oversight

International Monetary Fund: Approach Used to Establish and Monitor Conditions for Financial Assistance

Published by the Government Accountability Office on 1999-06-22.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                       United States General Accounting Office

GAO                    Report to Congressional Committees




June 1999
                       INTERNATIONAL
                       MONETARY FUND
                       Approach Used to
                       Establish and Monitor
                       Conditions for
                       Financial Assistance




GAO/GGD/NSIAD-99-168
United States General Accounting Office                                                          General Government Division
Washington, D.C. 20548




                                    June 22, 1999

                                    Congressional Committees:

                                    To facilitate congressional oversight of U.S. policy concerning the
                                    International Monetary Fund (IMF), the Omnibus Appropriations Act for
                                    1999 required us to report on the conditions the IMF establishes with its
                                                          1
                                    borrower countries. IMF member countries may request financial
                                    assistance from the IMF when they face or anticipate balance-of-payments
                                    problems, that is, when they have difficulty obtaining the financial
                                    resources needed to meet their payments to nonresidents. IMF staff and
                                    the borrower country agree upon the financial assistance and policy
                                    changes that the country intends to undertake as conditions for that
                                                                                                 2
                                    assistance. Upon approval from the IMF’s Executive Board, the country
                                                                                     3
                                    gains initial access to the financial assistance.

                                    The objectives of this report are to (1) describe how the IMF establishes
                                    financial arrangements with borrower countries and the types of
                                    conditions set under these arrangements and assess how this process was
                                    used for six borrower countries; and (2) describe how the IMF monitors
                                    countries’ performance and assess how this process was used for the same
                                    six borrower countries, detailing the conditions met and not met, the
                                    reasons why conditions were not met, and the actions the IMF took in
                                    response. We reviewed the most recent IMF financial arrangements for the
                                    following six borrower countries: Argentina, Brazil, Indonesia, Republic of
                                    Korea (hereafter referred to as Korea), the Russian Federation (Russia),
                                    1
                                     The Omnibus Appropriations Act for Fiscal Year 1999 (P.L. 105-277, Oct. 21, 1998) appropriated about
                                    $18 billion for the IMF and required us to report on a seven-point mandate for reviews of the IMF. We
                                    are addressing this mandate in three reports— this report on the terms and conditions of IMF financial
                                    assistance; one addressing the IMF’s financial condition, to be issued by September 30, 1999; and the
                                    third addressing borrower countries’ trade policies, to be issued in June 1999 (GAO/NSIAD/GGD-99-
                                    174, June 22, 1999).
                                    2
                                     The Executive Board is the IMF’s primary decision-making body. The Board comprises 24 Executive
                                    Directors who are appointed or elected by member countries or by groups of member countries.
                                    3
                                      With the exception of some financing for low-income countries, the IMF does not loan funds to a
                                    country, per se. Rather, the country “purchases” the currency it needs from the IMF with an equivalent
                                    amount of its own currency and then later “repurchases” its own currency according to the terms
                                    applicable to the IMF financing policy. For the purposes of this report, we will use the terms
                                    “disbursement” and “loan” to refer to “purchases,” and “repayments” to refer to “repurchases.” We use
                                    the term "arrangement" to describe the broad concept of IMF's financial assistance to countries and the
                                    associated conditions that are intended to address the underlying causes of the countries' need for
                                    financial assistance. We use the term "program" to describe the conditions, which are the policy
                                    changes or reforms, as outlined in the documents countries prepare in the context of their IMF
                                    financial assistance.




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                   and Uganda. We selected these countries because they are geographically
                   diverse and represent a mix of borrowers that were having actual or
                   potential balance-of-payments difficulties. Several of these countries were
                   in the midst of a financial crisis at the time they requested assistance.
                   Unless otherwise noted, data in this report are current as of April 30, 1999.

                   The IMF’s process for establishing and monitoring financial arrangements
Results In Brief   with member countries gives it wide latitude in assessing a country’s initial
                   request for assistance, establishing terms and conditions for that
                   assistance, and determining the country’s continued access to IMF
                   resources. Under its Articles of Agreement, as amended, the IMF limits
                   financial assistance to those countries with a balance-of-payments need. In
                   practice, the IMF has broadly interpreted this provision to encompass a
                   wide array of financial difficulties. Continued disbursement of assistance
                   to a country is based on the IMF’s consideration of data on and judgment
                   of the country’s progress in meeting the agreed-upon conditions. The IMF
                   has continued making disbursements to countries that have not met all key
                   conditions when it decided that the country had made sufficient progress.
                   However, when the IMF determined that a country’s progress in meeting
                   key conditions was insufficient, disbursements have been delayed and
                   have not been resumed unless or until, in the IMF’s judgment, satisfactory
                   progress has been achieved.

                   Over time, the IMF has developed a broad framework for establishing a
                   financial assistance arrangement that is to be applied on a case-by-case
                   basis considering each country’s circumstances. This process, based on
                   the IMF’s analysis of country data and projections of future economic
                   performance, gives the IMF considerable latitude in establishing the
                   balance-of-payments need, the amount and timing of resource
                   disbursements, and the conditions for disbursements. Under its Articles of
                   Agreement, as amended, the IMF provides financial assistance only to
                   those countries with a balance-of-payments need. These Articles do not
                   precisely define “need,” and, according to IMF documents, the IMF’s
                   Executive Board has been reluctant to establish guidelines that would add
                   greater specificity to the Articles’ general criteria. The broad interpretation
                   of need has enabled it to consider countries’ circumstances and changes in
                   the international monetary and financial system, such as the increasing
                   amounts and variability of capital flows between countries. The specific
                   conditions that the IMF and the country authorities establish are intended
                   to address the immediate and underlying problems that contributed to the
                   country’s balance-of-payments difficulty, while ensuring repayment to the
                   IMF. These conditions can include a variety of changes in a country’s
                   fiscal, monetary, or structural policies; changes in structural policies may



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  include revisions to financial market regulation or tax policies. Political
  constraints and economic uncertainty can make these sensitive, difficult
  negotiations. After a country fulfills any early IMF requirements, known as
  “prior actions,” and the IMF Executive Board then approves the financial
  arrangement, the program is to take effect and the country is eligible to
  receive its first disbursement of funds.

  According to information we reviewed for the six countries in our study,
  the IMF generally followed this process to establish the financial
  assistance package and the conditions for the assistance. The underlying
  causes and magnitude of the balance-of-payments difficulty varied among
  the countries but generally stemmed from concerns about their continued
  access to external financing. In some cases, the concerns were embedded
  within a larger set of reasons for IMF assistance, including continued
  support for the countries’ economic reform programs. Thus, the specific
  financing arrangement and conditions also differed, as exemplified by the
  programs for Korea and Argentina.

• Korea’s program provided substantial funding at the earliest stage of the
  program to counter an ongoing balance-of-payments crisis in late 1997
  resulting from substantial losses in Korea’s foreign currency reserves and
  the depreciation of the won, Korea’s currency. The main goals for the
  program’s monetary policy were to limit the depreciation of the won and
  contain inflation. Structural reforms were centered in the corporate,
  financial, and international sectors as well as in the labor market.

• In contrast, Argentina’s 1998 program was designed as a precaution against
  a potential balance-of-payments problem that could result from external
  economic shocks; its program was concerned principally with maintaining
  fiscal discipline and enacting labor market and tax reforms that were
  intended to maintain investor confidence and strengthen the economy’s
  competitiveness.

  The IMF’s process for monitoring a country’s progress toward overall
  program goals and compliance with program conditions is designed to
  respond to an individual country’s progress and situation. According to
  IMF staff, many IMF disbursements are conditioned only on the
  determination by IMF staff that the country has met prenegotiated
  quantitative criteria; other disbursements are subject to reviews by the
  IMF Executive Board. The process for conducting IMF Board reviews,
  which involves the borrower country and the IMF, is designed to
  incorporate data on a country’s economic performance as well as the
  judgment of the IMF Executive Board and staff. IMF staff reviews a



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  member’s economic performance and implementation of policy changes
  that were negotiated as conditions of the financial assistance; then the
  staff formally reports to the IMF Executive Board at regularly scheduled
  intervals for each assistance program. In situations where conditions have
  not been met, the staff formally or informally advises the IMF Executive
  Board. The staff may recommend that the Executive Board grant a waiver
  for the nonobservance of the unmet conditions. If there is no waiver,
  additional financial assistance is not to be made available to the country.
  At that time, the program is effectively suspended until there is an
  agreement between IMF staff and the country that is approved by the IMF
  Executive Board. This agreement may mandate policy changes before any
  further assistance is granted and change the conditions for future
  assistance.

  According to the information we reviewed, the monitoring of the IMF’s
  conditionality program in the six countries in our study was generally
  consistent with this approach. IMF missions to each country reviewed the
  country’s economy and documented the country’s progress in satisfying
  conditions. In some cases, the IMF determined the countries had made
  sufficient progress in meeting program conditions so that additional funds
  could be made available. In other cases, however, the IMF determined that
  country progress in meeting the conditions had not been sufficient, and its
  response varied depending on the specifics of the condition and the
  judgment of the IMF staff and Executive Board on the country’s overall
  progress. Some examples of this flexibility are the following:

• The IMF Executive Board granted Argentina, Uganda, and Russia waivers
  for nonobservance of specific conditions at various points during their
  programs. These waivers were based on the IMF’s judgment that there was
  sufficient overall progress in implementing the program and that
  deviations from meeting required conditions were minor. Access to
  funding was not delayed in these cases.

• The IMF Executive Board delayed disbursements to Brazil, Indonesia, and
  Russia at various points during their current programs. In most of these
  cases, waivers were granted for nonobservance of particular conditions,
  and/or the country agreed to additional conditions as part of the IMF’s
  decision to resume disbursements. For Brazil and Indonesia, the most
  recent delays lasted until the IMF determined that the country had made
  sufficient overall progress in meeting the program requirements; however,
  in Russia’s case, the program was terminated at Russia’s request in March
  1999. In April 1999, IMF staff and Russian authorities announced they had
  reached agreement on an economic program that IMF management hoped



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             to be able to recommend to the IMF Executive Board in support of a new
             arrangement. As of June 16, 1999, the IMF Board had not approved the
             new arrangement.

             The IMF and borrower countries may also negotiate changes in conditions
             to respond to unanticipated developments. For example, the IMF and
             Korea revised Korea’s program several times during its first 2 months. The
             IMF acknowledged that the initial program was “overly optimistic” as
             economic conditions worsened; Korea continued to have access to
             financial assistance during these renegotiations.

             The International Monetary Fund, established in 1945, is a cooperative,
Background   intergovernmental, monetary and financial institution. As of April 1999, it
             had 182 members. The IMF’s first purpose is the promotion of
             international monetary cooperation. Its Articles of Agreement (as
             amended), or charter, also provide that it may make its resources available
             to members experiencing balance-of-payments problems; this is to be done
             under “adequate safeguards.” Making resources available to counter
             balance-of-payments problems is intended to shorten the duration and
             lessen the degree of these problems and avoid “measures destructive of
             national or international prosperity.”

             Member countries govern the IMF through the Executive Board—the
                                                   4
             IMF’s primary decision-making body. The IMF Executive Board comprises
             24 Executive Directors who are appointed or elected by one or more IMF
             member countries. The U.S. Executive Director, for instance, represents
             the United States at the IMF. When a country joins the IMF and later when
             IMF members agree to increase the IMF’s capital, the country pays a quota
             or a capital subscription to the organization. The quota serves several
             purposes: (1) the funds paid to the IMF contribute to the pool of funds that
             the IMF uses to lend to members facing financial problems and (2) the
                                                                                 5
             amount of quota paid determines the voting power of the member. The
             IMF calculates the quota by assessing each member country’s economic
             size and characteristics—economically larger countries pay relatively
             larger quota amounts. The United States pays the largest quota and thus
             4
              The IMF’s Board of Governors is the top policy-making body of the IMF and generally meets once a
             year. The members are usually ministers of finance, heads of central banks, or officials of comparable
             rank. The Executive Board is responsible for conducting the business of the IMF and exercises the
             powers delegated to it by the Board of Governors.
             5
              The quota has also, traditionally, been the basis for determining how much the contributing member
             can borrow from the IMF under stand-by and extended arrangements–the more a country contributes,
             the more that it can borrow, other things being equal. For example, the guideline on access limits for
             stand-by or extended arrangements is 100 percent of each country’s quota annually or 300 percent
             cumulatively, but these limits may be exceeded in “exceptional circumstances.”




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has the largest single share of voting rights. The IMF also has access to
lines of credit provided by member countries under the General
Arrangements to Borrow and, more recently, under the New Arrangements
            6
to Borrow.

As part of the IMF’s mission to promote economic and financial
cooperation among its members, the IMF may provide financial assistance
to countries facing actual or potential balance-of-payments difficulties that
request such assistance. Balance-of-payments difficulties may have short-
term, as well as longer-term aspects. The IMF’s approach to alleviating a
country’s balance-of-payments difficulties is intended to address both
aspects, as needed. As such, the IMF’s approach has two main
components—financing and conditionality—that are intended to address
both the immediate crisis as well as the underlying factors that contributed
to the difficulties. Although financing is designed to help alleviate the
short-term balance-of-payments crisis by providing a country with needed
reserves, it may also support the longer-term reform efforts by providing
needed funding. Similarly, although conditionality, usually in the form of
performance criteria and policy benchmarks, is intended to primarily
address the underlying causes of the balance-of-payments difficulties over
the medium term, it can also assist in alleviating the immediate balance-of-
payments problems by, for example, reducing the country’s aggregate
demand, including imports.

The access to and disbursement of IMF financial assistance is conditioned
upon the adoption and pursuit of economic and structural policy measures
                                           7
the IMF and recipient countries negotiate. This IMF “conditionality” aims
to alleviate the underlying economic difficulty that led to the country’s
balance-of-payments problem and ensure repayment to the IMF. As the
reasons for and magnitude of countries’ balance-of-payments problems
have expanded (due, in part, to the growing importance of external
financing and changes in the international monetary system since the
6
 The General Arrangements to Borrow are long-standing arrangements under which 11 industrial
countries stand ready to lend to the IMF to finance purchases that aim at forestalling or coping with a
situation that could impair the international monetary system. Under the New Arrangements to
Borrow, which became effective in November 1998, 25 member countries or their financial institutions
stand ready to lend to the IMF under circumstances similar to those covered by the General
Arrangements to Borrow.
7
 As described in footnote 3, IMF financing is not generally in the form of a loan but is rather a
purchase or repurchase of currency. As such, the IMF does not consider the establishment of a
conditionality program to be a "negotiation.” Rather, the member explains the economic reform
program in the documents it prepares in the context of its request for financial assistance and the IMF
Executive Board decides whether to support the program. The decision takes the form of the
“arrangement,” which notes certain aspects of the member’s program that will be conditions for
continued IMF financing under the arrangement.




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  1970s), conditionality has also expanded. According to IMF staff,
  conditionality has moved beyond the traditional focus of reducing
  aggregate demand, which was appropriate for relieving temporary balance-
  of-payments difficulties, typically in industrial economies. Structural
  policies—such as reducing the role of government in the economy and
  opening the economy to outside competition—that take longer to
  implement and are aimed at increasing the capacity for economic growth
  became an important part of conditionality. More recently, the financial
  crises in Mexico (1994-95) and in Asia and Russia (1997-99) have resulted
  in an increased focus on strengthening countries’ financial sectors and the
  gradual opening of the economy to international capital flows.

  The main instruments used by the IMF to provide financial assistance are

• Stand-by Arrangements (SBA), that provide short-term assistance for
  problems of a temporary nature;

• extended arrangements, under the Extended Fund Facility (EFF), that
  provide longer-term balance-of-payments assistance for problems arising
  from structural maladjustments; typically, when established, a program
  lists the general objectives for the first year; objectives for subsequent
  years are spelled out in program reviews;

• a Supplemental Reserve Facility (SRF), provided under an SBA or
  extended arrangement, that provides assistance for exceptional balance-
  of-payments problems owing to a large and short-term financing need
  resulting from a sudden and disruptive loss of market confidence reflected
  in pressure on the capital account and reserves; it is likely to be used when
  the magnitude of capital outflows may threaten the international monetary
  system; and

• an Enhanced Structural Adjustment Facility (ESAF), which is the principal
  means for providing financial support (highly concessional, or low-
  interest, loans) to low-income countries facing protracted balance-of-
                        8
  payments problems.

  The first three arrangements are funded through the IMF’s general
  resources account (GRA). The ESAF is funded through separate


  8
   These IMF financing instruments were used for the countries in our study. The IMF has other
  instruments, including the recently approved contingent credit line, that we do not discuss in this
  report.




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              9
resources. A country may also draw on its “reserve tranche,” that is, call
                                                                   10
on funds that initially represented about one-quarter of its quota. Except
for the highly concessional ESAF loans, the country pays market-based
                                    11
interest rates on money it receives. The SRF is a new facility that charges
a higher amount for its use than other IMF instruments. According to the
IMF, for a member country to use this facility, there should be a
reasonable expectation that the implementation of strong adjustment
policies and adequate financing will result in the early correction of its
difficulties.

IMF financial assistance may be a part of a larger package of financial
assistance committed to countries in crisis. Brazil, for example, received
commitments for a package that included about $18 billion to be provided
by the IMF and approximately $4.5 billion each from the World Bank and
the Inter-American Development Bank–primarily to provide improved
social safety nets and banking reform. Additional bilateral sources agreed
to provide $14.5 billion in financing, primarily to guarantee credits
extended to Brazil from the Bank for International Settlements. The
resulting package for Brazil amounted to more than $41 billion in
commitments.

An IMF program can also serve as a catalyst for debt relief from other
creditors. For example, to qualify for debt relief from the Paris Club of
                     12
creditor governments, countries must reach agreement with the IMF on a
reform program. The Paris Club conditions its debt relief on countries’
9
  Under the IMF’s Articles of Agreement, as amended, financing under the GRA is not in the form of
loans, as noted in footnote 3. Financing from the ESAF is in the form of loans and is governed by the
ESAF Trust Instrument adopted under Article V, Section 2(b). The ESAF Trust’s primary source of
financing is lending from contributor countries.
10
   A member’s reserve tranche position is equal to the difference between a member’s quota and the
IMF’s holdings of its currency. This amount was initially equal to one-quarter of its quota subscription.
The position changes as the IMF uses its holdings of the member’s currency in its financing activities.
A reserve tranche position is part of a member’s external reserves, upon which the member can draw
any time without being required to take specific policy actions.
11
  The interest rate charged by the IMF is not necessarily what the borrowing country would have to
pay on the open market. Rather, it is determined by reference to a combined market interest rate,
which is a weighted average of yields or rates of short-term instruments in the capital markets of the
members whose currencies comprise the special drawing right (SDR). The special drawing right is a
reserve asset created by the IMF and a unit of account that the IMF uses to denominate all its
transactions. Its value comprises a weighted average of the values of the euro (representing the
currencies of France and Germany), Japanese yen, pound sterling, and U.S. dollar. The rate of charge is
set in relation to the IMF’s cost of financing and includes an amount to cover the IMF’s administrative
expenses, the financial consequences of charges that members have not yet paid, and an addition to
the IMF’s precautionary balances.
12
 The Paris Club is an informal group of creditor countries that meets, on an as-needed basis, to
negotiate debt relief efforts on official debt.




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                           implementation of economic and structural reforms under IMF-supported
                           financing programs. Part of the motivation for Russia’s IMF arrangement in
                           1996 was to facilitate its debt rescheduling from the Paris Club.

                           The IMF’s general framework for establishing a financial assistance
The IMF’s Process for      arrangement is intended to be applied on a case-by-case basis that
Establishing Programs      considers each country’s individual circumstances. This process gives the
Incorporates Country-      IMF considerable latitude in establishing the balance-of-payments need,
                           the amount and timing of resource disbursements, and the conditions for
specific Data and          disbursements. Under its Articles of Agreement, as amended, the IMF
Analysis as Well as IMF    limits financial assistance to those countries with a balance-of-payments
Judgment                   need. However, the Articles do not precisely define “need,” and, according
                           to IMF documents, the IMF’s Executive Board has been reluctant to
                           establish guidelines that would add greater specificity to the charter’s
                           general criteria. The specific conditions that the IMF and the country
                           authorities negotiate are intended to address the underlying problems that
                           contributed to the country’s balance-of-payments difficulty, while ensuring
                           repayment to the IMF. These conditions include a variety of changes in a
                           country’s fiscal, monetary, or structural policies. After the country
                                                             13
                           completes any “prior actions” and the IMF Executive Board approves the
                           financial arrangement, the program is to take effect and the country is
                           eligible to receive its first disbursement of funds. We found that the IMF
                           generally followed this process for the six countries we reviewed.

The IMF’s Process for      The formal process the IMF generally uses to establish countries’ financial
                           arrangements is outlined in figure 1. IMF staff, the IMF Executive Board
Establishing Financial     members, and country authorities may also consult informally at any stage
Arrangements With Member   throughout this process.
Countries




                           13
                              Prior actions—policy measures that the IMF views as key to the effectiveness of a country’s
                           program—may have to be implemented before the IMF Board approves an IMF arrangement or
                           disbursement. Such actions are particularly important if severe imbalances exist or in cases where the
                           record of policy implementation has been weak.




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Figure 1: The Formal Process Generally Used to Establish and Monitor an IMF Financial Arrangement




                                         Note: This figure summarizes the process the IMF generally uses to establish financial arrangements
                                         with member countries. In the case of monitoring, this flowchart focuses on disbursements that
                                         require review by the IMF Executive Board. Countries may receive IMF funding disbursements
                                         without IMF Executive Board action, if they meet quarterly performance criteria in between scheduled
                                         IMF Executive Board reviews.

                                         Source: GAO analysis of IMF documents.




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Establishment of an IMF financial arrangement begins with discussions
between IMF staff and country officials and continues through the IMF


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  Executive Board’s approval of the arrangement. If a member country
  determines that it is experiencing or could experience a balance-of-
  payments problem, it can initiate discussions with IMF staff that may lead
  it to request IMF financial assistance. These discussions can occur at any
  time, including during the country’s annual consultation with the IMF or
  through informal consultations requested by the member. At these
  consultations, IMF staff and country authorities discuss economic data
  and policies as well as the

• nature of the country’s balance-of-payments difficulty,

• amount of financing expected to be provided by various sources and the
  amount that may be requested from the IMF,

• instruments under which the IMF resources could be provided,

• potential schedule for reviewing countries’ performance and disbursing
  funds, and

• likely conditions for assessing countries’ performance under the program.

  IMF staff noted that key tasks during country missions to conduct the
  negotiations are (1) the collection of extensive data describing the
  country’s economic conditions and (2) an analysis of those data to
  recommend the amount and timing of the IMF financial assistance and
  conditionality. The IMF’s review of a country’s economy is an iterative
  process that is often based on country-provided data, projections of key
  macroeconomic variables, and judgment by the IMF staff and country
  officials.

  The design of an IMF program is complicated, and negotiations between
  IMF staff and country authorities can be difficult for several reasons. First,
  the countries are facing an adverse or uncertain economic situation.
  Second, the negotiators may disagree on the type, pace, or feasibility of the
  reforms needed to help overcome the difficulty. In some cases, needed
  reforms reflect long-standing problems and are difficult to undertake due
  to political constraints. For example, reforms may entail changes to labor
  practices opposed by unions or removal of tax preferences benefiting
  certain sectors. Third, conditionality and financing are based, in part, on
  projections of key variables such as estimated growth rates and access to
  external financing. Fourth, in some cases, the country may lack reliable
  data for analyzing the current situation or making projections.




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                            IMF staff and country authorities may or may not reach agreement on a
                            package of financing and conditionality. If they do not reach agreement,
                            then the member may seek other means for addressing its difficulty. If they
                            reach agreement, the arrangement is presented to the IMF Executive
                            Board for approval. IMF staff generally brings to the IMF Board only
                            arrangements it believes the IMF Board will accept. After the country
                            satisfies any required “prior actions” and the IMF Executive Board
                            approves the arrangement, the arrangement will take effect and the
                            country can get funds from the IMF.

The IMF Has a Broad         Under the IMF’s Articles of Agreement, as amended, the IMF considers any
                            of the following three elements to be a basis for providing financial
Framework for Assessing                14
                            assistance from the GRA:
Countries’ Balance of
Payments                  • the country’s balance of payments,

                          • the country’s reserve position, and

                          • developments in its reserves.

                            However, the Articles do not precisely define the elements or provide
                            criteria for assessing need. While the IMF Executive Board has not
                            established guidelines that would add greater specificity to the Articles’
                            general criteria, over time the IMF has developed a broad framework that
                            serves as a basis for analyzing a country’s economy and forming judgments
                            regarding the existence and magnitude of balance-of-payments deficits and
                            the adequacy of international reserves.

                            The first element—the country’s balance of payments—represents the
                            economy’s external financing requirement and equals the sum of a
                            member’s current and capital account balances. The current account
                            primarily includes exports and imports in goods and services; transfers;
                            and income payments, such as interest payments. The capital account
                            provides summary data on the changes in the net foreign assets of
                            domestic residents arising from transactions such as external borrowing or
                            repayments, foreign direct investment, portfolio investment (equity and



                            14
                              For a country to access funds through the GRA, its balance-of-payments need can be ongoing at the
                            time IMF financial assistance is sought, or a precautionary program can be negotiated prior to the
                            actual emergence of a balance-of-payments need. A country does not have to demonstrate a balance-of-
                            payments need at the time it requests an IMF arrangement, but it is expected to demonstrate need
                            before receiving a financial disbursement.




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                                                            15
bonds), and short-term capital movements. The second element—the
country’s reserve position—refers to the amount of resources (hard
currency, reserve position in the IMF, special drawing rights, and monetary
gold) that can be used to pay for imports and make payments on external
debt. IMF documents indicate that the third element—developments in the
reserve position—has a very narrow application. This element is intended
to ensure that members of the IMF whose currency is a reserve currency
(such as the United States) would be able to use IMF resources when
requested, despite the absence of a need as outlined in the first two
          16
elements.

The IMF’s framework has enabled it to consider countries’ individual
circumstances and changes in the international monetary system. These
include increased capital flows between countries and changes in the
composition and source of those flows as well as the shift in the primary
recipients of IMF financial assistance from industrialized countries to
                       17
developing countries. Given such considerations, decisions about a
country’s need for IMF resources have become more difficult. According
to IMF documents, determining need based solely on the overall balance-
of-payments position is relatively clear-cut because the balance is either in
surplus or deficit. Assessing need based on whether a country’s foreign
reserves are sufficient requires a greater degree of judgment because no
precise criteria define the appropriate level of reserves. In determining the
sufficiency of a country’s reserves, the IMF can adjust the definition of
“sufficient” reserves to account for such country-specific factors as the
volume and variability of exports and imports, the size and variability of
capital flows, the amount of short-term liabilities, and the nature of the
                                 18
country’s exchange rate regime. Significant declines in the foreign reserve


15
  In the IMF’s monthly publication International Financial Statistics, changes in a country’s reserves
are not included in the capital account.
16
   This element is designed to cover situations in which a country may not have a balance-of-payments
deficit or a weak reserve position but may still have a need because of a development in its reserves.
For example, the IMF Board was concerned that the first two concepts would preclude members of the
European Economic Community (the predecessor to the European Union) from requesting IMF
assistance in discharging obligations among each other. By virtue of their currency being a reserve
asset, the use of their currency in foreign transactions would not result in a balance-of-payments deficit
or weak reserve position by such countries, although difficulties in the external environment may still
require some support.
17
 As late as 1977, developed countries accounted for about 50 percent of credit outstanding from the
GRA. Since 1988, developed countries have had no outstanding credit from the GRA.
18
   In principle, a country with a fixed exchange rate could be expected to need a higher level of reserves
to assist in defending the rate than a country that allowed its currency to float. However, in practice,
such distinctions are difficult to make. Most IMF members have adopted some type of floating
exchange rate regime, with the degree to which the currency is allowed to float depending on domestic




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position may be of concern if they indicate that a country may have
difficulty financing its imports or repaying its external debt in the future.

IMF documents indicate that the Executive Board has been reluctant to
establish guidelines that would add greater specificity to the general
criteria for balance-of-payments need set forth in the Articles of
Agreement, as amended. Members of the IMF Board have been concerned
that “codification” of the concept of need would create unnecessary
inflexibility. For this reason, they urged that the concept of need should
continue to be applied on a case-by-case basis. As a result, application of
this concept involves considerable data analysis as well as judgment.

The IMF uses somewhat different criteria for low-income countries
requesting resources under the ESAF. In contrast to the criteria for
demonstrating a need for GRA resources, when assessing whether a
member that meets income and other criteria for ESAF eligibility has a
protracted balance-of-payments problem, emphasis is to be placed on the
components of its balance of payments rather than solely on its overall
balance-of-payments position. According to IMF staff, the underlying
balance-of-payments problems of many low-income countries did not
necessarily result in conditions similar to those reflecting the GRA criteria;
that is, an actual balance-of-payments deficit or low reserves. For this
reason, emphasis would have to be placed on those indicators that would
normally evidence “poor external performance.” Such indicators include a
deterioration in the terms of trade and diminished access to capital
markets. Moreover, protracted balance-of-payments problems would often
be reflected by exchange rate restrictions, payments arrears, or prolonged
                       19
use of IMF resources. As with the GRA criteria, the IMF Executive Board
agreed to continue to use flexibility in applying the ESAF criteria. Some
Board members have expressed the opinion that a low-income country, by
definition, has a protracted balance-of-payments problem.

Once a balance-of-payments need is established under the GRA or ESAF,
the country may be eligible to receive IMF financing. IMF staff and country
authorities will estimate the total amount of financing the country requires
as well as the amounts that may be provided by the IMF and other sources.
The IMF’s share is based on several factors, including the member’s

and external developments. For example, owing to a rundown in its reserves, a country may allow its
currency to float more freely until adjustment policies take effect and reserves are rebuilt.
19
   In addition, for an ESAF arrangement to be approved, a country generally must have a protracted
balance-of-payments problem. However, the country is not required to have a present need when it
actually requests a disbursement.




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                             resource needs, IMF quota, outstanding IMF resources, and previous
                             performance in using IMF financing; the strength of its adjustment
                             program; and its capacity to repay the IMF. While the IMF has discretion in
                             deciding the total amount of resources it will provide to a country,
                             disbursements are to be limited to the amount needed by the country. If
                             the IMF later discovers that a country drew IMF funds without a need for
                             those funds (that is, the information on which the financing need was
                             determined was later found to be incorrect), it can undertake remedial
                             action.

                             The IMF Executive Board encourages countries to request its assistance
                             early and to undertake corrective actions early in order to minimize the
                             potential costs and disruption of correcting the underlying causes of a
                             balance-of-payments problem. However, a number of factors—including
                             the belief that the problem is temporary or can be solved without official
                             assistance, or the concern that political and social problems may arise
                             from needed structural changes—can cause some countries to hesitate in
                             asking for IMF assistance. For example, Korea did not draw on IMF
                             resources until its reserves had fallen substantially.

IMF Conditionality Focuses   Once the IMF staff has determined the balance-of-payments needs of a
                             member and its eligibility to draw resources, the IMF must be satisfied that
on Fiscal, Monetary, and     the member can meet its repayment obligations to the IMF and that the
Structural Reforms           policy measures agreed to are sufficient to overcome the member’s
                             balance-of-payments problem. The IMF does this, in part, through
                             conditionality. Fundamental weaknesses in the underlying economy, such
                             as a large budget deficit and/or high inflation, or in the structure of the
                             financial or corporate sectors, may contribute to the balance-of-payments
                             problem of a country. Conditionality may vary with each country’s
                             individual program as it seeks to address these weaknesses. As such,
                             according to the IMF, there is no “rigid and inflexible” set of operational
                             rules in the establishment of a country’s conditionality program. The
                             process is one of negotiation between the country authorities and the IMF
                             to reach agreement on a number of issues, ranging from economic
                             assumptions to the speed and magnitude of structural reforms.

                             The IMF arrangement often occurs within the context of the country’s
                             larger reform efforts. As a result, not all of a country’s policies or reform
                             efforts may be included as conditions of the IMF arrangement. For
                             example, some structural reforms and trade liberalization measures may
                             be mentioned in the arrangement reached between the IMF and the
                             country authorities, but only the actions the IMF judges to be particularly
                             important for achieving program objectives will become performance



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criteria and benchmarks within the arrangement. IMF officials noted that
achieving performance criteria is not the ultimate goal of conditionality;
rather, the performance criteria are selected as clearly observable and
measurable indicators that a country is making progress toward the overall
program goals, such as strengthening the balance of payments and
reducing inflation. The IMF uses two types of performance criteria that
generally must be met for members to qualify for disbursements. The first
are quantitative performance criteria, or macroeconomic indicators, such
as monetary and budgetary targets. The second are structural performance
criteria, or quantifiable/observable actions that demonstrate progress
toward the borrower country’s structural reform goals. Benchmarks are
points of reference against which progress may be monitored but
disbursements are generally not dependent on meeting them. Benchmarks
are not necessarily quantitative and frequently relate to structural variables
and policies, such as tax reform and privatizing state-owned enterprises.

IMF conditionality tends to focus on three areas: fiscal, monetary, and
structural. These three areas are designed to support a general framework
that aims to strengthen the balance-of-payments position, achieve market-
based growth, and decrease the role of the government in a country’s
economy. Borrower country IMF arrangements generally consist of a
combination of efforts in these three areas, which depend on the country’s
particular circumstances.

According to the IMF, poor fiscal management in a member’s economy
generally has been a major factor underlying such problems as high
inflation, large current account deficits, and sluggish growth. Large and
persistent budget deficits may tend to overheat the economy, contributing
to high inflation (especially when financed by the printing of money),
excess imports, and low domestic savings. IMF staff and the member
country negotiate ways to address this fiscal deficit, including instituting
reductions in government spending and increases in tax revenues.
Numerical targets for the fiscal level consistent with these reforms are
often part of a country’s quantitative performance criteria.

Similarly, IMF staff and the member country will negotiate monetary
policy changes as part of the conditionality package. The underlying goals
of these conditions are typically strengthening the balance-of-payments
position, safeguarding or rebuilding international reserves, restoring
market confidence, reducing sizeable exchange rate changes, restraining
growth in domestic credit, and/or reducing inflation. For example, limits
may be imposed on the increase in short-term debt owed or guaranteed by
the government; this may be done in an effort to restrict the ability of a



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government to use short-term external financing to meet reserve targets or
finance fiscal deficits. Another performance criterion that is frequently
used is a limit on the net domestic assets of the central bank. By limiting
the resources made available by the central bank to the economy, the
growth of the money supply is slowed and inflation is lessened. Frequently,
the country and the IMF reach agreement on the minimum level of foreign
reserves that the country may hold; such a requirement reduces the
country’s ability to manage its exchange rate through interventions in the
foreign currency market. The performance criterion on international
reserves is a key indicator of progress toward external viability.

According to IMF staff, the presence of pervasive structural problems in a
member’s economy and the need to ensure the sustainability of a country’s
reform effort require that structural policy changes be included within the
overall conditionality negotiated. These structural problems encompass a
broad array of issues, including inefficient state enterprises, trade
restrictions, and lack of transparency in the financial and corporate
sectors. Reforms in these areas are included as part of a country’s
structural benchmarks, which the country is strongly encouraged to
satisfy, although the benchmarks do not have the same significance as the
performance criteria. However, in certain instances, structural changes
may be established in a precise quantitative manner and made part of a
country’s structural performance criteria.

Once the financial arrangement has been negotiated, it is presented to the
IMF Executive Board for approval. The IMF Board generally accepts the
recommendations of the staff, largely because the staff brings to the IMF
Board only proposals that the staff believes the Board will accept. The
decision to approve an arrangement depends on a judgment by the IMF
staff, management, and Executive Board that the program is sufficient to
overcome the country’s balance-of-payments difficulty and the country will
be able to repay the IMF. After the country completes any prior actions
and the IMF Executive Board then approves the arrangement, the
arrangement will take effect and the country becomes eligible for its first
disbursement of IMF funds. The country is then expected to implement the
policy measures agreed to under the arrangement.

(See app. I for more information on the IMF’s process for establishing
financial arrangements.)




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The IMF Generally         According to the IMF documents we reviewed, the IMF generally followed
                          the process described previously in establishing the financial assistance
Followed its Process in   arrangements with each of the six countries that we reviewed. In each
Establishing the Six      case, the balance-of-payments problem was described and the
Arrangements              conditionality program was intended to address the underlying problems
                          of the individual countries as defined by IMF staff and country authorities.
                          Our analysis showed that, to varying degrees, the balance-of-payments
                          problems of the six countries we studied stemmed from concerns
                          regarding the access of the countries’ public and private sectors to
                          external financing. In addition, the reform programs of each country
                          generally addressed the areas of concern identified by country and IMF
                          officials as contributing to the balance-of-payments problems. Moreover,
                          the type of financial arrangement each country received, the time period of
                          the arrangement, and the total amount of financing the IMF agreed to
                          provide were based on the IMF’s analysis of the needs and circumstances
                          of the individual countries. In determining the potential amount of IMF
                          assistance, the IMF also considered the country’s outstanding IMF
                          resources in relation to its quota. Table 1 outlines the current IMF financial
                          arrangements for the six borrower countries.




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Table 1: Current Financial Arrangements Agreed to by the IMF and Six Borrower Countries
                                                                                                                            Total amount
                                                                                                                               disbursed
                                                                   Expiration of      Total amount agreed           (as of April 30, 1999)
                                                                                                             a
Country       Type of arrangement   Date of arrangement            arrangement               ($ in millions)               ($ in millions)
Argentina     EFF                   Feb. 4, 1998                    Feb. 3, 2001                    $ 2,822                              0
Brazil        SBA/SRF               Dec. 2, 1998                    Dec. 1, 2001                      17,668                       $ 9,570
Indonesiab    SBA/EFF               Nov. 5, 1997                    Nov. 5, 2000                      12,267                         9,215
Korea         SBA/SRF               Dec. 4, 1997                    Dec. 3, 2000                      21,026                        19,305
Russiac       EFF/SRF               Mar. 26, 1996                  Mar. 25, 1999                      17,915                        10,486
Uganda        ESAF                  Nov. 10, 1997                   Nov. 9, 2000                         136                            76
                                         a
                                           The amounts were initially calculated in SDRs. Because the value of the SDR relative to the U.S.
                                         dollar changes daily, the dollar value of amounts converted from SDRs also changes daily. For this
                                         table, we used the 1998 average SDR conversion rate of $1.3565.
                                         b
                                           The information presented includes the 3-year SBA agreed to in November 1997 and the EFF
                                         agreed to in August 1998. The SBA was terminated and replaced with the EFF.
                                         c
                                          Russia terminated this arrangement with the IMF in March 1999. In April 1999, IMF staff and
                                         Russian authorities announced they had reached agreement on an economic program that IMF
                                         management hoped to be able to recommend to the IMF Executive Board in support of a new
                                         arrangement. As of June 16, 1999, the IMF Board had not approved the new arrangement. The total
                                         amounts listed include funding under the Compensatory and Contingency Financing Facility (about
                                         $2.8 billion) and increased EFF funding (through the SRF) agreed to by Russia and the IMF in July
                                         1998.
                                         Source: IMF documents.


                                         (These arrangements are described in greater detail for each country in
                                         apps. II to VII.)




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According to our analysis, the balance-of-payments problems of the six
countries we studied were due to concerns about the countries’ continued
ability to obtain external financing. In the cases of Korea, Indonesia, and
Brazil, concerns over severely diminished reserves and continued access
to external financing were clearly identified as important factors in the
initial set of documents that recommended the establishment of an IMF
financial arrangement in these countries. In the cases of Argentina, Russia,
and Uganda, concerns over continued access to external financing were
not as clearly defined but were embedded within a larger set of reasons for
IMF assistance, including continued support for the countries’ economic
reform programs. Nonetheless, the information provided by IMF staff and
country authorities was sufficient to determine that a potential balance-of-
payments problem existed in each of these three countries.

Our analysis also indicated that the individual IMF programs were geared
toward the specific IMF assessment of the needs of the six countries, as
shown in table 2.




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Table 2: Basis for and Key Initial Conditions in Current IMF Financial Arrangements With Six Countries
Country     Reasons IMF assistance requested Balance-of-payments problem                  Underlying causes of the problem
Argentina   - Precautionary program to support     - Widening current account deficit and - Strong import demand coupled with
            reforms and maintain market            its potential financing                recent weaknesses in the export sector
            confidence                                                                    - Uncertain investor confidence given
                                                                                          international environment
Brazil      - Loss of foreign investor confidence  - Declines in current account          - Large and growing government
            - Protect the exchange rate regime     - Foreign reserves declined sharply    budget deficits
                                                                                          - Substantial short-term private sector
                                                                                          debt in need of refinancing

Indonesia    - Sudden currency depreciation              - Substantial fall in the capital account   - Weaknesses in financial sector
             - Loss of financial market confidence       resulting in a sharp decline in reserves    - Structural impediments in economy,
                                                                                                     such as import monopolies
                                                                                                     - Substantial short-term private sector
                                                                                                     debt in need of refinancing
Korea        - Usable foreign reserves declined          - Capital flight                            - Weaknesses in corporate and
             sharply                                     - Sharp drop in reserves                    financial sectors
             - Sharp currency depreciation                                                           - Market confidence turned
             - Substantial short-term private sector                                                 overwhelmingly negative
             debt                                                                                    - Foreign exchange reserves declined
             - External financial conditions                                                         as central bank provided support to
             deteriorated                                                                            prevent domestic banks from defaulting
                                                                                                     on foreign debt
Russia       - Federal budget deficit                    - Current account is expected to            - Inability to collect tax revenues
             - Inflation                                 weaken over next several years              - Excessive government spending
             - Need to transition to a                   - Need to achieve medium-term               - Culture of nonpayment of taxes
             market-based economy and to                 balance-of-payments viability               - Weak banking system
             build required institutions and legal       - Stabilize ruble exchange rate             - Lack of an institutional and legal
             framework                                                                               framework to support market economy
             - Need for comprehensive debt                                                           - Bunching of debt obligations
             restructuring                                                                           anticipated
                                                                                                     - Inadequate level of reserves
                                                                                                     - Net capital outflows
Uganda       - Maintain macroeconomic stability          - Projected current account deficits        - Fragile external position
             - Support structural and institutional      - Uncertain financing from official         - Vulnerability to external shocks
             reforms                                     creditors                                   - Uncertainty over revenue measures
             - Support economic liberalization                                                       - Substantial expenditure pressures
                                                                                                     - Deterioration in terms of trade




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                                                     Fiscal performance       Monetary performance
Country     Overall key goals                        criteria                 criteria                Key structural reforms
Argentina   - Maintain investor confidence           - Limit government       - Decrease net domestic Benchmarks:
            - Complete structural reforms            deficit, debt, and       assets of central bank  - Tax reform
            - Promote sustained growth in            expenditures                                     - Labor market reforms
            production and employment                                                                 - Privatization
            - Reduce the vulnerability of the                                                         - Government administration
            economy
Brazil      - Quickly arrest the rapid growth of     - Limit public sector    - Limit net domestic    Benchmarks:
            public sector debt                       debt                     assets of central bank  - Pension and tax reforms
            - Maintain existing exchange rate                                                         - Improvements in the budgetary
            regime                                                                                    process
            - Safeguard international reserves                                                        - Administrative reform
                                                                                                      - Reduction in the number of state-
                                                                                                      owned banks
Indonesia   - Restore market confidence              - Limit short-term    - Limit net domestic       Performance criteria:
            - Reverse decline in external            government            assets of central bank     - Financial sector restructuring
            financing                                borrowing and new     and stock of base          - Trade liberalization and domestic
            - Correct underlying weaknesses          publicly guaranteed   money                      deregulation
            in the financial sector and              debt                  - Set minimum level of     - Privatization
            remove structural impediments            - Limit on overall    net international          Benchmarks:
            in the economy                           Central Bank          reserves                   - Corporate, financial, regulatory,
                                                     balance                                          and government reforms
Korea       - Restore investor confidence            None                  - Limit net domestic       Benchmarks:
            - Build international reserves                                 assets of central bank     - Financial sector restructuring
            - Set the stage for resuming and                               - Set minimum level of     - Corporate governance reform
            sustaining growth                                              net international reserves - Capital account liberalization
            - Contain inflation                                            - Set minimum charge       - Increased transparency
                                                                           on foreign exchange
                                                                           given to Korean
                                                                           commercial banks or
                                                                           their overseas branches
Russia      - Achieve financial stabilization        - Limit government    - Limit net domestic       Benchmarks:
            while transitioning to a market-         budget deficit        assets of monetary         - Tax administration
            based economy                            - Increase            authority                  - Banking system
            - Lay basis for sustained growth         government cash       - Set minimum level of     - Privatization
                                                     revenues              net international          - Natural monopolies
                                                                           reserves of monetary       - Social safety net
                                                                           authority                  - Budget system and process
                                                                           - Limit credit to the
                                                                           government
Uganda      - Promote broad-based economic           - Limit claims of the - Limit net domestic       Prior action:
            growth                                   banking system on the assets of banking          - Remove 3 import bans
            - Liberalize and diversify economy       government            system and short-term      Performance criterion:
            - Promote good governance                - Limit short-term    debt of the central bank - Increase taxpayer audits
            - Promote structural reforms             government debt and - Set minimum level of       Benchmarks:
                                                     nonconcessional       net international          - Privatization of public sector
                                                     government debt       reserves                   enterprises
                                                     - Set minimum                                    - Bank inspections
                                                     spending on social                               - Government restructuring
                                                     areas                                            - Taxpayer audits
                                                Source: GAO analysis of IMF and borrower country documents outlining initial arrangements.




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The purpose of the programs was to address the immediate or potential
balance-of-payments problem of each country as well as the underlying
factors that IMF staff and country officials identified as contributing to
that problem. The fiscal, monetary, and structural objectives of all six
countries’ arrangements had the goal of helping to improve the medium-
term economic growth and/or bolster investor confidence in order to
continue to finance or reduce the balance-of-payments deficit or to build
reserves. However, within the context of these general goals, the
magnitudes and definitions of the performance criteria and the specifics of
structural reforms differed across the countries.

The financing of each package addressed the balance-of-payments
problem of each country. In the cases of the three countries with
significant losses in their reserves (Brazil, Indonesia, and Korea), the
amount of the IMF financing was substantial and frontloaded, meaning
that the countries were to receive much of the funding early, with the
intent of providing a signal to market participants that the commitment to
these countries was strong. In the three remaining countries, IMF
financing was designed to be more evenly distributed throughout the
duration of the program. The financing for Russia and Uganda was to be
provided in relatively equal installments over the life of the program to
assist in addressing the reforms agreed to under the program. Argentina’s
financing was viewed as a precautionary line of credit, available only if
necessary.

Korea and Argentina exemplify the differences that can exist between
countries’ financial arrangements with the IMF. The IMF’s approach to the
financial crisis in Korea was intended to address the country’s immediate
need for financing as well as the underlying causes identified by IMF staff
and country authorities as contributing to the balance-of-payments
difficulties. The IMF arrangement in Korea was heavily frontloaded, with
the country receiving much of the agreed-to financing at the beginning of
the arrangement, in order to address the country’s immediate need to
replenish depleted reserves. The country faced balance-of-payments
problems primarily due to significant capital outflows. Korean banks had a
large amount of foreign debt, composed substantially of short-term
external loans that needed frequent refinancing. As market confidence fell,
the willingness of external creditors to roll over (that is, refinance) the
debt declined rapidly. The attempt by the government to support the
former exchange rate rapidly depleted the foreign reserves by providing
creditors with the hard currency that they ultimately withdrew as short-
term debt matured. As reserves reached precariously low levels, Korea




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abandoned its attempt to support the exchange rate, moved to a flexible
rate, and sought IMF support.

The conditions outlined in the IMF arrangement were intended to address
immediate concerns as well as the underlying causes of the balance-of-
payments difficulties as determined by IMF staff and Korean authorities.
The immediate causes were a loss of market confidence, depleted foreign
reserves, and a rapidly depreciating currency. The arrangement’s
immediate goal was to restore calm in the markets and contain the
inflationary impact of the currency’s depreciation by providing substantial
financing and requiring a tightening of monetary policy. In terms of longer-
term changes, IMF staff and Korean authorities identified weaknesses in
the corporate and financial sectors as underlying causes for the
difficulties. Specifically, increases in corporate bankruptcies (caused by
large debt burdens and excess capacity) and nonperforming (unpaid) loans
exacerbated weaknesses in the banking system. Weaknesses in the
banking systems included a focus on maximizing revenues (not profits)
and limited experience in managing risk, combined with lax prudential
supervision. As a result, under Korea’s IMF arrangement, compared to
other countries’ arrangements, greater emphasis was placed on structural
reforms—particularly corporate and financial restructuring.

Unlike Korea’s IMF arrangement, Argentina’s arrangement addresses a
potential, rather than existing, balance-of-payments problem. Although
Argentina enjoyed good access to capital markets and employed a strategy
to lengthen the maturity of its debt and borrow when interest rates were
low, it faced an uncertain future due to deteriorating conditions in the
international financial environment and the effect this likely would have
on its future access to capital markets. To address this potential problem,
Argentina and the IMF reached agreement on a precautionary program,
with Argentina agreeing to access IMF resources only if external
                                20
conditions made it necessary.

