Somalia - Recent economic developments and medium-term prospects

Report No. 6542-SO Somalia Recent Economic Developments and Medium-Term Prospects February 10, 1987 Country Programs II Eastern and Southern Africa Region FOR OFFICIAL USE ONLY U Dmiuf. eW_ ] MUMaA _M-ay btured tecipients a"un. ks contemay n otherwise  CURRENCY EQUIVALENT Currency Unit = Somali Shilling (So. Sh.) = 100 cents ABBREVIATIONS ADC - Agricultural Development Corporation AMF - Arab Monetary Fund ASAP - Agricultural Sector Adjustment Program CPE - Centrally Planned Economics CPI - (Mogadishu) Consumer Price Index CSD - Central Statistical Department DAC - Development Assistance Committee DOD - Debt Outstanding and Disbursed ECA - UN Economic Commission for Africa ENC - The National Commercial Agency HASA - Hides and Skins Agency MNP - Ministry of National Planning MOF - Ministry of Finance OECD - Organization for Economic Corporation and Development OPEC - Organization for Petroleum Exporting Countries NBB - National Banana Board ONAT - Farm Machinery and Agricultural Services Corporation PIP - Public Investment Program TYDP - Three-Year Development Plan (1979-1981) UNHCR - United Nations High Commission for Refugees GOVERNMENT OF SOMALIA FISCAL YEAR January 1 - December 31  FOR OMCIL US ONLY This report is based largely on the findings of an economic mission which visited Somalia during June-July 1986. The mission comprised Messrs. Swadesh Bose (Mission Chief), Jack van Holst Pellekaan (agriculture), George Beier (public investments), Ashok Khanna (industry), Alberto Agbonyitor (micro-economics), Thorveld Moe (external debt, consultant), and Ms. Seema Hafeez (public finance, consultant). Swadesh Bose is the principal author of this report. The draft report was discussed with the Somali authorities by Messrs Bose and Beier in January 1987. ---------------------------------------------------------------__--------- 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.  SOLIAt RECENT ECONOMIC DEVKLOPMHNTS AND MEDIW-TERM PROSPECTS Table of Contents Pate No. COURY DATA (i-iii) EECUTIE S AR Y (iv-ix) CHAPTER I Introduction 1 Scope of Report 1 Background 2 An Overview 4 CHAPTER II Recent Economic Developments 6 Production Growth 6 Domestic Investment and its Distribution by Sector 9 Macro-Economic Imbalances 10 Balance of Payments 13 External Debt 16 Fiscal and Monetary Developments 21 Key Performance and Incentive Indicators 26 CHAPTER III Progress of Policy Reform and Remaining Issues 30 A. Liberalization and Incentives to Promote 31 Production B. Exchange Rate Regime 36 Background 36 Evolution of Exchange Rates 37 Operation of the Free Foreign Exchange Market 39 Effects of the Exchange Rate System 40 C. Fiscal Policy and Public Expenditure Program 41 Public Sector Resource Mobilization 42 Commodiry Aid Utilization for the Budget 44 Public Expenditures 46 Public Sector Salaries 50 D. Summarv and Recommendations 50 CHAPTER IV Medium-Term Prospects 54 Constraints 54 Growth Prospects 55 Balance of Payments Prospects 57 Debt Relief 61 Government Budget Prospects 67 STATISTICAL AMN=E 71  SOMALIA COUNTRY DATA Economic Indicators ONP Per Capita n US3281 (19865)1 Annual Rate of Growth of GDP at Constant Factor Cost (t) Gross Domestic Product in 19865 (Fiscal Years) US$ Min X 1980-83 1984 1985 CDP at Market PrIces 1516.0 136.0 4.6 3.6 8.3 Investment 232.1 15.3 Resource Balance -275.5 18.2 Export of Goods and NFS 14096 9.8 Import of Goods and NFS 416.1 27.4 Output In FY 1985 Value Added (Factor Cost) Agriculture 829.1 67.6 Industry 127.2 8.8 Services 482.7 38.6 1439.9 lW-. CENTRAL GOVERNMENT FINANCE 1980 1981 1982 1988 1984 1986 ti l l l1t o n So. Sh) Total Revenue 1421 2268 2769 4263 8979 5220 Curront Expenditure 1892 2295 2906 4716 8140 9918 Current Surplus or Deficit (-) -861 -32 -146 -463 -4161 -4898 Investment Expenditures la8 1426 2481 1920 3182 7949 Overall Deficit -1711 1467 2689 2_83 7343 12638 l/Exchange rate used for conversion into US dolars is 1US$ = 63.6 So. Sh. This exchange rate is derived by assigning 50 percent weight to the official exchange rate and 50 percent weight to the average of the commercial and free market rates.  BALANCE OF PAYMENTS 1960 1901 1932 t 1914 1901 Merchandiso Exports (f.o.b) 134 114 157 101 62 9J Merchandise Imports (c.l.f.) -461 -422 -434 -41U -496 -362 Trade Balance -W1 -ai 7 -J49 -5M N1 Non-factor service -6 9 23 24 -3 - Interest Paymwnt. -2 -10 -14 -21 -44 -43 Private transfers, not 57 64 go 51 72 29 Current Account Balance -271 !i5 -2Wf -2WC -ST -2W1 Official Loans, Not 143 16S 157 140 174 179 Other Capita 37 79 123 1in 46 69 (Incl. rrors A omissions 21 3 -36 -39 -46 -36 Overall Balance -27 -13 -44 -86 -139 so RATE OF EXCHANGE W1101l Rate From 1973 to June 39, 1901 - US81.0 * So. Sh. 6.295 July 1, 1981-Juno 3J, 1982 - A dual exchange rate with: USS1.11 a 6.295 (for essential lmports) USJ1.49 a 12.59 (all other foreign transoctleas) July-l, 1902-Oct. 22, 1983 -- USJ1.00 a So. Sh. 15.227 Oct. 23, 198W-Sept. 14, 1914 - USSn.OO a So. Sh. 17.55 Sept. 15, 1094-Doc. 31, 1984 - USS1.40 So. Sh 26.00 Jan. 1, 1986-Feb. 28, 1905 - USS1.00 a So. $h. 36.09 Official Rate Free Market Rate 1985 March 37.0 91.4 June 40.6 97.8 Sept. 40.6 100.7 Dec. 42.5 114.7 1986 Jan. 64.5 114.8 March 82.5 138.6 June 74.5 152.3 sept. 86.6 134.0 Dec. 90.5 132.0  - iii. MONEY. CREDIT AND PRICES Doe. Doc. Doe. Doc. D1c. Doe 1960 19 1902 19118 1964 165 (Million So. Sh) Bank Claim, on Government (net) 1,982 2,260 2,199 1,805 4,378 6,252 Bank Claim on Privato Sector 426 675 1624 2298 8727 4024 Bank Claims on Public Enter. 1651 1722 1890 1168 1511 2671 Mon.y Supply (MI) 2,768 8,619 $,911 4,167 6,676 9,117 (Index Numbers) Consumer Price Index (1977=199) 218.7 818.4 848.2 624.0 1996.6 1867.9 Annual Percontage Change Consumer Price Index 69.0 44.6 22.6 36.4 92.1 37.9 Bank Clalm on Private Sector -4.7 85.0 102.4 41.2 62.5 6.9 Bank Claim on Public Enter. 21.8 11.9 -24.6 -19.6 29.9 87.1 Money Supply (MI). 19.2 80.9 0.1 8.8 22.2 79.5 MECHANDISE EXPORTS Av*rcog 199-62 1968 1984 1986 USSIMIn _ USS Min _ US SMln X USS Min X Livestock 1M1.$ 79.8 72.0 71.5 83.1 5$.4 66.9 71.4 Bananso 9.4 7.3 15.9 14.9 14.1 22.7 1 J. 14.1 Met A &Mt Products 9.6 9.4 9.2 9.1 - - - - Hides and Skins 6.2 4.0 1.5 1.5 8.9 6.8 4.8 4.6 Fish A Flh Products 1.8 1.9 2.8 2.8 0.4 0.6 0.2 0.2 Others 10.2 6.9 9.7 9.7 19.5 17.0 9.0 9.7 TOTAL 1H El. 19.-.7 199 . 62. 1 9i5 liU. EXTERNAL DEBT US$ Min. Public Dobt (Doc.31,1989) 1542.7 DEBT SERVICE RATIO (1965) X Accrual basis 104.0 Cash basis 48.9 IDA LENDING (DEC. 31. 1986) Outstanding and Disbursed 215.23 Undisbur.ed 47.94 Outstaning Inc. Undisbursed 268.17  - jv_ EXECUTIVE SUMMARY INTRODUCTION 1. Somalia is among the least developed countries of the world. Endowed with rather limited known natural resources and a fragile environment for agriculture, it faces formidable constraints to economic development in the face of a 3 percent annual growth of population. Livestock production accounts for nearly 40 percent of GDP and 80 percent of exports, but cannot increase rapidly since the capacity of the rangeland has nearly been reached. A rapid growth of crop production which accounts for about 12 percent of GDP will require investments in irrigation rehabilitation and development, as well as in other infrastructure, research and extension. Development of the tiny industrial sector is constrained, among other things, by a scarcity of skills. Somalia's economic development is a challenging task requiring sound policies. On the contrary, pervasive Government controls led to grossly inefficient resource use and hindered growth in the 1970s; and for a number of years Somalia has been suffering from serious domestic and external financial imbalances, rapid inflation and debt service crisis. Since the first Consultative Group meeting in 1983, the Government with the support of the donor community embarked on a program of policy reform to achieve the twin objectives of