Mozambique - Economic Management Reform Operation Project

Document of The World Bank FOR OFFICLAL USE ONLY Report No. P-7276-MOZ REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED GRANT IN THE AMOUNT EQUIVALENT TO SDR 109.5 MILLION TO THE REPUBLIC OF MOZAMBIQUE FOR AN ECONOMIC MANAGEMENT REFORM OPERATION November 17, 1998 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS (as of November 1998) Currency Unit: Metical (Mt); plural: Meticais US$1 = Mt 12,084 FISCAL YEAR January 1 to December 31 ABBREVIATIONS AND ACRONYMS BCM Banco Comercial de Mo,ambique BM Bank of Mozambique BPD Banco Popular de Desenvolvimento CAS Country Assistance Strategy CG Consultative Group CFM Caminhos de Ferro de Mo,ambique national railways) CRF Clean Report of Findings EMOSE Empresa Mo,ambicana de Seguros EMR Economic Management Reform Operation EMRS Expenditure Management Reform Strategy ESAF Extended Structural Adjustment Facility GDP Gross Domestic Product GNP Gross National Product FIAS Foreign Investment Advisory Service HIPC Heavily Indebted Poor Countries IDA International Development Association IFC International Finance Corporation IMF International Monetary Fund LAM Linhas Aereas de Mo,ambique (national airline) MIGA Multilateral Investment Guarantee Agency PETROMOC Empresa Nacional de Petr6leos de Mo,ambique PSI Pre-shipment Inspection SAD Single Administrative Document SADC Southern Africa Development Community TERC Third Economic Recovery Credit UTRE Enterprise Restructuring Technical Unit VAT Value Added Tax Vice President Callisto E. Madavo Director : Phyllis Pomerantz Sector Manager : Ataman Aksoy Task Team Leader : Manuela Ferro  FOR OFFICIAL USE ONLY MOZAMBIQUE ECONOMIC MANAGEMENT REFORM OPERATION Table of Contents SUMMARY .......................................................... -ii PART I. THE ECONOMY ...................................................1..... A. BACKGROUND ......................................................... I B. RECENT ECONOMIC DEVELOPMENTS ........................................................ 3 PART II. MOZAMBIQUE'S ADJUSTMENT PROGRAMA .................................................... 4 A. CONSOLIDATING MACROECONOMIC STABILITY ......................................................... 5 B. PRIVATIZATION AND PRIVATE SECTOR DEVELOPMENT ........................................................ 9 C. HUMAN DEVELOPMENT AND POVERTY REDUCTION ......................................................... 1 0 D. MEDIUM-TERM PROSPECTS AND EXTERNAL FINANCING REQUIREMENTS ................................. 11 PART III. THE PROPOSED OPERATION ........................................................ 11 A. RATIONALE FOR THE OPERATION AND LINK WITH HIPC REFORM AGENDA ............................. 11 B. LINK TO THE CAS AND POVERTY IMPACT ......................................................... 12 C. OPERATION COMPONENTS ........................................................ 13 D. SPECIFIC AGREEMENTS UNDER THE OPERATION ........................................................ 16 E. OPERATION AMOUNT, DISBURSEMENT PROCEDURES AND IMPLEMENTATION ARRANGEMENTS ........................................................ 17 F. BENEFITS AND RISKS ........................................................ 17 PART IV. BANK OPERATIONS ........................................................ 18 PART V. COLLABORATION WITH THE IMF ........................................................ 18 PART VI. RECOMMENDATION ......................................................... 19 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not be otherwise be disclosed without World Bank authorization.  ANNEXES A. SOCIAL INDICATORS B. KEY ECONOMIC INDICATORS C. KEY EXPOSURE INDICATORS D. EXTERNAL FINANCING REQUIREMENTS AND SOURCES OF FINANCING E. STATUS OF BANK GROUP OPERATIONS IN MOZAMBIQUE F. SUPPLEMENTARY GRANT DATA SHEET G. MATRIX OF ACTIONS H. KEY MONITORING INDICATORS 1. MOZAMBIQUE AT A GLANCE J. LETTER OF DEVELOPMENT POLICY This operation was prepared by a team consisting of Manuela Ferro (Economist and Task Team Leader, AFTMI); Jehan Arulpragasam (Economist, AFTMI); Luis de Azcarate (Consultant); David Wilton (Sr. Financial Sector Specialist, AFTP I); Rocio Castro (Sr. Economist, AFTM4); Ataman Aksoy (Sector Manager, AFTM4); Peter Miovic (Sector Manager, AFTM2); Frederick Kilby (Lead Specialist, AFTM2); Kishor Uprety (Legal Counsel, LEGAF); Maria Teresa Benito-Spinetto (Research Assistant, AFTMI); and Adriana Flynn (Sr. Language Task Team Assistant, AFTMI).  MOZAMBIQUE ECONOMIC MANAGEMENT REFORM OPERATION SUMMARY Recipient: Republic of Mozambique Executing Agency: Ministry of Planning and Finance Amount and Terms: SDR 109.5 million (US$150 million equivalent). This is an IDA grant as part of HIPC Interim Measures. Description: The proposed operation builds on the implementation of previous economic reforms and the progress achieved in stabilizing and jump-starting Mozambique's post-war economy. The program airns at sustaining growth with poverty reduction and diminishing dependency on external aid over the medium to long run. In particular, the proposed operation would support measures to enhance the sustainability and efficiency of public sector operations, focusing on fiscal reform. Measures to improve revenue mobilization and the incentive regime include indirect tax reforms, trade liberalization, and the rationalization of the import process. Expenditure management and budgetary reform measures include formulation of a medium-term fiscal framework, identification of off-budget flows and mechanisms for their inclusion in future budgets. Benefits: The proposed operation, designed to support explicit CAS and HIPC objectives, is part of a continuing set of reforms designed to consolidate a stable macroeconomic environment, sustain growth., and reduce poverty through improvements in the sustainability of public service delivery. Risks: The proposed operation involves three categories of risk. First, in spite of progress in building institutional and managerial capacity, weaknesses remain which could slow down execution or comprornise the quality of reforms. Second, resistance to further trade liberalization and tax reform might be expected. Third, parliamentary and presidential elections are planned for 1999, involving some risk of slippage in implementing reforms perceived to be  unpopular. These risks are mitigated by the Government's demonstrated commitment to a wide-ranging reform program, and by its ongoing efforts to carry out systematic consultation with stakeholders. Disbursements: The proposed Grant of US$150 million will be disbursed in two equal tranches, the first upon effectiveness and the second when all second tranche conditions *are satisfied, expected by mid-1 999. Project ID Number: MZ-PE-1767  REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED ECONOMIC MANAGEMENT REFORM OPERATION TO THE REPUBLIC OF MOZAMBIQUE 1. I submit for your approval the following report and recommendation on a proposed IDA grant to the Republic of Mozambique for SDR 109.5 million, an amount equivalent to about US$150 million in support of its structural adjustment program. This operation would provide IDA interim debt relief in the context of the Heavily Indebted Poor Countries (HIPC) debt initiative. 2. The proposed Economic Management Reform (EMR) operation is Mozambique's sixth adjustment operation. Mozambique is successfully managing a transition from war to peace and from a centrally-planned to a market-driven economy. The end of the war and the establishment of a democratic system have restored political stability, improving the development prospects for the country. A series of wide-ranging economic reforms has been implemented since 1987, supported by substantial external assistance. The pace of economic reform has accelerated markedly in the past three years, notably on privatization and financial sector reformn. This has contributed to restoring macroeconomic stability and sustaining economic growth. As a result of the strong stabilization and adjustment record as well as the Government's reform pro!gram, Mozambique qualified for the HIPC debt initiative in April 1998, with a completion point of June 1999. The proposed EMR operation would build on satisfactory implementation of reforms under previous adjustment operations and is designed to support the reform agenda as outlined in the Final HIPC Document for Mozambique of March 31, 1998. Specifically, the operation would support the Government's efforts, focusing on fiscal reform, to enhance the sustainability and efficiency of public sector operations. It would also support the implementation of key reforms agreed to in the Policy Framework Paper for 1998-2000, and complement the third annual ESAF program approved by the IMF Board in August 1998. I. THE ECONOMY A. Background 3. Macroeconomic Reforms and Performance. Starting in 1987, prior to the end of civil war, the first structural reforms marked the shift from a centrally-planned economy to a market- oriented one and initiated the liberalization of import controls and the price regime. During the post-conflict stage from 1992 to 1997, production, commercial and financial activities were privatized, while increased shares of government resources were allocated to the social sectors and infrastructure. Reforms in indirect tax and trade regime were initiated and the basic legislative framework for improved public resource management was established.  