The government and the IMF identified fiscal discipline and structural
reforms (particularly in tax systems and labor markets) as two of the most
crucial elements of Argentina’s program. In Argentina, the goal of
maintaining fiscal discipline is to reduce the federal government deficit,
stimulate domestic saving, and strengthen confidence in the continued
viability of the convertibility regime, under which Argentine pesos are
exchanged at a 1-to-1 rate with U.S. dollars. Reducing the amount of the
government’s deficit lowers the amount of funds the government needs to
20
     As of May 31, 1999, Argentina had not drawn funds under the current arrangement.




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                         borrow from domestic and external creditors, therefore freeing up
                         resources for other uses and decreasing the government’s dependence on
                         external borrowing. Argentina’s government is limited in its ability to print
                         money (pesos) to finance its deficit because under its currency board
                         arrangement, the government has agreed to exchange each Argentine peso
                                                                                    21
                         circulating in the economy with a U.S. dollar if requested. Consistent with
                         this, the quantitative performance criteria agreed to under the IMF
                         arrangement emphasize fiscal issues and are intended to limit the federal
                         government’s budget deficit and government debt levels. Monetary issues
                         are not emphasized as strongly due to the government’s limited power to
                         affect the money supply and interest rates. Structural reforms aimed at, for
                         example, decreasing the costs of labor and lowering taxes on production
                         are aimed at making the economy more competitive, with the goal of
                         reducing the trade deficit and thus the current account deficit.

                         The IMF’s process for monitoring conditionality is intended to respond to
The IMF’s Process for    individual country progress in meeting required conditions. After the IMF
Monitoring               Executive Board approves the arrangement, the country is expected to
Conditionality Is        implement the conditions. The programs are subject to periodic reviews, at
                         which time decisions are made on future fund disbursements. In cases
Intended to Respond      where the IMF determines the country has made sufficient progress in
to Individual Borrower   meeting the program’s conditions, the next disbursement will be made
Country Progress in      available. The IMF Executive Board may grant waivers for nonobservance
Implementing Its         of conditions and approve access to funds for countries that do not meet
Program                  all required conditions if, according to the IMF, it concludes that the
                         deviation was minor and the country had made sufficient progress in
                         implementing the program. However, if the IMF staff concludes that a
                         country has not made sufficient progress in implementing policies and
                         meeting conditions it considered essential, it may recommend that
                         disbursements be delayed or funds withheld. In these cases, the IMF Board
                         is generally not asked to make a negative decision; rather, the review is not
                         completed and it is not formally brought before the Board for a decision at
                         that time. IMF staff and Executive Directors told us that these cases are

                         21
                            A currency board has governed Argentina’s monetary policy since 1991. Under the currency board
                         arrangement, the central bank maintains a sufficient level of U.S. currency in international reserves to
                         guarantee the convertibility of all outstanding Argentine pesos at the official exchange rate (1 peso
                         equals 1 dollar), known as the “convertibility regime.” While this arrangement provides comfort to
                         foreign investors that their investments are protected from fluctuations in the exchange rate, the
                         currency board significantly reduces the discretion of central bank authorities to influence Argentina’s
                         money supply. Argentina’s money supply rises and falls with the level of international reserves. For
                         example, the domestic money supply will contract if investors choose to convert their pesos into U.S.
                         dollars following a loss of confidence. Also, a balance-of-payments deficit that reduced reserves would
                         contract the money supply, raise interest rates, and reduce aggregate demand, including that for
                         imports. This self-correcting adjustment process can increase unemployment in response to such
                         factors as reduced investor confidence in world markets.




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                              discussed with the Executive Board informally and in “country matter”
                              sessions.

                              The IMF’s process for monitoring the conditions included in support
                              programs allows for program modifications, depending on a country’s
                              individual circumstances. Modifications are usually summarized in
                              updated program documents. The programs in each of the countries we
                              reviewed were modified, in some cases frequently, for a variety of reasons.
                              In some instances, modifications were made because of the effect
                              unforeseen internal or external factors had had on the country’s ability to
                              meet the conditions in the program. In other instances, the IMF
                              determined the initial conditions were not feasible or realistic.

The IMF’s Monitoring of a     As illustrated in figure 1, once the IMF Executive Board has approved a
                              program, the country is expected to implement its conditions. IMF staff
Borrower Country’s            monitors the program continually, and the program is subject to periodic
Program Is a Process That     reviews by the IMF Executive Board in order to evaluate if the country’s
Involves IMF Staff, Country   progress in meeting the conditions under the program justifies the
Officials, and the IMF        continuation of disbursements. In some cases, disbursements depend only
                              on a determination by the IMF staff that the country has met prenegotiated
Executive Board               criteria. As such, according to IMF staff, for most programs, review by the
                              IMF Executive Board is not required prior to each quarterly disbursement.
                              For these programs, semiannual reviews by the IMF Executive Board are
                              the more typical approach. In these cases, IMF staff reviews whether the
                              country has met its performance criteria quarterly and, if they have been
                              met, a disbursement can follow without a full IMF Board review. Larger
                              programs, such as several we studied, tend to have tighter monitoring, and
                              reviews can be held quarterly, bimonthly, or monthly. Future
                              disbursements are contingent on the outcome of these reviews. In order
                              for a country to be eligible for the next disbursement, the review has to be
                              considered “complete.” IMF staff missions to the country review the
                              country’s progress in meeting the program’s performance criteria and
                              other structural reforms with country officials. Progress is outlined in
                              documents provided to the Executive Board by both country authorities
                              and IMF staff. IMF staff appraises a country’s progress and makes a
                              recommendation to the Executive Board. According to IMF staff, this
                              process involves a considerable amount of judgment and allows for a
                              number of options depending on the country’s performance and the effect
                              of both internal and external events on that performance.

                              If the IMF Executive Board determines that a country has made sufficient
                              progress in meeting the program’s conditions, the next disbursement, as
                              specified in the arrangement, will be available for release. However,



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according to IMF staff, it is fairly common for one or more of the
program’s conditions to be missed, including performance criteria. When
this happens, IMF staff and country officials discuss the causes behind the
missed criteria and changes that may be needed in the program. According
to an IMF official, if the staff concludes that the deviation is minor and
self-correcting or the underlying objectives of the program can be met
despite the deviation, they may recommend to the IMF Executive Board
that it grant the country’s request for a waiver and be eligible for the next
disbursement. However, if the staff concludes that the reform program is
not on track and that the criteria were missed because the country was not
sufficiently pursuing an agreed-upon policy, the staff will not recommend
approval of a waiver at that time and will instead delay or suspend the
completion of the country’s review. Negotiations between the two parties
can continue if and until the two sides reach agreement on how to restart
the existing program or initiate an entirely new program, or the borrower
country requests that the program be terminated. When the staff is assured
that the country is once again committed to reform (sometimes by
undertaking “prior actions”), it can recommend to the Executive Board
that waivers be granted for the previously unmet conditions, and the
review be completed. Upon IMF Executive Board approval, the country is
eligible to receive the next disbursement. The documents we reviewed
demonstrated that this process was generally followed for the six
countries in our study, as summarized in table 3.




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Table 3: IMF Monitoring of Current Financial Arrangements With Six Countries, as of April 30, 1999
IMF Executive Board
reviews completed        Reviews completed       Waivers granted without    Delays in completing
under current            with no waivers         delays in completing       reviews and disbursing
arrangement              requested               review or disbursing funds funds                     Observations
Argentina
Since the arrangement    Two                     One - In March 1999, the   None                       In the course of its three
was approved in Feb.                             IMF Board approved a                                  reviews, the IMF Board
1998, three reviews were                         waiver because Argentina’s                            has determined that
completed in Sept. 1998,                         federal government deficit                            Argentina has met all
March 1999, and May                              exceeded the quantitative                             performance criteria
1999.                                            performance criterion. IMF                            except the one noted
                                                 staff concluded that the                              under “waivers.” The IMF
                                                 amount by which the                                   noted that Argentina
                                                 criterion was exceeded was                            performed in a
                                                 minor and that the                                    satisfactory manner in a
                                                 nonobservance was due to                              relatively turbulent
                                                 circumstances outside the                             international economic
                                                 government’s control.                                 environment.
Brazil
Since the arrangement    None                    None                       One - The first and        The review was delayed
was approved in Dec.                                                        second review,             until the IMF and Brazil
1998, one set of reviews                                                    scheduled for completion agreed to changes in the
was completed in March                                                      in February 1999, was      program to reflect the
1999.                                                                       delayed until March        impact of the new
                                                                            1999.a The IMF Board       currency regime. The
                                                                            granted a waiver           IMF said Brazil has made
                                                                            for the government’s       substantial progress in
                                                                            nonobservance of the       implementing its
                                                                            ceiling on net domestic    structural and fiscal
                                                                            assets of the central      program.
                                                                            bank.
Indonesia
Since the initial        Two                     None                       The IMF delayed            There were nine
arrangement was                                                             completion of four         revisions to the initial
approved in Nov. 1997,                                                      reviews for several        program, reflecting the
six reviews have been                                                       reasons, including lack of continuing evolution of
completed.                                                                  progress in meeting        the program. The IMF
                                                                            monetary criteria,         has been concerned
                                                                            privatizing state          about the government’s
                                                                            enterprises, and merging stability and its
                                                                            troubled banks. The IMF commitment to
                                                                            released funds after it    implement reforms.
                                                                            determined that
                                                                            Indonesia had made
                                                                            sufficient progress in
                                                                            implementing the IMF
                                                                            conditions.




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IMF Executive Board
reviews completed         Reviews completed    Waivers granted without    Delays in completing
under current             with no waivers      delays in completing       reviews and disbursing
arrangement               requested            review or disbursing funds funds                  Observations
Korea
Since the initial         Five                 Two - In December 1998             None                        Korea’s program
arrangement was                                and April 1999, the IMF                                        changed substantially to
approved in Dec. 1997,                         Board approved waivers                                         reflect the deeper-than-
seven reviews have been                        allowing more time for the                                     expected recession.
completed.                                     government to complete                                         Korea has made
                                               required structural                                            substantial progress in
                                               performance criteria. These                                    implementing financial
                                               actions have since been                                        sector policy changes
                                               completed, according to IMF                                    and has begun repaying
                                               officials.                                                     its IMF borrowings.
Russia
Since the initial         Five                 Two reviews were completed         The IMF delayed             The substantive reasons
arrangement was                                after the IMF Board granted        disbursements and/or        for Russia’s failure to
approved in March 1996,                        waivers for Russia’s               program approval five       meet key goals,
12 reviews were                                nonobservance                      times. The delays           according to IMF officials,
completed through June                         of performance criteria. In        occurred because Russia     have been a lack of
1998.                                          these instances, the               had gotten too far off      political will to collect
                                               government missed the              program regarding the       taxes and a pervasive
                                               performance criteria on            government deficit and      culture of nonpayment of
                                               the government deficit or          revenue targets. Also,      taxes.
                                               revenue targets.                   there were delays
                                                                                  because Russia had to       In March 1999, the
                                                                                  implement prior actions     program was terminated
                                                                                  and/or there were           at Russia’s request; the
                                                                                  cabinet changes.            IMF and Russia are
                                                                                                              currently negotiating
                                                                                                              terms for a new program.
Uganda
Since the arrangement     One                  One - In April 1998, the IMF       Following a February        IMF and U.S. Treasury
was approved in Nov.                           Board approved a waiver for        1999 IMF staff mission      officials have described
1997, two reviews were                         the quantitative performance       that found the              Uganda as generally
completed in April 1998                        criterion that limits              government missed five      exhibiting a strong
and Nov. 1998.                                 government obligations to          of nine performance         commitment to economic
                                               the banking sector, judging        criteria, disbursements     reform. Recent
                                               that non-observance was            have been delayed           developments indicate a
                                               due to a reversible technical      pending the findings of     greater emphasis by the
                                               factor rather than a failure of    the staff mission that      IMF on increasing priority
                                               policy.                            returns in June 1999.       social-sector spending,
                                                                                  Government officials        improving privatization
                                                                                  expect to meet              efforts, and new concern
                                                                                  the criteria then.          over increases in military
                                                                                                              spending.
                                         Note: More detailed discussions of these programs and IMF monitoring of compliance with terms and
                                         conditions are contained in the country-specific appendixes to this report.
                                         a
                                          According to IMF staff, Brazil’s first and second reviews were completed simultaneously because
                                         Brazil received funds under two different IMF policies, an SBA and an SRF, and drew from these
                                         sources simultaneously. If they had been drawn sequentially, the reviews would have been completed
                                         separately.
                                         Source: GAO analysis of IMF documents.




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The IMF Executive Board        As previously discussed, during the review process, if the IMF determines
                               that a country has met all of the performance criteria, the country is
May Approve Access to          eligible to receive its next IMF disbursement. If IMF staff believes that the
Funds if Overall Progress Is   country has satisfactorily implemented the requirements for the period
Sufficient                     under review but that all criteria were not met, it can recommend that the
                               IMF Executive Board grant the borrower country’s request for a waiver of
                               nonobservance of those unmet criteria. Generally, in these cases, the
                               deviations are determined to be minor, of a technical nature, or temporary.
                               The granting of such waivers generally happens fairly quickly, and access
                               to the next disbursement is not delayed. In addition to reviewing a
                               country’s progress on performance criteria, its progress toward meeting
                               indicative targets and structural benchmarks is also considered in the
                               review process and the decision to approve the next disbursement.

                               For example, Argentina requested a waiver for the IMF Board review in
                               March 1999 because its federal government deficit slightly exceeded its
                               target. This situation was primarily due to adverse external factors. In this
                               instance, the federal government deficit, estimated at $3.85 billion in 1998
                               (1.1 percent of gross domestic product [GDP]), exceeded its ceiling by
                               about $350 million, or around 0.1 percent of GDP. According to the
                               Argentine government, its efforts to contain expenditures could not
                               compensate fully for the revenue shortfall. The shortfall mainly reflected
                               the slowdown of economic activity in the second half of 1998 and its
                               adverse effect on taxes, particularly the value-added tax. IMF staff viewed
                               the deviation as minor and as not detracting from overall fiscal
                               performance. Hence, they recommended the waiver be granted; in March
                               1999, the IMF Executive Board approved the waiver.

                               In another example, Uganda requested a waiver for nonobservance of one
                               quantitative performance criterion during its April 1998 IMF Board review.
                               In this instance, the quantitative performance criterion was a limit on the
                               net claims on the government by the banking system. During the review
                               period that ended in December 1997, the Ugandan government
                               experienced a temporary shortfall in its checking accounts with the
                               banking system, thereby causing it to miss the performance criterion.
                               According to IMF documents, the shortfall was due to government
                               payments being made sooner than expected. IMF staff recommended the
                               waiver be granted because they viewed this nonobservance as minor and
                               of a technical nature rather than a policy violation; the IMF Executive
                               Board approved the waiver in April 1998. The shortfall was corrected
                               within a short period of time.




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The IMF May Delay or           During the review process, instances in which the country did not meet
                               key quantitative or structural performance criteria may be considered
Withhold Funds if Sufficient   significant enough to delay or suspend disbursements. According to IMF
Progress Is Not Made           staff, a country’s record in implementing performance targets and
                               benchmarks influences this determination. Under these circumstances,
                               IMF staff recommends to IMF management that the review not be
                               completed. If IMF management concurs, the staff will likely informally
                               brief the IMF Board, but the IMF Board will not be asked to make a formal
                               decision on the program’s continuation at that time. Depending on the
                               situation, IMF staff may continue to work with country officials to
                               negotiate new terms of the program so that it can be restarted or so a new
                               program can be initiated. If country officials and IMF staff are unable to
                               agree on terms, it is possible that the program will lapse.

                               Indonesia’s program is an example of a situation in which disbursements
                               were delayed several times. The Indonesian IMF program began with
                               Executive Board approval in November 1997, with completion of the first
                               review scheduled for mid-March. The IMF, however, delayed Indonesia’s
                               disbursements from mid-March to early May 1998 due to the IMF staff’s
                               determination that Indonesia had not made sufficient progress in carrying
                               out its program. The first review was completed in May 1998, with
                               Indonesia meeting none of the quantitative performance criteria and one of
                               the required structural performance criteria. IMF staff recommended and
                               the Executive Board granted Indonesia’s request for waivers of
                               nonobservance of these criteria based on actions taken by the government,
                               and disbursements resumed. At this time, the IMF moved from quarterly to
                               monthly reviews of Indonesia’s program. Disbursements were also delayed
                               in the process of completing several subsequent reviews.

                               Brazil’s program is a more recent example of a delay in disbursements. The
                               program began in November 1998, with the first disbursement occurring in
                               early December. In January 1999, the government of Brazil was forced to
                               devalue and then float its currency. Up until that time, Brazil’s currency
                               was pegged to the U.S. dollar, and maintenance of the exchange rate was
                               an objective of Brazil’s IMF program. Because Brazil received funds under
                               two different IMF policies and drew from these sources simultaneously,
                               the first and second reviews were scheduled to occur simultaneously.
                               Completion of this set of reviews and the second disbursement were
                               initially scheduled to occur no later than the end of February 1999. The
                               change in the currency regime required substantial revision to the
                               program, thus delaying until late March completion of the review. Brazil’s
                               program was modified to reflect new economic and exchange rate
                               circumstances. Brazil missed one of its quantitative performance criteria



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                             (a ceiling on net domestic assets in the central bank). The Executive Board
                             granted Brazil a waiver for the nonobservance of this performance
                             criterion, agreed to the program modifications, and approved completion
                             of the first and second review on March 30, 1999, thus opening the way for
                             Brazil to receive the next disbursement of funds.

                             Russia’s program is an example of one in which the IMF delayed
                             disbursements and program approval, reduced the amount of the
                             disbursement, and ultimately suspended the program. The IMF delayed
                             four disbursements: one in June and two in September and October 1996,
                             and then another in November 1997. Russia received no funds between
                             February and May 1997, pending approval of the 1997 program, which was
                             delayed until May 1997, based on Russia’s successful completion of prior
                             actions. The delayed approval of the 1998 program, due to cabinet changes
                             and difficulty in meeting the revenue package, meant that Russia received
                             no funds between January and June 1998. The program was finally
                             approved in June 1998, based on implementation of prior actions. In July
                             1998, the IMF approved additional funds to Russia but reduced the amount
                             of the initial disbursement from $5.6 billion to $4.8 billion due to delays in
                             getting two measures passed in the Duma (the lower house of the Russian
                             parliament). The IMF was scheduled to release the next disbursement in
                             September 1998, but Russia had deviated so far from the program that the
                             IMF made no further disbursements. Ultimately, according to the IMF, it
                             delayed disbursements because of Russia’s poor tax collections, reflecting
                             a lack of government resolve to collect these revenues. However,
                             throughout Russia’s program, the IMF staff expressed the view that
                             Russia’s key senior authorities were committed to the program and should
                             be supported; therefore, the IMF Executive Board continued to approve
                             disbursements. In March 1999, Russia requested that the program be
                             terminated. In April 1999, IMF staff and Russian authorities announced
                             they had reached agreement on an economic program that management
                             hoped to be able to recommend to the IMF Executive Board in support of
                             a new arrangement. As of June 16, 1999, the IMF Board had not approved
                             the new arrangement.

Conditions May Be Modified   Modifications to a borrower country’s program are usually based on an
                             agreement between the IMF and country officials summarized in updated
for a Variety of Reasons     program documents. In these cases, such agreements outline modified
                             performance criteria, indicative targets, and benchmarks.

                             IMF and country officials may modify conditions contained in borrower
                             country programs for a variety of reasons, depending on individual country
                             circumstances. Two reasons for modifications of programs are (1) the



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effect of unanticipated internal and external factors on the country’s
ability to fulfill the required conditions and (2) the determination that the
initial conditions were not realistic or feasible. In many instances, there is
overlap between these two reasons. Unanticipated internal factors
generally reflect events over which the government had less control than it
had hoped. Examples include the inability of the government to enact
required legislation, or other political turmoil. Unforeseen external factors
are generally changes in the global economic environment that affect the
ability of a borrower country to fulfill the macroeconomic conditions of its
program. Examples include such things as a decline in investor confidence
and/or capital flows, a decrease in demand for or price of primary exports,
default by a major debtor, a recession or other economic problems in
another country to which one’s economy is closely tied, and natural
disasters like droughts and floods. Unrealistic or unfeasible conditions can
result when a country’s problem is misdiagnosed or when the impact of
certain conditions is different from what was expected.

Developments in the early stages of Indonesia’s current program are an
example of an instance in which unanticipated internal events made it
difficult for Indonesia to fulfill the conditions it had agreed to. These
events included (1) circumvention of government decrees to dismantle
cartels and open up markets, (2) the government’s consideration of a
currency board (which was not part of the program), (3) social unrest, and
(4) the resignation of the president. Indonesia experienced a significant
loss of investor confidence that resulted in a run on the banks, the
reduction of foreign credit lines, and a continuing depreciation of the
currency. The IMF and Indonesia revised the economic program a number
of times before the situation stabilized.

Brazil is another example in which unanticipated internal events resulted
in program revisions. The maintenance of the exchange rate regime was an
objective of the country’s IMF program. Brazil turned to the IMF for
assistance in September 1998, when its currency came under pressure as a
result of the Russian crisis, and it experienced a significant loss of
reserves. This reserve loss decelerated after the negotiations began, but,
according to Brazilian officials, Brazil’s currency came under additional
pressure for a variety of reasons after its IMF program had started. These
reasons included three internal setbacks that were out of the government’s
control, including the defeat in Brazil’s congress of two tax measures
deemed crucial to the fiscal adjustment program and the reluctance of a
number of Brazilian state governors to fulfill their financial obligations to
the government. To try to stem the additional loss of reserves, the
Brazilian government found it necessary to devalue and then float the



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currency. The IMF program was then revised to reflect the new economic
situation and currency regime.

In Korea, a significant external factor that limited its macroeconomic
performance, in the view of the IMF, was the continued Japanese
recession. According to an IMF assessment, the weakening of the Japanese
yen affected Korea’s export competitiveness by making Korea’s exports
more expensive in comparison with Japanese exports. In addition, it was a
contributing factor in worsening and lengthening Korea’s own recession.

Reassessment of initial conditions can take place because these conditions
are later determined to be unfeasible or unrealistic due to economic
factors that were not well known at the time. For example, Treasury and
IMF officials told us the IMF projections for Korea were overly optimistic
at the beginning of the program. These estimates were based on Korea’s
past strong growth and did not accurately project the “rolling financial
crisis” throughout Asia. Also, the true state of Korea’s financial sector was
not clear when Korea’s initial program was designed. Part of Korea’s
agreement with the IMF was to improve transparency (openness) in its
financial reporting, but as greater information became available, investor
confidence dropped when the market learned more about the level of
usable international reserves, corporate debt, and banks’ nonperforming
loans.

Apart from waivers and reviews, quantitative performance criteria and
indicative targets can be changed by means of “adjusters” that are included
in some country programs. Adjusters are prenegotiated to account for
specific actions and assumptions about economic and financial
movements. We found that there were basically two types of adjusters in
the agreements we reviewed: adjusters due to unexpected external events
that temporarily affect a key variable and adjusters due to in-country
policy changes that affect a key variable or the measurement of that
variable.

The first type of adjuster automatically changes the level of a quantitative
performance criterion when there are unexpected changes—generally
outside of the country’s control—to one or more key variables. The
rationale is that occasionally countries may fail to reach a particular
quantitative performance criterion due to fluctuations in economic
conditions outside their control and that temporary changes in key
variables should not derail an IMF agreement. Also, some adjusters are
designed to take into account the effect of positive as well as negative
external developments on the quantitative performance criteria. For



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                         example, Uganda’s program had a quantitative performance criterion that
                         set a minimum level for net international reserves. This minimum level was
                         based on an assumed level of inflows of funds from bilateral and
                         multilateral lending agencies. An adjuster was added to the quantitative
                         performance criterion in order to adjust the required minimum level
                         upward (or downward) in the event that creditors provided more (or less)
                         debt relief than was expected.

                         The second type of adjuster automatically changes the level of a
                         quantitative performance criterion when policymakers choose to make
                         changes in their monetary or fiscal policy instruments in a manner that
                         would either directly or indirectly affect the target variables. For example,
                         an IMF official noted that a common performance criterion in programs is
                         a maximum permissible level of net domestic assets of the central bank,
                         usually included as part of a strategy to target the growth of the money
                         supply. However, other policy decisions can affect the level of the money
                         supply. For instance, decreases in the required reserve ratio (the
                         proportion of the total value of deposits that a commercial bank must keep
                         either in its vault or in an account at the central bank) may increase
                         commercial bank liquidity and the money supply. Thus, frequently the
                         quantitative performance criteria include an adjuster that automatically
                         decreases the performance criterion for the net domestic assets of the
                         central bank when the required reserve ratio is reduced to offset potential
                         increases in the money supply. This adjuster is intended to prevent policy
                         changes from compromising the achievement of overall program
                         objectives, such as price stability or low inflation.

                         Our objectives were to (1) describe how the IMF establishes financial
Objectives, Scope, and   arrangements with borrower countries and the types of conditions set
Methodology              under these programs and assess how this process was used for six
                         borrower countries; and (2) describe how the IMF monitors countries’
                         performance and assess how this process was used for six borrower
                         countries, detailing the conditions met and not met, the reasons why
                         conditions were not met, and the actions the IMF took in response. To
                         meet our objectives, we obtained access to IMF officials and documents
                         (public and nonpublic) through the Department of the Treasury and
                         through the staff of the U.S. member of the IMF Board of Executive
                         Directors. These documents describe the IMF’s background, policies, and
                         practices. We reviewed borrower country documents outlining IMF
                                                                                      22
                         arrangements and conditionality, including letters of intent, and

                         22
                           Letters of intent are prepared by the member country. They describe the policies that a country
                         intends to implement in the context of its request for financial support from the IMF.




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documents presented to the IMF Executive Board, such as staff reports on
arrangements. We also reviewed several IMF assessments of its
operations, including reviews of ESAF and the IMF’s response to the Asian
financial crisis.

We discussed the IMF’s process for establishing and monitoring the
conditions of its financial arrangements with officials of the IMF, U.S.
government agencies, and borrower governments. To obtain additional
information from in-country officials, in February 1999, we requested
access to Department of State cables related to the most current IMF
arrangement and economic and financial conditions in each of the six
countries. According to State, it identified and reviewed over 550 cables
that were determined to be responsive to our request. Due to the volume
of the cables and the limited time in which to review them, State was
unable to provide timely access for us to analyze the content of many of
these cables and meet the legislatively required reporting date. We also
obtained information from nongovernmental and academic organizations.
We did not evaluate the appropriateness or effectiveness of the IMF’s
terms and conditions.

We reviewed the most recent IMF financial arrangements for the following
six borrower countries: Argentina, Brazil, Indonesia, Republic of Korea
(Korea), the Russian Federation (Russia), and Uganda. We selected these
countries because they are geographically diverse, represent a mix of
borrowers that were having actual or potential balance-of-payments
difficulties at the time they requested IMF financial assistance, and have
varying histories with the IMF. Several of these countries were in the midst
of a financial crisis at the time they requested assistance. Three
countries—Argentina, Russia, and Uganda—had successive IMF financial
arrangements, whereas two other countries—Indonesia and Korea—had
not had IMF financial arrangements for about 10 years before their most
current arrangements.

The information contained in this report is based on the implementation of
countries’ programs from their inception through April 1999, unless
otherwise noted.

We conducted our review in Washington, D.C., between November 1998
and April 1999 in accordance with generally accepted government auditing
standards.




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                      We recognize that the IMF’s actions have been subject to debate and
                      criticism. An evaluation of these criticisms is clearly outside the scope of
                      this report. We identify some of these criticisms in appendix VIII.

                      We requested comments on a draft of this report from the Under Secretary
Agency Comments and   (International) of the Department of the Treasury and the Managing
Our Evaluation        Director of the International Monetary Fund. The Treasury provided
                      written comments on a draft of this report, which are reprinted in
                      appendix IX. These comments characterized the report as balanced and
                      informative. The Treasury did note its concern that our discussion of
                      flexibility in monitoring and implementing IMF programs could be
                      misunderstood. The Treasury commented that while the IMF’s process
                      does incorporate flexibility and latitude, “there is a fundamental link
                      between program implementation and program support.” We agree that
                      IMF’s process is designed to allow adjustment to a country’s program in
                      appropriate cases, taking into account changing circumstances. We
                      provide many examples of such adjustments in our description of the
                      arrangements for six borrower countries. Also, in response to the
                      Treasury’s concern, we added clarifying language to the Results in Brief to
                      note that the resumption of IMF disbursements following a delay depends
                      on IMF judgment that there has been satisfactory progress in meeting key
                      conditions. For a full discussion of the process, see appendix I of this
                      report.

                      Both the IMF and the Treasury provided technical and clarifying
                      comments, which we incorporated where appropriate. We also asked
                      responsible Department of State officials to review the accuracy of the in-
                      country information in the draft. They provided technical and clarifying
                      comments, which we have incorporated where appropriate.

                      We are sending copies of this report to Senator Connie Mack, Chairman,
                      Representative Jim Saxton, Vice Chairman, and Senator Charles Robb and
                      Representative Fortney Pete Stark, Ranking Minority Members, Joint
                      Economic Committee; Senator William Roth, Chairman, and Senator
                      Daniel Moynihan, Ranking Minority Member, Senate Committee on
                      Finance; Senator Phil Gramm, Chairman, and Senator Paul Sarbanes,
                      Ranking Minority Member, Senate Committee on Banking, Housing, and
                      Urban Affairs; and Representative Benjamin Gilman, Chairman, and
                      Representative Sam Gejdensen, Ranking Minority Member, House
                      Committee on International Relations. We are also sending copies of this
                      report to the Honorable Robert Rubin, the Secretary of the Treasury; the
                      Honorable Madeleine Albright, the Secretary of State; the Honorable Jacob
                      Lew, Director, Office of Management and Budget; and the Honorable



                      Page 38                            GAO/GGD/NSIAD-99-168 IMF Financial Assistance
B-281768




Michel Camdessus, Managing Director, IMF. Copies will be made available
to others upon request.

This report was prepared under the direction of Susan S. Westin, Associate
Director, Financial Institutions and Markets Issues, and Harold J. Johnson,
Jr., Associate Director, International Relations and Trade Issues. Please
contact either Ms. Westin at (202) 512-8678 or Mr. Johnson at (202) 512-
4128 if you or your staff have any questions about this report. Other major
contributors are acknowledged in appendix X.




Nancy R. Kingsbury
Acting Assistant Comptroller General
General Government Division




Henry L. Hinton, Jr.
Assistant Comptroller General
National Security and International
Affairs Division




Page 39                           GAO/GGD/NSIAD-99-168 IMF Financial Assistance
B-281768




LIST OF CONGRESSIONAL COMMITTEES

The Honorable Jesse A. Helms
Chairman
The Honorable Joseph R. Biden, Jr.
Ranking Minority Member
Committee on Foreign Relations
United States Senate

The Honorable Ted Stevens
Chairman
The Honorable Robert C. Byrd
Ranking Minority Member
Committee on Appropriations
United States Senate

The Honorable Jim Leach
Chairman
The Honorable John J. LaFalce
Ranking Minority Member
Committee on Banking and Financial Services
House of Representatives

The Honorable C.W. Bill Young
Chairman
The Honorable David R. Obey
Ranking Minority Member
Committee on Appropriations
House of Representatives




Page 40                         GAO/GGD/NSIAD-99-168 IMF Financial Assistance
Page 41   GAO/GGD/NSIAD-99-168 IMF Financial Assistance
Contents



Letter                                                                       1


Appendix I                                                                  46

The IMF’s Process for
Establishing and
Monitoring Countries’
Financial
Arrangements
Appendix II                                                                 57

The IMF's Financial
Arrangement with
Argentina
Appendix III                                                                72

The IMF's Financial
Arrangement with
Brazil
Appendix IV                                                                 85

The IMF's Financial
Arrangement with
Indonesia
Appendix V                                                                 116

The IMF’s Financial
Arrangement With
South Korea




                        Page 42   GAO/GGD/NSIAD-99-168 IMF Financial Assistance
                        Contents




Appendix VI                                                                 136

The IMF's Financial
Arrangement with
Russia
Appendix VII                                                                159

The IMF’s Financial
Arrangement with
Uganda
Appendix VIII                                                               175

Criticisms of the IMF
Appendix IX                                                                 178

Comments from the
Department of the
Treasury
Appendix X                                                                  180

GAO Contacts and
Staff
Acknowledgments
Glossary                                                                    181




                        Page 43    GAO/GGD/NSIAD-99-168 IMF Financial Assistance
Contents




Abbreviations

BCB         Brazil Central Bank
CBR         Central Bank of Russia
CCFF        Compensatory and Contingency Financing Facility
EFF         Extended Fund Facility
ESAF        Enhanced Structural Adjustment Facility
ESF         Exchange Stabilization Fund
GDP         gross domestic product
GRA         General Resources Account
HIPC        Heavily Indebted Poor Countries
IBRA        Indonesian Bank Restructuring Agency
IMF         International Monetary Fund
INDRA       Indonesian Debt Restructuring Agency
SBA         Stand-by Arrangement
SDR         Special Drawing Rights
SRF         Supplemental Reserve Facility
STF         Systemic Transformation Facility
VAT         Value Added Tax


Page 44                          GAO/GGD/NSIAD-99-168 IMF Financial Assistance
Page 45   GAO/GGD/NSIAD-99-168 IMF Financial Assistance
Appendix I

The IMF’s Process for Establishing and
Monitoring Countries’ Financial
Arrangements
                       The process that the International Monetary Fund (IMF) generally uses to
                       establish and monitor financial assistance arrangements is intended to be
                       flexible and applied on a case-by-case basis to address the specific
                       balance-of-payments problems of member countries. The IMF staff and the
                       member country begin the process by assessing the country’s overall
                       economy, balance-of-payments position, ability to finance any balance-of-
                       payment deficit, and potential need for IMF financial assistance. If the
                       country decides to seek IMF financing, the IMF staff and the country
                       negotiate an arrangement that describes the amount of financing, the type
                       of financing instrument, and the schedule for review. The IMF staff and the
                       country also negotiate conditions—the policy measures that the country
                       intends to fulfill in order to continue to access IMF funds. After the
                       arrangement is negotiated, the IMF Executive Board discusses and
                       approves it.

                       IMF staff conduct periodic reviews to monitor the country’s progress in
                       meeting the IMF program conditions. The frequency of the reviews
                       depends on the type of financial arrangement that the country is under and
                       the nature of its problem. The IMF uses both data and judgment in
                       assessing the extent of the country’s progress in meeting program
                       conditions. If it determines that the country is on track in implementing its
                       program conditions, additional allotments of funds can be made available.
                       In cases where the IMF determines deviations from the program are
                       significant, it can delay or withhold funding unless and until, in its
                       judgment, the country has made further progress.

                       When a member country faces an actual or potential balance-of-payments
Country Officials      problem, it may consult with the IMF to analyze information on the
Consult With the IMF   economy and discuss various methods of managing the problem. These
                       discussions may lead the country to request IMF financial assistance in
                       order to alleviate the imbalance. If the IMF and the country do not reach
                       final agreement on a financial assistance arrangement, the country may
                       seek other means to address the difficulty. Discussions can occur at any
                       time, including during the country’s annual “Article IV” consultation with
                                                                                              1
                       the IMF or during informal consultations as requested by the member.




                       1
                        The Article IV consultation is an annual review of members’ macroeconomic circumstances
                       conducted as part of the IMF’s “surveillance” responsibilities as spelled out in its Articles of
                       Agreement, which is its charter. The Articles also call on each member to provide the IMF with the
                       information needed for such surveillance.




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                        Appendix I
                        The IMF’s Process for Establishing and Monitoring Countries’ Financial Arrangements




                        To aid in the IMF’s assessment of a country’s overall economic situation
Country Officials and   and to determine the magnitude of potential financial assistance required
the IMF Analyze the     by the country, IMF staff evaluates the balance-of-payments problem and
Country’s Situation     determines the financial support measures that would assist in correcting
                        the imbalance. The IMF staff’s review of the state of a member’s economy
                        is an iterative process and is based on country-provided data, assumptions
                        about key macroeconomic variables, and judgment by the IMF staff and
                        country officials. To do this, the IMF staff examines the following four
                        related sectoral statistical systems over the medium term of 3 to 5 years
                        with the assumption that the government will follow its stated policies: (1)
                        national income and product accounts for gross domestic product (GDP),
                        (2) government financial accounts for the fiscal sector, (3) consolidated
                        banking system accounts for the monetary sector, and (4) external
                        accounts for the balance-of-payments position.

                        In order to analyze these four sectors, an IMF team (IMF mission) travels
                        to the country to review the situation within the country. The team begins
                        the analysis by reviewing the data previously collected from country
                        officials for the most recent Article IV consultation as well as other
                        requested information provided by the country. The information includes
                        data on the country’s balance of payments; fiscal variables, such as
                        government expenditures and receipts; and monetary variables, such as
                        monetary reserves and bank deposits, stock of currency, and interest rates.
                        In addition, it includes country authorities’ projections for areas such as
                        real GDP growth and inflation; real sector indicators, such as employment
                        levels, manufacturing, production, agriculture, and service sectors; budget
                        plans for government expenditures; and subsidies for public enterprises.

                        As part of the process of analyzing a country’s economy and determining
                        the balance-of-payments position, the IMF staff verifies the country-
                        provided information, searching for both consistency and contradictions in
                        the information. According to an IMF official, data inconsistencies may be
                        discovered in a variety of ways. For example, if IMF staff believed that the
                        country-provided trade data were inaccurate, it would cross-check that
                        country’s trade data with similar data of a neighboring county with whom
                        it trades in order to verify whether the information was accurate. In other
                        cases, if the data suggested that the manufacturing level in a country had
                        increased and at the same time indicated that electricity usage had
                        decreased, the staff would be alerted to the inconsistency and would seek
                        to verify the data. In such instances, the IMF team would work with
                        government employees in ministries or agencies to calculate and verify the
                        information. According to an IMF official, this type of analysis is, by
                        necessity, undertaken on a case-by-case basis, and it would be difficult to



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Appendix I
The IMF’s Process for Establishing and Monitoring Countries’ Financial Arrangements




develop a universal set of standards for verifying such information. For
this work, the IMF relies on its mission chiefs, who have acquired
knowledge and experience in each country to assist in verifying the data.

According to an IMF official, determining the balance-of-payments position
is central to both the analysis of the economy and the determination about
whether the country would be eligible for IMF financial support. The
concept of a balance-of-payments need is broadly defined in the IMF’s
Articles of Agreement and includes (1) the country’s overall balance of
payments, (2) the country’s foreign reserve position, and (3) developments
in its reserve position. IMF documents state that these three elements are
regarded as separate, and a member’s representation of a balance-of-
payments need can be based on any one of them. The first element—the
country’s overall balance of payments—represents the economy’s external
financing requirement and equals the sum of a member’s current and
capital account balances. The current account primarily includes exports
and imports of goods and services. The capital account provides summary
data on the changes in net foreign assets of domestic residents arising
from such transactions as external borrowing or repayments (borrowing
from or repaying foreign sources), foreign direct investment, portfolio
investments (both equity shares and bonds), and short-term capital
movements.

The second element—the country’s reserve position—refers to the amount
                                                           2
of resources (convertible currency, special drawing rights, and gold) a
country has to support its imports and external debt payments. The
reserves are under the control of the monetary authority. The third
element—developments in the reserve position--has a very narrow
application and is intended to ensure that members of the IMF whose
currency is a reserve currency (such as the United States) would be able to
use IMF resources when requested, despite the absence of a need as
                                   3
outlined in the first two elements.



2
 The special drawing right is a reserve asset created by the IMF and a unit of account that the IMF uses
to denominate all its transactions.
3
 It is designed to cover situations in which a country may not have a balance-of-payments deficit or a
weak reserve position but still has a need because of a development in its reserves. For example, the
Executive Board was concerned that the first two concepts would preclude members of the European
Economic Community, (the predecessor to the European Union) from requesting IMF assistance in
discharging obligations among each other. By virtue of their currency being a reserve asset, the use of
their currency in foreign transactions would not result in a balance-of-payments deficit or weak reserve
position by such countries, although difficulties in the external environment may still require some
support.




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Appendix I
The IMF’s Process for Establishing and Monitoring Countries’ Financial Arrangements




According to an IMF official, determining an actual balance-of-payments
need is easier than projecting a potential balance-of-payments need. This is
because the process of assessing an economy is subject to many
assumptions and uncertainties, including factors within and outside of the
country’s control. For example, in the case of Russia, the IMF documents
establishing the 1996 extended arrangement do not explicitly describe the
underlying balance-of-payments need. However, the IMF documents do
present a clear case for the role that IMF funding was to play in catalyzing
debt rescheduling and encouraging the inflow of private capital to avoid a
potential balance-of-payments problem. In 1996, Russia had a basic
weakness in its external accounts due in part to short-term capital
outflows and an inadequate level of reserves. Furthermore, many debt
service obligations were expected to occur between 1996 and 2000, adding
more stress to Russia’s external accounts. An IMF financial arrangement in
1996 was seen as critical for Russia to avoid a potential balance-of-
payments problem. The IMF arrangement helped Russia obtain debt
rescheduling to reduce the future burden on the federal budget and
improve Russia’s access to private capital markets.

Analyzing the nature, source, and severity of any existing or potential
balance-of-payments problem involves assessing data about the balance-of-
payments deficit and the country’s ability to finance it. To determine the
nature of the imbalance, the IMF determines whether the problem is short
term or longer term. For example, a short-term problem could be a cyclical
or seasonal imbalance caused by the falling price of a primary export. A
longer-term imbalance might be caused by underlying or structural
weaknesses in the economy, such as an unsustainable government budget
deficit. The IMF staff also determines to what extent the reasons for the
imbalance are within the government’s control, along with the dimensions
and urgency of the problem, including the availability of financing.

After the balance-of-payments gap analysis is complete and if the country
decides to seek IMF financial assistance, the country officials and IMF
staff begin to discuss IMF financing as well as the conditions for the
                   4
country program. However, according to the IMF, in order to adapt
programs to individual country circumstances, it has no inflexible set of
operational rules for establishing a country’s program. Nonetheless,
Deputy Managing Director of the IMF, said that staff enter into
negotiations with detailed instructions, agreed upon within the IMF staff

4
 According to the IMF, it provides financial resources to members under certain conditions designed to
encourage what it views as appropriate economic adjustment and ensure that the member’s use of IMF
credit is temporary and that it will have the capacity to repay the IMF on time.




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Appendix I
The IMF’s Process for Establishing and Monitoring Countries’ Financial Arrangements




offices and then by IMF management. This IMF official stated that
negotiations are often long and sometimes contentious, involving several
rounds of discussions. The disagreements tend to be over difficult issues,
for example, whether the budget needs to be tightened, the inflation rate
should be reduced less rapidly, or the agreed-upon balance-of-payments
deficit can be larger.

To address the balance-of-payments problem, typically the IMF uses
economic models to project the potential impact of a variety of adjustment
measures to develop several scenarios of possible program elements.
Based on these scenarios, the IMF staff and the country negotiate what
they view as the appropriate mix of fiscal and monetary adjustment,
structural reforms, and financing required to achieve their overall goals;
these goals can include an increase in economic growth or in investor
            5
confidence.

For example, for the external sector, two independent projections of
imports need to be made and reconciled. The first is based on the demand
for imports, derived from information including the projected level of
output and relative prices, and the second is based on the capacity to
import, derived from the target change in international reserves and
projections of other components of the balance of payments. For example,
if the demand for imports is greater than the country’s capacity to import,
the basic options for adjustment may include the following: (1) seek
additional foreign exchange, (2) lower the initial target for net
international reserves, (3) reduce the initial projection for output to lower
the demand for imports, or (4) some combination of the above. Similar
iterative analyses are also carried out for the fiscal and monetary sectors.

The IMF staff and the country negotiate an arrangement that describes (1)
the amount of financing expected to be provided by various sources and
the amount that may be requested from the IMF; (2) the instruments under
which the IMF resources could be provided, for example, Stand-by
Arrangement (SBA) or Extended Fund Facility (EFF); and (3) the potential
schedule for reviewing a country’s performance and disbursing funds. The
IMF has many instruments through which it provides financing to member


5
 IMF financing is not generally in the form of a loan but rather is a purchase or repurchase of currency.
As such the IMF does not consider the establishment of a conditionality program to be a “negotiation.”
Rather, the member explains the economic reform program in the documents it prepares in the
context of its request for financial assistance and the IMF Board decides whether to support the
program. The decision takes the form of an “arrangement,” which notes certain aspects of the
member’s program that will be conditions for continued IMF financing under the arrangement.




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                                                Appendix I
                                                The IMF’s Process for Establishing and Monitoring Countries’ Financial Arrangements




                                                countries. Table I.1 illustrates IMF instruments used by the six IMF
                                                member countries discussed in this report.


Table I.1.: Frequently Used IMF Financing Instruments
                                                                   Duration/
                                                                   Disbursements/
Instruments           Purpose                                      Repayments                  Reviews
Regular arrangements
Stand-by Arrangements Short-term, balance-of-payments              1-3 years/                     Periodic reviews provided that appropriate
                      assistance for deficits of a temporary       quarterly/                     monitoring of macroeconomic
Used by Indonesia,    or cyclical nature                           within 3-1/4 - 5 years of      developments would be ensured, normally
Korea, and Brazil                                                  each drawing                   through quarterly performance criteria.
                                                                                                  Staff prepare an analysis and assessment
                                                                                                  of the performance under programs
Extended arrangements, Longer-term, balance-of-payments                3-4 years/                 Periodic reviews, typically quarterly
under EFF                   assistance for (1) deficits arising from quarterly or semiannually/ performance criteria. Country provides
                            structural maladjustments in production 4-1/2 - 10 years of each annual reports on progress made, and
Used by Argentina,          and trade and widespread cost and          drawing                    policies and measures to be followed,
Indonesia, and Russia price distortions and (2) an economy                                        including any modifications.
                            characterized by slow growth and an
- Established in 1974,      inherently weak balance-of-payments
likely to be beneficial for position that prevents pursuit of an
developing countries in active development policy. Can provide
particular                  larger total amounts of assistance.
Special facilities
Supplemental Reserve Exceptional balance-of-payments                   1 year/                    Reviews done in conjunction with SBA or
Facility (SRF)              problems owing to a large, short-term 2 or more drawings/             extended arrangement.
                            financing need resulting from a sudden within 1- 1-1/2 years from
Used by Brazil, Korea, and disruptive loss of market confidence date of disbursement but
and Russia                  reflected in pressure on the capital       may be extended another
                            account and reserves. Likely to be         year, including surcharges
- Opened in 12/97,          used where the magnitude of outflows
provided under SBA or may threaten the international monetary
extended arrangement system.
Compensatory and            Helps members deal with temporary          Significant limits on      Board review at the time of request and, in
Contingency Financing current account shocks that are largely amounts; defined                    the case of the contingency element, on the
Facility                    beyond their control. A “compensatory” methodology for                occasions stipulated in the underlying
(CCFF)                      element is available in case of shortfalls determining whether        arrangement.
                            in export earnings or excesses in cereal CCFF is needed and, if so,
                            import costs. A “contingency” element type and amount.
Used by Russia              helps members with existing
                            arrangements keep their programs on Disbursements linked to
-Opened in 1988 to          track when faced with adverse current phasing of existing
combine the                 account shocks.                            arrangement. For the
Compensatory                                                           compensatory element,
Financing Facility with                                                disbursements normally in
contingency financing                                                  one installment. For the
                                                                       contingency element,
                                                                       disbursements linked to
                                                                       phasing of existing
                                                                       arrangements. Repayment
                                                                       is in 3-1/4 to 5 years.




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                                             Appendix I
                                             The IMF’s Process for Establishing and Monitoring Countries’ Financial Arrangements




                                                                  Duration/
                                                                  Disbursements/
Instruments             Purpose                                   Repayments                   Reviews
Concessional facility
Enhanced Structural     Principal means for providing financial   3 years/                     Quarterly monitoring of financial and
Adjustment Facility     support (highly concessional loans) to    semiannually/                structural benchmarks.
(ESAF)                  low-income members facing protracted      repaid in 10 equal semi-     Semiannual performance criteria are set for
                        balance-of-payments problems.             annual installments,         key quantitative and structural targets.
Used by Uganda                                                    beginning 5-1/2 years and
                                                                  ending 10 years after date
                                                                  of each disbursement.
                                             Source: GAO analysis of IMF documents.


                                             In addition, the country and the IMF staff negotiate the likely conditions to
                                             be used to assess a country’s performance under the arrangement. These
                                             conditions are generally intended to advance the country’s larger
                                             objectives–such as a reduced balance-of–payments problem, higher
                                             economic growth, and lower inflation—as well as the reform efforts
                                             undertaken to achieve those objectives.

                                             “Performance criteria” (quantitative and structural) and “prior actions” are
                                             conditions that a country is required to meet and that the IMF uses to
                                             monitor the country’s performance and determine whether it is eligible for
                                             disbursements of resources. “Benchmarks” and “indicative targets” are
                                             other measures the IMF uses to monitor a country’s progress; however,
                                             disbursements are not generally dependent on meeting them. “Quantitative
                                             performance criteria” are clearly defined numeric targets (macroeconomic
                                             indicators), such as a specified ceiling on the government’s budget deficit
                                             or on the net domestic assets of the central bank. According to IMF staff,
                                             “structural performance criteria” must be accurately and unambiguously
                                             defined so that no subjective judgment is involved in determining whether
                                             they have been met. For example, a structural performance criterion could
                                             be that a country has to solicit bids to privatize three state-owned
                                             enterprises by a prespecified date.

