the authorities’ supplement to the MEFP, to continue to address shortcomings by implementing two structural benchmarks. The inability to complete all elements of the prior actions on time, nevertheless, highlights risks to the EFF-supported program in a political environment that remains fragile.

1. The prior action on the tax strategy has been met. The Council of Ministers adopted in early May a strategy anchored on the principles of equity and efficiency of the tax system, with a timeline for: (i) broadening the VAT base by reducing exemptions; (ii) rationalizing VAT rates (from three to two); (iii) introducing a more progressive personal income tax (including through less deductions and a significantly higher tax threshold); (iv) reducing further the dichotomy between the offshore and onshore corporate tax rates by 2018; and (v) increasing the tax on dividends. A study on earmarked taxation is expected to further rationalize “special treasury funds” and the taxes funding them. The authorities are also working on reforming their tax incentives framework; staff urges the authorities to rationalize tax incentives as they distort economic decisions and have failed in the past to stimulate investment in Tunisia.

2. Notwithstanding considerable progress, the prior action on the central bank, banking, and bankruptcy laws has not been met. The new legislation enhances central bank independence, introduces a lender of last resort mechanism, establishes a banking resolution mechanism and a deposit guarantee fund, and modernizes the bankruptcy regime, representing considerable advances over the existing framework. The bankruptcy law is in line with good international practices. However, the prior action is not met in view of the remaining gaps with good international practices on central bank autonomy (e.g., government presence in the CBT board) and in the resolution framework (eg., constraints of the guarantee fund to finance transactions, creditor hierarchy in liquidation, and government presence in the resolution committee).

3. The prior action on the business plans of public banks has also not been met. All three banks revised their business plans, which were subsequently adopted by their boards. Staff judged that one business plan (BH) was in line with minimum regulatory requirements, with the planned issuance of subordinated loans helping BH comply with prudential ratios during the entire restructuring period. However, this was not the case for the business plans of two other banks:

• For the STB, progress has been made but not enough to meet minimum prudential requirements as new financial assumptions are more modest than in the initial plan but still depend on finalizing a NPL resolution strategy that is already underway. A newly hired external consultant will help the bank finalize its business plan by end-June.

• For the BNA, additional work is needed for it to meet minimum requirements. A Council of Ministers meeting in early May clarified the government’s policy on the agricultural sector and on government guarantees backing loans provided to SOEs. This decision paves the way for the bank to revise its plan in the next few weeks with a clear justification of the profitability of its exposure to the agricultural sector and of its NPL reduction strategy. Additional revisions are needed to ensure regulatory compliance throughout the restructuring period.

4. Staff regrets that the legislation does not meet good international practices in all respects, but welcomes the progress made and encourages the authorities to make future amendments to close remaining gaps. In addition, staff welcomes the authorities’ plans to address some of the shortcomings of the banking law regarding the resolution framework through decrees (e.g., for least–cost test of resolution) and by-laws (e.g., a short timeframe to determine resolution measures for systemic cases). Timely implementation of the related structural benchmarks, as outlined in the supplement to the MEFP, will be critical for the success of the program and hence for the completion of the first review. Staff will, furthermore, continue to work with the authorities to improve the CBT law and align it with good international practices during the EFF-supported program.

5. Staff regrets the latest delays in finalizing banks’ business plans and urges their swift adoption to ensure the implementation of sound operational restructuring. The finalization of proper business plans along the lines outlined in the supplement to the MEFP will be critical for the success of the program, and hence for the completion of the first review. Implementation will, furthermore, be enhanced by the signing of performance contracts, which should monitor banks’ financial performance on a consolidated basis (at least for some key indicators).

Supplementary Memorandum of Economic and Financial Policies

Tunis, May 17, 2016

Madam Christine Lagarde

Managing Director

700 19th Street, NW

Washington, DC 20431

USA

Madam Managing Director:

1. The information below updates the memorandum of Economic and Financial Policies (MEFP) annexed to our letter dated May 2, 2016 to reflect developments of the past few weeks and our latest commitments on banking reforms (Table 1).