2 4. The reform program has been comprehensive and its implementation sound, especially in the light of limited technical and institutional capacity. The Government's phased but determined approach to stabilization and structural adjustment has had a positive impact on confidence levels from development partners as well as investors. Reforms have been strongly supported by external donors, with around two thirds of budgetary expenditures supported by external aid. 5. The cornerstone of the stabilization program has been the containment and reduction of the quasi-fiscal deficit linked to the financial and non-financial state enterprises. Until 1995, monetary outcomes had been less satisfactory, with quasi-fiscal losses associated with the banking system creating difficulties for monetary control. Control over the fiscal and quasi-fiscal deficits was achieved only with the privatization of the two public banks (Banco Comercial de Movambique, BCM, in 1996 and Banco Popular de Desenvolvimento, BPD, in 1997), as well as most large state- owned enterprises. This enhanced the effectiveness of fiscal and monetary policies and was the decisive factor in the restoration of macroeconomic stability. Macroeconomic stability and lower inflation has, in turn, resulted in a stable currency for the first time since the adjustment program was initiated. The Government's sustained implementation of the key elements of the reform program has been endorsed by the international community at successive Consultative Group (CG) meetings, the most recent of which took place for the first time in Mozambique in September 1998. .5. As a result of economic reforrns, as well as population resettlement and a series of favorable crop seasons, the economy is experiencing a strong recovery. Although starting from a low base, Gross Domestic Product (GDP) growth rates have averaged over 6 percent during the last four years. In addition to strong growth, main macroeconomic developments during the last decade include the reduction of the fiscal deficit before grants since 1990, a sharp reduction in central bank financing of the Government since 1989, and a downward trend in the current account deficit as a percentage of GDP. Mozambique Sub-Saharan Africa GNP per capita (US$, 1997) 130 500 Life expectancy at birth (years) 45 52 Infant mortality (per 1,000) 134 91 Maternal mortality (per 100,000) 1,100 700 Illiteracy (% population age 15+) 60 43 Gross primary enrollment (% age group) 60 75 Of which: Female 50 67 Sources: Government of Mozambique and staff estimates (latest year, unless otherwise indicated). 7. Human development and poverty reduction. While progress on the economic front has been impressive, Mozambique's reconstruction needs, in terms of both econornic infrastructure and social services, remain large and pressing. With a per capita GNP of only $130 and one of the highest ratios of aid dependency in the world, Mozambique's recovery starts from a very low base. Mozambique's social indicators remain weak, even by Sub-Saharan Africa standards. Social service delivery suffered during the civil war, when one third of all rural health units and nearly 70  3 percent of the school network were destroyed or closed down. Despite a tight fiscal situation, the Government increased locally-financed health and education expenditures each year between 1990 and 1997 (with the exception of 1994, when significant resources had to be mobilized to finance elections, demobilization, and post-war resettlement). In health, efforts have focused on the rehabilitation of the primary health network, drug supplies, and training of health personnel. An integrated sector health sector expenditure program aimed at improving access and quality of health services, in particular in rural areas, was adopted in 1995. Service utilization expanded by 12 percent in 1994-95 and by an estimated 8 percent in 1996. Access to primary education has also increased after the war, but quality remains low. The number of primary classrooms, particularly in rural areas, has increased by about 40 percent between 1992' and 1996, and the average gross primary enrollment rate rose from 54 to 62 percent over the same period. Although improving, quality indicators such as teacher qualifications, availability oi textbooks, and the student/teacher ratio (58:1) remain unsatisfactory. As a result, repetition and drop-out rates are still high and enrollment rates for secondary education are only 3 percent. An integrated, basic education program financed by multiple donors is at an advanced stage of preparation. B. Recent Economic Developments 8. The main economic developments since 1996 have been the continuation of growth and the reduction in inflation. Real economic growth, strong since the start of adjustment in 1987, increased to 7.1 percent in 1996 and 12.4 in 1997.' Growth has been broad based, with transportation, agriculture, and more recently, industry showing particularly encouraging outcomes. The twelve- month inflation rate declined from 16.6 percent at end-96 to 5.8 percent at end-97, due to better monetary control, favorable weather, and declining import prices. This trend continued during the first semester of 1998. Net international reserves of the Bank of' Mozambique rose to the equivalent of 4 months of imports at end-1997 and the nominal exchange rate has been stable. However, the metical appreciated in real effective terms between late 1995 and early-1998, leading to concerns about a possible loss of external competitiveness. The external account deficit narrowed by about nine percentage points during 1996-97, reflecting an expansion of export volumes and an improvement in the terms of trade. The current account appears to be weakening in 1998, reflecting the start-up of large projects (the Mozal aluminum smelter, the Maputo Development Corridor, and rehabilitation of textile and sugar factories), as well as possibly an increased demand for imports associated with the real effective appreciation of the metical through early 1998. 9. A second three-year arrangement under the IMF's Enhanaced Structural Adjustment Facility (ESAF) was approved by the IMF Board in June 1996. Performance during the annual ESAF program that was completed in June 1998 and the 1997-1999 Policy Framework Paper has been generally satisfactory. End-December 1997 quantitative benchm,arks under the ESAF program were observed, except that relating to the net domestic assets of the banking system. Growth of money and credit to the private sector exceeded program targets in 1997 because of stronger-than-expected economic growth and money demand. A mid-term ESAF review was successfully completed in April 1998 and a new ESAF program was approved in late August 1998. Good progress is being I This document uses new national accounts series compiled by the National ][nstitute of Statistic (INE).  4 made in the implementation of the structural reforms included in the 1998-2000 Policy Framework Paper. In addition to the privatization of the two state-owned banks, 85 large enterprises and over 1000 small enterprises were privatized by June 1998. The importing and marketing functions of the oil company have been separated, the company's import monopoly eliminated, and a private oil importing company was created. Customs administration was entrusted to a specialized company in 1997 for a period of three years; a system of full reconciliation of import taxes due and paid was set up; and average import duties were lowered from 18 to 11 percent and exemptions curtailed. In addition, new budgetary recording and monitoring procedures were introduced; public administration is being decentralized and a civil service reform agenda is being implemented; banking supervision is being strengthened and bank reserve requirements were lowered, made more flexible, and extended to foreign currency deposits; and, the payments system is being modernized. 10. Progress with certain reforms has been slower than envisaged because of limited technical and implementation capacity rather than lack of commitment by the Government. This has been the case with the introduction of the Value Added Tax (VAT), which was delayed from the originally envisaged date of July 1, 1998 to April 1999, the improvements in the quality of economic and social statistics (for instance, the national accounts, balance of payments, poverty and employment statistics), and the modernization and simplification of the legal and regulatory framework to facilitate trade and investment. 11. Mozambique's debt burden remains heavy. At end-December 1997, the external public and publicly-guaranteed debt stock was US$5.5 billion, or 283 percent of GDP and its present value was 685 percent of exports of goods and nonfactor services. In 1997, total debt service payments after debt relief amounted to 24 percent of exports of goods and nonfactor services. To address the debt problem, and on the basis of its adjustment track record as well as the reform program it has defined through 1999, Mozambique qualified for the HIPC initiative in April 1998, with a completion point of June 1999. Subject to satisfactory performance in the implementation of key structural reformns under IDA and IMF-supported programs, including this operation, Mozambique will benefit from a stock of debt reduction under the HIPC initiative at the completion point. After the completion point, the stock of public debt is expected to decline to US$1.1 billion in net present value terms, and public debt service payments after debt relief are expected to fall below 20 percent of exports. II. MOZAMBIQUE'S ADJUSTMENT PROGRAM 12. Mozarnbique's medium- and long-term goals are to create the conditions for poverty- reducing growth, while lowering the country's dependence on external aid. The medium-term outlook is good, as the Government has been successful in stabilizing and jump-starting the economy after the war and has moved decisively towards adoption of the basic rules of a market economy. Peace has been restored, populations have resettled, growth has resumed, and stabilization is gradually being achieved. The Governmuent is now embarking on a set of reforms aimed at sustaining growth and ensuring a wider spread of its benefits, while gradually reducing dependence on external aid. These involve: (i) consolidation of macroeconomic stability through improved sustainability and efficiency of public sector operations; (ii) privatization and private  5 sector development; and (iii) human development and poverty reduction. 