                                             A prior action is a particular policy measure that is considered to be
                                             essential to the effectiveness of an adjustment program. Prior actions may
                                             be negotiated by IMF staff and country officials as part of the country’s
                                             initial arrangement or during subsequent program reviews; they generally
                                             have to be implemented before an IMF arrangement or a disbursement of
                                             funds is approved. An example of a prior action is the issuance of a
                                             regulation or other forms of legal reform.

                                             Other measures used to assess a country’s progress include benchmarks
                                             and indicative targets. They may relate to macroeconomic variables or to
                                             specific policy commitments, such as changes in key structural areas of


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                        Appendix I
                        The IMF’s Process for Establishing and Monitoring Countries’ Financial Arrangements




                        the economy. Benchmarks can be difficult to define and are best explained
                        as a set of specific target measures to be accomplished by a certain date,
                        used by the IMF to assess progress toward an overall goal. In general,
                        benchmarks could include targeted structural changes for tax policy and
                        administration reform, financial sector reform, or exchange system reform.
                        For example, to achieve the overall goal of strengthening a country’s
                        banking system, the IMF and the country may agree to a structural
                        benchmark, such as enacting legal reforms for bankruptcy or developing a
                        bank recapitalization plan. Indicative targets are quantitative targets set on
                        many of the standard goals of macroeconomic policy and could include
                        targets set on the balance of payments, the rate of inflation, or the public
                        deficit.

                        After the arrangement is negotiated, it has to be accepted by the IMF
The IMF Executive       Managing Director before it is brought before the IMF Executive Board.
Board Discusses and     According to an IMF official, the Executive Board generally accepts the
Approves Program        recommendations of the staff, largely because the staff brings to the
                        Executive Board proposals that the Board will accept. Generally, the
                        Executive Board is briefed formally or informally during the negotiation
                        process, and board decisions are made on a consensual basis. Since
                        negotiations with a country continue throughout the life of a program, the
                        Executive Board will often use a meeting to send signals about what it will
                        and will not accept in the future.

                        After the IMF arrangement is approved by the Executive Board, the
IMF Staff and Country   country is then expected to implement the agreed-upon conditions in the
Officials Review        IMF program. To determine whether the program is on track and the
Program Status          country is eligible to receive the next disbursement of funds, the IMF staff
                        conducts periodic reviews of the programs. The review schedule is built
                        into the arrangement between the country and the IMF. For the reviews, a
                        team of IMF staff and country officials assesses the program status,
                        including the country’s overall economic conditions and performance with
                        respect to criteria, prior actions, and benchmarks.

                        According to the IMF, reviews are typically held on a semiannual basis,
                        although disbursements can be made if countries achieve the quarterly
                        performance criteria and prior actions. Some countries, however,
                        including those suffering a financial crisis or receiving funds from the
                        Supplemental Reserve Facility (SRF), tend to have tighter monitoring
                        because funding tends to be heavily front-loaded and disbursed within a
                        year. In these cases, the program reviews can be held monthly or
                        bimonthly. SRF funding is for countries with exceptional balance-of-




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  Appendix I
  The IMF’s Process for Establishing and Monitoring Countries’ Financial Arrangements




  payments problems owing to a large, short-term financing need resulting
  from a sudden and disruptive loss of market confidence.

  The IMF staff monitors the program continuously and the program is
  subject to periodic reviews by the IMF Executive Board in order to
  evaluate if the country’s progress in meeting the conditions under the
  program justifies the continuation of disbursements. In some cases, IMF
  disbursements are conditioned only on the determination by IMF staff that
  the country has met prenegotiated quantitative criteria. According to the
  IMF, for most programs, review by the IMF Executive Board is not
  required prior to each quarterly disbursement. For these programs,
  semiannual reviews by the IMF Executive Board are the more typical
  approach. In these cases, IMF staff review whether the country has met its
  performance criteria quarterly and, if so, a disbursement can follow
  without a full IMF Board review.

  Larger programs tend to have tighter monitoring and all disbursements are
  subject to reviews by the IMF Executive Board. In these cases, through its
  monitoring, the IMF staff believes that the country has satisfactorily
  implemented the program or the staff believes that the country has not
  satisfactorily implemented the program. In the first case, the review is
  “completed” and the borrower country is eligible to receive an additional
  disbursement. In the latter case, review completion is delayed and the
  country is not eligible to receive a disbursement at that time.

  Satisfactory progress can be judged in one of two ways. If the IMF staff
  believes that the country has met all of the performance criteria and
  considers the review “complete,” the staff presents the results of the
  review to the Executive Board. In addition, the IMF and the country may
  negotiate a new or revised set of criteria and benchmarks. Upon the
  Executive Board’s approval, the country is eligible to receive the next
  disbursement of IMF funds.

  In other instances, the IMF staff could conclude that the country did not
  meet all performance criteria but that most deviations were minor and did
  not affect the country’s overall performance. The staff would then
  generally recommend to the Executive Board that a waiver be granted and
  the review would be completed on time. A country’s inability to meet a
  performance criterion could be due to

• cyclical or seasonal problems that are self-correcting;
• the difficulty in making economic projections, that is, if key factors, such
  as the money supply were underestimated;



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  The IMF’s Process for Establishing and Monitoring Countries’ Financial Arrangements




• unanticipated events, for example, a tumultuous political environment; or
• an incorrect assessment of the cause or solution to the problem.

  After the IMF Executive Board grants the waiver, the country is eligible to
  receive IMF funds.

  The IMF staff considers that a country has not made satisfactory progress
  when key conditions are not met and deviations are significant. In these
  cases, “completion” of the review and disbursements are generally delayed
  and are not resumed unless and until, in the IMF’s judgment, satisfactory
  progress has been achieved. During the delay period, country officials and
  IMF staff negotiate the steps necessary to complete the review and make
  funds available. According to IMF staff, if the country did not meet the
  performance criteria because it is unwilling or unable to do so, the IMF
  will negotiate with the authorities to determine the nature of the problem
  and possible corrective measures. In these instances, the IMF may request
  that the country demonstrate its commitment to the program by
  undertaking a specific prior action before it recommends the Executive
  Board grant waivers for nonobservance of the unmet criteria and
  “complete” the review.

  In other cases where the country has not met key performance criteria, the
  IMF staff may determine that deviations are so significant that it is not
  possible to negotiate steps to get the program back “on track.” When this
  happens, the IMF staff generally concludes that it is not in a position to
  complete the review and notifies IMF management. If management
  concurs with the recommendation, staff briefs the Executive Board on the
  situation. The review will not be completed at that time and disbursements
  would be delayed. In these cases, the IMF staff and the country may
  negotiate ways to restart the existing program or initiate a new program. In
  some cases, for example, in Russia, some deviations from the program
  may be significant enough that the IMF delays or withholds further
  disbursements for a considerable length of time, and the program lapses.

  Apart from waivers and reviews, quantitative performance criteria and
  indicative targets can be changed by means of “adjusters” that are included
  in some country programs. Adjusters are prenegotiated to account for
  specific actions and assumptions about economic and financial
  movements. There are two types of adjusters: (1) adjusters related to
  unexpected external events and (2) adjusters due to in-country policy
  changes. The first type of adjuster automatically changes the level of a
  quantitative performance criterion when there are unexpected changes—
  generally outside of the country’s control—to one or more key variables.



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Appendix I
The IMF’s Process for Establishing and Monitoring Countries’ Financial Arrangements




For example, in Uganda’s program, an adjuster was added to the
quantitative performance criterion that set a minimum level for net
international reserves in the event that creditors provided more (or less)
debt relief than was expected. The second type of adjuster automatically
changes the level of a quantitative performance criteria when policy
makers choose to make changes in their monetary or fiscal policy
instruments in a manner that would either directly or indirectly affect the
target variables. It is intended to prevent policy changes from
compromising the achievement of overall program objectives, such as
price stability or low inflation.




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Appendix II

The IMF's Financial Arrangement with
Argentina

              The current 3-year IMF Extended Fund Facility (EFF) arrangement agreed
Summary       to in February 1998 is intended to be precautionary, meaning that
              Argentina will draw IMF resources only if external conditions make it
              necessary. At the time it negotiated the arrangement, Argentina was not
              experiencing an actual balance-of-payments problem. The IMF expressed
              concern about the sizable current account deficits expected over the next
              few years—although these deficits reflect to a large extent the growth of
              productive investment—and the economy’s vulnerability to changes in
              external market conditions. The IMF arrangement of about $2.8 billion is
              intended to support the government’s medium-term economic reform
              program for 1998-2000. Given Argentina’s dependence on external capital,
              the arrangement is also focused on maintaining investor confidence in the
                                  1
              country’s economy. Because of the recent adverse external developments
              stemming, in part, from Brazil’s financial crisis, the IMF and the Argentine
              government agreed to adjust the performance criteria in May 1999. As of
                                                                                         2
              May 31, 1999, Argentina had not drawn resources under the arrangement.

              According to the Argentine government, the policy measures outlined in
              the IMF arrangement represent the government’s priorities. Argentina’s
              program with the IMF contains quantitative performance criteria under
              which the government agreed to limit the federal government budget
              deficit, central bank assets, and government debt. The goals of the fiscal
              deficit criteria are to reduce the federal government deficit, stimulate
              domestic saving, and strengthen confidence in the continued viability of
              the currency regime. The monetary program is intended to strengthen
              confidence in the banking system by maintaining a sound financial system
              and providing for an adequate cushion of liquidity. The structural
              benchmarks include reforms in the labor market, tax system, public sector
              budgeting and operations, health system, and judicial system as well as
              further progress in privatizing the remaining institutions. The government
              and the IMF identified fiscal equilibrium and structural reform
              (particularly in tax systems and labor markets) as two of the most crucial
              elements in the program.


              1
               For additional information on investor confidence, see International Financial Crises: Efforts to
              Anticipate, Avoid, and Resolve Sovereign Crises (GAO/GGD/NSIAD-97-168, July 7, 1997).
              2
               In late 1998, in response to turbulence in international capital markets, Argentina received World
              Bank and Inter-American Development Bank loans totaling approximately $2 billion, with another $2.5
              billion due in early 1999. The loans were intended to be precautionary and part of the effort to mitigate
              the social and economic impact of unsettled international financial markets and to advance the
              country’s reform agenda. The World Bank loans are to be used for reforms in banking, capital markets,
              access to credit, regulatory institutions, and intergovernmental fiscal relations; to help meet critical
              foreign exchange needs of the government; and as a line of defense for banking liquidity.




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The IMF Executive Board reviewed the current program three times
(based on IMF staff documents that provided data on and assessments of a
country’s performance), completing the first and third reviews with no
waivers requested from the Argentine government, granting a minor
technical waiver during the second review, and concluding that Argentina
had made progress in achieving structural reform. Under the first review in
September 1998, Argentina met all of its performance criteria and made
progress in completing several structural reforms, with the exception of
not fully passing labor market legislation. In the second review, Argentina
met all but one of its performance criteria. Argentina requested a waiver
because the target for lowering the federal government deficit was not
reached. IMF staff viewed the deviation as minor, primarily due to adverse
external factors, and as not detracting from overall fiscal performance; the
IMF Executive Board granted the waiver. The Argentine government noted
that, significantly, the structural deficit for 1998 was smaller than that of
1997. The government’s efforts to contain expenditures did not fully
compensate for the fall in revenue. In response, the fiscal deficit criterion
for the next review was raised. During the second review, the IMF
determined that Argentina made progress in carrying out several structural
reforms. The government implemented most of the tax reforms but was
only able to pass some of the intended labor market reforms. Under the
third review, the IMF Executive Board determined that Argentina met the
performance criteria as of March 1999 and agreed to adjust some of the
performance criteria for the next review in light of deteriorating external
conditions. The key events concerning Argentina’s current EFF are
outlined in table II.1.




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                                              The IMF's Financial Arrangement with Argentina




Table II.1: Chronology of Key Events Concerning Argentina’s Current IMF Arrangement
Year       Month            Event
1997       December         Argentina requested EFF and proposed performance criteria and structural benchmarks.
1998       February         IMF Executive Board approved 3-year EFF totaling about $2.8 billion.
           September        IMF Executive Board completed first review of EFF, as scheduled. The IMF Board determined that
                            Argentina met all performance criteria and made progress in structural reforms.
           October          Argentina accessed capital markets, among the first emerging market countries to do so after the Russian
                            financial crisis in August.
           November         The World Bank approved $3 billion in loans to Argentina intended to mitigate the impact of unsettled
                            international financial markets and advance reforms.
           December         The Inter-American Development Bank approved a $2.5 billion loan to Argentina designed to counteract
                            global financial shocks resulting from the crises in Asia and Russia.
1999       January          Argentina issued a policy memorandum and letter of intent:
                            - saying it met all but one of the IMF performance criteria (fiscal deficit level) as of December 1998. The
                            government made efforts to limit government expenditures but could not fully compensate for revenue
                            shortfalls.
                            - describing the policies the government intended to implement in 1999 under the EFF. The policies
                            remained broadly the same.

                             Brazil, Argentina’s largest trading partner, floated its currency, thus making exports to Brazil more
                             expensive because the currency depreciated.
          March              IMF Executive Board completed second review of Argentina’s program, as scheduled. The IMF Board
                             determined that Argentina met all 1998 performance criteria except one and granted a waiver for
                             nonobservance of the fiscal deficit criterion. IMF staff noted that the deviation was minor and did not detract
                             from the country’s overall fiscal performance.

                             IMF Executive Board agreed to performance criteria and structural benchmarks proposed by Argentina in
                             January. The level of the fiscal deficit criterion for the next review was raised because the government
                             missed the amount for the previous quarter due to deteriorating external conditions.
          May                Argentina requested an early review and modification of its 1999 performance criteria to address adverse
                             external conditions.

                             IMF Executive Board completed third review. The IMF Board found that Argentina had met all of its
                             performance criteria as of March 1999 and agreed to adjust the performance criteria for the next review in
                             light of external, cyclical changes.
                                              Sources: Documents from the IMF, World Bank, Inter-American Development Bank, and Argentine
                                              government.




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                       The IMF's Financial Arrangement with Argentina




                       Argentina has undergone radical changes since 1991 when it enacted the
Macroeconomic          Convertibility Law, which established the currency board arrangement.
Context When Current   Under this system, the central bank maintains a sufficient level of U.S.
IMF Arrangement        currency to guarantee the convertibility of all outstanding Argentine pesos
                                                                                   3
                       at the official exchange rate (1 peso equals 1 U.S. dollar). The currency
Negotiated             regime is seen as greatly helping to reduce Argentina’s inflation from over
                       1,000 percent in 1990 to less than 1 percent in 1998, instill fiscal and
                       monetary discipline, build investor confidence, and contribute to
                       economic growth. The government also undertook major structural
                       reforms between 1992-94, including substantial privatization, deregulation,
                       trade liberalization, and pension reform. The Argentine government
                       described the time from 1991-98 as periods of sustained growth
                       interrupted by external shocks, including the Mexican financial crisis in
                       1995 and the Asian, Russian, and Brazilian crises in 1998. Argentina has
                       had successive IMF programs since 1983. The previous arrangement was
                       an IMF Stand-by Arrangement of over $900 million from April 1996 to
                       January 1998.

                       According to IMF staff and the Argentine government, Argentina registered
                       a strong macroeconomic performance in 1997. The economy grew very
                       rapidly, the unemployment rate fell, and inflation was virtually zero. The
                       fiscal position improved as programmed, and there were no major
                       difficulties in financing a widening of the current account deficit. The
                       prudent borrowing strategy (preborrowing at lower interest rates,
                       stretching out maturities) followed by the public sector, and the
                       strengthening of the banking system achieved in recent years, allowed
                       Argentina to weather the turbulence that affected international capital
                       markets in 1997 without major immediate consequences for the economy.
                       Nonetheless, Argentina and the IMF decided an IMF financial assistance

                       3
                        The currency board has governed Argentina’s monetary policy since 1991. The currency board limits
                       the government’s ability to affect the money supply and exchange rates. While this arrangement
                       provides comfort to foreign investors that their investments are protected from fluctuations in the
                       exchange rate, the currency board significantly reduces the discretion of central bank authorities to
                       influence the operation of Argentina’s money supply. Argentina’s money supply rises and falls with
                       changes in the demand for the peso, with, for example the domestic money supply contracting if
                       investors insist on converting their pesos into dollars. This arrangement ensures that Argentina will not
                       have a balance-of-payments problem, since an “unsustainable” current account deficit will self-correct
                       as investors refuse to finance it, the money supply contracts, interest rates rise, and aggregate demand
                       declines, thus reducing imports and the current account deficit. However, this adjustment process
                       could be very painful and occur due to factors unrelated to the Argentine economy, such as (1) a
                       decline in export revenue, and thus a widening current account deficit, due to the economic
                       contraction in a major trading partner such as Brazil; or alternatively, (2) generally reduced willingness
                       of creditors to invest in developing economies stemming from the financial crises in Asia, Russia, and
                       Brazil. Argentina has the ability to partially mitigate this effect by relaxing its exchange rate guarantee
                       (holding up to one-third of its dollar reserves in government-issued, dollar-backed securities); however,
                       such an approach could undermine the investor confidence generated by the currency board.




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                         Appendix II
                         The IMF's Financial Arrangement with Argentina




                         program was necessary because of risks to the economy posed by events
                         in international financial markets.

                         Argentina and the IMF Executive Board reached agreement on the current
Current Arrangement      3-year EFF arrangement in February 1998. This arrangement is intended to
Intended to Be           be precautionary, meaning that Argentina will draw IMF resources only if
Precautionary            external conditions make it necessary. The government noted that the
                         agreement is of great significance because the IMF’s review of Argentina’s
                         accounts provides information to investors on the country’s economic
                         progress. The arrangement of about $2.8 billion is intended to support the
                         government’s medium-term economic reform program for 1998-2000 and
                         to help maintain investor confidence. When Argentina negotiated this
                         arrangement, the country did not have an actual balance-of-payments
                         problem. The country’s current account deficit had been increasing
                         primarily due to its widening trade imbalance, with rising imports
                         outpacing exports, but was funded with external capital. Foreign direct
                         investment covered over 50 percent of the deficit in 1997 and was
                         estimated to cover about 40 percent of the deficit in 1999. The IMF
                         expressed concern about the sizable current account deficits expected
                         over the next few years—although these deficits reflect to a large extent
                         the growth of productive investment—and the economy’s vulnerability to
                         changes in external market conditions. The policies implemented to meet
                         these targets were intended to promote sustained growth in production
                         and employment, increase public saving, and reduce the vulnerability of
                         the economy to disturbances on international financial markets. As of May
                         31, 1999, Argentina had not drawn resources under the current EFF
                         arrangement.

                         The current EFF arrangement includes quantitative conditions and
IMF Program Focused      structural benchmarks for the period 1998-2000. Consistent with the IMF’s
on Fiscal Conditions     approach, the government and the IMF negotiated the performance criteria
and Structural Reforms   and structural benchmarks for the first year of the EFF; criteria and
                         benchmarks for subsequent years have been negotiated on an annual basis.
                         As agreed to for 1998, Argentina’s program with the IMF contained
                         quantitative performance criteria that limited the federal government
                         budget deficit, central bank assets, and government debt. The structural
                         benchmarks for Argentina included reforms in the labor market, tax
                         system, public sector budgeting and operations, health system, and judicial
                         system as well as the completion of the privatization program. The
                         government and the IMF identified fiscal equilibrium and structural reform
                         (particularly in tax and labor) as two of the most crucial elements of the
                         program.




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                                             The IMF's Financial Arrangement with Argentina




                                             The Argentine government is on record as strongly supporting the
                                             conditions under the IMF program because they reflect the government’s
                                             own priorities. According to the Argentine government, disagreements
                                             between the IMF staff and Argentina officials have been minor. One area of
                                             disagreement has been the significance of the current account deficit.
                                             While IMF staff is concerned about Argentina’s increasing current account
                                             deficit, some government economic officials are less so. They contend that
                                             the current account deficit should not be overemphasized since it is due, in
                                             part, to investment-led growth and since external investors have been
                                             willing to finance it, thus signaling their confidence in Argentina’s
                                             economy.

Quantitative Performance                     As shown in table II.2, three of the four quantitative performance criteria
                                             focused on Argentina’s fiscal policy. The fourth—limits on central bank
Criteria Focused on Fiscal                   assets—targeted Argentina’s monetary policy.
Levels


Table II.2: Argentina’s Quantitative Performance Criteria and Indicative Targets, 1998-2000, (Dollars in Millions, U.S.), as Agreed
to in February 1998
                                                Dec. 1997 –     Dec. 1997-    Dec. 1997-    Dec. 1997-     Dec. 1998- Dec. 1999-
                                                                                                                       a             a
                                                  Mar. 1998     June 1998     Sept. 1998     Dec. 1998     Dec. 1999 Dec. 2000
Quantitative performance criteria
Cumulative federal government deficit               $ -1,400      $ -1,800        $ -2,750     $ -3,500        $ -2,650      $ -1,000
Cumulative change in net domestic assets of
                                                                                                       b
the central bank                                        -470          -530            -800        -800               —             —
Net cumulative disbursements of public sector
     c                                                                                                 d
debt                                                   2,900         5,200           6,800       5,700               —             —
Net cumulative increase in short-term debt             2,000         2,000           2,000        2,000              —             —
Indicative targets
                   e
Expenditure target                                   10,200        19,450          29,550       38,800               —             —
Combined deficit of the federal government and
provinces                                                 —         -2,175              —        -4,250          -3,250        -1,200
                                             a
                                              The criteria for 1999-2000 were proposed by the government but were not subject to IMF approval
                                             since, under an EFF, only the targets for the first year of the program are set.
                                             b
                                              The criterion could be adjusted by $200 million (to -$600 million) to reflect a temporary increase in
                                             the amount of government securities purchased from commercial banks. According to IMF staff, the
                                             “adjuster” accounts for central bank purchases of government securities from commercial banks in
                                             order to meet commercial banks’ temporary liquidity needs during December. The central bank will
                                             sell the securities back to the commercial banks in January.
                                             c
                                                 The criterion limits the total increase in public-sector debt (external and internal).
                                             d
                                              The criterion could be adjusted by up to $2 billion in overborrowing by the public sector and
                                             deposited in the central bank. According to IMF staff, the “adjuster” accounts for preborrowing by the
                                             public sector to meet 1999 financing needs. The IMF does not want to penalize the government for
                                             the preborrowing strategy, under which the government borrows funds at lower interest rates and
                                             longer maturities when possible, that has helped Argentina weather uncertainty in capital markets.
                                             e
                                                 The expenditure target sets the maximum level of government spending, excluding interest.
                                             Sources: IMF and Argentine government documents.




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                          The IMF's Financial Arrangement with Argentina




                          The goals of the fiscal deficit criteria were to reduce the overall federal
                          government deficit while increasing spending in social areas, stimulate
                          domestic saving, and strengthen confidence in the continued viability of
                          the currency convertibility regime. The $3.5 billion deficit represents about
                          1 percent of GDP, which was estimated at about $340 billion for 1998. The
                          monetary program was intended to strengthen confidence in the currency
                          board and the banking system by maintaining a sound financial system and
                          providing for an adequate cushion of liquidity that could compensate for
                          the limited role of the central bank as a lender of last resort.

Structural Benchmarks     Under the current EFF, the Argentine government agreed to meet the
                          following structural benchmarks by the end of 1998:
Covered Many Areas
                          Tax reform

                        • Submit to the Argentine congress a tax reform program before mid-1998
                          for approval before the end of 1998. Tax reforms were intended to improve
                          the efficiency and equity of the tax system and promote the
                          competitiveness of the economy. The reforms were aimed at contributing
                          to a reduction in labor costs by cutting employers’ payroll contributions,
                          diminishing distortions in corporate and individual taxes, broadening the
                          income tax base, applying the value-added tax to products not currently
                          taxed, introducing a single tax to replace the value-added and income
                          taxes due from small businesses, strengthening tax auditing procedures,
                          and modifying customs codes in line with MERCOSUR (the Southern
                          Common Market, or customs union) and World Trade Organization norms.
                          The changes were generally focused on decreasing taxes on production
                          and increasing taxes on consumption.
                        • Implement the first stages of a program to strengthen tax administration
                          by revising penalties and interest on past due tax obligations to help
                          normalize relations between taxpayers and tax authorities, privatizing
                          collection of past due taxes, and introducing pre-shipment inspection of
                          imports for the short term.


                          Labor market reform

                        • Implement labor reforms before mid-1998–a precondition for the
                          conclusion of the first review. Increased flexibility in the labor market was
                          intended to decrease unemployment, strengthen economic
                          competitiveness, and ultimately ensure the viability of the currency
                          convertibility regime. The reforms were to significantly reduce the costs of
                          dismissing employees, eliminate statutes that impede the renegotiation of



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  The IMF's Financial Arrangement with Argentina




  labor contracts (expired labor contracts remain legally binding if there is
  no agreement to renegotiate them between employers and unions) and
  inhibit entry into certain professions, eliminate certain temporary labor
  contracts, decentralize labor negotiations, and promote increased
  competition among union-run health care organizations.


  Public sector administration

• Reform budgeting operations. The government was to submit a multiple-
  year budget for income, expenditure, and results covering a 3-year period,
  with the goal of providing transparency, efficiency, and control for
  budgetary administration.
• Take measures to promote efficiency in public spending, especially in
  education, public health services, and the social security and social
  assistance systems, and improve the quality of public sector
  administration. The measures were to include governance rules for public
  employees outlining obligations and increasing penalties for corruption.


  Social sector reform

• Conclude reforms to the public social security system to help increase the
  efficiency of expenditures.
• Continue reforms to the health insurance system for retirees and health
  care organizations (public and private), as agreed with the World Bank, in
  order to strengthen health care, contain the demand for high-cost hospital
  care, and promote efficiency in health services.


  Judicial

• Take steps to speed up rulings in court cases involving taxes and financial
  guarantees and collateral.


  Privatization

• Grant leases for airports, telecommunications frequencies, and power
  stations.
• Draft proposals to privatize Banco de la Nación, the country’s largest bank.




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                                The IMF's Financial Arrangement with Argentina




                                Financial/corporate governance

                              • Revise legislation to help financial institutions more quickly execute
                                guarantees and collateral, and to develop a legal and supervisory
                                framework for financial derivatives.
                              • Approve new antitrust laws.

First Review: Argentina Met     The IMF Executive Board completed the first review of Argentina’s
                                program in September 1998, as scheduled. It found that all applicable
All Performance Criteria;       quantitative performance criteria were met in March and June 1998 and
Mixed Progress on               that substantial progress had been made in the implementation of
Structural Reforms              structural reforms, with the notable exception of labor market reforms.
                                Argentina’s congress passed some of the intended labor market reforms; it
                                passed legislation lowering dismissal costs but did not pass legislation
                                intended to make the collective bargaining process more flexible. The IMF
                                Board urged the Argentine authorities to take further steps in regard to
                                labor market reform, noting that the reform recently approved by
                                Argentina’s congress fell short of what would be necessary to enhance
                                labor market flexibility and reduce labor costs adequately. The IMF Board
                                also expressed concern over the possible adverse impact of the Russian
                                debt crisis on Argentina’s access to external financing and urged the
                                authorities to maintain firm macroeconomic policy to help promote a rapid
                                improvement in market confidence.

Second Review: Argentina        According to IMF and Argentine documents for the second review,
                                completed as scheduled in March 1999, Argentina met all but one of its
Met Most Performance                                              4
                                quantitative performance criteria (for which a waiver was granted) and
Criteria; Mixed Progress on     made progress on structural reforms. The waiver was requested because
Structural Reforms              the federal government deficit, estimated at $3.85 billion in 1998 (1.1
                                percent of GDP), exceeded its ceiling by about $350 million, or around 0.1
                                                 5
                                percent of GDP. However, IMF staff viewed the deviation as minor,
                                primarily due to adverse external factors, and as not detracting from
                                overall fiscal performance. The government noted that, significantly, the
                                structural deficit for 1998 was smaller than that of 1997. The IMF
                                Executive Board granted the waiver. According to the Argentine
                                government, its efforts to contain expenditures could not compensate fully
                                for the revenue shortfall. The shortfall mainly reflected the slowdown of
                                4
                                 At the time of the second review, the IMF adjusted two other performance criteria—addressing
                                central bank assets and public sector debt—in line with previously agreed-to levels due to factors
                                beyond the government’s control.
                                5
                                 The government also noted that the indicative target on aggregate provincial deficit is estimated to
                                have exceeded the ceiling by 0.2 percent of GDP, reflecting the combined effects of the tax revenue
                                shortfall and higher than programmed expenditures by some provinces.




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                   economic activity in the second half of 1998 and its adverse effect on
                   taxes, particularly the value-added tax. The government noted that debt
                   limits were met in the context of tighter conditions in international capital
                   markets. A larger than anticipated share of the deficit was financed using
                   public sector deposits and receipts from asset sales.

                   Argentina made progress in several areas of structural reform, according
                   to IMF and country documents. The government implemented most of the
                   tax reforms but was only able to pass some of the intended labor reforms.
                   The government implemented tax reforms that, among other things,
                   expanded the bases of the income and value-added taxes and improved tax
                   administration by enhancing tax audit procedures and hastening the
                   resolution of court cases involving tax enforcement. Regarding labor
                   reforms, Argentina’s congress approved a law to reduce dismissal costs
                   and eliminate most forms of temporary labor contracts with decreased
                   social security contributions. Reforms regarding collective bargaining
                   were not passed. While IMF staff stressed the importance of making
                   Argentina’s labor market more flexible—particularly given the uncertainty
                   about continued access to foreign financing and trade levels—they told us
                   that they do not expect the government to complete the remaining labor
                   reforms before the fall 1999 elections. As such, according to IMF staff, the
                   emphasis on labor reforms is likely to be eased. Argentina continued
                   making reforms to budgeting operations, public sector administration, and
                   the public hospital system. Restructuring of the health-care system
                   continued, as agreed with the World Bank. The government completed
                   leasing arrangements for airports and continued working on leasing
                   arrangements for telecommunications frequencies, which were delayed by
                   judicial challenges, and power stations. It concluded reforms to the public
                   social security system.

New Criteria and   In January 1999, the government outlined its proposed objectives, criteria,
                   and benchmarks for the second year of the arrangement. The government
Benchmarks         intends to continue to focus its economic policies on promoting
                   sustainable growth in output and employment, addressing priority social
                   needs, and maintaining low inflation and a viable external position. The
                   government noted that in light of the presidential election scheduled for
                   October 1999 and the uncertainty of the adverse international
                   environment, it recognized the critical importance of maintaining
                   disciplined and restrained macroeconomic policies, further improving
                   public finances, strengthening the financial system, enhancing
                   competitiveness, and deepening structural reforms. In March 1999,
                   Argentina and the IMF reached agreement on the quantitative performance




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                                             criteria and structural benchmarks for monitoring the country’s progress
                                             during 1999, as shown in table II.3.


Table II.3: Argentina’s Quantitative Performance Criteria and Indicative Target for 1999, (Dollars in Millions, U.S.), as of March
1999
                                                                  Jan. 1999 –        Dec. 1997-       Dec. 1998-          Dec. 1999-
                                                                   Mar. 1999         Sept. 1998       Dec. 1999           Dec. 2000
Quantitative performance criteria
Cumulative federal government deficit                                 $ -1,300         $ -1,675         $ -2,300             $ -2,950
Cumulative ceiling on noninterest expenditures of the federal
government                                                               9,500          18,800            28,700              38,050
                                                             a
Cumulative change in net domestic assets of the central bank                  -200                -325               -590                  -690
                                                  b
Net cumulative disbursements of public sector debt                           2,500               5,200              5,200                 4,000
Net cumulative increase in short-term debt                                   1,000               1,000              1,000                 1,000
Indicative target
Combined deficit of federal government and provinces                             —              -2,475                  —                 -4,400
                                             a
                                              The criterion will be adjusted upwards by the equivalent to any purchase from the IMF. The
                                             measurement of net domestic assets throughout the year will be adjusted to reflect any difference
                                             between the end-1998 stock of swaps and projected levels. The measurement for December 1999
                                             will also be adjusted downward for up to $300 million to account for temporary liquidity needs
                                             reflected in an equivalent increase in swaps.
                                             b
                                             The measurement of disbursements will be adjusted to reflect any difference between actual
                                             privatization receipts and projected levels.


                                             Sources: IMF and Argentine government documents.


                                             The estimated cumulative federal government deficit between January
                                             1999 and December 1999 was increased from $2.65 billion to $2.95 billion
                                             (0.8 percent of GDP) to reflect the criterion missed in the previous quarter.
                                             The ceiling on the noninterest expenditures of the federal government was
                                             changed from an indicative target to a quantitative performance criterion
                                             because, according to IMF staff, there was concern about the sufficiency
                                             of tax revenues.

                                             Many of the new structural benchmarks continue ongoing reforms. By the
                                             third review (August 1999) the Argentine government is to

                                          • present a proposal to reform the system of tax-revenue sharing with the
                                            provinces. In light of the fiscal deficit, IMF staff stressed the importance of
                                            achieving this reform. The reform of the tax-sharing arrangement between
                                            the government and the provinces is intended to strengthen the provinces’
                                            own revenue-raising capacity and design a more equitable, transparent,
                                            and flexible system of intergovernmental transfers.
                                          • lease telecommunication frequencies.
                                          • implement new monitoring systems for the external debt and the finances
                                            of provincial administrations.



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• implement the enabling regulations for the labor statute for small- and
  medium-size firms.
• submit to the Argentine congress a proposal to transform the Banco de la
  Nación into a state-owned corporation. This benchmark represents a
  change from the government’s original intention to privatize the bank.
  When it appeared that congress would not approve the privatization of the
  bank, the authorities decided to propose the transformation of the bank
  into a state-owned corporation that could include private capital and
  management, be listed in the stock exchange, and thus be subject to
  increased public disclosure requirements.
• submit to the Argentine congress a proposal to further reform social
  security.
• complete the sale of the first package of shares of the National Mortgage
  Bank.


  Also, by August 1999, the Argentine congress is to approve

• the proposed changes to the central bank charter and the financial entities
  law, which are intended to improve banking supervision and risk
  assessment of financial institutions; and
• the fiscal responsibility law, which sets limits on government
  indebtedness, constrains the growth of public expenditure, and establishes
  a fiscal stabilization fund to smooth out the impact of cyclical fluctuations
  or external shocks on tax revenue. The government intends to improve the
  efficiency of social spending in education and social protection programs.


  By the fourth review (Feb. 2000), the Argentine government is to

• implement the tax administration program aimed at, among other things,
  shifting to a new electronic tax filing and collection system; strengthening
  auditing procedures; and amending the customs code, after congressional
  approval, to incorporate MERCOSUR (the Southern Common Market, or
  customs union) norms and new World Trade Organization valuation rules;
  and
• eliminate the 3 percent import surcharge to the common external tariff.


  Also by this time Argentina’s congress is to approve the social security
  reform and new law for Banco de la Nación.




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                            The IMF's Financial Arrangement with Argentina




                            The key factors affecting Argentina’s short-term macroeconomic outlook
                            were the need for improvements in trade and the continued availability of
                            private-sector capital. Argentina recorded a satisfactory macroeconomic
                            performance in 1998, in a relatively difficult international macroeconomic
                            environment. However, the economy slowed considerably in the second
                            half of 1998, in response to the tightening of external financing conditions
                            in the wake of Russia’s and Brazil’s financial crises and the slowdown in
                            export earnings. For 1998, GDP growth was estimated at about 4.2 percent,
                            down from 7 ¼ percent in the first half of the year. Since mid-January 1999,
                            the external macroeconomic environment (trade and investment) has
                            deteriorated because of adverse events in Brazil. The program agreed to in
                            March 1999 (including quantitative performance criteria for 1999) was
                            negotiated in December 1998, consistent with the external environment at
                            that time. Argentina and IMF officials noted that the country had
                            weathered the turbulence in external markets well; however, given the
                            uncertain environment, the government and the IMF agreed to reexamine
                            the program and modify it, if needed.

Third Review Accelerated;   The third review was conducted 3 months ahead of schedule in order to
                            reevaluate the assumptions underlying the 1999 program and modify the
Performance Criteria        performance criterion in light of the deterioration in the external
Modified                    environment since the program was negotiated. Despite the decline in
                            Argentina’s economic activity and current account balance, preliminary
                            information indicated that the country made progress on the structural
                            reforms and met the quantitative performance criteria for end-March 1999.
                            However, GDP in 1999 is expected to decline by 1.5 percent (from the
                            previously projected gain of 2.5 percent), which is expected to significantly
                            reduce federal government revenues from the previous estimate by about
                            $2.5 billion.

                            Argentine government officials and IMF staff noted that while the
                            government was able to compensate for the revenue shortfall in the first
                            quarter of 1999, fully compensating for the total estimated shortfall
                            through additional spending cuts would seriously impair the quality of
                            public services and aggravate the economic downturn. The government
                            therefore requested an increase in the 1999 federal deficit performance
                            criterion from $2.95 billion (0.8 percent of GDP) to $5.1 billion (1.5 percent
                            of GDP), an increase of $2.15 billion, or about 70 percent, from the amount
                            agreed to in March 1999. The increase reflects about 85 percent of the
                            expected shortfall of $2.5 billion, with the government expected to absorb
                            the remainder. Attaining the new level will require cuts in government
                            expenditure, including spending for social programs.




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                                             The deficit level was increased to help ensure that additional government
                                             borrowing to finance the deficit does not crowd out private-sector
                                             borrowing or raise uncertainty about the government’s commitment to
                                             fiscal discipline. To help achieve the new target, the ceiling on the
                                             noninterest expenditures of the federal government is to be lowered by
                                             $450 million. The debt ceiling was raised in line with the increase in the
                                             deficit in order to accommodate additional borrowing. The modified
                                             performance criteria are shown in table II.4.


Table II.4: Argentina’s Proposed Quantitative Performance Criteria and Indicative Target for 1999, (Dollars in Millions, U.S.), as
of May 1999
                                                               Jan. 1999 –        Jan. 1999 –       Jan. 1999 –        Jan. 1999 –
                                                                  Mar. 1999        June 1999         Sept. 1999          Dec. 1999
Quantitative performance criteria
Cumulative federal government deficit                               $ -1,300          $ -2,850          $ -4,200          $ -5,100
Cumulative ceiling on noninterest expenditures of the federal
            a
government                                                             9,500           18,750            28,450             37,600
                                                              b
Cumulative change in net domestic assets of the central bank                   -200                  -325                -590                 -690
                                                  c
Net cumulative disbursements of public sector debt                            2,500                 6,800               7,350                6,150
Net cumulative increase in short-term debt                                    1,000                 1,000               1,000                1,000
Indicative target
Combined deficit of federal government and provinces                              —                -3,750                   —               -6,800
                                             a
                                              The amount will be adjusted upward in excess of the projections of tax refunds. This “adjuster” is
                                             intended to limit delays in granting refunds, which could create additional revenue and thus create
                                             room for increasing expenditures. The maximum cumulative adjustment will be $50 million, $250
                                             million, and $450 million in the second, third, and fourth quarters, respectively.
                                             b
                                              The amount will be adjusted upwards by the equivalent to any purchase from the IMF. The
                                             measurement of net domestic assets throughout the year will be adjusted to reflect any difference
                                             between the end-1998 stock of swaps and the projected level of $275 million. The measurement for
                                             December 1999 will also be adjusted downward for up to $300 million to account for temporary
                                             liquidity needs reflected in an equivalent increase in swaps.
                                             c
                                             The measurement of disbursements will be adjusted to reflect any difference between actual
                                             privatization receipts and projected levels. The amount of debt for December 1999 will be adjusted
                                             downward for any borrowing up to $2.5 billion related to financing requirements for the year 2000
                                             deposited at the central bank.
                                             Source: Argentine government document.


                                             The Argentine government recognized the importance of reinvigorating the
                                             structural reforms to improve economic efficiency and strengthen market
                                             confidence. Many of the new structural benchmarks continue or accelerate
                                             ongoing reforms. By the third review (May 1999) the Argentine government
                                             is to

                                          • present a proposal to reform the system of tax-revenue sharing with the
                                            provinces.
                                          • implement new monitoring systems for the level and composition of the
                                            financing to the provincial administrations.




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• submit to the Argentine congress a proposal to transform the Banco de la
  Nación into a state-owned corporation.


  By the fourth review (November 1999) the Argentine government is to

• submit to the Argentine congress a proposal to reform social security.
• implement a new monitoring system for conditions of access by
  commercial banks to external credit lines.
• submit to the Argentine congress a proposal to reform the tax code.
• lease telecommunication frequencies.


  Also by November 1999, the Argentine congress is to approve the fiscal
  convertibility law and the changes to the central bank charter and the
  financial entities law.




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Appendix III

The IMF's Financial Arrangement with Brazil


               The turbulence in international financial markets hit Brazil especially hard
Summary        in the fall of 1998. Brazil’s capital account came under serious pressure in
               the wake of the Russian crisis and Brazil’s foreign currency reserves
               declined substantially. To shore up confidence in its economy, Brazil
               negotiated a 3-year program with the IMF, which was announced in
                                 1
               November 1998. It consists of a 3-year Stand-by Arrangement (SBA),
               supplemented in the first year by the Supplemental Reserve Facility (SRF),
                                                                   2
               for a total amount equivalent to about $18 billion. The IMF Executive
               Board approved Brazil’s program on December 2, 1998, and Brazil received
               its first disbursement of $4.6 billion.

               The second disbursement was scheduled for February 1999 after the IMF
               completed the first and second reviews of Brazil’s progress in
                                            3
               implementing the program. Because of continued problems in Brazil’s
               economy and a new exchange rate regime after the first disbursement,
               Brazil’s IMF program needed to be revamped before a second
               disbursement would be made available. At the time of the combined SBA
               and SRF reviews, Brazil did not meet one of four quantitative performance
               criteria (meeting a ceiling on net domestic assets of the central bank). The
               IMF Executive Board granted a waiver for not meeting this criterion and
               approved the revised program on March 30, 1999, thereby opening the way
               for the next disbursement. Brazil received $4.9 billion from the IMF on
               April 6, 1999.

               The cornerstones of Brazil’s IMF program, as announced in November
               1998, were strong improvement in Brazil’s public finances, the acceleration
               of the congressional approval of structural reforms, and maintenance of its
               exchange rate regime that was pegged to the U.S. dollar. The program
               combined a large up-front fiscal adjustment of over 3 percent of gross
               domestic product (GDP) with reforms of social security, public
               1
                   Brazil’s IMF program is part of a package of international financial support totaling about $41 billion.
               2
                 The stand-by credit is equivalent to 600 percent of Brazil’s IMF quota. To help finance Brazil’s
               financial drawings from the IMF during the first year, the IMF also approved the first activation of the
               New Arrangements to Borrow. The New Arrangements to B orrow came into effect in November 1998.
               According to the IMF, it is designed to supplement resources available to the IMF to cope with an
               impairment of the international monetary system or deal with an exceptional situation that poses a
               threat to the international system. Of the total credit, 70 percent is to be made available under the SRF
               and the remainder through the IMF’s regular lending facilities.
               3
                According to the IMF, the completion of the first and second reviews simultaneously was required
               due to the fact that Brazil had received funds under two different policies, a credit tranche and the
               SRF. The second disbursement could have been drawn as a floating (second) tranche in December
               1998, if needed, after the first review had it been requested by the Brazilian government. Had that
               happened, the first and second reviews would not have taken place simultaneously. However, Brazil
               did not request a drawing of this floating tranche, and so the first and second reviews were carried out
               together.




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                                           The IMF's Financial Arrangement with Brazil




                                           administration, public expenditure management, tax policy, and revenue
                                           sharing. Although the Brazilian government was successful in passing
                                           many of the promised fiscal measures or instituting interim offsetting
                                           measures, delays in passing some of the fiscal measures, combined with
                                           reports that a state governor was unwilling to service his state’s debt to the
                                           federal government, further eroded market confidence and resulted in
                                           additional loss of reserves. Brazil was forced to devalue its currency on
                                           January 13, 1999, and then float its currency, the real, on January 15, 1999.
                                           IMF mission staff began meeting with Brazilian officials in late January to
                                           design a modified program, which was then announced in early March.

                                           Brazil’s revised program requires strengthened fiscal adjustment and
                                           replaces the exchange rate as the nominal anchor of the monetary system
                                           with a monetary policy targeted at securing low inflation. Fiscal policy
                                           aims to reduce the net public debt to GDP ratio to 2 percentage points
                                           below the original target of 46.5 percent by the end of 2001. The original
                                           program’s comprehensive structural reform agenda, in such areas as social
                                           security, civil service reform, tax policy, budgetary procedures, and fiscal
                                           transparency, has been enhanced. The government also intends to
                                           accelerate and broaden its privatization program.

                                           Table III.1 outlines a brief chronology of key events in Brazil’s current IMF
                                           arrangement.

Table III.1: Chronology of Key Events in
Brazil’s Current IMF Arrangement           Date                                          Event
                                                                                         Brazil’s capital account comes under
                                                                                         pressure in wake of Russian crisis;
                                           Aug. 1998                                     significant reserve outflows
                                                                                         Brazil began talks with the IMF and
                                                                                         announced that it would prepare a 3-year
                                                                                         fiscal program aimed at stabilizing the net
                                           Sept. 1998                                    debt to GDP ratio.
                                                                                         Brazil and the IMF announce agreement on
                                                                                         Brazil’s 3-year arrangement and an $18
                                                                                         billion IMF commitment (as part of a larger
                                                                                         $41.5 billion international financial support
                                           Nov. 13, 1998                                 package)
                                                                                         IMF Executive Board approves Brazil’s
                                                                                         arrangement, opening the way for Brazil’s
                                           Dec. 2, 1998                                  first disbursement of $4.6 billion
                                                                                         Brazil’s central bank widens real trading
                                                                                         band, thereby allowing an 8 percent
                                           Jan. 13, 1999                                 devaluation ($3 billion currency outflow)
                                                                                         Brazil’s central bank allows real to float free
                                                                                         of the trading band in foreign exchange
                                                                                         markets (results in an additional 12 percent
                                           Jan. 15, 1999                                 devaluation)




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                         The IMF's Financial Arrangement with Brazil




                         Date                                           Event
                                                                        Completion of the first and second reviews of
                         Feb. 1999                                      the IMF program scheduled
                                                                        Announcement of agreement between the
                         March 8, 1999                                  IMF and Brazil on a revised IMF program
                                                                        IMF Executive Board approves the revised
                                                                        IMF program, opening the way for Brazil’s
                         March 30, 1999                                 second disbursement
                                                                        Brazil receives second disbursement of $4.9
                         April 6, 1999                                  billion
                         Source: GAO analysis of IMF and other documents.


                         In August 1998, Brazil’s capital account came under serious pressure in the
Brazil’s November 1998   wake of the Russian crisis. The Brazilian authorities responded with a
IMF Program              sharp increase in interest rates; significant fiscal measures, including
                         substantial spending cuts; and strengthening of institutional mechanisms
                         to monitor developments in public finances and take further timely
                         corrective actions, if needed. The IMF Managing Director said he was
                         encouraged by the determination of Brazil’s president to give high priority
                         to further fiscal reforms. Brazil also began a dialogue with the IMF to
                         ensure that adequate financial support could be arranged quickly, if
                         needed. The government of Brazil saw the nature of the IMF program as
                         preventive—to assist the country in facing a period of deep uncertainty in
                         international financial markets and to enable the government to continue
                         gradual depreciation of the exchange rate without having to move to a
                         floating currency system.

IMF Program Announced    A 3-year IMF program was announced in November and approved by the
                         IMF Executive Board on December 2, 1998. The IMF program represented
                         one portion of a larger support package totaling about $41.5 billion made
                         up of commitments from the World Bank; the Inter-American Development
                         Bank; and bilateral financing from 20 countries, in most cases to guarantee
                         credits extended to Brazil by the Bank for International Settlements.

                         When the program was announced in November, the IMF stated, in its
                         press release, that the program first and foremost addresses the chief
                         source of Brazil’s external vulnerability—namely its chronic public sector
                         deficit (5-7 percent of GDP). The reduced savings of the public sector
                         necessitated a growing resort to external savings to finance the rise in
                         domestic investment, leading to an increase in the current account deficit
                         of the balance of payments from under 0.5 percent of GDP in 1994 to over
                         4 percent of GDP in 1997.




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                                The IMF's Financial Arrangement with Brazil




The IMF Arrangement and         The IMF program is supported by a 3-year SBA, augmented in the first year
                                by the SRF, for a total amount equivalent to about $18 billion. Around 70
the Objectives of the           percent of the funds were to be under the SRF. Brazil received its first
Conditionality Program          disbursement of $4.6 billion in early December. The second disbursement
                                was scheduled for February 1999 after completion of the first and second
                                reviews; however, due to the events in January, it was delayed until after
                                the revamped program was agreed upon by the IMF Executive Board on
                                March 30, 1999.

                                The November 1998 IMF program had four program objectives:

                              • a frontloaded fiscal adjustment effort (with most of the fiscal adjustment
                                expected to occur in the first half of 1999) aimed at arresting quickly the
                                rapid growth of public sector debt;
                              • maintenance of the exchange rate regime that existed at the time;
                              • a tightly controlled monetary policy, aimed at supporting the exchange
                                rate regime that existed at the time, while safeguarding net international
                                reserves; and
                              • wide-ranging structural reforms.

