Somalia - Industrial policies and public enterprise reform

Report No. 6639-SO Somalia Industrial Policies and Public Enterprise Reform December 7, 1987 industry and Energy Operations Division Eastern Africa Department FOR OFFICIAL USE ONLY Document of the World Bank This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS Currency Unit Somalian Shilling (So. Sh.) Exchange Rates Official Rate Same as Auction Rate (September 17, 1987) Last Auction Rate: So. Sh. 157.0 = US$1 (September 17, 1987) Parallel Market RaLe So. Sh. 195.0 = US$1 (September 17, 1987) Official Rate So. Sh. 100.0 = US$1 (October 26, 1987) Free Market Rate So. Sh. 180.0 = US$1 (October 26, 1987) Parallel Market Rate So. Sh. 210.0 = US$1 (October 26, 1987) Fiscal Year January 1 - December 31 GLOSSARY OF ABBREVIATIONS AA - Autonomous Agencies A&S - Administrative and Statistical ADC - Agricultural Dcvelopment Corporation CBS - Central Bank of Somalia CEO - Chief Executive Officer CG - Consultative Group CIP - Commodity Import Program CSBS - Commercial and Savings Bank of Somalia GOS - Government of Somalia GRP - Glass Reinforced Plastic Prodr ts HASA - Hides and Skins Agencv HIID - Harvard Institute for International Development IMF - International Monetary Fund IPE - Industrial Public Enterprises IPS - Industrial Production Surveys MA - Magistrate of Accounts MI - Ministry of Industry MF - Ministry of Finance PE - Public Enterprises SDB - Somalia Development Bank SICOS - State Insurance Company  - F- OR OFFICIAL USE ONLY SOMALIA INDUSTRIAL POLICIE'' AND PUBLIC ENTERPRISE REFORM TABLE OF CONTENTS Page No. EXECUTIVE SUMMARY ............................................. vi - xviii CHAPTER I . ................ ......... 1 INTRODUCTION.... 1 A. Economy ...1 B. Industry ....... . 2 CHAPTER II . ..................................................... 4 STRUCTURE, PERFORMANCE AND EFFICIENCY ............ 4 A. Size and Growth .............................................. 4 B. Capacity Utilization ....................................... 6 C. Investment Patterns ........................................ 6 D. Structure of Output and Value Added ........................ 6 E. Size Distribution ......... ................................. 9 F. Employment and Wages ....................................... 10 G. Productivity and Efficiency ...... .......................... 11 Productivity .................. ............................. :.1 Efficiency ............................. .................... 11 H. Technology ................................................. 13 I. The Private Sector ......................................... 15 J. Financial Sector ........................................... 16 Credit ..................................................... 16 CHAPTR III .............. ...................................... 19 POLICIES ..................................................................... 19 A. Exchange Rate ..................... 19 1. Background .. . ..... 19 2. Strtcture of the Free Foreign Exchange Market .......... 22 3. Effects of Exchange Rate System ........................ 23 B. Trade Regime ............................................... 24 1. Imports .................. 24 (i) Import duties ....... ............................ 24 (ii) Administrative and Statistical (A&S) Duty ....... 24 (iii) Stamp tax ........ ............................... 24 2. Exports ................................................ 27 C. Trade Regulation and Price Controls ........................ 27 This report is based on the findings of an industrial sector mission that visited Somalia during June-July 1986. Mission members were Messrs. Ashok Khanna and Sanjaya lall (Sr. Economists, co-missi9n leaders), Henry Laurant (consultant), Ivan Bergeron (consultant). Ms. Hilda L. Scioville typed the report. 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.  - iii - D. Taxation .................................................... 28 E. Labor .. ....................... ............................. 29 F. Licensing ...................................... ............ 30 G. Recommendations ... .................................... 31 CHAPTER IV ..................................................... 33 PUBLIC ENTERPRISES ........................ ...................... 33 A. Introduction ............................................... 33 B. Overview of Somalia's Public Enterprise Sector ............. 33 1. Evolution of PEs in Somalia ............................ 33 IPE Financial Performance in the 1970s ................. 35 The Beginnings of Reform ............................... 36 C. Legal and Institutional Framework .......................... 36 Autonomous Agencies ................................... ..... 36 Financial Enterprises ...................................... 37 Public Companies .......... ....................... .......... 37 Legal Constraints on PE Autonomy ....... ............ ....... 38 D. Government Supervision and Control ......................... 39 Sector Ministries .......................................... 39 Other GOS Agencies . ............................... 40 E. Survey of Industrial Public Enterprises (IPE) .............. 42 (a) MethodoLgy and Coverage .............. . . ................ 42 (i) General Information ........ ................ ..... 43 (ii) Financial Data ............................ .......... 43 (iii) Operational Data ......................., 43 (b) Financial Performance ....... ........................... 44 (i) Operating Results ...... ......... 44 (ii) Financial Structure ............................. 44 Net Worta .... ............. ... ..................... 46 Debt-to-Equity Relationships .................... 46 (c) Summary of Main Problems .............................. 47 (i) Inputs .......................................... 47 (ii) Management ....... ......... ...................... 49 (iii) Employmenit ............. ......................... 49 Levels of Remuneration .......................... 49 Inadequacy of Training ............. .. ........... 50 (iv) Management Systems ......... .. ................... 50 Planning, Budgeting, Financial Control and Accounting ....... ................. .............. 51 Production Planning, Scheduling and Control ..... 51 Management Information Systems .................. 52 Investment Planning and Capital Budgeting ....... 52 F. A Recommended Approach to Public Enterprise Reform ....... .. 52 1. The Background and Purpose of Refom ................... 52 2. Institutional Reform ................................... 55 PE Management and Supervision Functions .............. .. 55 Institutional ........ .................................. 56 Reform Coordination ...... .......... ................. ... 57 Legal Instruments ...................................... 58 The Role of Boards of Directors ...................... . . 59  - iv - 3. Personnel Reforms ..................,. .... ............... 59 Measures to Improve Hotivation ......................... 59 Training Requirements ......... . . . . . .. . . . . . . .. . . . . . . . .. . 60 G. Proposals Concerning the Industrial Public Enterprise Subsector ....................................... o4#*o.#... ..... t 61 Framework far Reform of IPEs .......... .......... 61 Diagnostic Studies *******............. .. .... 64 Preparation of a Rehabilitation Plan ....................... 64 Implementation of the Plan ....... . . . . . ................................. . 64 Monitoring of the Plan .......... . . .................................... . 65 APPENDIX I ......................... ................. 67 APPENDIX II .......................................... to.............. 76  4&,l e el
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 - v - LIST OF TEXT TABLES Paae No CHAPTER II II.1 Contribution of Manufacturing Sector to GDP, (1975-82) .... 4 II.2 Value Added in Organized Manufacturing by Ownership, 1975-82 8 II.3 Change in Manufacturing Value Added, 1975-82 by Subsector and Ownership ...... ................... ...... ..... . 8 II.4 Features of Manufacturing Establishments by Size, 1982 .... 9 II.5 Summary Results of DRC Analysis of 15 Enterprises ......... 12 II.6 Financial Indicators, 1980-84 ..................,......... 18 CHAPTER III 111.1 Exchange Rates, Dec. 1984-June 1986 ...................... 22 III.2 Summary Results of ERP Analysis of 27 Enterprises ........ 27 CHAPTER IV IV.1 Public Enterprises Grouped by Supervising (Parent) Ministry 34 IV.2 List of IPEs Visited During the Survey ................... 43 IV.3 Financial Performance: Selected Industrial Enterprises by 1984-1985 ..... *O..# ........................ .0..... .... .... .0. 45 IV.4 Utilization of Installed Capacity* Selected Industrial Public Enterprises by 1982-1986 ........................ 48 IV.5 Summary Listing of Public Enterprises According to First Provisional Result of Classification Exercise .......... 54  1 \  - vi - INDUSTRIAL POLICIES AND PUBLIC ENTERPRISE REFORM EXECUTIVE SUMMARY Introduction i. Somalia, a large but sparsely populated (5.8 million)l/ country, is one of the world's poorest economies, with a per capita GDP of US$260 in 1984. Since 1977-78 it has been afflicted by a serious economic crisis, characterized by large budgetary and balance of payments deficits, high inflation rates, near zero domestic savings and stagnating production. In 1981 the Government of Somalia (GOS) launched a stabilization program and implemented measures to improve economic incentives. After two successful years the program suffered a reversal in 1983 because of drought and declin- ing exports, as well as a slackening of stabilization efforts. The economic situation worsened in 1984, and a new stabilization program was launched in early 1985 with a fresh IMF standby agreement. Some policy improvements resulted, but the trade gap and budget deficit remain substantial, and inflation is around 40 percent per annum. While policies giving greater operating autonomy to public enterprises have been promulgated, there has been little effective progress in their reform. Successive episodes of exchange rate reform have moved the existing rates towards unification but have not yet accomplished it. Also, some export products remain Government monopolies. Structure, Performance and Efficiency ii. Somalia started at independence in 1960 with a tiny industrial base (9 formal sector units). The GOS took the lead in industrialization after 1963, and since 1969 nationalized most of industrial production, dis- tribution and finance. By 1978, the Government was responsible for 80 percent of industrial value added and employment, and 97 percent of gross capital formation. Industry's contribution to GDP remained small, reaching a peak of 3.8 percent in 1978, with consumer goods accounting for 84 percent of value added. After the late 1970s, industrial performance deteriorated. By 1984, capacity utilization in public enterprises was down to 26 percent, industry's share of GDP to 1.6 percent,2/ and its value added to 39 percent 1/ According to the Government of Somalia's latest estimates, the population is 8.5 million. 2/ This estimate is made from Industrial Production Surveys. However, the National Accounts show industry's share as about twice as much. This issue is discussed in para. 2.01 below.  - vii - of its real value in 1978. The number of formal manufacturing establish- ments had fallen by 44 percent, mainly in the private sector; however, total industrial employment rose because of the public sector's policy of recruit- ment despite declining output. The immediate cause of falling production was shortage of foreign exchange, but there were deeper underlying problems of managerial and technical inefficiency. iii. To start with, Somalia's industrial activities were largely con- centrated in simple consumer goods, a few based on local agricultural resources and the remainder on final assembly or packaging of imported intermediates. Even these activities made excessive demands on the scarce managerial and technological resources available to the public sector; they remain entirely inward-looking and high cost, and have been unable to improve their productivity over time. The private sector has been confined to a marginal role in even "easier' activities (final assembly and tradi- tional products like apparel, footwear and furniture); however, it too displays widespread inefficiency. Somalia's attempted entry into more complex activities (petroleum refining, urea manufacture and cement) has encountered severe problems of declining input availability and shortages of operacing skills. Infrastructural deficiencies, especially power shortages, have worsened these problems. iv. Somali industry is dominated by 23 large (100 or more employees) plants, predcminantly in the public sector, which account for 13 percent of the number of units but over 82 percent of employment, output and wages. The structure of industrial output has altered markedly since 1971. Food processing has dropped in share of output sharply (from 81 percent to 19 percent in 1971-84) because of the decline in food production. Consumer goods as a whole declined from 95 percent to 50 percent of total output. Intermediate products rose with the launching of the refinery and urea plants. Leather and tanning, potentially a major activity based on Somalia's most important resource (hides and skins), never exceeded 4 percent of total output. Total manufacturing value added declined by 26.5 percent in real terms between 1975-82, with the public sector declining by 18.2 percent and the private sector by 52.6 percent. The private sector was able to reduce employment (by shutting plants or retrenchment) b; 48 percent during 1975-82, along with falling activity, while the public sector increased its