Dire Economic Conditions Compel GSE to Court

C O N F I D E N T I A L ASMARA 000516

SIPDIS

SIPDIS

LONDON FOR AFRICA WATCHER
PARIS FOR AFRICA WATCHER

E.O. 12958: DECL: 6/15/2016
TAGS: ECON EAID EFIN PREL ER
SUBJECT: Dire Economic Conditions Compel GSE to Court
IMF; Donors Doubt ItQs a Match That Will Last

CLASSIFIED BY: AMB Scott H. DeLisi, for reasons 1.4 (b)
and (d).



1. (C) Summary: After two weeks of consultation, the IMF
mission team presented a hopeful image for the future as
GSE officials offered assurance of GSE interest and
commitment to a staff monitored program(SMP) as the first
step toward HIPC support for Eritrea. GSE interest is,
of course, tempered with concerns about requiring
monetary policy changes such as exchange rate adjustments
and opening the import market. Moreover, implementation
is fraught with tension both within the GSE and between
the donors and the GSE. DonorQs expressed heavy
skepticism about the GSEQs commitment and about its
willingness to transition to transparency. With the GSE
shutting out donors and withdrawing from bilateral
partnership with the US and other western nations over
the past year donor skepticism is unsurprising. Still, a
last chance to regain donor support for HIPC debt relief
may be a powerful incentive for the GSE to reengage and
consider compliance with IMF reforms. We are doubtful it
will happen, but given the GSEQs dire economic situation,
we expect the GSE to play out its dialogue a bit further
in hope that donors may still join the IMF in saving the
GSE from itself. End Summary.

COMPONENTS OF THE SMP
--------------


2. (C) With the sunset clause for HIPC support rapidly
approaching in December 2006, the pressure is on the GSE
to implement an IMF staff monitored program in hope of a
full program being approved by yearQs end. IMF staff, in
interim and final outbriefings with donors, reported that
macroeconomic stabilization - combining fiscal adjustments
with supportive monetary conditions - would be the
foundation of the SMP. The SMP monthly targets will
focus on: severe restrictions on domestic lending,
increasing net international reserves, controlling the
balance of payments, reducing government expenditures,
increasing tax revenue, and reducing the fiscal
deficit(primarily the domestic balance.) Measurement of
these targets would need to be completed by the end of
October in order to allow the IMF time to prepare for the
December board meeting. (Note: In the best case
scenario(and possibly unrealistic one),presuming
agreement and initiation by June 30, this would allow for
4 months of data.)


3. (C)Meeting the monthly targets is important, however,
these accomplishments alone will not be enough. The SMP
will also require increasing transparency in the
financial sector and regarding government budgetary
practices, including the publishing of a budgetary
framework and dialogue with donors. The IMF expects
that economic data such as the Consumer Price Index and
the fiscal data of the GSE will be made available.
Furthermore, the IMF requires that action plans be
implemented to address such issues as weaknesses in the
banking system. Finally, the IMF anticipates the World
Bank funded public expenditure review on the health and
education sectors will be completed in a timely manner.
All of these steps, according to the IMF team leader,
will demonstrate the GSE commitment to reform and show
that "they [the GSE] have a vision."

TIMING IS EVERYTHING
--------------


4. (C) Of greatest concern to the GSE, according to the
IMF staff, is the impact and timing of the monetary
policy changes; namely devaluation of the currency and
reopening/liberalization of the import market. Devaluing
the currency 15 to 19 nakfa to the dollar (which is the
IMF recommendation) will, with the current level of debt
and without donor support, lead to greater inflation.
With inflation reported to the IMF at 12%, but in reality


probably higher, the risk of inflation concerns the GSE.
The GSE is also reluctant to liberalize imports, another
IMF recommendation. With no exports to speak of there
will be little gain on that front from devaluation which
could offset the increased costs of imports. The effect
on the balance of payments and international reserves
will, as a result, likely be severe. (Comment: The GSE
currently uses currency controls and other mechanisms to
restrict private sector imports and those imports that
are allowed are destined for companies controlled by
government through its political party, the PeopleQs
Front for Democracy and Justice. Keenly aware as well
that increased economic freedom can lead to challenges to
political restrictions, the government has multiple
reasons to want to go slow on both devaluation and trade
liberalization. If they do proceed, it will be an
indication of just how dire the GSEQs economic situation
has become. End Comment.)