IMF Program Comprised           The economic program was centered on fiscal adjustment and structural
                                reform. The macroeconomic scenario underlying the fiscal program
Fiscal, Structural, and         assumed that confidence would be rebuilt gradually as measures were
Monetary Reforms                implemented and began to improve Brazil’s fiscal accounts and as access
                                to foreign financing improved.

Elements of the Fiscal and      The initial program had fiscal, external sector, and monetary targets. These
                                                                                                           4
Monetary Adjustment Program     were a mixture of quantitative performance criteria and indicative targets.
                                The fiscal targets were

                              • a performance criterion for the “public sector borrowing requirement,”
                                which set ceilings on the “cumulative borrowing requirement” of the
                                                                                  5
                                consolidated public sector through June 30, 1999;

                                4
                                 Quantitative performance criteria are macroeconomic indicators that the IMF requires a borrower
                                country meet in order to qualify for the next disbursement. Indicative targets are also macroeconomic
                                indicators, which the IMF uses to monitor a country’s performance, but disbursements are not
                                contingent on their being met.
                                5
                                 The cumulative borrowing requirement of the public sector is defined as the sum of the cumulative
                                borrowing requirements of the federal government, state and municipal governments, and the public
                                enterprises; the federal government includes the central government, the social security system, and
                                the Brazil Central Bank (BCB). The respective borrowing requirements are measured in Brazilian Reais
                                (R$), as the sum of total net financing from all sources, including, among others, changes in cash
                                balances of the public sector.




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• an indicative target that set a minimum on the primary surplus of the
  primary balance of the federal government; and
• an indicative target that set a minimum floor on the recognition of
  nonregistered public sector debt net of privatization proceeds.

  The fiscal quantitative performance criteria were intended to stabilize the
  ratio of the net public debt to GDP by the year 2000 and then reduce it
  gradually thereafter. Under these assumptions, the public sector
  borrowing requirement would decline to about 4.7 percent in 1999, to
  about 3 percent in the year 2000, and to 2 percent in 2001. The bulk of this
  adjustment was planned at the federal level; however, the states and
  municipalities were expected to shift their consolidated primary balance
  from an estimated deficit equivalent to 0.4 percent of GDP in 1998 to a
  surplus of 0.4 percent of GDP in 1999, rising to 0.5 percent in the years
  2000 and 2001. The main elements behind the assumption of the state and
  local governments’ primary balance improvement were the
  implementation of the administrative reform laws and the firm
  enforcement of their debt restructuring agreements with the federal
  government. The fiscal adjustment program had both revenue-raising and
  expenditure-reducing measures designed to yield overall budget savings of
  3.4 percent of GDP in 1999.

  Revenue measures to achieve the indicative target on the primary balance
  of the federal government included

• increases in the financial transactions tax rate from 0.2 percent to 0.3
  percent with a temporary surcharge of 0.08 percent for 1999;
• an increase in the rate of the tax on corporate turnovers from 2 to 3
  percent, one-third of which is to be creditable against the corporate
  income tax;
• an increase of 9 percentage points in the contribution to the public sector
  pension plan by civil servants earning more than R$1,200/month;
• the extension of this contribution to public sector pensioners (at the rate
  of 11 percent for those with pensions of R$1,200/month or less and of 20
  percent for the others); and
• a number of other measures aimed mainly at widening the bases of
  existing taxes and contributions, and eliminating distortions.

  Expenditure measures included substantial cuts in discretionary current
  and capital spending and savings expected from implementation of already
  approved constitutional reforms of the civil service and social security.




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                                 The external sector targets were

                               • a performance criterion on external debt of the nonfinancial public sector,
                                                                               6
                                 which set a ceiling on the stock of this debt;
                               • a performance criterion that set a ceiling on new publicly guaranteed
                                                7
                                 external debt;
                               • an indicative ceiling on total short-term external debt disbursed and
                                 outstanding; and
                               • a floor on net international reserves in Brazil’s Central Bank (BCB).
                                                                                                      8




                                 The monetary target was a performance criterion that set a ceiling on net
                                                            9
                                 domestic assets in the BCB.

                                 The goal of monetary policy was continued low inflation. The BCB
                                 intended to continue to apply a flexible interest rate policy as appropriate
                                 while safeguarding foreign exchange reserves, and to rely on indirect
                                 policy instruments to guide short-term interest rates. The government,
                                 with the support of the IMF, intended to maintain the pegged exchange
                                 rate regime with a gradual widening of the exchange rate band and to keep
                                 the increase in public sector external debt within prudent limits, around
                                 US$10 billion in 1999.

The Program Contained Varied     While Brazil’s program does not contain structural performance criteria, it
Structural Reforms               did include a variety of structural benchmarks and measures to address
                                 long-standing weaknesses in the budget process; the tax system and tax
                                 administration; public administration; social security; and the efficiency of
                                 public expenditure, especially in the social area. Table III.2 outlines the

                                 6
                                  The nonfinancial public sector includes the central, state, and municipal governments, the public
                                 enterprises, and the social security system. Excluded from measured debt stocks are any liabilities
                                 incurred in the context of the proposed financing package, either vis-à-vis the IMF or bilateral lenders.
                                 7
                                  The limit applies to all private external debt guaranteed by the public sector. The public sector
                                 includes the nonfinancial public sector (as defined above), the BCB, and the financial public sector.
                                 8
                                  The net international reserves in the BCB are measured in terms of the balance of payments concept
                                 of the net international reserves and include gross official reserves minus gross official liabilities.
                                 9
                                  This performance criterion is to be calculated on the basis of the following definitions: net domestic
                                 assets in the BCB are defined as the difference between the monetary base and the net international
                                 reserves in the BCB valued in Brazilian Reais (R$). The monetary base consists of currency issued and
                                 total reserves on demand deposits of financial institutions. Total reserves on demand deposits include
                                 both required reserves and free reserves. The net international reserves are equal to the balance of
                                 payments concept of net international reserves in the BCB. This performance criterion indicates the
                                 maximum level of net domestic assets in the BCB. There are adjusters applied to the net domestic
                                 asset ceilings (for an increase in the rate of the contribution on funds transfers; for changes in the
                                 required reserve ratio on demand deposits; for changes in the reservable base of demand deposits; and
                                 for an unforeseen loss of net international reserves).




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                                      various structural reforms contained in Brazil’s November 1998 IMF
                                      program.

Table III.2: Structural Reforms
Contained in Brazil’s November 1998   Type of Reform                             Description
IMF Program                                                                      Reforms aimed at strengthening budget
                                                                                 discipline at all levels of government–Fiscal
                                                                                 Responsibility Act to be submitted to the
                                      Budget process reform                      Brazilian Congress by December 1998.
                                                                                 A set of new legislative initiatives to be
                                                                                 presented to the Brazilian Congress in the
                                                                                 first quarter of 1999 based on the principle of
                                      Social security reform                     actuarial balance.
                                                                                 Legislation to be presented to the Brazilian
                                                                                 Congress before the end of 1998 to address
                                                                                 weaknesses in Brazil’s current indirect tax
                                                                                 system, which is viewed as inefficient and
                                      Tax reform                                 unduly complex.
                                                                                 Passage of enabling legislation already
                                                                                 submitted to the Brazilian Congress to
                                                                                 ensure administrative reform already passed
                                      Administrative reform                      begins to produce effects in 1999.
                                                                                 The government sent to the Brazilian
                                                                                 Congress a proposal for constitutional reform
                                                                                 that reduces restrictions on unions and
                                                                                 creates incentives for public collective
                                      Labor market reform                        bargaining.
                                                                                 Programs focused in public utilities (electrical
                                                                                 sector; and some water, gas, and sewage
                                      Privatization                              public utilities) and state banks.
                                                                                 The government intends to give priority to
                                                                                 primary education and basic health care in
                                                                                 the allocation of social expenditures, to
                                                                                 promote the more efficient use and financing
                                                                                 of health and education, and to better target
                                      Social expenditure programs                social expenditures to the poor.
                                                                                 Reduction in the share of total deposits of
                                                                                 the Brazilian financial system held by state
                                                                                 banks to about 7 percent by end-1999. All
                                                                                 remaining state banks are to be subject to
                                                                                 the same regulatory and supervisory scrutiny
                                                                                 as private banks.
                                                                                 Legislative and supervisory framework–
                                                                                 considerable strides have been made in
                                                                                 implementing the 25 basic principles of the
                                                                                 Basle Committee, and the government
                                                                                 believes that Brazil can be fully compliant by
                                                                                 the year 2000.
                                                                                 Addition of a stand-by facility to the deposit
                                                                                 insurance fund to improve its finances.
                                                                                 Measures to speed up the resolution of failed
                                      Banking reforms                            banks and to increase asset recovery rates.
                                                                                 Subscribe to the Special Data Dissemination
                                      Brazilian economic statistics improvements Standards as soon as technically feasible.
                                      Source: IMF documents.




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Trade-related Elements of the     The government committed to continue the policy of trade liberalization
                                                         10
Program                           by doing the following:

                                • promoting the integration of the Brazilian economy with those of its
                                  MERCOSUL (the Southern Common Market, or customs union) and other
                                  regional trading partners;
                                • increasing trade with countries outside the region; and
                                • not imposing trade restrictions or restrictions including for balance of
                                  payments reasons

                                  The government also said it would continue to promote the
                                  competitiveness of Brazil’s exports through steps aimed at leveling the
                                  playing field for Brazilian exporters, thus facilitating access to financing
                                  and to export credit insurance.

Prior Actions Contained in        The following prior actions were included in the November 1998 IMF
                                  agreement:
the November Program
                                • By end-November 1998, increase the rate of the financial transactions tax
                                  to 0.38 percent for 1999 is to be under consideration by the Brazilian
                                  Congress.
                                • For completion of the first review (which was scheduled by month-end
                                  February 1999, but could have been advanced to December 15, 1998),
                                  enact revenue and expenditure measures sufficient to give confidence that
                                  the fiscal program targets for 1999 are likely to be met, and enact the
                                  constitutional amendment for social security reform, for both the private
                                  sector social security system and the federal public sector social security
                                  system.

Brazil’s Progress in              The government of Brazil was initially successful in implementing many of
                                  the elements of the fiscal package that were the core of its program. Prior
Implementing the Program’s        to the approval of the Stand-by Arrangement by the IMF Executive Board
Components                        on December 2, 1998, it had successfully guided through the Brazilian
                                  Congress, the constitutional amendment on social security reform and an
                                  increase in the tax on corporate turnover. However, the proposed measure
                                  to increase the social security contribution on active civil servants and
                                  extend it to retired ones, was not approved in early December, and the
                                  government’s efforts to pass the financial transactions tax were delayed.
                                  These were requirements under the November IMF program. In response
                                  to delays in getting an increase in the financial transactions tax, the

                                  10
                                    See International Monetary Fund: Trade Policies of IMF Borrowers (GAO/GGD/NSIAD-99-174, June
                                  22, 1999) for a further description of Brazil’s trade-related conditions.




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                          The IMF's Financial Arrangement with Brazil




                          government increased taxes on corporate profits and financial operations
                          by executive decree.

                          In early January 1999, a few Brazilian state governors demanded better
                          payment terms on their debt payments to the federal government, and one
                          declared a moratorium on these payments (24 of Brazil’s 27 state
                          governors have agreements with the federal government whereby, in
                          exchange for fiscal adjustment, the federal government has assumed their
                          debt, rescheduled it over the long term, and agreed to charge preferential
                          interest rates). This action precipitated the most recent crisis and put
                          pressure once again on Brazil’s exchange rate, with major outflows of
                          international reserves.

                          In early January 1999, the president of the central bank resigned. On
                          January 13, his successor then widened the real’s trading band. This action
                          effectively devalued the currency by 8 percent. Massive currency outflows
                          followed, and 2 days later Brazil gave up defending its currency and let the
                          real float. This action, in turn, resulted in an immediate devaluation of
                          another 12 percent.

                          Progress continued on implementation of the fiscal program in January.
                          After the real was allowed to float and new negotiations began with the
                          IMF, Brazil’s Congress passed a law increasing the pension contribution of
                          civil servants, which had been rejected previously. Brazil also approved a
                          bill to increase the financial transactions tax, which had been delayed
                          before. Both of these measures were requirements of the November IMF
                          program. The BCB raised interest rates even further to try to encourage
                          investors to keep their money in Brazil.

                          Under Brazil’s arrangement with the IMF, completion of the first and
Completion of the First   second review was scheduled to take place no later than the end of
Review Was Delayed        February 1999; however, due to the change in the exchange rate regime
Slightly                  that was pegged to the U.S. dollar and the currency devaluation, Brazil and
                          the IMF delayed the review completion until March. As a result, Brazil did
                          not receive an additional disbursement as scheduled in February.

                          In addition to negotiating revisions to the economic program with the IMF,
                          Brazilian officials also negotiated voluntary support commitments with
                          their creditor banks. According to the IMF’s Managing Director, this effort
                          was integral to the success of the program and was seen as a key factor in
                          the IMF Executive Board’s consideration of the program in late March.
                          Brazilian officials reached the necessary agreement in mid-March. In the




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                                    The IMF's Financial Arrangement with Brazil




                                    voluntary agreement, banks agreed to keep trade and interbank credit lines
                                    at end of February levels until the end of August.

Revised Program                     On March 8, 1999, the IMF’s Managing Director announced his intention to
                                    recommend to the IMF’s Executive Board the approval of the revised
Announced in March                  economic program for 1999-2001 proposed by the Brazilian government.
                                    The amount of support to be provided by the IMF portion and the total
                                    package, including that provided by multilateral banks and bilateral
                                    financing, remained the same. The key elements of the revised program are
                                    strengthened fiscal adjustment and, in light of the floating exchange rate,
                                    the adoption of a new nominal anchor for monetary policy. The additional
                                    fiscal improvement and a firm monetary policy are expected to limit the
                                    impact of the currency depreciation on prices in the first half of 1999 and
                                    to facilitate a decline in the annualized monthly inflation rate to single
                                    digits by the end of the year. Brazil’s balance of payments is expected to
                                    improve as capital inflows recover and Brazil capitalizes on its improved
                                    competitiveness.

                                    The IMF’s Executive Board approved the revised program on March 30,
                                    1999, thereby opening the way for Brazil’s next disbursement. Brazil
                                    requested and was granted a waiver of nonobservance of one performance
                                    criterion—the ceiling on net domestic assets in the BCB. According to IMF
                                    officials, the nonobservance of the performance criterion was the result of
                                    a premature easing of monetary policy.

Fiscal and Monetary Elements of     Like the initial program, the revised program contains fiscal, external
the Revised Program                 sector, and monetary targets, some of which are the same as previous
                                    criteria or indicative targets and others of which are different. According
                                    to the IMF, the changes were the result of two factors: (1) understandings
                                    that were formulated in an informal way under the original program were
                                    made into performance criteria, and (2) the reformulation of the program
                                    required different performance criteria on technical grounds.

                                    The two fiscal targets are different from the initial program. They consist
                                    of:

                                  • a performance criterion that set a floor on the cumulative primary balance
                                                                     11
                                    of the consolidated public sector and

                                    11
                                      The public sector is defined to comprise the central government, state and municipal governments,
                                    and the public sector enterprises (including federal, state, and municipal enterprises). The central
                                    government includes the federal government, the social security system, and the BCB. The cumulative
                                    primary balance of the public sector is defined as the sum of the cumulative primary balances of the
                                    entities that make up the public sector.




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• an indicative target that set a ceiling on the total net debt outstanding of
                                   12
  the consolidated public sector.

  The government intends to steadily reduce the ratio of public debt to GDP
  to below 50 percent by end-1999, and to below the value initially projected
  in the November 1998 program for the end of 2001 (46.5 percent). The
  government expects to accomplish this through higher than originally
  targeted primary surpluses of the consolidated public sector in the next 3
  years. The government intends to increase the targeted primary surplus to
  at least 3.1 percent of GDP in 1999, 3.25 percent of GDP in the year 2000,
  and 3.35 percent of GDP in 2001. According to the IMF, the need for higher
  primary surpluses comes from the higher interest bill that resulted from
  the currency being devalued. Hence, to achieve the same debt-GDP ratio,
  primary surpluses needed to be higher.

  As in the initial program, the additional fiscal adjustment is to be achieved
  through a range of revenue-raising measures and expenditure cuts. This
  effort will be concentrated at the federal level, but the state and local
  governments are expected to contribute through the implementation of
  their debt restructuring agreements with the federal government and by
  complying with the requirements of the administrative reform laws.

  The first two external sector targets were the same as in the initial
  program, while four more performance criteria were added:

• a performance criterion that set a ceiling on the total external debt of the
  nonfinancial public sector,
• a performance criterion that set a ceiling on new publicly guaranteed
  external debt,
• a performance criterion that set a ceiling on total short-term external debt
                                    13
  of the nonfinancial public sector,
• a performance criterion that set a limit on net sales of foreign exchange by
           14
  the BCB,


  12
     The total net debt outstanding of the consolidated public sector equals the public sector’s gross debt
  net of its financial assets.
  13
     This criterion applies to all external debt (disbursed and outstanding) of the nonfinancial public
  sector with original maturities of strictly less than 1 year. According to the IMF, this performance
  criterion replaced an indicative target under the original program that covered all public debt. This
  more narrow definition allowed it to be a performance criterion.
  14
    According to the IMF, this performance criterion is similar in purpose to the net international
  reserves floor of the original program.




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                                 • a performance criterion on the BCB’s exposure in foreign exchange
                                                   15
                                   futures markets, and
                                 • a performance criterion on the BCB’s exposure in foreign exchange
                                                     16
                                   forward markets.

                                   The monetary target is the same—a performance criterion that sets a
                                                                              17
                                   ceiling on net domestic assets in the BCB; however, in the view of Brazil’s
                                   government, monetary policy became a more important component in the
                                   revised program. The overriding objective of monetary policy is securing
                                   low inflation. The BCB intends to put in place as quickly as feasible a
                                   formal inflation-targeting framework. This is expected to take some time
                                   and in the meantime, it intends to rely on a quantity-based framework
                                   under which it will target its net domestic assets.

Structural Benchmarks and          According to IMF documents, the Brazilian government has reaffirmed its
Reforms in the Revised Program     commitment to the wide-ranging program of structural reforms included in
                                   the November program in such areas as social security, taxation, fiscal
                                   transparency, and the financial sector. In most of these areas the
                                   government believes it has already made significant progress. Accelerating
                                   and broadening the scope of the privatization program is also a goal of the
                                   revised program. In addition, the government remains committed to the
                                   policy of trade liberalization (summarized in the November 1998 program)
                                   adopted by Brazil’s President. Table III.3 shows the structural benchmarks
                                   contained in the revised program.




                                   15
                                      This performance criterion says the BCB will refrain from entering into any new operations in the
                                   foreign exchange markets.
                                   16
                                      This performance criterion says that the BCB will refrain from entering into any foreign exchange
                                   futures contracts. According to the IMF, Brazil never had any exposure in foreign exchange forward
                                   markets. This performance criterion was added to clarify this issue.
                                   17
                                      A number of adjusters apply to this performance criterion. The first is an adjuster for net
                                   international reserves being below the baseline, up to a certain amount According to the IMF, this is to
                                   allow for a limited amount of sterilized intervention in the event of unforeseen capital outflows.
                                   Sterilized intervention in foreign exchange markets does not affect a nation’s money supply; rather, it
                                   offsets any monetary expansion or contraction from the intervention through domestic monetary
                                   policy tools. The two other adjusters are for changes in the required reserve ratio on demand deposits,
                                   and for changes in the reservable base of demand deposits.




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Table III.3: Structural Benchmarks in
Brazil’s March 1999 Revised IMF         Completion date                                Structural benchmark
Program                                 By end-May 1999                                Submission to the Brazilian Congress of a
                                                                                       law on the complementary private pension
                                                                                       system.
                                                                                       Submission to the Brazilian Congress of an
                                                                                       ordinary law on the pension system for
                                                                                       private sector workers.
                                                                                       Presentation to the Brazilian Congress of
                                                                                       the Fiscal Responsibility Law.
                                        By end-August 1999                             Issuance of new regulation on the foreign
                                                                                       exchange exposure of banks, in conformity
                                                                                       with international standards in this area.
                                                                                       Acceptance of the obligations under Article
                                                                                       VIII, sections 2, 3, and 4 of the IMF’s Articles
                                                                                       of Agreement, with a definite timetable for
                                                                                       removing any remaining restrictions (if any).
                                                                                       Proposal of an action plan for statistical
                                                                                       improvements that will permit Brazil’s
                                                                                       subscription to the Special Data
                                                                                                                   a
                                                                                       Dissemination Standards.
                                                                                       Submission to the Brazilian Congress of the
                                                                                       multi-year plan that incorporates
                                                                                       improvements in the budgetary process
                                                                                       along the lines described in the November
                                                                                       1998 program.
                                                                                       Implementation of the remaining
                                                                                       administrative improvements in the social
                                                                                       security system, as described in the
                                                                                       November 1998 program.
                                        By end-November 1999                           Submission to the Brazilian Congress of an
                                                                                       ordinary law on the pension system for
                                                                                       public sector workers.
                                                                                       Privatization of a number of state-owned
                                                                                       banks.
                                                                                       Implementation of a regulation for the
                                                                                       institution of a capital charge related to
                                                                                       market risks, based on the Basle Committee
                                                                                       (in line with technical assistance from the
                                                                                       World Bank).
                                                                                       Implementation of a forward-looking loan
                                                                                       classification system that takes into account
                                                                                       the capacity of borrowers to repay (and in
                                                                                       accordance with technical assistance from
                                                                                       the World Bank).
                                        a
                                         The Special Data Dissemination Standards have been developed by the IMF to guide members in
                                        the provision of macroeconomic and financial data to the public.
                                        Source: IMF documents.




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Appendix IV

The IMF's Financial Arrangement with
Indonesia

                           1                                  2
              Indonesia negotiated a $10.1 billion (special drawing rights (SDR) 7,338
Summary                3
              million), 36-month Stand-by Arrangement (SBA) with the IMF in the fall of
                    4
              1997. At the time, Indonesia faced the loss of confidence of financial
              markets demonstrated by a sharp currency depreciation, a fall in equity
              prices, a decline in foreign currency reserves, and a substantial fall in its
              capital account. Although Indonesia had had real GDP growth averaging 7
              percent annually since 1970, investors concerned about the 1997 currency
              devaluation in Thailand also became concerned about structural
              conditions in Indonesia. These concerns included long-standing
              weaknesses in the financial system; restrictive domestic trade regulations;
              import monopolies; and substantial, short-term, foreign-currency-
              denominated, private sector debt in need of refinancing, along with
              concerns about political transition, drought, and the resulting need to
              import food. The deep-seated nature of the balance of payments and
              structural problems facing the economy had become increasingly apparent
              to IMF officials, who believed a thorough restructuring of the banking and
              corporate sectors was needed for the economy to recover from the crisis.

              The IMF’s initial package of conditions in November 1997 called for
              various monetary, fiscal, structural, and other reforms. Monetary policy
              was to be tight to stabilize the exchange rate and foreign currency
              reserves. Once this was achieved, interest rates could be eased. Fiscal
              policy started off with a budget surplus, but became increasingly deficit
              oriented as the economic situation worsened. More so than in previous
              IMF programs with other countries, structural reforms took a central role.
              The initial IMF program and subsequent modifications attempted to
              restructure insolvent financial institutions, promote competition in the
              domestic economy, strengthen social safety nets, and address deficiencies
              in governance in financial, corporate, and government sectors. At one

              1
               Indonesia had a population of 202 million in 1997, had a nominal gross domestic product (GDP) of
              about $211 billion in 1997, and had a per capita income of about $1,047 in 1997, according to IMF.
              2
               This amount was augmented twice in July 1998 and March 1999 for a total amount available to
              Indonesia of $12.2 billion as of April 13, 1999.
              3
               U.S. dollar amounts are computed from SDR amounts based upon annual averages for the SDR/dollar
              exchange rate. For example, in 1997 one SDR was equivalent to $1.3760. For 1998 the rate was $1.3655
              and $1.3807 for the first part of 1999.
              4
               The announced amount of assistance for Indonesia was $23 billion of which $10 billion was from IMF,
              $4.5 billion from the World Bank, $3.5 billion from the Asian Development Bank, and $5 billion in
              central bank use of reserves. In addition, some countries—the United States, Australia, Brunei
              Darussalam, China, the Hong Kong Special Administrative Region, Japan, Malaysia, and Singapore--
              indicated that if necessary they would make available supplemental financing. Bilateral commitments
              amounted to over $18 billion. The tentative supplemental commitment from the United States was for
              $3 billion from the exchange stabilization fund (ESF).




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point, structural policy commitments in Indonesia’s program with the IMF
                              5
comprised 117 distinct items.

Between November 1, 1997, and April 30, 1999, the IMF’s financial
                                                                 6
arrangements with Indonesia went through nine letters of intent and six
reviews and evolved from an SBA to an Extended Fund Facility (EFF),
which allows Indonesia more time to repay the IMF. IMF officials told us
that in most cases new letters of intent reflect further development and
elaboration of the reform program rather than substantial revisions of the
program. Economic, social, and political developments following
Indonesia’s initial letter of necessitated program revisions—these adjusted
conditions were documented in new Indonesian letters of intent. Although
parts of the structural program have evolved over time, the structure of the
financial sector program was revised twice.

Continued access to IMF funds was contingent on meeting quantitative
performance criteria dealing with levels of currency reserves, the stock of
short-term debt contracted by the government of Indonesia or guaranteed
by Indonesia’s public sector, and other criteria. Accessibility of funds was
also contingent on an evolving set of structural performance criteria
dealing with the financial sector, domestic economic regulation and
monopolies, and food prices. These performance criteria changed as
economic and social conditions evolved, specific criteria were met or not
met, and new criteria were added.

In four of the six program reviews, the IMF Executive Board granted
waivers for nonobservance of performance criteria. In each of these four
cases, waivers on structural measures were requested and received. In one
case a waiver was granted for nonobservance of financial targets.

At least twice, scheduled disbursements were rephased to reduce the
amounts of funds available and spread the disbursements out over a longer
period of time. The completion of four of the IMF reviews was delayed,
and access to funds was temporarily withheld until Indonesia made
additional progress in implementing conditions. IMF officials told us that
only two reviews were significantly delayed—the first and second reviews
under the SBA. Reviews completed under the EFF, although concluded

5
 Structural policy commitments, terms used in the Indonesian letters of intent, are policy actions that
the government of Indonesia agrees to take within a certain timeframe. Structural performance criteria
and benchmarks are a subset of the larger group of structural policy commitments.
6
 Letters of intent are prepared by the member country. They describe the policies that a country
intends to implement in the context of its request for financial support from the IMF.




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                                              shortly after their scheduled completion, were broadly on schedule. These
                                              short delays in completion of reviews under the EFF, reflect provision of
                                              extra time to implement key actions or scheduling constraints given the
                                              frequency of reviews. As of March 25, 1999, a total of $9.38 billion (SDR
                                              6.793 billion) had been disbursed from the $12.2 billion of potentially
                                              available IMF funds. Disbursements were made at 8 points in time—2 on
                                              approval of the SBA and EFF and 6 disbursements were subject to
                                              reviews. (See table IV.1 for a chronology of events related to IMF
                                              conditionality in Indonesia.)


Table IV.1: Chronology of Selected Events in Indonesia’s Current IMF Arrangement
Year Month        Day Events
1997 July         2     Thailand ceases to maintain the exchange rate peg for the baht

        August    14     Bank Indonesia allows its currency, the rupiah, to float

        October   8      Indonesia seeks IMF aid to alleviate its financial difficulties

                  31     Indonesia requests IMF assistance and announces the first letter of intent under the SBA

        November 1       Indonesia closes 16 insolvent banks and places marginal banks under conservatorship or intensified
                         supervision

                  5      IMF Executive Board approves a 3-year SBA equivalent to $10.1 billion (SDR 7.338 billion). Supplemental
                         financing commitments included $18 billion as a second line of defense if the IMF money was not sufficient.
                         Indonesia receives a $3.0 billion (SDR 2.201 billion) disbursement

        December 30      Two-thirds of the banks, representing over one-half of the banking system assets, experience runs on their
                         deposits

                  31     Government announces plans to restructure the state-banking sector through mergers and privatization




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Year   Month     Day   Events
1998   January   12    Senior IMF officials visit Indonesia to consult with the President on an acceleration of reforms

                 15    Indonesia announces the second letter of intent under the SBA

                 26    Indonesia announces a comprehensive program to rehabilitate the banking sector and put into place a
                       framework for creditors and debtors to deal, on a voluntary and case-by-case basis, with the external debt
                       problems of corporations

                 1     Sixth Cabinet is dissolved

                 6     President reelected
       March
                 15    Scheduled completion of first review under the SBA

                 10    Indonesia announces third letter of intent under the SBA

                 4     The IMF Executive Board approves completion of the first review under the SBA. Indonesia receives a $995.7
       April           million (SDR 734 million) disbursement

       May       21    President resigns after several days of rioting, with fatalities reportedly numbering close to 1,000

                 4     Agreement reached with private creditors in Frankfurt, Germany, covering restructuring of interbank debt, a
                       trade facility, and a framework for restructuring corporate debt

       June      15    Scheduled completion of second review of the SBA

                 24    Indonesia announces fourth letter of intent under the SBA




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Year   Month     Day   Events
1998   July      15    The IMF Executive Board completes the second review of the SBA, disbursing $995.7 million (SDR 734
                       million), and approves an increase in IMF financing under the SBA by $1.37 billion (SDR 1 billion). IMF
                       announces that additional multilateral and bilateral financing for the program will be made available, in part
                       through an informal arrangement among bilateral creditors that involved debt rescheduling or the provision of
                       new money—for total additional financing of more than $6 billion, including the increase in IMF funding

                 29    Indonesia requests SBA be replaced by an EFF. Letter of Intent outlines first program under the EFF

       August    21    The government of Indonesia announces a major bank restructuring package that covers banks with almost
                       half banking system assets

                 25    IMF Executive Board approves a request to replace the SBA with an EFF. This program would last 26 months
                       in the amount of $6.336 billion (SDR 4.67 billion) and would be 312 percent of quota. Indonesia receives a
                       $995.7 million (SDR 734 million) disbursement

       September 9     Announcement of Jakarta Initiative—a framework designed to promote voluntary restructuring of corporate
                       debt

                 11    Indonesia announces second letter of intent under the EFF

                 23    Agreement reached on the rescheduling or refinancing of Indonesia’s bilateral external debt to official creditors

                 25    Scheduled and actual completion of first review of EFF. Indonesia receives a $928.26 million (SDR 684.3
                       million) disbursement

       October   19    Indonesia announces the third letter of intent under the EFF

                 24    IMF staff submits and IMF Executive Board approves completion of second review under the EFF. Indonesia
                       receives $928.26 million (SDR 684.3 million)

                 25    Scheduled completion of second review of the EFF

                 30    IMF Executive Board approves completion of second review of the EFF.

       November 6      Indonesian receives a $928.26 million (SDR 684.3 million) disbursement

                 13    Indonesia issues fourth letter of intent and memorandum of economic and financial policies


       December 15     Scheduled and actual completion of third review of the EFF. Indonesia receives a $879 million (SDR 648
                       million) disbursement

1999   February 15     Scheduled completion of fourth review under the EFF

       March     16    Indonesia announces its fifth letter of intent under the EFF.

       March     25    Completion of the fourth review under the EFF and approval of a request for augmentation of $985.8 million
                       (SDR 714 million). This was the first bimonthly review. Indonesia receives $465.3 million (SDR 337 million).

                       Scheduled completion of the fifth review under the EFF $465.3 million (SDR 337 million) available at
       June      7     disbursement.
                                            Source: GAO analysis of IMF documents.




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                         Until its recent financial crisis—starting in mid-1997—Indonesia had 30
Condition of Indonesia   years of real economic growth, averaging 7 percent annually, with annual
Prior to Its Financial   inflation held continuously below 10 percent in the previous 2 decades.
Crisis—Years of          Over the past 2 decades, the incidence of poverty was greatly reduced,
                         assisted by improvements in primary education, effective health care, and
Growth and Low           family planning. Poverty rates declined from 70 million people in 1970 to
Inflation                22.5 million in 1996. Universal primary school education was achieved in
                         the 1980s.

                         Indonesia’s economic performance over the past several decades ranked
                         among the best in the developing world. GDP per capita income was rising
                         toward the level of middle-income countries. The economic structure had
                         become diversified, as dependency on the oil sector had declined. An
                         export-oriented manufacturing sector had emerged led by a dynamic
                         private sector and fueled by high domestic savings and large inflows of
                         foreign direct investment. Prior to the regional market turbulence in 1997,
                         Indonesia’s macroeconomic situation appeared by many measures
                         reasonably sound: the budget was in balance, inflation had been contained
                         to single-digit levels, current account deficits were low, and international
                         currency reserves were at a comfortable level. This strong economic
                         performance helped attract large capital inflows.

                         These achievements masked persistent underlying structural weaknesses
                         in the economy, however, that made Indonesia vulnerable to adverse
                         developments. Extensive domestic trade regulations and import
                         monopolies impeded economic efficiency and competitiveness. Indonesia
                         had many commodities with restrictive marketing arrangements and many
                         state enterprises. A government agency—the State Logistics Agency—had
                         a monopoly over the importation of essential food items, a domestic
                         market monopoly, and the ability to restrict prices on these food items. A
                         lack of transparency in decisions affecting the business environment and
                         data deficiencies increased uncertainty and adversely affected investor
                         confidence.

                         Indonesia had a banking system that had expanded too rapidly and was
                         not prepared to withstand the financial turmoil that affected Southeast
                         Asia in the latter half of 1997. Too many weak banks had larger than
                         normal levels of nonperforming loans, foreign exchange risk, concentrated
                         bank ownership, large exposures to risks in the property sector, and
                         connected lending—lending to related companies. Furthermore, Indonesia
                         had a large, unhedged, private, short-term foreign currency debt prompted
                         by large differentials between domestic and foreign interest rates.
                         Indonesian corporations were heavily exposed to such debt and thus were



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                         The IMF's Financial Arrangement with Indonesia




                         vulnerable to the adverse effects of a currency depreciation. Growth in
                         short-term foreign liabilities outpaced growth in available international
                         currency reserves. Also, a severe drought in 1997, the year leading up to
                         the crisis, created a need for large food imports.
                                                                                             7
                         Following the widening of the intervention band on July 11, 1997, the
                         rupiah was allowed to float on August 14. By October 1997, the rupiah had
                         depreciated significantly as the regional financial crisis deepened. The
                         sudden rise in the rupiah value of the foreign-currency-denominated loans
                         and increased interest rates that ensued placed the banking and corporate
                         sectors under enormous stress. At the time, Indonesia faced the loss of
                         confidence of financial markets demonstrated by a sharp currency
                         depreciation, a decline in foreign currency reserves, and a substantial fall
                         in its capital account.

                         On October 31, 1997, Indonesian authorities requested and on November 1,
Initial SBA—Monetary,    1997, the IMF granted a 3-year SBA equivalent to $10.1 billion (SDR 7,338
Fiscal, and Structural            8
                         million). The typical SBA is designed to provide short-term, balance-of-
Conditions               payments assistance for deficits of a temporary or cyclical nature. The IMF
                         granted Indonesia the right to draw the funds provided Indonesia met the
                         conditions of the program. Drawings were scheduled in 13 disbursements
                         but were to be substantially front-loaded with $3.0 billion (SDR 2,201
                         million) disbursement on November 5, 1997, and an equivalent amount to
                         be released on March 15, 1998. Interest charges were levied on a quarterly
                         basis—at a rate slightly above the SDR interest rate. Repayments of
                         principal under this arrangement were to be in eight quarterly installments
                         beginning 39 months after disbursement and ending 60 months after
                         disbursement. The principal justification for such large access was that the
                         availability of sizable external financing would catalyze a speedy return to
                         confidence and the resumption of normal capital market financing.
                         Subsequent releases of $785.4 million (SDR 579 million) were to be
                         available on June 15, September 15, and December 15, 1998. Amounts of
                         $206.8 million (SDR 149.8 million) were to be released at eight times
                         during 1999 and the year 2000, according to the IMF.


                         7
                          Bank Indonesia set a central rate for the Indonesian currency, the rupiah, based on a basket of foreign
                         currencies and intervened in the foreign exchange market to buy or sell rupiah at an intervention band
                         around the central rate. The intervention band was gradually depreciated to offset the inflation
                         differential between Indonesia and its main trading partner countries. The intervention band was
                         widened three times in 1996.
                         8
                          As of April 30, 1999, Indonesia has an IMF quota of $2.9 billion (SDR 2,079.3 million). IMF holdings of
                         rupiah are $12 billion (SDR 8,726.7 million) or 419.7 percent of quota. The reserve position in the IMF is
                         $200.9 million (SDR 145.5 million).




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Tentative Financing From the    On October 31, 1997, the Treasury Secretary indicated that the United
U.S. Exchange Stabilization     States was prepared to provide contingent additional financial support that
Fund                            could be made available for a temporary period, if necessary, to
                                supplement the resources made available by the IMF. This support was to
                                be conditioned on the implementation of an appropriate set of
                                macroeconomic and structural policies supported by the IMF, the World
                                Bank, and the Asian Development Bank. The Treasury Secretary said that
                                the United States was prepared to provide up to $3 billion in assistance
                                              9
                                from the ESF. No negotiations on a possible ESF arrangement were ever
                                concluded. No legal agreement was reached concerning such financing. In
                                the event an agreement had been reached, provision of funds could occur
                                only upon a determination by the U.S. Treasury that conditions for a
                                drawing had been met. No money from ESF was ever disbursed to
                                Indonesia, according to the U.S. Treasury.

IMF Objective and Program       According to the IMF and documents we reviewed, the overarching
Design                          objective of the IMF financial arrangement was to restore market
                                confidence and reverse the decline in external financing. The rupiah
                                depreciation and loss of confidence in Indonesia following the Thai crisis
                                was far more severe than IMF staff expected. The assistance package was
                                formulated in the context of an urgent need to deal with the sharp
                                depreciation of the currency and avert a prolonged deterioration in the
                                economic situation. The crisis exposed and intensified underlying
                                weaknesses in the financial sector and structural impediments in the
                                economy. There was concern about the large private sector external debt
                                and whether a significant portion of this maturing debt would be renewed
                                in the short term. Thus, the package was designed to stabilize exchange
                                market conditions, ensure an orderly adjustment of the external current
                                account in response to lower capital inflows, and lay the groundwork for a
                                resumption of sustained, rapid growth. The program sought to reduce the
                                current account deficit to 2 percent of GDP and maintain gross official
                                reserves at about 5 months of imports. The IMF’s initial package of
                                conditions in November 1997 called for various monetary, fiscal,
                                structural, and other changes.

Monetary and Exchange Rate      Monetary policy was designed to strengthen the rupiah-dollar exchange
Policy Included High Interest   rate and limit increases in inflation. High interest rates were intended to
Rates                           make rupiah-denominated investments more attractive to domestic and
                                foreign investors, leading to a greater demand for the rupiah and an
                                increase in its value. In the period immediately following the

                                9
                                 The U.S. Treasury can use ESF to provide loans, credits, guarantees, and reciprocal currency
                                arrangements.




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                                 announcement of the program, Indonesian authorities were to tighten
                                 liquidity. If the rupiah appreciated, then interest rates could be eased.
                                 Authorities were allowed to intervene in the foreign exchange market to
                                 resist downward pressure on the exchange rate. However, it was not seen
                                 as appropriate to deplete reserves in an effort to resist pressure on the
                                 rupiah, however, so there were limits on foreign exchange intervention.

Fiscal Policy Aimed For a        The aim of fiscal policy was to preserve a budget surplus, despite a
Budget Surplus                   slowing of the economy, by reducing low-priority expenditures and
                                 implementing new revenue measures. The program targeted a budget
                                 surplus of about 1 percent of GDP in 1997/1998 and 1 percent in 1998/1999
                                 to facilitate external adjustment and provide resources to pay for financial
                                 restructuring. The fiscal measures involved cutting what were seen as low-
                                 priority expenditures, including postponing or rescheduling major state
                                 enterprise infrastructure projects; reducing government subsidies;
                                 eliminating value added tax exemptions; and adjusting administered
                                 prices, including the prices of electricity and petroleum products.

Financial Sector Restructuring   A key component of the Indonesian authorities’ reform and stabilization
Involved Closing and Merging     program was financial sector restructuring that would address the
Banks                            financial system weaknesses that underlay the crisis. The first step in
                                 restructuring was to separate nonviable institutions from the rest of the
                                 banking system. Insolvent banks were to be closed and placed under
                                 receivership. Special teams of banking experts were to take over these
                                 institutions, liquidate assets, and repay liabilities. State banks were to be
                                 merged. A timetable was to be developed for dealing with the remaining
                                 weaknesses in the financial sector.

                                 The second step in restructuring was to establish proper procedures and
                                 policies to deal with weak but viable institutions. Banks were to develop
                                 rehabilitation plans—outlining sources of new funding and changes in
                                 ownership and management—and the plans were to be evaluated by Bank
                                 Indonesia, Indonesia’s central bank. Banks without plans to restore
                                 solvency and bring them into conformity to prudential regulation were to
                                 be closed and placed under receivership.

                                 The third step in restructuring was to resolve specific problems of state
                                 and regional development banks. The goal was to make sure that the banks
                                 were safe and sound and reduce the risks to the government’s budget of
                                 ensuring their capital adequacy. Some state banks were to be merged,
                                 while others were to be privatized. A rehabilitation plan for regional
                                 development banks was to be developed so that they could adopt




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                                   commercial banking practices—institutions that could not be strengthened
                                   in 1 year were to be closed.

                                   The final step in restructuring was to improve the institutional, legal, and
                                   regulatory framework for banking operations. Laws governing the central
                                   bank, bank operations, bank liquidation, and bankruptcy were to be
                                   revised according to best international practices. Loans by Bank Indonesia
                                   to illiquid but solvent banks were to be fully collateralized. Bank Indonesia
                                   was to strengthen prudential regulations and supervision to reduce
                                   connected lending.

Other Structural Reform            Another part of the package concerned removing structural impediments
Included Dismantling               to economic activity and further deregulation of the domestic economy.
Monopolies                         Reform measures included liberalizing of foreign trade and investment,
                                   dismantling monopolies and price controls, allowing greater private sector
                                   participation in the provision of infrastructure, and expanding the
                                                                         10
                                   government’s privatization program. Numerous barriers still stood in the
                                   way of both imports and exports, significant sectors were not open to
                                   foreign investment, and extensive regulation restrained domestic
                                   competition. Tariffs on items already subject to tariffs were to be further
                                   reduced. Nontariff barriers such as quantitative import restrictions were to
                                   be diminished as well. Also, the scope of the tariff program was to be
                                   broadened by incorporating a number of major items previously excluded.
                                   Export taxes were to be lowered. Domestic competition was to be
                                   enhanced through deregulation and privatization. In addition five
                                   agricultural commodities controlled by the National Logistic Agency and
                                   subject to price controls, production controls, and distribution monopolies
                                   were to be deregulated.

Progress Was to Be Measured by     Indonesia’s implementation of the initial program was to be measured by
Quantitative and Structural        both quantitative and structural performance criteria. Quantitative
Performance Criteria               performance criteria were

                                 • a ceiling on the growth of the outstanding stock of base money,
                                                                                                                           11


                                 • a cumulative floor on the overall central government balance,
                                                                                                 12


                                 • a floor on net international reserves,
                                                                          13



                                   10
                                     For a more detailed description of trade conditions, see International Monetary Fund: Trade Policies
                                   of IMF Borrowers (GAO/NSIAD/GGD-99-174, June 22, 1999).
                                   11
                                     This is the currency in circulation, bank deposits at Bank Indonesia, private sector demand deposits
                                   at Bank Indonesia, aggregate debt balances at Bank Indonesia, and the aggregate reserve deficiency.
                                   12
                                     This is the negative of the sum of (1) net foreign borrowing, (2) change in net credit from the banking
                                   system, and (3) net financing from all other sources to the government.




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• a ceiling on the contracting or guaranteeing by the public sector of new
  nonconcessional external debt with an original maturity of more than 1
  year, and
• a ceiling on the stock of short-term external debt contracted or guaranteed
  by the public sector.

  Targets on base money and international reserves were to provide
  measures of the effectiveness of monetary policy. Targets on the central
  government balance, a limit on public sector contracting or guaranteeing
  of new debt with a maturity of more than 1 year, and a limit on the stock of
  short-term debt were to provide a measure of the effectiveness of fiscal
  policy.

  Structural performance criteria were

• the closure of banks placed under intensified supervision or
  conservatorship that did not submit rehabilitation plans or whose plans
  were not approved by Bank Indonesia by end-December 1997,
• the establishment of quantitative performance criteria for state-owned
  banks by end-December 1997,
• the issuance of implementation regulations on procurement and
  contracting procedures by end-December 1997,
• an increase in prices of petroleum products to eliminate subsidies by end-
  March 1998, and
• a rise in electricity prices of 30 percent by end-March 1998.

  Other structural measures were benchmarks by which program progress
  was measured but upon which the availability of IMF funding was not
  contingent. Benchmarks included financial, corporate, regulatory, and
  government reforms. The first IMF review of the IMF’s arrangement with
  Indonesia was to be March 15, 1998. Three billion dollars (SDR 2,201.5
  million) were to be available from the IMF at that time. IMF staff
  recommended to the Executive Board that the IMF should support
  Indonesia’s policy program because, in part, Indonesia had a record of
  taking prompt corrective actions in the face of adverse external
  developments and had a sound capacity to repay the IMF.




  13
     This is the sum of (1) the dollar value of gross foreign assets in foreign currencies minus gross
  liabilities in foreign currencies, (2) the net forward position of Bank Indonesia, and (3) reserves against
  foreign currency deposits.




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Program Revisions and       A series of letters of intent issued by the government of Indonesia and
                            program reviews by the IMF of the SBA followed. The SBA had 4 distinct
Board Reviews of the        letters of intent that documented program changes that took account of
SBA—Progress and            changing economic and social factors in Indonesia. The IMF reviewed the
Problems                    SBA twice during the November 1997-August 1998 time period. Fund
                            disbursements were delayed twice over the course of the SBA—
                            Indonesia’s access to funds associated with the completion of the first and
                            second reviews was withheld. At the end of the first review funding was
                            rephased so that amounts available for disbursement were reduced and
                            reviews were changed from quarterly to monthly. The initial Stand-by
                            program was not successful in restoring confidence in the economy. By
                            August 25, 1998, the SBA had been replaced by an EFF.

                            According to IMF documents, the first IMF Stand-by program with
                            Indonesia met with some initial success, as confidence appeared to be
                            boosted by the tightening of liquidity and exchange market intervention.
                            But financial market sentiment soon began to sour. This deterioration of
                            market sentiment reflected the government’s failure to follow through
                            quickly on the policy measures. The closing of 16 banks while other weak
                            banks continued operation also contributed to a loss of confidence.
                            Indonesia’s promise to carry out a tight monetary policy was derailed by a
                            strong liquidity expansion to deal with runs on banks. There was also
                            political uncertainty triggered by concerns about the health of the
                            President. Foreign creditors refused to roll over maturing credit lines, and
                            pressure on the exchange rate intensified. By early January 1998, the
                            rupiah had undergone a cumulative depreciation of some 75 percent from
                            pre-crisis levels. This created severe tension in both the corporate sector
                            and banking sectors.

Second Stand-by Letter of   On January 15, 1998, the Indonesian authorities released a new letter of
Intent—Implementation       intent which included major revisions to their economic program and
Commitment and Detailed     addressed new conditions. The new measures were designed to reverse
Banking and Corporate       the decline of the rupiah before it triggered a surge in inflation and a wave
Conditions                  of corporate bankruptcies. Key changes from the previous program
                            included a commitment to implement a tight monetary program, and to
                            accelerate deregulation and trade reform. In late January, the program was
                            strengthened with the introduction of a comprehensive bank restructuring
                            program—to be implemented by a new agency called the Indonesian Bank
                            Restructuring Agency (IBRA) and the announcement of a voluntary
                            scheme to restructure private corporate debt.

                            Market reaction to the January 15 letter of intent was swift and negative.
                            Shortly after the announcement of the new letter of intent, the rupiah was



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                                depreciating rapidly and had lost a cumulative 85 percent of its value
                                compared to 7 months earlier. Owing to difficulties in implementing
                                required policy changes following the announcement of the second letter
                                of intent under the SBA, continuing uncertainty about the government’s
                                commitment to elements of the program, and other developments, the
                                rupiah failed to stabilize, inflation picked up sharply, and economic
                                conditions deteriorated. Base money grew rapidly, fueled by Bank
                                Indonesia’s liquidity support for financial institutions. Moreover, program
                                implementation was sidetracked by a February announcement that the
                                government was considering the introduction of a currency board as a
                                means of stabilizing the rupiah. There was widespread international
                                concern that Indonesia’s financial and credibility crisis would make such a
                                measure extremely risky. IMF officials viewed a currency board as
                                inappropriate for Indonesia at this time because they were concerned
                                about the rupiah’s credibility and sustainability—especially at an exchange
                                rate far above the prevailing market rate—in light of ongoing capital
                                          14
                                outflows. Decisive policy action was also inhibited by preparations for
                                the change in government after a March presidential election. The
                                economic downturn deepened, while inflation accelerated sharply. Against
                                this background, as well as the need to await the appointment of a new
                                cabinet in the wake of the reelection of the President, the first IMF
                                quarterly review was delayed.