employment by 60 percent in this period. Consequently, the private sector was able to maintain productivity and real wages much better than the public sector. However, the prolonged economic crisis has affected industrial remuneration adversely. Real wages had fallen below subsistence levels by 1984, with skilled labor receiving around US$20 per month, and engineers around US$40-50 (at free market exchange rates). This has led to absenteeism, low morale and poor performance by the workforce, as well as a massive outflow of the best trained workers to local private sector and the Gulf. v. Ineffiziency is widespread in Somali industry. A study of effec- tive rates of protection for 27 enterprises by the Harvard Institute for International Development shows tnat some of these enterprises are not economically viable in Somalia and would not have existed in a less distor- ted incentive environment. It would save Somalia foreign exchange to close down some of them. Others should continue in operation, but under an incen-  - viii - tive structure that demands efficiency. However, any further investment needed to rehabilitate these enterprises should be evaluated carefully. The broad spread of inefficiency reflects several factors: poor choice of investments, shortages of managerial and technical skills, poor labor performance, infrastructural gaps and insdfficient maintenance of facili- ties, high and variable levels of protection resulting from quantitative restrictions and an ad hoc tariff structure. Exogenous factors such as the decline in foreign exchange availability have led to severe production prob- lems, but, in addition, Somali industry suffers from underlying structural problems which require long-term solutions. vi. The private sector is too small and inexperienced to take over and operate efficiently uost of the large public enterprises, though it has shown dynamism in the past, tuspecially in trading activities. The climate for private enterprise has improved slightly since 1980, but there are still cumbersome controls and financial constraints and confidence is still weak. However, the private sector is capable of developing small-scale industries, especially those based on domestic livestock and agricultural resources. They could cater for domestic demand from the livestock and agricultural sectors and, perhaps, some of the production could be exported. Small-scale industries could also provide considerable employment. vii. The financial system comprises the Central Bank of Somalia (CBS), the Commercial and Savings Bank of Somalia (CSBS), the Somali Development Bank (SDB), a postal savings system and the State Insurance Company, all state owned. Foreign banks were nationalized and reorganized in 1970. In 1983 competition in banking was legally allowed, but by 1986 no new finan- cial institution had been granted a charter. Despite upward revisions in recent years, real interest rates remain negative. This diminishes the supply of savings and encourages capital flight or investment in unproduc- tive real assets. Since 1980, the authorities have attempted to curtail credit to public enterprises in favor of the private sector, but the share of Government in total credit is still very large. The share of private sector credit rose from 11 pereent in 1980 to 39 percent in 1984, but con- nections continue to play a role in the allocation of p:ivate credit. Industry only took 13 percent of total credit in 1984, about half its share in 1980-82, while trade increased its share because of import liberaliza- tion. Policies viii. Exchange Rate. Somalia undertook a major reform of the exchange rate regime in 1985 after a period of high inflation, plummeting exports and a highly overvalued exchange rate. The official rate was devalued by 38.5 percent and a free ioreign exchange market was set up for most private tran- sactions. Quartitative restrictions on trade were lifted, along with most price controls on private enterprise. There was a third market, handled by the Commercial Bank, for tourist receipts, travel and aid-financed Commodity Import Programs. The unification of all three rates at a market-determined rate was not achieved in 1985 because of unforeseen shortfalls in export earnings and hiL, ar-than-anticipated inflation levels, and a new program was launched in 1986 with IMF support. Slippages occurred again by mid-1986: the official rate (So.Sh. 74.5 to the dollar) remained at 46 percent of the free rate and the commercial rate remained unchanged at So.Sh. 84 per  - ix - dollar. Under a World Bank initiative, most of the Agricultural Sector Adjustment Program Credit of, US$70 million is being channelled through an exchange auction. The commercial bank rate has been eliminated but the free market rate continues to function. The first auction was on September 1, 1986, followed by others at 15-day intervals. The auction was temporarily suspended in mid-January 1987 for a short period while the foreign exchange pool was replenished.3/ In the event, the exchange rate was not unified by the end of 1986 although the trend was in that direction. ix. The incomplete liberalization of the foreign exchange market has had undesiralble consequences. Exporters continue to be required to surren- der half their earnings at the official rate. This encourages under- invoicing of exports to minimize the penalty (27 percent compared to a full repatriation at the free rate). Importers similarly underinvoiced to evade customs duties, purchasing the exchange tney nieeded from exporters. Multiple exchange rates have distorted allocation between activities or firms with differential access to cheaper foreign .exchange. Capacity utilization has worsened despite the existence of the free market (only 17 percent of free market imports in 1985 were for industrial inputs), partly because of inherent operating problems and uncompetitiveness, and partly because importers preferred to wait for inputs under CIP schemes (at the commercial bank rate). The impact of the foreign exchange auction on indus- trial activity is not yet known. X. Trade Regime. Quantitative trade restrictions were almost entire- ly dismantled in 1985, though the Ministry of Commerce occasionally uses import licenses to protect domestic suppliers. Import duties are assessed at the official exchange rate, greatly diluting their protective impact. As noted earlier, there is also widespread evasion by underinvoicing and smug- gling. The tariff structure, set up to generate revenue and implement social objectives (restrict luxury consumption), does not offer a coherent protective structure for industry. The taxation of imports is made up of: import duties ranging from 4 percent to 700 percent, with capital goods exempt and basic necessities charged least; administrative and stamp duties of 20 percent of CIF values; stamp duties of 2 percent; and supplemental charges for handling, transportation, clearance and forwarding. xi. A study of effective rates of protection (ERP, of 27 enterprises showed high levels of ERPs in a large number of firms and a wide dispersion of ERPs, across industries as well as across firms in the same industry. This often results in serious misallocation of resources among and within 3/ The exchange rate system has changed twice while this report was being processed. The system described above con-inued until July 1987 when an enhanced auction was implemented to provide foreign exchange for all goods transactions that were previously financed through the limited auction and free market. Exporters received the iuction market rate for their foreign currency earnings and importers pu!chased foreign exchange at that rate too. The auction rate moved rapidly from So.Sh. 134 to the US dollar in June 1987 to So,Sh. 159.8 by mid-September 1987. Because of the rapid devaluation, the Government decided to suspend the aucticn on October 18th, 1987 and fixed the exchange rate at So.Sh. 100 with a provision for a 40 percent retention of export earnings. This regime is still under review and may be changed :n the near future.  - x - activities; there is thus a strong case for a reform of the tariff structure to simplify it and make it more transparent and uniform. Discretionary powers over import controls and foreign exchange allocation should be mini- mized. Public enterprises should not be given preferznce over private ones. There are presently no policies to promote exports and industrial exports are nonexistent; however, the promotion of potential exports requires that appropriate measures be implemented. xii. Domestic Trade Regulations and Price Controls. Trade regulations and price controls were pervasive in Somalia until recently. In January 1985 price controls were removed except for those on public enterprises. However, since these account for most of manufacturing activity, the effect of controls on industry are still significant. The cigarette and pasta factories, for instance, face low controlled prices and are discouraged from expanding output. The Hides and Skins Agency (HASA) offers very low prices to producers, inducing waste and smuggling to Kenya; HASA's monopoly of hides and skins export prevents more efficient private tanneries from expor- ting. Parallel markets have emerged in several products. It would be economically beneficial to allow market forces and competition a greater role. xiii. Taxation. Subject to some exemptions, the private sector is taxed at 35 percent of income. Public enterprises face a high income tax (with several elements combined) of 80 percent, which creates a strong disincen- tive for declaring profits. In addition, they are levied a depreciation tax of 50 percent, which discourages revaluation of assets and replacement of equipment. A proposed amendment to public er,terprise taxation will eliminate the depreciation tax and reduce income tax to 35 percent, though the Minister of Revenue can impose a discretionary income tax of 80 percent. The tax structure is complex and has many discretionary exemptions that can distort incentives. It should be simplified and standardized. xiv. Licensing and Labor. The Ministry of Industry licenses private investors and is supposed to evaluate investments and guide investors to agro-based, small-scale activities Tn nractice, its advisory and evaluativ'e capabilities are limited. The licensing procedures llave been improved but can still be slow and arbitrary. It should ideally become only a registration procedure, allowing investors to respond freely to com- petitive market forces. Foreign investments are regulated by Law No. 7 of 1977, which offered incentives and guarantees which are less attractive than in other developing countries. A revised law, which offers better terms to foreign investors, has been recently approved and will be made public shortly. xv. GOS has liberalized some of the regulations on hiring, firing and wages which in the past led to overmanning and low productivity. In 1983, the employment guarantee for school leavers was dropped. In 1984, the free- dom of enterprises to fire workers and set wages was increased. Private enterprises have greater effective freedom than public enterprises, many of which still carry a full complement of staff despite low capacity utiliza- tion.  - xi - Policy Recommendations xvi. The thrust of the policy recommendations is to move the incentive structure for industry away from being administratively determined by the Government to one that relies on automatic, across the board incentives and competitive market forces. Where it remains necessary for the Government to intervene, that intervention should be transparent, simple and not create differential incentives between activities and firms: - there should be one market determined exchange rate and no foreign exchange retention limits imposed on exporters; - the discr^tion exercised by MI in issuing import licenses should be curtailed. Import tariffs should be simplified and rationalized to provide uniform and reasonable protection for domestic production while garnering adequate revenue for the Government. The bias against exports of manufactures should be removed by implementing an export compensation scheme; - interest rate structure and levels should be market determined or, at least, be changed towards being positive in real terms and not discriminate between borrowers. Competition in banking se:vices should be allowed by granting charters to private sector banks; - the remaining price controls on public enterprises should be removed and competition allowed in the distribution of commodities now monopolized by the Government; - the tax structure should be simplified and discretionary exemp- tion minimized; private and public enterprises should be taxed equally; and - the industrial licensing process should be simplified and made automatic. Regulations governing foreign investment should be amended to be made the same as those for domestic inves...ment and competitive with other countries. Public Enterprises xvii. There are about 45 Public Enterprises (PE) reporting to 11 minis- tries; about 18 of these report to the Ministry of Industry. The focus of this report is on these 21 industrial PEs. Somali PEs originated as a small number, created because the private sector was not considered capable of the relatively large invev-ments involved. The 1969 revo'ution gave greater emphasis to PEs, and three waves of nationalization, in 1970, 1972 and 1975, extended their presence to the entire modern sector of the economy, including trade, manufacturing, banking and business services. xviii. Legal and Institutional Framework. PEs are divided into three categories: autonomous agencies (AAs), financial enterprises and public companies, each