13. For the medium-term, annual growth is projected at over 7 percent, led by domestic and foreign investment and agricultural exports. The strategy for attaining these objectives involves reliance on private-sector led growth, which will be fostered through the enhancement of export competitiveness and reduction of the anti-export bias in the tax and tariff system, as well as the creation of a business-friendly environment. Growth-oriented policies will be complemented by institutional and policy reforms to improve the quantity and quality of delivery of public services and assistance to the poor. Progress is being made in resolving the external debt problem with Mozambique's recent eligibility for the HIPC initiative. A. Consolidating Macroeconomic Stability 14. The Government plans to capitalize on the macroeconomic stability gains achieved so far by strengthening fiscal management, including the coordination between fiscal and monetary policies. The macroeconomic framework for the 1998-2000 period targets: (i) real GDP growth of about 7 percent (excluding large projects); (ii) end-of-period inflation o f 6 to 8 percent; (iii) the maintenance of gross international reserves at approximately 5 months of projected imports in 1998, declining to 4 months in 2000; and (iv) zero net government repayments to the banking system in 1998 and 1999. Several large-scale private investment projects in energy (electricity and gas) and other sectors (iron, steel, aluminum), including activities associated with the Maputo Development Corridor, are expected to push total GDP growth to over 9 percent in 1998 and 1999. (a) Fiscal Policies 15. Mozambique's inherited large fiscal and external imbalances, if they persist, will continue to imply levels of foreign assistance which are neither assured nor desirable. Despite progress in 1996 and 1997, fiscal reform will remain at the center of Mozambique's reform agenda in the coming years. Given Mozambique's high degree of dependence on external aid and its still weak revenue base, as well as the need to improve the quality and quantity of public services, the attainment of fiscal sustainability is a critical objective, from the point of view of both short-term macroeconomic management and growth prospects. Complementing the external debt relief to be provided under the HIPC debt initiative, the Government's reform program for attaining fiscal sustainability involves: (i) developing a more efficient and less distorting revenue mobilization system; and (ii) improving sustainability and efficiency of public expenditures, including local and externally- financed expenditures. (i) Revenue Mobilization and the Incentive Regime 16. Until recently, revenue growth has outweighed considerations of an optimal tax structure in the Government's taxation policy. This was unavoidable because continuing to pursue fiscal adjustment through expenditure reduction would have underrmined priority social and economic programs. The focus on revenue growth, while justified in terms of macroeconomic adjustment,  6 public expenditure needs, and reduction in aid dependence, can have costs in terms of resource misallocation if it is based on a distortive tax system. Furthermore, the rapid economic growth of the past decade has increased the number of taxpayers but also the incentives and opportunities for tax evasion, as tax laws, administration, and audit capabilities have become increasingly inadequate for Mozambique's new economy. 17. The basic structure of domestic tax system suffers from a number of problems, including high rates, coupled with exemption and special incentive regimes, and weak administration. Following a 1986 tax revision, Mozambique's Government shifted to a greater reliance on indirect taxes. In 1997, taxes on goods and services (turnover, consumption, petroleum) accounted for 56 percent of total tax revenue, while direct taxes and trade taxes contributed around 20 percent each. The turnover tax, which generates around one third of total tax revenue, is a cascading sales tax that applies at all production stages, reaching rates of over 25 percent and distorting economic incentives. The consumption tax still has the features more of a general sales tax than of a selective excise duty. Corporate tax rates are high by international standards, but yielded only 10 percent of tax revenue in 1997. Furthermore, non-uniform rates (35 percent for agriculture, 40 percent for manufacturing, and 45 percent for all other activities) discriminate against service industries, which are labor intensive and could contribute to reducing unemployment. 18. The trade tax system has been substantially rationalized and the level of trade taxes reduced since the early 1990s. A major trade reform, implemented in 1996, further simplified the import tariff structure, lowered the average (trade-weighted) nominal duty rate from 18 percent to 11 percent, and limited exemptions. This reform represented an important step toward improving economic incentives for producers, lowering prices for consumers, and simplifying customs administration. However, with a top duty rate of 35 percent on final goods and 2.5 to 7.5 percent on intermediates (5 percent on capital goods), effective protection on final products remains high while that on raw materials could be low or negative. Further, import surcharges were introduced for a few commodities and a number of goods remain misclassified. Given that Mozambique recently signed the protocol creating the Southern Africa Development Community (SADC) free trade area, it is committed to eventually eliminating import tariffs on intra-SADC trade.2 19. Although improving, tax administration is still very weak, allowing for high levels of tax evasion and fraud. The main problems confronting the tax administration are the shortage of qualified personnel, unproductive paperwork due to outdated and complicated procedures, inadequate data generation, and absence of vital sections such as a research and policy unit, statistical unit and survey unit. On the trade side, the customs reform program has begun and has three components: (i) management of customs: a specialized firm was contracted in 1997 to manage day-to-day customs operations for a period of three years; (ii) customs restructuring: to sustain improved management, a program of training, computerization, procedural review, and reorganization has already started and will be completed in 1999; and (iii) pre-shipment inspection (PSI): under a new PSI contract, full reconciliation of all import taxes due and paid is being carried out. 2The SADC protocol will become effective when two-thirds of signatory members have ratified it. The protocol sets a period of 8 years for the elimination of tariffs on goods originating within the trading area after it becomes effective.  7 20. The Government has now embarked on a comprehensive medium-term revenue mobilization effort which will expand the tax base, lessen distortions due to the structure of the current tax regime, lower reliance on trade taxes, and continue to reduce tax exemptions. Some of these reforms have already started. In addition to the 1996 trade reform that lowered and simplified the tariff, export taxes were eliminated for all but two commodities (cotton and raw cashew) and even for these their level has been reduced. The coverage of the conrsumption tax was reduced in 1996 and preparations to replace the cascading turnover tax with a Value Added Tax (VAT) are at an advanced stage. 21. Tax reform is a long haul operation. The Government has recently lowered the level and rationalized the structure of the labor income tax and will begin rationalizing the corporate profit taxes by early-1999. In 1998 and 1999, key measures in the Government's tax reform program will be implemented: (i) replacing the turnover tax with a VAT; (ii) replacing the consumption tax with a narrower excise tax; (iii) further liberalizing the trade regime by reducing the top import duty rate for finished (consumer) goods from the current 35 percent; (iv) and simplifying the annual importer registration procedures as well as the import process. Because trade reform and the reform of customs administration are complementary undertakings, the Government will also continue its program to strengthen customs administration. The Government is also increasing the number of qualified personnel to administer and enforce tax laws, accelerating the process of defining tax identification numbers, and computerizing tax offices. (ii) Expenditure Management and Budgetary Reform 22. Since the end of the war in 1992, the Government has significantly reallocated expenditures towards health, education, and infrastructure. Military spending was reduced following the peace accords, the civil service is not considered to be large, and government salaries are extremely low. Currently, there is little scope for expenditure reduction due to pressing demands for increased social service delivery and infrastructure rehabilitation. There is a need to ensure adequate budgetary recurrent funds to finance health and education programs, maintain infrastructure, and to decompress civil servant salaries. 23. Given that about two thirds of the budget are financed with external aid, the Government is particularly concerned with the sustainability of expenditures over the medium term. The three-year rolling public investment plan, in place since 1989, has been a useful tool to evaluate and program the investment budget, but it has not allowed for the overall assessment of both recurrent and capital expenditures within a medium-term resource envelope. Moreover, still incomplete budgetary coverage, inadequate classification - with a considerable share of recurrent costs included in the investment budget, as well as poor monitoring of budget execution, particularly of grant-financed projects, have made it difficult to ensure the sustainability and efficiency of public expenditures. 