First Review of SBA—Access to   The first quarterly review was scheduled to be completed on March 15,
IMF Funds Temporarily           1998, and was to be tied to targets for December 1997 according to the
Withheld                        IMF. However, the review was not completed—and hence additional funds
                                were not available to Indonesia—until May 4, 1998. During February and
                                March 1998, only limited progress was made in implementing the revised
                                program. There had been a precipitous depreciation of the exchange rate
                                and a large-scale outflow of capital. The banking sector and the private
                                corporate sector were basically insolvent. Consumer prices increased 39
                                percent in the first quarter of 1998. In addition, Indonesia’s overall external
                                payments position deteriorated sharply, especially the capital account,
                                because of a decline in new inflows, the reluctance of foreign creditors to
                                roll over bank and corporate external debt, and the repatriation of
                                portfolio investment. IMF officials were concerned that, without a strong
                                adjustment effort, Indonesia would encounter an even more severe crisis
                                and a deepening recession.



                                14
                                  See Lane, Ghosh, Hamann, Phillips, Schulze-Ghattas, and Tsikata. “IMF Supported Programs in
                                Indonesia, Korea and Thailand: A Preliminary Assessment.” Washington, D.C.: IMF, Jan. 1999.




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Bank Indonesia had lost control over monetary policy in the first quarter of
1998. Monetary policy was dominated by the crisis in the banking system,
with liquidity support provided to the banks reflecting the drawdown in
foreign currency deposits, the reduction of credit lines by foreign banks, a
shift into foreign currency from rupiah deposits, losses on forward
contracts, and higher nonperforming loans. Moreover, Bank Indonesia had
been hurt by the complete turnover of staff in the most senior positions.
To deal with the crisis, foreign experts were appointed to a monetary panel
to help strengthen implementation of monetary policy. The budget, too,
was adversely affected by the deterioration in the economic environment,
experiencing substantial revenue losses and increased outlays.
Furthermore, government decrees designed to dismantle cartels and open
up markets were delayed and circumvented in several sectors, which
raised concern about the government’s commitment to the IMF program.

None of the five quantitative performance criteria required for completion
of the first review were met, and only one of four structural performance
criteria was implemented. Quantitative performance criteria were not
observed on base money and public sector short-term debt outstanding at
end-December 1997 and end-March 1998. Quantitative performance
criteria were also not observed on the government balance and net
international reserves at end-March 1998.

One structural performance criterion was completed on schedule—that
Indonesia issue implementation regulations on procurement. Two
structural performance criteria were superseded by the creation of IBRA—
the closure of banks under intensified supervision and the establishment
of performance criteria for state-owned banks. Two performance criteria
were pending and were expected to be implemented by end-June 1998—
increases in petroleum prices and increases in electricity prices.

The Indonesian government requested waivers for the nonobservance of
the performance criteria. IMF staff supported granting these waivers in
view of actions undertaken prior to the proposed completion of the review
and the proposed actions of Indonesian authorities included in the revised
program. Originally $3 billion (SDR 2,201.5 million) was to be available for
Indonesia, but this amount was restructured so that equal amounts of $1
billion (SDR 733.8 million) were to be available each month over the next 3
months. On May 4, 1998, the IMF Executive Board granted the waivers and
Indonesia received a $995.4 million (SDR 733.8 million) disbursement. At
that point the IMF moved from scheduling quarterly to monthly reviews of
the arrangement.




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Third Stand-by Letter of Intent—   On April 10, 1998, the IMF and the government of Indonesia issued a third
117 Structural Policy              letter of intent to address the far-reaching changes that had occurred in
Commitments                        political, social, and external circumstances. The new program
                                   complemented and modified the program outlined in the previous letter of
                                   intent. According to IMF documents, the economic situation had
                                   deteriorated since the beginning of 1998: prices had increased, the
                                   government’s budget was under severe pressure as a result of the decline
                                   in economic activity, subsidies were needed to protect low-income groups
                                   from the rise in prices of staples and essentials due to the depreciation of
                                   the rupiah, restructuring the banking system was costly, and international
                                   oil prices had declined. In addition, the financial position of the domestic
                                   banking system had dramatically deteriorated and Bank Indonesia had
                                   granted very large-scale liquidity support. Furthermore, foreign banks had
                                   cut trade and other credit lines to Indonesian banks.

                                   The revised program built on the program specified in the previous letter
                                   of intent but placed more emphasis on debt strategy, banking system
                                   restructuring, privatization, and bankruptcy procedures. The revised
                                   program comprised 117 structural policy commitments covering fiscal
                                   issues, monetary and banking issues, bank restructuring, foreign trade,
                                   investment and deregulation, a social safety net, the environment, and
                                   other issues.

                                   The program required sharply raising interest rates to secure a sustained
                                   appreciation of the rupiah and strict control over the net domestic assets
                                   of Bank Indonesia. Liquidity support to banks was to be brought firmly
                                   under control. The program included an accelerated strategy for
                                   restructuring the banking system—including the takeover of seven banks
                                   that accounted for most of the liquidity support and raising the capital
                                   levels of healthier banks. The cost of bank restructuring was estimated to
                                   be 15 percent of GDP. The revised program also sought reform of
                                   bankruptcy procedures. It required a revised budgetary framework, with
                                   higher subsidies for some food and other items to soften the impact of the
                                   currency depreciation on the poor, as well as funds to cover the costs of
                                   bank restructuring. The revised program outlined a framework for
                                   restructuring private corporate debt with limited government support.

                                   This letter of intent shifted one quantitative performance criterion—the
                                   monetary policy target—from base money to net domestic assets because
                                   the net domestic assets of Bank Indonesia had been the source of
                                   monetary instability. The change was made because of the necessity of
                                   bringing under control the rapid expansion of central bank credit to banks
                                   with liquidity problems, according to Indonesian government



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                              documentation. Other quantitative performance criteria remained, with
                              targets changed. New structural performance criteria were to

                            • merge Bank Bumi Daya and Bank BAPINDO and transfer problem loans to
                              the asset management unit of IBRA by end-June 1998;
                            • initiate sales of additional shares in listed state enterprises including, at a
                              minimum, the domestic and international telecommunications
                              corporations by end-September 1998; and
                            • reduce export taxes on logs and sawn timber to 20 percent by end-
                              December 1998.
                                                                                                      15
                              New or strengthened structural policy commitments since January 15,
                              1998, included

                            • raising profit transfers to the budget from state enterprises including
                              Pertamina—the state oil company,
                            • publishing key monetary data on a weekly basis,
                            • appointing high-level foreign advisors to Bank Indonesia to assist in the
                              conduct of monetary policy,
                            • setting minimum capital requirements for banks of rupiah 250 billion after
                              loan loss provisions,
                            • providing external guarantees to all depositors and creditors of all locally
                              incorporated banks,
                            • establishing IBRA,
                            • transferring 54 weak banks to IBRA,
                            • transferring claims resulting from past liquidity support from Bank
                              Indonesia to IBRA,
                            • announcing 7 enterprises to be privatized,
                            • submitting to Parliament draft law on competition policy, and
                            • establishing a monitoring system for structural reforms.

Second Review of the SBA—     The second review of the SBA was scheduled to be completed on June 15,
Access to IMF Funds           1998, but the review and the subsequent disbursement of $995.4 (SDR
Temporarily Withheld          733.8 million) was delayed by about a month. The social unrest that boiled
                              over in mid-May and culminated in the resignation of the president. There
                              were runs on Indonesia’s largest private bank, and unemployment and
                              inflation started to rise dramatically. The country was seen as facing an
                              extremely severe and rapidly deepening systemic economic crisis. As a
                              result, the review was completed on July 15, 1998. Indonesia did not have
                              access to additional IMF funds during the delay period.
                              15
                                Availability of IMF funds was contingent on satisfaction of quantitative and structural performance
                              criteria but not on structural policy commitments.




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According to IMF documents, the April 1998 program had gotten off to a
good start. Monetary performance was kept within program targets
specified in the April letter of intent, even though liquidity support to
banks was higher than expected. Banks requiring most of Bank Indonesia’s
liquidity support were put under the control of IBRA. New bankruptcy
procedures were enacted, and restrictions on foreign investment in
wholesale trade were lifted.

However, IMF documentation shows that the social disturbances and
political change in May 1998 derailed the April program despite generally
good policy implementation. Arson, rioting, and looting in Indonesia
undermined business confidence and damaged the distribution system.
Business confidence was shaken, capital flight resumed, and the rupiah
depreciated sharply pushing many corporations and banks further into
insolvency. GDP fell by 8.5 percent in the first quarter of 1998 and by 7 to 8
percent in the second quarter of 1998. The banking system was
paralyzed—unable or unwilling to lend to corporations—and the corporate
sector was deeply insolvent. According to MF documents, at this time, the
Indonesian economy faced the risk of falling into an even deeper systemic
crisis, with normal financial market mechanisms breaking down
completely, banks unwilling to lend to insolvent corporations, and access
to international markets denied.

Despite this situation, Indonesian officials reported that Indonesia had met
three of the four IMF quantitative performance criteria. For example, they
judged the structural performance criterion to increase petroleum prices
and eliminate subsidies to have been met because petroleum prices had
been raised on average by 38 percent, although the increase in kerosene
prices was subsequently rescinded to assist poor households. Data on two
quantitative performance criteria were not available—the end-June
performance criteria on the contracting or guaranteeing of new external
debt and the stock of public sector short-term debt outstanding.

Indonesia met the end-June 1998, structural performance criteria to raise
fuel and electricity prices according to an agreed schedule. One of the
structural performance criteria was not met—the end-June 1998, merging
of two banks and the transfer of problem assets to the asset management
unit of IBRA were delayed. The Indonesian government requested a waiver
for its nonobservance. The IMF staff supported this request because the
preparatory work took longer than anticipated, and the merger was
expected to take place by end-July 1998. The IMF staff also supported
Indonesia’s request to waive the applicability of the other quantitative and
structural performance criteria that were not met. On July 15, 1998, the



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                                  IMF Executive Board granted the waivers and Indonesia received a $995.4
                                  million (SDR 733.8 million) disbursement. At this time, the government of
                                  Indonesia requested and the IMF’s Board approved a $1.4 billion (SDR 1
                                  billion) augmentation of the SBA.

Fourth Stand-by Letter of         On June 24, 1998, the government of Indonesia issued a fourth letter of
Intent—Strengthening the Social   intent to address the prevailing economic conditions. Although the overall
Safety Net                        objectives and policy content of the revised program remained the same as
                                  in previous letters of intent, the new program was to be substantially
                                  revised to reflect the deterioration in the economic situation, and the
                                  emphasis placed on some IMF conditions changed to some extent. The
                                  economy faced a serious crisis as a result of the social and political
                                  upheavals in May. Tight monetary policy was thought necessary to prevent
                                  hyperinflation. The new monetary program envisaged no increase in base
                                  money or net domestic assets. The budget was the area where major
                                  changes were made to the IMF program, including requirements for a
                                  substantially increased subsidy bill for basic foodstuffs, petroleum
                                  products, and electricity; greater expenditures for health and education;
                                  and expansion of employment-creating projects. Deficit spending was
                                  expected to amount to more than 8 percent of GDP—with the recognition
                                  that this deficit was not sustainable and would need to be reduced as the
                                  economy recovered. The bank-restructuring strategy—focused on putting
                                  in place as quickly as possible a core functioning banking system—
                                  envisioned an increased role for foreign advisors. A revised strategy was
                                  added to assist the resolution of the problems of the corporate sector
                                  through the establishment of the Indonesian Debt Restructuring Agency
                                  (INDRA), which was designed to provide exchange rate protection for
                                  restructured debts.

                                  A strengthened social safety net to cushion the escalating effects of the
                                  crisis on the poor was now required. As a result of the reduction in real
                                  incomes, the number of households below the poverty line was growing
                                  rapidly. The food distribution system was to be repaired to ensure
                                  adequate supplies of food and other essential items to all parts of the
                                  country. Nevertheless, it was thought that the revised program was likely
                                  to encounter great risk from unsettled political conditions and growing
                                  social strains.

                                  Quantitative performance criteria were the same as in the prior letters of
                                  intent, but targets were changed. New structural performance criteria were
                                  as follows:




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                        • Initiate sales of additional shares in listed state enterprises including, at a
                          minimum, the domestic and international telecommunications corporation
                          by end-September 1998.
                        • Submit to parliament a draft law to institutionalize Bank Indonesia’s
                          autonomy by end-September 1998.
                        • Reduce export taxes on logs and sawn timber to 20 percent by end-
                          December 1998.
                        • Complete audits of the State Oil Company, the State Logistics Agency, the
                          State Electric Company, and the Reforestation Fund by end-December
                          1998.

                          New or strengthened structural policy commitments included the
                          following:

                        • Issue presidential decree to provide appropriate legal powers to IBRA,
                          including its asset management unit.
                        • Reduce the minimum capital requirements for existing banks.
                        • Take action to freeze, merge, recapitalize, or liquidate the six banks for
                          which audits have already been completed.
                        • Conduct portfolio, systems, and financial reviews of all other banks by
                          internationally recognized audit firms.
                        • Introduce community-based work programs to sustain purchasing power
                          of poor in both rural and urban areas.
                        • Increase subsidy for food and essential items.
                        • Introduce microcredit scheme to assist small businesses.

                          On July 29, 1998, Indonesia requested that the SBA be canceled and the
Request for an EFF—                                                                 16
                          existing policy program be supported instead by an EFF. Several IMF
Indonesia to Get More     Board members had previously suggested that such an arrangement might
Time to Repay the IMF     be more appropriate than a SBA due to the deep-seated nature of
                          Indonesia’s structural and balance-of-payments problems. The EFF was
                          established to provide assistance to meet balance-of-payments deficits
                          over longer periods of time. By this time, Indonesia had received $4.96
                          billion (SDR 3.66 billion) in disbursements under the SBA. The EFF was to
                          cover the remaining period of the SBA—26 months—and access under the
                          new arrangement was to be the same as the amount remaining to be drawn
                          16
                             The third review of the SBA was incorporated into the analysis of the request for an EFF.
                          Quantitative performance criteria—for contracting or guaranteeing new external debt and limits on the
                          stock of public sector short-term debt outstanding—were met. One structural performance criterion
                          was completed on schedule—raising fuel and electricity prices according to a schedule. One structural
                          performance criterion was delayed, and the IMF Board granted a waiver for its nonobservance on July
                          15, 1998—merge Bank Bumi Daya and PABINDO and transfer problem loans to the asset management
                          unit of IBRA. IMF officials told us that if the August 1998 disbursement had not been made on approval
                          of the EFF, no waivers would have been needed for the completion of the third review of the SBA.




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                                 under the SBA—$6.33 billion (SDR 4.67 billion). An EFF allows a country
                                 more time to repay the IMF, according to an IMF official. Repayment of
                                 principal under an EFF was to be made in 12 semiannual installments
                                 beginning 4-½ years after disbursement and ending 10 years after the date
                                 of each disbursement whereas repayments under an SBA are scheduled 3-
                                                                      17
                                 ¼ to 5 years after each disbursement.

                                 The deep-seated nature of the structural and balance-of-payments
                                 problems facing the economy had become increasingly apparent. A
                                 thorough restructuring of the banking and corporate sectors was needed
                                 for the economy to recover from the crisis, even if this restructuring would
                                 take some time to complete. IMF staff supported the Indonesian
                                 government’s request that the SBA be replaced by an EFF. On August 25,
                                 1998, the IMF Board approved the request for an EFF, and Indonesia
                                 received a $995.4 million (SDR 733.8 million) disbursement.

Program Revisions and            A series of five letters of intent and four reviews followed the switch to an
                                 EFF. The five letters were an elaboration of the elements of the reform
Board Reviews of the             program, according to the IMF. Monetary policy requirements continued to
EFF—Progress and                 be tight and focused on getting the exchange rate into an acceptable range.
Problems                         Fiscal policy requirements pinpointed deficit spending. Structural policies
                                 focused on reforming the financial sector, eliminating anticompetitive
                                 structures in the Indonesian economy, and providing social safety
                                 measures. Disbursements were on time twice and delayed twice when IMF
                                 officials judged that Indonesian officials were not satisfactorily
                                 implementing the set conditions.

First EFF Letter of Intent—New   On July 29, 1998, at the time the government of Indonesia requested an
Social Safety Net and Banking    EFF, Indonesia issued a new letter of intent to address the prevailing
Measures                         conditions. Program modifications were introduced in budgetary
                                 management, corporate debt restructuring, and bank restructuring. There
                                                                                         18
                                 was progress in implementing the Frankfurt agreement with foreign
                                 commercial banks and the introduction of auctions for central bank
                                 instruments. Progress was also being made on elaborating the details of
                                 the plan for bank restructuring. IBRA and its asset management unit were
                                 fully operational, and foreign investment banks and a leading foreign

                                 17
                                   See Financial Organization and Operations of the IMF (Washington, D.C.: Treasurer’s Department,
                                 IMF, Sept. 1998).
                                 18
                                    The Frankfurt agreement was reached on June 4, 1998. It (1) restructured interbank debt falling due
                                 before end-March 1999, (2) made available a trade facility under which participating banks would use
                                 their best efforts to maintain their aggregate trade credit to Indonesian banks to help restore normal
                                 flows of trade financing, and (3) established a framework for voluntary restructuring of corporate debt.




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  commercial bank were assisting the bank restructuring process. These
  developments had a beneficial impact on market confidence.

  At the time of the request for the EFF, the economic situation remained
  precarious. Output had declined 10 percent and was likely to decline as
  much as 15 percent for 1998/1999, according to the IMF. Inflation was
  projected to be 80 percent for 1998. Food security was a continuing
  concern—food prices had risen dramatically since the beginning of May
  1998. Severe problems in the banking system and corporate sector were
  still not adequately addressed. Actions to resolve six private banks that
  were taken over were needed. Actions were also needed on the
  recapitalization of sounder banks and the restructuring of state banks.
  Progress on corporate debt workouts was very slow, and IMF staff judged
  that the Indonesian government needed to be involved in facilitating such
  workouts. The outlook for the program was vulnerable to changes in the
  political and social climate. The June program had slippages in monetary
  policy—concerns about further bank closures led to renewed withdrawals
  of deposits from troubled banks, and the move by Bank Indonesia to
  reabsorb liquidity led to a rise in interest rates. Strenuous efforts were
  necessary to bring base money in line with program targets.

  New measures were added to repair and strengthen the distribution
  system, to mitigate the humanitarian effects of the crisis by expanding
  social safety net programs and improving the targeting of subsidies, to
  remove obstacles to corporate sector restructuring through the adoption
  of regulatory and administrative reforms, and to restructure insolvent
  banks. The distribution and subsidy systems were improved to ensure that
  essential goods were available at affordable prices. In addition, a new
  program was created to provide rice at highly subsidized prices to the
  poorest families. Components of this strategy were the following:

• The State Logistics Agency was to release large quantities of rice of all
  qualities into the market.
• The rice was to be released into the market at less than the market price.
• The State Logistics Agency was to increase direct deliveries of medium-
  quality rice to retailers and cooperatives.
• To put further downward pressure on prices, the value-added tax on rice
  was to be suspended.
• The program for delivering rice at prices well below market prices to poor
  families was to be expanded as quickly as possible, with the help of
  provincial governors.
• The State Logistics Agency was to actively seek new imports for rice to
  ensure that stocks remained adequate.



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                               • Private traders were to be freely allowed to import rice.

                                 Quantitative performance criteria were the same as those in effect in the
                                 final letter of intent of the SBA except for changes in targets. Structural
                                 performance criteria were to:

                               • initiate sales of additional shares in listed state enterprises including, at a
                                 minimum, the domestic and international telecommunications
                                 corporations by end-September 1998;
                               • submit to parliament a draft law to institutionalize Bank Indonesia’s
                                 autonomy by end-September 1998;
                               • reduce export taxes on logs and sawn timber to 20 percent by end-
                                 December 1998; and
                               • complete audits of the State Oil Company, the State Logistics Agency, the
                                 State Electric Company, and the Reforestation Fund by end-December
                                 1998.

                                 New or strengthened structural policy commitments included

                               • an IMF review of public expenditure management,
                               • the transfer of assets of the seven frozen banks to the asset management
                                 unit,
                               • the transfer of the responsibility for six state banks from the Ministry of
                                 State Enterprises to the Ministry of Finance,
                               • the launch of the Indonesian Debt Restructuring Agency,
                               • the institution of tax neutrality for mergers,
                               • the submission to the Indonesian parliament of a new arbitration law
                                 consistent with international standards,
                               • the completion of a review of accounting and auditing standards to make
                                 them consistent with international standards, and
                               • the establishment of a voluntary framework to facilitate corporate
                                 restructuring.

First Review of the EFF—Good     On September 17, 1998, IMF staff presented its first review of the EFF to
Policy Implementation            the IMF’s Executive Board. Completion of the review was to be based on
                                 indicative fiscal and monetary targets, as well as external targets for end-
                                 July and end-August 1998. IMF staff recommended that the review be
                                 completed and that Indonesia continue to have access to IMF assistance.
                                 The policy discussions with the government of Indonesia were conducted
                                 in close collaboration with the World Bank and the Asian Development
                                 Bank.




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According to IMF documents, Program implementation was generally good
and the program was broadly on track. Market sentiment had improved as
a result of good implementation and increased financing for the program.
Steps were being taken in key areas where problems had occurred,
especially in regard to food security, or where progress needed to be
accelerated, such as corporate restructuring. A cautious easing of
monetary policy was seen as possible once inflation had been brought
down from its high levels. The challenge for policy at that time was to
proceed with structural reforms-–chiefly banking system and corporate
restructuring. Improving the food situation was crucial for ensuring social
stability.

Real GDP was estimated to have declined by 12 percent in the first half of
1998, while cumulative inflation for the first 8 months of the year was 69
percent. Although the political situation had stabilized to some degree by
September, it remained fragile, as indicated by street protests. The
privatization program was behind schedule, and a shortfall from the target
for privatization revenues was believed to be likely. The budget was
running far within program targets in part because of delays in increasing
spending on social programs. Because the government had adopted a
strategy for addressing the urgent problems created by the recent rapid
increase in rice prices, IMF staff believed it helped limit risks to the
program from social unrest.

On the other hand, bank restructuring had been subject to delays. The
transfer of assets to the asset management unit was being delayed pending
passage of amendments to the banking law. In addition, little progress had
been made in corporate restructuring. To address some of these issues, a
package of measures to address bank restructuring was announced on
August 21, 1998. The package included the recapitalization of core banks,
the closure of six large private banks, the merger of four state banks, and
other items. An important development with respect to corporate
restructuring was the announcement of the Jakarta Initiative—a voluntary
framework to guide and streamline out-of-court restructuring of corporate
debt. This initiative was announced in early September 1998 and used
approaches that were proven successful in other countries. The approach
covered all foreign and domestic debt and applied equally to all creditors.
To promote financing to distressed companies, the principles encouraged
creditors to subordinate their existing claims to lenders that were willing
to provide interim financing.

Several benchmarks were implemented during the course of this review.
The end-June 1998 measure to allow transferability of forest concessions



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                                    and to de-link their ownership from processing of new concessions was
                                    done by end-August. The end-July measure to issue a presidential decree
                                    to provide appropriate legal powers to IBRA, including its asset
                                    management unit, was done on schedule. The end-August measure to
                                    submit to parliament a draft amendment to the banking law, incorporating
                                    procedures for the privatization of state banks, and the removal of the
                                    limits on private ownership of banks was done on August 24, 1998. On
                                    September 25, 1998, the IMF Board completed the review and Indonesia
                                    received a $928.3 million (SDR 684.3 million) disbursement.

Second EFF Letter of Intent—        On September 11, 1998, at about the time of the first IMF review of the
New Strategy for Rice and Banks     EFF, the government of Indonesia announced a revised program to
                                    address the new conditions. The letter of intent established indicative
                                    targets for monetary and fiscal variables and for international reserves.
                                    The letter of intent indicated that the program intended to continue to
                                    implement a firm monetary policy. As inflation declined, the government
                                    of Indonesia expected interest rates to decline, easing pressure on the
                                    corporate and banking sectors. Development expenditures, particularly
                                    those for the social safety net, which were running below the programmed
                                    levels, were to be stepped up. Rice was to be provided at highly subsidized
                                    levels to poor families. For the first time in 30 years, the government was
                                    to allow private traders to import rice. This letter of intent included
                                    commitments related to an August 21, 1998, announcement by the
                                    government of Indonesia of a major bank-restructuring package that
                                    covered banks with almost half the assets of the banking system.

                                    The end-September targets for net domestic assets, overall central
                                    government balance and net international reserves, and net international
                                    reserves were quantitative performance criteria. The letter of intent
                                    contained an updated matrix of structural policy commitments with the
                                    following new or strengthened commitments:

                                  • Eliminate subsidies on imports of sugar, wheat, wheat flower, corn,
                                    soybeans, soybean meal, and fishmeal.
                                  • Strengthen public expenditure management.
                                  • Prepare a final plan for restructuring three banks.
                                  • Complete the legal requirements for the merger of four state banks.
                                  • Prepare a plan for the operational merger and restructuring of four state
                                    banks.

Second Review of the EFF—           On October 23, 1998, IMF staff submitted a second IMF staff review of
Waivers Requested and Granted       Indonesia’s program. IMF staff reported that further progress had been
                                    made with stabilization since the last review and that policy



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  implementation under the IMF program continued to be generally good.
  The priority for policy at this juncture was to foster recovery in output,
  consolidate gains in stabilization, and strengthen programs to protect the
  poor. IMF staff recommended that waivers for nonobservance be granted
  for two missed structural performance criteria provided that there was a
  satisfactory arrangement for the repayment of liquidity support by private
  banks.

  The situation remained fragile and the economy extremely weak.
  Unemployment and poverty were on the rise. Although the political
  situation had stabilized, the outlook remained uncertain and, in the IMF
  staff’s view, further turbulence in coming months was not ruled out. There
  had been slippages in some areas, notably privatization. Privatization of
  several mining companies and the domestic telecommunications concern
  had been postponed until market conditions improved. The inability of
  most corporations to pay high rates on loans had resulted in a negative
  spread between commercial bank deposit and lending rates, contributing
  to continuing decapitalization of the banking system. At this time there
  was no satisfactory agreement on the repayment of liquidity support by
  private banks.

  By the third week in October 1998, the rupiah had strengthened beyond
  expectations, inflation had moderated, and prices for many staple food
  items had declined. Key elements of bank restructuring were moving
  ahead. Indonesia then announced a government-assisted recapitalization
  program for viable banks. The merger of four state banks had been
  initiated, and plans had been announced for resolving the debt situation of
  six major private banks. Progress was being made in establishing the
  appropriate legal and regulatory framework for the Jakarta Initiative.

  Completion of the second review under the EFF was to be based on
  indicative and performance targets for end-August and end-September
  1998. The government of Indonesia had complied with performance
  criteria for end-September 1998 on net domestic assets and net
  international reserves. However, Indonesia requested a waiver for the
  following end-September performance criteria due to the lack of available
  data on

• the central government balance,
• the contracting or guaranteeing of new external debt, and
• the short-term external debt outstanding.




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                                One benchmark for the end of September 1998 was done on schedule
                                while the completion of another benchmark was delayed. The benchmark
                                to complete action plans for all 164 state enterprises was done on
                                schedule. The benchmark to complete divestiture of two state enterprises
                                that were unlisted was delayed because of weak market conditions.

                                The government also requested waivers for structural performance criteria
                                that were not met. These criteria dealt with share sales of domestic and
                                international telecommunications companies and submission to
                                parliament of a draft law to institutionalize Bank Indonesia’s autonomy.
                                Although share sales of one company had been completed, other shares
                                had not been sold due to weak market conditions. The draft law was
                                nearing completion, and submission to parliament was expected by mid-
                                November. On October 30, 1998, the IMF Board granted the requested
                                waivers. On November 6, 1998, Indonesia received a $928.3 million (SDR
                                684.3 million) disbursement.

Third EFF Letter of Intent—     On October 19, 1998, the government of Indonesia announced a new letter
Additional Banking Reform and   of intent incorporating adjustments to prevailing conditions. This was the
Corporate Debt Restructuring    third letter of intent to be announced under the EFF. This revision
Commitments                     contained several measures to further strengthen the IMF program,
                                especially in the areas of banking and corporate debt restructuring. The
                                letter of intent called for lowering interest rates as long as the rupiah
                                remained strong and inflation was falling. Development spending was to be
                                accelerated. Monitoring of development spending was to be strengthened
                                to protect against leakage and corruption. The preparation of the master
                                plan for privatization was completed—all but a few selected enterprises
                                were to be privatized within the next decade. The program included
                                requirements to streamline the food distribution procedures and make
                                adequate food supplies available to the most vulnerable groups.

                                On September 28, 1998, the government announced the formal merger of
                                four state banks into the newly established Bank Mandiri. The next day,
                                Bank Indonesia announced key elements of a bank recapitalization
                                program for potentially viable private banks—including higher capital
                                adequacy ratios, injections of new capital, lower levels of nonperforming
                                loans in accordance with new prudential requirements, and preparation of
                                business plans demonstrating achievement of medium-term viability and
                                compliance with prudential regulations. Indonesia’s parliament approved
                                amendments to the banking law on October 16, 1998, which facilitated the
                                restructuring process by strengthening the legal powers of IBRA and its
                                asset management unit.




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                                 The Jakarta Initiative on corporate debt restructuring was expected to be
                                 fully operational by end-October. The decrees necessary to give effect to
                                 the Initiative were signed and a chairman appointed. At this time about a
                                 dozen companies, with a combined debt exposure in excess of $3 billion,
                                 were entering the process. On October 23, 1998, a draft government
                                 regulation was to be signed to provide for tax neutrality for mergers and
                                 removal of other tax disincentives for restructuring.

                                 Quantitative performance criteria were as specified in the first EFF, with
                                 targets changed. New and strengthened structural policy commitments
                                 were to

                               • complete a review by Bank Indonesia of business plans of relatively strong
                                 private banks,
                               • recapitalize banks whose business plans are accepted by Indonesia,
                               • transfer to IBRA banks that are determined to be insolvent and ineligible
                                 for the recapitalization plan,
                               • resolve 26 banks currently subject to IBRA control for which audits were
                                 expected to be completed by mid-November,
                               • establish centralized control of lending decisions and treasury
                                 management in the four state banks that were being merged into Bank
                                 Mandiri,
                               • reach final settlement with former owners of two private banks for
                                 repayment of Bank Indonesia liquidity support,
                               • encourage the initiation of negotiations between debtors and creditors
                                 under the Jakarta Initiative, and
                               • expand the subsidized rice scheme to 17 million poor families.

Fourth EFF Letter of Intent—     On November 13, 1998, the government of Indonesia issued a letter of
Implementing Corporate and       intent and supplementary memorandum of economic and financial policies
Financial Restructuring          that detailed revised conditions under the EFF. The new letter of intent
                                 undertook a number of additional steps to implement the key areas of
                                 corporate and financial restructuring. The letter of intent reaffirmed the
                                 government’s commitment to keep base money under control so as to
                                 stabilize prices and accommodate further appreciation of the rupiah.
                                 Progress continued to be made on lengthening the maturity structure of
                                 monetary instruments. Development expenditure was targeted to rise. The
                                 revised program sought collaboration at all levels in stepping up internal
                                 government oversight mechanisms to help identify leakages and ensure
                                 accountability. The letter of intent had a commitment to sell majority
                                 interests in the Jakarta container port and minority interests in the Jakarta
                                 airport operations, the largest palm oil plantation in Indonesia, and the
                                 international telecommunications enterprise. The letter of intent contained



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                                 a commitment to taking steps to release detailed financial information
                                 about the state logistics agency, the state oil company, and the state
                                 electric company. Banking sector reforms included requirements for
                                 recapitalization of private sector banks, resolution of debt in certain frozen
                                 banks, and other actions.

                                 There was to be a renewed effort to implement the Jakarta Initiative. A
                                 foreign exchange monitoring system was to be developed to allow Bank
                                 Indonesia to oversee foreign currency flows on a more timely basis. As of
                                 April 30, 1999, the system had been approved by the government of
                                 Indonesia but had not begun operations.

                                 The letter of intent only had one structural performance criterion—reduce
                                 export taxes on logs and sawn timber to 20 percent by end-December 1998.
                                 New and strengthened structural policy commitments included the
                                 following:

                               • Raise aviation fuel prices to international levels.
                               • Complete terms and conditions of bank recapitalization bond.
                               • Reach agreement with former owners of six banks for repayment of Bank
                                 Indonesia liquidity support and connected lending.
                               • Issue three new prudential regulations on connected lending, the capital
                                 adequacy ratio, and the semi-annual publication of financial statements.
                               • Establish a mechanism for the appointment of ad hoc judges to the
                                 Commercial Court.
                               • Expand the subsidized rice scheme and increase monthly allocations to 20
                                 kilograms per family.
                               • Eliminate exchange rate subsidies for rice imports by the National
                                 Logistics Agency and replace them with explicit budgetary subsidies.

Third Review Under the EFF—      On December 15, 1998, IMF staff presented their third review under the
Completion of Review Delayed     EFF to the IMF Board. In its view, macroeconomic policies were on track,
                                 financial sector reform was proceeding, progress was being made on
                                 corporate restructuring, and slippages and delays in some areas were
                                 being addressed. The rupiah had strengthened, allowing money market
                                 rates to begin falling. Inflation had abruptly slowed. Fiscal policy had been
                                 less stimulative than envisaged but development spending was
                                 accelerating. Moreover, the rice program was being broadened beyond the
                                 initial target of 7.5 million families. The privatization agenda was narrowed
                                 to 4 or 5 enterprises from the original list of 12 enterprises. Financial
                                 sector and corporate restructuring was moving forward on several fronts
                                 with the aim of restoring the soundness of the banking system. On
                                 November 7, 1998, final agreement was reached with the previous owners



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                                 of four banks to repay the equivalent of 9 percent of GDP in obligations
                                 stemming from loans obtained by their enterprises from these four banks.
                                 An increasing number of companies were seeking assistance in initiating
                                 negotiations with creditors.

                                 The review noted slippages in some areas of the program, including
                                 privatization and some risk that political unrest could again derail the
                                 program. Government authorities remained reluctant to finance the
                                 restructuring costs because of the political implications. There had only
                                 been limited progress in corporate debt restructuring—further steps were
                                 needed in expediting regulatory approvals for restructuring, establishing a
                                 public registry to facilitate interim financing, and streamlining the
                                 Commercial Court.

                                 According to IMF documents, Indonesia met the indicative targets on net
                                 domestic assets and net international reserves. Data were not available for
                                 the indicative target for the central government balance, but the IMF
                                 believed that the target had been met. IMF staff recommended completion
                                 of the third review and supported the introduction of three bimonthly
                                 reviews during the first half of 1999 before moving to quarterly reviews. On
                                 December 15, 1998, the IMF Board approved completion of the review.
                                 Indonesia received a $928.3 million (SDR 684.3 million) disbursement.

Fourth Review Under the EFF—     On March 25, 1999, the IMF completed its fourth review of the EFF and the
Indonesia Requested Additional   request for augmentation of funds. The review was scheduled to have been
Funds                            completed on February 15, 1999. This was the first bi-monthly review.
                                 Although progress was reported in implementing the IMF program, delays
                                 had occurred in implementing key banking and corporate restructuring
                                 measures. Nevertheless, the IMF staff was satisfied that policies and
                                 developments were continuing to evolve as well as could be expected
                                 under difficult and unsettled domestic conditions. Progress toward
                                 achieving macroeconomic stability had been helped by a firmer and more
                                 consistent monetary policy. The external current account kept its solid
                                 surplus of almost 5 percent of GDP in 1998-1999, offsetting a weaker
                                 capital account. A trade surplus of $17 billion accounted for the bulk of the
                                 improvement in the current account. In mid-March 1999, net international
                                 reserves of $15 billion remained above the program targets. Opposition
                                 political parties supported the IMF program.

                                 Indonesia continued to pose exceptional risks for the IMF, particularly
                                 until the political transition was further advanced, according to IMF staff.
                                 The economy had not yet bottomed out. Export volumes had declined
                                 sharply, and domestic banks were reluctant and unable to extend credit to



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                                  exporters. Although the judiciary had not implemented the bankruptcy law
                                  in a manner consistent with international practice, Indonesian authorities
                                  were believed to be cooperating fully in carrying out a corrective strategy.
                                  This corrective strategy included proposed legislation aimed at improving
                                  governance of the judiciary and expectations that state banks and IBRA
                                  were aggressively to pursue their largest borrowers. Corporate debt
                                  restructuring under the Jakarta Initiative had yet to spread rapidly—only
                                  15 companies, involving about $2 billion in foreign currency debt, had
                                  concluded debt restructurings with creditors.

                                  Several benchmarks were completed on schedule. For example, the
                                  measure to finalize a decision on the resolution of all banks that fail the
                                  criteria for eligibility to the recapitalization program was implemented in
                                  that all these banks were closed or intervened on March 13, 1999. The IMF
                                  granted a waiver for nonobservance of the structural performance
                                  criterion—to reduce the export tax on logs and sawn timber to 20 percent
                                  at end-December 1998. The measure was adopted in February 1999. The
                                  result of the review was that on March 25, 1999, Indonesia received a
                                  $465.3 million (SDR 337 million) disbursement, and the total amount
                                  available to Indonesia was increased $985.8 million (SDR 714 million).

Fifth EFF Letter of Intent—       The government of Indonesia issued a fifth letter of intent under the EFF
Strengthening the Program for     on March 16, 1999. This letter of intent included a number of new steps to
the Banking System and            strengthen the program—especially the banking system and corporate
Corporate Restructuring           restructuring. Banking reforms requirements included state bank
                                  resolution; private bank recapitalization; resolution of debt in banks under
                                  IBRA control; and improvement of the legal, regulatory, and supervisory
                                  framework.

                                  Steps to strengthen the corporate restructuring framework included the
                                  following:

                                • A regulation became effective that removed company law limitations on
                                  debt-to-equity conversions.
                                • The Ministry of Finance passed a decree providing more favorable tax
                                  treatment of cancellation of indebtedness income in restructurings.
                                • Legislation was to be submitted for the registration of security interests
                                  that would give certainty concerning the priority rights of lenders.

                                  Actions related to the rice situation included

                                • elimination of the state trading agency’s exchange rate subsidy for imports
                                  of rice,



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• a public procurement floor price policy that was aimed at keeping
  domestic rice prices broadly in line with world prices, and
• the unhindered import of rice by the private sector.

  To supplement the People’s Economy Initiative for development of small-
  and medium-sized enterprises and cooperatives, Indonesia was to

• review commercial lending practices to and the financing needs of small-
  and medium-sized enterprises and cooperatives,
• transform the BRI state bank into a specialized bank with a mandate to
  lend only on commercial terms, and
• simplify directed credit schemes to cooperatives and small- and medium-
  sized enterprises and ensure that lending rates are positive in real terms
  and adjust them periodically to reflect market conditions.

  The letter of intent set end-March and end-May quantitative performance
  criteria and indicative targets for the rest of 1999 and the year 2000 as well
  as structural performance criteria and benchmarks through September
  1999. There were no new structural performance criteria in this letter of
  intent. Policy actions were to continue to be guided by the matrix from the
  November 1998 letter of intent.




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Appendix V

The IMF’s Financial Arrangement With South
Korea

                                                                                        1
              South Korea, officially named the Republic of Korea, experienced an
Summary       external financing crisis in late 1997, which stemmed from underlying
              weaknesses in its corporate and financial sectors. These sectors relied
              heavily on short-term external borrowing. This reliance stemmed in part
              from a government policy that allowed flexibility in short-term capital
              flows, while retaining controls on long-term capital flows. A common
              belief that the government would prevent major firms in certain sectors
              from failing may also have contributed to the heavy reliance on debt
              financing. In November 1997, when Korea requested the IMF’s assistance,
              Korea had almost depleted its foreign reserves and its currency was
              depreciating rapidly. In an effort to stabilize Korea’s economy and
              stimulate economic growth, the IMF negotiated a large financing package
              for Korea, combining adjustments in macroeconomic policies with
              accelerated and strengthened structural reforms. Korea’s IMF program
              was intended to restore market confidence, limit private capital outflows,
              and restore economic growth.

              The macroeconomic and structural reforms were considered complex and
              aggressive. The macroeconomic program initially focused on stabilizing
              Korea’s currency exchange rate and increasing Korea’s foreign currency
              reserves by raising interest rates and limiting government spending.
              Financial sector restructuring was a key focus of the structural reforms. As
              the program progressed, the program’s reforms in the banking and
              corporate sectors became more specific and detailed. As Korea’s domestic
              economy began to contract, the IMF encouraged Korea to lower interest
              rates and increase government spending, bringing Korea’s formerly
              balanced budget into a deficit position. For example, when Korea’s IMF
              program began, Korea’s fiscal target was to have a surplus of 0.2 percent of
              gross domestic product (GDP). The IMF adjusted its growth projections in
              the first quarterly review to reflect declining economic conditions in
              Korea. In Korea’s March 10, 1999, letter of intent signed with the IMF,
              Korea’s fiscal target was lowered to a deficit of 5 percent of GDP that was
              budgeted for in 1999.

              After announcing Korea’s program on December 4, 1997, the IMF
              monitored Korea’s progress beginning in December 1997 with its first
              biweekly review. In January 1998, the IMF conducted a second biweekly
              review, followed by four quarterly reviews beginning in February 1998. The
              IMF conducted its fifth quarterly review in March 1999. All reviews were
              completed and disbursements made. The IMF accelerated its
              disbursements to Korea at the end of 1997, and the majority of the IMF’s
              1
                  We will refer to the Republic of Korea as “Korea” in this appendix.




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                        funding ($19.3 billion out of $21 billion) was disbursed by April 30, 1999.
                        Korea met all its performance criteria until its fourth quarterly review. IMF
                        staff recommended a waiver for meeting a condition of the agreement at
                        the fourth quarterly review due to delays in obtaining bids for the sale of
                        two Korean banks. Korea has subsequently obtained bids for these sales.
                        In addition, the IMF staff requested waivers at the fifth quarterly review for
                        (1) completing an audit of the Korea Asset Management Corporation to
                        reflect any losses identified in the external audit in the Corporation’s
                        audited financial statement and (2) the delivery of recommendations to the
                        Ministry of Finance and Economy as to any remedial action based on a
                        financial supervisory review of the Korea Development Bank. These two
                        actions have since been completed.

                        Although Korea’s IMF program began slowly due in part to its presidential
                        election, Korea has made substantial progress in advancing its financial
                        sector reforms and has begun repaying its IMF borrowings. As of April 30,
                        1999, Korea has repaid about $6.1 billion of its IMF borrowings. Some
                        officials we spoke with noted that Korea still faced difficult reforms in its
                        corporate sector and emphasized that it would take time for Korea to
                        complete the reforms it has begun.

                        Prior to Korea’s 1997 financial crisis, Korea had experienced about 30
History of the Crisis   years of economic growth and was considered to have had broadly
                        favorable macroeconomic performance. Korea had recorded real GDP
                        growth of about 6 percent in the first 3 quarters of 1997, and inflation was
                        around 4 percent. Korea’s external financing crisis stemmed from
                        fundamental weaknesses in its corporate and financial sectors. Korea had
                        experienced a mild recession in 1993. In response, Korea’s elected officials
                        promised growth and encouraged Korea’s conglomerates (called
                        “chaebols”) to invest heavily in new factories. In turn, Korean firms made
                        substantial investments, leaving Korea with excess production capacity
                        and large debt burdens for Korean firms. This overcapacity led to falling
                        prices for its main exports—computer memory chips, cars, ships, steel,
                        and petrochemicals—and weakened profitability.

                        The large amount of short-term borrowing compounded these other
                        problems. Most of the corporate debt was either short-term borrowing
                        from domestic financial institutions or from the issuance of promissory
                        notes. At the end of December 1997, the 30 largest conglomerates owed
                                                         2
                        approximately 111.3 trillion won (the Korean currency) in loans and

                        2
                         Using the conversion rate of 1,900 won (approximate exchange rate at the end of December 1997) to
                        the dollar this amount is about $58.6 billion.




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payments to Korean banks, according to Korea’s Office of Bank
Supervision. The conglomerates’ current liabilities (less than 1 year)
accounted for 60 percent of total liabilities and roughly half of nominal
GDP in 1996. These factors resulted in an increase in bankruptcies
beginning in 1997, including a large Korean steel company and car
manufacturer.

These bankruptcies weakened the financial system, since bank loans were
not being paid off, and non-performing loans rose sharply, causing strains
in the banking system. Korean government estimates of nonperforming
                                                3
loans at the end of 1997 were 34.9 trillion won. Weaknesses in the banking
system were thought to be based on a lack of commercial orientation (that
is, a focus on increasing market share over improving profitability) and
limited experience in managing risk, combined with lax prudential
supervision. These factors, as well as the large-scale, external short-term
borrowing of the Korean banks, made Korea vulnerable to the contagion
effects of financial problems in Southeast Asia.

The weak state of the banking sector led to successive downgrades by
international credit rating agencies and a sharp tightening in the
availability of external financing. External creditors began to reduce their
debt exposure to Korean banks in the latter part of 1997, causing a sharp
decline in usable reserves. A large amount of these reserves were being
used to finance the repayment of the short-term debt of Korean
commercial banks’ offshore branches. Historically, Korean authorities had
a policy of not letting private banks go into default. Consequently, the
Bank of Korea was providing foreign exchange support to commercial
banks as foreign creditors reduced their exposure on short-term lines of
credit. The total amount of foreign currency reserves the Bank of Korea,
the central bank of Korea, held at the end of December 1997 was $20.4
                                                       4
billion, the usable portion of which was $8.9 billion. As of December 31,
1997, the total amount of Korea’s private and governmental external
liabilities was $154.4 billion, calculated under IMF standards. The Korean
government estimated that at the end of December 1997, approximately
$27.3 billion was due by the end of the first quarter in 1998. The ability of

3
 Using the conversion rate of 1,900 won to the dollar (approximate conversion rate at the end of 1997),
the amount would be $18.4 billion.
4
 Under the IMF program, Korea tightened its definition of “usable reserves” and has reported its
reserves under this stricter definition. Previously, Korea had included its deposits with overseas
branches of Korean financial institutions when reporting its foreign exchange reserves, thus
overstating its usable reserves. Usable foreign currency reserves equal the total foreign currency
reserves less amounts on deposit with overseas branches of Korean financial institutions and swap
positions between the Bank of Korea and other central banks.




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                                            Korea to repay its short-term foreign debts was dependent on the
                                            willingness of foreign lenders to extend the terms of existing loans and/or
                                            to offer new financing.

                                            Korea had made earlier attempts to reform the financial sector and had
                                            taken steps to liberalize its capital account. Korea permitted short-term
                                            foreign borrowing but had not allowed domestic banks access to longer-
                                            term foreign borrowing, which added to Korea’s financing problems. Korea
                                            was faced with depleted foreign reserves and a rapidly depreciating
                                            currency when it asked for IMF assistance in late November 1997. It had
                                            been 10 years since Korea had had an IMF program, and Korea did not
                                            have any outstanding IMF credit. Korea had made its last repayment of
                                            prior borrowings to the IMF in 1988. Table V.1 presents a history of Korea’s
                                            recent financial problems.


Table V.1: Chronology of Selected Events Concerning Korea’s Financial Problems, 1997-May 1999
Year Month       Day Action
                        Hanbo Steel, a large Korean conglomerate, collapses under $6 billion in debts, first bankruptcy of a Korean
1997 January            conglomerate in a decade.
        April           President’s Committee on Financial Sector Reform recommends short-term reform measures.
        July     2      Thailand devalues its currency, the baht.
                        Kia, Korea’s third largest carmaker, requests emergency loans.
                        Korean government announces plan for providing special financing for certain commercial and merchant
                        banks. Announced government guarantee for overseas foreign currency borrowings by Korean commercial
        August   25     banks.
                                                                                  a
        October         IMF mission goes to Seoul for an Article IV consultation.
                        Credit rating agencies begin to downgrade the ratings of Korea and Korean companies to below investment
                        grade.
                 22     Kia Motors Corp. announces bankruptcy.
                        Bank of Korea intervenes to attempt to halt the decreasing value of the won. IMF announces it is ready to
        November 6      provide assistance if needed.
                                                                                              b
                 19     Bank of Korea loosens band on currency, won begins to drop sharply.
                 21     Korean government requests IMF assistance.
                        Korea bank asset workout program announced. Korea Asset Management Corporation reorganized to acquire
                 24     and dispose of nonperforming loans.
        December 4      $21 billion IMF package announced, which was part of a larger financing package totaling about $58 billion.
                 16     Korea eliminated its daily currency exchange rate band.

                                            a
                                             Under Article IV of the IMF’s Articles of Agreement, the IMF holds bilateral discussions with
                                            members, usually every year. A staff visits the country, collects economic and financial information,
                                            and discusses with officials the country’s economic developments and policies.
                                            b
                                              As discussed later, in 1997 Korea had operated with a currency exchange rate system that permitted
                                            exchange rates to float freely within a daily range of plus or minus 2.25 percent. On November 19, 1997,
                                            the Korean government announced that the range of daily exchange rate fluctuations would be
                                            expanded from plus or minus 2.25 percent to plus or minus 10 percent. The daily exchange rate band
                                            was eliminated as of December 16, 1997 and, as a result, the exchange rate for the won now floats
                                            according to market forces.




