Tunisia - Agricultural Sector Adjustment Project

Docuams Of The World Bank FOR OFFICIAL USE ONLY Report No. P-4368-TUN REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN IN AN AMOUNT EQUIVALENT TO USt150.0 MILLION TO THE REPUBLIC OF TUNISIA FOR AN ASRICULTURAL SECTOR ADJUSTMENT LOAN September 3, 1986 I 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 EQUIVALENIS Currency Unit - Tunisian Dinar (D) First Semester CY1985 CY1986 US$1.00 = D 0.757 D 0.770 D 1.00 = US$1 321 US$1.299 FISCAL YEAR January I to December 31 WEIGHTS AND MEASURES 1 kilometer (km) = 0.6214 mile (mi) I hectare (ha) = 2.4711 acres (ac) 1 liter (1) = 1.0567 quarts (qt) 1 metric ton (ton) = 2,204.6226 pounds (lb) I quintal (qt) = 220.46226 pounds lb) GLOSSARY OF ABBREVIATIONS AI :Artificial Insemination (Ins6mination artificielle) ASAL ;Agricultural Sector Adjustment Loan (Pr&t sectoriel d'ajustement agricole) BNT :National Bank of Tunisia (Banque nationale de Tunisie) BNDA :National Bank for Agricultural Development (Banque nationale pour le developpement agricole) CCGC :Central Cooperative for Field Crops (Cooperative centrale des grandes cultures) CRDA :Regional Agricultural Development Commission (Commissariat regional de developpement agricole) COCEBLE :Central Cooperative for Wheat (Cooperative centrale du ble) CTV :Local Extension Center (Cellule territoriale de vulgarisation) DERV :Department of Training, Research and Extension (Direction de 1'enseignement, de la recherche et de la vulgarisation)  FOR OMCIAL USE ONLY DGR : Department of Rural Engineering (Direction du genie rural) DPA : Department of Animal Production (Direction de la production animale) DPSAE : Department of Planning, Statistics and Economic Analyses (Direction de la planification, des statistiques et des analyses 6conomiques) DPV : Department of Crop Production (Direction de la production vegetale) DRGR : Center for Rural Engineering Research (Centre de recherche du genie rural) FOSDA : Agricultural Development Funds (Fonds sp6ciaux de developpement agricole) IFAD : International Fund for Agricultural Development (Fonds international pour le d6veloppement agricole) IFPRI : International Food Policy Research Institute (Institut international de recherche sur la politique alimentaire) INRAT : National Institute of Agricultural Research (Institut national de recherche agronomique tunisien) ISNAR :International Service for National Agricultural Research (Service international pour la recherche agricole nationale) MOA :Ministry of Agriculture (Ministere de l'agriculture) MOE :Ministry of Public Works (Ministere de 1'equipement) MOPF :Ministry of Planning and Finance (Ministere du plan et des finances) MTASAP :Medium-Term Agricultural Sector Adjustment Program (Programme d'ajustement du secteur agricole a moyen-terme) OC :National Cereal Board (Office des c6r6ales) OEP :National Livestock and Range Agency (office d'elevage et du pa turage) 3MV :Irrigation Development Office (Office de mise en valeur) ONH :National Oil Board (Office national des huiles) PDRI :Integrated Rural Development Program (Programme de d6veloppement rural int6gre) PPI :Public Irrigation Perimeters (Perimetres publics irriguks) SMS :Subject-Matter Specialist (Conseiller sp4cialisi) SONAM :National Farm Mechanization Company (Soci6t6 nationale de motoculture) STEC :National Fertilizer Company (Soci6t& tunisienne des engrais chimiques) UCe :Production Cooperative (Unitk cooperative de production) USAID :United States Agency for Internatioral Development (Agence des Etats-Unis pour le d6veloppement international) 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.  REPIMLIC OF TUfNISIA AGRICULTURAL SECTOR ADJUSTMENT LOAN Loan SuurX Borrower The Republic of Tunisia Amount: US$150.0 million equivalent Tems: 17 years. including 4 years of grace, at the standard variable Interest rate Loan Description: The proposed Loan would support the first phase or implementation of the Governnent's program of agricultural sector reforms, within the framework of a general macro-economic restructuring program. The principal objectives of the sector adjustment program are to maintain the growth rate In agriculture in order to reduce the sector trade deficit. within the overall macro-economic constraints on public resources. To achieve this objecttve, actions would be taken, in both the short and medium term, to: (i) improve the prices and incentives framework; (ii) re-orient the public investment program in agriculture: (iii) strengthen agricultural support services including rationalizing the role of the private sector; (iv) improve management of natural resources of land, forests and fisheries: and (v) build up institutional capacity for sector performance monitoring and policy analysis. The Government's macro-economic restructuring program Is focusing on measures to limit growth of domestic demand (wage and salary, budget and monetary policies), to stimulate growth of non-traditional exports (exchange rate policies, export promotion), and to improve the allocation and use of scarce economic resources (interest rate policies, gradual liberalization of domestic prices, investments and imports); it should also result in a more rapid creation of new employment and reduced underemployment. The foreign exchange provided by the Loan would be used to finance general imports based on a negative list and agricultural inputs needed to stimulate agricultural production, including fertilizer and raw materials for its manufacture. insecticides and herbicides, animal feed, diesel fuel, spare parts, tractors and pumps, veterinary supplies, raw materials for the manufacture of irrigation pipes and fisheries inputs. Benefits and Risks: The reforms agreed under the Loan are expected to create a more favorable environment for overall economic and sectoral growth In a time of resource constraints. In particular, changes in the agricultural pricing and incentives framework and publitc expenditure priorities are expected to make the sector a more efficient producer of import substitutes and export products. Risks relate to the length and difficulty of the process, possible social and political pressures. unpredictable developments in the external environrment and uncertainties in the response of the private sector. These risks are limited by the Government's strong commitment to objectives of the macro and sector adjustment programs, and by the inherent flexibility of the phased medium-tern approach. Estimated Disbursements: The proceeds of the Loan would be disbursed in two tranches: US$100 million equivalent soon after effectiveness; US$50 million equivalent after implementation of specific actions, including an overall review of the implementation of the macro-economic and sectoral reform programs. Aooraisal Report: This is a conbined President's and Staff Appraisal Report. A detailed Medium-Term Agricultural Sector Adjustment Program (HTASAP) is available on request. Hbos No. IBRD 19855 No. IBRD 19856 No. TBRD 19857  REPUBLIC OF TUNISIA AGRICULTURAL SECTOR ADJUSTMENT LOAN Table of Contents Page No. LOAN SUMMARY PART I : THE ECONOMY 1 PART II :THE GOVERNMENT'S ECONOMIC ADJUSTMENT PROGRAM 4 A. Structural Problems and the Need for Structural Change 4 B. Recent Policy Measures Taken by the Government 6 C. The Short- and Medium-Term Adjustment Program 7 D. Medium-Term Projections 11 E. Social Impact of the Adjustment Program 15 PART III :BANK GROUP OPERATIONS IN TUNISIA 16 PART IV :THE MEDIUM-TERM AGRICULTURAL SECTOR ADJUSTMENT PROGRAM 19 A. The Need for Adjustment 19 B. The Sector Adjustment Program 22 - Origin and Objectives 22 - Improving the Prices and Incentives Framework 23 - Reorienting Public Expenditures 28 Strengthening and Privatizing Support Services 34 Improving Management of Natural Resources 43 - Building Up Sector Performance Monitoring and Policy Analysis Capabilities 46 PART V THE LOAN 47 A. Origin and Objectives 47 B. Action Program Under the Loan 47 C. Loan Administration 52 D. Management, Coordination, Monitoring and Evaluation 55 E. Justification and Risk 56 PART VI : RECOMMENDATION 59  Table of Contents (cont'd) ANNEXES r. 'ountry Data II. Status of Bank Operations III. Supplemental Loan Data Sheet IV(a). Government Letter of Economic Development Policy IV(b). Government Letter of Agricultural Development Policy V. Sector Adjustment Matrix VI. Table of Contents of Medium-Term Agricultural Sector Adjustment Program (MTASAP) VII. Production Levels and Growth Rates of Key Agricultural Products VIII. Agricultural Balance of Trade MAPS IBRD 19855 - Rainfall and Irrigated Areas IBRD 19856 - Soil Suitability for Crops IBRD 19857 - Location of Main Crops  INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE JBRD TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE REPUBLIC OF TUNISIA FOR AN AGRICULTURAL SECTOR ADJUSTMENT LOAN L. I submit the following report and recommendation on a proposed loan for the equivalent of US$150 million to the Republic of Tunisia to help finance an agricultural sector adjustment program. The loan would have a term of 17 years, including 4 years of grace, at the standard variable interest rate. PART I - THE ECONOMY 2. An economic report entitled "Tuni3ia - Country Economic Memorandum: Mid-term Review of the Sixth Development Plan ([982-86)", in two volumes (No. 5328-TUN), was distributed to the Executive Directors in October 1985. An economic mission to review the macro-economic framework of the VIIth Plan (1987-91) visited Tunisia in January 1986; its findings, as well as updated information obtained at the time of appraisal of the proposed Agricultural Sector Adjustment Loan in April 1986, and by a mission in June/July 1986, are reflected in this part and the country data sheets attached in Annex I. 3. Tunisia is a medium-size, middle-income country with a population of 7.5 million and a per capita income of about US$1,100.1' Much of Tunisia is arid or semi-arid. Only 3% of arable land is irrigated, and areas where rainfed agriculture is possible are subject to severe year-to-year fluctuations in rainfall. Nevertheless, agriculture still occupies nearly one out of every three Tunisians in the labor force. Tunisia's most important raw materials are phosphates, petroleum and natural gas. Known exploitable reserves of oil and gas are approaching depletion, and the limited new reserves require costly off-shore drilling. Barring large new oil and gas discoveries, and given the rise in domestic energy demand, Tunisia is expected to turn into a net oil importer in the early 1990s. The low quality al phosphate deposits constrains the expansion of the highly efficient Tunisian phosphate processing industry. The country also has considerable tourism potential. 4. Tunisia has undertaken a massive effort to develop its human resources, paying special attention to family welfare, education, and technical and vocational training. As a result, between the early 1960s and the early 1980s, the infant mortality rate declined from almost 160 to 79, life expectancy at birth rose from 48 to 62 years, the adult literacy rate increased from about 151 to about 621, and average caloric intake per capita increased from 95% to 1211 of minimum standard requirements. An active family planning policy pursued by the Government led to a decrease in fertility and birth rates. Even though mortality rates also decreased, the gross reproduction rate decreased markedly from 3.5% to 2.4% over the same period. However, since net emigration of Tunisians abroad was sharply reduced by restrictive measures taken in the EEC countries and Libya, the growth rate of the labor force accelerated, a main reason for the rapidly growing, serious LI 1985 figure at current prices and 1985 exchange rates.  - 2 - unemployment problem. Open unemployment reached 141 in 1963 and under- employment is extensive. These problems are particularly serious among young school dropouts. 5. Recent economic developments. During the 1970s, the Tunisian economy did well. Rapid growth in the range of 7-8Z was accompanied by substantial structural transformation as manufacturing and tourism became more important and their share in total exports increased. Economic performance benefitted from substantial terms of trade gains due to the rapid price increase of oil, allowing both consumption and domestic savings to increase and investment to remain high (over 30% of CDP). It also benefitted from improved economic management with a cautious shift toward a more liberal, market-oriented economy. The inflation rate remained modest, averaging 6.1% over the decade. The balance of payments current account deficit, averaging 51 to 6% of GDP over the period, was easily financed, much of it by direct foreign investment, and the debt service ratio was a low 10.7% in 1979. The only major problem was a persistently high rate of unemployment/underemployment. 6. The VIth Plan (1982-86) proposed a number of policy reforms to face the consequence of rising unemployment and the progressive decline in net energy exports. Its main objectives were employment generation, export promotion, regional development and public sector efficiency. Investment priority was given to agriculture, engineering industries and tourism. The overall rate of investment was projected to decline during the Plan period. To minimize the effects on economic growth and employment, measures were proposed to increase the efficiency of exi0ting investments and to encourage a shift to labor-intensive activities. They were to be accompanied by a substantially tightened income policy, in particular cautious wage and salary policies, and a considerable slowdown in the growth of recurrent budget expenditures. 7. Economic performance, however, deteriorated during the Plan period. Oil production virtually stagnated; in 1982, a prolonged drought depressed agricultural output and agro-industrial production; technical problems plagued the phosphate and cement industries; and tourism and exports of manufactured goods were adversely affected by the recession in Europe, high domestic prices and a sizable appreciation of the Tunisian dinar vis-h-vis the currencies of most competitor countries as well as the US dollar. The economy recovered in 1983 and 1984 due to buoyant growth in manufacturing output, stimulated by rapidly expanding local demand. Growth was further stimulated in 1985 by an exceptionally good agricultural crop and resumed growth in tourism, bringing the average annual GDP growth in the first four years of the Plan to 3.7%, compared to 6.3% targeted. This performance was nonetheless favorable in view of the world recession and as compared with other countries. 8. The Government was slow, however, in adjusting domestic demand to the decelerated economic growth. Ir, contrast to the Plan's macro-economic objectives, the investment rate remained high rather than declined, mainly due to higb public enterprise investments in energy and transportation, while domestic consumption expanded rapidly, fuelled by sharp increases in wages and salaries in 1982 and early 1983. This strong demand pressure, facilitated by rather liberal credit policies, was reflected in rising inflation which averaged nearly 10.51 in 1981-84, compared to 8.01 over 1977-81. It also contributed substantially towards the marked worsening of the current account deficit of the balance of payments which rose to 11% of GDP in 1984. The  - 3 - Government's overall budget deficit also increased slightly from Ln average of 2.7% of GDP in 1981-82 to 3.2% in 1983-84, excluding deot amortization. This reflected increases in recurrent expenditures due to higher wage and salary outlays; higher subsidy payments to households and public enterprises; and higher public investments. 