24. In order to meet these concerns and ensure that medium-term priorities, such as continuing to increase the coverage and quality of health and education, are addressed, the Government launched a comprehensive Expenditure Management Reform Strategy (EMRS) in 1997. The objectives of the reform strategy are to ensure fiscal sustainability while increasing the transparency  8 and efficiency of public expenditures, including those financed through external aid. In particular, the EMRS focuses on: (i) improving the effectiveness of the budget as a tool to ensure that fiscal aggregates are sustainable in the medium term; (ii) improving the prioritization of public expenditures to attain stated policy objectives and outputs; and (iii) enhancing the transparency of public resource use. 25. Major steps in the implementation of the Government expenditure program have already been taken. In 1997, a new Budgetary Framework Law (Lei de Enquadramento Orqamental) was enacted, putting into place the fundamental principles for preparing, managing, executing, controlling, and accounting for the budget. These principles were already adopted for the 1998 budget. In 1998 and 1999, critical steps in the Government's expenditure and budgetary reform program include (i) identifying off-budget flows (both expenditures and revenues); (ii) identifying recurrent expenditures now in the investment budget and formulating a methodology for their correct reclassification as recurrent expenditures in future budgets; (iii) putting into place a computerized system to manage and control the budget; (iv) developing a rolling five-year medium- term fiscal framework to be used in the annual budgeting process (starting with the 1999 budget proposal) and to move towards linking budgeting decisions to specific outcomes; and (vi) examining alternative modem accounting systems for public accounts, for possible application in Mozambique in the near future. (b) Financial Sector Reform and Monetary Policy 26. Over the past three years, Mozambique's financial system has been transformed from an oligopolistic, state-dominated structure, into a more diversified and increasingly competitive system, better equipped to intermediate savings in support of the enterprise sector. New banking entry has been important in engendering greater competition and better banking services. Mozambique now has nine financial institutions operating within a majority privately-owned sector, including seven commercial banks, one leasing company and one cooperative bank. Nevertheless, the costs of banking activities remain high and obstacles to financial intermediation remain. These include limited availability of collateral, the small number of clients with proper accounting, and deficiencies in the judiciary system. As a result, real interest rates and interest rate spreads still remain high, albeit declining. While the reform of the financial sector is far from complete, recent trends indicate that more and better financial services are being offered to the banking public. 27. With an increasing number of participants, central bank oversight of the banking sector has become critical to ensure the continuing overall health of the financial system and macroeconomic stability. Several donors are assisting the Bank of Mozambique (BM) in its efforts to strengthen on- and off-site supervision. Annual on-site inspections of all banks operating in Mozambique will continue to be carried out and, starting in 1999, banks will be required to publish half-yearly financial statements. BM is more closely monitoring commercial banks' lending portfolios, exposure limits, overdraft, rediscount and refinancing facilities, as well as foreign exchange operations.  9 28. The privatization of the two large public banks, low inflation, and entry of new financial institutions have created the basic preconditions for a further deepening of the financial system. The Central Bank will phase in indirect monetary control instruments gradually. While it is too early for a shift into indirect controls as the primary method for imolementing monetary policy, the Government is establishing the cornerstones for the development of these instruments, namely, improved cash management at Treasury and coordination with the Central Bank, and continued emphasis on banking supervision. For instance, efforts are being focused on the development of a framework for forecasting changes in excess reserves and for actively managing the level of excess reserves through open market operations and increased use of the Treasury bill market. Simultaneously, quarterly net domestic assets ceilings for individual banks have been made indicative only and consideration will be given to shifting the semi-annual net domestic asset ceilings to an indicative basis as well. The BM is prepared to place and discount central bank or Treasury bills as required by its policy stance. Reliance on direct measures is expected to decline as the development of financial markets increases the efficiency of monetary policy. (c) Public Administration Reform 29. Another aspect of the Government's effort to strengthen public administration is civil service reform. This involves reclassification of career streams, revision of the compensation system, decompression of salaries, and increased training. The new career streams and compensation structure will be fully implemented by April 1999; they are intended to make Government employment, particularly at senior levels, more competitive with comparable jobs in the private sector and help the Government attract and retain qualified staff. Salaries were decompressed in April 1998 from a ratio of highest to lowest salary from 9.6:1 to 13:1. Further salary decompression, bringing the ratio to 17:1, is planned for April 1999. Also, non-wage incentives will be given to employees to work in the provinces, as part of an overall strategy to improve the delivery of social services in rural areas, strengthen local administration, and prepare the way for the creation of local government assemblies. B. Privatization and Private Sector Development 30. Mozambique's development strategy is premised on private sector-led growth. The Government is now completing a strong privatization program, and efforts in the sector will now increasingly focus on removing impediments to and establishing the legal and regulatory environment for competitive private sector development. All large enterprises in the Government's privatization program (those on the privatization list of the Technical Unit for Enterprise Restructuring) have been brought to the point of sale, with the exception of EMOSE, the national insurance company, and LAM, the national airline, which will be converted into limited liability companies by mid-1999. All small and medium-size enterprises are expected to be privatized by mid-1999. By the end of the privatization program in mid-1999, the government will have privatized about 88 large and 1,170 small and medium-size enterprises. The remaining public  10 enterprises after the current privatization program is completed are mainly utilities (electricity, telecommunications, water), and those involved in transport (airport authority, railways and ports, and Maputo bus transport), importation and distribution of petroleum products, news reporting (radio and television), dredging, and energy (hydrocarbons). The Government's objective is to make these entities function as commercial enterprises, through concessioning on long-term leases, demonopolization, and privatization of management. Concessioning of all railway company and port terminals is advancing and is expected to be completed by end-1999. Management of the five major urban water companies is to be privatized by mid-1999. A study on options for the telecommunications sector is expected to be completed in 1998, following which the Government will decide an appropriate course of action. A law to allow private participation in the energy sector was approved in June 1997. A public enterprise monitoring unit has been set up at the Ministry of Planning and Finance and will oversee Government participation in private sector enterprises, as well as the remaining state-owned enterprises. 31. Mozambique inherited a bureaucratic and cumbersome legal and administrative framework, which is a combination of outdated pre-independence laws and regulations, and the legal framework developed during the administrative-command system of central planning. This imposes high administrative costs on companies. The "Red Tape" study, conducted by FIAS in 1996, and four Private Sector Conferences, held annually in Maputo since 1995, have highlighted specific areas of needed changes. In 1997, the Government adopted an action plan aimed at removing unnecessary administrative barriers to investment and facilitating entry into productive and commercial activities. During 1998 and 1999, the Government will be implementing key measures, including simplification of procedures for company registration and for granting commercial and trading licenses, introduction of copyright legislation and of arbitration mechanisms to settle commercial disputes, and the revision of the Commercial Law, the Industrial Law and the Commercial Code. C. Human Development and Poverty Reduction 32. The Government's medium-term social objectives are consistent with the social objectives of the HIPC debt relief initiative. The medium-term goal is to improve poverty indicators to levels that at least match the average of sub-Saharan African countries. The Government's program emphasizes ensuring that adequate provision is made in the budget for recurrent health and education expenditures, that these sectors' budgets are executed as programmed, and that effectiveness of expenditures is improved through the development of multi-donor, integrated, sector expenditure programs and outcome-oriented budgeting. 33. An integrated Health Sector Recovery Program is under implementation, and an education sector expenditure program is being finalized. The health program focuses on: (a) increasing access to and the quality of health care through the rehabilitation and construction of first-level care facilities and rural hospitals, the provision of adequate medical supplies and pharmaceuticals, and the support of the nutrition program for severely malnourished children; (b) improving institutional and management capacity at the Ministry of Health, at both the central and provincial levels; and, (c) developing human resources through training of health workers and enhancement of university medical training. Regarding the education program, a draft sector strategy on which the program  11 will be based, Plano Estrategico da EducaVdo, has been comipleted in 1998 along with a public expenditure review for the sector. The program will support an expansion of the school network to increase access to primary and secondary education, and will promote greater participation of girls and people living in under-served regions. The progress andi impact of the program are being measured against specific targets and actions. 