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                                            The IMF’s Financial Arrangement With South Korea




Year   Month      Day   Action
                  17    IMF staff conduct first biweekly review of Korea’s program.
                  18    South Korea elected opposition party Kim Dae-jung to serve a 5-year presidential term.
                  22    Moody’s rating service announces that it lowered Korea’s foreign currency ratings.
                        Won drops to its low of 1,963 won to the dollar. Standard & Poor’s announces that it lowered Korea’s long-term
                  23    foreign currency credit ratings.
                        IMF funding accelerated, debt restructuring talks begin. IMF and 12 country lenders agree to advance Korea
                  24    $10 billion to prevent default. Korea issues second letter of intent with accelerated and strengthened reforms.
                        Korea’s National Assembly passes 13 financial reform bills designed to facilitate financial sector restructuring,
                  29    accelerate capital market liberalization, and improve prudential regulation.
1998   January    8     IMF conducts second biweekly review of Korea’s program.
                  28    $22 billion in Korean foreign debt restructured.
                        Tripartite accord (among labor, management, and the government) reached on Korea’s restructuring program
       February 6       and sharing the burden of reform.
                17      IMF conducts first quarterly review of Korea’s program.
                25      President Kim and the new administration take office.
       April            Korea issues global bond offering of $4 billion to add to its official reserves.
                1       Financial Supervisory Commission formed.
       May      29      IMF conducts second quarterly review of Korea’s program and completes its Article IV consultation.
       July     23      Korea signs memorandum of understanding with the World Bank for implementing corporate sector reforms.
       August   28      IMF conducts third quarterly review of Korea’s program. Review completed and disbursement made.
                        IMF conducts fourth quarterly review of Korea’s program. Korea requests waiver for obtaining bids for the sale
                        of Korea First Bank and Seoul Bank. IMF Board approves waiver, review is completed, and disbursement
       December         made.
                31      Korea First Bank signs Memorandum of Understanding with Newbridge Capital for sale of Korea First Bank.
1999   February 22      Seoul Bank signs memorandum of understanding with HSBC for sale of Seoul Bank.
                        IMF conducts fifth quarterly review of Korea’s program. IMF recommends waivers for completion of an audit of
                        Korea Asset Management Corporation and delivery of recommendations based on a financial supervisory
                        review of Korea Development Bank. The financial supervisory review was conducted within the timetable
                        under the review, and the remaining actions were subsequently completed. IMF completes review and
       April      7     disbursement was made.

                                            Source: GAO analysis of IMF, Korean, Treasury, Securities and Exchange Commission, and State
                                            Department documents.

                                                                                                                                               5
IMF Agreement Announced                     On December 4, 1997, the IMF approved a 3-year stand-by arrangement
                                                                                                         6
                                            with Korea for an amount equivalent to special drawing right (SDR) of
                                            15.5 billion (amounting to about $21 billion). This program was formulated
                                                                         7
                                            under emergency procedures and later drew on the IMF’s newly


                                            5
                                             A Stand-by Arrangement is a decision of the IMF by which an IMF member is assured that it will be
                                            able to make purchases (drawings) from the General Resources Account (GRA) up to a specified
                                            amount and during a specified period of time, usually 1 to 2 years, provided that the member observes
                                            the terms set out in the supporting arrangement.
                                            6
                                             Special drawing right is defined by the IMF as the international reserve asset created by the IMF in
                                            1969 as a supplement to existing reserve assets.
                                            7
                                             According to IMF documents, under an emergency financing mechanism, the IMF has developed “a
                                            set of exceptional procedures to facilitate rapid Executive Board approval of IMF financial support for
                                            a member while ensuring the conditionality necessary to warrant such support. These emergency
                                            measures are used only in circumstances representing, or threatening to give rise to, a crisis in a
                                            member’s external accounts that requires an immediate IMF response.”




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                          The IMF’s Financial Arrangement With South Korea




                                                                                     8
                          established Supplemental Reserve Facility. The World Bank and the Asian
                          Development Bank committed $14 billion to the Korean government. In
                          addition, interested countries pledged $22 billion as a second line of
                                   9
                          defense for a total package of $58.4 billion. At the time of the
                          announcement, the IMF staff team continued to work with Korean officials
                          to develop more fully the policy measures for the program. The full
                          program was to be reviewed by the IMF’s Executive Board in January
                          1998. It was planned that the review would expand the scope of the
                          performance criteria and set performance measures and benchmarks for
                          1998. Customary clauses were also included as conditions for Korea’s IMF
                                     10
                          program. Each subsequent review adjusted and expanded the
                          performance criteria for the next reviews, that is, they were set as “rolling”
                          performance criteria. The IMF’s monitoring of Korea’s program started
                          with two biweekly reviews in 1997 and quarterly reviews for 1998 and the
                          first quarter of 1999. After the fifth quarterly review in March 1999, the IMF
                          plans to conduct reviews every 6 months, and Article IV consultation
                          discussions are planned for June or July 1999.

                          The IMF program for Korea included a combination of macroeconomic
IMF Program               policies—changes to monetary and fiscal policies—and structural reforms.
Comprised                 The IMF-directed response was to tighten monetary policy, including
                                                                          11
Macroeconomic             raising interest rates to stabilize the currency and reduce government
                          spending, along with an ambitious reform program for financial sector and
Policies and Structural   corporate restructuring. Macroeconomic policies were an essential part of
Reforms                   Korea’s program. The large official financing package was assembled to
                          help break the cycle of capital outflows, exchange rate depreciation, and
                          financial sector weakness. However, compared with other countries’ IMF
                          programs, the structural reforms in Korea, as well as Indonesia and

                          8
                           The Supplemental Reserve Facility is a facility (window) established in December 1997. Its aim is to
                          provide financial assistance to IMF members experiencing exceptional balance-of-payments difficulties
                          due to short-term financing needs resulting from a sudden and disruptive loss of market confidence
                          reflected in pressure on the capital account and the members’ reserves.
                          9
                           The United States offered Korea a line of credit using the Exchange Stabilization Fund in December
                          1997, as a bilateral agreement. According to Treasury officials, this line of credit was not used by
                          Korea. According to IMF officials, Korea did not use the second line of defense offered by other
                          countries.
                          10
                           For Korea, the customary clauses on overdue financial obligations to the IMF, on no accumulation of
                          external payment arrears, on exchange restrictions, on multiple currency practices, on bilateral
                          payments agreements inconsistent with Article VIII, and on import restrictions for balance-of-payments
                          purposes apply as performance criteria.
                          11
                             Since Korea’s currency, the won, was losing its value in the foreign exchange markets (Korea’s
                          exchange rate), raising interest rates was seen as a way to encourage current and new investors to hold
                          their won-denominated investments or to invest in won-denominated undertakings that would help to
                          stabilize or raise the country’s overall reserves.




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                                 The IMF’s Financial Arrangement With South Korea




                                 Thailand, were central to dealing with the underlying causes of the
                                 financial crisis, restoring market confidence, and setting the stage for
                                 resuming and sustaining growth in Korea.

                                 According to Korea’s December 3, 1997, IMF letter of intent, Korea’s IMF
                                 program was “built around (1) a strong macroeconomic framework
                                 designed to continue the orderly adjustment in the external current
                                 account and contain inflationary pressures, involving a tighter monetary
                                 stance and substantial fiscal adjustment; (2) a comprehensive strategy to
                                 restructure and recapitalize the financial sector, and make it more
                                 transparent, market-oriented, better supervised and free from political
                                 interference in business decisions; (3) measures to improve corporate
                                 governance; (4) accelerated liberalization of capital account transactions;
                                 (5) further liberalization of trade; and (6) improvement in the transparency
                                 and timely reporting of economic data.”

                                 The broad policy goals of restoring investor confidence and building
                                 international reserves have remained throughout the program, although
                                 the emphasis has changed and adjustments have been made in specific
                                 targets as Korea’s reforms progressed.

Quantitative Performance         Korea’s macroeconomic program included monetary and fiscal policy
                                 measures. The initial letter of intent did not fully specify Korea’s reform
Criteria Outlined in Initial     program but did provide a framework of reforms that Korea intended to
Agreement                        pursue. IMF staff continued to work with Korean officials to develop more
                                 detailed policy measures to be taken. To monitor Korea’s progress under
                                 the program, the initial agreement detailed the following quarterly
                                 quantitative performance criteria:

                               • a ceiling on net domestic assets of the Bank of Korea,
                                                                                                           12


                               • a floor on net international reserves of the Bank of Korea, and
                                                                                            13



                                 12
                                   In this agreement, the IMF provided precise definitions of the quantitative variables monitored under
                                 the program. The IMF set indicative targets for reserve money and broad money (M3) and provided
                                 definitions to be used. In addition, it was agreed that the ceiling on net domestic assets and the
                                 indicative limit on reserve money would be increased (or decreased) for any increase (or decrease) in
                                 required reserve ratios.
                                 13
                                    The net floor on net international reserves of the Bank of Korea was defined as the sum of (1) the
                                 U.S. dollar value of gross foreign assets in foreign currencies minus gross liabilities in foreign
                                 currencies and (2) reserves against foreign currency deposits. The floor of the net international
                                 reserves was to be adjusted (1) downward by the U.S. dollar equivalent (converted at the program
                                 exchange rate) of the increase in foreign liabilities of the Bank of Korea associated with the emergency
                                 financing package, (2) upward by the amount of financing under the emergency financing package in
                                 excess of the program baseline (and downward by any shortfall), (3) upward by the amount by which
                                 deposits of the Bank of Korea at overseas branches and subsidiaries of domestic financial institutions
                                 are below the baseline specified in the program, and (4) upward for any increase in the net forward
                                 position over the end-November position of US $6.2 billion.




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  The IMF’s Financial Arrangement With South Korea




• the interest rate charged by the Bank of Korea on foreign exchange
  injections to Korean commercial banks or their overseas branches was not
  to be below 400 basis points above LIBOR.

  These quantitative macroeconomic performance criteria, in addition to
  other indicative targets, structural performance criteria, and structural
  measures, were used to monitor Korea’s progress. The IMF and Korea also
  agreed to indicative targets to monitor Korea’s economic progress,
  including

• a floor on the consolidated central government balance,
                                                                                14


• reserve money, and
                  15


• broad money (M3).
                     16




  The principal macroeconomic objectives of Korea’s IMF program, as
  detailed in the initial December 3, 1997, letter of intent, include

• building the conditions for an early return of confidence so as to limit the
                                                       17
  deceleration of real GDP to about 3 percent in 1998, followed by a
  potential recovery in 1999;

• containing inflation at or below 5 percent; and

• building international reserves to more than 2 months of imports by end-
  1998.



  14
    The “consolidated central government balance” is defined as the consolidated balance of the central
  government (comprising the general accounts and the special budgetary funds) and the public
  enterprises special accounts. The balance is the difference between the total revenues and the sum of
  total expenditures and net lending. Expenditures include all interest costs associated with the
  restructuring of the financial sector borne by the public sector (including monetary authorities and
  public banks).
  15
   “Reserve” money is defined as the bank notes and coins issued plus reserve deposits of domestic
  money banks.
  16
     Korea’s IMF agreement defines “M3” as “M2” plus deposits of other financial institutions, debentures
  issued, commercial bills sold, “deposits of credit unions,” mutual credits of the National Federation of
  Fisheries, “Community Credit Cooperatives,” Mutual Savings and Finance Cooperatives situated in
  local and reserve life insurance companies, certificates of deposit, repurchase agreements, and cover
  bills. “M2” is defined as currency in circulation plus deposit money (demand deposits at monetary
  institutions, time and savings deposits, and residents’ foreign currency deposits at monetary
  institutions).
  17
    In Korea’s initial program, the IMF had not yet projected Korea’s declining GDP for 1998. The IMF’s
  projections were revised in the first quarter of 1998.




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Monetary Policy   The main objective of the monetary policy was to contain inflation to 5
                                                                    18
                  percent in 1998 and limit depreciation of the won. To demonstrate to
                  markets the government’s resolve to confront the crisis, monetary policy
                  was tightened immediately—interest rates were raised—to restore and
                  sustain calm in the markets and contain the inflationary impact of the won
                                 19
                  depreciation. The government of Korea reversed its policy of providing
                  liquidity to Korean banks and allowed money market rates to rise to a level
                                                  20
                  sufficient to stabilize markets. The day-to-day conduct of monetary policy
                  was guided by movements in the exchange rate and short-term interest
                  rates, which were used as indicators of how tight monetary conditions
                  were. A flexible exchange rate policy was maintained, with monetary and
                  exchange rate policy being implemented in close coordination with IMF
                        21
                  staff.

Fiscal Policy     Fiscal policy in Korea had traditionally been formulated prudently,
                  according to the IMF. In recent years, the Korean government’s budget was
                  in broad balance, with government savings of around 8 percent of GDP and
                  a low level of public debt. Unlike economic problems in Latin America
                  (large public debts), the Korean crisis was centered in the private sector.
                  For 1998, Korea was to maintain a tight fiscal policy—by cutting
                  government spending and raising certain taxes—to limit upward pressure
                  on interest rates and to provide for the still uncertain costs of restructuring
                  the financial sector.




                  18
                     Foreign investors will often hold foreign currencies, in this case the won, to earn profits and interest.
                  For the profits to be valued, foreign investors must exchange their earnings in won into their own
                  currency. If the value of the won falls in value, foreigners’ earnings on the won-denominated asset will
                  also fall. To encourage foreign investors to invest in Korean won-denominated assets, Korea must pay
                  a higher interest rate to attract investors.
                  19
                     As the won depreciates, exports may increase as Korean goods become cheaper when paying for
                  them in other currencies. If exports expand too quickly, excess demand could lead to inflation. Prices
                  of imports increase with won depreciation.
                  20
                    The quantitative performance criteria limiting Korea’s net domestic assets and the understandings on
                  the call rate were used to guide monetary policy.
                  21
                     Historically, the Bank of Korea set daily exchange rates—the Bank of Korea concentration base
                  rate—for the won based on a trade-weighted, multicurrency basket system. Starting in 1989, the
                  Korean government followed a plan intended to progress gradually to a free-floating exchange rate. By
                  1997, the government was operating with an exchange rate system that permitted exchange rates to
                  float freely within a daily range of plus or minus 2.25 percent. In response to the substantial downward
                  pressures on the won caused by Korea’s economic difficulties in late 1997, on November 19, 1997, the
                  Korean government announced that the range of daily exchange rate fluctuations would be expanded
                  from plus or minus 2.25 percent to plus or minus 10 percent. The daily currency exchange rate band
                  was eliminated as of December 16, 1997, and, as a result, the exchange rate for the won now floats
                  according to market forces.




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                         The IMF’s Financial Arrangement With South Korea




                         The quantitative performance criteria were adjusted at subsequent reviews
                         to reflect changes in economic assumptions, discussed more fully below.
                         The first quarterly review of the full program was completed in February
                         1998, which expanded the scope of performance criteria and set
                         performance criteria and benchmarks for 1998. Two biweekly reviews
                         were conducted in the interim period after announcement of the Korea
                         program and before the first quarterly review in February 1998.

Structural Performance   The IMF used numerous structural performance criteria to monitor
                         Korea’s progress in making structural reforms. Korea’s structural reforms
Criteria                 focused on financial sector reforms, capital account liberalization,
                         strengthening corporate governance and corporate structure, labor market
                         reforms, trade liberalization, and information provisions and program
                         monitoring. After the first IMF quarterly review, measures to increase
                         spending for Korea’s social safety net, including unemployment insurance,
                         were added to the program. The third quarterly review added a World
                         Bank component on corporate sector reforms.

                         For monitoring Korea’s reforms, the IMF set benchmarks in the initial
                         letter of intent for the first and second biweekly reviews. As Korea
                         implemented its reforms, the structural performance criteria used to
                         monitor progress changed to reflect the reforms undertaken (see table V.2
                         and discussion that follows). The IMF set Korea’s benchmark for the first
                         biweekly review “to comply with the understandings between the Korean
                         government and the Fund staff regarding the implementation of interest
                         rate policy.” For the second biweekly review, to be completed on January
                         8, 1998, Korea was “to call a special session of its National Assembly,
                         shortly following its presidential elections in December 1997 to pass
                         reform bills on financial sector reforms, capital account liberalization, and
                         trade liberalization.” Korea was also “to publicize its foreign reserve data.”
                         Also, “the Bank of Korea was not to increase its deposits with nonresident
                         branches and affiliates of domestic financial institutions after December
                         1997.”

                         At the first quarterly review, and at each quarterly review throughout 1998,
                         the IMF and Korea agreed to additional specific structural performance
                         criteria to monitor Korea’s reform efforts. For example, at the third
                         quarterly review, Korea was to obtain bids for the sale of Korea First Bank
                         and Seoul Bank by November 15, 1998. Korea was monitored against this
                         performance criterion at its fourth quarterly review in December 1998.
                         Table V.2 details Korea’s reported progress and changes in its structural
                         performance criteria from the initial IMF program in December 1997
                         through the fifth IMF quarterly review in March 1999.



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                                              The IMF’s Financial Arrangement With South Korea




Table V.2: Structural Performance Criteria for Korea’s IMF Program
Date of
review       Structural benchmarks and performance criteria to be met                                   Disposition
First       Structural benchmark set:                                           Call rate rose to about 30 percent on Dec. 24, 1997.
biweekly    Compliance with understandings between the Korean                   Increase in interest rate cap from 25 percent to 40 percent
review,     authorities and the IMF regarding the implementation of interest    was approved by cabinet on Dec. 16 and became
12/17/1997 rate policy.                                                         effective Dec. 22, 1997.
Second      Structural benchmarks set:
biweekly    Call a special session of the National Assembly after elections     Passed the three financial reform bills by the National
review,     to pass reform bills that (1) revise Bank of Korea Act to provide   Assembly on Dec. 29, 1997. The Financial Supervision
1/8/1998    central bank independence; (2) consolidate bank supervision;        Board will be under the Prime Minister’s office.
            and (3) require corporate financial statements to be prepared on
            a consolidated basis and certified by external auditors.
            Submit legislation to harmonize the Korean regime on equity          Raised ceiling on aggregate foreign ownership of listed
            purchases with the Organization for Economic Cooperation and         Korean shares from 26 to 50 percent and the individual
            Development’s practices.                                             ceiling from 7 to 50 percent on Dec. 11, 1997. Raised the
                                                                                 aggregate ceiling on foreign investment in Korean equities
                                                                                 to 55 percent on Dec. 30, 1997. Under Korea’s foreign
                                                                                 direct investment law, Korea already allowed foreign
                                                                                 investors to buy equity in the stock market (as well as
                                                                                 over the counter) for the purpose of friendly mergers and
                                                                                 acquisitions, without limits.
            Submit legislation concerning hostile takeovers to harmonize         Legislation submitted to allow greater foreign ownership
            Korean legislation on abuse of dominant positions in line with       of banks. It was announced that foreign participation in
            industrial countries’ standards.                                     merchant banks would be allowed without limit.
            Publication of foreign reserve data.                                 Publishing data on Korea’s foreign reserves began Dec.
                                                                                 17, 1997. Data on usable reserves of the BOK is
                                                                                                                    th
                                                                                 published twice monthly (for 15 and the last day of each
                                                                                 month) within 5 business days. Data on net forward
                                                                                 position of the Bank of Korea is being published monthly.
                                                                                 All of these data were placed on the Bank of Korea’s web
                                                                                 site, starting May 15, 1998.
            The Bank of Korea’s deposits with nonresident branches and           Began Dec. 24, 1997. The Bank of Korea was to limit its
            affiliates of domestic institutions will not be increased after end- funding of financial institutions to short-term liquidity
            Dec. 1997.                                                           support, which the BOK offered to commercial banks
                                                                                 through its liquidity support program.
First       Eliminate interest rate ceiling. Korea was to submit legislation to Increase in interest rate cap from 25 percent to 40 percent
quarterly   National Assembly to remove interest rate ceiling as soon as         was approved by cabinet on Dec. 16, 1997, and became
review,     necessary procedures are completed, but not later than Feb.          effective on Dec. 22, 1997.
Feb. 1998   28, 1998.

            Assume government control of Korea First Bank and Seoul             These banks came under intensive supervision beginning
            Bank and request the management of these banks to write             Dec. 24, 1997. The equity capital was written down, and
            down the equity of existing shareholders.                           the government recapitalized these banks and took
                                                                                effective control of the banks by Jan. 31, 1998.
Second      By March 31, 1998
quarterly   Complete second round evaluation of the remaining 20           Completed Feb. 26, 1998.
review,     merchant banks and suspend operations of those banks that fail
May 1998    to pass the evaluation.
            Allow foreign banks and brokerage houses to establish          Came into effect on Mar. 31, 1998
            subsidiaries.




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                                              The IMF’s Financial Arrangement With South Korea




Date of
review       Structural benchmarks and performance criteria to be met                                  Disposition
            By June 30, 1998
            Complete an assessment of the recapitalization plans of              Completed June 29, 1998
            commercial banks.
            Introduce legislation to allow a full writedown of existing          Legislation was enacted to allow the writedown of existing
            shareholder equity, eliminating the current minimum bank             shareholders’ equity in insolvent financial institutions.
            capital floor for this purpose.
            Establish a unit for bank restructuring under the Financial          Unit established on Apr. 1, 1998.
            Supervisory Board with adequate powers and resources to
            coordinate and monitor bank restructuring and provision of
            public funds.
Third       In addition to the end-June performance criteria, IMF added the
quarterly   following for end Sept. 1998:
review,     Submit legislation to allow for the creation of mutual funds (by     Legislation submitted to the National Assembly on Aug. 8,
Aug. 1998   Aug. 31, 1998)                                                       1998; related legislation put into effect in Sept. 1998.
            Require listed companies to publish half-yearly financial            Completed.
            statements prepared and reviewed by external auditors in
            accordance with international standards (by Aug.31, 1998)
            For end-Dec. 1998:
            Obtain bids for Korea First Bank and Seoul Bank (by Nov. 15,         At the fourth quarterly review, the IMF staff recommended
            1998)                                                                a waiver to extend the date for obtaining bids for Korea
                                                                                 First Bank and Seoul Bank from Nov. 15, 1998, to end-
                                                                                 Jan. 1999. Korea First Bank: memorandum of
                                                                                 understanding signed with Newbridge Capital, Dec. 31,
                                                                                 1998; Seoul Bank: memorandum of understanding signed
                                                                                 with HSBC on Feb. 22, 1999.
            Introduce consolidated foreign currency exposure limits for          Completed July 1998.
            banks, including their offshore branches (by Nov. 15, 1988).
Fourth      In addition to end-Dec. 1998 performance criteria, additional
quarterly   criteria were set for end-March 1999:
review,     To complete an audit of Korea Asset Management Corporation   IMF staff recommended a waiver for this action at the fifth
Dec. 1998   to international standards by a firm with international experience
                                                                         quarterly review but it has since been completed. External
            in auditing this type of agency and to reflect any losses    audit report completed March 12, 1999. Losses identified
            identified in the Korea Asset Management Corporation’s       in external audit report were reflected in the Korea Asset
            financial statement                                          Management Corporation’s financial statement as of April
                                                                         30, 1999.
            The Financial Supervisory Commission to complete supervisory IMF staff recommended a waiver for this action at the fifth
            examination of the Korea Development Bank and make           quarterly review but it has since been completed.
            recommendations to Ministry of Finance and Economy, as       Financial Supervisory Commission completed its
            needed, as to any remedial actions required.                 examination of the Korea Development Bank March 20,
                                                                         1999. Recommendations coming from the examination
                                                                         were submitted to the Ministry on April 26, 1999.




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                                              The IMF’s Financial Arrangement With South Korea




Date of
review        Structural benchmarks and performance criteria to be met                               Disposition
Fifth        Period of April 1-August 31, 1999                                 Ongoing.
quarterly    (1) Issue regulation by April 1, 1999, requiring insurance
review,      companies that fail to meet the mandatory solvency margin         (1) Regulation was issued on March 26, 1999.
March 1999   thresholds (specified in the Memorandum of Economic Policies
             for the fifth review of the stand-by arrangement) to submit
             recapitalization plans by July 31, 1999.
             (2) By June 1, 1999, begin publishing data on revenue,
             expenditure, and financing of the consolidated central
             government on a monthly basis with no more than a 4-week lag.
             (3) By June 30, 1999, issue new loan classification guidelines
             that fully reflect capacity to repay. These guidelines would also
             cover the treatment of restructured loans and the valuation of
             equity and convertible debt acquired as part of corporate
             restructuring.
             (4) For merchant banks, implement prudential rules for foreign
             exchange liquidity and exposures based on a maturity ladder
             approach by July 1, 1999.
             (5) Issue instructions, effective July 1, 1999, that at least 20
             percent of the new guarantees issued by Korea Credit
             Guarantee Fund and Korea Technology Guarantee Fund will
             cover only 80-90 percent of the value of guaranteed obligations
             depending on the credit rating of the firm.
                                              Sources: GAO analysis of Korea’s letters of intent, and IMF and Korean documents, in addition to
                                              discussions with Korean and IMF officials.


Financial Sector Restructuring                The centerpiece of Korea’s structural reform package was financial sector
                                              restructuring. Korea’s goals were to have a sound, transparent (improved
                                              Korea’s financial reporting, according to international accounting
                                              standards), and more efficient financial system. Korea had already begun
                                              efforts to reform its financial sector prior to seeking IMF assistance but
                                              had not been successful in passing reform legislation. Korea’s initial IMF
                                              letter of intent detailed the government’s plans for addressing the financial
                                              restructuring of the banks. The Korean government, in consultation with
                                              the IMF, prepared a comprehensive action program to strengthen
                                              supervision and regulation in accordance with international best practices.
                                              The IMF agreement built upon the framework for financial sector reforms
                                              that the Korean government had published in November 1997.

                                              In its original letter of intent, Korea specified the need for a credible and
                                              clearly defined method for closing troubled banking institutions. The
                                              strategy required that troubled institutions present viable rehabilitation
                                              plans and close those insolvent financial institutions that failed to carry
                                              out their rehabilitation plans within specified periods. Korea also planned
                                                                                                                            22
                                              to set a timetable for all banks to meet or exceed Basle capital standards.

                                              22
                                                Bank regulators from industrialized countries adopted common risk-based standards for bank capital
                                              for internationally active banks in 1988 under the auspices of the Bank for International Settlements.
                                              Known as the Basle Accord, the standards were fully implemented in 1992 by member countries. The




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                              The IMF’s Financial Arrangement With South Korea




                              The disposal of nonperforming loans was to be accelerated. All forms of
                              assistance to banks, including financing from the Korean Asset
                              Management Corporation and the deposit insurance funds, would be
                              provided only as part of viable rehabilitation plans. All support to financial
                              institutions, other than Bank of Korea liquidity credits, were to be
                              recorded transparently in the fiscal accounts. In addition, blanket
                              guarantees were to be phased out and replaced by a limited deposit
                              insurance scheme.

                              In its first IMF agreement, Korea stated its intentions to restructure and
                              recapitalize troubled financial institutions. Timeframes and rules for doing
                              this were detailed in later agreements that accelerated and strengthened
                              Korea’s plans for addressing these problems. For example, the Koreans
                              were successful in passing financial reform legislation and established a
                              high-level team to negotiate with foreign creditors by the end of December
                              1997. The Korean government (1) appointed a high-level task force to
                              develop and implement a strategy to address the financial crisis, (2)
                              assumed control of Korea First Bank and Seoul Bank and hired outside
                              experts to develop a privatization plan, and (3) hired experts to conduct
                              due diligence with respect to the balance sheets of merchant banks and to
                              assess the rehabilitation plans.

Other Structural Measures     Other measures included in Korea’s initial IMF agreement were reforms in

                            • trade liberalization,

                            • capital account liberalization,

                            • corporate governance and corporate structure,

                            • labor market reforms, and

                            • information provisions and program monitoring.

                              The reforms for trade liberalization were part of changes already
                              underway in line with Korea’s World Trade Organization commitments and
                                                                             23
                              were accelerated during Korea’s IMF program. The changes in Korea’s

                              standards are formula-based and apply risk-weights to reflect different gradations of risk. Since 1992,
                              the rules have been amended. One of the most notable change is the establishment of risk-based
                              capital requirements to cover market risk in bank securities and derivatives trading portfolios.
                              23
                               For more specifics on Korea’s efforts to liberalize its trade policies, see International Monetary Fund:
                              Trade Policies of IMF Borrowers (GAO/NSIAD/GGD-99-174, June 22, 1999).




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                            The IMF’s Financial Arrangement With South Korea




                            capital account were aimed at increasing competition and efficiency in the
                            financial system. The schedule for allowing foreign entry into the domestic
                            financial sector was to be accelerated. The United States supported these
                            reforms and sought to move them forward quickly. Treasury officials told
                            us that these were conditions they considered necessary to address
                            underlying structural problems. More details were added in later
                            agreements about the other structural reforms. For example, details about
                            support for Korea’s social safety net were added after the first quarterly
                            review in February 1998.

                            As part of monitoring Korea’s progress in meeting IMF conditions, the IMF
The IMF Made                conducted quarterly reviews. After these quarterly reviews, monetary and
Adjustments in              fiscal targets were revised for the conditions outlined in the original IMF
Performance Criteria        agreement. From the initial review to Korea’s present program, the IMF
                            added details and conditions to structural reforms that address underlying
After Each Review           problems in the financial and corporate sector. According to IMF,
                            Treasury, and State Department officials, changes in conditions for Korea’s
                            program reflected the progress made under the IMF’s program.

                            Korea’s initial program was intended to restore market confidence and
                            limit private capital outflows through the large financing package, which
                            was heavily front loaded, together with sound economic policies.
                            However, according to program documents and our discussions with IMF
                            officials, the program was not initially successful in restoring investor
                            confidence, and private capital outflows far exceeded program
                            projections. According to IMF officials, the changes made to Korea’s
                            macroeconomic targets reflected worsening conditions in the external
                            environment (for example, the weakening of the Japanese yen, affecting
                            Korea’s export competitiveness) and were adjusted to match actual
                            economic data. Nevertheless, the IMF was criticized for the fact that the
                            policies taken in Korea to stabilize the economy caused monetary
                            conditions to become too tight. IMF and Treasury officials told us the IMF
                            projections were overly optimistic at the beginning of the program, based
                            on Korea’s past positive growth, and emphasized that the IMF did not
                            accurately project the “rolling financial crisis” throughout Asia.

Within First 2 Weeks, the   According to IMF officials and program documents, Korea’s response to
                            the program was slow at first because of its national presidential election
IMF Modified Korea’s        on December 18, 1997. The positive impact of the announcement of the
Program to Accelerate       IMF program on exchange and stock markets was small and short-lived. In
Funding Disbursements       the 2 weeks from the announcement until the first biweekly review, the
                            won dropped to its low of 1963 won per dollar on December 23, 1997.
                            Before the crisis, the value of the won was 915 to the dollar on September



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The IMF’s Financial Arrangement With South Korea




30, 1997. Investor confidence was further undermined by doubts about
Korea’s commitment to the IMF program, as the leading candidates for the
presidential election hesitated to endorse it publicly. Moreover, new
information became available about the state of Korea’s financial
institutions, the level of its usable reserves, and short-term obligations
falling due, raising concerns among investors about Korea’s widening
                24
financing gap. Part of Korea’s agreement was to improve transparency in
its financial reporting because the levels of usable international reserves,
corporate debt, or banks’ nonperforming loans had not been readily
apparent from published data.

A temporary agreement was reached with the private, foreign bank
creditors on December 24, 1997, to continue lending to Korean borrowers
(to roll over short-term loans), and discussions on voluntary rescheduling
of short-term debt were initiated. At the same time, Korea issued another
letter of intent requesting the IMF to accelerate its funding, which the IMF
agreed to do. Specifically, on December 24, 1997, Korea asked the IMF to
modify the disbursement date under the stand-by agreement to December
30 from the original date of January 8, 1998, to permit an advancement of
its IMF drawings. In negotiating the advancement of funds, Korea agreed
to strengthen its structural reform agenda to accelerate financial sector
restructuring and facilitate capital inflows into the domestic economy and
bond market. Interest rates were raised significantly to about 30 percent at
end-December 1997 from rates of about 12 percent in September 1997.
Conditions for the Bank of Korea to provide foreign currency liquidity
support to banks were tightened. One condition (quantitative performance
criterion) of the IMF agreement was to raise the interest rate on Bank of
                                                       25
Korea foreign exchange loans to commercial banks. These actions were
considered a signal of a clear commitment by the incoming administration
to support reforms under the IMF program.

According to IMF documents, signs that Korea’s economy was stabilizing
emerged by the time of the second biweekly review on January 8, 1998.
Korea met the end-December 1997 quantitative performance criteria for
the net domestic assets and net international reserves. The other
conditions for the review were met, and efforts to liberalize Korea’s capital
account were accelerated substantially. For example, Korea lifted the
24
   According to Treasury officials and IMF documents, a leak of IMF documents to the press released
specific information on two Korean banks and the low levels of usable international reserves that had
not been readily apparent from public sources. IMF documents showed the actual adjusted net
international reserves as a negative $3 billion at the end of December 1997.
25
 The rate was gradually increased from 400 basis points above LIBOR on December 2 to 1,000 basis
points by December 23, 1997, and would be raised further, if necessary.




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                         Appendix V
                         The IMF’s Financial Arrangement With South Korea




                         restriction on foreign borrowing of over 3-year maturity on December 16,
                         1997.

                         To address Korea’s vulnerability to its short-term debt and improve its
                                        26
                         rollover rates, on January 28, 1998, Korea reached an agreement-in-
                         principle with private bank creditors. IMF and Treasury documents note
                         that this agreement was a voluntary rescheduling of Korean banks’ short-
                         term debt into loans with longer-term maturities. The agreement covered
                         interbank deposits and short-term loans maturing during 1998, equivalent
                         to about $22 billion.

First Quarterly Review   The IMF completed its first full quarterly review of Korea’s program in
                         February 1998. According to IMF documents, Korea’s exchange market
Showed Korea’s Market    situation was improving, but there were growing signs of a decline in
Situation Improving      economic activity. According to IMF, Treasury, and Korean officials, the
                         agreement with bank creditors had helped to improve Korea’s financing
                         conditions. Korea’s usable reserves had increased, and the won had
                         appreciated by nearly 20 percent from the low in late December 1997.

                         In terms of fiscal policy, the IMF said it had proved difficult to adjust
                         government spending rapidly. With the large currency depreciation
                         occurring and domestic demand contracting, the IMF made adjustments in
                         Korea’s program. The revised program was based on lower (but still
                         marginally positive) growth projections. The fiscal target for 1998 was
                         lowered from a surplus of 0.2 percent of GDP in the original program
                         (including bank restructuring costs) to a deficit of 0.8 percent of GDP. The
                         IMF and Korea agreed that Korea would maintain a tight monetary policy
                         as long as the exchange market situation continued to be fragile.

                         While Korea had already taken a number of steps to implement the
                         program’s comprehensive structural reform agenda, the revised program
                         specified additional commitments in financial sector restructuring and
                         capital account and trade liberalization. For example, Korea was to
                         establish a unit for bank restructuring under the Financial Supervisory
                         Board with adequate powers and resources to coordinate and monitor
                         bank restructuring and the provision of public funds. Korea established
                         this unit in April 1998.
                         26
                            The effective rollover rate is defined as the proportion of short-term loans by foreign lenders to
                         domestic financial institutions that are either rolled over or are matched by the opening of new lines of
                         credit. This term is considered the rate that investments are converted or “rolled over” into another
                         investment. The term is often used by banks when they allow a borrower to delay making a principal
                         payment on a loan. Also, a country that has difficulty in making its debt payments may be granted a
                         rollover by its creditors. With governments themselves, rollovers in the form of refundings or
                         refinancings are routine.




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                            The IMF’s Financial Arrangement With South Korea




                            After the new government took office in late February 1998, business,
                            labor, and the government reached a tripartite accord. Based on this
                            accord, the reform agenda was broadened to include measures to
                            strengthen the social safety net, increase labor market flexibility, promote
                            corporate restructuring, and enhance corporate governance.

At Second Quarterly         According to IMF documents and announcements, Korea’s program
                            remained on track, and market confidence in the new government’s
Review, the IMF Reported    commitment strengthened. Growth projections were marked down further
that Korea’s Reforms Were   during the second quarterly review, which was completed May 29, 1998.
on Track                    Korea had successfully launched a global sovereign bond issue, significant
                            capital inflows into the domestic stock and bond market had been
                            registered, and usable reserves now exceeded $30 billion. According to
                            IMF documents, Korea’s sharp decline in economic activity, however, was
                            weighing heavily on corporations, necessitating an acceleration of
                            structural reforms in the financial and corporate sectors. Korea had
                            lowered interest rates, but monetary policy continued to focus on
                            maintaining exchange market stability. In view of the weaker outlook for
                            growth, the fiscal target was eased further to permit automatic stabilizers
                            (that is, adjustments in tax and government spending) to take effect.

                            In Korea’s July 1998 letter of intent, Korea reported that it had made
                            substantial progress in overcoming its external crisis. However, market
                            sentiment weakened somewhat in June in view of growing concerns about
                            the domestic recession and the impact of economic conditions in the
                            region. Nevertheless, the won remained broadly stable and appreciated vis-
                            à-vis the U.S. dollar in July, permitting Korea to further lower interest rates
                            to pre-crisis levels. The Korean government prepared a supplementary
                            budget to support economic activity and strengthen the social safety net.
                            Output was now projected to decline by 4 percent in 1998, inflation had
                            decelerated and was expected to average 9 percent during the year, and
                            the current account surplus was expected to reach nearly $35 billion (over
                            10 percent of GDP).

The IMF’s Third Quarterly   The IMF’s third quarterly review, completed on August 28, 1998, focused
                            on a further easing Korea’s macroeconomic policies to mitigate the
Review Focused on           severity of the recession and on strengthening Korea’s structural reform
Strengthening Structural    agenda. For example, Korea broadened its corporate restructuring efforts
Reforms                     significantly, supported by the World Bank. In a July 23, 1998,
                            memorandum of understanding between the government of Korea and the
                            World Bank, Korea agreed to develop a framework and capacity to do
                            voluntary corporate workouts and to provide policy support for corporate
                            restructuring, in addition to taking other actions to reform the corporate



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                             Appendix V
                             The IMF’s Financial Arrangement With South Korea




                             sector. By the end of October 1998, Korea had drawn $27.2 billion of the
                             total financing package for Korea, including $18.2 billion from the IMF and
                             $9 billion from the World Bank and the Asian Development Bank.

                             Output was projected to contract by 5 percent in 1998, inflation had
                             decelerated further and was expected to average 8.5 percent during the
                             year, and the current account surplus was still expected to reach nearly
                             $35 billion. Exchange market conditions permitting, interest rates were to
                             be lowered again. According to Korean officials, they reluctantly agreed
                             with the IMF to raise Korea’s fiscal deficit target to 4 percent of GDP.
                             Korea introduced a supplementary budget to increase government
                             spending, including additional spending for social programs for those most
                             affected by Korea’s recession.

IMF Staff Recommended a      The IMF completed its fourth review of Korea in December 1998. The IMF
                             staff recommended, and the Executive Board granted, a waiver for the
Waiver in Fourth Quarterly   structural performance criterion to obtain bids for the sale of two Korean
Review                       banks. According to IMF staff, Korea’s implementation of policies had
                             been good, and all their quantitative criteria had been observed. It was
                             apparent that Korea would not obtain bids for selling two Korean banks by
                             the November 15, 1998, deadline, although the bidding process had begun.
                             Since the World Bank was assisting Korea with this process, according to
                             IMF staff, completing this action was a matter of timing, and it was
                             necessary to allow a sufficient period for Korea to complete these
                             negotiations. This action has since been completed.

Fifth Quarterly Review       The IMF Executive Board met on April 7, 1999, for Korea’s fifth quarterly
                             review. According to IMF documents, the Korean authorities met all their
Completed                    quantitative performance criteria for end-December 1998 and fulfilled its
                             policy commitments under the program. However, the IMF staff
                             recommended waivers for (1) completing an audit of Korea’s Asset
                             Management Corporation to reflect any losses identified during the audit
                             in its financial statement and (2) delivery of recommendations based on a
                             financial supervisory review of the Korea Development Bank. According to
                             IMF and Treasury officials, Korea has since completed these actions.
                             Korea completed its audit of Korea’s Asset Management Corporation on
                             March 12, 1999, and the losses identified during the audit were reflected in
                             its financial statement as of April 30, 1999. Also, Korea’s Financial
                             Supervisory Commission finished its supervisory examinations of the
                             Korea Development Bank on March 20, 1999, (within the timetable of the
                             review) and made recommendations to the Ministry of Finance and
                             Economy on April 26, 1999.




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                        The IMF’s Financial Arrangement With South Korea




                        IMF, Korean, U.S. Treasury, and State Department officials we spoke with
Status of Program—      were consistent in their views that Korea’s reform efforts remain strong,
Reform Efforts Remain   but difficult reforms still need to be made in Korea’s corporate sector. As
Strong                  noted earlier, Korea’s program began slowly due in part to a presidential
                        election. But to date, Korea has made substantial progress in its financial
                        sector reforms. The U.S. Department of the Treasury reported to
                                   27
                        Congress that Korea had complied with its IMF program. The Treasury
                        reported that Korea’s external financing crisis has been alleviated—the
                        Bank of Korea’s usable foreign exchange reserves recently surpassed $50
                        billion, reflecting a current account surplus in 1998 of nearly 12 percent of
                        GDP and strong net inflows of portfolio capital. According to the
                        Treasury’s report, Korea’s short-term external liabilities declined by nearly
                        half, from $63.2 billion at the end of 1997 to an estimated $32.5 billion at
                        the end of 1998. The Treasury also reported that Korea’s continued
                        adherence to the restructuring program set forth by the IMF and World
                        Bank will be crucial to Korea’s sustained recovery. Korea has already
                        begun to repay its IMF borrowings for a total of about $6.1 billion, as of
                        April 30, 1999.

                        According to Korean government documents, Korea’s domestic economy
                        remains weak, although stable. While Korea’s economy still is vulnerable
                        to external shocks, the government is projecting growth for 1999. IMF
                        officials have changed its growth projections for 1999 from a negative 1
                        percent to a positive 2 percent GDP growth rate. As of April 1999, other
                        private sector projections for Korea were also more optimistic. Some
                        officials we spoke with noted that Korea still faced difficult reforms in its
                        corporate sector and emphasized that it would take time for Korea to
                        complete the reforms they have begun.




                        27
                         This report was the Treasury’s first semi-annual report, dated March 15, 1999, to the U.S. Senate
                        Committees on Banking, Housing, and Urban Affairs and on Foreign Relations, in addition to the U.S.
                        House of Representatives’ Committees on Banking and Financial Services and on International
                        Relations. This report provided details on financial stabilization programs in Brazil, Indonesia, and
                        Korea.




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Appendix VI

The IMF's Financial Arrangement with Russia


              When the Soviet Union disintegrated in 1991, Russia suffered a massive
Summary       output collapse, with real GDP estimated to have fallen by 35 percent
              during 1991-94. Since the dissolution of the Soviet Union, Russia has
              borrowed from multilateral, official bilateral, and private creditors to meet
              its financing needs. Beginning in 1992, the IMF became the main vehicle
              for assisting Russia and promoting economic reform. The IMF faced the
              challenging task of helping Russia achieve financial stabilization while
              making rapid progress in transforming the economy to a market-based
              system. This was difficult from the start, as the reformers never had full
                                             1
              control over economic policy. Nevertheless, Russia was then, and
              remains, a focal point of U.S. national interests. Russia’s political and
              economic stability are critical for the rest of the former Soviet Union,
              Eastern and Central Europe, and bordering areas. Further, Russia is a
              nuclear superpower and has large supplies of some of the world’s key
              resources, including oil, natural gas, and strategic metals. According to the
              IMF, the world’s stake in Russian reform has been too critical not to make
              the effort to help the economy.

              Russia negotiated the now-terminated $10 billion, 3-year Extended Fund
                                    2
              Facility arrangement with the IMF in March 1996. Disbursements under
              the EFF were to be largest in the 1st year (65 percent of the quota in the
              first year and 55 percent in the second and third years); they were to be
              made monthly until early 1997 and quarterly thereafter. Performance under
              the program, to be monitored through its quantitative targets, was also to
              occur on a monthly basis, switching to a quarterly basis beginning in 1997.
                                                                                   3
              (It was the only IMF program to be monitored monthly at the time.)
              Monthly “indicative targets” were established to serve as early warning
              signals of slippages in the program and to trigger the implementation of
              revenue measures in the event of deviations from the program revenue
              path. The 1996 program also contained a number (20) of structural
              benchmarks aimed at accelerating transition to a market-based system.
              These structural measures were formulated through intensive
              collaboration with the World Bank staff beginning June 1995, and Bank

              1
               The current President, Boris Yeltsin, and the Duma, the lower house of Russia’s parliament dominated
              by the Russian Communist Party, have frequently been in conflict. According to an IMF official,
              President Yeltsin, the Duma, regional governments, and portions of the federal executive all failed to
              support measures that were unpopular, especially with powerful interest groups.
              2
               The Extended Fund Facility (EFF) is designed to support medium-term programs that generally run
              for 3 years. The EFF aims to overcome balance-of-payments difficulties stemming from
              macroeconomic and structural problems. Repayments are made in 4½ to 10 years.
              3
               The IMF Executive Director representing Russia attributed the positive developments Russia
              achieved under adverse political circumstances during 1996 to the IMF’s stepped-up monitoring of
              Russia’s economy.




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Appendix VI
The IMF's Financial Arrangement with Russia




staff participated in every mission that dealt with structural policy
contents of the program.

During the IMF program, Russia achieved some notable successes
including sharply reduced inflation, a freely traded and convertible ruble,
the abolition of central planning, a reduction in trade barriers, and the
continued spread of privatization initiatives throughout Russia. Then, as
now, the critical problems facing Russia were fiscal and monetary
imbalances, combined with very slow progress toward a functioning
market-based economy. While external developments, including the Asian
crisis and associated weakness of energy prices, contributed to Russia’s
financial difficulties, the root cause of the unsustainable and intractable
fiscal situation was Russia’s inability to collect taxes. Building on the
earlier programs, the 1996 extended arrangement continued to press for
further reductions in the fiscal deficit and inflation, and for
implementation of the key structural reforms that underpin a market
economy. Increased revenue collection and improved government
expenditures were the centerpiece of the program, given Russia’s
significant weaknesses in these areas, which persisted during the entire
program.

Between March 1996 and July 1998, there were 12 reviews of the program,
most of which included program modifications. Russia missed quantitative
performance criteria targets in more than half of these reviews, and the
IMF delayed disbursements and/or program approval numerous times.
There are several explanations as to why Russia missed its targets:
elections and political uncertainty, high interest rates and large interest
payments, spending pressure and rise in arrears, investor uncertainty, and
capital outflow. However, the substantive reasons for Russia’s failure to
achieve key goals, according to the IMF, were a fundamental lack of
political will to collect revenues and the pervasive culture of nonpayment.
The staff always noted the uncertainties and risks the IMF assumed in
providing support to Russia. However, based on the IMF’s assessment that
Russia’s efforts warranted continued IMF support, the IMF granted
waivers for Russia’s nonobservance of quarterly performance criteria,
citing Russia’s exemplary cooperation with the IMF and the determination
of key senior officials to abide by the program.

Amidst the financial crisis of summer 1998, Russia requested and received
additional IMF funds on the condition that Russia undertake major tax and
other structural reforms. However, this was not enough to halt the crisis.
Russia’s persistently weak fiscal position and delays in structural reform,
in combination with the adverse impact of the declining price of oil on



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                                          Russia’s external balance and heavy reliance on short-term foreign capital
                                          inflows led to a full-scale banking and currency crisis by mid-August.
                                          Subsequently, Russia deviated so significantly from the program that the
                                          IMF halted further disbursements. In March 1999, the program was
                                          officially terminated upon Russia’s request. Currently the IMF and Russia
                                                                               4
                                          are negotiating a new arrangement. Key events are indicated in the
                                          timeline in table VI.1.