subject to its own legislation and with its own management structure. AAs are headed by a management committee (including a labor committee until 1984). Public companies are headed by a general manager and a board of directors; the former appointed by Presidential decree. The  - xii - legal form of PEs has no correspondence with the sector of operation; the same management structures are utilized for a broad range of enterpxises without accounting for their special needs. xix. Nine 'parent' ministers have a direct supervisory role for one or more PEs. The Ministry of Industry (MI) supervises 17 enterprises with a staff of only two. Other ministries conduct even less fonmal supervision, and in general few of the necessary supervisory and support functions are exercised at all. The Ministry of Finance (MF) exercises most of the supervisory functions. In late 1985, the MF established three general- directorates to deal with PEs, one to assist in budget preparation, one to do financial monitoring and one to undertake "economic reforms". MF's authority over PEs is pervasive, ranging from autnorizing new investment and expansions (together with the Ministry of Planning), budget, accounting and expenditure controls, to transferring a share of profits and depreciation to the Government and (jointly with the Magistrate of Accounts) auditing. The Magistrate of Accounts has a large staff and considerable authority over PE accounts, but delays in its auditing have induced several PEs to go to private auditors and submit accounts to the Magistrate only for certification. xx. Survey of Industrial PEs (IPEs). The mission's survey of IPEs was based on interviews, annual reports and other documents, questionnaires and relevant consultant or other studies. Fifteen IPEs were visited, and secon- dary data was obtained on 3 other firms. The sample is estimated to cover 80-90 percent of IPE output. Specific recommendations on action will, how- ever, require more thorough studies. xxi. Financial Performance The financial performance of IPEs is characterized by negative or low returns on capital, liquidity problems and an er'"ming capital base. About half of the 15 enterprises made losses in 1984 and 1985; where profits were made they were overstated because of inadequate depreciation allowances (unadjusted for inflation and devaluation of the S. shilling), especially in 1985. Thus, only six firms (Juba Sugar, Pasta Factory, Cigarette and Match Factory, Km. 7 Tannery, Snai-Biasa and GRP) made "real" profits in 1985, while three (Snai-Jowhar Sugar, Urea Plant and Aluminum Utensils) recorded substantial losses. Accumulated losses and indebtedness have eroded IPEs' net worth; three enterprises' equity has been completely wiped out. The debt-equity ratios are high for many IPEs: of 11 firms with information, 6 have ratios of over 3, and 4 of over 10. Initial undercapitalization has been a serious financial problem for Somali PEs and subsequent losses have exacerbated this problem. These operating results show further deterioration from the already poor record observed by Bank missions in 1975 and 1980. Thus, industrial PEs have not brought signifi- cant returns to the investments by GOS. Many firms have failed to generate cash even to conserve their initial plant and renew it. Assets have been physically degraded through improper maintenance and lack of spares. Press- ing day-to-day difficulties have overshadowed significant longer-term weak- nesses in operation and management. The close inter-relationship among such problems, and the lack of adequate data, make it difficult to diagnose the main causes if the problems and to prescribe appropriate remedies.  - xiii - xxii. The problems observed by the mission are summarized below in order of relative inportance. This also reflects the mission's view of the priority for remedial actions which could be incorporated in a rehabilita- tion program. The main difficulties of IPEs, other than the broader ones relating to the legal/institutional context covered in the previous section, are classified under four headings: inputs, management, employment, and management systems. (i) Inputs xxiii. The foremost nroblem of IPEs seems to be the severe difficulties experienced by .11 firms ir. securing a reliable and adequate supply of raw materials, energy and spare parts. For example: in 1985, Juba Sugar obtained only 37 percent of its diesel requirements for irrigation; through end-1986, supply was so inadequate as to cause anticipated sugar production for the year to be reduced by 25 percent; - the Urea Plant, which depends partly or outside electrical supply for its process, experiences several outages per month. The plant was not in operation at the time of the mission for other reasons, but it is hard to see how it can ever operate under these conditions, because each power supply interruption requires a fou.-to-five day period for cleanup and restart; - the Foundry and Mechanical Workshop is faced with power outages of such magnitude that during some weeks machines operate only one day out of six; - the Aluminum Utensils Plant cannot procure its basic input, alumi- num sheet coils, apparently because of lack of foreign exchange. Instead it has to use ingots or scrap for which it does not have the proper processing equipment; and - In the Somaltex textile plant, spinning is less than 75 percent operative, and weaving 30 percent, due in part to lack of spare parts. Some of its electric generators are out of operation for the same reason. Dyes and chemicals are obtained very irregularly and in inadequate quantiLies. xxiv. One of the main results of the lack of inputs has been a decline in capacity utilization over the last few years. Over the period 1982-1985, no enterprise exceeded a 30 percent capacity utilization level except Juba Sugar, the Refinery, and the Pasta Factory. Although many factors contri- bute to this low ratio, the input supply problem is the most important cause of the wasteful idleness of expensive plant and machinery. (ii) Management xxv. The management of Somali IPEs was found to possess insufficient training and experience to properly exercise its functions. None of the mdnagers interviewed appear to have received specialized management training or to have much experience of industry. Only one wholly state-owned indus- trial firm, Juba Sugar Project, employs a foreign management team. Two  - xiv - others also call upon ioreign management help: Somalfruit, a mixed-owner- ship enterprise, and GRP Products, which is in the process of being partly privatized. In erieral, the management tear. has to rely largely on its own ingenuity to run a specialized industry, sometimes assisted by young univer- sity graduates ox technicians, some of whcm have spent time in training in similar industries abroad. xxvi. Upgrading of IPE management has a priority only second to that of solving the input supply problem and improving the institutional environ- ment. Sector-wide measures to reform the institutional framework, including identification of training needs and coordinating training programs, are expected to contribute significantly to the gradual improvement of IPE mana- gement. However, without the presence of properly trained management in plants the impact of improvements in the first two areas will be conside- rably blunted. These measures should be supplemented by the increased use of foreign technical expertise, major efforts in industry-specific training, setting up systems of management incentives and increased autonomy and accountability. (iii) Employment xxvii. Levels of Remuneration. The general level of remuneration has fallen to levels that are too low and have failed to keep up with inflation. Average IPE remuneration decreased in real terms by more than 40 percent between 1975 and 1982. Between 1982 and 1986, salaries increased in most enterprises, but by far less than the threefold increase in the cost of living. For example, salaries have increased by 140 percent over two years (1984-85) in the textile r.ill, by 33 percent per year for the past three years in the Snai-Jowhar complex (these two probably represent the best records in the TP7 ubsector) and by a range of 12 perceni to 42 percent in the Juba factc 1985. In most other enterprises, yearly annual average wage increases have been 15 percent to 20 percent. This situation contribu- tes to the following: - a "bra_n drain" of the best trained and most experienced workers, technicians and professionals to the neighboring oil-exporting countries, although some of them may be returning due to the downturn in economic activity in those countries; - a neet movemnwrt of labor from IPEs to private industry--workers leave the IPEs once they have acquired technical training in state-ox,med plants; - absenteeism, "moonlighting", and pilferage and other petty illegal activities; and - low-motivation and, as a result, very low labor productivity. Combined with frequent overstaffing, low work loads, and lack of discipline on the shop floors, this also leads to carelessness, bad workmanship, and sometimes, as reported by the textile industry, frequent breakdown of machinery. xxviii. Inadequacy of Training. The second general problem associated with employment in IPEt is the inadequacy of training provided both outside and within the enterprises. This affects various technical levels:  - xv - - ngineers do not receive sufficient training before they are hired by enterprises; however, they are usually promoted rapidly to a supervisory level in order to justify a higher salary. This would not be a serious problem if there were more senior, experienced professionals who could train them. Such on-the-job training does take place at Juba Sugar and to some extent in the Urea plant. But in other enterprises (such as the Foundry and Mechanical Workshop operational deficiencies occur because young engineers with no more than a year or two of exposure to plants abroad (sometimes in countries where industry is still in an early process of development) are put in charge of departments, with no professional guidance to turn to; Technicians are trained in the German-funded vocational school in Mogadishu, in the plants, and sometimes abroad by equipment manufacturers. However, levels of proficiency are generally low as training is insufficient to keep up with turnover; and Semi-skilled and skilled workers are usually trained only in the plants. Except in one firm where significant resources have been devoted to a formal training program (Juba Sugar), such on-the-job training usually takes place in an environment where even the most experienced workers have not mastered their trade. Combined with rapid turnover, this results in a fairly inexperien- ced workforce, with ensuing low productivity, wastage of materials and poor workmanship. (-v' Management Systems xxix. Most IPEs visited seem to lack the basic tools which enable mana- gement to plan firm activities, or to obtain regular feedback reports to permit performance monitoring. Major shortcomii,Es observed were in the following areas: xxx. Planning, Budgeting, Financial Control and Accou"ting. Lack of planning is quite general. In some cases, there is unrealistic planning, e.g. a recent UNIDO study cites the case of a plant whose production objec- tives exceeded the physical capacity of the machines by almost 100 percent, but without a sales plan. Although the preparation of an annual budget to be approved by the Ministry of Finance is obligatory, the document is often not prepared in time and does not appear to be used as a management tool. Accounting reports are crude and probably would not permit the timely repor- ting required for using the budget as an instrument of management control. Finally, as a rule, there is no cost accounting. xxxi. Production Planning, Scheduling and Control. It appears that these functions are inadequate in many IPE plants. While input supply dis- ruptions could defeat the purpose of any production planning, many enter- prises would still benefit from better production scheduling, elaborating production standards, monitoring performance, and from preparing and adher- ing to preventive maintenance programs. Some sort of inventory control seems to be practiced in most of the places visited. However, systems for triggering timely ordering of supplies usually work poorly, and procurement procedures are long and cumbersome. Quality control is generally lacking, a situation which contributes in part to the marketing problem of some enter- prises such as Somaltex and the Foundry.  - xvi - xxxii. Management Information Systems. Most managers were found to lack knowledge of many aspects of their own enterprises, and to operate in an information vacuum. For example, the manager of a large IPE plant knew that a formal commitment has been made to the large labor force to raise salaries by a certain percentage over the next two years, yet was unable to tell what the percentage was, find it in his papers, or obtain it from subor- dinates. Similarly, the chairman of another major IPE apparently did not keep any financial statements in his office and required several days to have them sent over from the plar.t located outside of the capital. Yet one of the basics of managing is, to put it simply, knowing what is going on. In many cases crude and simple reporting systems, used in conjunction with some simple operation planning, would permit managers to be effectively in control, and to take immediate remedial action whenever deviations from established plans appear. xxxiii. Investment Planning and Capital Budgeting. The whole process of public enterprise investment planning and control. including mechanisms for revieu and approval by Government and inclusion in the Public Investment Programs for securing required financing, appears to be ill defined, espe- cially regarding the respective roles of enterprise management and Govern- ment agencies. This area is in need of an in-depth review, which will be best achieved in the context of redefining the sector's institutional frame- work and determining the roles and responsibilities of the involved parties. A Recommended Approach to PE Refom xxxiv. Background and Purpose: The poor performance of public enterpri- ses has taxed the resources of the Treasury and banking system over the years. Reform of the sector is urgently needed to stem the flow of further resources into loss-making enterprises, many of which are of dubious econo- mic viability. At the same time, in recent years GOS policy has moved towards "opening up" the economy, giving greater scope to private enterprise and to economic incentives. Reform of the sector is, therefore, possible at present. The 1985 Committee on Public Enterprise Reform prepared, on grounds of viability, "essentiality" and strategic importance, a provisional list of PEs which should be retained in the public sector (in their existing condition or substantially improved to render them viable) and those that should be divested through privatization or liquidation. This list was reviewed and modified by a high-level working group. The necessary reform program of the PE sector, including improvements, privatization and liquida- tion, should be based on the understanding that it will have to be a long- term process, and that enterprises retained in the PE sector must function efficiently. The reform process proposed below would include improvements in the PE sector overall institutional environment, and enterp"ise-specific improvements and actions. xxxv. Institutional Reform: The operation of PEs as autonomous decen- tralized bodies requires that a balance be sought between managerial auto- nomy to enable enterprises to run efficiently and Government supervision to safeguard its ownership interest and to ensure that its objectives are being attained. To achieve this balance, a reformed system must be instituted, to perform certain functions which are necessary to PE-Government relations and successful PE operations; such functions are currently not being performed  - xvii - at all or are performed unsatisfactorily (irregularly, partially or with arbitrariness). These functions include setting PE objectives, planning and budgeting to attain these objectives, monitoring of operations by the Government, and ex post, performance evaluation. Fulfilling these functions should serve as the basis of institutional reform of the PE sector. PEs supervision should stay within their present parent ministries and current supervisory functions exercised by the Ministries of Finance and Planning and the Magistrate of Accounts should be retained. However, these functions should be more rationally distributed and better performed, and greater managerial autonomy should be given to PEs. It will be a difficult task to build up such institutional capabilities. It may be advisable to use the existing small PE unit in MI as a pilot operation, to develop its ability to first monitor a few enterprises in Mogadishu, and then gradually expand its supervision to the remaining IPEs. xxxvi. The Ministry of Finance (MF) should take the lead in designing and coordinating the reformr program for all PEs. MF should be endowed with the kind of persuasive and implementation authority required, and the unit deal- ing with reform upgraded. The inter-ministerial task force on PEs, or the more recent high-level working group on PEs should be made into a ministe- rial level steering group on reform. The legal framework, which presently suffers from having been repeatedly patched-up rather than thoroughly revised, needs comprehensive review. Legal and regulatory instruments must give the proposed institutional framework authority and link it to operating principles. xxxvii. Frarnework for IPE Reform Enterprise specific measures should emphasize those in greatest difficulty. To start with, IPEs can be clas- sified into (a) those of uncertain economic viability, (b) those which car. be made viable with urgent rehabilitation, (c) those not in serious diffi- culty at present. The mission made a tentative classification along these lines. Work on privatization can proceed concurrently with rehabilitation. xxxviii. IPEs in category (a) could include the petroleum refinery, the urea plant arnd the Kismayo meat factory. The refinery, due to small size and obsolet, design, loses significant amounts of foreign exchange compared to importing the finished product. The urea plant is also too small and uses the untested process, and is affected by severe and prolonged "teeth- ing" problems. The Kismayo meat factory faces a depressed market, problems of local supply and general disrepair of systems and machinery. These enterprises should be carefully examined for basic economic soundness, and unviable ones should be closed down, or used for some other purpose. xxxix. IPEs in category (b) have shown poor performance recently, yet seem to be worth rehabilitating if they can be run more efficiently. These may include: Foundry and Mechanical Workshop; Cigarette and Match Factory; Somaltex; Aluminum Utensils; Snai-Jowhar Sugar; HASA Km. 7 Tannery and Shoe Factory. Rehabilitation may involve changes in ownership status in some cases. xl. The third category of IPEs are operating relatively satisfacto- rily, though some suffer from weaknesses and all need improvements of various types. The scarcity of resources deems that these IPEs should be  - xviii - provided only with the sector-wide improvements noted above and a general liberalized environment. This category includes: Pasta and Flour Mill, Juba Sugar, Snai-Biasa and the State Printing Agency. xli. Among the enterprises mentioned above, GOS has classified the following for privatization: Somaltex, HASA Km. 7 Tannery and Shoe factory, Foundry and Mechanical workshop, Aluminum Utensils factory and Snai-Biasa. Preparatory work for privatization of ownership or management can commence concurrently with rehabilitation, especially for Srai-Biasa and the Pasta and Flour factory which are not in need of major attention. Studies to estimate the sales value of all these enterprises can be commissioned and a search for potential buyers or managers begun. Summary of Recommendations xli_. Public enterprise reform is the most urgent area of concern in the industrial sector. Without immediate attention the drain on the Treasury or the banking system to support IPE losses, will continue and the physical plant of IPEs will deteriorate rapidly. At the same time policies to develop the private sector, on which the future growth of industry in Somalia depends, should be implemented. The PE reforms and policy changes should include: - Public Enterprises: o diagnostic studies for liquidation of non-viable IPEs followed by action; o valuation studies for IPEs to be privatized followed by action; o rehabilitation of remaining IPEs accompanied by (i) training for managers and technicians in IPEs and supervision staff at MI; (ii) price decontrol; (iii) adiustment of real wages and salaries; (iv) adjustment of IPE taxation to equalize it with the private sector; and (v) change of the institutional and legal structure for IPE supervision. - Policies: o allowing private sector banking and liberalizing interest rates; o rationalizing and simplifying tariffs and other import duties; o delicensing investment and review of the tax code and foreign investment regulations to facilitate investment; and o improvement of price policies in agriculture and livestock; decontrol of export monopolies and distribution of imports; and improvement of power supply and transportation.  '3  - 1 - CRAPTER I InTRODUCTION A. Economy 1.01 Somalia is a fairly large but sparsely populated country with a population of 5.8 million. It is among the poorest countries in the world with a per capita income of US$260 in 1984. During the 1970s Somalia's real GDP fluctuated considerably, but it was no larger in 1980 than in 1972, while population increased by 2.6 percent p.a. It has been in a critical economic situation for a number of years, with large budgetary and balance of payments deficits, high rates of inflation, near zero domestic savings and large external debt and service arrears. As the crisis deepened, the Somali Government made a major shift in policy beginning mid-1981. It laun- ched a stabilization program to curtail demand expansion and provide incen- tives to the productive sectors by exchange rate adjustments, fiscal and monetary restraint, increased interest rates and substantial increases in producer prices. Real GDP rose by 6.4 percent p.a. in 1981 and 1982; the overall budget deficit decreased from 17 percent of GDP in 1978-80 to less than 10 percent in 1981-83; and the inflation rate fell from 59 percent in 1980 to 23 percent in 1982. 1.02 Real GDP growth fell to 4 percent and inflation increased to 36 percent in 1983 as drought conditions adversely affected agricultural pro- duction and a Saudi ban on cattle imports from Somalia, its main export, led to a severe shortage of foreign exchange. The Government decided not to implement additional policy measures, including devaluation, liberalization of trade and price controls and financial restraint. As a result, the financial crisis worsened in 1984; the budget deficit grew to 23 percent of GDP, the external position deteriorated and inflation reached a record 92 percent. Faced with this declining economic situation, the Government adop- ted a major adjustment program for 1985 under a new IMF Stand-by Arrange- ment, which came to an end in September 1986. The official exchange rate was devalued by 28 percent in foreign currency terms and a free foreign exchange market was established for most non-Government transactions; the two rates were to be unified by the end of 1986. Quantitative export and import restrictions were virtually eliminated, most price controls were dismantled and fiscal and monetary measures to constrain demand were imple- mented. 1.03 Despite these improvements, serious weaknesses remain in the Government's financial management and control. Fiscal and monetary policies have not succeeded in stabilizing the economy. The trade gap and budget deficit are quite substantial, while inflation is running at 40 percent p.a. The exchange rate has not yet been unified and little progress has been made in public enterprise reform. While most trade and price controls have been dismantled, there are still some products, including hides and skins, frank- incense and myrrh, that remain under Government control.  - 2 - B. Industry 1.04 At independence in 1960, Somalia inherited a very small industrial base. There was only one large industrial establishment, the sugar mill at Jowhar, and a few mediumn-sized plants--three fish processing factories, a printing and publishing house, a furniture making unit, a tannery and s'Loe factory, an edible oil mill and an electric power station. In the early 1960s, the economy was run on free market system, with little Government intervention of any kind. However, the First Development Plan, covering 1963-67, sought to expand the industrial base by establishing state-owned and operated medium- and large-scale industries while not discouraging the private sector; eleven new industrial enterprises were established, in the public and private sectors, before the 1969 revolution. In 1970, the new Government formally announced its adherence to "scientific socialism' which relies on development through public sector ownership of the commanding heights of the economy. Three waves of nationalization followed between 1970 and 1972, leaving most of industrial production, distribution, banking and insurance under the Government's purview. In addition, the Government made several new investments in industry, largely based on the processing of agricultural products (fruits, vegetables, sugar and cotton), livestock and fish to substitute for imports and create export possibilities. By 1978, the public sector was respons4 ble for about 80 percent of both value added and employment and 95 percent of gross capital tormation in industry. 1.05 During the 1970s Somalia's industrial sector drew heavily on the Government's deve.l.opment funds and resources of the financial sector. From 1974 to 1978, irdustry accounted for 27 percent of public investment expenditure, and between 1976 and 1980, industry received 21 percent of total loans and advances. About 60 percent of the loans provided by the Somali Development Bank, the primary source of long-term finance, went to industry during the 1971 to 1982 period. Manufacturing value added of the formal sector (over five employees) grew in real terms through most of the 1970s, reaching a peak contribution of 3.8 percent to GDP in 1978, still remaining a very small sector. The number of establishments rose to a peak of 375 in 1974, with about 10 percent being large, publicly-owned companies and the rest small private sector enterprises. About 84 percent of manufacturing value added in 1978 was in the production of consumer goods, mostly food (39 percent), beverages and tobacco (12 percent) and textiles (17 percent). 