financial stabilization, and economic adjustment and growth through fostering greater market orientation. Recent Economic Performance 2. Real GDP growth in 1984 and 1985 was between 3 and 6 percent per year originating mainly from livestock and crops. The reform program involving trade liberalization, exchange rate reform, and dismantling of agricul-ural prices and marketing controls, with favorable weather, led to the recovery of production and exports. For two consecutive years, production of crops particularly foodgrains has increased remarkably. Maize production increased from 235,000 tons in 1983 to over 380,000 tons in 1985 (Table 2.2). Export earnings increased from $62 million in 1984 to $93 million in 1985 as the search for new markets for livestock began to yield results. Real economic growth was accompanied by a modest decline in imports from $406 million in 1984 to $362 million in 1985 as increased domestic production led to reduced food imports. Domestic inflation declined from 92 percent in 1984 to about 37 percent in 1985 and 1986. There was a marginal reduction in the current account deficit on the balance of payments due considerably to about $150 million debt relief obtained in 1985. Still new paymen-ts arrears were accumulated in 1985 which added up to total arrears of $173 million. There was modest improvement of the budget deficit as domestic revenue made some recovery. Implementation of Policy Reforms 3. After the relapse in 1984, implementation of policy reform improved in 1985 and has continued through 1986. Pricing and marketing of most agricultural goods have been liberalized, major price controls have  been dismantled. Most of the controls on export and import trade have been liberalized. A gradual but large devaluation of the official exchange rate (So. Sh. 90.5 - $1 in December 1986, compared with So. Sh. 26-$1 in December 1984) and the introduction of a free foreign exchange market for 50 percent of all *xport earnings are yielding an export rate of about Sh. 115 - $1 in late 1986 (See Table 3.1) and providing incentives to agricultural production for exports and import-substitution. In the implementation of exchange rate reform, however, a de facto transient multiple exchange rate system emerged with distortive effects on resource allocation. In addition to the export rate, various imports face different rates: the official rate, the free market rate (about So. Sh. 135 to the dollar in late 1986), the auction rate (about So. Sh 110 - $1), and the commercial rate (of So Sh 83.60 - $1, but discontinued since September 1986). 4. However, there are still some important areas in agricultural pricing and marketing which remain to be liberalized in order to provide incentives for export expansion through the participation of private operations. One such area is trade in hides and skins, and frankincense and myrrh where existing public sector control is hindering potential export expansion (para. 3.6). Studies in this area have been commissioned. Another area is government control on petroleum importing, pricing and distribution which is hindering efficient resource allocation for adjustment and growth (para. 3.9). The subsidization of tractor services by ONAT (the Government tractor hire agency) constitutes a barrier to entry of private operators for agricultural investment (para. 3.8). This issue Is also being studied under the ASAP credit. 5. In the industrial sector, there is still price control on some public enterprises (para. 3.13). 6. The unsatisfactory performance of industrial public enterprises results in a continued drain on the budget or the economy. Improvement of efficiency of resource use in public enterprises which constitute the bulk of the industrial sector is essential for future economic and industrial production. Despite the Government's commitment since 1984 to public enterprise reform through a combination of phasing out clearly unviable enterprises, privatizing (or forming joint ventures), restructuring and rehabilitating others in the public sector, substantive progress has yet to be made. (para. 3.16) 7. Nominal interest rates were increased but are still below the rate of inflation. The creation of the Ministry of revenues in response to deterioration of tax effort has contributed to a recovery of revenues particularly in 1986. However, the basic factors inhibiting revenue growth remain unchanged. (1) Imports are valued for import duty purposes at the official exchange rate instead of the free market exchange rate. (2) Tax avoidance and evasion continue to undermine efforts at improved revenue collection. (3) There is very little recovery of the costs of public investment and services.  - vi - 8. Fiscal Policy and Public Experiditure Program. The current budget deficit still remains large as a result of slow growth in domestic revenues and a continued expansion in expenditures. The continuing large public dissavings are thwarting correction of the domestic financial imbalance and weaknesses in the expenditure program are undermining the productivity of public investment. Improvement of public sector resource mobilization and of public expenditure program remain two major issues for Somalia. 9. In the absence of adequate public sector resource mobilization, local counterpart funds generated from cash and commodity aid were in 1985 (according to donor estimates) equivalent to the domestic revenues on the Government budget in 1985 and these funds would increase in the coming years (para. 3.46). In general, budgetary expenditure records and accounting remain less than comprehensive. Certain items of current expenditure do not appear in the budget. And one third of the budget is a contingency item in the Ministry of Finance budget for which no disaggregation is available (para. 3.49 - 3.50). In addition, it is unclear if there are any explicit subsidies (and to whom) included in the budgetary expenditures called " transfers and recurrent expenditures". 10. Under-Funding of Recurrent Expenditure. The development expenditures (i.e., PIP expenditures) of the Government remain large relative to the recurrent budget. The future recurrent cost implications of new development projects (PIP) are not worked through during the preparation of the public investment program. The budget formulation process does not attempt to quantify and mobilize resources for recurrent cost needs of completed development projects. To provide adequately for operating and maintenance costs, the 1986 recurrent budget for the productive sectors would have to be increased several times. (para. 3.44, Table 3.5). General services including defense consumed 88 percent of the recurrent budget in 1985 while the combined shares of economic and social services dropped to 12 percent from about 34 percent in 1976-80. But despite the Government's declared intent to the contrary this share was further reduced in the 1986 budget. This share is extremely low compared to Sub-Saharan Africa (37 percent) as a whole (Table 3.6). The gross underfunding of recurrent costs led to deterioration of physical facilities, and services provided; e.g., roads and irrigation facilities deteriorated badly requiring costly rehabilitation, and elementary school enrollment ratio fell from 30 percent in 1980 to 19 percent in 1984. 11. Civil Service Reform. Somalia has an oversized and ill-paid civil service with adverse impact on morale and motivation. Without a well- compensated and well-functioning civil service public policy and expenditure management would not improve adequately. There is need to  - vii - recast salaries and restore the purchasing power of earlier years, and make overall compensation more visible. The additional expenditure can hardly be met without a substantial increase in domestic revenue and a reduction in the number of employees. Donor support towards an increased salary bill must be only temporary and consistent with the stabilization objectives. The Government acknowledges the problem, but no substantive progress has been made in this regard. Overall Policy Performance 12. This mixed overall policy performance in 1985 and 1986 is, however, an improvement over 1984 when the implementation of the IMF stabilization program was suspended in the wake of sharp decline in exports and tax revenues. 