MEETING THE DEADLINE: WHAT REMAINS TO BE DONE
--------------


5. (C) According to the IMF team the GSE has agreed to
these measures "in principle," however no agreement
exists on the data points. What is still missing? A
three year macroeconomic framework, the selection and
agreement on the actual numbers for five or six fiscal
benchmarks for monitoring and an action plan for
interaction with stakeholders, such as civil society and
the donors. Moreover, there is no agreement yet on the
timing of devaluation or on what actions will be taken
when in regard to trade liberalization. Although the
"theory" of a staff-monitored program is agreed, the IMF
team acknowledged that they departed on June 10 with a
lot of oral commitments but nothing in writing.


IT ALL SOUNDS GOOD: DOES THE GSE REALLY WANT IT?
--------------


6. (C) While the IMF team leader praised the cooperation
of the Ministry of National Development and Minister
WoldaiQs understanding and commitment to reform, the team
leader did share with the Ambassador the reluctance of
the Ministry of Finance to engage. During the first week
of the visit, the Ministry of Finance, including the
Minister, refused to meet with the IMF team. Reportedly,
Minister Woldai traveled down to Massawa to ask President
Isaias to direct the Minister of Finance to cooperate.
This effort resulted in the IMF being able to obtain what
it needed from the Ministry of Finance. Noting these
differences within the GSE during his outbrief for
donors, the IMF team leader suggested that donor support
for an IMF program with the GSE might also support and
strengthen the position of "the more progressive actors
within the GSE." The IMF team noted as well that the GSE
had indicated that without assurances of donor support
there were certain steps that it could not take,
including action on currency devaluation and
liberalization of trade policy. Under any circumstance,
however, the GSE indicated that it would, in fact, want
to delay these two measures as long as possible.

WILL THE DONORS HELP?
--------------


7. (C) Donor response throughout the IMF teamsQ visit was
widely skeptical reflecting a considerable lack of trust
in the GSEQs professed commitment to reform. Many
donors, especially the Dutch, also discounted the
significance the IMF attached to the prospect of Minister
Woldai signing an agreement with the Fund. Noting the
GSEQs readiness to abrogate and completely disregard
contracts and agreements regarding food aid, the Dutch
Deputy Chief of Mission dismissed any signed document by
the GSE as being meaningless. He also noted that his
government would be unwilling to offer any sort of
support until the GSE takes irreversible and solid steps

toward reform. The European Commission indicated that
while donor support for an IMF program was planned for
2007 and beyond, the trust level was extremely low and
the monies at this point unlikely to be released.

COMMENT
--------------


8. (C) Comment: We fully share the skepticism about the
GSEQs willingness to ultimately proceed with an IMF staff
monitored program and, if it does proceed, remain
doubtful that it will ultimately enact promised reforms.
Nonetheless, we are struck by the extent of the GSE
engagement with the IMF and the fact that the GSE invited
the Fund back for these discussions and claims to be
committed in principle to a SMP has surprised us all. It
may be a hopeful sign that at least on economic issues
the GSE is rethinking its disastrous insistence on
control. More likely, however, it reflects a growing
realization for the GSE that the problems associated with
high debt, virtually no exports and negligible hard
currency reserves has brought the economy near collapse.
If so, it may perhaps offer donors a degree of leverage
with the GSE, and pledges of economic support in
conjunction with efforts to reach agreement on border
demarcation and normalization, could be an important
incentive to elicit GSE cooperation.


9. (C) Comment continued. That said, we question whether
the senior leadership of the GSE will ultimately accept
participation in a SMP, knowing it would be tantamount to
admitting they are in deep trouble. The Minister for
National Development in fact, within days of the IMF
teamQs departure, told one international visitor that
"current conditions and national requirements" (i.e. the
border conflict) would make it very difficult for the GSE
to enact the required reforms. The GSE knows as well that
donors -- who are still reeling from the GSEQs travel
restrictions, seizure of food aid, and expulsion of many
partner NGOs are likely to be reluctant to offer
support absent truly meaningful reform. As a result, we
would not be surprised to see the GSE play out its
dialogue with the IMF and then, when it decides the
reforms are too much to accept, turn the blame on donors
claiming that yet again they were abandoned by an
international community that unhesitatingly provides
abundant support to arch-rival Ethiopia. End Comment.

DeLisi