9. While the situation had not reached crisis proportions, the trend observed during 1981-i4 clearly could not be sustained. Faced with this deterioration, the Government started to implement a package of policy measures aimed at stabilizing the economy as described in some detail in Part 11 below. These measures together with the imposition of drastic foreign exchange and import restrictions, brought the balance of payments current account deficit back to about 7% of GDP in 1985, despite reduced exports of oil, phosphate, and manufactured goods to Libya. While this improved the immediate situation, the underlying disequilibrium has not been resolved, and problems usually associated with controls, such as growing shortages of raw materials, semi- finished products and spare parts, have appeared. Meanwhile, the budget deficit rose to 5% of GDP in 1985 because of a slow growth in revenues, despite a slight decline of capital expenditures in real terms. The authorities prepared a restrictive budget for 1986, as discussed below (para. 21). 10. Over recent years, the Government had consulted informally with the IMF on a wide variety of economic and financial issues, but had not asked for financial support. Before and during the July 1986 Article IV consultation mission, however, there were discussions with the IMF on a possible stand-by agreement cum compensatory financing facility, which will be formalized during a mission, scheduled for early September. II. Social issues. Since Independence, the country has gone a long way towards meeting the basic needs of its population. Over 16% of GDP is now devoted to social programs, and the number of absolute poor declined from 17% of total population in 1975 to 12.8% in 1980 (para. 48). This improvement was largely concentrated, however, in urban areas. Since 1981, social issues have faced a different context than in the 1970s, when an easy financial situation allowed a relatively unconstrained expansion of social services. On one hand, the Tunisian population has become increasingly aware of and sensitive to income distribution issues, and the beneficial effects of past rapid expansion in social services have created a demand for improved standards in social services delivery. On the other hand, the provision of adequate social services - education, health, urban infrastructure, housing - is being increasingly hampered by budgetary constraints. To reduce the financial burden of social services, the administration is reviewing the cost structure of the various types of social services, including free or below-cost delivery, the possible introduction of some user fees, and improved social infrastructure management, in particular as regards hospitals. Also, decentralization of social facilities to deprived zones will have to be assessed carefully because costs for servicing and maintaining them could become prohibitive. 12. To reduce socio-economic differences, in particular between rural and urban areas, and between workers in the modern sector and those precariously employed in informal activities, the Government is channelling more resources into regional development and youth employment. Integrated rural programs are being developed to stimulate creation of productive jobs and grassroots participation Subsidies and credit facilities are granted for young  - 4 - technicians to create their own enterprises and for entrepreneurs to create new projects in underdeveloped regions. More efforts are needed, however, to strengthen the coordination of vocational and on-the-j'b training with market demand and to ensure that rural programs create economically viable and sustainable assets and activities. 13. External assistance and foreign debt. During the second half of the 1970s, foreign borrowing was modest and a large share of foreign funds was provided by public sources at relatively soft terms. At the end of 1979, debt outstanding and disbursed was estimated at US$3.0 billion, or 42% of GDP; debt service was less than 11 of export revenues. For reasons mentioned earlier (para. 8), the balance of payments deficit has increased substantially since then, as has foreign indebtedness. According to preliminary estimates, total public foreign debt outstanding and disbursed reached nearly US$4.4 billion (about 50% ot GDP) at the end of 1985 and the debt service ratio rose to about 22%. However, the Tunisian authorities bave always followed cautious debt management policies; while the share of short-term borrowings has increased slightly since 1980, Tunisia's overall foreign debt remains predominantly long and medium-term, and debt service requirements are projected to increase only slowly. During 1980-84, 60% of foreign loan disbursements were from official sources, and nearly 31% on concessional terms. Over 70% of official disbursements came from bilateral sources (mainly Arab oil-producing countries, France, Japan, the Federal Republic of Germany), about 20% from the Bank Group, and 10% from other multilateral sources. Overall borrowing terms were favorable, averaging 8% interest and 15.3 years maturity. 14. The balance of payments and foreign debt outlook, including Tunisia's creditworthiness, are assessed in paragraphs 43-45 below. PART H - THE GOVERNMENT'S ECONOMIC ADJUSTMENT PROGRAM A. Structural Problems and the Need for Structural Change 15. The brief description of recent economic trends and present situation as presented above highlights three major problems facing the Tunisian economy today, one rather immediate, two somewhat longer term. The immediate problem is the high and persistent deficit o( the balance of payments current account, and the consequent rapid increase in the country's foreign debt. In 1986, the decline in oil prices, lower tourism revenues as a result of political uncertainties around the Mediterranean, and lower workers' remittances have put further pressure on the balance of payments. While there is no danger of an immediate crisis, the situation cannot be allowed to continue much longer. The two l1:jger term, but equally important, problems are the progressive decline in net hydrocarbon exports, requiring the development of other sources of export revenues and import substitution (non-traditional exports, tourism, agriculture), as well as the high and growing unemployment and underemployment rate and the danger of an even worse trend given the high rate of growth of the active population, at a time of lower overall economic growth. 16. No single policy instrument can deal successfully with all three problem areas; only a carefully balanced and timed package of different policy measures can do so. Such a comprehensive policy package should be based on three n.ain considerations:  (a) A return to an export driven growth strategy, as was pursued quite successfully until 1981, is a key to the success of any future development program aiming to achieve satisfactory economic growth and employment creation, given Tunisia's limited domestic market1' and the fact that most obvious import substitution industries are already well developed. With petroleum production ceasing to be a major engine of export growth, and export possibilities in agriculture limited by market constraints in the EEC, manufacturing will have to become much more export oriented than in the past, when it catered primarily to domestic demand fueled by high petroleum revenues. This requires fundamental changes in industrial policies so as to increase incentives to export. Such changes are also necessary to revitalize existing export oriented economic activities, such as tourism. Emphasis in agriculture will be to promote efficient import substitution in commodities such as grains, milk and meat, for which Tunisia has a comparative advantage. (b) A major improvement in the efficiency of resource use and allocation is required. With the highly profitable production and export of petroleum declining progressively, economic resources in Tunisia, domestic as well as foreign and private as well as public, will become increasingly scarce. Under these circumstances, the country can only achieve a satisfactory rate of overall economic growth and an acceptable level of new employment creation if it uses and allocates these resources with the utmost efficiency. The liberalization measures covering prices, investments and imports, included in the Government's economic adjustment program, serve primarily to improve efficiency in the private sector by gradually introducing more competition, while proposed changes in lbudget policies, public investments and public enterprise management would improve efficiency in the public sector. (c) Last but not least, economic development must become much more labor intensive in order to create more employment in spite of lower overall economic growth. Future increases in production should be achieved mostly through increasing the number of employed workers and new investments should serve mostly to create new employment. This would be achieved through a marked change in relative factor costs, making labor less expensive relative to capital. Macro-economic projections indicate clearly that if real salaries had continued to increase by 4.5-5 per year, as was the case during the 1970s, and if interest rates had continued to be largely negative in real terms, one could not expect the creation of even half as many new jobs as necessary to absorb the rising number of new job seekers during the period of the VIlth Plan (1987-91). Furthermore, priority must be given to the development of labor-intensive sectors with relativeLy low investment costs such as small and medium enterprises, electrical and mechanical industries, and agriculture. There is in fact a substantial potential for employment creation in this latter sector particularly through stimulating import substitution. 1/ Less than 10% that of Switzerland and about 5% that of Spain.  - 6 - B. Recent Polioy Measures Taken bY the Government 17. The Government of Tunisia already recognized the importance of such economic adjustments during preparation of the VIth Development Plan (1982-86) and a substantial number of concrete policy changes have been implemented over the last few years, as detailed in this section, some of them bold and often unpopular. These efforts need to be pursued and expanded over the coming years, along the lines presented in Section C below. 18. For the last three nnd half years, the Government has pursued strict wage and salary policies. Since Jonuary 1983, when wage increases were delinked from the cost oE living index, no general salary increases have been granted. As a result, average real salaries have declined by more than 15%. This decline has eliminated the main source of the rapid increase in domestic consumption experienced during 1980-83. While the Covernment raised the minimum salary by 10% irT July 1986, it does not plan to grant a general salary increase this year. 19. Exchange rate policies have become more flexible since mid-1985, resulting in a gradual downward adjustment of the exchange rate by over 18% vis-A-vis a basket of seven currencies between mid-1985 and mid-1986. Together with the formal devaluation of 10% announced in mid-Aagust 1986, this has reduced by 28% the nominal exchange rate on a trade weighted average, more vis-i-vis the major European currencies (DM, FF), less vis-a-vis the U.S. dollar. While the real effective exchange rate has depreciated somewhat less, these changes nevertheless made it possible to more than offset the rise in the value of the dinar in relation to competitor country currencies observed over the last couple of years, and so to improve the competitiveness of Tunisia's non-traditional exports. 20. The Government has also started to use interest rate policies as a more active instrument of economic policy making. For the first time in four years, general interest rates were raised by 1-2 points in April 1985 and by 3-4 points for the particularly low special rates in Spring of 1986. Together with the 1.7 point decline in the inflation rate in 1985, itself a very satisfactory achievement (from 8.2 to 6.5%), these nominal interest rate increases raised real interest rates by 3-5 points in 1985; most rates are now positive in real terms, in line with the recommendations of the Bank's Financial Sector Report (No. 5263-TUN of December 16, 1985). In agriculture. however, interest rates are not yet high enough to cover financial and operating costs and risks. 21. Budgetary outlays. As mentioned above (para. 9), 1985 ended with a markedly worse overall budget deficit (5% of GDP) in spite of a nearly 2% decline in development outlays, as Government revenues from oil and import taxes declined even more substantially. In 1986, the situation is expected to improve gradually, in spite of a likely further decline in revenues, reflecting lower oil prices and depressed imports. Through a number of tough measures, the Government intends to reduce total budget outlays (net of debt service) by some 9% in real terms. Sales taxes on alcoholic beverages and tobacco were raised; recurrent expenditures (net of interest payments) will be reduced by 2.5% in real terms, and subsidies to households and public enterprises as well as development outlays (net of debt amortization) will be reduced by 22% in real terms. As a result, the overall deficit is expected to decline to 3.9% of GDP. The substantial reductions in subsidy outlays reflect the Government's policies of gradually adjusting the prices of goods subsidized by the budget and the tariffs charged by public enterprises for their services.  - 7 - 22. For several years, agricultural producer prices have gradually been decontrolled and the ones still controlled (particularly cereals and milk) have been raised more rapidly than inflation. As a result, by end-1985, nearly 75% of domestic agricultural production was sold freely in the domestic market and/or exported. While producer prices in general are not aligned with border prices, producer incentives have improved progressively. 23. Investment controls, while not reduced, have been streamlined, and focused more sharply on new investment priorities. Among others, renewal investments and investments in tourism (other than hotels) receive priority and incentives similar to those of investments in other sectors. 