Table VI.1: Chronology of Key Events in
Russia’s IMF Arrangements (SDRs in
Millions)                                 Date                     Event
                                          Mar. 26, 1996            IMF Executive Board approves $10billion, 3-year EFF
                                                                   arrangement to Russia
                                                                                       st
                                          Mar. 29, 1996            Russia receives 1 tranche (233.63 SDRs)
                                                                    st
                                          Apr. 29, 1996            1 Monthly Review
                                                                   Modify deficit limit (strong spending pressure and revenue shortfall
                                                                   coming).
                                                                                                                  st
                                                                   Concern over presidential elections for the 1 half of 1996.
                                                                                       nd
                                          May 3, 1996              Russia receives 2 tranche (233.63 SDRs)
                                                                    st                       nd
                                          Jun. 5, 1996             1 Quarterly Review (2 Monthly Review)
                                                                   Modification of deficit target.
                                          Jun. 1996                Presidential election
                                                                                       rd
                                          Jun. 10, 1996            Russia receives 3 tranche (233.63 SDRs)
                                                                    rd
                                          Jun. 24, 1996            3 Monthly Review
                                                                   Missed May floor targets for international reserves for external
                                                                   reasons.
                                                                                       th
                                          Jun. 28,1996             Russia receives 4 tranche (233.63 SDRs)
                                                                    th
                                          Jul. 31,1996             4 Monthly Review completion delayed - program too far off track.
                                                                   Missed end-June targets: net domestic assets, monetary authority
                                                                   credit, reserves.
                                                                   Barely complied with deficit target.
                                                                   Lack of revenue collection effort.
                                                                   Broad performance modifications.
                                                                   Waiver for nonobservance of end-June targets.
                                                                                                 nd
                                                                   Postpone completion of 2 Quarterly Review.
                                                                   Delay in June disbursement.
                                                                                                                  nd
                                                                   Concerns over weak health of president in 2 half of 1996.
                                                                    th
                                          Aug. 24,1996             4 Monthly Review complete based on July targets
                                                                                       th
                                          Aug. 26,1996             Russia receives 5 tranche (233.63 SDRs)
                                                                    nd                        th
                                          Sep. 13,1996             2 Quarterly Review (5 monthly review)
                                                                   Focus on structural policies and found disappointing slippages.
                                                                   Missed additional end-June performance criteria: monetary
                                                                   authority credit to government, deficit of enlarged government.
                                                                   Waiver requested for nonobservance of additional end-June
                                                                   criteria.
                                                                                       th
                                          Sep. 18,1996             Russia received 6 tranche (233.63 SDRs)



                                          4
                                           The IMF’s Managing Director announced on April 28, 1999, that IMF staff and Russia had agreed on an
                                          economic program involving Fund finance of approximately $4.6 billion over 18 months. As of June 16,
                                          1999, the IMF Board had not approved the arrangement.




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Date                 Event
                       th
Oct. 9,1996          6 monthly review
                     Met all end-August targets.
                     Continuing pressure against ruble.
                                         th
Oct. 8,1996          Russia receives 7 tranche (233.63 SDRs)
                       rd                      th
Dec. 13,1996         3 Quarterly Review (7 monthly review) – completion delayed.
                     Missed 3 end-Sept. targets (deficits, reserves).
                     Missed 1 end-Oct. target.
                     Waiver for nonobservance of end-September performance criteria.
                     Modification of performance criteria.
                     Delay in Sept. and Oct. disbursements.
                                         th
Dec. 13,1996         Russia receives 8 disbursement (233.63 SDRs)
                       th                      th
Feb. 7, 1997         4 Quarterly Review (8 monthly review).
                     Complied with end-Dec. targets.
                                         th
Feb. 12, 1997        Russia receives 9 tranche (467.25 SDRs to make up for 1996
                     delays).
                     No disbursements until 1997 program approved; dependent on
                     implementation of prior actions; also purchase schedule revised.
                                                   th
May 16, 1997         Article IV Staff Report (9 monthly review) and approval of 1997
                     program.
                                            th
May 16, 1997         Russia receives 10 disbursement (500 SDRs)
Jun. 1997            Preliminary data show first signs of growth in years
                       th                         th
Sep. 3, 1997         5 Quarterly Review (10 monthly review)
                     Missed end-June cash revenue floor.
                     Signs of recovery becoming apparent.
                     Waiver for nonobservance of revenue target.
                                            th
Sep. 3, 1997         Russia receives 11 disbursement (500 SDRs)
Oct. 1997            Financial crisis in world financial markets affects Russia’s financial
                     markets.
                     Substantial foreign exchange outflows.
                     Decline in world oil prices.
                       th                         th
Jan. 8, 1998         6 Quarterly Review (11 monthly review) Completion delayed due
                     to non-observance of Jan.-Sept. 1997 performance criteria on
                     federal government revenue.
                     Program continues to face serious risks.
                     Persistent fiscal fragility relating to revenue collection and
                     expenditure control, and continued financial turmoil.
                     1997 progress: revitalization of privatization on transparent basis,
                     continued progress in closing and restructuring smaller banks, and
                     further rationalization of natural monopolies.
                     Missed end-Sept. targets: cash revenue and international
                     reserves.
                     End-Sept. performance criteria not operationally relevant.
                     Deviations from program path widened making achievement of
                     end-Dec. performance criteria impossible.
                     Modification requested for end-Dec. performance criteria (cash
                     revenue, monetary aggregates, net international reserves)though
                     Dec. performance criteria not available yet (being revised during
                           th
                     the 6 review).
                     Waiver of applicability of end-Dec. performance criteria.
                     Delay in Nov. disbursement.
                                         th
Jan.13, 1998         Russia receives 12 disbursement (500 SDRs)




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Date                  Event
Mar. 23, 1998         Prime Minister Chernomyrdin dismissed.
                      Weakening of oil prices.
Apr. 24, 1998         Duma approves Sergei Kiriyenko as Prime Minister
Mid-May 1998          Severe financial crisis in Russia coinciding with renewed financial
                      instability in South East Asia; reversal in market confidence; labor
                      unrest in Russia – miners’ strike.
                      No disbursements until 1998 program approved. Delay in approval
                      of 1998 program.
                      Contingent on implementation prior actions.
                      Fiscal targets revised with staff visits in April and May; also
                      purchase schedule revised.
                      Oil prices still weak.
                                                                             th
                      Staff supports request for extension of EFF for a 4 year.
                        th                      th
Jun. 12, 1998         7 Quarterly Review (12 review) and approval of 1998 program.
                      Missed end-March targets (federal cash revenue, deficit).
                      Waiver requested for noncompliance with end-Dec. (1997)
                      targets.
                      Delay in disbursement of quarterly tranche until June due to
                      cabinet changes and difficulty in meeting revenue package; fiscal
                      targets revised.
                                                                                  th
                      Russia requested extension of EFF arrangement for a 4 year
                                           th
Jun. 30, 1998         Russia receives 13 disbursement (500 SDRs)
Jun. 23-Jul. 16, 1998 IMF mission in Moscow to negotiate augmented package
Jul. 17, 1998         Russia requests augmentation of extended arrangement and
                      requests purchase under CCFF.
Jul. 20, 1998         IMF Board approves $11.2billion additional financial support to
                      Russia.
                      End-June data not available to assess compliance with June
                      targets, so requirement was waived.
Jul. 20, 1998         Russia receives disbursement, but amount reduced from $5.6 to
                      $4.8 billion because of delays in passing two key tax measures
                      (personal income tax and pension fund). No further payments
                      made.
Aug. 17, 1998         Russia government imposes unilateral restructuring of its ruble-
                      denominated sovereign debt and announces a 90 day moratorium
                      on private external debt payments.
                      Subsequently ruble depreciates by more than 60 percent.
Sep. 11, 1998         German government acknowledges that Russia missed virtually
                      all of a DM800 million interest payment due on August 20 on
                      Soviet era sovereign debt.
Sep. 11, 1998         Dissolution of the Kiriyenko government; Duma approval of
                      Yevgeny Primakov as Prime Minister.
Sep. 1998             Remaining $10.3 billion IMF commitment from the July 1998
                      package is no longer available. Negotiations begun on new
                      economic program.
Mar. 31, 1999         Program officially terminated at Russia’s request.
Apr. 28, 1999         IMF Managing Director announces that Russia and the IMF
                      agreed in principle on an approximately $4.6 million Stand-by
                      Arrangement; not yet approved by IMF Executive Board.
                                                                                         th
May 12, 1999          President Yeltsin dismisses Prime Minister Yevgeny Primakov (4
                      prime minister dismissed in 14 months).
Source: IMF and Russian government documents.




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                          The early IMF programs in Russia faced unsettled conditions, systemic
Early Programs and        problems, and large macroeconomic imbalances. During 1992-94, the initial
the Context of the 1996   period of market reform, Russia received financial assistance from the IMF
IMF Russia Programs       in the form of a first credit tranche Stand-By Arrangement (SBA) and two
                                                                                           5
                          purchases under the Systemic Transformation Facility (STF). From the
                          outset, the Russian economic programs focused on reducing
                          macroeconomic imbalances and moving toward a market-based economy.
                          The IMF, along with the World Bank and other bilateral and multilateral
                          agencies, also began providing a broad range of technical assistance that
                          would develop the supporting macroeconomic management capability.
                          These early programs were implemented under unsettled political and
                          constitutional conditions that severely complicated the already daunting
                          task of stabilizing the economy while transforming its basic features. While
                          significantly reducing the fiscal deficit and curtailing credit expansion
                          aided a decline in consumer price inflation from 2,500 percent at end-1992
                          to around 200 percent at end-1994, none of the programs was successfully
                          carried through: stabilization remained elusive, reforms fell short of the
                          goals, and inflation remained excessive.

Inflation Was a Primary   The 1995 SBA was negotiated over several months against the backdrop of
                          policy failures and worsening economic performance. For example, in
Focus of 1995 Stand-by    January 1995—midway through program negotiations—the monthly
Arrangement               inflation rate accelerated to 18 percent and there was a further $1 billion
                          reserve loss. The SBA was approved in April 1995, despite a large measure
                          of uncertainty regarding the Russian government’s ability and
                          determination to implement the program. The program itself was
                          characterized by what the IMF considered to be a large reliance on
                          expenditure restraint. The SBA program focused on Russia’s achieving a
                          substantial and sustained reduction in inflation, seen as essential for
                          economic recovery. This was to be effected by imposing an even tighter
                          monetary policy and a reduction of the deficit from 5 percent of GDP in
                          1996 to 2 percent of GDP in 1998. Although inflation in Russia declined
                          significantly in 1995 – the consumer price index was 134 percent at the end
                          of 1995 – it nonetheless remained significantly above the level targeted in
                          the SBA program.

                          The focus of the 1996 arrangement was on reducing fiscal and monetary
The 1996 Extended         imbalances while transitioning to a market-based economy. The primary
Fund Facility Program
                          5
                           The STF was a temporary facility in effect between 1993 and 1995 to assist transition economies. It’s
                          purpose was to provide financing to member countries facing balance-of-payments difficulties arising
                          from severe disruptions of their international trade and payments arrangements owing to a shift away
                          from significant reliance on state trading at nonmarket prices toward multilateral, market-based trade.




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                                problems were the fiscal deficit, weak tax collection, and excessive
                                government spending.

                                The recently terminated $10-billion, 3-year EFF arrangement, approved by
                                the IMF in March 1996, was negotiated on the heels of the 1995, 12-month,
                                SBA arrangement, under increasingly adverse political circumstances. The
                                program’s broad objectives were to achieve financial stabilization while
                                transitioning to a market-based economy and to lay the basis for sustained
                                growth. This was to be accomplished by reducing the budget deficit from
                                around 5 percent in 1995 to 4 percent in 1996 and 2 percent in 1998,
                                lowering the inflation rate from around a 7-percent monthly average in
                                1995 to 1.9 percent per month in 1996, and implementing key structural
                                reforms. In addition to improving tax administration and limiting
                                government expenditures, the fiscal strategy was to reduce the deficit by
                                improving revenue collections – raising the revenue-to-GDP-ratio from
                                around 10 percent in 1995 to 11 percent in 1996 and to 15 percent by 1999.
                                The monetary strategy was to continue to lower inflation and strengthen
                                the banking system by resolving the problem of weak and insolvent banks.

                                At the time the IMF and Russia were negotiating the 1996 arrangement, the
                                critical problems facing Russia were – and continue to be – fiscal and
                                monetary imbalances, combined with very slow progress toward a
                                functioning, market-based economy. At the heart of the fiscal deficit
                                problem lay weakness in tax revenue collection and government spending
                                in excess of what was affordable. To address the revenue problem, the
                                program focused on improved tax administration, collecting outstanding
                                tax arrears – especially from the energy sector – and eradicating the
                                culture of nonpayment. The Russian government also agreed to resist
                                strong spending pressures and to make cuts in noninterest spending to
                                achieve the deficit reduction target. A restrained credit stance was
                                intended to lower inflation further toward a single-digit annual rate and to
                                serve as the first line of defense against depreciation pressures on the
                                ruble. The 3-year EFF program also continued to press for implementation
                                of the structural reforms key to a market-based economic system,
                                including improving the structure of government spending and treasury
                                functions, strengthening the banking system, reaccelerating the
                                privatization process, and completing the process of trade policy
                                liberalization.

Need to Strengthen Balance of   IMF funding in 1996 was also seen as critical for Russia to establish
Payments                        medium-term balance-of-payments viability. At the time of the 1996
                                extended arrangement, the IMF described Russia’s trade balance as
                                “robust”: the trade balance had been in surplus since 1993. However, the



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                             current account was expected to weaken over the next few years as
                             investment recovered, private savings declined, and imports rose. Also,
                             Russia was experiencing a basic weakness in its external accounts, due in
                             part to net short-term capital outflows and an inadequate level of reserves.
                             Further, a bunching of debt service obligations was expected to occur
                             between 1996 and 2000. IMF funding was viewed as critical in catalyzing
                             both Paris and London Club debt rescheduling and encouraging the inflow
                             of capital to the private sector. This would reduce the future burden on the
                             federal budget and strengthen Russia’s balance of payments.

Progress Measured by         Key to evaluating Russia’s progress in the program, and to the decision to
                             release the next quarter’s loan tranche, were the quarterly performance
Quantitative Performance     criteria. These quantitative quarterly performance criteria included the
Criteria and Structural      following fiscal, monetary and international reserve targets:
Policy Benchmarks
                           • federal and enlarged (including regional and extrabudgetary funds)
                             government deficit,
                           • federal government cash revenue floor,
                           • limit on the stock of net domestic assets of the monetary authority (that is,
                             currency in circulation and bank deposits at the Central Bank of Russia,
                             [CBR]),
                           • limit on the monetary authority’s claims on the federal and enlarged
                             government, and
                           • floors on both gross and net international reserves.

                             The 1996 plan was based on an ambitious structural reform program aimed
                             at improving the functioning of markets. The following are some of the 20
                             structural benchmarks proposed under the 1996 program:

                             By March 31, 1996, Russia was to complete an evaluation of the financial
                             condition of the 10 largest banks.

                             By June 30, 1996, Russia was to

                           • establish procedures for gas prices to reflect variation in transmission
                             costs to launch audit of 5 major fully or majority-owned state owned
                             enterprises and
                           • submit legislation for move to an accruals-based system for the profit and
                             value added tax.




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                      By September 30, 1996, Russia was to

                    • ensure that all remaining import duties rates above 30 percent are replaced
                      with excise taxes,
                    • submit specific legislation to improve the fiscal relations between the
                      federal and subnational governments, and
                    • conclude an evaluation of the financial situation of the 200 largest banks.

                      By December 31, 1996, Russia was to

                    • complete an annual audit of the Pension and Employment Funds
                      according to international standards,
                    • prepare a list and launch an audit of an additional 5 major enterprises in
                      which the state has full of majority ownership, and
                    • initiate an implementation procedure to deal with problem banks.

                      Russia also had to undertake certain prior macroeconomic actions (for
                      example, introduce additional revenue measures) and structural policy
                      actions (for example, revoke import restrictions on alcoholic beverages)
                      before the IMF Executive Board would approve the 1996 EFF program.
                      Both structural performance benchmarks and prior actions for IMF Board
                      reviews of the program were altered frequently throughout the program to
                      reflect changing conditions.

                      Overall, the IMF determined that Russia’s efforts during 1996 fell short of
IMF Board Reviews     the targets. There were seven program reviews during the program’s first
                      year. These seven reviews included four instances of program
                      modification, three occurrences of waivers for nonobservance of
                      performance criteria, and three delays in disbursements. While Russia had
                      success in moderating inflation – the monthly average inflation rate for
                      1996 was 1.7 percent – there was less success in achieving fiscal goals. For
                      1996, the federal deficit registered 6.3 percent of GDP instead of the
                      planned 4 percent, and federal revenues fell from 10.5 percent of GDP in
                      1995 to only 9.5 in 1996, in contrast to the targeted increase of nearly 1
                      percent in 1996. Moreover, exchange rate stability was bought at the
                      expense of a significant loss of reserves. Additionally, progress in pursuing
                      structural reforms was disappointing, according to the IMF. In the first half
                      of 1996, uncertainties related to the election outcome influenced fiscal
                      performance and revealed the fragility of the 1996 fiscal framework; in the
                      second half of 1996, concerns about the health of the Russian president
                      contributed to heightened uncertainty. More fundamentally, however,
                      fiscal slippages were attributable to a lack of sufficient political
                      commitment to insist on the payment of tax liabilities, especially by large



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                            taxpayers, as well as the weak capacity of tax administration and the
                            deficiencies in the tax system. Nonetheless, while they delayed the
                            completion of a number of reviews for failure to meet program conditions,
                            the IMF staff continued to recommend approval of the program, despite
                            uncertainties about the government’s capacity to implement it, because, as
                            the staff said, the new government demonstrated strong leadership, which
                            could lead to a successful program if backed at the highest level.

Program Adjustment and      Russian presidential election concerns dominated the first half of 1996.
                            During this period, the IMF reviewed the program four times (three
Disbursement Delays         monthly reviews and one quarterly review), modifying the deficit limits in
Marked the First Four       the first two reviews and making broad performance modifications in the
Months of Program Reviews   fourth month review. Inflation continued to decline as the monetary
                            authority adhered to a tight credit stance, and the central bank was able to
                            maintain a stable exchange rate corridor despite the political uncertainty
                            and pressure toward ruble depreciation. There were other positive
                            developments: Russia had (1) achieved some structural reforms in banking
                                                             6
                            and tax-related fiscal measures; and, (2) satisfied the quantitative targets
                            in the first two reviews, aided by modification of the deficit limits to
                            accommodate the clearance of accumulated wage arrears and the jump in
                            treasury bill rates. However, the fiscal situation remained quite vulnerable,
                            owing to both internal and external factors. The continuing weakness in
                            revenue collection reflected the lack of will to enforce existing law,
                            deficiencies in the tax system, rising tax arrears, and strong spending
                            pressures with the approaching June presidential elections. The higher
                            treasury bill rates, which raised the interest payments to higher levels than
                            assumed under the program, was in large part due to the highly charged
                            political environment. On this basis, Russia and the IMF agreed to an
                            upward adjustment in the deficit ceiling, while securing the government’s
                            commitment to focus on collecting tax arrears. Two other areas that were
                            also a source of ongoing concern were the sustained depreciation
                            pressures on the ruble, which put the international reserve targets at risk,
                            and the sluggish progress on structural reforms. The staff also attributed
                            the pressure against the ruble, and the consequent loss in reserves, to the
                            market sensitivity generated by this historic, election-dominated situation.




                            6
                             At the second monthly review, on May 29, 1996, Russia had fulfilled 3 of the 20 structural benchmarks
                            and 19 of the 38 structural measures.




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Officials Committed To       Throughout this period, the IMF staff commented on the determination of
                             key senior officials to abide by the program, noting their commitment and
Program, But Systemic        determined efforts. However, the completion of the fourth review and the
Weakness in Tax Revenue      disbursement of the July tranche was postponed until late-August because
Collection Continue          the program had gotten too far off track. Russia had missed its monetary
                             targets and had barely complied with the deficit target. The main concern
                             was the progressive weakening of the federal government’s cash tax
                             revenues, reflecting an environment in which paying taxes appeared to be
                             more a matter of choice than an obligation. The upcoming heavy interest
                             payment schedule and accumulation of wage and pension arrears made
                             the deficit target virtually out of reach. Hence there was a broad
                             reassessment of policy requirements for the remainder of the year to bring
                             the program back on track. The completion of the fourth review was made
                             conditional upon Russia’s meeting end-July targets as modified and
                             significantly increasing tax revenues. Russia also received a waiver for
                             nonobservance of end-June targets. In the end, the IMF staff’s support for
                             the program reflected their assessment that immense pressures had led to
                             Russia’s missing the targets, that the Russian authorities were taking
                             actions to bring the program back on track, and that the Russians’ efforts
                             “deserve the benefit of doubt and warrant continued Fund support.”

Missed Targets, Waivers,     Three reviews were completed from August through December 1996
                             (following the completion of the fourth review). The first review focused
Program Modifications, and   on progress in structural policies and found the results disappointing,
Delays in Disbursement       though structural reform efforts had been recently stepped up. Fourty-four
Characterized the            modifications were proposed for the structural program, and the Russian
Remainder of the 1996        authorities agreed to a revised set of 10 new structural benchmarks for the
                             remainder of the year. During this period, the IMF continued to encourage
Program                      the government to open the treasury bill market to nonresidents so that
                             Russia could have better access to private capital markets. The CBR
                             officials agreed in principle but expressed concerns regarding the volatility
                             of foreign capital inflows that could easily be converted into dollars rather
                             than rolled over into new debt. Meanwhile, by September, the dominant
                             concern was continuing pressure on the ruble and international reserves,
                             despite the favorable inflation trend and the cautious macroeconomic
                             policy. The IMF staff believed that noneconomic, temporary, and
                             reversible factors such as concerns about President Yeltsin’s health, the
                             postponement of the completion of the fourth review, changes in the rules
                             governing nonresident access to the Treasury bill market, and concern
                             about the health of the banking system contributed to the exchange
                             market pressure. While continuing to note the major risks and difficulties
                             in the Russian situation, the IMF maintained a cautious optimism that the




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                             authorities would address these problems and continue to achieve
                             program objectives.

At Third Quarter Review,     However, by the third quarterly review, originally scheduled for
                             completion in October 1996, Russia had gotten too far off the program, and
Program Off Track, and       the review was delayed until December. Consequently, both October and
Review and Disbursement      November disbursements to Russia were delayed. Russia had missed the
Delayed–Weakness in          September international reserve and deficit targets – the deficit of the
Revenue Collection at        federal government amounted to 6.7 percent of GDP. There was a marked
                             deterioration in revenue performance because of a tax code change that
Source                       gave priority to wage payment over meeting tax payments: revenues had
                             declined to 9 percent of GDP at November 1996. The nonobservance of the
                             deficit target was due, in part, to the need to make large interest payments
                             on treasury bills that had been issued at high interest rates in the second
                             quarter. But more fundamentally, the deficit continued to originate from a
                             weakness in revenue collection due to a lack of government resolve to
                             enforce tax laws. As a result of weaker-than-anticipated revenue and
                             higher-than-anticipated interest payments, the IMF and Russia agreed to
                             modifications to the fiscal and monetary performance criteria for end-
                             December 1996. These modifications were to serve as the first step of the
                             1997 program. Also, understandings were reached on a comprehensive
                             action plan that sought to improve revenue collection by creating a tax-
                             paying culture in Russia rather than just proposing tax measures.

Progress in Structural       The IMF staff noted that, in hindsight, the structural work plan might have
                             been too ambitious for Russia to manage, given its limited institutional
Reform Lagging, Fiscal       capacity. Even though program revisions had just been introduced in
Situation Difficult–Waiver   August/September to reflect the slower pace of implementation of
Granted Based on Good        structural reforms in the first half of 1996, progress in the structural policy
Faith Efforts                agenda was still lagging at this time. With the important exception of
                             banking reform – where actions were in line with the program – structural
                             reforms fell short of the objectives in all areas in 1996. Only two of the
                             seven structural benchmarks that were the subject of this review had been
                             met, and immediate action was required before the staff could recommend
                             completion of the third quarter review. At the end of 1996, the situation in
                             Russia remained fragile, and the fiscal situation was difficult. However, the
                             staff determined that the authorities continued to demonstrate their firm
                             intention to maintain a restrained credit stance to forestall inflation and to
                             reduce pressure on international reserves. The staff also acknowledged the
                             authorities’ good faith efforts and exemplary cooperation with the IMF. In
                             the end, the IMF granted Russia a waiver for its nonobservance of end-
                             September performance criteria.




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Approval of 1997 Program      The completion of the May 1997 Article IV staff report also gave the
                              Executive Board’s approval of the 1997 EFF program. The report followed
Delayed Pending               the April negotiations and the setting of program targets. The approval
Completion of Prior Actions   came after Russia implemented a series of prior actions, including
                              submission of the tax code and a new 1997 spending plan to the Duma, a
                              crackdown on large tax debtors, and announcement of transparent
                              privatization procedures. The 1997 program included a revised schedule of
                              disbursements for the 1997 program year (Russia had received no program
                              disbursements since the one following the completed eighth month review
                              in mid-February 1997). As envisaged under the program, performance was
                              to be monitored quarterly on the basis of quarterly performance criteria.
                              However, because of the significant risks that Russia still faced, the IMF
                              continued to closely monitor developments throughout the period of the
                              extended arrangement.

                              A major focus of the fiscal program in 1997 was the reversal of the
                              declining trend in federal cash revenues in relation to GDP and the
                              elimination of the use of noncash revenue sources. Cash revenues were
                              targeted to increase, on average, to 8.3 percent of GDP in 1997, compared
                              with 7 percent of GDP in 1996. To improve revenue collection, the Russian
                              authorities agreed to major tax reform and the full implementation of the
                              comprehensive November 1996 action plan. The annual limit on the federal
                              deficit in 1997 was set at 5.5 percent of GDP, higher than the original EFF
                              target of 3 percent of GDP for 1997, but lower than the 6.3 percent deficit
                              at yearend 1996. A further reduction in inflation to a monthly rate of 1
                              percent in 1997 was one of the program’s main economic goals. In addition
                              to implementing the November 1996 action plan in full, the structural
                              program for 1997 was designed to accelerate the process of building the
                              institutional and legal framework to support a market economy. Table VI.2
                              shows Russia’s performance in some critical areas.




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Table VI.2: Russian Federation: Federal
Budget Aggregates and Inflation, 1993-                                                                                           1997 IMF
1997 (in Percent of GDP)                                                 1993             1994            1995        1996       Program
                                          Revenue                        13.7             11.8            10.6         9.5           9.4
                                           of which:
                                            Cash                         13.7             11.4              9.1        7.0             8.3
                                          Expenditures                   20.2             23.2             15.4       15.8            15.0
                                            Noninterest                  18.2             21.2             12.5       11.3            10.8
                                            Interest                      2.0              2.0              2.9        4.5             4.2
                                          Fiscal deficit                 -6.5            -11.4             -4.8       -6.3            -5.5
                                          Inflation                     874.5            307.4            197.4       47.6            14.2
                                          (annual                                                                            (actual 1997,
                                          percent                                                                                    14.6)
                                          change)
                                          Source: Various IMF documents.


Positive Developments in                  Preliminary data at this time were showing that the economy had begun to
                                          turn around since the third quarter of 1996. Output appeared to have
First Half of 1997                        stabilized in 1997 after years of decline; inflation continued to decelerate –
                                          the monthly percent change for the last quarter of 1996 had declined to 1.7
                                          percent; and the exchange rate was stable. Structural reforms had gained
                                          momentum in the areas of natural monopolies and public utilities, and the
                                          government had eased restrictions on access to capital markets by
                                          nonresidents. While the authorities had used a sizable reserve cushion to
                                          defend the ruble during 1996, there was a reversal of exchange market
                                          pressure in the first half of 1997 attended by large capital inflows. The
                                          easier monetary conditions due to the capital inflows and the clearing up
                                          of arrears brought with them the associated risk of renewed inflation, and
                                          the IMF monetary program was revised for the second half of 1997.
                                          Compared to the severe difficulties experienced in 1996, the developments
                                          during the first half of 1997 were encouraging. The IMF staff noted,
                                          however, that there were still considerable uncertainties in Russia, and
                                                                                                      7
                                          that the IMF assumed a potentially large exposure to risk in providing
                                          support to the country. Given Russia’s substantial reliance on energy
                                          exports, there was also a risk of external shocks, for example, due to a
                                          decline in the price of oil or gas. Amid uncertainties about the
                                          government’s capacity to implement the program, the IMF approved the
                                          1997 program based on the strong leadership demonstrated by the new
                                          government as well as the completion of the prior actions.




                                          7
                                              The risk that Russia would not be able to repay the loan.




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                                The IMF's Financial Arrangement with Russia




Fall 1997: Ripple Effects       In mid-1997, the economic crisis that started in Thailand quickly spread to
                                other Asian countries and to Russia, aborting the nascent economic
From the Asian Financial        recovery that had just begun in Russia after 8 years of deep output decline.
Crisis Spill Over to Russia’s   From October 1997 on, Russia continued to experienced recurrent
Financial Markets,              financial crises. The government and the CBR attempted to protect the
Compounding Russia’s            main economic policy achievements of the recent years—low inflation, a
                                fixed ruble, and the living standards of the people – through foreign
Fiscal Problems                 exchange market interventions and interest rate hikes, both seen as
                                needed to defend the ruble.

Waivers, Modifications, and     The spillover from the Asian financial turbulence in the fall of 1997 spread
                                to Russia’s financial markets and further undermined investor confidence,
Program Delays Ensue            already adversely impacted by Russia’s ongoing fiscal problems. Federal
                                cash revenue collections were not improving, and the government was
                                able to achieve the deficit target only by holding down cash expenditures,
                                thus creating new expenditure arrears. Substantial foreign exchange
                                outflows accompanied the financial turbulence. The CBR’s response was
                                to sell foreign exchange and, later, to raise interest rates. Consequently,
                                Russia was unable to meet its international reserve target. Originally
                                intended to be an assessment of end-September performance, the IMF’s
                                sixth quarterly review and the corresponding quarterly disbursement were
                                delayed until January 1998. The delay was due to the serious underlying
                                weakness and slow progress in addressing the fiscal problems, as
                                indicated by the nonobservance of the government revenue performance
                                criterion from January to September 1997. The review also indicated that
                                the September performance criteria, which Russia did not meet, were no
                                longer operationally relevant. The December criteria were being modified,
                                as they were no longer attainable either, and thus could not be applied
                                against Russia’s performance yet. Thus, the review requested a waiver of
                                                                                       8
                                the applicability of December performance criteria. During this period,
                                structural reforms proceeded generally as envisaged under the 1997
                                program, particularly in the areas of natural monopolies (gas) and
                                privatization, and there was continued progress in closing and
                                restructuring smaller banks. Overall, however, the IMF staff recognized
                                that the program continued to face serious risks.




                                8
                                 A “waiver of applicability” generally is used when a review slips. If the IMF staff believes it cannot
                                certify the country’s compliance with the performance criteria during the relevant time period but is
                                confident that the program is on track, this waiver will be recommended. However, the staff is likely
                                to try to verify the country’s compliance with the waived performance criteria at a later time, generally
                                the next review.




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New Fiscal Action Plan   In late 1997, the IMF and Russia created a credible fiscal action plan and
                         developed monetary policy actions and targets to reestablish monetary
Addresses Budget         policy restraint, which had deviated considerably from the program. On
Difficulties and Tax     the fiscal side, the discussions emphasized the difficulties in controlling
Collection               budget expenditures, as well as ineffective efforts to collect taxes from
                         large debtors, as the source of fiscal problems. For example, the inability
                         of the government to pay its own bills, combined with extensive use of
                         monetary offsets and noncash mechanisms to settle budgetary arrears
                         against tax debtors’ arrears, undermined incentives for paying taxes in
                         cash. The Russian government agreed to take steps (prior actions) based
                         on the newly developed strategy to bring the fiscal program back on track,
                         including the abolition of all types of noncash tax arrangements on
                         January 1, 1998. The monetary policy discussions were concerned with the
                         CBR’s response to sizable foreign exchange outflows and how to ensure
                         that these outflows would not become a source of inflationary pressure.
                                                                 9
                         Informal and flexible understandings were reached on a revised monetary
                         program for end-December 1997 that permitted some room for expansion
                         of base money but also emphasized keeping inflation on a downward trend
                         and protecting international reserves. To complete the review, the
                         government had to undertake fiscal measures, agree upon targets for the
                         1998 federal budget, revise monetary performance criteria for end-
                         December 1997, and complete actions on the structural side.

Lack of Political Will   The IMF staff conceded that little had been accomplished on the fiscal side
                         by end-December 1997, particularly in the collection of tax revenues,
Behind Lax Revenue       owing to a lack of “forceful and focused implementation,” along with slow
Collection               progress in improving tax administration, and that the credibility of the
                         Russian authorities was at stake. However, they recommended the
                         completion of the sixth review based on the newly adopted fiscal action
                         plan that brought a new approach to tackling the fiscal problem and the
                         expectation that the authorities would make a concerted effort to follow
                         through this time.




                         9
                          For example, the mission staff stressed that when faced with sizable foreign exchange outflows, the
                         CBR should allow domestic money market conditions to tighten (that is, let interest rates rise), or at
                         least refrain from intervening to prop up the price of treasury bills. The CBR concurred.




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Cabinet Changes Delayed      During February 1998, amid the ongoing pressures on Russia’s financial
                             markets, an IMF mission team visited Moscow to hold discussions for the
1998 Program Approval and    seventh quarterly review and to complete the talks begun earlier on the
Disbursement of First        1998 program. The subsequent dismissal of Prime Minister Victor
Tranche–Low Oil Prices Led   Chernomyrdin in March and the Duma’s approval of Yevgeny Kiriyenko in
to Further Program           April, together with weak oil prices, delayed the review and
                             implementation of the program, as well as the disbursement of the $700
Modifications                million credit tranche. Follow-up staff visits took place in April and May to
                             revise the fiscal targets and policies for 1998.

1998 Program Approved        In mid-May, following the formulation of the 1998 program, a severe
                             financial crisis hit Russia, coinciding with renewed financial instability in
Amid May Financial Crisis    Asia (Indonesia) and labor unrest in Russia. The CBR’s interventions in the
                             foreign exchange market led to a large decline in reserves, and sharp
                             increases in interest rate and financial volatility underscored Russia’s
                             vulnerability to changes in market sentiment. The IMF staff again
                             recognized that the program might have to be revisited unless confidence
                             returned. The completion of the review and approval of the 1998 program
                             occurred in June 1998, following Russia’s completion or satisfactory
                             progress in 27 fiscal, financial, and structural measures (many were from
                             the November 1997 Fiscal Action Plan) and observance of the March
                             targets. Some measures included (1) collecting taxes from large tax
                             debtors, (2) taking steps to improve tax collection, (3) establishing better
                             monitoring and control over expenditure commitment, and (4) identifying
                             additional expenditure cuts. Although Russia missed the deficit and cash
                                                                                        10
                             revenue targets for end-March, no waiver was requested, though a waiver
                             was granted for nonobservance of one December 1997 performance
                             criterion. The staff also supported Russia’s request for the extension of the
                             EFF arrangement for a fourth year in light of the delayed purchases during
                             1996-97 and the need to catch up with the original program objectives.

The 1998 Program             The Russian government favored achieving the deficit target through
                             spending cuts, as officials did not think that they could collect the required
Emphasized Expenditure       amount of cash tax revenues or that the Duma would agree to the required
Cuts and Pursuit of Tax      tax measures. However, the IMF staff’s opinion was that expenditure cuts
Debtors With Large Arrears   often translated into new expenditure arrears, hence they emphasized
                             strengthening collections from large, delinquent tax debtors. In the end,
                             the program relied on both approaches. For example, the Emergency Tax
                             Commission met in May and made a decision to collect arrears from a
                             10
                                The IMF Board discussed the seventh quarterly review on June 25, 1998. The relevant performance
                             criteria were those that were established for end-December 1997. There were no performance criteria
                             for end-March 1998 (only indicative targets) and, as a result, the end-December 1997 performance
                             criteria remained in effect at the time of the IMF Board review.




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                            number of large tax debtors, and the Expenditure Reduction plan was
                                                                                11
                            adopted by presidential decree that month as well . Eliminating mutual
                            offsets, which undermined the incentives to pay taxes in cash, was also
                            critical to resolving the fiscal problem. No new offset operations had been
                            approved since January 1, 1998, and federal government abstention from
                            any offset operations was to be a performance criterion under the 1998
                                       12
                            program.

Structural Reforms Were     The 1998 structural reform program was front loaded with a wide range of
                            measures taken as prior actions ahead of the IMF Executive Board’s
Front-Loaded;               consideration. Structural reforms that would have important
Transparency and            macroeconomic impact over the medium term were designated
Accountability Were         benchmarks for each quarter. Some areas of focus for the structural
Emphasized                  reform agenda included making improvements in corporate governance
                            through ensuring a more transparent accounting by public utility and
                            transport monopolies, engaging in an open and competitive privatization
                            process, liberalizing the trade regime, and strengthening the prudential and
                            supervisory framework of the banking sector. Some of the fiscal prior
                            actions Russia had to undertake for the completion of the seventy
                            quarterly review were based on elements from the November 1997 Fiscal
                            Action Plan, for example, collecting taxes from large tax debtors,
                            establishing better monitoring and control over expenditure commitments,
                            and identifying additional expenditure cuts needed to observe the program
                            targets. Progress in structural reforms continued to be based on an overall
                            assessment, but with a particular emphasis on the structural benchmarks.

1998 Program Had            While the IMF’s projections for 1998 and beyond indicated a strengthening
                            of Russia’s balance of payments over the medium term that would permit
Substantial Risks           Russia to service its obligation to the IMF, the IMF staff was cognizant of
                            substantial risks to the program, such as:

                          • a variability in capital flows and foreign exchange outflows, magnified by
                            Russia’s dependence on nonresident’s participation in the treasury bill
                            market (as illustrated by May 1998 events);
                          • a vulnerability to external shocks, given Russia’s reliance on energy
                            exports;
                          • a sluggish pace in transitioning to a market economy; and

                            11
                                 One item, for example, in the Expenditure Reduction Plan included reducing the number of spending
                            units from 139 to 99.
                            12
                              According to the U.S. Treasury, the Russian government did another round of offsets in February
                            1999.




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                             • the upcoming elections that could undermine the government’s will and
                               ability to implement tough measures.

                               Nevertheless the IMF staff indicated that the program was deserving of
                               continued IMF support because of the government’s strong commitment to
                               the program and the important steps it took to stabilize and reform the
                               economy during the first 2 years of the EFF. Further, the staff noted, the
                               Russian authorities were taking additional prior actions before the IMF
                               Board meeting, were implementing many of the fiscal measures, and were
                               committed to an ambitious structural reform agenda.

Economy Vulnerable to          The Russian government had financed its high, and ultimately
                               unsustainable, budget deficits by selling ruble-denominated, short-term
Variable Capital Flows and     debt to both foreign and domestic investors. By May 1998, nonresident
Foreign Exchange Outflows      investors were holding about one-third ($20 billion) of domestic treasury
                               securities. The government borrowed in capital markets and issued
                               treasury bills and bonds at high yields to attract capital. This added a
                               heavy debt service burden to the Russian budget. Further, the short-term
                               maturity of the debt meant that Russia constantly had to roll over the debt.
                               This made the economy highly vulnerable to changing investor sentiments
                               in the capital market. As long as foreign and domestic investors were
                               willing to renew short-term debt, this practice could continue, but Asia’s
                               financial problems intensified the instability in global financial markets.
                               The combination of high yields, deteriorating investor sentiment, and the
                               short-term maturity of the treasury bills raised investor concerns that the
                               Russian government would not be able to meet around $1.5 billion in debt
                               service that fell due each week in the remainder of 1998. By June 1998,
                               domestic borrowing to finance the federal budget came to a virtual halt.

June 1998: Russia Requests     The Russian government had been in a race between its need to collect
                               more taxes and to pay the rising interest bill on its growing debt – the
Additional Funds to Avert      government had to roll over more than $1 billion per week of treasury bills.
Financial Crisis               This became impossible, as export revenues declined with falling oil and
                               commodity prices and interest rates sharply increased when capital fled
                               the country. The persistent weaknesses in tax collection and government
                               spending in excess of what was affordable exacerbated the situation.
                               Russia was forced to request international assistance

                             • to replenish international reserves,
                             • to overcome liquidity problems arising from foreign investors redeeming
                               their short-term ruble-denominated debt, and




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                         • to provide the government with reserves of dollars and other foreign
                           currencies to keep the ruble at its current value in foreign exchange
                           markets.

                           The government needed more dollars to attempt to prevent the ruble from
                           losing too much of its value against the dollar. A depreciated ruble could
                           create serious problems for the Russian banks and industries that had to
                           buy dollars with rubles to repay their loans from foreign banks. It could
                           also reignite the ruinous inflation that had plagued Russia in the early
                           1990s by raising the price of imports.
                                                                                     13
IMF Approves Request –     Recognizing that it was a calculated risk, and to try to help Russia avoid
                           devaluation, the IMF made a decision to provide $11.2 billion in extra
Exceptional Risk Noted     funding on an augmented EFF arrangement on July 20, 1998. The financing
                           consisted of an increase in the EFF arrangement of about $8.3 billion, and
                           about $2.9 billion under the Compensatory and Contingency Financing
                                            14
                           Facility (CCFF) to compensate for a shortfall in export earnings, mainly
                           due to lower oil prices. Of the augmented amount to be provided under the
                           extended arrangement, about $5.3b was to be made available under the
                                                           15
                           Supplemental Reserve Facility (SRF), and the remainder was new EFF
                           funding. The augmentation of the extended arrangement came from
                           borrowing the equivalent of about $8.3 billion under the IMF’s rarely used
                           General Agreement on Borrowing.

                           As June 1998 data were not available to assess Russia’s performance under
                           the 1998 program, this requirement was waived in the proposed decision,
                           and the IMF approved the first disbursement under the CCFF. The
                           remainder of the disbursements were to be in three additional installments
                           phased through February 1999. Because of Russia’s delays in implementing
                           the personal income tax and pension measures, the amount being made
                           available immediately was reduced from $5.6 billion to $4.8 billion. The
                           difference was to be made available in September, assuming the measures
                           were satisfactorily implemented.


                           13
                              The risk to the IMF was that in this deteriorating situation the attempt to avert devaluation and its
                           adverse impacts would fail and Russia would not be able to deliver on its policy commitments.
                           14
                              The CCFF provides financial assistance to IMF members experiencing temporary export shortfalls.
                           Repayments are made over 3¼ to 5 years. A decline in world oil prices had reduced Russia’s foreign
                           exchange earnings.
                           15
                              The Supplemental Reserve Facility provides financial assistance for exceptional balance-of-payments
                           difficulties due to a large, short-term financing need resulting from a sudden and disruptive loss of
                           market confidence. Repayments are to be made within 1 to 1½ years.




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New Package Could Not           The new package included fiscal measures to aimed at reducing the fiscal
                                deficit. These included:
Halt Crisis
                              • tax reforms, measures to increase tax revenues, and spending cuts;
                              • new structural reforms to address the arrears problem and promote
                                private sector development; and
                              • steps to reduce the vulnerability of the government debt position (for
                                instance, a voluntary restructuring of short-term treasury bills).

                                The July 20, 1998 announcement of the IMF’s additional policy package
                                had a positive, but very short-lived, effect on Russia’s financial markets.
                                Ultimately, the Duma’s lack of support for the program in the areas of
                                personal income tax and pension fund financing and the veto by the
                                president of several measures led the IMF to reduce the initial amount of
                                                                                     16
                                the disbursement from $5.6 billion to $4.8 billion. The program also faced
                                opposition in the key energy sector, and the collection of overdue tax
                                payments from a number of oil companies proved difficult. Finally, the
                                government-owned Sberbank’s decision to not roll over its sizable treasury
                                bill holdings falling due in the last 2 weeks in July culminated in cancelled
                                bond auctions because of prohibitively high borrowing rates. With
                                pressure growing against the ruble and spreading to the banking sector,
                                the CBR was forced to intervene on a large scale. However, these actions
                                were not enough to avert a serious crisis. Russia was facing a full-scale
                                banking and currency crisis by mid-August.

                                Russia’s persistently large fiscal imbalances, heavy reliance on short-term
                                foreign borrowing financed at high interest rates, the impact of the
                                declining price of oil on Russia’s external balance, and delays in structural
                                reform led to Russia’s replacing Asia in August 1998 as the center of the
                                financial crisis afflicting emerging markets, thus potentially erasing many
                                of the gains of prior years.

Russia Defaults on Debt and     In August 1998, the Russian government abandoned its defense of a stable
                                ruble exchange rate – one of the major accomplishments of the previous
IMF Suspends Program            years – essentially devaluing the ruble, forced a restructuring of
                                government domestic debt, and placed a 90-day moratorium on
                                commercial external debt payments. The financial crisis intensified
                                following the dissolution of the Kiriyenko government and the approval of



                                16
                                   The IMF program required the passing into law, ahead of IMF approval on July 20, a series of
                                measures needed for the achievement of revenue and expenditure targets.




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                                                                                                          17
                        Yvegeny Primakov as Prime Minister on September 11, 1998. On that day
                        as well, the German government acknowledged that Russia missed
                        virtually all of a DM800 million interest payment due on August 20 on
                        sovereign debt dating from the Soviet era. Russia’s decision to unilaterally
                        restructure its ruble-denominated sovereign debt and impose a
                        moratorium on private external debt payments had significant
                        repercussion in the financial markets, effectively destroyed Russia’s
                        external creditworthiness, and cut Russia off from international capital
                        markets. Currently, Russia’s debt service exceeds Russia’s ability to pay.
                        The IMF’s second tranche was scheduled to be delivered on September 15,
                        1998, but the IMF has made no further payments following the initial $4.8
                        billion disbursement because of the Russian government’s failure to meet
                        its loan conditions.

                        According to the IMF, the immediate cause of the Russian economic crisis
                        was the growing loss of financial market confidence in the country’s fiscal
                        and international payments situation, leading to a loss of reserves and an
                        inability to roll over treasury bills as they matured. However, fundamental
                        problems having to do with Russian economic policy and economic
                        structure lay behind Russia’s vulnerability.

                        According to the IMF and the Congressional Research Service, deeper
Russia’s Problems Are   problems involving the incomplete restructuring of Russia’s economy
Deeper Than the         caused Russia’s vulnerability. Russia’s fiscal problem originated in Russia’s
Deficit                 failure to reform its huge and inefficient tax system, resulting in
                        inadequate tax collection. Further, the culture of nonpayment and the
                        widespread use of barter have made it difficult to resolve the fiscal
                        imbalances. According to one estimate by Russia scholars, more than 50
                        percent of payments are conducted by barter and 40 percent of the tax
                        revenues are paid in a nonmonetary form. Public spending has not been
                        adequately controlled, and the government has not been able to cover its
                        expenditures with revenues. Other structural problems include the lack of
                        clarity in the administrative relationship between the federal government
                        in Moscow and the regional and local governments. This situation
                        produces confusion and conflict over control of assets and tax authority.
                        The vagueness of relationships is further complicated by problems in
                        dealing with the oligarchs, a group of individuals who have amassed a
                        great deal of wealth and who control the major banks and enterprises.
                        There has also been slow progress in making key structural reforms such
                        17
                           On August 23, 1998, President Yeltsin dismissed then-Prime Minister Sergei Kiriyenko and his
                        government. According to the Congressional Research Service, Primakov chose for his government
                        individuals largely considered to be less inclined to pursue economic reforms than had the previous
                        government.




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as introducing accountability and transparency at all levels of government
operations, establishing a federal treasury system, and restructuring
enterprises and the legal framework, which adversely affects the
economy’s performance more broadly.




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Appendix VII

The IMF’s Financial Arrangement with
Uganda

               Uganda has had continuous IMF arrangements since 1987. In November
Summary        1997, the IMF approved a new 3-year arrangement of about $138 million
               under its Enhanced Structural Adjustment Facility (ESAF). The IMF
               arrangement was requested by the Ugandan government to support its
               1997-2000 economic program. The arrangement was approved by the IMF
               Executive Board on the basis of the government’s balance-of-payments
                      1
               needs. IMF and U.S. Treasury officials described the Ugandan government
               as a good performer that had consistently met IMF terms and conditions
               and attributed this performance to the Ugandan president’s commitment to
               economic reform. U.S. Treasury officials said the IMF program is in line
               with U.S. objectives for the country. However, an IMF official said that
               Uganda did not meet some of the conditionality for completion of the
               February/March 1999 midterm review, and began undertaking prompt
               remedial measures to enable the review to be completed after a lag of a
               few months. The IMF consequently, delayed the second disbursement of
               the arrangement until the review is completed.

               The IMF established the ESAF in 1987 to address macroeconomic policy
               and structural reform measures in low-income countries facing protracted
               balance-of-payments problems. ESAF loans have lower interest rates and
               longer terms than regular IMF arrangements. ESAF loans carry a
               concessional interest rate of 0.5 percent a year and are to be repaid in 10
               equal semiannual installments, beginning 5 ½ years and ending 10 years
               after the date of each disbursement. ESAF loans are disbursed
               semiannually, beginning with approval of the arrangement by the IMF
               Executive Board and subsequently upon the ESAF borrower’s adherence
               to performance criteria and following a midterm review by IMF staff. In
               contrast, regular IMF arrangements have quarterly reviews and
               disbursements. ESAF borrowers must develop a 3-year policy framework
               paper, which is updated annually, setting forth the macroeconomic and
               structural adjustment policy objectives and measures to be undertaken,
               along with the external financing needs. The purpose of the process is to
               catalyze and coordinate financial and technical assistance from assistance
               donors.

               The Ugandan government outlined its principal objective for its economic
               program, to be supported by an ESAF arrangement, as sustaining high and
               broad-based economic growth in which the poorest segment of the

               1
                Structural reforms are a key element of ESAF arrangements. The IMF rationale for supporting
               structural reforms is that they are critical elements in achieving balance-of-payments viability and lay
               the basis for sustainable economic growth by eliminating institutional rigidities, such as market
               segmentation and vested interests’ resistance to change, which channel resources away from efficient
               use.