13. Despite these gains in policy reform, real GDP growth, recovery of exports, and decline in imports, the external current account deficit and the domestic savings investment gap remain large, about 22 percent of GDP in 1985. Recent developments do not indicate that the unsustainably large macro-economic imbalances of the economy are being steadily corrected. Aggregate consumption exceeds GDP, so savings are nil or negative. Export earnings cover only about a quarter of the value of imports. 14. External debt servicing is in a crisis state with the accumulation of over 170 million in arrears at the end of 1985. No rescheduling through the Paris Club has been arranged for 1986. Multilateral debt servicing alone would absorb about 50 percent of export earnings (Table 4.5) while the total debt service, excluding about $70 million frozen arrears accrued to Bulgaria, China and the USSR is over 100 percent of expected export receipts in the medium term. 15. It is to be emphasized that the economy has responded to policy reform in positive ways through agricultural growth, lower inflation, reduction of imports, and some recovery of exports. However, the effects of these positive developments on the macro-economic imbalances of the economy is yet negligible mainly because the imbalances in themselves have been enormous and deeply entrenched. Need for Sustaining Adlustment Policies 16. If the economy is to adjust, then the correction of these fundamental imbalances together with growth promotion must be central to adjustment programs in the medium and long-term. 17. Progress towards adjustment of these imbalances would require among other things a sustained implementation of the remaining aspects of the policy reform program and new measures to promote efficient use of resources in the economy. These include: (a) unification of the exchange rate and its maintenance at a realistic level;  - viii - (b) elimination of current budget deficits through increases in revenue, and restructuring of recurrent expenditure in favor of economic and social services; (c) improving productivity of public investment through use of profitability criteria in selecting projects with a focus on the growth generating sectors; (d) removal of remaining controls on prices, marketing, exports and imports, especially of petroleum, hides and skins, and frankincense; (o) improved food aid management to sustain Incentives for domestic crop production; (f) further improvement of incentives and opportunities to encourage private savings and investment, interest rate adjustment to improve credit allocation and introduction of private bank(s) to improve services to the private sector; (g) civil service reform with a reduction of numbers and a recasting of salaries; and (h) public enterprise reform to phase out unviable enterprises and to improve resource use efficiency. 18. Exchange rate policy and public expenditure management are critical elements in improving resource use efficiency and correcting the external imbalance. Though exchange rate reforms have impos,ed discipline on the private sector, the larger share of imports channeled through the public sector through grants and loans is not subject to the same market discipline induced by adjustments in the exchange rate. 19. The PIP imports which constitute the largest single import item are not, for example, subject to effective market discipline through exchange rate reform. Even after the expected unification of exchange rates the larger share of total imports for the public sector will be influenced not by the exchange rate per se, but by the inflow of grants and loans. 20. Hence to enforce efficiency in the use of imported goods, and induce a reduction in the external imbalance would require thats (a) institutions for aid coordination and aelection of projects be strengthened and used to enhance the productivity of the public investment program. (b) use of imported goods is channeled increasingly through the private sector.  - ix - Medium Term Prospects and Aid Requirements 21. With sustained policy reform and favorable weather complemented by aid flows, GDP growth of about 4.1 percent a year is feasible in the medium term. Sustained export recovery is also feasible with exchange rate adjustments, relaxation of restrictions on remaining exports and continued search for markets for livestock outside Saudi Arabia. 22. With GDP growth above population growth, and assuming that socio- political constraints would not permit any compression of real per capita consumption, there would be slow (a) increase in the savings ratio from -7 percent in 1985 to +1 percent in 1991, (b) increase in the investment to GDP ratio from nearly 15 percent in 1985 to 17 percent in 1991, (c) reduction in the ratio of trade deficit to GDP from 21 percent in 1985 to 15 percent in 1991, and (d) overall internal and external adjustment in the medium term as the consumption ratio declines, export ratio rises, and the import ratio falls. (Table 4.2) 23. The economy would however, still depend on import surpluses to support consumption and investment with overall financing requirements including debt service obligation between $400 million and $450 million per year over the medium term. (Table 4.4) Even with growth, debt servicing will be unmanageable (Table 4.5) without extra-ordinary measures. Multilateral debt service alone would require about 50 percent of expected export earnings in the medium tem. Total debt service obligations would average about $150 million per year during 1986-91. 24. Two scenarios of debt relief were simulated. Each case is based on assumption that (a) all multilateral debt service must be paid and, (b) 95 percent of all other debt is rescheduled. The analysis shows that to provide positive capital inflow required to support growth and to improve the debt service profile to a manageable debt service burden in the medium and long term would require a combination of (i) multi-year or regular annual rescheduling of all bilateral obligations on soft (close to IDA) terms, and (ii) quick disbursing grants, including cash grants. 25. Two points deserve emphasis. First, even with policy reform and prospective growth, adjustment of the external deficit will be slow, and the economy will in the foreseeable future, lack the capacity to meet external debt obligations. Second, rescheduling on soft terms need be predicated on sustained implementation of policy reform. 26. During 1987 and 1988 Somalia will require average annual aid disbursements of nearly $400 million, about $250 million in grants and $150 million in (mostly concessionary) loans (Table 4.7); roughly one-half of these tnflows will be required for quick disbursing commodity aid and balance of payments support in the form of food, petroleum, other commodities and cash. Disbursements from the aid pipeline would amount to about $300 million a year, and hence additional disbursements of nearly $100 million from new aid commitment will be necessary. In addition, about $70 million in debt relief per year will be required. As the existing aid pipeline gets exhausted, larger new aid commitments are required for 1989 and beyond. Through the Consultative Group process it should be possible to coordinate donor support to mobilize resources to finance the prospective gap, provided the Somali authorities sustain and strengthen the policy and institutional reforms required for adjustment and growth.  