24. Export promotion. A number of measures have been taken to stimulate exports, streamline export procedures, establish export credit and insurance, develop export marketing, and facilitate re-exports, in line with the reconiendations of the Bank's Industrial Policy Mission of January 1985. The liberalization of all necessary imports for exporting enterprises, as announced in mid-August 1986, will provide an additional powerful stimulus to exports. C. The Short- and Medium-Term Adjustment Program 25. As indicated in paragraph 9 above, the package of policy changes implemented by the Government over the last years has shown some positive results, particularly concerning private domestic demand and the budget deficit; however, its restrictive elements have also created a number of "tblems, such as the lack of essential imports for directly productive activities. Over the coming years, two kinds of measures are of vital importance: (a) to maintain and strengther. the positive measures already taken; and (b) to complement these measures through changes in other fields destined to reinforce the effectiveness of the program and minimize its adverse effects. Included in this second group are measures to restructure the economy through a progressive liberalization including prices, investments and imports. This program of macro-economic adjustment measures provides the policy base for the proposed Agricultural Sector Adjustment Loan (ASAL), as well as the proposed Industrial and Trade Policy Adjustment Loan currently under preparation (para. 53). It is described below, as well as in the c,overnment's Letter of Economic Development Policy [Annex IV(a)]. 26. Wage and salary policy. Maintaining cautious wage and salary policies may weLl be the single most important policy measure to achieve a long-term sustainable balance of payments equilibrium and more rapid employment creation; it can also contribute significantly to achieving a rapid improvement in the present balance of payments deficit. Wages and salaries are an important determinant of (a) domestic demand and in consequence of import demand; (b) the cost of production of manufactured goods and services, and consequently of the competitiveness of Tanisia's manufactured exports and tourism; and (c) relative factor costs and, thus, the labor intensity of future economic activities and growth of employment. The Government is determined to maintain the restrictive wage and salary policies started in 1983, and limit the growth of the total wage bill to that of GDP during 1988-91, while keeping it below that in 1986-87 (limiting it to less than the increase of the CPI), when only the minimum wage is raised. While such measures will slow down the improvement in the standard of living of the labor force already employed, they are necessary and adequate to speed up the creation of new employment and, thus, reduce unemployment and improve income distribution.  - 8 - 27. Exchange rate policy. An appropriate exchange rate, allowing for competitive exports of non-oil/non-phosphate goods and services is a vital precondition for the success of an export-oriented growth strategy in Tunisia. The measures taken since mid-1985 have achieved this goal. The Government has committed itself to pursuing a flexible exchange rate policy with the objective of maintaining a competitive rate vis-i-vis its main competitor countries. It is in active discussions with the IMF on this issue. Any adjustments in the exchange rate will be reflected, among others, in domestic producer prices for agricultural products. 28. As regards interest rates, as a result of measures taken recently, most rates are now positive. In order to maintain this situation, the Government intends to pursue more flexible interest rate policies than in the past, changing interest rates in line not only with the inflation rate but also with financial and operating costs and risks. 29. As mentioned above (para. 21), budget outlays have been cut considerably in 1986. In the context of the VlIth Development Plan, the Government plans further reductions in the overall budget deficit over the coming years; in order to achieve its balance of payments and foreign debt targets during the VIIth Plan and beyond (paras. 43-44), the Government intends to eliminate the overall budget deficit by 1991 (see Table 1). This objective would be achieved largely through cuts in expenditures, since budgetary revenue is already high (nearly 31X of GDP) and likely to increase less rapidly than GDP given declining oil incomes, low growth of imports and the proposed reduction in many customs tariffs (para. 36), as well as the tax incentives given for exports and regional development. Even given the planned major Government effort to mobilize new sources of revenues (improved collection ot direct taxes, full introduction of the VAT, introduction of additional sales taxes on luxury goods), a gradual decline in total budget revenues as a percentage of GDP is virtually unavoidable. Table 1: OVERALL BUDGET DEFICIT (In percentage of GDP, net of debt amortization) 1986 Average Annual 1985 Revised 1987 1988 1991 Growth 86-91 Actual Budget ----- Projected ---- In Real Terms Revenues 31.8 30.6 30.0 29.0 27.0 0.2 Recurrent ex;enditures 25.2 25.2 24.0 23.0 21.0 -1.3 Capital expenditures 11.6 9.3 8.0 7.5 6.0 -2.3 Total Expenditures 36.8 34.5 32.0 30.5 27.0 -1.6 Overall deficit 5.0 3.9 2.0 1.5 -  - 9 - 30. Under these circumstances, gradual achievement of a balanced overall budget requires substantial reductions of expenditures in real terms as well as in relation to GDP. These can be achieved without impairing the provision of appropriate social and economic services by the Government, through careful setting of priorities among budgetary outlays. The recommendations of the Bank's Public Expenditure mission will provide an important input into this task. For recurrent expenditures, it will be achieved primarily through two measures: (a) a considerable slow-down in the growth of salary outlays as the hiring of civil servants will be limited to a maximum of 2% p.a., and salary increases will be as limited as in the private sector; and (b) a systematic reduction in subsidies of 52 p.a. in nominal terms. Among others, the latter is possible as a result of the public enterprise reform that the Government started in 1985 and plans to pursue more vigorously over the coming years; this reform will reduce the number of public enterprises and the deficits of the ones retained. In addition, the Government is in the process of devising new policies to focus consumer subsidies more strongly on the really needy and do away with the present across-the-board subsidization of the entire population (para. 49). For capital expenditures the reductions will be achieved by reducing Government subsidies and capital contributions to the remaining public enterprises, whose capital requirements will be progressively covered by the development banks. Direct Government investments in sociaL and other infrastructure would be maintained at about the present level. 31. Money and credit policies have been quite expansionary over recent years, with growth of money circulation (M2) exceeding that of GDP by a substantial margin (17% p.a. vs. 14X p.a. on average during 1981-85) in spite of comprehensive Central Bank controls. The Government intends to prevent growth of money circulation during 1986-91 from exceeding that of GDP, and will keep it below that under normal circumstances. Given the projected considerable decline in the Government's overall budget deficit and, thus, in its need for new borrowing, tighter monetary and credit policies can be followed without hampering productive investments in the private sector. 32. The liberalization program. As mentioned above (para. 16), a major improvement in the allocation and use of economic resources, as well as in the relative incentives for export production compared to production for the domestic market, are key preconditions for Tunisia to achieve satisfactory economic growth and employment creation at a time of tightening balance of payments constraints. Progressive liberalization of the economy and introduction of more competition - domestic as well as foreign - is th.e only effective way to achieve this. Given the fact that Tunisia's modern sector has operated for decades in a highly controlled and well protected environment, the necessary phasing out of controls on prices, investments and imports can only be attained gradually. The Government is determined, nevertheless, to complete the phasing out of controls largely by the end of the VlIth Plan (1991). 33. Price controls. In addition to the ongoing gradual decontrol of agricultural producer prices, the Government intends to abolish price controls for all manufactured goods by 1991, with the exception of a small number of key staples suach as bread and edible oils. In a first phase (1986-88), controls will be abolished in well-established industries where the number of domestic producers is sufficiently large to ensure appropriate competition. The list of such industries, which account for about 601 of total manufacturing output, and a schedule for the decontrol of their prices is included in the Letter of Economic Development Policy. In a second phase (1989-91), the controls will be abolished in all other industries. With  - 10 - respect to those products for which price controls will continue for an interim period, a new more flexible price control system will be introduced at the beginning of 1987, which avoids the major shortcomings of the present cost-plus system, such as over-investment, low use of installed capacities, and lack of incentives to control production costs, including energy use. 34. Investment controls. At present, all new investments need Government approval, including replacement investments and expansions of existing installations. At the same time, investment incentives are provided to virtually all approved investment projects. The Government intends (a) to introduce a much more selective system of investment incentives, limiting them to high priority projects (export industries, regional development, technology transfer); and (b) to phase out by 1991 at the latest investment approval procedures for all projects which do not receive special incentives. 35. For this second category of projects and in line with the planned phasing out of quanititaLive restrictions on imports of capital goods (para. 36), the Government intends, by the beginning of 1987, to abolish investment controls on all investments below D 200,000 and on replacement investments not requiring a specific authorization to import capital equipment. It will continue the abolition of investment controls during 1987-88 for other well-established industries for which the number of domestic producers is sufficiently large to ensure appropriate competition. As mentioned above (para. 33), those sectors account for about 60% of total manufacturing production. Finally, investment controls in all remaining sectors, except for investments for which special investment incentives are requested, will be abolished during 1989-91. 36. Import liberalization is the third essential liberalization measure without which the effects of price and investment liberalization would remain very limited. It is also essential to improve incentives for export production, by making production for the local market less attractive. The Government intends to take two sets of measures in this respect: (a) to phase out all quantitative restrictions on imports before the end of 1991. In line with the country's import priorities, liberalization will start with spare parts for use in industry, agriculture, hotels, hospitals and other services, raw materials and semi-finished products for enterprises that export at least 25% of their output, and capital goods for investmnat projects approved by the Industrial Investment Promotion Agency (API), the Agricultural Investment Promotion Agency (APIA) and the Tourism Investment Board after October 1, L986; the first two of these were announced in August 1986, and liberalization of capital goods for newly-approved investment projects is expected in September 1986. Confirmation of all of the above issues will be a condition of effectiveness of the proposed Loan. These measures would be followed by liberalization of semi-finished products for firms that are well integrated or that export at least 15% of their output, as well as all other raw materials and spare parts by January 1987; and of capital goods and the remaining semi-finished products by January 1988. As a result of the above measures, about 75% of all imports would be liberalized by the end of 1.988. During 1989-91, all remaining quantitative restrictions, essentially on consumer goods imports, would be phased out;  - 11 - (b) to reform the tariff system by reducing high import tariffs and the disparities in the levels of effective protection between the different sectors of the economy with the aim of achieving a lower and reasonably uniform effective protection rate of about 25% by the end of the VlIth Plan. To achieve this objective, the Government intends to prepare a program of gradual tariff reductions for impLementation over the 1989-91 period. As an interim measure, it wilL amend the present tariff system no later than January 1, 1987 so that there is a universal minimum tariff of 15%, all existing tariffs between 25% and 31% are reduced to 25% and all tariffs presently between 32% and 56% are reduced by 6 percentage points, and all higher tariffs are reduced to a maximum of 50%. Not later than January 1. 1988 all tariffs then being between 25% and 34% will be reduced to 252 and all tariffs between 35% and 50% will be reduced by 9 percentage points. The Government intends to replace some of these reduced import tariffs by domestic sales taxes covering imports as well as domestically produced goods. 37. The entire macro development program, as described above and in the Government's Letter of Economic Development Policy [Annex IV(a)] would be monitored by a Coordinating Committee (para. 160) and by Bank missions. Bank confirmation of satisfactory progress in implementation of the overall program would be a condition of second tranche release. D. Medium-Term Proiections 38. As mentioned above, the economic adjustment program is aimed at addressing three major areas. First, the direct export promotion measures together with the exchange rate adjustments and reduced import protection would stimulate the growth of non-oil exports to over 6% p.a., compared to 3.3% achieved so far during the VIth Plan. Second, the pricing and investment incentive policies aimed at raising the efficiency of resource utilization and allocation would reduce the investment rate from 28% of GDP in the last five years to 22% during the Vlith Plan without seriously affecting output growth, and would 'educe the incremental capital-output ratio from the present high level of 10 to 6.4 between 1986-91. Third, the substantial changes in relative factor costs would stimulate the creation of new employment, expected to average close to 50,000 new jobs p.a. or a 2.5-3% p.a. increase over the Plan period. Even this nearly 162 increase over the VIth Plan actual figures, however, will only permit absorption of about 70% of new job seekers. 