34. The Department of Population and Social Development, in the Ministry of Planning and Finance, is responsible for integrating poverty issues in the planning and policy making processes. With peace and the ensuing recovery in agriculture, emergency assistance is being phased out and the remaining safety nets are being restructured to improve cost-effectiveness and the targeting of benefits. The first national household survey was recently completed. The household survey will provide the basis for the National Poverty Assessment and a Poverty Action Plan by end- 1998. D. Medium-Term Prospects and External Financing Requirements 35. Medium-term macroeconomic prospects for Mozambique assume political stability and continued commitment to the implementation of the reform program. Broad-based growth is expected over the medium-term, reaching 7 percent in 1998 and 1999 (excluding large projects in energy and mineral processing). Export prospects are good, with export growth expected broadly in line with GDP growth. The country's external position may show some volatility over the near future, as construction of large, lumpy investments takes off. Early estimates indicate that the external account deficit may worsen in 1998, with first quarter imports increasing over 10 percent over the same period in 1997. This increase in imports maty already reflect the start of large investment projects, such as Mozal, as well as increased demand for imports resulting from the real effective appreciation of the metical through early 1998. In 1998, exports are expected to grow as a share of GDP, although not as rapidly as imports. Concessional assistance is expected to continue to play a significant role in Mozambique's economic development. For 1998, external financing requirements will amount to about US$1.8 billion, including rescheduling of arrears and current maturities on debt to the Russian Federation and other non-Paris Club bilateral creditors, and on the private commercial debt of Cahora Bassa. For 1999, the required amount is expected to decline to about US$1.4 billion. Private sector financing is expected to continue increasing, reflecting increased confidence in the economy. Financing gaps before ]IIPC assistance of US$606 million and US$570 million are projected for 1998 and 1999, respectively, and are expected to be covered by multilateral and bilateral grants and credits, including this operation. A Consultative Group meeting took place in September 1998, and provided indications that the external financing needs for 1998 and 1999 would be fully met by multilateral and bilateral grants and credits, including this operation. III. THE PROPOSED OPERATION A. Rationale for the Operation and Link with HIPC RefDrm Agenda 36. The proposed Economic Management Reform operation builds on the progress achieved in  12 stabilizing and jump-starting the country's post-war economy. It would support Mozambique's overall adjustment program and specifically assist in the implementation of the reforms highlighted under the HIPC initiative for Mozambique. Assuming continued implementation of a favorable macroeconomic framework, the proposed operation would focus on reforms aimed at improving the sustainability and efficiency of public sector operations, with a special focus on fiscal reform, and improving the business environment for sustained, private-sector led growth. 37. The Bank has supported Mozambique since the early stages of the reform program in 1987 with five adjustment credits.3 Two Economic Rehabilitation credits and the first Economic Recovery Credit supported the basic reforms that eased import controls and started liberalizing the price regime, even prior to the end of war. The Second and Third Economic Recovery Credits supported the reforms undertaken during the post-conflict stage from 1992 to 1997. The proposed EMR operation would build on satisfactory implementation of reforms under the previous credits and would support the implementation of key reforms agreed to in the Policy Framework Paper for 1998-2000. It complements the third annual ESAF program approved by the IMF Board in August 1998. The proposed operation was explicitly designed to support the reform agenda as outlined in the Final HIPC Document for Mozambique of March 31, 1998 and would also provide interim debt relief in the context of the HIPC initiative. B. Link to the CAS and Poverty Impact 38. The Bank's latest Country Assistance Strategy (CAS) for Mozambique was discussed by the Board in December 1997. The CAS supports the Government's program for poverty reduction through sustainable economic growth, emphasizing support to rural areas where most of the poor live. The CAS' strategic priorities aim at: (i) promoting rapid, broad-based private sector-led growth -- by supporting the macroeconomic reform agenda, supporting high potential growth sectors, creating a "business-friendly environment", and improving environmental management and assessment; (ii) building capacity and developing human resources -- by increasing Mozambican participation in the private sector, supporting public sector reform and decentralization, and increasing the coverage and quality of health and education services; and (iii) strengthening development partnerships -- by reinforcing the Bank Group/Government partnership, forging closer links with other aid partners, strengthening ties with civil society, including non-governmental organizations and the private sector, promoting regional partnerships, and ensuring coordination within the Bank Group. By supporting reforms aimed at improving the sustainability and efficiency of the public sector, this operation focuses directly on the first two priorities of the CAS. The operation is expected to benefit the poor through its emphasis on fiscal reform and on ensuring the sustained financing of priority social sector expenditures, such as health and education. 3 Table I, Annex I, summarizes the reforms undertaken under previous adjustment operations.  13 C. Operation Components (i) Revenue Mobilization and the Incentive Regime 39. Tax and Trade Policy. The proposed EMR operation will support the Government's comprehensive medium-term tax system reform. The main goals are three-fold: (i) to reduce the tax-induced distortions by moving towards a system of taxation that will interfere less with the efficient allocation of resources; (ii) to improve the efficiency of taxation; and (iii) to identify institutional changes that will improve the quality of tax administration. Specifically, during 1998 and 1999 the Government will: (i) lower the top import duty rate from 35 to 30 percent; (ii) effectively put exporters on a free trade basis, by maintaining low duty rates on raw materials, intermediates and capital goods; (iii) replace the cascading turnover tax and the consumption tax with a VAT plus selective excise taxes on a narrow range of products; (iv) continue implementing the overhaul of customs administration; and, (v) undertake a comprehensive review of the tax system, including the costs and benefits of special regimes in both trade and domestic taxes, with a view to rationalizing them and limiting their use in the future. 40. The next step of the indirect tax reform, which the proposed operation would support, is the introduction of the VAT plus a selective excise tax, to replace the turnover and consumption taxes.4 The planned VAT is broad based, covering services such, as electricity, transportation, and telecommunications. The main proposed exemptions include public medical services and drugs; non-profit activities; agriculture and fishing (producers can opt to have their activities taxed, in which case they would be eligible to receive VAT refunds); and firms with sales of less than Mt 50 million per year. Exports will be zero rated. A simplified regime is proposed for firms with sales from Mt 50-100 million/year, as these are not expected to have the organized accounting records essential for the normal application of the tax. Such firms will pay a tax of 5 percent on the volume of sales, with no deduction for taxes paid on inputs, on a quarterly basis. It is expected that a single VAT rate of 17 percent will be applied. The scope of the consumption tax will be narrowed to cover products whose consumption is considered to have negative effects on health and the environment (tobacco and alcoholic beverages), passenger moltor vehicles, as well as a few luxury items. Petroleum products are subject to a separate tax. Products are to be taxed ad valorem, at rates between 20 and 75 percent. 41. The proposed operation would also support the Government's efforts aimed at further liberalizing and rationalizing the trade regime. During the 1996 trade reforn, the Government was unable to reduce the top import duty further due to revenue considerations. Improved efficiency of duty collections that resulted from strengthened customs administration and the reduction in exemptions now allow for a reduction in the top duty rate from 35 to at least 30 percent, thus reducing the average duty rate from the current 11 percent to around 9 percent, as well as the dispersion in the tariff. The duty rates on raw materials, capital goods, and intermediate goods (classes M, K, and I in the tariff) will remain unchanged at 2.5, 5, and 7.5 percent, respectively. In 4Planned indirect tax reforms (replacement of the turnover tax with a VAT plus the narrowing of the consumption tax) are expected to be revenue neutral.  14 the coming year, the Government will also consider further reductions in the top duty rate as well as the elimination of import surcharges, which apply to four lines of the tariff, and rectification of remaining misclassifications. 42. Specific measures that the operation would support include: (i) definition of VAT coverage, adoption of the VAT rate, and issuance of Council of Ministers' decree creating the VAT Code (completed by negotiations); (ii) replacing the turnover tax with a VAT (Condition of Second Tranche release); (iii) replacing the consumption tax with a narrower set of excises, Imposto sobre Consumos Especificos (Condition of Second Tranche release); (iv) reducing the top import duty rate for finished (consumer) goods from 35 percent to 30 percent (Condition of Second Tranche release). The proposed operation would support the Government's plans to undertake an overall assessment of the tax system including the role of different tax instruments and tax incentives for new investments, namely, those currently provided under the Investment Law, the Industrial-Free Zone Law, and the Zambezi Valley Regime. 43. Customs Reform and Import Administration. The Government is continuing to strengthen customs administration and removing red tape in the import process. Important milestones in the customs reform program for 1998 and 1999 include: (i) customs restructuring, where a program of training, computerization, procedural review, and reorganization has already started and will be completed in 1999; and (ii) reconciliation of import taxes due and paid, including information on revenue foregone due to exemption regimes. 