CHAPTER I INTRODUCTION Scope of the R&Port 1.1 This economic memorandum focuses on the adjustments that will be required over che next few years if Somalia is to achieve realistic goals of stabilization and economic development with a viable external payments position. Based mainly on the findings of an economic mission which visited Somalia in June-July 1986, the present report is clearly less comprehensive than the previous economic report.l It covers the recent developments mainly since 1984, and review the progress of implementation of the reform orogram with an assessment of exchange rate reform, and liberalization policies so far implemented. The central theme of the report is recent macro-economic adjustment for growth in light of the Government's reform program, the recommendations of the previous Bank economic report and the 1985 Consultative Group (CG) understanding, and policy measures needed to sustain growth over the medium term, e.g. improvement of financial management and public investment program, effective incentives and better allocation of resources, and liberalization to extend the market discipline. 1.2 Chapter II provides a review of recent economic and financial developments with attention to progress towards correcting large macro- economic imbalances in the external current account and the government budget, and towards correcting distortions in the policy framework, especially in prices, exchange rates, and interest rates. Chapter III especially deals with policy implementation under the reform program, discusses achievements and shortcomings in three broad areas -- pricing and marketing liberalization, exchange rate regime, and fiscal policy and public sector resource mobilization, and outlines the unfinished agenda of actions which need to be Implemented for sustaining the process of adjustment with growth over the medium term. Chapter IV discusses the economy's prospects of growth assuming that the recommended measures will be largely implemented and indicates the requirements of external aid and debt relief to support this process. The financial implications of medium-term growth of GDP are analyzed along with a projection of the balance of payments. Since Somalia's huge debt service burden makes the future prospects very bleak without debt relief, alternative scenarios of debt relief are also presented along with aid requirements, to indicate overall financing requirements. Finally, the chapter also provides a normative projection of the government budget in order to indicate how fiscal management should and can evolve in order to achieve financial stabilization and to support adjustment with growth in the medium term. L/ World Bank (Report No. 5584-SO), Somalia: Towards Economic Recovery and Growth (August 1985).  -2- BackRround 1.3 Somalia is a large but sparsely populated country of about 5.5 million people (excluding refugees).2 With an estimated per capita income of about $260 it is among the poorest countries in the world, and is classified by the United Nations as a least developed country. The average life expectancy at birth is only 46 years. Somalia's crude death rate of 20 per thousand and infant mortality rate of 150 per thousand live births are among the highest in Sub-Saharan Africa. Modern health care is entirely confined to urban areas. The population per physician is 16,000, or about the same for low-income countries. 1.4 The country is poor in natural resources, with no known minerals or fossil fuels. Its low and variable rainfall and largely rugged terrain present a harsh and fragile environment for agriculture. About 13 percent of the land is considered arable. Due to the limited physical and social infrastructure, and with water being the limiting constraint, hardly 10 percent (or 1 million hectares) of the potentially arable land is actually cultivated, mostly under rainfed conditions. About 50 percent of the population are nomadic pastoralists who depend on livestock for their livelihood; roughly 25 percent are settled farmers, and the remaining 25 percent are engaged in various non-agricultural occupations and live mostly in urban areas. Somalia suffers from serious institutional weaknesses in both public and private sectors. There is a critical shortage of skilled labor and of personnel with technical and managerial expertise, along with an apparent excess supply of school leavers at almost every level of education, reflecting an imbalance between the output of the education system and the needs of the economy. 1.5 Following a major border conflict with Ethiopia in 1977/78, Somalia has been experiencing a serious economic and financial crisis in the face of relatively stagnating production. The immediate consequences of the conflict were sharp increases in government expenditures, mainly for defense, and in bank financing of large budget deficits leading to high rates of inflation. The balance of payments counterpart of these budgetary developments was a surge in imports through 1980, and a sharp decline in foreign reserves, accompanied by reduced capital flows (as the aid from the USSR ceased and before other donors stepped up their aid). Beginning in 1981, the Government decided to introduce policy and institutional reforms towards improving incentives, liberalizing the economic system from extensive government controls and moving to correct policy-induced distortions that had led both to economic stagnation and grossly insufficient resource use in the 1970's and to external and domestic financial crises since the late 1970s. The reform measures mainly comprising exchange rate adjustments, fiscal and monetary restraint, interest rate increases, increases in agricultural producer prices and de facto elimination of the government monopoly of grain purchases, generated some recovery in the economy and led to increased external aid. 1.6 In 1983, the Government prepared a medium-term recovery program comprising a public investment program (PIP) for 1984-86 and a program of 2/ The official figure used by the UNHCR for refugees in camps is 700,000.  - 3 - phased policy reform for achieving financial stabilization and rationalizing the pricing and incentive structure for output growth. The program called for: improvement in macro-economic management through fiscal, monetary and exchange rate policies; improvement in financial discipline and public investment programming; liberalization of agricultural pricing and marketing; and an incentive framework for encouraging the private sector. At the first Consultative Group meeting in October 1983, donors welcomed the reform program and pledged support for the PIP and the associated policies. However, because of the ban on Somali cattle exports to its principal market, the impact of the 1983 drought, and the slackening of stabilization efforts by the Government and its decision not to implement additional policy measures including devaluation and financial restraint, a severe financial crisis reemerged in 1984 with a record inflation, and mounting external debt service arrears. 1.7 Faced with a rapidly deteriorating situation, the Government adopted an adjustment program for 1985 under an IMF Stand-by Arrangement designed to reduce domestic and external imbalances, and to stimulate economic growth. At a special Consultative Group (CG) meeting in January 1985, donors commended this program and pledged quick-disbursing assistance to finance Somalia's balance of payments gap for 1985. 