1.06 Since the late 1970s, however, the performance of the industrial sector, espacially public enterprises, has been dismal. By 1984, capacity utilization in public enterprises was down to an average of 26 percent and the sector's contribution to GDP dropped to about 1.6 percent, only 39 per- cent of its value in 1978. In per capita terms this amounts to US$0.8 (at the parallel market rate), one of the lowest in the world. The number of establishments declined steadily, reaching 161 in 1982 (27 public and 134 private). The decline was borne largely by the private sector, which lost 60 percent of its establishments in 1978-82, while the public sector lost only 20 percent. The private sector also cut back on employment, but the public sector took on more employees despite falling production. Total employment in formal manufacturing rose by 18 percent in 1975-82.  - 3 - 1.07 These developments in Somalia illustrate clearly the problems of industrialization in a small poor country with few natural resources, a very narrow capital base, direct Government irvolvement in industry, substantial Government policy intervention and an economy in disenuilibrium for many years. The small population and low per capita income provide too small a market to achieve economies of scale in many products. Furthermore, the market is fragmented, with 50 percent of the population being nomadic and another 20 percent living on scattered agricultural holdings. Somalia's resource endowment is poor. Livestock, the main resource, accounts for 80 percent of total exports and provides 60 percent of the population with a living. Cattle, goats and camels are exported on the hoof to the Gulf states where cultural traditions limit the market for processed meats. Hides and skins are exported in a wet or dry salted state. but distribution and price controls have limited the development of this industry. Some aromatic gums are also exported. Apart from this, Somalia does not grow or7 extract anything in quantities that car, meet domestic consumption or find foreign markets. Scarcity of technical and managerial skills and experience is a major constraint which has been accentuated by migration to the Gulf states. Shortage of capital is endemic with the domestic savings rate at below 2 percent of GDP. The core public investment program is financed entirely by foreign grants and loans. 1.08 The Government's direct involvement in industry through the 1970s was in relatively simple technologies, intended to exploit local agricul- tural and other resources. It was in the early 1980s that some sophisti- cated, capital-intensive projects were undertaken. However, even the early ir-stments were too demanding of managerial and technical resources for the public sector to handle, especially iP. an environment of economic disequili- brium. As a consequence, these industries have fared badly, sustaining huge losses. They have utilized low levels of their capacity and their products are expensive and of poor quality. The Government protected industry by restricting and taxing imports and by compelling public enterpvises to sell and buy from each other. Government intervention in management, pricing, distribution and employment and so on, worsened matters. Finally, the economic imbalances of the past six or seven years, with large budget and balance of payments deficits, high inflation and foreign exchange shortages, have made it difficult for industry to survive in spite of some liberaliza- tion implemented by the Government. Future prospects for industry in Somalia depend on stabilizing the economy and implementing policie- that wixl provide stable incentives for a competitive and efficient industrial sector to grow as well as ensure a supply of skilled managerial and tech- nical manpower. Meanwhile, public enterprises will have to be reformed to become more efficient, privatized or iiquidated, and the private sector prepared to respond to the new incentives based on market forces.  CHAPTER II STRUCTURE. PERFORMANCE AND EFFICIENCY A. Size and Growth 2.01 There are two sources of estimates for manufacturing contribution to GDP: Industrial Production Surveys (IPS) and GDP Statistics, both from the Ministry of Planning. The IPS data show a considerably lower manufac- turing contribution to GDP than the GDP Statistics data. The difference exceeds the estimated amount of informal sector activity, which is included in GDP Statisticb but not in IPS data. The IPS data appear to be the more reliable because they are based on actual returns filed by all formal sector enterprises; these are used in Table II.1. The share of formal manufacturing in GDP reached a peak of 3.8 percent in 1976 and 1978, and declined sharply thereafter to 1.7 percent by 1982. If the informal manufacturing sector produced another 0.8 percent of GDP (using other low income countries in the region as a guide, its contribution to GDP is arournd 20 percent of the for- mal sector), the total share of manufacturing would Ltach 4.6 percent in the peak years. By this reckoning, it declined to 2 percent by 1982. Table II.1: SOMALIA - CONTRIBUTION OF MANIFACTURING SECTOR TO GDP (1976-82) (So.Sh. m.) 1976 1976 1977 1978 1979 1980 1981 1982 GDP (Factor Cost, Current% 3,948 4,678 5,373 6,365 8,730 12,421 17,822 24,308 Formal Sector Value- added (current) 118 174 118 241 234 417 335 423 As % of GDP 8.0 3.8 2.2 3.8 3.6 3.4 1.9 1.7 Formal Sector V.A. (1977 prices) 160 193 118 220 172 192 107 110 Growth of Formal Sector (X) (constant terms) - 29.2 -39.0 88.0 -21.6 11.6 -44.8 -8.0 Share of Public Sector (%) in V.A. 78.0 82.3 78.0 78.4 77.8 85.8 76.0 84.6 No. of Eats. 288 266 257 282 242 152 140 l18 (of which, public) (84) (37) (33) (38) (32) (22) (23) (27) Source: Ministry of National Planning and Industrial Productlon Survey (various).  - 6 - B. Capacity Utilization 9.05 CapacLty utilization, calculated on a one shift basis, is officially est-.mated at 26 percent for 23 public sector firms in 1984, dowr from 33 perce.it in 1983. Of these firms, 6 had no produCtion in 1984 (4 operating plants closed down and 2 have yet to go into production after prolonged teething problems); 6 had utilization rates of 0v-20 percent, nine between 2] percent and 40 percent, and only two of 41 percent to' 60 percent (none were over 60 percent). Comparable data on the private sector are not available, but examples suggest only a slightly better performance. 2.06 The situation had not improved much in 1986, despite the ongoing partial liberalization of the foreign exchange market. This may be so for three reasons. First, most intermediate input imports are currently provided under aid-financed Commodity Import Programs (CIPs), which the Government sells at a significantly lower foreign exchange rate than the free market rate. This policy induces manufacturers to wait for cheap imported inputs even at the cost of idle capacity. Second, to the extent that public enterprises have a captive market in each other, they may be reluctant or unable to raise selling prices sufficiently to buy inputs at the free market rate. Third, inputs purchased at the free market rate, about twice as expensive as CIP inputs, appear to Iender much of Somali industry unable to compete with imports. Recent trade liberalization removed most quantitative restrictions on imports, and evasion and smuggling tend to dilute the effects of import duties. All these factors contribute Lo capacity underutilization, in turn further raising costs and reducing competitiveness. C. Investment Patterns 2.07 The industrial censuses in Somalia do not provide any data on the stock of fixed capital in manufacturing. They do, however, show yearly additions to fixed capital. The subsectoral and ownership distribution of additions during 1975-82, in total (current prices) ar.d per employee (employment in 1982) are shown in Appendix I, Table 6. In these eight years, the total current value of additions to fixed assets in the formal sector came to So. Sh. 910 million, of which 87.4 Dercent was accounted for by the public sector. The largest investment in this period was made in the food industry (Juba Sugar in 1981-82), followed by textiles (Somaltex). The tobacco firm comes next, followed by the cement plant, the Government prin- ting press and the tanneries. In the private sector, furniture, chemicals, metal products and beverages received the largest additions to fixed assets. In terms of investment per employee, and bearing in mind that the public sector greatly expanded its employment while private sector contracted, the former's investment was much higher than the latter's. The most capital- intensive activity in the public sector was textiles, while in the private sector it was furniture. D. Structure of Output and Value Added 2.08 The structure of formal sector manufacturinig output has changed noticeably since the early 1970s (Appendix I, Table 2). However, because of large falls in the real value of activities, it is difficuilt to discern any clear pattern. In 1971, food processing accounted for Al percent of the  - 5 - 2.02 For 1983-84, production data are only available for the 27 public sector manufacturing units (Performance of the Somali Economy in 1984, MinJqtry of National Planning, 1985). Their value added rose by 4.3 percent in 1983, then declined by 19 percenl in 1984. If these trends are extrapo- lated to the entire formal sector, w..i Is predominantly public, total manufacturing value added in 1977 prites comes tc. So. Sh. 93 m. in 1984, 1.6 percent of GDP, and only 39 percent of its peak value in 1978 (Appendix I, Table 1). The GDP statistics, by contrast, show the manufacturing contribu- tion at a peak of 6.9 percent in 1980, down to 6 percent in 1982, and 5.1 percent in 1984. In per capita terms, manufacturing value added in 1984 lay between US$2.7 (at the official exchange rate) and US$0.8 (at the parallel market rate), one of the lowest in the world. 2.03 The share of the public sector in industrial value added fluctua- ted between 76 percent and 86 percent during 1975-82. In the same period, its share of employment rose from 62 percent to 82 percent, and it accounted for 87 percent ^f total additions to fixed assets in industry. While Somalia did not, for the most part, go for large, capital-intensive, sophis- ticated industtial projects until the 1980s, even its early investments, intended to exploit local agricultural and other resources, were too demand- ing of managerial and technical resources for its public sector to handle. As a consequence, they never developed beyond the technologically simple, first-stage assembly or packaging phases. These industries stayed high cost and uncompetitive, and were unable to raise their productivity over time. The private sector was confined to a marginal role, and chose even "easier" activities (essentially mixing, assembling, packaging and selling imported components, or making traditional products like apparel, footwear and furni- ture); however, it too suffered from widespread inefficiency. 2.04 High levels of protection against imports were needed to sustain this structure, which was unable to produce any manufactured exports. Pro- tection was given partly by restricting and taxing imports, partly by compelling public enterprises to sell to and buy from each other. The coun- try's major resource, hides and skins, was exported predominantly in non- manufactured form; as such, it did not provide a basis for industrial growth. Until 1984, unrealistic exchange rates also held back potential export activities. Government intervention in management, pricing, wages and employment, worsened matters. Infrastructure was weak, and power supply failed to keep up with industrial needs. In the 1980s, Somalia entered more demanding activities (petroleum refinery, urea plant, and in the near future cement and pharmaceutical plants). Projects already completed ran into problems very quickly, partly because o' import and infrastructural cons- traints, and partly because of inherent operating difficulties and skill shortages. Thus, the combination of some poorly chosen projects, policy interventions, high dependence on imported inputs, poor management and unre- liable infrastructure led both to sharp fluctuations in industrial activity as well as to its rapid decline in th2 1980s. The foreign exchange problem was the most immediate cause of dec._ining production, but the other factors played a major underlying role.  - 7 - total, and consumer goods were 95 percent of the total while producer goods were only 5 percent. By 1974, the share of food had dropped sharply to 55 percent, while producer goods rose to 19 percent (though some of the items classified here, like toiletries under chemicals and some "others," could be consumer goods). The decline in the share of food continued until 1982, when, because of very low production, it contributed only 19 percent of total output. Beverages and tobacco showed a large increase after 1977, mainly l-ecause the public sector cigarette factory boosted its turnover by selling imported cigarettes. Textiles showed a healthy expansion until 1977, then lost their share as the main producer (Somaltex) ran into operating difficulties. Leather and footwear never exceeded 4 percent of total output despite Somalia's large supply of hides and skins; their share declined steadily as the state agency in sole charge of collecting hides and skins (HASA) paid progressively lower real prices to producers, and so provided less raw material to HASA's own tanneries and to other tanneries, while encouraging smuggling. 