44. The restructuring of customs administration now requires the rationalization of the import process. The Government has introduced two key simplifications in import administration procedures, which this operation would support: (i) adoption of a streamlined registration mechanism for importers (completed as Condition of Board Presentation), instead of the previous annual registration according to 21 import classes (each subdivided into several categories); the new system requires just one general registration issued by the Ministry of Industry, Commerce and Tourism. The new registration will be renewable yearly, against a flat fee, for each importer in good standing (particularly with the tax authorities) with no restrictions as to the types of goods that can be imported; (ii) replacement of the current import documentation (Boletim de Registo de Importacao, Clean Report of Findings, and Despacho Aduaneiro) with a Single Administrative Document (SAD) (completed as Condition of Board Presentation). These simplifications will permit increasing transparency of the system as well as reducing the time, complexity, and therefore the costs, of the current system. In this context, procurement rules will apply only to imports financed by donors that so require. (ii) Expenditure Management and Budgetary Reform 45. The proposed operation would support critical elements of the Government's ongoing Expenditure Management Reform Strategy.5 In particular, the operation will support improvements 5 The policy changes are also being supported by parallel institutional capacity building programs, namely the Fiscal Management Review and the Financial Sector Capacity Building Project, both of which are being supported by IDA, as well as technical assistance support from ASDI, GTZ, UNDP, SDC, and DFID.  15 in: (i) budgetary management; (ii) sustainability and prioritization of Government resources; and (iii) accountability and transparency of budgeting. 46. Budgetary Management. The Government is putting into place a computerized management system that will allow it to better monitor budgetary allocations relative to the programmed budget, also taking into account mandated budget alterations during the course of the year. The system will establish routines and procedures for intra-annual budgetary management utilizing the new computerized system. After implementing the system centrally in 1998, an assessment will be made of the viability of implementing it at the provincial level. By June 1999, the Government plans to identify those budgetary flows which are currently off-budget and develop mechanisms for their inclusion in the budget. Furthermore, a detailed analysis of all expenditures currently classified as investment expenditures is being carried out so as to identify recurrent expenditures incorrectly classified in the investment budget and to include them in the recurrent budget, commencing in fiscal year 1999. 47. Specific milestones in the Government's reform prograrn that the proposed operation would support include: (i) identification of off-budget flows (expenditures and revenues in fiscal year 1998) and classification according to defined criteria, including function, size, origin, and statutory/legal basis (Condition of Second Tranche release); (ii) identification of recurrent expenditures currently in the investment budget (based on the fiscal year 1999 budget) and formulation of a methodology for their correct reclassification as recurrent expenditures in future budgets (Condition of Second Tranche release). 48. Sustainability of Expenditures. In order to ensure sustainability of public expenditures, the Government is developing a five-year medium term fiscal framework, which will aggregate planned sectoral expenditure programs within a framework consistent with the medium term available resources. Improved integration of the processes of macroeconomic planning and expenditure programming will tie more closely the prograrnming of revenue generation and financing with that of expenditure planning. The medium term fiscal framework will be formulated on a rolling basis each year, to serve as an input into its annual budgeting exercise. The framework will be presented annually prior to the budget preparation cycle to the Conselho Econ6mico (Cabinet Economic Subcommittee), starting with a submission in September 1998. Furthermore, the framework will be utilized to set sectoral budget limits at the beginning of the budget preparation cycle. 49. The Government is also moving to link budgeting decisions to outcomes defined by policy. The process of developing the fiscal framework at the sectoral level is aimed at linking the costs of expenditure programs to the activities and results that they are supposed to deliver. This will represent a fundamental change in the manner in which budget allocations are made, from an incremental budgeting system across all ministries, to one in which expenditure allocations will be made on the basis of defined sector expenditure programs aimed at delivering on agreed sectoral objectives. In this, the Government will build on the work already undertaken at the sectoral level. This includes sectors which either have sector expenditure programs in place (health, roads) or are in the process of designing them and putting them into place (agriculture, education, water). In support of these programs, the Government continues to be comimitted to expanding the share of the  16 social sectors in total spending, including in the locally-financed recurrent expenditures. In 1998, the share of current expenditures for health and education is expected to have increased from 8 to 9 percent and 17.3 to 17.9 respectively relative to 1997. In real terms, this would represent an increase of 20 percent in health and 16 percent in education. At the sectoral level, the Government intends to utilize activity- and outcome-based budgeting for three pilot sectors, namely, agriculture, education and health. These reforms are expected to directly bolster implementation of both the CAS and HIPC social objectives. 50. Specific milestones in the Government's reform program that the proposed operation would support include: (i) formulation of a rolling five-year medium term fiscal framework (Cendrio Econdmico de Medio Prazo) that links resource availability from the macro framework to a sector-based expenditure framework, presented annually to the Conselho Economico (Cabinet Economic Subcommittee), commencing in September 1998 (completed by negotiations); (ii) submission to the National Assembly of a budget proposal for fiscal year 1999 consistent with the medium-term fiscal framework, including increased shares of locally-financed recurrent expenditures for health and education, relative to the fiscal year 1998 budget (completed by negotiations). 51. Accountability and Transparency. The Government is beginning to take steps to improve its accounting system by improving reconciliation and further computerizing accounting. Computerized systems will improve institutional performance and productivity in the collection, processing, analysis and dissemination of information. Moreover, as per the new Budget Framework Law, the Government intends to close its accounts and present the annual Conta Geral do Estado (State accounts) to the National Assembly, commencing with that for the 1998 budget (to be presented by end- 1999). The Conta Geral do Estado will include all public institutions with all their revenues and expenditures and all types of public financial transactions. Work is under way to develop and adopt a new accounting system. By June 1999, the Government intends to examine options and define the new system of public accounts as well as a timebound program for its implementation. D. Specific Agreements under the Operation 52. Prior to Second Tranche release, the Government will: * Introduce VAT in replacement of the turnover tax; specifically, pursuant to the Decree No 50/98, dated September 29, 1998, the Govermment will issue a notice informing the public of the introduction of the Value Added Tax. * Introduce new consumption tax (Imposto sobre Consumos Especificos) on a narrow range of products; specifically, pursuant to the Decree No 51/98, dated September 29, 1998, the Government will issue a notice informing the public of the introduction of the new consumption tax (Imposto sobre Consumos Especificos).  17 * Reduce top import duty rate from 35 to 30 percent; specifically, the Government will issue a Decree stipulating the reduction of the import duty rate for consumption goods from 35 to 30 percent. * Produce and furnish to IDA a report which identifies off-budget flows (expenditures and revenues in FY98) and classifies them according to defined criteria (e.g. function, size, origin, and statutory/legal basis) so as to permit decision as to their future status including incorporation into the budget. * Produce and furnish to IDA a report which identifies recurrent expenditures now in the investment budget (based on the FY99 budget) ancl formulates a methodology for their correct reclassification as recurrent expenditures in future budgets. E. Operation Amount, Disbursement Procedures and Iimplementation Arrangements 53. Amount and Tranching. The proposed operation of US$150 million will be disbursed in two equal tranches, the first upon effectiveness and the second when all second tranche conditions are satisfied, expected by mid-1999. The program was designed to be "front-loaded". i.e., emphasizing actions taken prior to operation approval. The operation was also explicitly designed to assist in the implementation of the specific reforms highlighted under the HIPC initiative for Mozambique. The operation is in the form of a grant in order to provide interim debt relief under that initiative. 