1.8 ARainst this background, the previous World Bank Economic report on Somalia3 presented to the second Consultative Group meeting held in November 1985 noted that the main issues facing the economy were inadequate domestic resource mobilization, negative savings, stagnating exports, very high import dependence, low productivity of public investment, and poor financial discipline and public expenditure management. As noted in Chapter III of the present report, it stresseed the need for strong policy measures to raise domestic revenue and savings, to enforce public expenditure control and restrain monetary expansion for achieving financial stabilization, to liberalize price, trade and exchange controls for improving incentives and resource allocation, and for encouraging the private sector to boost production and exports, and to raise the quality of the public investment program for sustaining economic recovery and growth. Keeping in view Somalia's long-term development, the report reviewed the main constraints to developments in agriculture and industry, eLnd discussed measures aimed at augmenting production and promoting the private sector. It also drew upon other sector studies to emphasize the need for population policy and improved energy demand management for the long-term development of Somalia. 1.9 The constraints to Somalia's long-term development in the face of a 3 percent annual growth of population noted in the previous report remain unchanged and will not be elaborated in the present report. The livestock subsector--accounting for nearly 40 percent of domestic production--is and will continue to be the major contributor to GDP and exports in Somalia for quite pome time. However, it is widely considered that the capacity of the rangelands to sustain additional numbers of animals is at or near its limit. There is, thus, a serious structural constraint to a rapid growth of GDP, and, to a lesser extent, of exports. Crop production which 3/ World Bank (Report No. 5584-SO), Somalia: Towards Economic Recovery and Growth (August 1985).  - 4 - accounts for about 12 percent of GDP, can be increasingly more important for both import substitution and export expansion. This is, however, contingent, among other things, upon irrigation rehabilitation, new irrigation development and improved water management, as well as increased productivity of rainfed agriculture through better cultural practices, improved inputs, research and extension. In addition to Somalia's very small market and poor resources endowment, a serious scarcity of managerial and technical skills remains a major supply-side constraint to industrial development. Public enterprises account for nearly 80 percent of the output of the small manufacturing sector which contributes 6-7 percent of GDP. Originally envisaged to process local agricultural, livestock and fisheries products for consumer-oriented import substitution and exports these enterprises have become heavily dependent on imported materials and operate at a low level of capacity hindering output growth. Much of the sector suffers from inherent incompetitiveness and from an ineffective protective system. An Overview 1.10 As a result of the liberalization of agricultural prices and marketing, exchange rate reform, search for and access to new export markets, and a favorable weather, real production increased in 1984 and 1985, and exports recovered from the depressed 1984 level. Real GDP growth was accompanied by decline in imports, especially of food imports. Thus, trade deficit and inflation were reduced in 1985 and 1986. 1.11 Policy performance also improved, following the lapse of reforms in 1984. A new adjustment program was adopted in 1985 and continued through 1986. Exchange rate reforms were implemented, leading to a transient ma'ltiple exchange rate system; agricultural prices and marketing controls were dismantled, the prices of export and import goods were partially liberalized (the petroleum market is still controlled); and interest rates were increased, though they are still below the rate of inflation. 1.12 While these developments in economic and policy performance are positive and in the right direction towards improving incentives and resource allocation to boost exports and domestic savings, the impact on the fundamental internal and external imbalances of the economy so far is negligible. Consumption exceeds real production, so savings remain negative. Government tax revenues are grossly below government expenditures. Exports, despite the recovery, cover only about a quarter of imports; the balance of payments deficit, though reduced, remains close to $300 million (22 percent of GDP in 1985). There is a debt service crisis with nearly $200 million arrears at the end of 1985, and a debt service ratio of well over 100 percent of exports per annum in the medium term. 1.13 Sustained policy reform with respect to the removal of the remaining controls, interest rate changes, public enterprise reform, exchange rate unification and decontrol of remaining export and import goods are required for the recovery to continue. Even with sustained policy reform and a feasible GDP growth of 4.1 percent a year, the basic macroeconomic imbalances relating to savings and investment, consumption and production, and the balance of payments would improve only marginally  in the medium term (1986-91). Even with a constant (i.e., allowing for no increase in) real per capita consumption, the economy would still require large external aid inflow to support investment and consumption. 1.14 While the ratio of the trade deficit to GDP would be reduced in the medium term with continued policy reform, the balance of payments deficit and external debt servicing crisis would persist. Given that multilateral debt service which is on average well over 50 percent of export earnings a year up to 1991 and is not eligible for rescheduling, the economy would have no capacity to support an orderly debt service financing even if all bilateral debt were rescheduled on very soft terms. Because of the large non-reschedulable debt service obligations, Somalia faces a serious cash problem over the medium term. An orderly external financing scenario with growth would require a combination of (a) sustained policy reform, (b) large inflow of soft aid including cash grants, and (a) rescheduling of eligible debt service on soft terms.  -4- CHAPTER II RECENT ECONOMIC DEVELOPMENTS Production Growth 2.1 The performance of the Somali economy improved with increases in aggregate production in real terms in 1984 and 1985. Somalia does not have any official national accounts. Available data on gross domestic product suffer from serious weaknesses. Though specific figures on the growth of GDP from different sourcesl are not consistent, the overall evidence suggests a real annual GDP growth of about 3 to 6 percent in 1984 and 1985. 2.2 Data concerning Somalia's national accounts collected largely through ad hoc limited surveys, still remain very weak. This is true especially for the large livestock sector for which the official statistical base is no better than guesstimates, giving rise to implausibly wide year-to-year fluctuations in livestock production and also in GDP.2 The livestock production data used by the Central Statistics Department for GDP estimates are unreliable. The Ministry of Livestock suggests an average annual real growth of between 2.5 and 3 percent. Discounting these very wide fluctuations in livestock production, estimated growth of GDP in recent years is shown in Table 2.1. However, specific GDP figures and growth rates of real GDP must be viewed with caution since they may be subject to wide margins of error. 1/ The IMP, Somalia: Recent Economic Developments, September 1986, and the tentative estimates by the Central Statistics Department (CSD), Ministry of National Planning, show the following annual rates of growth of real GDP: 1982 1983 1984 1985 1980-84 1981-85 IMF 11.2 2.4 2.3 10.2 6.2 6.2 CSD 7.1 -16.0 13.5 18.0 2.5 5.0 2/ The CSD's figures show a 41 percent decline in livestock production in 1983, 40 percent increase in 1984 and another 21 percent increase in 1985. These wide fluctuations are due to an implausible assumption that the animal herds suffered the largest death loss in 1983, even larger than the death loss incurred in worst drought years of 1973 and 1974.  