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The IMF’s Financial Arrangement with Uganda




population can participate. To accomplish this objective, the government
intended to (1) maintain macroeconomic stability; (2) continue
liberalization of the economy to promote diversified, export-oriented
growth; (3) undertake structural and institutional reforms that will further
reduce impediments to economic growth; and (4) promote good
governance.

According to the IMF, key elements for the government’s achievement of
its objectives are completion of ongoing structural reforms in the financial
sector, public service, tax policy and administration, external trade,
privatization, and public enterprise restructuring. IMF staff reported that
the government must also improve its technical capacity and statistical
data bases, especially those relating to balance of payments, monetary
statistics, and social indicators.

IMF quantitative performance criteria and benchmarks include ceilings on
the net domestic assets of the banking system, net claims on the
government by the banking system, gross issuance of promissory notes by
the government, and external borrowing and debt, as well as increases in
the central bank’s international reserves, minimum revenues, and
minimum expenditures on priority (including social) areas in the
government’s 1998/99 economic program. Structural performance criteria
focus on government arrearages and bank examinations. Structural
performance benchmarks specify reforms in trade, fiscal, and privatization
issues; and in the civil service and financial sectors. There were also prior
actions relating to trade liberalization and privatization for completion
prior to the February/March 1999 midterm review.

In performing their first review in December 1997, IMF staff found that the
government had met the quantitative and structural performance criteria
except for the ceiling on net claims by the banking system. An IMF official
said the IMF Executive Board issued a waiver after deciding the non-
observance of the criterion was due to a reversible technical factor that
had not seriously jeopardized government performance. According to this
official, the government has generally met IMF benchmarks, although
observance of some elements was delayed by a short period due to
technical reasons. However, the government’s nonobservance in meeting
benchmarks in the area of privatization of state-owned enterprises was
characterized by IMF staff as “significantly set[ting] back the privatization
program.”

An external evaluation of ESAF done for the IMF in March 1998 concluded
that Uganda had been successful both in terms of achieving stabilization



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The IMF’s Financial Arrangement with Uganda




and growth and stated that key decisions were taken by the government on
                   2
its own initiative. IMF officials indicated that Uganda was one of the few
countries where there had been no major program interruptions over a
number of years. They attributed this to the government’s commitment to
reform. Also, government officials were aware of IMF procedures and
generally were careful to avoid nonobservance of program conditionality.
In some instances, however, program performance criteria or benchmarks
were not observed mainly due to unintended technical factors, or the
government was unable to deliver on implementation. For example, the
pace of privatization fell short of what was envisioned for in the first half
of 1998/99 and was a major reason for the IMF delaying the completion of
the February/March 1999 midterm review. The midterm review mission
also found that some of the quantitative performance criteria were not
met, although by modest amounts. The government was expected to get
back into program targets within a short period of time, according to an
IMF official. An IMF staff mission was in Uganda in May 1999 to reassess
the situation regarding completion of the midterm review.




2
 Report by a Group of Independent Experts, External Evaluation of the ESAF (Washington D.C.: IMF,
1998).




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                                           Table VII.1 shows the timeline for Uganda’s current 3-year ESAF
                                           arrangement.

Table VII.1.: Timeline of Key Activities
for Uganda’s Current Arrangement           Year       Month      Activity
                                           1997       October    — Uganda requested a new 3-year ESAF arrangement

                                                      November   — Ongoing ESAF arrangement completed
                                                                 — IMF approved a new 3-year ESAF arrangement
                                                                 — IMF made the first disbursement under the first annual
                                                                 arrangement

                                           1998       February   — Article IV consultations and midterm review by IMF staff
                                                                 mission assessed Ugandan observance of performance criteria
                                                                 — Uganda did not meet all criteria for December 1997

                                                      March      — Uganda requested waiver from IMF for nonobservance of
                                                                 criterion

                                                      April      — IMF Executive Board granted waiver
                                                                 — IMF made second disbursement under the first annual
                                                                 arrangement

                                                      October    — Uganda requested approval for second annual arrangement

                                                      November   — IMF staff review completed
                                                                 — IMF approved second annual arrangement
                                                                 — IMF made first disbursement under the second annual
                                                                 arrangement

                                           1999       February   — IMF Article IV and midterm review by IMF staff mission
                                                                 assessed Ugandan observance of performance criteria
                                                                 — Uganda did not meet all December 1998 criteria
                                                                 — Completion of IMF review delayed to provide time for the
                                                                 government to take corrective actions
                                                                 —Second disbursement under the second annual arrangement
                                                                 delayed until completion of the review

                                                      May        — IMF staff mission in Uganda to reassess progress on program
                                                                 implementation prior to completion of the midterm review and
                                                                 subsequent release of the second disbursement

                                           Source: IMF data.


                                           Years of war and civil strife in the 1970s-1980s destroyed Uganda’s
History of the IMF                         infrastructure, public services, and agricultural production and
Arrangements With                          impoverished the population. Per capita GDP in 1986 was 60 percent
Uganda                                     below its level of 1970, annual inflation had risen to 240 percent, and
                                           external debt service was more than 50 percent of exports. Exports other
                                           than coffee had all but ceased by 1987. The country had annual declines in
                                           terms of trade each year from 1986 to 1992. However, the country has been
                                           undergoing successful macroeconomic adjustment and structural reform



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with IMF and other donor support since 1987. Economic growth has
averaged over 5 percent per annum since 1987, but a European Union
representative in Uganda told us in April 1998 that much of the country’s
growth has been “recovery growth” and that the country was only reaching
levels in 1998 that it was at in 1972. He also said that, after 25 years of war
and chaos, with the society surviving largely at the subsistence level, the
country was vulnerable to corruption.

Uganda has had 10 IMF arrangements since 1987. The current 3-year ESAF
arrangement approved by the IMF Executive Board in November 1997
totals about $138 million and is to support the Ugandan government’s
1997/98-1999/2000 economic plan. The first semiannual installment of $27.6
million of the first annual arrangement was made in November 1997. In
April 1998, Uganda was the first country to complete an international
initiative aimed at reducing the debt burden of some heavily indebted poor
            3
countries. The IMF has had a resident representative in Uganda since July
1982. U.S. Treasury officials said that, over the past few years, problems
have become apparent in (1) government privatization of state-owned
enterprises, (2) corruption within government, and (3) government
military spending. IMF and U.S. Treasury officials said that, unlike many
governments, the Ugandan government is committed to addressing the
corruption problem. There appears to be increased emphasis by the IMF
and other donors on reducing corruption within the government and
holding down military expenditures to ensure that funds are available for
needed social spending. The IMF resident representative also told us in
April 1998 that the rule of law needs to be strengthened since laws,
regulations, and procedures are weak throughout the system.

According to the external (independent) experts’ 1998 evaluation of ESAF,
the government’s reform program benefited from intensive public
education and consensus-building initiatives. The external evaluation also

3
 In 1996, the World Bank and the IMF proposed the Debt Initiative for the Heavily Indebted Poor
Countries (HIPC Initiative) in response to creditors’ concern that some poor countries face debt
burdens too large relative to their ability to pay, even after receiving debt relief through the then-
existing mechanisms. The Initiative’s stated goal is to reduce countries’ debts to levels that are
sustainable, meaning that in the future they can make debt payments on time and without
reschedulings. As a condition to receiving HIPC assistance, countries must undertake economic and
social reforms. As a result of its adjustment record, Uganda was the first country to be granted a Paris
Club stock-of-debt operation on Naples terms in February 1995 – the equivalent of restructuring 32
percent of its outstanding debt with Paris Club creditors. Uganda was the first country to reach its
completion point under the Initiative in April 1998, resulting in receipt of $69 million in HIPC debt
relief. Uganda’s total external debt was US$3.7 billion as of June 1998. In nominal terms, total debt
relief over time under the Initiative is estimated to amount to US$650 million. The Ugandan
government said it intends to spend the funds garnered from debt relief in the health and education
sectors. For more information on the HIPC initiative see the GAO report Developing Countries: Status
of the Heavily Indebted Poor Countries Debt Relief Initiative (GAO/NSIAD-98-229, Sept. 30, 1998).




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                         noted that the Ugandan president defended government policies in the
                         face of public opposition and protests, rather than opting for political
                         expediency as is done by “most presidents.” IMF officials said the Ugandan
                         parliament supports the ESAF program, although there are some questions
                         among legislators about the speed at which it is implemented. While the
                         Ministry of Finance is responsible for specific monitoring of program
                         performance criteria and benchmarks, the parliament’s Economy
                         Committee monitors the program in a general way. IMF missions to
                         Uganda meet with the president, the Ministry of Finance, and the Central
                         Bank, and in recent years have also met with noneconomic ministries,
                         parliamentary committees, nongovernmental organizations, and private-
                         sector organizations.

                         The IMF is providing technical assistance to the government to

                       • implement changes in customs management and administration,
                       • establish a large-taxpayer unit for the 100 largest taxpayers,
                       • improve budget management through improved expenditure control and
                         financial accounting,
                       • promote secondary markets in treasury bills, and
                       • improve the statistical base through enhanced collection and reporting of
                         national accounts, revenue, expenditures, balance-of-payments and debt
                         statistics, and implementation of prior technical assistance missions’
                         recommendations.


                         The IMF reported that, during the annual arrangement in 1994/95-1996/97,
Uganda’s Performance     annual real GDP growth averaged 8 percent and inflation was 5 percent.
Under the 1994/95-       The fiscal deficit, excluding grants, was reduced from 11.2 percent of GDP
1996/97 Annual           in 1993/94 to 6.5 percent in 1996/97. The external current account deficit,
                         excluding grants, declined to 6.1 percent in 1996/97, and improved balance
Arrangement              of payments increased international reserves to 4.6 months of imports of
                         goods and nonfactor services. Government elimination of marketing
                         boards, price controls, export taxes, and foreign exchange restrictions
                         contributed to expansion and diversification of the export base. Uganda’s
                         debt service ratio as measured by the annual payments on debt
                         outstanding as a ratio of export earnings fell from 53.7 percent in 1993/94
                         to 18 percent in 1996/97 following Paris Club debt reschedulings.

                         The external experts’ 1998 evaluation reported that the 1994-97 ESAF
                         arrangement did not need a stabilization component and consequently
                         focused on a development agenda of structural reforms. The scope of IMF-
                         government policy dialogue focused on issues not traditionally within the



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                        IMF’s area of expertise. As part of Uganda’s structural adjustment, the
                        following reforms were undertaken.

                      • The civil service was reduced in size by 25 percent, noncash benefits were
                        monetized and salaries increased, and army demobilization was
                        completed.


                      • Within tax policy reforms, the tax identification number system was
                        expanded, a value-added tax (VAT) introduced, most discriminatory tax
                        exemptions were eliminated, and a new income tax bill was submitted to
                        parliament.


                      • The Bank of Uganda was restructured and its recapitalization begun, two
                        commercial banks were restructured, the Uganda Commercial Bank was
                        recapitalized and steps to privatize it begun, and enforcement of adequate
                        capital requirements in the banking sector was undertaken.


                      • Fifty-five public enterprises were privatized, actions were initiated to
                        privatize telecommunications, and a communications act and amendments
                        to remove the Uganda Electricity Board’s monopoly and regulatory powers
                        were submitted to parliament.


                      • Import tariffs and import duty exemptions were reduced, export taxes
                        were eliminated, and an external debt-management and borrowing strategy
                        that eliminates nonconcessional borrowing was implemented.


                        IMF disbursements for the 3 -year arrangement were $24.5 million in
                        September 1994 and $26.3 million in April 1995; $29.8 million in December
                        1995 and $29 million in May 1996; and $33.7 million in December 1996 and
                        $32.5 million in May 1997.

                        On October 22, 1997, the government requested a new 3-year ESAF
Uganda’s New 3-Year     arrangement of about $138 million to support its economic plan for
Arrangement and the     1997/98-1999/2000. Uganda’s fragile external position left it vulnerable to
First Annual            external shocks; and it faced deteriorating terms of trade, uncertainty over
                        the effectiveness of revenue measures, and substantial expenditure
Arrangement             pressures. The IMF approved the arrangement on November 10, 1997. IMF
                        officials said that other donors wanted Uganda to have an IMF program as



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                             an anchor for their assistance. They also said that some IMF executive
                             directors felt that Uganda needed assistance on structural issues such as
                             financial sector reform, privatization, trade liberalization, and social
                             spending. IMF and U.S officials emphasized the Ugandan government’s
                             commitment to reform. The IMF made its first disbursement to Uganda
                             under the new arrangement in November 1997 for $27.6 million.

Quantitative Performance     The quantitative performance criteria for Uganda focus chiefly on
                             bolstering Uganda’s liquidity and creditworthiness by improving its ability
Criteria and Benchmarks      to reduce inflation, by garnering resources readily usable for the purpose
                             of financing deficits in the balance of payments, and by stabilizing the
                             foreign exchange value of the currency (Ugandan shilling).

                             The quantitative performance criteria for the first annual arrangement
                             covered the following:

                           • Ceilings were set on net domestic assets of the banking system as a
                             monetary policy measure intended to control the rate of inflation by
                             limiting the amount of money in circulation. Increases in the net domestic
                             assets of the banking system are, in effect, increases in outstanding loans
                             to the nonbanking sector that raise the amount of money in circulation and
                             represent a potential source of inflation.


                           • Limits were set on the net claims of the banking system on the
                             government, as a mechanism to restrict the growth rate of government
                             borrowing. Net claims of the banking system on the government are loans
                             to the government by the banking system. Bank loans to the government
                             may either increase the amount of money in circulation and possibly raise
                             the rate of inflation in the country or raise the interest rate by fostering
                             competition with the private sector for loans. Moreover, by discouraging
                             banks from lending to the government, limiting net claims may also serve
                             as a fiscal restraint on the government.

                           • A prohibition was set on the issuance of promissory notes by the
                             government to curb the rate of growth of government spending financed
                             through issuance of negotiable instruments, such as bonds. This fiscal
                             restraint prohibits government borrowing from the public to finance
                             government expenditures.

                           • Arrears on outstanding external debt was forbidden. This prohibition
                             enforces the Ugandan government’s agreement with the IMF and the




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  World Bank to maintain an on-time payment history to remain eligible for
  past and future debt reduction benefits under the HIPC.

• The Bank of Uganda was prohibited from incurring debt with a maturity of
  less than 1 year. Short-term external debt of the Bank is loans from
  external sources contracted by the Bank when it is unable to provide
  sufficient foreign exchange to pay for expenses that are incurred for
  routine international transactions. This prohibition, therefore, ensures that
  the Bank maintains sufficient foreign exchange on hand to pay for each
  year’s imports of good and services. Consequently, short-term credit
  extended to Uganda to facilitate trade with international trading partners
  cannot be converted to long-term international debt.

• Limits were established on new public- or publicly-guaranteed
  nonconcessional debt. This was intended to reduce total external debt by
  restricting government borrowing from international sources, unless the
  debt contains a grant element of at least 35 percent.

• A minimum net international reserve level for the Bank of Uganda was set.
  Setting a minimum reserve level enhances the availability of foreign
  exchange for the purposes of stabilizing the value of the currency and
  maintaining adequate foreign exchange to pay for several months of
  imports of goods and services.




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                                            Table VII.2 shows the specific criteria and timetable, or benchmarks, for
                                            the first annual arrangement.

Table VII.2: Quantitative Performance Criteria and Benchmarks for the First Annual Arrangement
Quantitative criteria                        Performance    Benchmark Benchmark Remarks
                                               criteria for  for March      for June
                                               December           1998          1998
                                                      1997
Ceiling on the increase in net domestic                                               Adjustments to be made for import support in
                               a                                                    b
assets of the banking system                     U sh 24.8    U sh 36.2   U sh 29.8 excess of cumulative projections.
                                                                                      Adjustments to be made for debt service
Ceiling on the increase in net claims on the                                          paid by the central government in excess of
                                     a
government by the banking system                U sh -35.0   U sh -40.5   U sh -55.9 cumulative projections.
Ceiling on issuance of promissory notes by                                            Excludes notes issued to regularize domestic
                 a
the government                                            0           0            0 payment arrears not to exceed 24.1 billion.
Ceiling on the stock of external payment                                              This criterion must be continuously
       c
arrears                                                   0           0            0 observed.
Ceiling on new nonconcessional external
borrowing over one year contracted or                                                 Excludes debts contracted in the context of
                                 c
guaranteed by the government                         $10.0        $10.0        $10.0 reschedulings.
Ceiling on outstanding short-term external                                            External debt with maturity of less than 1
                             c
debt of the Bank of Uganda                                0           0            0 year excluding normal import related credit.
                                                                                      Concurrent adjustments to be made in case
Minimum increase in net international                                                 of adjustments in ceiling of net domestic
                                   c
reserves of the Bank of Uganda                       $35.9        $64.2        $71.7 assets and net claims on government.
                                            a
                                                Cumulative change in billions of Ugandan shillings from end of June 1998.
                                            b
                                                This benchmark was originally set at 36.9 million Ugandan shillings.
                                            c
                                                Cumulative change in millions of U.S. dollars from end of June 1997.
                                            Source: IMF.

Structural Performance                      The structural performance criterion for the first annual arrangement was
                                            to complete government auditing of at least 200 VAT payers, 50 of which
Criterion and Benchmarks                    would be from the top 400 VAT-registered taxpayers, and the rest of which
                                            would be based on revenue-risk criteria. Achievement of the criterion was
                                            to be completed by December 31, 1997. Three prior actions for the removal
                                            of import bans by March 31, 1998, were also established. Table VI.3 shows
                                            the structural performance benchmarks for the first annual arrangement.




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Table VII.3: Structural Performance Benchmarks for the First Annual Arrangement
Category       Performance benchmark
Privatization •Relinquish government control of 80 public enterprises by December 31, 1997.
               •Relinquish government control of 89 public enterprises by March 31, 1998.
               •Relinquish government control of 95 public enterprises by June 30, 1998.
               •Divest 23 enterprises including 7 with asset values of 5 billion Ugandan shillings or more by June 30, 1998; divestiture of
               at least 3 of these 7 large enterprises by December 31, 1997.
               •Offer Uganda Telecommunications Ltd. for sale following its separation from the Uganda Posts and Telecommunications
               Corp. by December 31, 1997.

Government •Set the size of the number-limited civil service on the payroll, excluding primary school teachers, at 57,100 by December
restructuring 31, 1997, and 55,600 by June 30, 1998.
              •Gain Cabinet approval of agreed structures and establishments for 9 central ministries/departments by January 31, 1998.
              •Reduce Uganda Electricity Board employment from 3,060 as of June 1997 to 2,800 by December 31, 1997, and 2,300 by
              June 30, 1998.
              •Ensure minimum nonwage budgetary expenditures for the Priority Program Areas of health and education at $24.6
              million by December 31, 1997, and $45.5 million by June 30, 1998.
Taxation      •Audit 600 taxpayers based on revenue/risk criteria by June 30, 1998.
Banking       •Conduct annual on-site inspections of at least 40 percent of banks by June 30, 1998.
                                               Source: IMF.


Uganda’s Observance of                         In its March 24, 1998, Article IV consultation and midterm review, the IMF
                                               staff reported that the government had met its quantitative and structural
Criteria and Benchmarks                        performance criteria for December 31, 1997, with the exception of the
                                               government’s net position vis-à-vis the banking system. This criterion was
                                               missed, according IMF staff, because of the more rapid liquidation of
                                               domestic nonbank liabilities than expected (government checks cleared
                                               the banking system sooner than expected). The IMF Executive Board
                                               granted a waiver because nonobservance was deemed to be technical in
                                               nature, as opposed to a policy violation. Performance was reported as
                                               satisfactory with respect to the structural benchmarks. However, some of
                                               the benchmarks were categorized by IMF staff as “observed with delay,”
                                               meaning that the benchmarks were met but not within the timeline
                                               envisioned. In addition, the removal of three import bans, a prior action
                                               with a completion date of March 31, 1998, was met according to the IMF.
                                               In the October 28, 1998, IMF staff paper to the IMF Executive Board on
                                               Uganda’s request for a second annual arrangement, the staff stated that the
                                               government had met the removal of bans on three imports on time. The
                                               IMF disbursed $27 million in April 1998.

                                               On October 28, 1998, the Ugandan government requested the second
Uganda’s Second                                annual ESAF arrangement. The IMF staff had reported in its October 28,
Annual ESAF                                    1998, ESAF policy framework paper that heavy rains in 1997/98 had
Arrangement                                    adversely affected Ugandan food and coffee production, transportation,



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                             and exports; real GDP growth was 5.5 percent and inflation 5.8 percent.
                             The current account deficit excluding grants as a share of GDP was 8.3
                             percent. Capital and official transfers financed the current account deficit
                             and generated a balance-of-payments surplus so that gross international
                             reserves rose to 4.9 months of imports of goods and services. The IMF
                             Executive Board approved the arrangement on November 11, 1998. The
                             first disbursement of $23.1 million was made November 25, 1998.

Quantitative Performance     The quantitative performance terms and conditions for Uganda‘s second
                             annual arrangement added two criteria to those of the first annual
Criteria and Benchmarks      arrangement:

                           • a minimum amount of total revenue was to be collected in order to reduce
                             fiscal deficits, and


                           • a minimum amount of nonwage expenditures to be made in the priority
                             program areas of education and health so that the social sector would not
                             be overlooked relative to other priorities, particularly military
                             expenditures.

                             Table VII.4 shows the quantitative performance criteria and benchmarks
                             for the second annual arrangement.




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Table VII.4: Quantitative Performance Criteria and Benchmarks for the Second Annual Arrangement
Quantitative criteria                        Performance Benchmark Benchmark Remarks
                                               criteria for for March     for June
                                                December          1999        1999
                                                      1998
Ceiling on the increase in net domestic                                             Adjustments to be made for import support
                              a
assets of the banking system                     U sh 50.1   U sh 36.9    U sh 29.3 in excess of cumulative projections.
                                                                                    Adjustments to be made for debt service
Ceiling on the increase in net claims on the                                        paid by the central government in excess of
                                    a
government by the banking system                 U sh -9.1  U sh -41.9   U sh -73.8 cumulative projections.
Minimum revenue collected by the Uganda
                    a
Revenue Authority                               U sh 440.0  U sh 671.0 U sh 924.0
                                                                                    Minimum expenditure would be increased
                                                                                    by no less than 50 percent of the first 8.6
Minimum nonwage expenditures on priority                                            billion of import support in excess of
                a
program areas                                    U sh 75.6  U sh 124.6 U sh 179.1 cumulative projections.
                                                                                    Excludes notes issued to regularize
Ceiling on issuance of promissory notes by                                          domestic payment arrears not to exceed U
                  a
the government                                            0          0            0 sh 24.1 billion.
Ceiling on the stock of external payment                                            This criterion has to be continuously
       b
arrears                                                   0          0            0 observed.
Ceiling on new non concessional external
borrowing over 1 year contracted or                                                 Excludes debts contracted in the context of
guaranteed by the government                         $10.0       $10.0       $10.0 rescheduling agreements.
Ceiling on outstanding short term external                                          External debt with maturity of less than 1
debt of the Bank of Uganda                                0          0            0 year excluding normal import related credit.
                                                                                    Concurrent adjustments to be made in case
Minimum increase in net international                                               of adjustments in ceilings of net domestic
reserves of the Bank of Uganda                       $18.9       $50.2       $94.8 assets and net claims on government.
                                            a
                                            Cumulative change in billions of Ugandan shillings from end of June 1997.
                                            b
                                            Cumulative change in millions of U.S. dollars from end of June 1997.
                                            Source: IMF.



Structural Performance                      The following structural performance criteria for the second annual
                                            arrangement (1998/99) were to be completed by December 31, 1998:
Criteria and Benchmarks
                                         • verification by the Verification Subcommittee of the Ugandan government
                                           line ministries’ report on arrears outstanding at the end-June 1998 and
                                           submission of its findings to the Arrears Monitoring and Reporting Unit,
                                           and

                                         • completion of follow-up site examinations of the banks for which the Bank
                                           of Uganda sent a timetable of corrective actions.




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                                              Prior actions that were to be completed by March 31, 1999, for the midterm
                                              review were

                                           • the removal of the import ban on cigarettes, and
                                           • approval of divestiture plans in 1998/99 by the Divestiture and Reform
                                             Implementation Committee and commencement of investment search
                                             (defined as issuance of information memorandum, advertisement of sale,
                                             or placement of shares on stock exchange) for 10 enterprises by March 15,
                                             1999, of which 5 were to be high-priority enterprises.


                                              Table VII.5 shows structural performance benchmarks for the second
                                              annual arrangement.

Table VII.5: Structural Performance Benchmarks for the Second Annual Arrangement
Category         Performance benchmark
Privatization    •Approval of divestiture plans in 1998/99 by the Divestiture and Reform Implementation Committee and
                 commencement of investment search (define as issuance of information memorandum, advertisement of sale, or
                 placement of shares on stock exchange) for 16 enterprises by June 30, 1999.
                 •Decision by the Cabinet on options for increasing private sector involvement in the operations of the Uganda Railways
                 Corporation by December 31, 1998.

Government       •Finalization by the Arrears Monitoring and Reporting Unit of a plan to clear verified outstanding arrears within 3 years
restructuring    by end-February 1999.
                 •Reduction in the size of the number-limited civil service on the payroll, excluding primary school teachers to 53,190 by
                 December 31, 1998, and 512,640 by June 30, 1999, with a margin of error of up to 99 for new pending cases.
                 •Limitation of the waiting period between the date of reporting to work and that of being put on the payroll to no more
                 than 4 weeks to be a continuous benchmark beginning October 1, 1998.

Taxation         •Completion by the Large-Taxpayer Unit of 10 comprehensive on-site audits by December 31, 1998.
                 •Completion by the Large-Taxpayer Unit of an additional 40 comprehensive on-site audits by June 30, 1999.
                 •Completion of on-site audits of all retail and nonretail gasoline outlets by the Uganda Revenue Authority by June 30,
                 1999.


Banking          •Completion of on-site examination of four commercial banks that have been identified as showing less-than-full
                 compliance with bank regulations or being in need of stronger management practices, and issuance of relevant
                 examination reports by September 30, 1998.

                                              Source: IMF.


                                              In the IMF staff paper to the Executive Board on Uganda’s request for the
                                              second annual arrangement, the staff stated that the government had met
                                              its macroeconomic objectives for 1997/98 and that real growth was
                                              reviving and inflation was low. The staff also said the end-June 1998
                                              quantitative and structural benchmarks were largely met, with the
                                              exceptions of net claims on the government by the domestic banking
                                              system (which was exceeded by a very small margin) and the number of



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                          public enterprises privatized (which set back significantly the privatization
                          program).

                          The 1998 external experts’ evaluation of ESAF noted that the IMF’s
                          traditional role is crisis management and that this has generally been the
                          context for the extension of ESAF arrangements. The evaluation stated
                          that Uganda had fully achieved stabilization and the major macroeconomic
                          reforms had been implemented, and consequently, the IMF has reached
                          the point where it had to decide whether to (1) maintain its exclusive focus
                          on crisis-management and so withdraw from Uganda, or (2) extend its
                          mandate and remain in Uganda. It noted that the case for withdrawal from
                          Uganda is that the IMF’s work is done. The case for continued involvement
                          was that (1) investors and donors still regard Uganda as high risk and want
                          the reassurance that an IMF presence brings, (2) the Ugandan government
                          still needs IMF expertise, and (3) ESAF resources are most productive in
                          an already reformed policy environment such as Uganda’s. The evaluation
                          favored continued IMF involvement in Uganda. U.S. Treasury officials felt
                          that continued IMF involvement in Uganda is warranted because the
                          reform program is still in a fragile state due to (1) serious weaknesses in
                          human and institutional capacity that the IMF is uniquely suited to help
                          remedy, and the recently-identified problems with corruption that are in
                          part related to these capacity deficiencies, and (2) the threats to fiscal and
                          economic stability posed the military security problems in the region.

                          IMF staff conducted their midterm review of Uganda’s performance under
Uganda’s                  the arrangement in February/March 1999 in conjunction with their annual
Nonobservance of          Article IV consultations. Staff found that the government had missed the
Criteria Results in the   December 1998 quantitative performance criteria on (1) net domestic
                          assets, (2) net credit to the government by the banking sector, (3) issuance
IMF Delaying of           of promissory notes for current expenditures, (4) minimum non-wage
Disbursement              expenditures in the social sectors of health and education, and (5)
                          minimum net reserves. The structural performance criterion on the
                          verification of arrears was also missed. The midterm review was
                          consequently not completed and the IMF delayed the second disbursement
                          under the arrangement.

                          An IMF official said the non-observance was marginal and the country’s
                          macroeconomic picture had not changed, with inflation remaining low and
                          the real growth rate possibly exceeding the government’s target of 7
                          percent. The official said that Ugandan revenues were very good due to (1)
                          improved controls of corruption in customs, (2) improved tax
                          administration, and (3) income tax reforms, such as a broadened tax net
                          and elimination of tax exemptions, which were paying off. However, the



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Appendix VII
The IMF’s Financial Arrangement with Uganda




official said the government had used the unexpected revenues to increase
military spending from 1.9 percent of GDP to 2.5 percent. Although the
increased military spending does not violate IMF criteria, the official
expressed concern that government officials not continually expect
revenues to exceed expectations in order to pay for increasing military
expenditures. The official said that IMF staff’s major concern was that
Uganda’s privatization effort was completely off track due to political
factors and corruption. The official said there is a loss in government
credibility and therefore buyers are reluctant to bid for enterprises in the
privatization program. The parliament had suspended the program while it
conducts an investigation. The IMF staff set prior actions relating to the
privatization program and the financial sector, which the government must
meet prior to the staff’s completion of the midterm review, which resumed
in May 1999 and is expected to be completed in June 1999. Despite these
problems, the IMF official said the Ugandan government has been quick to
react to IMF findings, is making efforts to meet IMF conditions, has fired
corrupt officials, has promised to hold down military spending, and should
still be classified as a good performer.




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Appendix VIII

Criticisms of the IMF


                The financial support that the IMF has provided to member countries,
                along with the conditions attached to that support, has long been a topic of
                debate. This issue recently received considerable prominence when the
                U.S. Congress considered an increased U.S. quota contribution to the IMF
                in 1998. While a full discussion of these issues is outside the scope of this
                report, several themes, including “moral hazard,” the appropriateness of
                IMF conditionality, and the effect of IMF programs on the poor, have been
                consistently raised and illustrate the complexity of this debate.

                The issue of moral hazard has two components: (1) the willingness and
                ability of an international financial institution, such as the IMF, to “rescue”
                a country from problems that may be of its own doing; and (2) the concern
                that the financing provided by these institutions is shielding private sector
                participants from the risks inherent in their investments. In the first
                instance, critics argue that the incentives for a country to avoid financial
                difficulties are diminished by its reliance on IMF assistance to lessen the
                impact of its policy mistakes. In response to this criticism, the IMF
                stresses that crises inevitably bring painful consequences, and that, in
                exchange for receiving its financial assistance, countries have to agree to
                adopt a stringent conditionality program that is designed to address each
                country’s underlying problems. The adjustments required in implementing
                such a program can be very costly and painful, and thus should provide
                sufficient disincentive to countries from pursuing questionable policies.
                Furthermore, countries are obligated to repay the IMF for the financial
                assistance provided.

                Under the second moral hazard issue, critics of the IMF contend that in
                providing financial support to countries, the IMF also “bails out” large
                international banks and other private lenders. When a member country
                receives financial assistance from the IMF, the funds can be used to pay
                off existing creditors including those in the private sector. This activity has
                raised concerns about the efficiency of the international financial system
                by shielding private sector participants from the risks inherent in their
                investments. If some creditors are not fully assuming investment risk, and
                are lending under the assumption that the IMF and other official support
                will be forthcoming if necessary, distortions could be introduced into the
                                                                                          1
                international financial system. The IMF and the Group of Seven (G-7), in
                recent public announcements, have acknowledged the existence of this
                threat to the international financial system and are exploring strategies for
                reducing it. However, it has been argued that the danger of moral hazard

                1
                 The G-7 consists of seven major industrialized countries (Canada, France, Germany, Italy, Japan, the
                United Kingdom, and the United States) that consult on general, economic, and financial matters.




                Page 175                                      GAO/GGD/NSIAD-99-168 IMF Financial Assistance
Appendix VIII
Criticisms of the IMF




should be balanced against the danger of the further spread of financial
difficulties, or “contagion.” During a crisis, lenders and investors may try
to limit their exposure to all developing countries, not just those in crisis.
This can result in countries with sound economic policies experiencing a
financial crisis, driven largely by external events out of their control. By
providing assistance to nations facing such a crisis, the IMF may also slow
or stop the exit of private-sector lending to other developing countries and
thus help minimize this potential threat to the international financial
system.

The appropriateness of IMF conditionality has also been subject to a
considerable amount of debate. First, some critics believe that the IMF has
overstepped its original mission by including conditions related to
economic and social development strategies (“mission-creep”). Second,
some critics have stressed that the imposition of an IMF conditionality
program, under crisis conditions, that lacks a political consensus is
unlikely to be successful and could in fact generate instability within the
country. Third, during the Asian financial crises, several critics questioned
the IMF’s underlying economic assumptions for these countries, believing
the initial IMF programs in Korea, Thailand, and Indonesia represented the
IMF’s standard approach to crises (macroeconomic austerity) that was
inappropriate for these countries’ situations. According to those critics, the
IMF’s “cookie-cutter approach” was doing those countries more harm than
good. In response, the IMF has said that the flexibility of its approach to
countries has allowed it to adapt to changing situations. In particular, its
increasing emphasis on structural issues has reflected a growing
understanding that balance-of-payments problems cannot be resolved if an
economy suffers from deep-seated structural weaknesses. Moreover, the
IMF has emphasized that its arrangements for individual countries
constantly evolve, depending on developments, and that conditions are
modified as necessary. The Thai, Indonesian, and Korean programs, for
instance, were modified to take account of these countries’ unexpectedly
severe recessions. The IMF has also striven in recent years to coordinate
its efforts with other international financial institutions, including the
World Bank.

The IMF has also been criticized because of the belief that its programs
impose undue hardships on the poor. These critics point out that IMF
programs often require that governments cut expenditures and reduce
budget deficits in order to meet the IMF’s macroeconomic goals. They
argue that such cuts often result in reductions in spending on health,
education, and other social programs vital to the poor. The IMF has
acknowledged that, in certain cases in the past, programs for the poor



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Appendix VIII
Criticisms of the IMF




have been excessively reduced. To lessen this potential, the IMF says that
it now pays considerable attention to social issues and to social safety
nets, to the point of sometimes now requiring that countries maintain
minimum spending levels for social programs, despite the need for a
general reduction in government spending.




Page 177                          GAO/GGD/NSIAD-99-168 IMF Financial Assistance
Appendix IX

Comments from the Department of the
Treasury




Now on p. 3.




Now on p. 2.




               Page 178   GAO/GGD/NSIAD-99-168 IMF Financial Assistance
Appendix IX
Comments from the Department of the Treasury




Page 179                              GAO/GGD/NSIAD-99-168 IMF Financial Assistance
Appendix X

GAO Contacts and Staff Acknowledgments


                  Susan S. Westin (202) 512-8678
GAO Contacts      Harold J. Johnson (202) 512-4128

                  James McDermott, Thomas Melito, Barbara Keller, Cheryl Goodman,
Acknowledgments   Gezu Bekele, John DeForge, Patrick Dynes, Nima Patel Edwards, Debra
                  Johnson, Bruce Kutnick, Samantha Roberts, RG Steinman




                  Page 180                           GAO/GGD/NSIAD-99-168 IMF Financial Assistance
Glossary


                          This glossary is provided for reader convenience, not to provide
                          authoritative or complete definitions for IMF funding arrangements,
                          programs, and facilities.

Arrangement               A decision by the IMF that gives a member the assurance that the
                          institution stands ready to provide foreign exchange or special drawing
                          rights (SDRs) in accordance with the terms of the decision during a
                          specified period of time. An IMF arrangement—which is not a legal
                          contract—is approved by the IMF Executive Board in support of an
                          economic program under which the member undertakes a set of policy
                          actions to reduce economic imbalances and achieve sustainable growth.
                          Resources used under an arrangement carry with them the obligation to
                          repay the IMF in accordance with the applicable schedule, and to pay
                          charges on outstanding purchases (drawings). (See “purchases and
                          repurchases.”)

Article IV Consultation   Under Article IV of the IMF’s Articles of Agreement, the IMF holds bilateral
                          discussions with members, usually every year. A staff team visits the
                          country, collects economic and financial information, and discusses with
                          officials the country’s economic developments and policies. On return to
                          headquarters, the staff prepares a report, which forms the basis for
                          discussion by the Executive Board. At the conclusion of the discussion, the
                          Managing Director, as Chairman of the Board, summarizes the views of
                          directors, and this summary is transmitted to the country’s authorities.

Articles of Agreement     An international treaty that sets out the purposes, principles, and financial
                          structure of the IMF. The Articles, which entered into force in December
                          1945, were drafted by representatives of 45 nations at a conference held in
                          Bretton Woods, New Hampshire. The Articles have since been amended
                          three times, in 1969, 1978, and 1992, as the IMF responded to changes in
                          theworld economic and financial structure.

Balance-of-Payments       A country’s balance-of-payments accounts summarize its dealings with the
                          outside world. Balance-of-payments accounts are usually divided into two
Accounts                  main parts, the current account and the capital account. A country is said
                          to have a surplus in its balance-of-payments if there is an increase in its net
                          official assets (official reserves minus its liabilities to foreign official
                          institutions). It is said to have a deficit (or external deficit) if there is a
                          decrease in its net official assets.

Basis Points              The smallest unit in quoting yields on bonds, mortgages, and notes, equal
                          to one one-hundredth of one percentage point.




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                          Glossary




Basle Capital Standards   Bank regulators from industrialized countries adopted standards for credit
                          risk exposure for internationally active banks in 1988 under the auspices of
                          the Bank for International Settlements. Known as the Basle Accord, the
                          standards were fully implemented in 1992 by member countries. The
                          standards are formula-based and apply risk-weights to reflect different
                          gradations of risk to each asset category. Since 1992, the standards have
                          been amended. The most notable amendment is the establishment of risk-
                          based capital requirements to cover market risk in bank securities and
                          derivatives trading portfolios.

Basle Core Principles     A set of standards for effective bank supervision, issued by the Basle
                          Committee on Banking Supervision in September 1997. The core principles
                          were developed in close collaboration with supervisors from around the
                          world, the IMF, and World Bank. The standards are comprised of 25 core
                          principles that form a sound framework on which to build supervisory
                          structures that meet the needs and conditions prevalent in individual
                          countries.

Benchmarks                In the context of IMF programs, a point of reference against which
                          progress may be monitored. Benchmarks are not necessarily quantitative
                          and frequently relate to structural variables and policies. In Enhanced
                          Structural Adjustment Facility Arrangements, some benchmarks are
                          designated as semiannual performance criteria and are required to be
                          observed in order to qualify for phased (semiannual) borrowings. In
                          addition, quantitative benchmarks are set for the quarters for which there
                          are no performance criteria, and structural benchmarks are set for any
                          date agreed upon under the arrangement.

Capital Account           The capital account of the balance-of-payments shows all flows that
                          directly affect the national balance sheet. It includes (1) direct investment
                          by foreign firms in domestic affiliates and by domestic firms in their
                          foreign affiliates; (2) portfolio investment, which include net purchases by
                          foreigners of domestic securities and net purchases by domestic residents
                          of foreign securities; (3) net lending to domestic residents and net lending
                          by domestic residents to foreigners; and (4) changes in cash balances,
                          which include changes in cash balances held by banks and other foreign-
                          exchange dealers, resulting from current and capital transactions.

Compensatory and          A special IMF financing facility (window) that was established in 1988 to
                          combine the long-standing Compensatory Financing Facility (retaining its
Contingency Financing     essential features) with elements of contingency financing. The
Facility                  compensatory element provides resources to members to cover shortfalls
                          in export earnings and services receipts, as well as excesses in cereal



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                         Glossary




                         import costs, that are temporary and arise from events beyond the
                         members’ control. The contingency element may help members with IMF
                         arrangements to maintain their economic programs when faced with a
                         broad range of unforeseen adverse external shocks.

Conditionality           As defined by the IMF, economic policies that members intend to follow as
                         a condition for the use of IMF resources. These are often expressed as
                         performance criteria (for example, monetary and budgetary targets) or
                         benchmarks, and are intended to ensure that the use of IMF credit is
                         temporary and consistent with the adjustment program designed to correct
                         a member’s external payments imbalance.

Current Account          This is the broadest measure of a country’s international trade in goods
                         and services. Its primary component is the balance of trade, which is the
                         difference between merchandise exports and imports. The current account
                         shows all the flows that directly affect the national-income accounts. It
                         includes exports and imports of merchandise and services, inflows and
                         outflows of investment income, and grants, remittances, and other
                         transfers.

Emergency Financing      A set of exceptional procedures established by the IMF to facilitate rapid
                         Executive Board approval of IMF financial support for a member while
Mechanism                ensuring the conditionality necessary to warrant such support. These
                         emergency measures are to be used only in circumstances representing, or
                         threatening to give rise to, a crisis in a member’s external accounts that
                         requires an immediate IMF response.

Enhanced Structural      An IMF facility established in December 1987 to provide assistance on
                         concessional terms to low-income member countries facing protracted
Adjustment Facility      balance of payments problems. The ESAF’s operations are financed
                         through borrowing by a trust administered by the IMF as a trustee.

Exchange Rate Policy     A government’s policies concerning at what price (or whether) it will seek
                         to stabilize or otherwise influence the rate of exchange between domestic
                         currency and other currencies.

Exchange Stabilization   Currency reserve fund of the U.S. government employed to stabilize the
                         dollar and foreign exchange markets. ESF is managed by the Treasury. The
Fund                     Federal Reserve Bank of New York acts as fiscal agent for the Treasury.
                         ESF holds special drawing rights allocated to the United States by the IMF.

Extended Arrangement     A decision of the IMF under the Extended Fund Facility that gives a
                         member the assurance of being able to purchase (draw) resources from



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                            Glossary




                            the General Resources Account, in accordance with the terms of the
                            decision, during a specified period, usually three to four years, and up to a
                            particular amount.

Extended Fund Facility      A financing facility (window) under which the IMF supports economic
                            programs that generally run for three years and are aimed at overcoming
                            balance-of-payments difficulties resulting from macroeconomic and
                            structural problems. Typically, an economic program states the general
                            objectives for the 3-year period and the specific policies for the first year.
                            Policies for subsequent years are spelled out in program reviews.

External Deficit            See “Balance of Payments Accounts.”

Fiscal Policy               Taxation and government spending policies designed to achieve
                            government goals, such as achieving full employment, price stability, or
                            growth in the economy.

Foreign Direct Investment   Foreign direct investment occurs when citizens of one nation purchase
                            nonfinancial assets in some other nation. Distinguished from portfolio
                            investment (below), foreign direct investment generally involves
                            ownership of assets used in production (e.g., factories).

Foreign Portfolio           The purchase by one country’s private citizens or their agents of
                            marketable noncontrolling positions in equity and debt securities issued by
Investment                  another country’s private citizens, corporations, banks, and governments.
                            Commonly, these marketable noncontrolling positions can be easily
                            reversed.

Foreign Exchange            Foreign exchange is the money issued by a foreign country.

Foreign Exchange Market     The foreign exchange market is an interbank or over-the-counter market in
                            foreign exchange that is a network of commercial banks, central banks,
                            brokers, and customers.

Foreign Exchange Reserves   The stock of liquid assets denominated in foreign currencies held by the
                            monetary authorities (finance ministry or central bank). Reserves enable
                            the monetary authorities to intervene in foreign exchange markets to
                            affect the exchange value of their domestic currency in the market.
                            Reserves are typically part of the balance sheet of the central bank.
                            Reserves are invested in low-risk and liquid assets—often in foreign
                            government securities.




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                          Glossary




Front-loading             In an IMF arrangement, placing a more that proportional part of the
                          disbursement of the financial resources available to a member near the
                          beginning of the arrangement.

General Arrangements to   Long-standing arrangements under which 11 industrial countries stand
                          ready to lend to the IMF to finance purchases (drawings) that aim at
Borrow                    forestalling or coping with a situation that could impair the international
                          monetary system. Since the establishment in 1962, these arrangements
                          have been renewed every four to five years and been invoked 10 times,
                          according to IMF documents. Additional funds are also available to the
                          IMF under an “associated agreement” with Saudi Arabia.

General Resources         Assets, whether ordinary (owned) or borrowed, maintained within the
                          IMF’s General Resources Account.

London Interbank Offer    Key interest rates at which the major banks in the London interbank
                          market are willing to lend funds to each other at various maturities and for
Rates (LIBOR)             different currencies. LIBOR has become the most important floating rate
                          pricing benchmark for loans and debt instruments in the global financial
                          markets. These rates are published daily by the Bank of England and are
                          based on a sampling from a group of reference banks that are active in the
                          Eurocurrency market, but agreements that use LIBOR do not necessarily
                          rely on quotes published by the Bank of England.

Macroeconomic Policy      Macroeconomic policy is governmental and central bank policy
                          concerning a nation’s economy as a whole including, among other things,
                          price levels, unemployment, inflation, and industrial production. The
                          macroeconomic analysis of open economies is concerned with the effects
                          of international and domestic transactions on output, employment, and the
                          price level and the effects of these in turn on the balance of payments and
                          exchange rate. It is also concerned with the implications of openness and
                          of exchange-rate arrangements for the functioning of monetary and fiscal
                          policies.

Monetary Policy           Monetary policy is the central bank’s use of control of the quantity of
                          money and interest rates to influence the level of economic activity. The
                          quantity of money can affect price levels and, for a given real income, the
                          level of nominal income within a given system. The central bank often
                          concentrates its policy actions, such as the interest rates it charges banks
                          to borrow, to achieve a money stock target. In theory, the demand for
                          money changes with changes in income and interest rates, in addition to
                          other factors.




                          Page 185                           GAO/GGD/NSIAD-99-168 IMF Financial Assistance
                            Glossary




New Arrangements to         Arrangements under which 25 member countries or their financial
                            institutions would be ready to lend to the IMF under circumstances similar
Borrow                      to those covered by the General Arrangements to Borrow (see General
                            Arrangements to Borrow). The New Arrangements to Borrow are not to
                            replace the General Arrangements to Borrow, and the total amount of
                            resources potentially available under the New Arrangements to Borrow
                            and the General Arrangement to Borrow is about $46 billion. The New
                            Arrangements to Borrow can be activated when participants representing
                            85 percent of the credit lines’ resources determine that there is a threat to
                            the international financial system. The New Arrangements to Borrow
                            became effective on November 17, 1998 and were activated in December
                            1998 in connection with the financing of an arrangement for Brazil.

Performance Criteria        Measurable and observable indicators, such as monetary and budgetary
                            targets, or structural (policy) adjustments, that must be met, typically on a
                            quarterly basis, for a member to qualify for purchases under a country’s
                            arrangement with the IMF. These indicators measure a country’s
                            implementation of conditions agreed to under the country’s IMF program.
                            Performance criteria are generally categorized as quantitative or structural
                            depending on the conditions being measured. (See also “benchmarks.”)

Phasing                     The practice of making the IMF’s resources available to its members in
                            installments over the period of an arrangement.

Purchases and Repurchases   When the IMF makes its general resources available to a member, it does
                            so by allowing the member to purchase SDRs or other members’
                            currencies in exchange for its own (domestic) currency. The IMF’s general
                            resources are, by nature, revolving; purchases (or drawings) have to be
                            reversed by repurchases (or repayments) in installments within the period
                            specified for a particular policy or facility.

Quantitative Performance    See “performance criteria” and “benchmarks.”
Criteria

Quota                       The capital subscription, expressed in SDRs, that each member must pay
                            to the IMF on joining, up to 25 percent is payable in SDRs or other
                            acceptable reserve assets and the remainder in the member’s own
                            currency. Quotas, which reflect members’ relative size in the world
                            economy, are normally reviewed every five years.




                            Page 186                           GAO/GGD/NSIAD-99-168 IMF Financial Assistance
                         Glossary




Sovereign Debt           The debt instruments issued or guaranteed by the central government of a
                         country. Debt instruments are typically bonds evidencing amounts owed
                         and payable on specified dates or on demand.

Special Drawing Right    International reserve asset created by the IMF in 1969 as a supplement to
                         existing reserve assets. Its value as a reserve asset is derived, essentially,
                         from the commitments of participants to hold and accept SDRs and to
                         honor various obligations connected with its proper functioning as a
                         reserve asset. The IMF defines its value in terms of a basket of major
                         international currencies that fluctuates with market conditions.

Stand-by Arrangement     A decision of the IMF by which a member is assured that it will be able to
                         make purchases (drawings) from the General Resources Account up to a
                         specified amount and during a specified period of time, usually one to two
                         years, provided that the member observes the terms set out in the
                         supporting arrangement.

Structural Performance   See “performance criteria” and benchmarks.”
Criteria

Supplemental Reserve     A facility (window) established in December 1997 to provide financial
                         assistance to members experiencing exceptional balance of payments
Facility                 difficulties due to short-term financing needs resulting from a sudden and
                         disruptive loss of market confidence reflected in pressure on the capital
                         account and the members’ reserves.




                         Page 187                            GAO/GGD/NSIAD-99-168 IMF Financial Assistance
Page 188   GAO/GGD/NSIAD-99-168 IMF Financial Assistance
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