54. Disbursement Procedures. The operation will follow the Bank's new simplified disbursement procedures for structural adjustment operations. Under the revised procedures, the Operation proceeds will be disbursed against satisfactory implementation of the adjustment program. Upon effectiveness, the proceeds of the first tranche of the operation will be deposited by IDA in an account at the Bank of Mozambique at the request of the Borrower. If, after deposit of either of the two tranches in this account, the proceeds of the operation are used for ineligible purposes as defined in the Grant Agreement, IDA will require the Borrower to either: (a) return the amount to the account for use for eligible purposes; or (b) refund the amount directly to IDA. The execution of this operation will be the responsibility of the Ministry of Planning and Finance. Although an audit of the deposit account will not be required, lhe Bank reserves the right to require audits at any time. 55. Impact Indicators. To monitor the proposed operation's impact on fiscal sustainability, and growth, the following indicators will be monitored during supervision and included in the implementation report: (i) inflation rate; (ii) effective rates of import duty collection; (iii) anti- export bias; (iv) elapsed time for import application; and (v) export growth. F. Benefits and Risks 56. This operation, designed to support explicit CAS and HIPC objectives, is part of a continuing process of reform designed to consolidate a stable rnacroeconomic environment, sustain growth and alleviate poverty. The operation is expected to contribute to the consolidation of macroeconomic gains and to improve the sustainability and effectiveness of public sector services.  18 However, the proposed operation also involves risk in three areas. First, in spite of substantial progress in institutional and managerial capacity, many capacity weaknesses remain which can slow down execution or compromise the quality of reforms implemented. The complex process of VAT implementation, for instance, has been delayed in the past. Second, resistance to changes in the tax regime and further trade liberalization could face opposition from formal sector industrialists, some of whom are bound to suffer from decreased protection. Strong resistance has been experienced already in previous stages of the trade reform, namely from producers of consumer goods and the cashew nut processing industry. Resistance might also be expected regarding the replacement of the turnover tax with a VAT, which can be perceived as increasing the tax burden and administrative demands on companies. The Government is doing a great deal to mitigate these risks by instituting and actively carrying out systematic consultation with stakeholders and increasingly informing the public about the need and benefits of reforms. Examples of this approach are the consultations on trade reform and the ongoing public information campaign for the VAT. Third, parliamentary and presidential elections are planned for 1999, therefore increasing the risks for slippage in implementation of reforms perceived to be unpopular. The Government has reiterated its commitment to the adjustment program in general, including the HIPC reform agenda, and the reforms supported through this operation in particular. IV. BANK OPERATIONS 57. As of September 30, 1998, there were 16 ongoing IDA credits to Mozambique totaling about US$698 million. About US$322 million remain undisbursed. IFC's total approved investments of US$146 million include $76 million in loans, $5 million in equity, and $65 million in quasi-equity. A MIGA guarantee of US$40 million was recently approved. V. COLLABORATION WITH THE IMF 58. Bank and Fund staff collaborate closely in designing and monitoring the macroeconomic framework and the structural reform agenda. The Bank and the IMF have been working with the authorities since the early stages of the adjustment program in Mozambique on the preparation of successive Policy Framework Papers, and most recently on the preparation of the Debt Sustainability Analysis and the Board documents for Mozambique's access to the HIPC debt initiative. The latest annual ESAF arrangement was approved by the IMF Board on August 25, 1998 and the tenth PFP, which will guide the ongoing reform program from 1998-2000, was distributed to the Bank and Fund Boards on August 11, 1998.  19 VI. RECOMMENDATIODN 59. I am satisfied that the proposed operation would comply with the Articles of Agreement of the Association and I recommend that the Executive Directors approve it. James D. Wolfensohn President by Sven Sandstr6m Washington, D.C. November 17, 1998 Attachments  ANNEX A Page 1 of 1 Mozambique Social Indicators Latest single year Same regionlincome group Sub- Saharan Low 1970-75 1980-85 1990-96 Africa income POPULATION Total population, mid-year (millions) 10.5 13.5 18.0 596.4 3,236.2 Growth rate (% annual average) 2.2 2.3 3.5 2.7 1.8 Urban population (% of population) 8.6 19.4 35.5 31.7 29.1 Total fertility rate (births per woman) 6.5 6.5 6.1 5.6 3.2 POVERTY (% of population) National headcount index Urban headcount index Rural headcount index INCOME GNP per capita (US$) 11 150 110 490 490 Consumer price index (1987=100) 27 3,109 266 275 Food price index (1987=100) INCOME/CONSUMPTION DISTRIBUTION (,Y of income or consumption) Lowest quintile Highest quintile SOCIAL INDICATORS Public expenditure Health (% of GDP) .. 4.6 .. 1.5 Education (% of GNP) 4.2 6.3 5.3 3.6 Social security and welfare (% of GDP) Net primary school enrollment rate (% of age group) Total 51 40 Male 56 45 Female 47 35 Access to safe water (% of population) Total .. 9 32 45 76 Urban .. 82 17 63 80 Rural .. 2 40 34 72 Immunization rate (% under 12 months) Measles 39 71 56 80 DPT 29 57 55 81 Child malnutrition (% under 5 years) .. 47 Life expectancy at birth (years) Total 42 41 45 52 63 Male 41 40 44 51 62 Female 44 43 46 54 64 Mortality Infant (per thousand live births) 168 147 134 91 68 Under 5 (perthousand live births) 281 285 214 147 94 Adult (15-59) Male (per 1,000 population) 498 468 431 448 231 Female (per 1,000 population) 382 361 339 376 206 Maternal (per 100,000 ive births) .. 300 1,100 700 Source: World Development Indicators 1998 CD-ROM. World Bank and staff estimates. 11 For Mozambique, the national accounts source is the National Statistics Institute which in average is 30% higher than previous official figures from the National Planning Commission.  ANNEX B Page 1 of 3 Mozambique - Key Economic Indicators Actuals Estimate Projected Indicator 1995 1996 1997 1998 1999 2000 2001 National accounts (as % GDP at current market prices)' Gross domestic product 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Agricultureb 27.1 28.5 27.7 27.7 27.2 26.4 24.5 Industryb 20.5 21.1 21.7 19.9 19.5 19.2 19.0 Servicesb 42.1 40.8 40.1 41.2 42.0 42.4 44.2 Net indirect taxes 10.3 9.7 10.5 11.1 11.3 12.0 12.3 Total Consumption 89.4 90.6 86.4 84.0 84.1 80.6 76.6 Gross domestic fixed 36.1 30.1 29.5 35.2 41.0 40.6 40.1 investment Government investment 11.0 9.3 10.0 9.1 9.2 9.1 8.8 Private investment 25.1 20.8 19.5 26.0 31.8 31.5 31.2 (includes increase in stocks) Exports (GNFS)C 21.0 20.8 18.2 18.9 19.2 18.8 22.3 Imports (GNFS) 46.4 41.5 34.1 38.1 44.4 40.0 38.9 Gross domestic savings 10.6 9.4 13.6 16.0 15.9 19.4 23.4 Gross national savingsd 10.4 8.9 13.7 14.3 14.4 16.3 17.9 Memorandum items Gross domestic product 1937 2301 2753 3093 3412 3763 4352 (US$ million at current prices) Gross national product per 100.0 110.0 130.0 150.0 160.0 170.0 200.0 capita (US$, Atlas method) Real annual growth rates (%, calculated from 1995 prices) Gross domestic product at 4.3% 7.1% 12.4% 9.1% 9.6% 6.9% 13.6% market prices Gross Domestic Income 7.6% 6.0% 13.1% 9.0% 9.6% 6.9% 13.5% Real annual per capita growth rates (%, calculated from 1995 prices) Gross domestic product at -0.5% 3.5% 9.4% 6.2% 6.8% 4.1% 10.7% market prices Total consumption -13.9% 3.9% 4.9% 4.6% 6.0% 0.8% 3.7% Private consumption -9.7% 4.6% 3.2% 4.3% 6.1% 0.5% 3.6% (ContinUied)  ANNEX B Page 2 of 3 Mozambique - Key Economic Indicators (Continued) Actuals Estimate Projected Indicator 1995 1996 1997 1998 1999 2000 2001 Balance of Payments (US$m) Exports (GNFS)C 406.9 479.3 499.7 584.8 656.0 708.1 968.5 Merchandise FOB 174.3 226.1 221.0 291.8 343.3 370.8 604.6 Imports(GNFS)c 899.2 954.7 937.4 1178.3 1513.6 1506.9 1691.4 Merchandise FOB 727.0 782.6 760.0 980.5 1314.5 1302.8 1482.8 Resource balance -492.3 -475.4 -437.7 -593.5 -857.6 -798.9 -722.8 Net current transfers 0.0 0.0 0.0 0.0 0.0 0.0 0.0 (excluding capital official grants) Current account balance -337.6 -358.8 -263.1 -464.2 -652.2 -781.3 -781.4 (after official capital grants) Net private foreign direct 45.0 72.5 64.4 141.3 198.0 285.0 293.3 investment Net long-term loans(scheduled) 18.8 166.1 120.1 66.6 184.7 66.7 137.7 Other capital (net, including 333.4 279.5 193.3 286.3 301.5 402.6 390.7 errors and omissions) Change in reserves' -59.6 -159.3 -114.6 -30.0 -32.0 27.0 -40.3 Memorandum items Resource balance (% of -25.4% -20.7% -15.9% - 19.2% -25.1% -21.2% -16.6% GDP at current market prices) Real annual growth rates (1995 prices) Merchandise exports -2.9% 31.0% -4.4% 27.4% 13.5% 6.3% 35.2% (FOB) Merchandise imports -25.3% 8.2% 1.3% 27.2% 32.3% -2.2% 12.4% (CIF) Public finance (as % of GDP at current market prices)f Current revenues 14.0 13.4 14.4 14.7 14.2 15.0 15.5 Current expenditures 12.7 11.8 13.4 13.9 14.6 14.4 13.5 (Continued)  ANNEX B Page 3 of 3 Mozambique - Key Economic Indicators (Continued) Actuals Estimate Projected Indicator 1995 1996 1997 1998 1999 2000 2001 Current account surplus (+) 1.3 1.6 1.0 0.8 -0.4 0.6 2.0 or deficit (-) Capital expenditure 17.2 14.2 15.2 14.3 14.0 13.8 13.4 Foreign financing 16.9 14.2 16.1 13.6 14.4 13.2 11.4 Monetary indicators M2/GDP (at current market 28.6 22.9 23.3 23.4 23.4 23.4 23.6 prices) Growth of M2 (%) 54.7 21.1 24.4 17.0 16.0 15.1 21.1 Privatesectorcreditgrowth/ 139.4 171.2 152.0 99.0 100.0 100.0 100.0 total credit growth (%) Price indices( 1995 =100) Merchandise export price 95.9 95.0 97.1 100.6 104.3 106.0 108.2 index Merchandise import price 134.3 133.7 128.2 130.0 131.7 133.4 135.1 index Merchandisetermsoftrade 71.4 71.1 75.8 77.4 79.2 79.5 80.1 index Real exchange rate 45.0 51.8 56.4 56.5 56.5 56.5 56.5 (US$/LCU)5 Real interest rates Consumer price index' 54.4% 44.6% 6.4% 3.3% 7.7% 6.0% 6.0% (% growth rate) GDP deflator' 52.0% 40.9% 8.8% 7.0% 5.8% 7.7% 5.6% (% growth rate) Source: Bank of Mozambique, National Statistics Institute, National Planning Commission, IMF and staff estimates. a. Based on national accounts prepared by the National Institute of Statistics (INE). b. GDP components are estimated at factor cost. c. "GNFS" denotes "goods and nonfactor services." d. Includes net unrequired transfers excluding official capital grants. e. Includes use of IMF resources. f. Refers to Central Government. g. "LCU" denotes "local currency units." An increase in US$/LCU denotes appreciation. Based in period average exchange rates. h. Based on CPI and GDP deflator indices in 1995 prices.  