2.09 The share of chemical output shot up after 1980 as the public sector refinery came on stream. By 1984, however, this share had declined dramatically as a shortage of crude petroleum reduced the refinery's output to 12 percent of its 1981 figure. Plastics production practically disap- peared in the 1980s. The metal prcducts industry in Somalia reached 2 per- cent of the total by 1982. It is small and engaged in very simple assembly or fabrication activities. There is no mechanical engineering sector to speak of. The lack of basic mechanical engineering skills is a major weak- ness of Somali industrvy It means, not only that the country remains enti- relv dependent on imports for the simplest tools, parts, replacements or technr1cal "trouble shooting" services, but also that routine operation er maintenance of plant is often deficient. The Government did set up a plant, the Foundry and Mechanical Workshop, to serve as the hub of development of mechanical engineering activities in Somalia, but it has turned in a dismal performance. 2.10 The structure of value added by ownership in 1975 and 1982 is shown in Appendix I, Table 3 and Table I1.2 below. The public sector accounted for 76 percent and 85 percent of total industrial value added in those two years. Its predominance increased considerably in consumer goods, mainly because of the large trading profits made by the Cigarette and Match Factory in 1982. while the private sect_r suffered a loss in this same sub- sector. The public sector also dominated in food, textiles, printing and publishing and, in 1982, in chemicals. It accounted for less than half of total value added in 7 subsectors in 1982. Of these, its share has increased during 1975-82 in 3 (apparel, leather and footwear, metal products) and decreased in 3 (furniture, pottery, china, etc., and "others"); it never undertook jewelry manufacture. With this last excep- tion, however, the spread of public sector activities is striking. In 1982, the most important sources of value added in the public sector were tobacco, printing, food (mainly sugar), chemicals (refined petroleum) and textiles, while in the private sector: they were china etc. (mainly structural clay), foco (mainly bakeries), wooden furniture, metal products (again mainly fur- niture), chemicals (mainly soaps and toiletries) and apparel. Overall, the private sector appears to show a transformation from consumer to producer goods over the 1975-82 period, but this is mostly due to the negative value added in domestic prices for beverages in the latter year.  - 8 - Table II.2: SOMALIA - VALUE ADDED IN ORGANIZED MANUFACTURING BY OWNERSHIP, 1976-82 (So.Sh. million) X chang; 1975 1978 1977 1978 1979 1980 1981 1982 1975-82 Total V.A. (current) 118.3 174.1 118.0 241.4 243.1 418.5 884.5 422.8 257.2 Total V.A. (1977 pricos) / 149.7 193.4 118.0 219.6 172.1 191.9 108.9 110.1 -28.6 Public Sector (current) 89.9 143.8 89.7 189.2 182.1 358.6 254.1 367.6 297.8 Public Sector (1977 prices)6/ 113.8 159.2 89.7 172.0 133.9 164.8 81.2 98.1 -18.2 Private Sector (currertt) 28.4 30.8 28.3 62.2 52.5 60.0 80.4 66.0 128.9 Private Sector (1977 pricos)b/ 85.9 34.2 28.3 47.5 38.2 27.6 26.7 17.0 -52.8 Share of Public Sector (current) 78.0 82.3 76.0 78.4 77.8 86.8 76.0 84.6 Source: Goneral Directorate of Statistics, 0Industrial Production Survey' (varioua). Notes: a/ All establishments with 5 or more employees. / The price deflator used is the manufacturing GDP deflator of the Ministry of National Planning. 2.11 Table II.3 shows subsectoral changes in value added in the public and private sectors during 1975-82, furnishing detail to the growth figures presented earlier. The public sector declined more in producer goods than consumer goods, while the private sector did the reverse (because of nega- tive value added in beverages). Overall, six sectors showed increases in value added, and eight showed declines. The public sector had six instances of decline (including two of complete demise, plastics and china). The private sector also had six cases of decline (but no deaths). The erratic distribution of growth or decline is evidence of the unsettled and shallow nature of the Somali industrialization process, with widespread Government intervention and exogenous shocks exerting very large impacts. Table II.3: SOMALIA - CHANCE IN MANUFACTURING VALUE ADDED, 1976-82 BY SUBSECTOR AND OWNERSHIP (Percentage) Subsector Public Private Total Subsector Public Private Total Consumer Goods -12.7 -72.8 -25.6 Producer Goode -41.7 -8.4 -29.8 Food -68.8 -58.4 -67.2 Paper Infinite - Infinite Beverage, Tobacco 473.6 -196.2 161.9 Chemicals 1700.0 -28.1 205.4 Textilas 6.0 -68.6 -8.7 Plastics -100.0 Infinite -99.2 Apparel 400.0 10.0 28.8 Chine, Clay -190.0 23.5 -44.7 etc. Leather, Footwear 38.4 -62.6 -32.7 Metal Prods. Infinite 62.8 110.6 Furniture -71.4 20.0 -12.8 Other -96.8 -70.8 -87.0 Prihting, Publishing -44.3 - -44.3 Jewellery - 60.0 60.0 Total Manufacturing -18.2 -62.6 -28.6 Source: Appondix Table 3. Noto: Valuo added at 1977 prices.  - 9 - E. Size Distribution 2.12 The size distribution of formal sector industrial establishment in 1982 is shown in Appendix I, Table 4. Establishments are grouped into 6 sizes by employment, and various characteristics of each group are shown. Table II.4 below summarizes some features of these groups. It shows a heavy bias towards the largest plants (100 plus employees): these 23 units account for only 13 percent of the total number of establishments, but for 82-89 percent of total employment, wages and output. Of these large estab- lishments, 19 (83 percent) are in the public sector, in which the dominance of the largest plants is even greater (93-96 percent of employment, wages and output). In the private sector, both ends of the size distribution are important, accounting for the largest shares of employment, wages and output. Average wages per employee show an unusual profile by size of establishment (Appendix I, Table 4). The smallest units, which would normally be expected to pay least, in fact pay the second highest wages, after the largest plants. The six smallest public sector plants (all of which are in water supply or power generation, vnich could not be separated from manufacturing activity for the analysis of size) pay over twice the average industrial wage. In the private sector, wages tend to rise with size, except for the group with 50-99 employees which shows an inexplicable dip. Employment and wages are described further below. Table II.4: SOMALIA - FEATURES OF MANUFACTURING ESTABLISHMENTS BY SIZE, 1982 (Porcontages) Size Distribution by Employment h-9 10-19 20-29 30-49 -0-99 100+ Total No. of Establishments: Total 66.4 9.8 7.3 9.8 6.1 13.0 100.0 Public 14.0 4.7 4.7 20.9 11.8 44.2 100.0 Private 88.7 11.2 8.2 8.0 3.0 8.0 100.0 Employment: Total 4.4 1.7 2.3 4.9 4.9 81.8 100.0 Public 0.3 0.3 0.6 3.0 3.6 92.5 100.0 Private 26.6 9.6 12.1 16.2 12.2 24.3 100.0 Total Wages: Total 3.0 1.0 1.7 3.0 2.5 88.8 100.0 Public 0.7 0.2 0.3 1.2 2.2 96.4 100.0 Private 20.8 7.3 12.9 18.6 4.1 38.4 100.0 Output: Total 4.6 2.1 1.8 3.9 2.5 86.2 100.0 Public - 0.6 1.6 1.8 98.1 100.0 Private 27.0 12.4 8.7 15.8 8.0 32.0 100.0 Sources: 1982 Industrial Production Survey, Ministry of National Planning, 1988. Note Thase data includo 18 public soctor water supply and power generating plants.  - 10 - F. Employment and Wages 2.13 While value added declined by over one-quarter in 1975-82, total employment in the formal manufacturing sector increased by 18 percent. The public achieved by shutting down loss-making establishments and firing employees in operating plants, while public enterprises expanded employment even when making losses. Appendix I, Table 5 shows the subsectoral break- down of employment and wages in the two years for public and private firms. The largest employer in the public sector is the food industry, which nearly doubled its labor force when its value added fell by 69 percent. This is followed by textiles, printing and publishing, tobacco and chemicals. In the private sector, the largest employers are chemicals, food, beverages, furniture and leather and footwear. 2.14 Public sector wages were on average 1.8 times higher than private wages in 1975, and exceeded them in every subsector except for furniture. By 1982, public sector wages were 21 percent higher than private wages, and private wages were higher in six activities. However, the Somali economy had suffered a large decline in real wages during this period, and the aver- age total industrial wage had fallen (in 1977 prices) from So. Sh. 6.2 thou- sand per annum to So. Sh. 3.9 thousand, a decline of 37 percent. Public sector wages had fallen by 49 percent and private sector by 20 percent. Thus, by cutting total employment more or less in line with production, the private sector had succeeded in preserving real wages better than the public sector. After 1984 it appears that the public sector was permitted to shed some labor and raise wages, but in 1986 there still appears to be gross overmanning, and real wages were still abysmally low. Skilled labor received around US$20 per month while a top Somali engineer got around US$40-50 (converted at the free market exchange rate of So. She 150 to the dollar). Private sector wages had reportedly exceeded public sector wages bv 1986, but were still very low by international standards (for instance, skilled labor in India receives over US$120 per month and engineers around US$500 per month in organized industry, and India is reckoned to be a very low-wage country). 2.15 While the availability of labor at such low wages constitutes a potential source of competitive advantage to Somali manufacturing--if it had the other attributes needed to set up and run efficient industries--there are several o.fsetting factors. First, labor morale is extremely low, absenteeism is rampant, and there is tremendous slack in work practices. Second, the quality of the work force is poor. Formal education levels are low, in quantity and quality, in-house training by enterprises is weak and the low wage levels are a major disincentive to the accumulation of skills, both at educational establishments and in the workplace. Finally, there is a massive outflow of qualified labor to the Gulf. This deprives Somali industry of the best trained and most enterprising of its workers and professionals. It is evident that any reform of Somali industry would have to simultaneously raise salary levels significantly and cut a substantial part of the public sector labor force. Over the longer term, the quality of employees would have to be raised at all levels, not just by providing higher remuneration, but by training, education and tightex discipline.  - 11 - Pi oductivity and Efficiency 2.16 The low degr-e of capacity utilization and widespread Government controls aiid i1teiv(ent ioIl make it difficult to gauge the real productivity of Soma i industry. The normal measure, value added per employee, does not correctly show un)deily.ing relative productivities under these conditions. Nevertheless, no better measure is readily available. Appendix I, Table 7 shows total valuie added and non-wage value added p.r employee, by ownership and subsector, fUl 1975 and 1982. Both measures declined by about 40 per- cent between 1975 and 1982, and the decline is entirelv accounted for by the public sector. I(deed, if the anomalous negative value added in private sector beverages and tobacco in 1982 is removed, then the private sector would actually shiow an increase in both measures. This corroborates both the better adjustmewn of the private sector to difficult economic circum- stances and the ability of the public sector to continue operations in spite of declining profitability and productivity. Only three subsectors out of twelve for which data exist for 1975 and 1982 show an increase in both total value added and nonwage value added per employee; these were apparel, furnitur-e and jewellery. However, these subsectors represented a mere 4 percent of ranula( 'i urug output in 1982. Efficiency 2.17 The data and reports on Somalia's industries suggest widespread inefficiency ill the industrial sector. Visits to plants and lack of manufactured exp(orts corrohorate this view. The only concrete evidence, however, is conta:ned in a Harvard Institute for International Development (HIID) studyl of Somalia's industrial sector, commissioned by USAID, and completed in 1985. The study team conducted a firm level survey, collected adequate data from 27 firms to calculate effective rates of protection (ERP) for all, and domestic resource cost (DRC) ratios for 15. The sample, which covered a wide spectrium of activities2 in the public and private sectors, and about 10-15 percent of sectoral output, was not scientifically designed. While no definite conclusions can be drawn from the results, they are never- theless indicative f) the state of the sector. 1/ "Quantitative Analysis of Incentives and Disincentives for Expansion of Industrial OutpuL and Employment in Somalia', Cambridge (Ma.), July 1985 (mimeo) . 2/ Food & beverages (6), textiles & apparel (3), leather and footwear (3), furniture (2), chemicals (4), plastics (3), clay products (1), metal products' (3), othXer (2).  - 12 - 2.18 ERP results will be discussed in an appropriate section below. Before reporting the DRC results, however, some general insights into the fficiency of the sector can be gained from the measurement of value added at world prices, the denominator for the ERP ratios, for all 27 enterprises. When an activity has negative value added at 'world prices, it means that it would cost Somalia less foreign exchange to import the final product than to import the inputs (or to use domestically produced tradeable inputs) and process them domestically. value added can be estimated in two ways: not counting depreciation, thereby treating capital as a sunk cost, and includ- ing depreciation. Five out of 27 enterprises (see Appendix I, Table 8), close to 25 percent of the sample, show negative value added at world prices without taking depreciation into account. In other words, even if invested capital is treated as a sunk cost, these enterprises consume more foreign exchange in their current operation than they save by substituting for im- ports. It can be shown that the economy would be better off if these enter- prises were closed. I-hen depreciation is included in value added, another 7 enterprises acquire negative value added, making 12 in total, or about 40 percent of the sample. 