39. Concerning growth of GDP (Table 2), the decline in the production and export of oil tends to overshadow at first glance the projected substantial improvements in the non-oil sectors, particularly when compared with historical performance. Such improvement is vital for Tunisia to achieve a satisfactory overall growth over the coming years. Table 2 shows that even though the average GDP growth of the VIIth Plan is slightly lower than the VIth, the growth of non-oil industries is substantially higher (5.5% compared to 4.4% p.a.). Agriculture's decline (from 4.0% to 3.6% p.a.) is a reflection of the exceptionally good agricultural output in 1985; the projected 3.6% p.a. growth of the sector is significantly better than the 1.6% achieved during the 1976-81 period. Output of the non-oil productive sectors is expected to increase rapidly, as a result of direct measures stimulating the agricultural and industrial sectors (improving productivity and efficiency of rainfed agriculture, making more efficient use of irrigation, improving land use  - 12 - policy, strengthening export promotion institutions) and indirect measures affecting the incentive framework. Developments in the oil sector are heavily influenced by world oil prices, as the production of small oil fields would only become attractive if oil prices increase again substantially. The present outlook is for production of crude to decline to 4.4 million tons by the end of the VIIth Plan, compared to 5.2 million tons in 1985/86. Production of associated gas would decline in parallel. Table 2: GROWTH OF OUTPUT AND EXPENDITURES -i (Annual growth rates in percentage) 1976-81 1981-86 1986-91 (Actuals) (Preliminary) (Projected) CDP (mp) 6.1 3.6 3.4 Agriculture 1.6 4.0 'b 3.6 Industry 8.9 3.0 3.6 Hydrocarbon (8.3) (-0.5) (-3.0) Non hydrocarbon (9.2) (4.4) (5.5) Services 6.5 3.9 3.3 Consumption 7.4 4.4 2.5 Private (7.8) (4.5) (2.7) Public (5.8) (4.3) (2.0) Gross Investment 6.6 -4.2 3.5 Imports GNFS 10.8 -1.8 0.2 '' Exports GNFS 8.5 1.1 1.9 /a Constant 1980 prices and calculated by least squares. lb Growth rate is affected by exceptional weather conditions. ic Due to reduction in oil imports on account of the new refinery. 40. The two major exports of goods, oil and phosphate derivatives, are affected by two factors in addition to a depressed price outlook- . The coming on stream of the refinery extension at Bizerte will reduce crude oil exports by 1.5 million tons, as more Tunisian crude wi'll be processed locally. While recently-completed fertilizer plants could increase exports of phosphate derivatives by over 7% p.a., it is likely that this capacity cannot be fully utilized in view of the projected glut in world supply, and of the poor quality of indigenous phosphate rocks. These exports are thus expected to grow by no more than 6% p.a. during 1986-91. 41. In consequence, manufacturing industries, tourism and agriculture will have to become the major engines of future export growth. Assuming that the policy measures concerning the agricultural sector discussed in Part IV below are implemented in a timely fashion, there should be a significant reduction in the agricultural trade deficit. Potential export growth lies in olives, vegetables, dates, wine and fishery products. Overall, manufactured LI The medium-term projections assume an oil price of US$13-14 per barrel in 1986, gradually increasing to US$22 in current prices in 1990, while the price of TSP, the major fertilizer product of Tunisia, is expected to increase from the present level of US$120 to US$160 per metric ton.  - 13 - exports excluding phosphate derivatives are expected to grow at 7.8% p.a., with the greatest potential in electrical and mechanical, textile and other manufacturing industries. Tourism is expected to resume a more satisfactory growth, albeit not at the rate experienced during the late 1970s. Average annual growth of exports, both historical and projected, is shown in Table 3. Table 3: GROWTH OF EXPORTS AND COMPONENTS (Annual growth rates in percentage, constant 1980 prices and calculated by least squares) 1976-81 1981-86 1986-91 (Actual) (Preliminary) (Projected) Agricultural Products 2.4 -1.1 4.7 Crude Petroleum 7.4 -4.2 -19.8 Phosphate + Derivates 2.7 4.5 6.0 Processed Food -3.4 6.6 4.9 Textiles 23.7 3.2 7.2 Electrical/Mechanical 23.9 9.0 11.9 Other Goods 6.8 2.5 20.3 NFS 9.2 2.8 5.0 Total Exports, GNFS 8.5 1.1 1.9 Total, excluding petroleum 9.0 3.3 6.5 42. Concerning imports, the pivotal role of exports in generating economic growth will require corres.ponding increases in imports, particularly of raw materials and intermediate goods needed for industrial growth; growth of these imports is assumed to be at par with industrial growth, allowance being made for the expected improvement in efficiency. The elasticity of energy consumption would decline to 1 during the VlIth Plan, compared to 1.3 at the present time, reflecting a continued energy conservation effort being supported, in part, by a recent Bank loan. Total energy imports are expected to decline by 17 p.a. throughout the period, also partly as a result of the refinery extension mentioned above. In addition to stimulating exports, the policy measures proposed by the Government are expected to substantially stimulate import substitution of agricultural products. The growth rate of food imports is expected to be more than halved from 4.8% p.a. during 1977-86 to about 1.7% during the VlIth Plan, despite a rapid growth of the population (2.5% p.a.) and of food processing industries (42 o.a.). The greatest potential in this category includes durum and bread wheat, barley, milk and beef. Imports of other consumer goods are likely to remain low between 1986-88, due to the impact of short-term stabilization measures, which are expected to keep growth of domestic consumption below that of total GDP; they are expected to pick up rapidly thereafter as growth resumes and the impact of the liberalization program begins to be felt.  - 14 - 43. Balance of Payments and external debt. Emigration has slowed down in the face of weakening demand for foreign workers in Europe, in Libya and in the countries of the Arab peninsula, and therefore inflows of workers' remittances are expected to decline slightly in real terms. Over the past five years, these remittances have averaged over 161 of commodity exports, equivalent to about 4% of CDP. Given this and the above-discussed export and import outlook, the current account deficit is expected to decline from an average of about US$707.0 million, or 9% of GDP in 1984/85, to about US$536.0 million, or 3.9% of GDP in 1991. In view of the depressed oil price outlook and assuming no major new oil field discoveries, direct foreign investment is expected to remain at the current level in real terms. Table 4: TUNISIA - PROJECTED BALANCE OF PAYMENTS (Millions of current dollars) (With adjustment)" Actual Projected 1985 1986 1988 1991 Exports of Goods and NFS 2,678.3 2,579 3,306 4,448 Imports of Goods and NFS 3,175.6 3,354 3,922 4,918 Net Factor Services -52.6 -56 -80 -82 Current Account Deficit 539.2 819 682 536 Net Foreign Investment 130.6 176 197 231 Public M & LT Borrowing (gross) 653.1 1,139 1,131 1,219 Amortization on M & LT Debt 388.3 520 629 889 Public M & LT Borrowing (net) 264.8 619 502 330 Selected Financial Indicators Debt Service Ratio (X of exports of goods and services) 22.7 27.6 26.2 26.1 Current Account Deficit (X of GDP) 6.6 8.7 6.2 3.9 /a This includes the effects of the Government's adjustment program described herein. 44. Gross foreign loan disbursements required to finance such a current account deficit, to repay maturing debt and to maintain reserves at a level equivalent to I month of imports would average slightly above US$1.0 billion annually during 1987-91. About two-thirds of this would come from official sources, compared to 60% in the last three years. Debt outstanding and disbursed as a percentage of GDP would increase slightly, from 50% in 1984/85 to about 52% in 1991, while the debt service ratio would be 26.1%. Average borrowing terms are not expected to harden much. The average interest rates would remain in the 6-7% range between 1987-91, while the average maturity would be slightly shortened to about 13 years from the current level of 15-17 years.  - 15 - 45. This scenario obviously depends on the policy changes to be initiated during the next few years, in particular on a timely implementation of policy measures to accelerate exports, reduce public investments, slow down growth of domestic demand and liberalize the economy by phasing out regulations and controls. As mentioned in Section B above, the Government lhas already taken several steps in implementing such a strategy. Considering its long record of prudent external debt management, there are good grounds to assume that Tunisia will implement the necessary policy changes along the lines discussed above and remain creditworthy for a continuled high volume of Bank lending. 46. Domestic resource mobilization. With exports growing Easter than imports, the resource gap is expected to decline to less than 3.5% of GDP by the end of the V]Ith Plan. This still rather high overall gap, however, disguises a strenuous effort in savings mobilization in the non-oil sectors. Indeed, the non-oil resource gap declines from an average of 14% of GDP in 1984185 to about 3.9% in 1991. The marginal propensity to save over the period 1987-91 is estimated at a high 26% (in current prices), assuming successful implementation of the structural reforms to control domestic demand. Limiting Central Government current budget expenditures to below 21% of GDP and capital expenditures net of debt repayment to about 6% of CDP by the end of the VIIth Plan period should allow Government savings to finance over 70% of public sector investment (including public enterprises), up from 43% in 1984/85, and should increase the percentage of overall investment financing by domestic savings to over 80% on average over the period. While this would help to reduce the pressure on the balance of payments, it also gives a clear signal to the private sector that the public sector investment program will not lead to a crowding out of private investments but rather will supplement it by providing the necessary infrastructure. 47. The medium-term framework discussed above corresponds largely with the Government's own planning scenario for the VEIth Plan. While there are clearly downside risks involving such exogenous factors as the growth of the world economy, in particular in the EEC countries, and movements in international prices, it is clear from the analysis of the recent past that there is no alternative to the proposed export-oriented strategy. Slower export growth would lead rapidly to sLower GDP growth, in order to keep the balance of payments manageable. Such a situation would greatly worsen the unemployment rate. As mentioned above, even implementation of the full structural adjustment program will not allow absorption of more than 70% of new job seekers during 1987-91; any lesser effort would further worsen the unemployment situation with serious political and social consequences. E. Social Impact of the Adjustment Program 48. According to the latest household survey, almost 12.8% of the total Tunisian population (823,000 persons) was living below the absolute poverty level in 19B0.1' Most of the poor and lower income groups are located in rural areas, followed by smaller towns; these groups account for about 14% of the total rural population, and 12% of the total urban population. They are largely employed in agriculture (43%) and construction (16%), where significant underemployment exists. Over 18% of the total work force in construction, 16% in agriculture, 14% in mining and 10% in transport are considered to be poor. They spent almost 85% of their budget on fulfiLling their basic needs for food, housing and clothing. I/ In 1980, the absolute poverty level was D 60/person/year in rural areas and D 120/person/year in urban areas.  - 16 - 49. The Government's program of economic adjustment could worsen the situation of the absolutely poor in two major ways: (i) through the gradual reduction of budget subsidies; and (ii) through increases in consumer prices triggered by changes in the exchange rate and increases in agricultural producer prices. The present system of consumer subsidies is clearly important to the well-being of the poorest segment of the population, as such subsidies account for nearly 19% of their total expenditures - 20% for the urbarn poor and 17% for the rural poor. However, the subsidies overwhelmingly profit the better-off segments of the population, with over 60% of all consumer subsidies going to the highest income groups, and only less than 10% going to the absolute poor, particularly to the urban poor (6X). This situation means that while it would appear socially and politically impossible and undesirable to deprive the absolutely poor from the support they currently receive, there is ample room to reduce consumer subsidies by as much as 90% without taking away anything from the really poor. This requires that ways and means be found to target this assistance more directly to the realLy needy. The Government is clearly aware of this situation; it recently established a Special Commission to study how to target and efficiently distribute consumer subsidies, so as to gradually introduce a more focussed and less expensive system of support for the poor as overall subsidy outlays are reduced. 50. The adjustment program also includes a number of important measures designed to improve the situation of the poor: (a) the rural poor, particularly in rainfed areas, will profit from increased agricultural producer prices as well as from increases in agricultural production for import substitution and exports; (b) the urban poor will profit from the increase in the minimum wage introduced in mid-1986; and (c) both groups will profit from the stimulating effects of the adjustment measures on employment creation, as export industries, agriculture and tourism are all relatively labor-intensive sectors. As the bulk of the absolute poor are employed in sectors with a high underemployment rate, the expected more rapid creation of new employment and decline in underemployment ought to have a sizable effect on the standard of living of the poor labor force employed in the modern sector. Given the fact that the informal sector will benefit little from minimum wage changes and the other measures mentioned above, the Government has initiated several specific programs for the support and development of this sector (para. 12). PART mI - BANK GROUP OPERATIONS DIN TUNISKA 51. Since 1962, the Bank has committed to Tunisia seventy-one loans and ten IDA credits amounting respectively to US$1,515.0 million and US$75.2 million (net of cancellations) of which forty-four loans and credits have been fully disbursed. Annex II contains a summary statement of Bank loans, IDA credits and IFC investments as of March 31, 1986. Project implementation is generaLly satisfactory. As of March 31, 1986, overall disbursements amounted to 57.7% of appraisal estimates, which is in line with experience in other countries in the region. Disbursement performance for agriculture, energy, water supply and sewerage, highway and port projects has generally been above the country average, while longer than average disbursement delays have been experienced for education, health, technical assistance and urban projects, due to project-specific problems that are being addressed tbrough supervision missions and sector discussions. In a number of sectors, important policy changes and institutional improvements have been achieved, and autonomous  - 17 - agencies have been created or strengthened to ensure the efficient management of the related sectors or sub-sectors. 