ANNEX C Page 1 of 1 Mozambique - Key Exposure Indicators Actual Estimate Projected Indicator 1994 1995 1996 1997 1998 1999 2000 2001 Total debt outstanding and 8671 8911 9279 7432 7150 7051 7297 7637 disbursed (TDO) (US$m) a/ Net disbursements scheduled before debt relief -34 4 152 140 76 171 11 109 (US$m) a/ Total debt service due after debt relief 265 301 227 128 196 242 282 289 on Naples terms(US$m) a/ Debt and debt service indicators (%/0) TDO/XGS b/ 2115 1912 1717 1319 1102 977 943 739 TDO/GDP 473 460 403 270 231 207 194 175 TDS/XGS 65 65 42 23 30 34 37 28 IBRD/IDA exposure indicators (%) IDA TDO (US$m)d 714 890 1015 1162 1309 1444 1566 1686 Source: Bank of Mozambique, IMF and staff estimates. a/ Includes public and publicly guaranteed debt, private nonguaranteed, use of IMF credits and net short- term capital. b/"XGS" denotes exports of goods and services, including workers' remittances.  ANNEX D Page 1 of 1 Mozambique- External Financing Requirements and Sources of Financing (US$ million) Actual Estimate Projected Indicator 1995 1996 1997 1998 1999 2000 Total financing requirements 787 1007 4919 1760 1405 1384 Current account deficit (excl. gran.s) 677 642 618 808 1099 1066 Amortization (incl. IMF) 278 214 212 293 287 376 Changes in arrears (increase-) -189 65 3933 619 0 0 Changes in reserves (increase +) 45 145 134 40 18 -57 Other Outflows -24 -58 22 0 0 0 Total identified financing 667 721 771 855 1103 981 Direct foreign investment 45 73 64 141 198 285 Grants 339 283 355 344 447 285 Balance of payments support 92 82 127 107 235 84 Project financing 160 150 174 181 184 184 Other support a/ 88 51 54 56 28 17 Loans 282 366 352 369 458 412 Official creditors 235 289 262 262 198 180 Multilateral 217 288 262 262 198 180 of which: IDA 175 220 148 150 100 150 Balance of payments support b/ 100 114 48 50 0 50 Project financing 75 106 100 100 100 100 of which: IMF 0 18 35 34 17 0 Bilateral and other 18 2 0 0 0 0 Commercial 48 76 90 107 260 232 Debt relief c/ 121 286 4148 237 109 0 Remaining gap d/ 0 0 0 669 193 403 Source: Bank of Mozambique. IMF and staff estimates. a/ Includes food aid. special programs and non food emergency aid. b/ For 1999. IDA adjustment lending (US$150 million) is in Grants as part of IDA's interim measures under HIPC. c/ Includes only concluded agreements; in 1996, debt relief includes US$286 million in arrears and current obligations falling due to Paris Club creditors and Brazil: in 1997.1998, and 1999, debt relief includes US$211 million, US$229 million, and US$100.6 million respectively, in current obligations falling due to Paris Club creditors and Brazil. Some HIPC assistance is also included in 1998 (US$7.4million) and in 1999 (US$8.4million). d/ For operational purposes only. financing gaps are assumed to be covered by a stock of debt operation on Naples terms on non Paris Club bilateral debt in mid-1997, except for Russia, for which a concessionality of 90 percent in present value terms is assumed. Includes expected assistance under the HIPC initiative. It also assumes rescheduling of the private Cahora Bassa hydropower project debt in mid 1997 including payments equivalent to 75 percent of export proceeds, starting in 1998.  Status of Bank Group Operations in Mozambique Operations Portfolio As of 04-Nov-98 Difference Between expected Original Amount in US$ Millions and actual Fiscal disbursements a/ Project ID Year Borrower Purpose IBRD IDA Cancellations Undisbursed Orig Frm Rev'd Number of Closed Projects: 15 Active Projects MZ-PE-39015 1998 GOVERNMENT OF MOZAMBIQUE NATIONAL WATER I 0.00 36.00 0.00 35.12 .81 0.00 MZ-PE-1792 1996 GOVT HEALTH SEC RECOVERY 0.00 98.70 0.00 81.83 44.21 0.00 MZ-PE-1780 1994 GOVT GAS ENGINEERING(ENGY 0.00 30.00 0.00 11.15 7.35 0.00 MZ-PE-1804 1994 GOVERNMENT 2ND ROAD AND COSTAL 0.00 188.00 0.00 96.66 52.90 0.00 MZ-PE-1811 1994 GOM FINANCE SECTOR CAPAC 0.00 9.00 0.00 4.69 3.92 0.00 MZ-PE-1791 1993 GOVT LOCAL GOVERNMENT EN 0.00 23.20 5.02 8.12 12.99 5.58 MZ-PE-1796 1993 GOVERNMENT RURAL REHABILITATION 0.00 20.00 0.00 7.47 6.71 0.00 MZ-PE-1797 1993 GOM CAPACITY BUILDING(HU 0.00 48.60 0.00 24.63 22.63 0.00 MZ-PE-1801 1993 GOVERNMENT FOOD SECURITY 0.00 6.30 1.25 1.78 2.76 .76 MZ-PE-1802 1993 GOVERNMENT MAPUTO CORRIDOR 0.00 9.30 0.00 3.51 3.34 3.34 MZ-PE-1810 1993 GOM LEG & PUB SEC. CAPAC 0.00 15.50 2.93 2.07 4.97 .57 MZ-PE-1781 1992 GOVT. AGR.SER. REHAB. 0.00 35.00 12.30 10.25 16.28 .60 MZ-PE-1790 1992 GOVT OF MOZAMBIQUE FIRST ROAD & COASTAL 0.00 74.30 0.00 20.75 18.14 0.00 MZ-PE-1776 1991 GOVT EDUCATION II 0.00 53.70 0.00 4.64 2.93 2.93 MZ-PE-1784 1990 GOVT INDUSTRIAL ENTERPRIS 0.00 50.10 0.00 15.64 9.46 6.44 Total 0.00 697.70 21.50 328.31 209.40 20.22 Active Projects closed Projects Total Total Disbursed (IBRD and IDA): 360.30 962.20 1,322.50 of which has been repaid: 0.00 4.73 4.73 Total now held by IBRD and IDA: 676.20 914.79 1,590.99 Amount sold 0.00 0.00 0.00 of which repaid : 0.00 0.00 0.00 Total Undisbursed : 328.31 2.38 330.69 a. Intended disbursements to date minus actual disbursements to date as projected at appraisal. Note: Disbursement data is updated at the end of the first week of the month and is currently as of 31-Oct-98. Generated by the Operations Information System (OIS)  ANNEX F Page 2 of 2 Mozambique STATEMENT OF IFC's Committed and Disbursed Portfolio As of 30-Sep-98 (In US Dollar Millions) Committed Disbursed IFC IFC FY Approval Company Loan Equity Quasi Partic Loan Equity Quasi Partic 1992 Polana Hotel 1.93 0.00 0.00 0.00 1.93 0.00 0.00 0.00 1995 AEF Bonar .26 0.00 0.00 0.00 .26 0.00 0.00 0.00 1996 AEF Cahora Bassa .21 0.00 0.00 0.00 .21 0.00 0.00 0.00 1996 BIM 0.00 5.00 0.00 0.00 0.00 5.00 0.00 0.00 1996 Caju Mocita 3.00 0.00 0.00 0.00 3.00 0.00 0.00 0.00 1997 Agrimo 2.00 0.00 0.00 0.00 2.00 0.00 0.00 0.00 1997 MOZAL 55.00 0.00 65.00 0.00 0.00 0.00 0.00 0.00 1997 SEF CPZ 1.00 0.00 0.00 0.00 1.00 0.00 0.00 0.00 1997 SEF CTOX .73 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Total Portfolio: 64.13 5.00 65.00 0.00 8.40 5.00 0.00 0.00 Approvals Pending Commitment Loan Equity Quasi Partic 1997 AEF AFRISTEM .57 0.00 0.00 0.00 1996 AEF EMPRESA 1.36 0.00 0.00 0.00 1996 BIM 10.00 0.00 0.00 0.00 1998 BIM-INVEST 0.00 .30 0.00 0.00 1998 SEF JOAO JAMAL .24 0.00 0.00 0.00 1999 SEF ROBEIRA .19 0.00 0.00 0.00 Total Pending Commitment: 12.36 .30 0.00 0.00 Generated by the Operations Information System (OIS) on 11/12/98  ANNEX F Page 1 of 1 MOZAMBIQUE ECONOMIC MANAGEMENT REFORM GRANT SUPPLEMENTARY GRANT DATA SHEET Timetable of Key Events (a) Time taken to prepare: 7 months (b) Operation prepared by: Minisitry of Planning and Finance; Bank of Mozambique; Ministry of Industry, Commerce and Tourism (c) Project Preparation: April 1998 (d) Appraisal mission: June-July 1998 (e) Negotiations: October 1998 (f) Planned date of effectiveness: Januaiy 1999 Previous Adjustment Operations Second Rehabilitation Credit (FY88, Cr. 1841) Third Rehabilitation Credit (FY89, Cr. 2021) Economic Recovery Credit (FY92, Cr. 2384) Second Economic Recovery Credit (FY94, Cr. 2628) Second Tranche Release Memorandum, July 1995 Third Tranche Release Memorandum, October 1996 Third Economic Recovery Credit (FY97, Cr. NO10) Second Tranche Release Memorandum, March 1998  ANNEX G Page 1 of 2 The Reform Agenda Supported by the EMRO: Matrix of Actions Policy Area Condition Status A. Revenue Mobilization and the Incentive Regime 1. Domestic Taxation a. Define VAT coverage (including exemptions), adopt Condition Fulfilled VAT rate; Council of Ministers will issue decree creating the VAT Code b. Introduce VAT in replacement of the turnover tax Condition of Second Tranche release c. Introduce new consumption tax (Imposto sobre Condition of Second Consumos Especificos) on a narrow range of products Tranche release 2. Trade Regime a. Reduce top import duty rate from 35 to 30 percent Condition of Second Tranche release b. Replace current import documentation (Boletim de Condition Fulfilled Registo de Importaq o, Clean Report of Findings and Despacho Aduaneiro) with a Single Administrative Document c. Streamline importer registration procedures and Condition Fulfilled eliminate importer categories (as listed in Diploma Ministerial 17/91 of the Ministry of Commerce and Diploma Ministerial 21/91 of the Ministries of Commerce and Finance).  ANNEX G Page 2 of 2 Policy Area Condition Status B. Expenditure Management and Budgetary Reform 1. Budgetary Management a. Identify off-budget flows (expenditures and revenues in Condition of Second FY98) and classify according to defined criteria (e.g. Tranche release function, size, origin, and statutory/legal basis) so as to permit decision as to their future status including incorporation into the budget. b. Identify recurrent expenditures now in the investment Condition of Second budget (based on the FY99 budget) and formulate a Tranche release methodology for their correct reclassification as recurrent expenditures in future budgets. 2. Sustainability and Prioritization of Expenditures a. Complete formulation of a rolling five-year medium Condition Fulfilled term expenditure framework (Cendrio Econ6mico de Mddio Prazo) and present to the Conselho Econ6mico. b. Submit to National Assembly a budget proposal iFor Condition Fulfilled FY99 consistent with the medium term expenditure framework, including increased shares of locally-financed recurrent expenditures for health and education, relative to FY98 budget.  ANNEX H Page 1 of 1 MOZAMBIQUE ECONOMIC MANAGEMENT REFORM OPERATION PERFORMANCE INDICATORS Several indicators of economic performance will be used to asses this operation. These relate to economic outcomes rather than the agreed policy and institutional changes themselves. Outcome indicators will be reviewed during supervision and after the operation has been completed, which expected in mid-1999. Given that the reform program supported by this operation and disbursements are expected to occur over a relatively short period of time (less than one year), monitoring of these indicators will continue over the medium run. To monitor the proposed operation's impact on fiscal sustainability and growth, the following indicators will be monitored during supervision and included in the implementation report: * Inflation rate * Effective rate of import duty collection * Anti-export bias * Elapsed time for processing import applications * Export growth  ANNEX I Page 1 of 2 Mozambique at a glance 11,12g8 Sub. POVERTY and SOCIAL Saharan Low- Mozambique Africa income Development diamond' 1997 Population, mid-year (millions) 18.5 614 2,048 Life expectancy GNP per capita (Atas method, USS) I/ 130 500 350 GNP (Atlas method, US$ billions) 2.4 309 722 Average annual growth, 1991-97 Population (%) 4.2 2.7 2.1 Labor force (%) 3.3 2.6 2.3 GNP