2.19 DRC ratios are a measure of the economic efficiency of firms. They compare domestic factor costs at economic prices with value added, also at economic prices. A DRC less than one indicates that an activity is economically profitable--in the absence of Government policy this activity would produce more than enough value added to remunerate labor and capital. Alternatively, it would suggest that Somalia has a comparative advantage in a product because factor costs incurred in its manufacture are less than the direct foreign exchange earnings or savings. Summary results are presented in Table II.5 below. Table II.5: SOMALIA - SUMMARY RESULTS OF DRC ANALYSIS OF 15 ENTERPRISES (No. of Firms) DRCs Infinite 10.0 5-10 1-5 0.5-0.9 0.1-0.5 Total L/Term 11 1 - 2 - 1 15 S/Term 2 - - 1 6 6 15 Source: HIID, op. cit. See Appendix I, Table 8 for details. 2.20 When the full opportunity cost of capital is taken into account (long-term DRC), 11 of the 15 enterprises show negative value added at world prices and therefore infinite DRC ratios. Three of the remaining four show DRC ratios of about three or more, meaning that it costs Somalia at least three shilling&'s worth of domestic resources to save a shilling's worth of  - 13 - foreign exchange. Only one enterprise (construction) appears highly effi- cient, costing the economy only 14 cents in domestic resources per shillings worth of foreign exchange saved (but the HIID study suspects under-reporting of capital costs in this case). When invested capital is treated as a sunk cost (short-term DRC), two enterprises (leather and metal products) still 04s?lay infinite DRC ratios. An additional enterprise (metal products) still appears inefficient. The remaining twelve appear quite efficient and there is a case for keeping them operating in the short-run, as long as no new investment is needed. Whether they merit remaining in operation ovet the long-run depends on the Government pursuing policies that encourage enterprises to make efficient use of capital invested in future replacement and expansion. 2.21 In summary, the survey results indicate widespread inefficiency in a sector that has been officially promoted (although still very small) and allowed to exist by virtue of a long standing policy of high protection for domestic pioduction. Some of these investments are not economically viable in Somalia at present and would not have been made in a less distorted incentive environment. Now that they have been made, it would save Somalia foreign exchange to close a few down. Others should .ontinue in operation, but under an incentive structure that demands efficiency. Any further investment needed to rehabilitate these enterprises should be evaluated carefully against the use of those funds elsewhere in the economy. 2.22 What accounts for this dismal state of Somali Industry? The Somali Government's own assessment mentions most of the relevant factors: inappropriate investments; shortages caused by foreign exchange scarcity (fuel oil, spares, raw materials and intermediate inputs); migration to the Gulf of skilled manpower; poor training and overemployment; poor technical and operational management; inadequate preventive and normal maintenance; low wages, lack of productivity-based incentives; lack of autonomy in mana- gement of public sector establishments; and a taxation system which does not provide public enterprises with sufficient retained earnings for equipment balancing, replacement or modernization.3 H. Technology 2.23 The technological factors affecting the performance of Somali industry include, not only the choice of techniques which are overly capital intensive in relation to Somalia's given factor endowments (because of wrong prices attached to capital in relation to labor and to imports versus domestic goods), but also the general shortage of technological capabilities to assess and implement industrial investments, operate them efficiently, improve them over time and link them to the rest of the economy. As far as the choice of production technique was concerned, all the equipment was imported as was the process technology for all except the very simple or small-scale activities. While this may have led to some deployment of relatively modern capital-intensive techniques (e.g. the use of shuttleless looms in Somaltex), in most activities the techniques were not obviously inappropriate. Leather processing, metal working, furniture making, construction materials manufacture or garment malking employed simple, 3/ Ministry of National Planning, Performance o_ Somalia Economy in 1984, Mogadishu, 1985, pp. 136-37.  - 14 - relatively unsophisticated techniques. Where more mechanization was employed (some food processing like large-scale bread or pasta manufacture, printing, cigarette making, chemicals), it is likely that scale and quality considerations made the use of more capital-intensive techniques necessary. 2.24 If the choice of industry and technique was not too unsuitable for a country starting to industrialize, why does the evidence suggest such gross inefficiency? Apart from the shortage of imported inputs, spare parts and power supplies, two sets of technological factors are responsible. First, the lack of scale economies in some activities (petroleum refining, urea, textile spinning and possibly the cement plant). Second, and more fundamental, the widespread lack of technological and managerial capabi- lities at all stages of the industrial process. In the setting up of new plants, the absence of local project design and implementation capabilities led to several cases of expensive delays, the use of obsolete technologies and prolonged running-in problems. In the operation of received techno- logies, there existed inadequacies in the capabilities required for mainte- nance, quality control, production and process knowhow, training, etc. These represented the most serious single handicap to efficient industrial operation in Somalia. Over time, Somali enterprises also failed to adapt and improve their facilities, further reducing their competitiveness as raw materials, market demands, technologies and equipment performance changed. The industrial structure remained shallow and import-dependent as the ori- ginal manufacturers did not develop the ability to transfer technology to potential local suppliers and subcontractors. 2.25 These different technological capabilities are the basis of long- term efficient industrialization in any country. Their tremendous scarcity in Somalia, and the absence of evidence that two decades of industrializa- tion have led to their accumurlation, have far-reaching implications of industrial strategy. The existing industrial structure is inefficient and costly, not just because of exogenous events or infrastructural deficiencies, but also, perhaps mainly, because of inherent shortages of the requisite kinds of technical and managerial skills. The shortages are traceable to the initial socioeconomic conditions and historical background of the country. They afflict the private sector as well as the public, though the former is perhaps better placed in managerial terms since it enjoys greater autonomy and faces more market discipline. Privatization and liberalization in general will not of themselves provide a solution to the fundamental problem of technological incapacity: what they will provide is a more competitive setting where the incentives to accumulate the capabilities are present, and the direction in which technical effort is directed is a healthy one. 2.26 As it stands, however, the needs of the Somali industrial sector vastly exceed the supply of technical and managerial manpower required to run it with some degree of efficiency. Expatriates can fill a part of the gap. But expatriates are expensive. They cannot provide the large middle- ground of expertise between shop-floor workers and top managers, and they are necessarily temporary. The only viable industry Somalia can support over the long term is that which Somalis themselves can operate effectively, given realistic estimates of the additional trained manpower which can be produced or attracted back in the time horizon set. However, increasing the supply of technological skills may be worth little unless macroeconomic, ownership and financial sector policies are geared to efficient growth.  - 15 - I. The Private Sector 2.27 The private sector played a very marginal role in manufacturing for the past 15 years but, since the move towards liberalization, it has become the hope for future development of industry. Somalia has a tradition of commerce, and a reaeonable stock of experienced traders who could have formed a viable entrepreneurial class in industry. Many may have been daunted by the waves of nationalization, lack of financing available, cumbersome controls, including investment licensing, foreign exchange allocation procedures, price controls, labor codes and finally, poor banking and insurance services and infrastructure. Others may have been pre-empted from investing because of direct Government involvement in industry during the 1970s. 2.28 In spite of these difficulties, a sizeable number of entrepreneurs did take the initiative over the years to set up first-stage manufacturing activities. Some learned to prosper within the regulatory system but subs- tantial numbers have been driven out of business. Thus, during 1974-82, the private sector lost 60 percent of its establishments, when the public sector lost only 20 percent. The fall in value added was similarly dispropor- tionate, with the private sector losing 53 percent in 1975-82 and public sector 18 percent. At the same time, the private sector was able to adjust to adverse circumstances better than the public sector precisely because enterprises could be shut down. By so doing, rhe private sector was able to maintain real wages and productivity relatively more than public enter- prises, which carried more unproductive labor and could continue making a loss because they were supported by subsidies and other privileges. 2.29 Since 1980, when Government policies began to move away from socialism towards a market economy, the climate for the private sector has improved. Short-term and long-term financing was more readily available and many controls, including those on product and labor prices, were lifted. However, virtually all private industrialists interviewed said that they did not feel that the Government fully supported the private sector. The economy is in disequilibrium, inflation is high and access to foreign exchange is limited. Doing business in Somalia is still difficult. It still takes 2-3 years to start an enterprise. Licensing procedures, obtai- ning financing and foreign exchange are time consuming. There is no compre- hensive national company law that governs business transactions: the North operates on Indian company law introduced by the British and the South on Italian. Once a business gets started, after the initial tax holiday, taxa- tion exacts a heavy burden. Government monopolies in banking, insurance and transportation provide poor services and infrastructure is deplorable. 2.30 Until the present, the private sector has not responded to the new policy environment with increased activity. For instance, it has not taken advantage of the free foreign exchange market to increase capacity utiliza- tion, preferring to wait for foreign exchange allocation at the commercial rate of exchange. It is heavily protected through subsidized foreign exchange, import licensing that limits competitive imports and tariffs and other charges levied on imports, although this protection is vitiated where products can be smuggled in. The inefficiency of private manufacturers is corroborated by the HIID study, and it also faces the skill shortages that  - 16 - confront public enterprises. However, this is still a transition period from Government intervention in every aspect of the economy to one that is more market based and liberal. Only when a market-based incentive structure and an open competitive economy have been in place for a few years, and supporting measures are undertaken to provide managerial and technological skills, will increased efficient private sector activity be forthcoming. In the meantime, expectations that the private sector will expand rapidly, especially if protection is lowered, are probably not realistic. 2.31 There has been some discussion of privatizing industrial public enterprises, partly to reduce direct Government involvement in industry, and partly to stem the drain on the exchequer caused by subsidies given to keep these enterprises operating. At the moment the capability of private busi- ness to take over existing public enterprises is limited. They do not have the management experience, technical expertise or finances to buy and operate the larger and more complex operations, except perhaps in one or two cases. Over time, as some entrepreneurs accumulate capital, expand their operations and acquire knowhow, they may bc able to purchase some public enterprises and operate them efficiently. 