Table 1.

Tunisia: Additional Structural Benchmarks

Table 1.

Tunisia: Additional Structural Benchmarks

Proposed Structural Benchmarks	Objective	Date
Financial sector reform
Approval, by the board of Directors of STB and BNA, of revised business plan ensuring regulatory compliance throughout the restructuring period and in line with the principles detailed in the MEFP.	Financial sector stability	Jul-16
Approval of secondary legislation to address some of the weaknesses in the banking law regarding the bank resolution framework through the (i) adoption of a government decree to implement the framework of the Bank Deposit Guarantee Fund that includes a least cost-test for resolution with an exception for systemic cases; and (ii) adoption of a bylaw of the Resolution Committee providing a short timeframe to determine resolution measures for systemic cases.	Financial sector stability	Aug-16

View Table

Table 1.

Tunisia: Additional Structural Benchmarks

Proposed Structural Benchmarks	Objective	Date
Financial sector reform
Approval, by the board of Directors of STB and BNA, of revised business plan ensuring regulatory compliance throughout the restructuring period and in line with the principles detailed in the MEFP.	Financial sector stability	Jul-16
Approval of secondary legislation to address some of the weaknesses in the banking law regarding the bank resolution framework through the (i) adoption of a government decree to implement the framework of the Bank Deposit Guarantee Fund that includes a least cost-test for resolution with an exception for systemic cases; and (ii) adoption of a bylaw of the Resolution Committee providing a short timeframe to determine resolution measures for systemic cases.	Financial sector stability	Aug-16

2. The new legislation on the central bank, bankruptcy and banking statutes was adopted in early May 2016. These laws will have a large transformational impact on Tunisia’s business environment and banking sector, accelerating the modernization of the country’s economic structure in a more efficient and equitable way. To ensure the recently approved legislation reduces the remaining gaps with good international practices on banking resolution, we will introduce improvements in the resolution framework by end-August (structural benchmark) through: (i) adoption of a government decree to implement the framework of the Bank Deposit Guarantee Fund that includes a least cost-test for resolution with an exception for systemic cases; and (ii) adoption of a bylaw of the Resolution Committee providing a short timeframe to determine resolution measures for systemic cases.

3. All three public banks revised their business plans, but two of them need further revisions to ensure regulatory compliance throughout the restructuring period. The recently appointed management of the STB and BNA public banks initiated their organizational restructuring, but found that more time was needed to revise the business plans in order to fine tune their business strategy and adjust accordingly the new organization and terms of reference of each business unit. To remedy the weaknesses already noted by the Central Bank of Tunisia’s banking supervision department, the public banks are working on a new version that will be approved by their boards by end-July 2016 (structural benchmark) and address the following concerns:

• The plan for STB will fully incorporate revised macroeconomic and financial assumptions. It will take into account the forthcoming capital requirements on operational risk as well as the lifting of forbearance on new NPLs (granted following the 2015 terrorist attacks) and will focus on a proper NPL resolution strategy rather than on an aggressive growth strategy.

• The plan for BNA will focus on maintaining an adequate liquidity and solvency levels throughout the restructuring plan, starting with booking a sale of non-strategic assets as soon as possible to ensure it has enough buffers to continue to meet its capital requirements during the entire restructuring period (2016-20). The plan will take into account the forthcoming lifting of forbearance on new NPLs and the recent government decision on the treatment of new loans to agriculture on a commercial basis (the impact of old loans will gradually fade as these get repaid or resolved, helping profitability). The confirmation of government guarantees (callable on first demand) for loans to public entities will help the bank meet regulatory requirements throughout the restructuring period. Sound operational restructuring will help the bank to properly assess, price, monitor and manage credit risk on all loans.

Sincerely yours,

/s/	/s/
Chedly Ayari	Slim Chaker
Governor of the Central Bank of Tunisia	Minister of Finance

View Table

/s/	/s/
Chedly Ayari	Slim Chaker
Governor of the Central Bank of Tunisia	Minister of Finance