Tablo 2.1 SOMALIA - Annual Growth Rates of GOP kg Sector (At conotint 1977 prices) Sector Shar*a AM"fif cx of WP) 1989 1981 12 1968 1984 1966 - N Aricultur Sector 6.4 16.8 10.6 2.6 6 6 7.8 8.7 57.6 Crop Production 8.0 8.6 1.9 -19.2 $.e 88.2 7.4 12.0 Livestock 9.6 22.5 18.4 4.8 6.1 2.8 9.7 89.2 Industry Sector 0.4 1.6 1.5 -14.7 -10.9 7.2 -3.1 8.8 Services Sector 9.6 -9.9 7.9 8.1 8.9 4.4 2.7 88.6 Govornrent Se rvIc- a1 -Uf 17! 171 -17C -471 -47 T7 Othor Services -8.8 1.8 109. 7.9 4.2 5.6 5.9 26.4 GDP-Factor Cost 8.8 4.4 6.5 2.4 8.6 6.8 650 100.0 Source: Annex Table 2.2. 2.3 The shares of the major sectors in GDP are approximately 39 percent for livestock, 12 percent for crops, 6 percent for forestry and fisheries, 9 percent for industry and about 34 percent for services. Agriculture (including livestock, crops, forestry and fishery) was the major source of growth in 1984 with most contribution coming from livestock and crops. Following the drought of 1983, the growth of livestock production in 1984 has been higher than and in 1985 close to the long-term annual average noted later. 2.4 Somalia's crop production has increased remarkably for two consecutive years -- 1984 and 1985. Further increases in production are expected in 1986. Improved incentives -- the liberalization of agricultural prices and marketing -- and favorable weather conditions account for the increased production of crops, particularly foodgrains. No notable improvement occurred in the irrigation system, and better seed varieties and other improved inputs were not available in significantly larger quantities. However, the land area under crop production increased from 700,000 hectares in 1980 to over 900,000 in 1984 and 1985. Though the production statistics (Table 2.2) are subject to errors, the reported increase in maize produetion from 235,000 tons in 1983 to 382,000 tons in 1985 is almost spectacular. These production increases led to an accumulation of maize stock and decline in food imports in 1985.  - 8 - 2.5 The production and acreage of sorghum, the major rainfed crop, did not show any strong trend increase since 1980, although year-to-year fluctuations have been considerable. But the increases in the production of maize -- an irrigated and rainfed crop -- is a major phenomenon in the 1980's. The area planted to maize which varied between 100,000 ha to 150,000 ha up until 1980, is reported to have increased to 350,000 ha in 1984 and 1985. While the reported data indicate considerable yield increazes in 1985, maize yields have remained around 0.75 tons per hectare witho'at any trend increase during 1980-84, reflecting rapid expansion of ma'ze in rainfed areas. Table 2.2 Somalia: Output of Maior Crops (Metric Tons 000) 1980 1982 1983 1984 1985 Banana 60 79 99 62 59 Maize 110 150 235 270 382 Pulses 9 59 21 32 39 Rice 17 20 3 4 6 Sesame 38 57 60 46 100 Sorghum 140 235 120 221 226 Sugar (Cane) 420 483 450 342 416 Source: Annex Table 7.1. 2.6 The production of pulses and oilseeds (mainly sesame) also increased very significantly in 1984 and 1985 (Table 2.2). In regard to bananas, the most important export crop grown on irrigated land, there has been a notable recovery in the area planted (including new plantings), reflecting improved price Incentives and better availability of inputs fuel and tractor services. Although output (and yields) shows modest increases since 1982, they remain significantly below the levels obtained during the early 1970s. There was some apparent decline in production in the past two years, although trade data do not corroborate this decline. The production of sugarcane -- an important import-substitution crop grown on irrigated land -- declined in 1984 due to a shortage of water at the Juba Sugar Estate3 due to a combination of the low river water level in the dry season and a shortage of fuel for irrigation pumps. Although the scarcity of fuel has continued, good rains and improved cultivation led to a substantial insrease in the area under cultivation resulting in a recovery of cane production in 1985 (Table 2.2). Other agricultural sector activities such as forestry increased only slightly (about 2 percent) in 1984 and 1985, while production of fish was unstable with a decline in 1985. 3I With the closure of the Jowhar Sugar Factory for repairs in 1983, Juba is the only sugarcane/sugar production center in Somalia.  - 9 - 2.7 Manufacturing production, which declined or stagnated in 1983 and 1984, showed considerable real growth in 1985, due to improved availability of inputs. The growth of manufacturing output growth was strongly influenced by food processing, particularly sugar production at Juba which is the single largest manufacturing subsector. Domestic Investment and its Distribution by Sector 2.8 Gross domestic investment in recent years has been maintained at around 15 percent of GDP, while gross domestic savings remained negative (Table 2.3). However, the level of fixed investment increased to about 14 percent of GDP in 1984 and 1985, up from around 9 percent in the early 1980s. The changes in stock ( the difference between total and fixed investment) in Somalia are more volatile and mainly reflect drought-induced changes in livestock raised entirely in the private sector. Table 2.3 Somalia: Domestic Savints and Investment, 1980-85 (Percent of GDP) 1980 1981 1982 1983 1984 1985 Investment 4.8 16.3 15.1 14.2 15.6 15.3 Of which: Fixed Investment 9.4 6.8 8.4 11.0 13.9 14.0 Domestic Savings -12.2 6.3 -2.8 -0.7 4.1 -5.5 Memorandum Itemst Volume Indices in: Per cap resource 100.0 101.3 105.2 103.5 99.2 97.1 Per cap GDP 100.0 103.7 106.5 105.6 101.2 105.8 Per cap private con 100.0 96.1 100.9 103.2 99.2 96.5 Source: Annex Tables 2.3 and 5.1. 2.9 Around 80 percent of the estimated domestic fixed investment has been undertaken by the public sector; the largest share (over one-third) of this investment has been in the agricultural sector, the second largest share (about 30 percent) has gone to economic infrastructure (energy, water, transport and communications), a declining share (around 12 percent) to manufacturing, and an increasing share (from 6 percent in 1980-81 to 14 percent in 1984-85) on education and health (Table 2.4). The general thrust of public investment strategy has in the 1980s changed in favor of increasing concentration on rehabilitation and development of infrastructure and support services to encourage the private sector as the  - 10 - main source of production growth, rather than large investments to establish and expand public enterprises as in the 1970s. The sectoral distribution of private fixed investment accounting for around 20 percent of total domestic fixed investment is not known. But it is undertaken in livestock and crop production, small-scalAmanufacturing, retail trade, a major part of road transport and almost the whole of residentisl construction in which the private sector dominates. The progress in liberalization and changes in public investment strategy have so far not resulted in any significant increase in the share of private fixed investment over the period 1981-85 for reasons which will be discussed in Chapter III. However, the share of private fixed investment in total gross fixed investment has increased from about 15 percent4 in 1976 and 1977 to over 20 percent in 1985. Moreover, including changes in stock raises the share of private sector in total gross domestic investment. Table 2.4 Somalia: Share of Public Sector Investment by Sector, 1980-85 (Percent) 1980 1981 1982 1983 1984 1985 Agriculture 33 38 46 39 36 40 Manufacturing and Mining 26 11 8 16 12 10 Energy, Water, Transport and Communications 24 36 22 28 34 28 Education and Health 6 6 9 11 14 14 Others 11 9 15 6 4 8 Total 100 100 100 100 100 100 Source: Ministry of Planning, National Development Strategy and Programme, Mogadishu, September, 1985. Macro-economic Imbalances 2.10 Recent developments do not indicate that the unsustainably large macro-economic imbalances of the economy are being steadily corrected. It should be stated at the outset, however, that because of the serious weaknesses of the Somali data, possible errors are involved especially in estimated ratios of macro-economic magnitudes to GDP. Data presented in Table 2.5 provide an overview of the external current account balance and the domestic investment-savings balance for recent years as percent of GDP (the saving-investment balance is also disaggregated into private and 4/ See, Somalia, Ministry of National Planning, Development Strategy and Public Investment Pro ramme, 1984-86, Mogadishu, September 1983.  - 11 - public sectors). An external current account deficit and a domestic investment savings gap are normal features of a poor economy in the process of developing with external assistance. In the case of Somalia, these gaps are enormous. requiring large external financing. The current account deficit on the balance of payments remains a large proportion of GDP rising to 22 percent in 1985. The apparently low ratio for 1984 (and also 1983) is an aberration because the magnitude of the deficit was grossly understated in local currency by the highly overvalued official exchange ra_e which was adjusted in 1985. The gap between domestic investment and domestic savings remains large, rising to over 21 percent of GDP in 1985. (If the official exchange rate, rather than the trade weighted average of the multiple exchange rates, is used for conversion, the ratios of the current account deficit to GDP and the resource gap to GDP for 1985 become 12.2 percent and 11.3 percent respectively. But even this soes not indicate a decline in the external imbalance relative to GDP.) This gap is financed by foreign savingslaid flows reflectedi in net imports (excess of imports over exports of goods and non-factor services). Domestic savings have, in most years, remained negative in both private and public sectors, and external assistance financed part of domestic consumption as well as 100 percent of all investment. However, the much larger public dissavings constitute the major factor behind the persistently large doniestic and external financial imbalances, which we shall discuss later on. The extremely large investment savings imbalance indicates the gross inadequacy of domestic resource mobilization which combined with still inadequate external sector policies resulted in continuing large current account deficit on the balance of payments. 2.11 It is to be emphasized that the economy has responded to the changed policy environment and favorable climate in positive ways through agricultural growth, lower inflation, reduction of imports and recovery of exports. However, the effect of these positive developments on the macro- economic imbalances of the economy is still negligible mainly because the imbalances in themselves have been enormous and deeply entrenched to start with. The following two sections of this chapter will elaborate on the external payments situation and the domestic financial situation. The final section provides an overview of how incentives have evolved and to what extent important distortions are being corrected in recent years.  - 12 - Table 2.5 Somaliat Macroeconomic Balances. 1980-85 (Percent of GDP) 1980 198j 1982 1983 1984 1985 Foreign Savints Current A/C Balance -14.2 -8.1 -16.3 -13.6 -10.7 -21e7 Net imports (Resource Balance) -17.0 -9.9 -17.9 -14.9 -11.6 -20.8 Private Sector Gross Dom Inv -2.7 10.9 8.9 5.6 4.8 4.1 Fix Inv 1 1.9 1.4 2.2 2.4 3.1 2.8 Chg in Stk 2 -4.5 9.5 6.7 3.2 1.8 1.3 Dom Savings -9.1 6.5 -2.2 0.6 10.5 -0.6 Inv - Sav 6.4 4.3 11.1 5.0 -5.7 4.8 Public Sector (coss Dom Inv 7.5 5.4 6.2 8.6 10.8 11.2 Fix Inv 7.5 5.4 6.2 8.6 10.8 11.2 Chg n Stk 3 -- -- -- -- -- -- Dom Savings -3.1 -0.2 -0.6 -1.4 -6.4 -4.9 Current Rev 11.5 11.9 11.2 12.4 6.1 5.4 Current Exp 14.6 12.1 11.8 13.7 12.5 10.3 Inv - Sav 10.6 5.6 6.8 10.6 17.2 16.0 Public & Private Inv - Sav 17.0 9.9 17.9 14.9 11.6 20.8 Memo Item Share of Gross Dom. Inv. financed by foreign savings (2) 100 94 100 100 96 100 1/ Split between public and private investment is taken from government document, "Performance of the Somali Economy, 1983", and staff estimates. 2/ Change in stock data primarily refer to livestock. Due to weak data base, may include some public sector stock changes. 3/ Included In private change in stocks. Source: Annex Tables 2.3, 3.1 and 5.1  _ 13 - Balance of Payments 2.12 The balance of payment situation remained precarious during 1985 despite some improvements over 1984. Exports increaeed to US$93 million, and imports fell to US$362 million, leading to an improvement in the trade balance of US$75 million compared with 1984. Private transfers fell on the other hand, because of the changing employment opportunities in the neighboring oil exporting countries, and the deficit on the current account was reduced only by US$21 million. Not capital inflows (including official transfers) were moderately higher than in 1984, and the overall balance of payments deficit was reduced by some US$50 million from 1984 to 1985. This deficit was financed largely by accumulation of payment arrears in 1984. In 1985, it was financed partly by debt relief (see Table 2.6).  - 14 - Tablo 2.6 SOMALI1 - Balance of Payents Summaryv 1901-1986 (in millions of US dollars) 1991 1962 1998 1964 1985 Exports, f.o.b. 114 17 101 62 98 Imports, C.I.f. -422 -484 -450 -498 -862 Trade Balance -S8 -847 -849 -844 -269 Non-factor services (not) 9 28 24 -S -8 Resource Balance -299 -324 -325 -847 -275 Interest Poyments -10 -14 -21 -44 -48 Private Transfors (workers' remittance) 64 so 51 72 20 Current Aeo.unt Sol. -245 -268 -295 -S19 -298 Offieial Transfors (net) 159 167 148 174 179 Public Loans (net) 79 128 1N 46 69 (disbursements) (98) (181) (16) (106) (114) (rpayments) (-14) (-8) (-7) (-U) (-46) Other Capitol (inel *rrors and omi s ione) (not) a -a6 -89 -40 -88 Overall Balance -18 -44 -88 -189 -88 Financing 14 44 so 189 88 Central BDnk B8 64 47 18 26 of which: Net credit from IMF 30 34 44 -8 82 Com"rcial Bank -20 -20 89 29 -82 Arrears - - - 71 -58 Debt Roelo - _ - 26 160 Memo Items; aros reserves as X of total Imports 10 8 4 1 2 Current account deficit/GOP (U) -8.1 -12.6 -18.6 -9.8 -12.7 Debt srvice ratio (as X of exports of goods and services) accrual basl 20 21 28 166 104 cash basis n.e. n.a. n.n. 19 48 Source: Annex Table 8.1  - 15 - 2.13 Exports increased by 50 percent from 1984 to 1985, from US$62 million to US$93 million. This was eatirely due to a doubling of livestock exports, from US$33 million to US$66 million. The recovery was due to the good performance of exports of sheep and goats (Table 2.7). Part of the increase was the result of a concerted effort to open up now export markets in Egypt and North Yemen especially for cattle, following the ban on import of Somali cattle in its traditional export market. The devaluation of the Somali Shilling in 1985 along with the introduction of a free market for selling part of foreign exchange earnings from exports is having a positive effect on livestock exports. Still cattle exports of 32,000 head in 1985 were far below the peak level of 157,p0u in 1982. Table 2.7 Somalia: Livestock Exports (Thousand Head) 1980 1981 1982 1983 1984 1985 Camels 16 12 12 6 5 6 Cattle 89 103 157 38 7 32 Goats 734 680 719 557 351 749 Sheep 747 658 730 569 350 709 Total Livestock Units* 238 231 285 150 82 197 *Converted at camel-l.2 LU; cattle-0.8 LU; goat-0.1 LU; sheep=0.1 LU) Source: Somalia, Ministry of Livestock. There were, however, only minor improvements in other exports in 1985. Banana exports remained at the 1984 level. Exports of incense, and hides and skins recovered only slightly in 1985. Compared to the number of animals slaughtered, the collection rate of hides and skins remains low as price and marketing remain controlled. 