4. The authorities have recognized the critical nature of their financial situation and have expressed a firm commitment to restoring sustainability. In this context, they recently announced the intention to approach their external private sector creditors to seek debt service relief.

5. In the mission's view, a credible plan for returning to fiscal and external viability, safeguarding the currency peg, and creating conditions for durable economic growth would have to contain at least three key elements:

• Policies to address immediate risks: To mitigate the risk that external payments difficulties arise while a medium term framework is being formulated and consultations with creditors take place, ongoing efforts to secure bilateral and multilateral lending should be combined with a tightening of macroeconomic policies.

• A sustainable medium-term framework: There is a need to design and implement a macroeconomic framework, which-together with possible relief from a debt operation-closes the large projected medium-term financing gaps and reduces the public debt burden to safer levels.

• Supportive structural reforms: A comprehensive package of fiscal, monetary and financial sector reforms should be implemented to facilitate the required medium-term effort and increase the resilience of the economy against adverse shocks.

Addressing immediate risks

6. The low level of reserves warrants a tighter macroeconomic policy stance in the short term. While the foreign financing gap for 2006 is largely closed, further steps to contain demand and reduce balance of payments pressures are still justified because of very large financing needs next year and the importance to demonstrate policy commitment as creditors are being approached. In this regard, the most recent increase in reserve requirements (effective September 1) is welcome, although the authorities need to monitor monetary developments closely and take additional action if this proves insufficient to mop up excess liquidity. In the fiscal area, the better-than-expected budget execution during March-June should be maintained during the remainder of the fiscal year to achieve a primary surplus of at least 3½  percent of GDP. To this end, restraint in current and capital expenditures remains critical, along with a successful implementation of the General Sales Tax (GST), which has so far been satisfactory. The authorities should continue to resist pressures to dilute the GST base and remain prepared to adopt corrective actions should its revenue yield fall short of projections.

Developing a sustainable medium-term framework

7. The authorities' commitment to fiscal and balance of payments sustainability should be reflected in a credible medium-term macroeconomic framework. In this context, the framework should aim at eliminating balance of payments and fiscal financing gaps over the next five years, significantly reducing the debt burden, and allowing for a recovery of international reserves.

8. The medium-term framework could build upon a combination of additional fiscal effort, continued monetary restraint, and relief from the envisaged debt operation. To illustrate this point, the mission simulated an active scenario that comprises both a front-loaded fiscal effort to raise the primary surplus to about 4½ percent of GDP during 2007-09 and about 4 percent of GDP thereafter, and monetary restraint to keep the expansion of commercial bank credit below nominal GDP growth. This adjustment seems feasible without compromising the prospects for economic growth, and would require that the authorities save the bulk of currently projected petroleum revenues. In addition, current government expenditure-particularly the public wage bill-would need to rise at a significantly lower rate than nominal GDP. On the assumption that debt service relief from private creditors will become available, this package could achieve the goals of filling the financing gaps, gradually reducing the public debt burden and replenishing international reserves.

9. A swift and successful completion of the intended debt operation would be a critical component of the outlined framework. The mission commends the government for pursuing agreement on this matter in the context of a close and constructive dialogue with its private creditors.

Supportive structural reforms

10. To help maintain the required fiscal effort over a prolonged period of time, the authorities should undertake a broad set of supportive structural fiscal reforms, including:

o Modernizing tax administration: After the GST-implementation phase is completed, the authorities should seek to strengthen their tax administration, including through a reorganization away from tax types and toward business processes and common functions, such as taxpayer services, audit, and collection enforcement.

o Tax reform: To support the buoyancy of the tax system in the medium term, the authorities should streamline their system of fiscal incentives, including by eliminating business tax holidays under the Fiscal Incentives Act, terminating import duty exemptions for specific organizations, and converting import licenses into tariffs. To ensure a more stable level of revenues, the authorities should also substitute the revenue replacement duty on fuels with a specific excise tax, and establish an automatic adjustment mechanism for fuel prices.

o Pension reform: The non-contributory pension plan for public servants (PSP) harbors substantial liabilities for the government budget in the future, and the authorities should consider a phase-out of the PSP for new entrants (who would still be covered by the general social security system) and parametric adjustments, such as introducing a contribution from beneficiaries, increasing the years of required service, and/or raising the retirement age.