52. The Bank's lending strategy in Tunisia aims at supporting the country's transition from a situation of reliance on petroleum exports to a sectorally-balanced post-hydrocarbon era through appropriate changes in economic policies and programs as described in Part II above, while taking measures to increase employment and target development to low-income groups. In support of the above, the overall objective of Bank lending is to emphasize projects which have a direct and rapid impact on production, employment and exports (or import savings) and which minimize Government net contributions. The focus of lending for agriculture and industry meets this objective. In addition to the above, proposed Bank lending would focus on improvement of public enterprise performance, conservation and development of energy resources, and continued support to the social sectors and operations targeted to low-income groups. For the latter, attention would be given to increased efficiency and cost-effectiveness of institutions and investments, and to linkages with directly productive sectors (e.g., education reforms stressing vocational training). We envisage only marginal lending for basic economic infrastructure, focussed in areas where Bank guidance would still be useful, such as rural water supply and highways maintenance. 53. Past Bank lending emphasized support for long-term investments in infrastructure and social development, with increasing support in recent years for agriculture and industrial financing. Bank/IDA commitments to date are distributed as follows: urban, water supply and sewerage, 23%; agriculture and industry. 21% each; transport, 17Z; energy, 111; education, 5%; and health and technical assistance, 1S each. Within the broad framework noted in para. 52, we expect increasing emphasis on agriculture and industry, which shouLd represent over half of our lending. In addition to recent loans for energy conservation demonstration and urban development, and the proposed Agricultural Sector Adjustment Loan, programued lending in the next couple of years would include an Industrial and Trade Policy Adjustment Loan as well as projects for highways maintenance, grain storage and credit lines for small-scale industries and agriculture. 54. Bank group lending for agriculture in Tunisia started in 1967, and to date 17 projects have been approved for a total of US$407.9 million of Bank/IDA funds. Of these, eight are ongoing. Performance under these projects has been mixed reflecting the institutional constraints in the sector. The First Fisheries Project (Cr. 270-TUN) was completed at the end of 1979, and the Project Performance Audit Report (PPAR) identified cost overruns and low loan recoveries for boats as major problems. These problems were addressed under the Second Fisheries Proiect (Ln. 1746-TUN), but recoveries remain a problem. The First and Second Agricultural Credit Projects (Ln./Cr. 7791263-TUN and Ln. 1340-TUN) financed lending by the National Bank of Tunisia (BNT) for on-farm development. While the projects achieved good rates of return, the continuing problem of higher interest rates on Bank funds than on Government- supplied credit and the lack of profitability of agricultural credit operations, as highlighted in the PPAR's for these projects, caused disbursements to be slower than anticipated. The Third Agricultural Credit Project (Ln. 1885-TUN) is addressing priority credit problems including the level of interest rates and recoveries. Action has been taken to decentralize BNT's operations, raise interest rates, and encourage improved recoveries. The physical implementation of the poverty-oriented Northwest Rural Development  - 18 - Project (Ln. 1997-TUN) is proceeding satisfactorily. The Grain Storage Project (Ln. 2052-TUN) is also progressing well after inital delays and the recruitment of new consulting engineers. Under the Technical Assistance Project (Ln. 2197-TUN), strategies have been or are being developed for sevural sub-sectors including farm input distribution, farm mechanization, produce marketing, research and extension, and improved operation and manLtenance of existing irrigation infrastructure. These strategies have contributed to the design of the proposed operation. Implementation of the irrigation projects - First Irrigation Rehabilitation Project (ln. 1068-TUN), Sidi Salem Project (Ln. 1431-TUN), Southern Irrigation Project (Ln. 1796-TUN), Medjerda/Nebhana Irrigation Project (Ln. 2157-TUN), Central Tunisia Irrigation Project (Ln. 2234-TUN), and the recently started Gabes Irrigation Project (Ln. 2605-TUN) - has generally been satisfactory and on schedule. The PPAR for the First Irrigation Rehabilitation Project also found that the increased reliability of water supply brought about by rehabilitation works carried out under the project had a major impact on farm production and incomes in the project area by increasing farmers' willingness to take higher risks by planting higher value crops. Partly to avoid the need for future rehabili- tation projects caused by lack of maintenance, the Irrigation Management Improvement Project (Ln. 2573-TUN) is designed to support nationwide improvements of the operation and maintenance of existing irrigation systems as well as policy and institutional reforms to increase the efficiency and self-financing of the Irrigation Development Offices (OMVs). The Northwest Agricultural Production Project (Ln. 2502-TUN) will help alleviate the constraints to increased production of cereals and livestock products in Northwest Tunisia, inter alia by introducing an extension system based on the Training and Visit (T&V) system. 55. The Bank's economic and sector work will address the increasing complexity of the macro-economic and sector problems that Tunisia will face in the medium term, and continue to focus on strengthening the macro-economic and sector base for our lending ptogram. However, while in the past it was mainly devoted to the study of major structural problems, it is focussed on implement- ing the policy recommendations of these studies through sector lending in agri- culture, industry and trade, public enterprises and transport; it will there- fore concentrate on the following main tasks: (a) preparation and monitoring of the macro-economic framework of the VlIth Plan, which provides the policy base of sector lending; (b) review of public expenditures under the Plan to provide guidance for the neressary reductions in budget outlays; (c) assessment of public enterprise reforms prepared by the Government to reduce their drain on the State budget; and (d) monitoring of the agreed macro-economic and sector policy changes. The program also includes studies on education administration and finance, municipal finance and development, energy pricing, and the impact of the adjustment program on various income groups. 56. The Bank and IDA accounted for about 27.81 of total commitments from official sources to Tunisia during 1982-1984. Their share in total debt outstanding and disbursed at the end of 1984 (including loans from private sources) was an estimated 14.5%, and their share in debt service during 1984 was 11.7%. The share of the Bank and IDA in Tunisia's disbursed external debt is expected to increase to about 14.7% and their share in the debt service to about 15.7% in 1986. 57. As of March 31, 1986, IEC's net commitments in Tunisia totalled about US$7.5 million. IFC has supported the Economic Development Bank of Tunisia (BDET) to foster development projects, and the National Bank for Tourism  - 19 - Development (BNDT) to promote and invest in tourism projects. It has Jlso ;isisted the Soci6t6 Touristique et H6teli6re (RYM), a large hotel development; tthe Industries Chimiques du Fluor (ICF), a producer of aluminum fluoride frmn local fluorspar for export; and the Societ6 d'Etudcs et de D6veloppement de Sou:4s,s-Nnrd for an integrated tourism development project. In FY85, IFC aiiproved an equity investment in Fluobar, a project to privatize, rehabil i telt ;iiid eIxIlpand an existing fluorspar mine. Two investments in Tunisia Ienas Ilg Csi'!'jyinY, Llte first Leasing company in Tuniisia to provide financing to tile irndti,strinl sector, were approved in FY85 and 86. In FY86, IFC approved tin -uitiy inivestment in Soclet6 Industrielle de Textiles (SITEX) which wotild lithlp pr,-ivittize an existing state-owned textile mill, and an equity inlvestment ill AdjWYD SA., a company which will produce pharmaceutical products from imported ;mrtivi' ingredients. I'AitT IV - THE MEDIUM-TERM AGRICULTURAL SECTOR ADJUSTMENT PROGRAM A. The Need for Adjustment In trodtLcLion "8. Like many other middle-inicome countries, Tunisia has experienced a decline in the relative importance of agriculture in its economy over the past 25 years. Today, agriculture in Tunisia accounts for about 13% of GDP, 35X of employment and 8% of export earnings, which represent sharp drops from 1960 levels of 24% of GDP, 56X of employment, and 601 of export earnings, due mainly to the more rapid growth of other sectors, principally petroleum, manufacturing and tourism. The performance of the sector has also deteriorated recently. After a period of rapid growth in the late 1960s and first half of the 1970s, when agricultural GDP grew at 8.81 p.a. (1967-76), growth slowed down to 3.3% in the late 1970s and first half of the 1980s (1977-86). 59. The reduced growth of the past decade has meant that Tunisia has also experienced a widening "food gap" which has placed an increasing strain on the balance of payments. Domestic food production has failed to keep pace with increased demand generated by a combination of rapid population growth (2.6X), a high rate of urbaniization (4.4%) and domestic consumer price subsidies (US$300.0 million per year in recent years). The ready availability of cheap food imports, subsidized both by the exporting countries and through the overvalued exchange rate, has diverted attention from the underlying problems. Food imports have increased by about 3.81 per annum (1977-86) and the rate of self-sufficiency for key items has declined over the last decade (e.g., for cereals from about 75% to 50%). Meat imports more than doubled from 1982 to 1984. If present trends continue unchecked, recent projections done by the International Food Policy Research Institute (IFPRI) indicate that by the year 2000 Tunisia will have a cereal deficit of almost 1.3 million tons per year (compared to the current 0.9 million tons), a milk deficit of about 800,000 tons per year (compared to the present 244,000 tons) and a meat deficit of abotut 200,000 tons per year (compared to the existing 57,000 tons). 60. Agricultural exports, consisting principally of olive oil (481), dates (14%), citrus (5%) and wine (4%), have stagnated with the result that the proportion of sector imports covered by sector exports has fallen from 81% in 1976 to 49% in 1985. As a result, the agricultural sector has accounted for a rising share of the overall trade deficit (from 5% in 1976 to 20% in  - 20 - 1985). Based on current trends, without policy correction, the agricuJtural trade deficit, currently about D 185 million per year, could, under the IFPRI assumptions, rise to over D 565 million (in 1986 constant terms), exerting unsustainable pressure on the already difficult balance of payments situation. 61. The sector's overall performance has also not matched the growth of 6% p.a. in gross fixed investment in agriculture during the decade 1975 to 1985, a rate about twice as high as for the economy as a whole. During the recent Vith Plan period too, investment in the sector was 16% of the total, somewhat in excess of the sector's contribution to the GDP. The proportion of total sector investment by the private sector was only 31%, significantly below Plan projections. Investments by the public sector were concentrated in Irrigation (42% compared to 22% in the early 1970s). As a result, most of Tunisia's irrigation potential is now harnessed, but downstream investments and activities to ensure optimal utilization are lagging behind. Similarly, investment in fishing port infrastructure and processing remain largely underutilized, and agro-industry operates at well below capacity (see para. 80). This capital-intensive nature of investments and low utilization of installed capacity is not sustainable in the new macro-economic situation of fiscal resource constraints and need to rapidly create employment opportunities. The VIIth Plan, recognizing the uncertainty in the resource base, calls for the proportion of sector investment to shift towards the private sector from a ratio of 31% to 501. These shifts require not only a prioritization and adjustrment of public expenditures to focus on improved utilization of established capacity, but also a selective reduction in the public sector role to create the room for private sector participation, and a shift in sector policies to provide greater incentives to private investments. Resource Base and Structure 62. Growth in the sector has been concentrated in the predominantly modern irrigated sector, which covers less than 5% of the cultivated land, but accounts for 38% of agricultural CDP. Not only has the Government concentrated its investment resources in the irrigated areas, but approximately one tIird of the input subsidies on fertilizer, seed and herbicide has also been consumed in irrigated areas. Moreover, the crops produced in these areas, consisting largely of fruits and vegetables, have not been subject to any Government output price intervention. This combination of subsidized, capital-intensive development and free market pricing has been very successful, and irrigated output has expanded by 4-6% per year. Sustaining such growth under a more demanding regime concerning fiscal resources is the major challenge facing the Tunisian Government. Potential for Increased Production 63. Tunisia's agricultural potential is far from being fully realized. The levels of inputs used to increase yields could be increased substantially in rainfed as well as irrigated areas. In rainfed areas, especially where rainfall exceeds 350 mm, major productivity improvements could be obtained from widespread introduction of improved farming techniques such as shallower land preparation using tined implements, increased use of inputs and more intensive cropping patterns including pulses and, in some areas and for certain  - 21 - farm sizes, integration of crop and livestock production.1' In the irrigated areas, there is also considerable scope for yield increases-Z and production growtht through greater intensification in the existing schemes. Cropping intensity iFl the areas already equipped for irrigation through public financing averages anly 70% while it could be in excess of 100%. Over the next decade, the impact of such measures could represent the equivalent of a doubling of the currently irrigated areas. Considerable room for improvement remains to be achieved for the citrus growing areas of the northeast (Cap Bon), where use of additional water from the rivers further west could enable citrus production to double. Constraints 64. The pace of achievement of this potential is geared to the speed at which adjustments are made in macro-economic and sector policies to maintain agricultural growth under a constrained external and fiscal environment (paras. 8-9). Past macro-economic policies have not favored the sector's development. The past policy of overvalued exchange rates has handicapped the sector's growth, since it has simultaneously discouraged exports and artificially cheapened food imports to the detriment of locaL food production. 