2.32 Private foreign direct investment is largely absent in Somalia: in 1986, one German firm invested US$500,000 and another Egyptian firm US$200,000. Somalia is not a very attractive country to invest in, especiallv if protection is reduced and kept at moderate levels. However, whatever potential exists has not been properly exploited. Private foreign investment could fulfill a very useful function in providing a package of capital, technology, management and marketing. There are a couple of successful joint ventures between foreign investors and the Government-- Somalfruit and GRP Products. This example could be followed by Somalia's private sector to their benefit. J. Financial Sector 2.33 The Somali financial system comprises the Central Bank of Somalia (CBS), the Commercial and Savings Bank of Somalia (CSBS), the Somalia Development Bank (SDB), a postal savings system and State Insurance Company (SICOS), all Government owned. In 1970, all branches of foreign banks operating in the country were nationalized and reorganized over the years to provide for areas of credit specialization, and ensure compatibility of banking activities with economic policy objectives. Day-to-day banking operations are controlled by CBS, commercial banking activities by CSBS and term lending by SDB. In 1983, the law was amended to permit competition in commercial banking services, but no domestic or foreign institutions have yet been granted a charter. Credit 2.34 While there have been changes in the level of interest rates in the past few year-., they remain significantly negative in real terms. This diminishes the supply of savings for credit creation and encourages capital flight or conversion into real assets that appreciate with inflation. Indeed, as Table II.6 shows, between 1980 and 1984, total credit claims outstanding decreased by 47 percent in real terms.  - 17 - 2.35 Since 1980, as part of a strategy to promote private sector acti- vity, a deliberate effort has been made by the authorities to curtail credit to public enterprises and make it available to the private sector. Between 1980 and 1984, the private sector increased its share of total credit out- standing from 11 percent to 39 percent, whereas parastatals decreased their share from 40 percent to 16 percent: the private sector received about two- thirds of all new credit while parastatals received virtually nothing. This is a welcome development after many years during which the Government crowded out the private sector from access to credit. Even now the Govern- ment still retains a total of 61 percent of credit outstanding, considerably hirner than the 40 percent in neighboring Kenya. This share has to decrease further to facilitate long-term sustained development of the private sector. Furthermore, allocation of credit to the private sector continues to be based on connections rather than intrinsic creditworthiness of the borrower or the project and banking services are generally slow and poor. Allowing competition in the banking sector would help the private sector get access to credit and improved services, and result in a better allocation of resources. 2.36 As Table II.6 shows, most of the banking system credit goes to trade and this share nas increased from about 50 percent during 1980-82 to 60 percent in 1983-84 because of import liberalization policies. Both industry and agriculture's shares declined as a consequence. Indeed, indus- try's share declined to 13 percent, about half of the earlier period, proba- bly because demand also declined with decreasing investment and capacity utilization. Industry's share of long-term loans from SDB were just over 50 percent of total loan approvals between 1980-84. In the past two years virtually all of these loans have been for the private sector. 2.37 Negative real interest rates appear to be resulting in declining resource mobilization, inefficient allocation of capital, capital flight and perhaps currency speculation. This is a direct consequence of liberal import and foreign exchange policies with inappropriate interest rate poli- cies and a monopoly in banking services. Interest rates, like the foreign exchange rate, should be determined by competitive market forces. The Government should move towards positive real interest rates and grant charters to encourage competition in commercial banking services. While the private sector has increased its share of credit considerably, it is still low for sustained lor.g-term development. In any case, in the present econo- mic environment, most. of the private sector credit is used for trade rather than agriculture or industry. Breaking the Government's banking monopoly and changing interest: rate policy will go a long way in promoting private sector activity in agriculture and industry, if supported by measures to rationalize tariff protection and enhance the supply of managerial and tech- ni-:al skills.  Tablo 11.6: SOMALIA - FINANCIAL IMOICATCSi (1980-84) 1980 (0 ) 1981 (5) 1982 (5) 1983 (5) 1984 (S) Total Credit Claims Ou standing: a (So. Sh. millions, Current PrIes3' Private Sector 426 ( 11.0) 575 12.6 1.624 32.3) 2 293 43.6) 3 727 (38.8 Public Entitieo 1.551 40.0) 1721 97.e9 1,800 25.95 1 16S 22. 1511 5 15.71 Covernsnt (Not) 1,903 49.0) 2,250 49.5) 2.100 41.8) 1,805 343 4.78 (4 Total 3,8SO 100.0) 4,546 100.0 5.024 100.0' 5.261 100.0' 9,816 100 Total Credit Claims Outstanding (So. Sh. millien Constant 1977 Prices) 1,790 1.450 1,808 1,004 955 Commercial A Saving, Bank 6 ding Londing Interest Rates J 7.5-12.5 10.0-12.8 12.0-14.5 12.0-14.5 12.0-14.5 Annual percent Increoae in Mogadi shu Conosumer Price Index 59 45 23 36 82 Distribution of Banking System b Credit by Activity (Percentage:): Agriculture 1S.6 21.9 23.2 18.5 14.3 Industry 25.1 25.6 24.6 13.6 13.4 Trade 53.0 47.8 48.8 64.1 59.8 Other 6.8 4.7 3.4 3.8 13.0 Somelis Develop ent Bank, Share of Lean Approvals for Industry (Percentages) 52.0 52.0 73.0 Sb.O 57.0 n Contral I Bank of Soma lia. I IKF, Rcent Ekonomic Devoloseneo (various issues).  - 19 - CHAPTER III POLICIES A. Exchange Rate 1. Background 3.01 Somalia undertook a major reform of the exchange rate system at the start of 1985. The previous year had been one of severe hardship. Exports had plummeted as a consequence of a Saudi ban on livestock importp from Somalia, and foreign aid had declined while debt arrears had mounted. The Government had eased on its earlier stabilization efforts, leading to a trebling of the budget deficit, rapid monetary growth and an inflation rate of 92 percent per annum. The official exchange rate (So. Sh. 26 to the dollar in 1984) had become highly overvalued, and the parallel market rate had reached So. Sh. 80-100 to the dollar by the end of 1984. 3.02 A major adjustment program was adopted in 1985 under a new IMF Stand-by Agreement, in the formulation of which Bank staff had been closely involved. The official exchange rate was devalued by 38.5 percent to So. Sh. 36 to the dollar or. January 1, 1985, and a free foreign exchange market was set up to handle most private transactions. A franco valutal system, which had been re-introduced in 1984 as a means of easing the severe short- age of imports, was abolished. This was accompanied by the lifting of most quantitative controls on exports and imports and a virtual dismantling of the pervasive apparatus of price controls on private sector activity. Measures to control monetary growth, raise interest rates to positive real Levels, reform public enterprises and reduce the budget deficit were antici- pated. 3.03 It was also anticipated that the exchange rates would be unified at a market-determined rate by end-1985, following a progressive monthly devaluation of the official rate and a gradual transfer of items from the official to the free market rate. The official market handled all aid and debt transactions, military imports, petroleum imports and diplomatic expen- ditures, while the private market handled all private imports, some public enterprise imports and capital transfers. There was also a third market for foreign exchange administered by the Commercial and Savings Bank, used main- ly for tourist receipts, overseas travel and educational expenditures and imports brought in under aid-financed Commodity Import Programs (CIPs). The commercial bank rate, set initially at So. Sh. 84 to the dollar (when the free market rate was So. Sh. 89), was supposed to change in line with the free market rate until the unification of all rates was achieved. 3.04 In the event, only some elements of this policy package were inplemented in 1985. Monetary and fiscal targets could not be met and inflation was higher than expected. Foreign receipts fell far short of projections, causing external arrears to increase; the Standby was suspended as Somalia also fell into arrears with the IMF. Interest rates continued to be negative. The devaluation of the official exchange rate was slowed down, retarding the unification of the foreign exchange market as the free market rate depreciated. The commercial bank rate was not adjusted, and was still 1/ Imports purchased with the buyers own foreign currency resources.  - 20 - at So. Sh. 84 per dollar until mid-1986. No transactions were transferred from the official to the free market. Tariff duties were charged at an artificially low rate rather than, as agreed, at the free market rate. Reform of public enterprises and the banking system was also delayed. 3.05 The IMF renewed its Agreement in early-1986 under a revised time- table. The official rate was devalued by 22 percent, from So. Sh. 42.5 to the dollar in December 1985 to So. Sh. 54.5 in January 1986, and was depre- ciated by So. Sh. 4 per month so as to reach parity with the free market rate by end-1986. The commercial bank rate was to be adjusted every 10 days in line with the free market rate. Private exporters had to surrender 50 percent of their export receipts at the official exchange rate (raised from 35 percent in 1985), with the remainder sold at the free market rate. By mia-1986, slippages had again occurred. The rate of inflation continued to exceed projections, and the official rate (at So. Sh. 91/US dollar by Octo- ber) was still only 68 percent of the free market rate. The commercial bank rate remains unchanged. The interest rate remains negative in real terms-- the commerciA1. bank overdraft rate was 15-20 percent while prices were ris- ing at around 40 percent per annum. 3.06 Under a World Bank initiative, most of the Agricultural Sector Adjustment Program (ASAP) credit of US$70 million is being channelled through an exchange auction, which acts as a "wholesale" market for foreign exchange, usable for essential imports only. The commercial bank rate has been eliminated and the free market continues to function rather like a retail foreign exchange market. Bids at the auction can range from a mini- mum of US$5,000 to a maximum of US$200,000. Private and public enterprises (except Somalpetrol) and individuals can participate in the auction to pur- chase any imports except military equipment and luxury goods. The first auction was held on September 1, 1986, followed by others at 15-day inter- vals. The auction was temporarily suspended in mid-January 1987 until the foreign exchange pool could be replenished.2 In the event, the exchange rate was not unified by the end of 1986. The official rate was So. Sh. 90.5 to the dollar WLhe auction rate was S'o. Sh. 113 to the dollar and the free market rate So. Sh. 140 to the dollar. The trend was, however, towards unification and a broadening of the auction market with additional funds as well as an enlargement of allowed importables will provide an improved basis for unifying the exchange rate in the future. 2/ The exchange rate system has changed twice while this report was being processed. The system described above continued until July 1987 when an enhanced auction was implemented to provide foreign exchange for all goods transactions that were previously financed through the limited auction and free market. Exporters received the auction market rate for their foreign currency earnings and importers purchased foreign exchange at that rate too. The auction rate moved rapidly from So. Sh. 134 to the USdollar in June 1987 to So. Sh. 159.8 by mid-September 1987. Because of the rapid devaluation, the Government decided to suspend the auction on October 18th, 1987 and fixed the exchange rate at So. Sh. 100 with a provision for a 40 percent retention of export earnings. This regime is still under review and may be changed in the near future.  - 21 - 3.07 Table III.1 shows the evolution of the various exchange rates in Somalia. The parallel market rate at end-1984 is also shown for comparison; this market almost disappeared when the free market was introduced, since the latter fulfilled all its functions more conveniently and legally. According to Somali authorities, a tiny parallel market still exists for illegal (contraband) transactions and for people who do not have the required US$1,000 to open an external account, but its rates are practically the same as the free market rate. The free market rate started squarely in the middle of the parallel market range in January 1985. During the first six months (January-June), it depreciated by 9.9 percent, the next six months by 17.3 percent and, by 31.4 percent in the first six months of 1986. Over the period, while the rate of fall was fairly steady,3 it decelerated around the third quarter of 1985, then speeded up in 1986 (the greatest acceleration took place around April-May 1986). For the whole of 1985, the depreciation of 29 percent was more or less equal to the rate of inflation (around 30 percent). In 1986, the rate of inflation was around 37 percent p.a. but the rate of depreciation was only 22 percent, resulting in an appreciation in real terms. Table III.1: SOMALIA - EXCHANGE RATES, DEC. 1984 - JUNE 1986 (So. Sh. per US$ at end-period) Ratio of Official Parallel Free to Central Commercial Free Market Auction Market Official Bank Bank Rate Market Rate Rates 1984 Dec. 26.0 - - - 80-100 3.1 - 3.8 1985 Jan. 36.0 80.4 89.0 - - 2.5