1/ The scope for increasing yields in rainfed areas is evident from the following estimates of present and potential yields for rainfed crops iu, the high and low rainfall zones of northern Tunisia made by the FAO/CP during preparation of the Northwest Agricultural Production Project (higher yields on larger farms being mainly due to better resource endowment): High Rainfall Zone Low Rainfall Zone Present Potential Present Potential ---------------- (tons/ha) ---------------- 10-50 ha Farms Barley 1.2 2.0 0.8 1.5 Wheat 1.1 1.8 0.8 1.5 Feed Pulses 0.5 1.3 0.3 0.6 Forage (hay equivalent) 2.8 3.8 2.0 2.5 Over 50 ha Farms Barley 1.5 2.5 1.2 2.0 Wheat 1.3 2.1 1.0 1.7 Feed Pulses 0.9 1.7 0.7 1.6 Forage, (hay equivalent) 3.5 5.0 2.5 3.0 2/ In the irrigated areas. average yields obtained compare with the best areas as follows: Irrigation Dev. Offices Results Crop (OMVs) Average in Better OMVs -- (tons/ha) ------------ Cucurbits 8 20 Potatoes 12 18-20 Field Tomatoes 25-30 40-45 Greenhouse Tomatoes 60 80 Apricots 12 20 Forage (green matter) 30 50  - 22 - The pollcy of subsLdlzing domestic food consumption has reinforced the import bias, particularly when faced with fiscal contraints. Both the processing Industries and the Government have found it to their short-term advantage to purchase imports at the expense of providing markets to local food production. Finally, the higher relative incentives to other sectors compared to agriculture, notabLy industry, has made agriculture an unattractive place for new private direct investment or in support services. Restrictions on inmports of spares and new equipment to encourage domestic industry has led to reduced levels of maintenance services and inefficiency in operations. Tunisin's macro-economic adjustment program (Part II) aims to ensure that this bias against agricultural growth is steadily eliminated. Actions compLementary to the macro-econcmic adjustment program are needed in order to overcome those constrrints to efflcient growth which are sector specific. The Government's medium-term agricuLtural sector adjustment program (MTASAP), discussed in Section B below, aims to identify these constraints and launch an action program to resolve them. B. The Sector Adjustment Pogtram Origin and Objectives 65. The main objectives of the Government's MTASAP described below were developed in late 1985 and earLy 1986 as part of Tunisia's efforts to adjust its economy to a more constrained macro-economic situation. For this, Bank assistance was made available to the Government in the form of macro-economic st:ategy discussions and assessments of sector poteatLal and policy and institutional constraints. Consistent with the macro-economic objective of improving the balance of payments situation and alleviating the burden on the Government's budget, the main objective of the MTASAP is to promote greater efficiency and economy in the increased production of agricultural products, which can substitute for increasing imports and lead to increasing exports, and in the use of public resources in the .ector, including enhancing the role of the private sector in the provision of commercially-viable sector support services. The MTASAP includes specific actions to address the identified constraints over a six-year period (1986-91) and aims to achieve its objectives by: (a) improving the prices and incentives framework so that prices and price formation mechanisms are further deregulated or linked to world market prices and incentives made more effective. This involves achievement within a reasonable time frame of alignment of producer prices with world market prices and elimination of input subsidies, and will result in better farmer response for those crops and livestock production activities for which Tunisia has a medium-term comparative advantage; (b) reorienting the public investment and expenditure program towards lnw cost, high priority, quick maturing projects and programs with lower budgetary demands while assuring adequate funding for maintenance of past investments; (c) strengthening basic services in support of farmers, while privatizing those Government services which are commercially viable, and improving cost recovery in others; (d) improving productivity of land use and management of the country's forest and fisheries resources; and  - 23 - (e) building up the sector performance monitoring and policy analysis capabilities of the Ministry of Agriculture. Details of the above actions and the analyses behind them are presented in a separate Medium-Term Agricultural Sector Adjustment Program (MTASAP) available on request. An outline of the MTASAP is contained in Annex VI, and a summary is given below. I. proving the Prices and Incentives Framework (Chapter I of MTASAF) 66. Even though the prices of -'n estimated 751 of agricultural production are market-determined, Government intervention in agriculEure through taxes, subsidies and price controls has a major impact on the incentives to producers, processors and providers of services in the sector, especially on resource allocation within the sector, among farming systems and products. Main instruments which have been used are fixed producer and consumer prices for basic products, marketing controls, and input and investment subsidies. In brief, producer prices of cereals, milk and industrial crops are administered through a variety of public and quasi-public agencies. Prices of fertilizers and herbicides, improved seed, irrigation water and feed concentrates are regulated, and price formation in agro-processing and marketing is subject to a system of fixed margins. 67. Based on available data in Tunisia and in the Bank, a preliminary analysis has been made to assess the general effect of these interventions. This analysis shows that: (a) the high value of the dinar in recent years has been an important disincentive to export development and increased agricultural production; (b) the sector compared to other sectors such as industry (which have benefitted from cost plus pricing and high tariffs) has suffered from high relative net taxation, and input subsidies have been far from adequate to compensate for this; (c) within the agricultural sector, the incentive patterns vary signifi- cantly between rainfed farming, particularly cereals which are import substitutes, suffering from low or negative protection, and irrigated farming, especially fruits and vegetables and other exportables, which have enjoyed relatively high positive effective protection; and (d) price formation processes in the farm to retail market chain, particularly in agro-industrial processing, represent significant inefficiency and avoidable fiscal cost to the Government. 68. Currency valuation. The high value of the dinar in recent years has had two major consequences for the agricultural sector: (a) it has depressed sector exports by artificially reducing the dinar proceeds from export sales; and (b) it has artificially stimulated food imports by making them cheaper in relation to domestic food production. When combined with other factors such aa reduced export markets, subsidized food exports on the world market and domestic consumer price subsidies, it is not surprising that the sector has experienced an increasing trade deficit (para. 60), but more importantly overall agricultural production has been depressed by the adverse effects of the overvalued currency.  - 24 - 69. The value of agricultural exports (Chapter IX of MTASAP), including processed food, declined by 1.42 per year over the 1977-85 period (Annex VIII). Prospects for Tunisia's leading agricultural export, olive oil, are not bright on the traditional European market due to the enlargement of the EEC to include the world's largest olive oil producer, Spain. As a cushion, Tunisia has negotiated a 46,000-ton p.a. quota for its olive oil exports to the EEC, representing about 80% of the present export level. Efforts are now needed to diversify to other markets and these efforts would require improving the competitiveness of Tunisian exports and better incentives to exporters. On the other hand, exports of marine products have grown rapidly in recent years, and are now the second most important agricultural export. Although traditional marine exports (shrimp, squid and sponges) have reached their maximum sustainable yield, there is considerable untapped production potential for swordfish and lobster, exports of which could generate an additional D 8.0 million per year by 1991. Strong export growth is still possible in dates where Tunisia already accounts for 25% of the world's production of the highly prized "Deglet-Nour" variety, the export price of which commands a 100% premium over common varieties. However, the rapid increase in domestic consumption has reduced the exportable surplus to only 30X of production. As supplies increase in response to recent investments in replanting, additional earnings from dates are estimated at D 15 million per year by 1991. Export prospects for Tunisian citrus are also better than often thought due to the unique quality characteristics of the "Maltaise" orange which account for virtually all exports. Incremental citrus exports could generate an additional D 2.0 million p.a. in foreign exchange by 1991, provided export profitability is improved to overcome the increased trading costs, 40% of which are in transport and handling in the importing country. Tunisian wine exports, used mainly in blending, face a difficult future because of increasing surpluses on the EEC market. Nevertheless, encouraging exporters to shift into higher quality wine production, Tunisia could expect to earn an additional D 1.0 million per year by 1991. Incentives for the expansion of off-season vegetables could bring in another D 3.0 million per year by 1991. It is estimated that total agricultural exports could increase by about D 34.0 million per year by 1991, enough to reduce the agricultural trade deficit by 18%. Achieving the above export potential, however, will require the development of better incentives for export and of new, product-specific marketing strategies and channels. To bring this about, the Government's MTASAP relies on a flexible competitive exchange rate policy (para. 27) and the application to the sector of temporary measures to keep exporters from paying the high promotional costs of developing new markets. Product-specific export strategies targeted to particular markets would be developed through a sector export promotion action program, to be developed based on a study, draft terms of reference for which (in the MTASAP) were discussed at negotiations. Specific measures, the appropriateness of which would be evaluated in the study, are, among others: (a) extending export company benefits to agricultural export enterprises; (b) reducing wholesale market taxes for export products; (c) eliminating taxes on processing of export products; (d) giving agricultural import licenses to agricultural exporters; and (e) renegotiating air and sea transport routes to increase frequency of appropriate services for agricultural exports. 70. The effect of exchange rate policy has also been important regarding food imports which have increased by 5.9% p.a. These imports have always entered Tunisia tariff-free, in consideration of the Government's policy of low consumer prices. Two other factors combining with this policy and leading to depressed domestic production incentives are: (a) the availability of  - 25 - imports often subsidized significantly in the country of origin and available in Tunisia 30-40% below world market prices; and (b) the fiscal constraints on the Government. As a result, producer prices have been depressed below world market prices, particularly for cereals, milk and meat. 71. Inter-sectoral terms of trade. The industriaL sector has been cushioned from the effect of exchange rate policies through high tariff barriers and favorable price formation mechanisms, whiLe agricultural products were allowed to enter the country virtually duty-free. More recently, restrictions have had to be imposed on imports of many industrial products produced Locally. As a result, relative incentives between agriculture and industry have remained strongly against agriculture, which has faced depressed output prices, and also higher costs for inputs, often products of protected and still inefficient domestic industries. In 1981, the Quantitative Economics Institute of the Ministry of Planning (Institut Ali Bach Hamba) estimated that effective protection of agriculture was about 25%, compared to 75% for industry and 35% for the economy as a whole. More recent analysis has put the average protection level for agriculture at a low 5% in 1984. 72. The consequences of these high inter-sectoral variations in relative incentives for allocation of resources in agriculture have been quite serious. Not only have the Plan's objectives of achieving a 50% share of private investment not been attained, but also most fixed investment in the sector has either had to be made by the Government (e.g., 60% of cold storage is publicly owned) or had to be dependent on special investment subsidy programs covering virtually all on-farm and marketing investments (farm machinery, buildings, animals, pasture establishment and storage) costing D 8 million in 1985. The administrative inertia associated with Government-financed programs is now compounded by fiscal constraints facing the Government, and correction of the low relative incentives in the sector is needed to ensure the adequate flow of private resources. The Government's MTASAP relies on shifts in macro-economic and industrial policies, particularly the reduction in high industrial tariffs, the liberalization of prices and the price formation process, and the introduction of a 15% minimum tariff (para. 36) to start a process of correcting these large imbalances in relative protection. The latter would affect the producer prices for key food imports directly. 73. Intra-sectoral incentives. Within the sector, production incentives vary widely among farming systems and crops as a result of Government interventions. Despite the generally free market environment, the Government fixes the prices of the three major cereals, durum wheat, bread wheat and barley, as well as of milk and some other crops. Cereal prices have consistently been set below world market price levels even at the official exchange rate. The Government, through the Office of Cereals, purchases 30-40% of the cereal harvest at the officially fixed producer prices: official purchases vary from a low of 10-20% of production in the case of barley to 60-701 in the case of bread wheat. However, prices in free markets, particularly at harvest time in major production areas, are not always at official prices, since, due to an active price intervention at the consumer level, parallel markets have tended to disappear and farmers have limited themselves to subsistence production only. PotenLial for producer price distortion is the highest in the case of wheat, which attracts the bulk (60% or D 160.0 million) of direct Government subsidies for food, and the least in barley, which is virtually free from active intervention (D 2.0 million p.a.). Although influenced by the good crop year in 1985, the 15-year growth pattern (5% p.a. for barley, 1.4% for durum wheat, and 0.7% for bread wheat) suggests the effects of these price interventions.  - 26 - 74. Even at the official exchange rate, official prices are below world market prices: in cereals, nominal protection in 1984/85 was -15% to -20% for the wheats and -7% for barley. Despite a premium on world markets of 30-40% tnr duirwu wheat over bread wheat, the Tunisian policy of self-sufficienicy has led to the establishment of identical offical producer prices. Given roughly equal yields for the two wheats in the Tunisian North, the extra fiscal and fozeign exchange cost of this policy (roughly D 1.4 million and 7.5 million, respectively) needs to be reviewed against the psychological benefits ot self-sufficiency. Citrus and potatoes, both exportables, are free from G;overnment price interventions and their domestic prices have been 25-45% above world market prices at the official exchange rate. In the case of milk and beef,' official prices have been close to their world market eqtuivalents, but the Government, due to its fiscal constraints and availability of often subsidized imports, has offered little incentive to agro-industry to buy domestic production: only 20% of the milk and 5% of the beef enter official channels, and producer prices remain depressed (see also paras. L07- 110). Poultry production is free from output price interventions and has grown at 20% p.a., but has been supported by strong input subsidies. 75. On the input side, subsidies to agriculture amounted to a total of D 69.0 million (US$95.8 million) in 1985, of which about 33% was for irrigation water (both capital and O&M), 24% for fertilizers (superphosphate, triple superphiosphate and ammoniwn nitrate), 23% for animal feed (maize, soybean meal and barley), 14% for on-farm investments, 4% for seed and 2% for herbicide (2-4-D and multipurpose). ' Unit subsidies for fertilizer have ranged from 55-70%, and those for animal feed from 15-26%; herbicides and cereal seed subsidies have been 50% and 25%, respectively. These subsidies have been introduced partly to compensate for the low producer prices, but in case of products manufactured locally (e.g., fertilizers and animal feed concentrates) part of the subsidies have often been absorbed by domestic industry since ex-factory prices are often higher than world market prices. The subsidization of itrigation water has strongly favored commodities like milk and vegetables which dominate irrigated production. Animal feed subsidies have given a stimulus to the imported concentrate-based poultry industry, but has had adverse consequences for barley producers and mutton/lamb producers since it constitutes a major disincentive to the increased use of forage, larger qulantitLies of which could be efficiently produced in conjunction with cereal production. Cereal seed subsidies have stimulated use of improved seed, butL by their system of administration may be hampering wider distribution (paras. 99-101). 1/ The producer price of which has been recently liberalized. 2/ 1985 Subsidy Amount Input (D million) % of Total Irrigation Water 23.0 33 Fertilizers 16.5 24 Animal Feed 15.9 23 On-farm Investments 9.9 14 Seeds 2.5 4 Herbicides 1.2 2 69.0 100  - 27 - 76. As a result of these Government interventions in product and factor markets, preliminary estimates of relative incentives for cereals under different rainfed production systems give a range of effective protection from -301 to +10%, which, An view of the average protection oF the agricultural sector as a whole of 5%, implies a net relative protection for cereals in the range of +5% to -351. In irrigated farming, on the other hand, levels of effective protection are well above the sectoral average with particularly high levels for irrigated citrus and potatoes. 77. As a prime feature of its MTASAP, the Government recognizes that its macro-economic policies must be consistent with and supportive of the objective of fully developing the untapped potential of the agricultural sector and suitable adjustments are being made (para. 64). Since an important factor in increasing production in the higher rainfall areas is greater integration of cereals, livestock, forage crops and pulses, and in irrigated areas, a more intensive use of irrigated land, the primary objective of the MTASAP is to progressively improve the prices and incentives framework in the sector so as to encourage rainfed production of cereals, milk and meat under efficient production systems while promoting shifts toward more efficient cropping patterns and input utilization patterns in irrigated areas. 78. The Government's MTASAP aims to eliminate the distortionary effect of its input subsidy program and to rationalize its output price interventions in order to allow world market price trends to be reflected in its sector pricing structure. Combined with macro-economic adjustments. the relative incentives between industry and agriculture would be brought closer to reduce current intersectora! distortions and the large differences between incentives for various commodities would be narrowed. The Government's ultimate objectives are an across-the-board alignment of producer prices with world market prices and elimination of input subsidies. In order to give farmers and consumers time to adjust to the new price signals, these actions are beir.g phased in over a reasonable time frame. Over three years, the system of administered producer prices for the wheats and barley would be reshaped progressively to reflect world market price levels plus the 15% tariff. This would specifically involve an upward adjustment of the durum wheat price to restore the 30-40Z differential that exists between the two wheats on international markets. The use of this formula for setting domestic producer prices would not preclude Tunisia from continuing to take advantage of cheap imports. 79. For inputs, the Government's MTASAP aims to elimate current subsidies while allowing for the temporary need to promote the adoption of new technology among small and medium-size farmers in order to accelerate production growth. The adjustments, spelled out in the Government's Letter of Agricultural Devel- opment Policy (Annex IV(b)], would involve: (a) in accordance with agreement already reached in the context of the Irrigation Management Improvement Project, full recovery of the O&M costs of irrigation water over a period of 10 years including full O&M cost recovery on 65% of th. -rrigated area by 1991; (b) elimination of input subsidies on fertilizer, animal feed, 2-4-D herbicide and improved cereal seed over a period of three to five years, depending on the input; and (c) charging the full cost of support services which continue to be provided by the Government until they are fully transferred to the private sector. The Government's objective is to completely eliminate the fertiliier subsidy by the 1990/91 crop season. In view of the input-output price relationships prevailing in Tunisia, the elimination of the fertilizer subsidy is not expected to adversely affect production. Crop fertilizer price ratios in Tunisia are high and value-cost ratios reflecting crop responsiveness are higher than the threshold levels considered necessary to induce fertilizer use.  - 28 - As regards animal feed subsidies, the Government's program calls for their complete elimination by the 1989/90 season. This would encourage forage production and storage as well as more efficient use of Tunisia's extensive rangelands in the Center and South of the country. Improved cereal seed subsidies would also be phased out by the 1989/90 crop season (see para. 138 for details), and the justification for those to be continued beyond that date on potatoes and other crops would be reviewed. The subsidy on 2-4-D herbicide would be phased out by the l9B8/8s crop season, and that on multipurpose herbicide, whose use the Government is currently promoting over 2-4-D, thereafter. As for the commercial services provided by the public sector in the large irrigated areas, the Government's objectives are to reach full costing of the commercial services in Government's hands, and to progressively transfer them to the private and cooperative sectors (see para. 95). 80. The price formation process in agro-industry is essentially a cost plus system and is therefore subject to extensive administrative controls. Preliminary analysis of the reasons for low capacity utilization rates in agro-industry leads to the conclusion that it is the price formation process that primarily causes inefficiencies and high costs and eliminates competitive pressure in domestic marketing. The animal feed industry has expanded from 18 plants in 1973 to 146 in 1983, but the industry is operating on 801 imported raw materials which are subsidized by 15-26%, at only 301 of its installed capacity. The canning industry, mostly in the private sector, has also grown rapidly at 8.51 p.a., but demonstrates signs of inefficiency: the tomato processing industry has a processing season of only 35 days against an international norm of 100 and operates only at 431 capacity. Rigidity in pricing policy which contributes to peak arrivals had led to installation of increased daily capacity, while low plant utilization has been absorbed in the cost plus pricing system. Similar trends are apparent in other vegetable products (e.g., harissa at 201 utilization and fish canning at 401). The resulting high production costs make Tunisian products expensive for the local consumer and uncompetitive in the export market. The small sugar industry, mostly in the private sector, supplies only 101 of the demand. The newer plants are still operating at 20-351 of installed capacity due to inadequate raw materials, and cube making at 35% of capacity, protected by a guaranteed profit pricing formula. Only the export segment of the olive oil industry, which has been influenced by the competitive pressure of export markets and cheaper alternatives, is basically competitive, able to produce at about half the price of EEC producers (prior to the accession of Spain and Portugal). The Government's MTASAP recognizes the need for a review of the price formation mechanisms from the producer to the retail level through the agro-industry. The progressive move towards price liberalization and gradually subjecting the local industry to competitive pressure from imports (paras. 33 and 36) should create incentives for higher capacity utilization and efficiency, and allow sector growth to be achieved under a situation of reduced availability of investment resources. The price policy review (para. 131), to be executed under TORs agreed with the Bank, would include a detailed analysis of the effect of the policy environment on efficiency in selected key agro-industrial activities. Reorienting Public Expenditures (Chapter I1 of MTASAP) 81. Public investment. The allocations of investment resources to the sector in the 1970s were generally below the sector's share in GDP, as other sectors such as petroleum and manufacturing were growing more rapidly. Under the about-to-be-completed VIth Plan, actual investments in the sector at 161 of the total have been below the original Plan estimates of 191. While total  - 29 - public agriculture expenditures have been maintained at levels envisaged, the decline reflects a level of private investment much below Plan projections: only 31% of the total as opposed to 50% anticipated in the Plan. 82. Within the sector, as the following table indicates, in the 1970s there was an increasin2 emphasis on fully developing the limited irrigation potential and irrigation investment reached 441 of total investment in the late 1970s. Investment in livestock and fisheries also increased. In the livestock sector, the shift in emphasis has been from poultry towards dairy, and 472 of these investments were financed by the private sector. Public investments have emphasized a rather doubtful but rapid program of importing exotic production animals at the expense of a slower but more cost effective cross-breeding effort. The increase in the fisheries sub-sectoral investments, mostly in infrastructure and processing facilities, have been fruitful since the sub-sectoral growth and exports (131) have exceeded all Plan projections. However, capacity utilization remains low. On the other hand, investments in forestry and soil conservation, fruit trees, research and extension, which were seen to have only longer-term benefits, were progressively de-emphasized: a neglect which is now beginning to constrain sectoral growth, since 401 of extension expenditures are in irrigated areas which cover only 5Z of the cultivable area. Investment in farm machinery increased in the 1960s and 1970s, as the newLy developed irrigated areas needed mechanization, but utilization rates are low (para. 112). Tunisian research expenditures are about 1.42 of agricultural GDP - much higher than other developing countries like China, India or in Latin America. However, this expenditure is spread out thinly over a large number of un-coordinated institutes and agencies, and almost 601 of those expenditures are devoted to fruits, vegetables. and industrial crops. Table 5: INVESTMENT IN AGRICULTURE BY SUB-SECTORS, 1962-86 (In percentage of total) 1962-71 1972-76 1977-81 1982-86 Irrigation 27.0 22.2 43.6 42.4 Livestock 3.9 11.5 12.0 11.0 Forestry and Soil Crnservation 25.3 9.5 7.5 8.5 Fruit Trees 15.4 13.4 5.0 6.3 Farm Machinery 15.8 29.1 17.5 13.4 Fishing 4.2 9.2 7.0 8.6 Research, Extension, Studies 8.4 4.5 4.1 3.6 Cereal Storage - - - 1.5 PDRI - - - 1.5 Others _ _ 3.3 3.2 Total 100.0 100.0 100.0 100.0 Total Amount (D million) 272.0 235.1 584.0 1,382.2 Note: Irrigation investment includes the full cost of construction of dams, which is carried out by the Ministry of Equipment. The Integrated Rural Development Program (PDRI) is administered by the Ministry of Planning and Finance.  - 30 - 83. In view of the country's increasingly strained financial situation, the Government's MTASAP calls for the implementation of a sector expenditure strategy in which investments are designed to: (a) boost the efficiency of resource use by maximizing returns on past investment; (b) increase efficient production of cereals, meat, milk and wood for import substitution and dates, citrus,- fish and off-season vegetables for export; (c) privatize all commercially viable services and ensure a policy framework encouraging private investments; and (d) bring about greater labor intensity in investment (also to be tackled by wage policy and interest rates). This requires first the development of appropriate sub-sectoral investment/ expenditure strategies; second, the identification and preparation of specific project pr.tDosals able to meet the above strategy and rigorous economic rate of return and other criteria; third, to prepare for uncertain developments in resource availability, to establish a "core" program of high priority expenditures which would be preferentially protected in case of resource shortfalls. B4. Sub-sectoral investment strategies. Specific sub-sector strategies consistent with this overall sectoral strategy have been developed and are described in the Government's Letter of Agricultural Development Policy [Annex IV(b)]. These strategies will guide project identification and preparation for the VIIth Plan, and their main features are as follows: (a) in grain storage, focus on rehabilitation to increase capacity and improve the domestic collection network, and on modernization, including bulk handling, to improve cost effectiveness; (b) in livestock, concentrate on the development of local forage resources to substitute for imported concentrates by developing forage reserves throughout the country, focussing extension efforts on the integration of Livestock with cereal production, promoting systematic use of crop by-products such as feed (straw, bran and by-products of the olive oil industry); strengthen the genetic improvement program through greater reliance on cross-breeding versus imports of purebred stock; encourage wider participation of private individuals and cooperatives in providing artificial insemination services; and encourage the privatization of veterinary services; (c) in research, emphasize better coordination of expenditures on research and focus research on priority import substitution or export products such as cereals, livestock products, dates, citrus and off-season vegetables; in extension, without substantially increasing the present level of total expenditures, reorganization of multiple commodity-specific, extension programs would permit increased efficiency in use of operating funds, while first ensuring adequate staffing and funding for the transportation, operation and maintenance of existing centers; new centers would be built in rainfed areas, with housing close to field areas;  - 31 - (d) in forestry, increase the financial resources available for development to arrest the loss of forest cover in order to better mobilize the sub-sector's productive potential and reduce imports; priority needs to be given to establishment of nurseries, to improved means of guarding and protecting the natural regeneration areas, to mechanized exploitation and reforestation and improved inventories and studies; (e) in fruit trees, encourage maintenance of existing plantations; in the center of the country, promote the establishment of pasture within the framework of a balanced system of livestock and fruit trees; and favor the development of export crops such as citrus in the north, pistachios and almonds in the center and date palms in the south; (f) in fisheries, optimize utilization of existing infrastructure, while holding back additional expenditure on ports, fish processing facilities and the coastal motorized fleet; encourage the development of strategically located inland cold storage and ice plants to develop and exploit domestic markets for under-exploited bluefish; and (g) in irrigation, finish downstream investments under existing projects in order to rapidly increase the availability of water at farm level; promote rehabilitation and maintenance of existing irrigation infrastructure; and encourage investments designed to increase water use efficiency. 85. Project selection criteria. A part (12Z) of the sector expenditure program consists of general activities of a program nal -e which do not fall into a project format, and those that do, except for son.e externally funded projects, are not routinely subjected to critical evaluation of investment strategy and economic impact. To strengthen its investment planning and monitoring process, the MTASAP calls for the widespread application of an improved project/program evaluation methodology to all new investments for the VIIth Plan, improving the capacity of the DPSAE in project evaluation and establishing a system of project monitoring and budget surveillance. 86. All projects to be continued or started during the period of the MTASAP will be first tested for their consistency with the above sub-sectoral development strategies, followed by evaluation according to the following project selection criteria. In order of priority, these criteria are: (a) economic rate of return above 10% (based on economic pricing of inputs and outputs, including labor and foreign exchange); (b) positive impact on the agricultural trade balance; (c) productive employment creation at low cost per job created (norms to be established); and (d) low Government contribution to investment and operating costs. Some trade-off between criteria may be necessary, but the minimum rate of return would guide all project selections.  - 32 - 87. "Core" program. In the VIIth Plan period, which coincides with the MTASAP, a planning figure of 22% has been established by the Ministry of Planning and Finance for the proportion of total investments to be allocated to the agricultural sector. An underlying assumption is of increased private sector participation (from 31% to 502) in sector investment. This assumption also reflects the uncertainty in the overall resource base and thus the need to limit public investments, which are programmed to decline by at least 7-10% in real terms. To ensure that in the event of an unexpected shortfall in public investment funds or lack of response from the private sector, the available resources are devoted to a coherent set of high priority and strategically appropriate projects, the Government's MTASAP aims to have a system of a pre-screened program of "core" projects which would be assured of funding on a priority basis; as an indicative target, this set of "core" projects would represent 651 of the initial indicative allocation to the sector under the VIIth Plan. The criteria to be applied to put projects in the "core" program would be: (a) short gestation or remaining completion periods; (b) small reliance on Government budgetary resources (e.g., through greater private sector involvement); and (c) high priority in the overall sectoral development strategy. 88. An analysis of the projects under implementation at the end of the Vlth Plan confirms that completion of ongoing viable projects would account for roughly 75% of the indicative si7e of the "core" program. The room for introducing new projects could thus be quite limited. The Government plans to have ready a draft list of projects and project ideas for the VlIth Plan by December 1986, including those earmarked for inclusion in the "core" program. The project list and the "core" would be subject to review and amendment as feasibility and evaluation work are completed. However, the establishment of this systematic approach to project selection and pruning of programs in case of resource constraints would help to significantly improve the efficiency of sector investments. 89. Expenditures monitoring system. Close monitoring of public expenditure patterns during the resource constrained VIIth Plan would be critical to ensure that available resources are used most efficiently. This will involve monitoring sub-sectoral distribution, project-wise expenditures and the adequacy of OhM expenditures as well as the focus of resources on the "core" program. 90. Recurrent expenditures. Reduced allocations of budgetary resources for maintenance of existing investments has been evident in the recent past. This is especially true of the irrigation sub-sector where the burden on the Government has increased rapidly as the network has expanded and cost recovery from farmers amounts to only 40% of the O&M costs. 91. As agreed under the Irrigation Management Improvement Project (Ln. 2573-TUN), the Government's MTASAP calls for a ten-year action program to achieve full O&M cost recovery in the Irrigation Offices (OMVs) which would generate incremental revenue over the next ten years with a view to bringing the 11 OMVs to a break-even self-financing level. Under the agreed program, 65% of the irrigated area would reach 1002 of O&M cost recovery before 1991 and the balance during the program period (except in a few areas in the center  - 33 - part of the country where farmers' ability to pay may be a constraint). In addition the Government is establishing a set of norms for the maintenance of equipment and civil works which would serve as guidelines for ensuring adequate funding. The list of maintenance coefficients for various types of existitig irrigation inivestments is contained in Chapter II of the MTASAP. The allocationi of adequate 06M budgets in relation to these norms and actual expenditures would be monitored with the aid of the computerized expenditure tracking system being developed (pora. 85). 92. Private investment and credit (ChapterIV of MTASAPJ. Creotrr reliance on private investment as opposed to direct public investment is a key clement of the Government's MTASAP (para. 61). Private activity in the sector is guided by the Agricultural Investment Code which created a package of incentives for private investment. Typically, farmers finance 201 of the cost of these investments, with about 801 coming from budgetary resources in the form of low interest loans or outright subsidies. Private investment now accourts for about one-third of total investment in agriculture, a figure unchanged from the Vth Plan. Apart from the tree crops and farm machinery sub-sectors, private sector participation is the highest in the livestock sector (562), followed by fisheries (302), and by private irrigation (131 of the total). Most private investments are associated with lending by the National Bank of Tunisia (BNT), a multipurpose commercial bank which accounts for about 75X of total banking system credit to agriculture. Most of the remaining 251 is accounted for by short-term lending by commerciaL banks. The National Agricultural Development Bank (BNDA) handles less than It of total banking system credit to the sector. 93. Agricultural credit in Tunisia is financed largely by Government subsidized special funds (FOSDA, FOSEP, FODERI) which not only are becoming a heavy burden on the budget (a total of D 19.5 million now budgeted for 1986 including both loans and subsidies), but also by undercutting the participation of the commercial banking sector, they create serious problems for the overall credit system. These funds also need annual replenishment from the budget since recoveries average less than 50% as the Government (not the BNT which handles them) bears the risk of default.-' Liberal eligibility criteria allow 901 of Tunisian farmers access to those special but progressively limited amounts of funds; this, combined with the lack of development of other credit systems, seriously affects the overall flow of institutional credit to promote private investment. 94. The Government's MTASAP aims to use the agricultural credit system as a primary tool to promote greater private sector participation in agricultural development and at the same time to reduce the budgetary burden on the Government. Specifically, the MTASAP aims to: (a) improve the incentives for banks to apply their own resources to agricultural Lending, notably through a policy of interest rates which cover the financial and operating costs at reasonable efficiency and risks of agricultural lending, thereby enabling the shift from public to private sector lending to take place; in the medium-term, the Bank's preliminary estimate is that this would imply interest rate increases of 2-4X, up to 9-12%; (b) reduce progressively (in light of the mobilization of other resources to support a Larger program of agricultural credit) the budgetary 1/ BNT recoveries on loans made from its own resources are above 92Z, and those in which it shares a part of the default risk are above 751.  - 34 - allocations to FOSDA, FOSEP and other special funds (FOSDA loans granted rose to D 21.8 million in 1985) which have the potential to undercut commercial credit, with the ultimate objective of better targetting these funds to the poorest farmers; (c) transfer progressively to BNT and to the banking sector a larger part of the risk assumed by the State in association with the higher interest rates under (a) above; and (d) apply better recovery measures, notably the "Privilege d'Etat:" reschedule certain debts when justified by natural disaster, for example, and stop taxing bad debt provisions made to cover the risk of a non-repayment. Strengthening and Privatizing Support Services 95. The pattern followed in Tunisia has been one of strong and active involvement of the Government and its agencies in the entire range of marketing and support services in Tunisia. Partly because they are often not charged at their full cost, but also because of the limitations imposed by the financial constraints on the expansion of these services in line with demand, the Government has reassessed the need for its continued involvement in provision of these services. The MTASAP recognizes the benefits from private sector involvement in the provision of commercial services, and the adverse consequences of strong Government involvement in providing subsidized services which discourage the private sector from participating in providing poten- tially viable commercial services. However, in some areas such as research, extension, disease control, and management of irrigation infrastructure, the MTASAP recognizes the need to strengthen the quality of continued Government involvement. Action programs have thus been devised under the MTASAP to increase cost recovery in public services, to stimulate private sector partici- pation in commercially viable activities like input marketing, farm mechani- zation and some livestock services, while strengthening essential support services such as research, extension and irrigation management which will remain in the public domain. 96. Input marketing: Fertilizer (Chapter VII of KTASAP). Tunisia is a major producer of fertilizer, chiefly of triple superphosphate and ammonium nitrate. Only 181 of triple superphosphate, 421 of ammonium nitrate and 83% of single superphosphate production are consumed by domestic agriculture, the remainder being exported. The only major imported fertl.izer is potassium. Since 1985. when domestic production of nitrogenous fertilizer commenced, the public sector Tunisian Chemical Fertilizer Company (STEE' has had the wholesale monopoly for phosphate anid nitrogen fertilizers. It is at the wholesale level through STEC that the Government subsidizes the three most widely used fertilizers (superphosphate, triple superphosphate and ammonium nitrate). The Office of Cereals (OC) is the main retail agency handling about 50% of phosphate and 40% of nitrogen fertilizer distribution. The OC has played a useful role in linking marketing of inputs with domestic procurement of cereals, and has thus helped in developing the domestic fertilizer market from 34,000 tons in 1964 to 230,000 tons in 1984. In this period, nitrogen fertilizer use increased about tenfold, and phosphate fertilizer by about 4 112 times, while use of potassium fertilizer, which is not subsidized and is imported by the private sector, has remained relatively stable at 6,000 - 10,000 tons/year.  - 35 - 97. Retail marketing, in addiLion to OC, is done by cooperatives and the private sector. During the VIth Plan, there has been an expansion of the OC's network of retail outlets and this combined with absorption of OC's losses by the Government and the controls on private sector retail margins, particularly for the subsidized products, has led to a retail trade which has become dominated by the OC. In 1982, only 37% of the retail outlets were in the cooperative or private sector. In addition, the private sector has concen- trated 70% of its outlets in the citrus growing northeast, where the major market is for potassium, a fertilizer market relatively free from Government involvement. As a result, many smaller farmers, not linked with OC through grain narketing and in Lemote areas, have been without assured and timely access to fertilizer. The growth of private retailing has been constrained by the lower prices permitted to the public sector. For example, in the 1985/86 crop season: Product Public Sector Mark-up Private Sector Margin