2.14 Total imports in current dollars declined by 10 percent in 1984, and by another 10 percent in 1985 to $362 million. The reduction in overall imports was entirely due to a substantial decline in foreign exchange imports while the total level of imports under commodity aid and public investment program (PIP) in 1985 was not lower than in the previous year.  - 16 - Table 2.8 Somalia: Total Imiorts (Current USS millions) 1984 1985 Foreign Exchange Imports 156 111 Commodity Aid 110 97 (of which oil) (20) (37) PIP Imports 140 154 Total Imports 406 362 Sources IMF, Somalia Recent Economic Developments, April 1986; and Bank staff estimates for 1985. The decline in foreign exchange imports in 1985 was not the result of an absolute decline in foreign exchange availability (export earnings, private remittances plus cash grants), which actually increased somewhat. It largely reflected, the impact of price and exchange rate adjustment on private sector imports, and some substitution of foreign exchange imports by commodity aid as the latter's composition improved. 2.15 Despite the decline in total foreign exchange imports as well as total imports, real GDP increased in 1985 because production originated mainly from the agricultural sector which depends much less on imports than other sectors. 2.16 The lower imports and the recovory of exports in 1985 contributed to a modest decline in the trade deficit, though it still remained 4 times the value of exports. With the decline in private transfers in 1985, the overall financing requirement, the current account deficit plus loan repayment obligation, exceeded $400 million in 1984 and $380 million in 1985. Aid disbursements in forms of project aid, commodity aid and cash grants amounted to $280 million in 1984 to over $290 million in 1985 (about $60 per capita). While in 1984, financing of the remaining gap was done largely through accumulation of arrears, in 1985 this was achieved mainly through a debt relief of $150 million and a net credit of $32 million from the IMF. Thus the economy depended on large external grants and loans and debt relief to meet the external financial obligations. Yet, Somalia accumulated new payments arrears by the end of 1985. External Debt 2.17 Somalia's external debt (outstanding and disbursed) has increased to reach US$1.54 billion as of December 31, 1985 from US$1.35 billion at the end of 1984. Around 33 percent of this total outstanding debt is owed to multilateral agencies including the International Monetary Fund and the Arab Monetary Fund (see Table 2.9; details are shown in Annex Table 4.1). About one-third of this multilateral debt originates from OPEC  - 17 - institutions. The remaining 64 percent of total external debt is owed to different bilaterals. OECD countries including suppliers credits (SACE, Italy) have the largest share (34 percent). OPEC countries including bilateral agencies (Kuwait Fund and Saudi Fund) have 16 percent, and CPE countries have another 16 percent. A large part of CPE debt is de facto frozen. Table 2.9 SOMALIA: External Public Debt Outstanding, end 1985 US $ Z of Million Grand Total Official Creditors: Multilateral 324 20.9 IDA 164 10.6 OPEC 113 7.3 Other 47 3.0 Bilateral 814 52.7 OECD 318 20.6 OPEC 253 16.4 CPE 243 15.7 Total (excl. IMF/AMF) 1,138 73.6 IMF 142 9.2 AMF 50 3.2 Private Creditors: Suppliers credits 213 14.0 Grand Total 1,543 100.0 Source: Appendix, Table 4.1; Ministry of Finance, Debt Unit. 2.18 Actual debt service payments (excluding IMF) increased from US$3.8 million in 1984 to US$26.0 million in 1985. Actual debt service payments including payments to IMF increased from nearly US$12 million in 1984 to about US$50 million in 1985, of which US$27 million represented repayment of principal. Thus, the larger portion of debt service payments are due to the IMF. Yet, actual payments have remained a small proportion of debt service obligations (Table 2.10).  - 18 - Table 2.10 Somalia: Debt Service Oblization, and Actual Payment. In 1984 and 1985 (Million US$) 1984 1985 Obligations Payments Obligations Payments Multilateral (excl. IMF) 18 2.2 15 6.1 Bilateral (OPEC) 28 0.9 23 19.2 Bilateral (OECD) 44 0.7 43 0.7 CPEs 12 0.0 13 0.0 IMF 8 8.0 26 24.0 Total 112 11.6 120 50.0 Source: Ministry of Finance, Debt Unit, and staff estimates. 2.19 Shortages of foreign exchange in the official market continued to be a constraint on the Government's debt service capacity in 1985, but a large cash grant from Saudi Arabia enabled the Government to discharge outstanding arrears and current debt service with two bilateral agencies-- the Saudi Fund and the Kuwait Fund. Debt service payments to other agencies were partly financed through purchase of foreign exchange in the free foreign exchange market (around US$3 million) or settled in local currency (around US$2 million).5 2.20 Somalia's debt service arrears increased rapidly from US$31 million at the end of 1981 to US$224 million as of December 31, 1984. Around US$98 million of these. arrears were settled in 1985, but another US$46 million in new arrears were incurred in the same period. Table 2.11 shows the change in arrears by donor groups. 5/ The Central Government budget shows a debt service for 1985 of So.Sh. 1.4 billion, equivalent to about US$26.4 million at an average exchange rate of 53 Sh/US$1.  _ 19 - Table 2. 11 Change in Arrears, end 84 to and 85 (Million US$) Settled New Arrears Arrears Multilateral (Excl. IMFIAMF) 12.6 10.3 Bilateral (OPEC) 75.9 16.1 OPEC 11.3 2.5 OECD 70.4 0.0 CPE 4.2 13.6 IMFIjAMP 0.0 19.4 Total 98.5 46.4 Sources Ministry of Finance, Debt Unit 2.21 Seventy million US dollars in arrears to OECD countries were settled as part of the 1985 Paris Club agreement. Arrears were also settled with certain agencies during 1985 (the African Development Bank, the African Development Fund, the Islamic Development Bank, the Kuwait Fund and the Saudi Fund), but now arrears were built up with other agencies (Arab Fund, OPEC Fund, Arab Monetary Fund, and the IMF). Around US$16 million of new arrears were built with CPE countries and OPEC bilaterals. This debt includes frozen debt to CPE countries. 2.22 Dturing 1985, through the Paris Club reschedulings and bilateral arrangements with other official creditors, Somalia received debt relief on current debt service and arrears totalling US$150 million. Bilateral reschedulings arranged at the 1985 Paris Club meeting were finalized in 1985 with only two creditors-,France and the U.S. Similar arrangements arising from the 1985 Paris Club rescheduling were finalized with Italy and the U.K. in 1986. Long negotiations on interest rates rosulted in this delay in formal agreement. The delay with Italy was due to (successful) efforts at converting some of the rescheduled loans into grants. The Paris Club arrangements gave Somalia 10 years maturity and 4 years grace for the majority of debt rescheduled. The interest rates set in bilateral agreements with individual creditors varied between 2 and 12 percent, with a weighted average rate of 4.5 percent per year. 2.23 The position of arrears by donor as of December 31, 1985 is shown in Table 2.12 (for details, see Appendix, Table 4.3). Total outstanding  - 20 - arrears as of December 31, 1985 was estimated at US$173.8 million. Close to three quarters of this is, however, arrears on 'frozen' debt. This includes US$85.6 million owed to CPE countries (mostly to Bulgaria and the USSR) which are unilaterally 'frosen', with no servicing or formal rescheduling being arranged. Similarly, US$40 million in arrears owed to Abu Dhabi (out of US$44.3 million in arrears to OPEC bilaterals) appears to be virtually frozen with no rescheduling arrangements. Table 2.12 Arrears (Million US$) end-1984 end-1985 Multilateral 20.2 18.4 OPEC 19.6 17.6 Others 0.6 0.8 Bilateral 189.7 129.9 OECD 60.5 0.0 OPEC 53.0 44.3 CPE 76.2 85.6 IMF/AMF 4.5 25.5 Total 214.4 173.8 Source: Appendix, Table 4.3, Ministry of Finance, Debt Unit. 2.24 The Government could not achieve its objective (as set out in the 1985 adjustment program supported with IMF stand-by) of virtually eliminating by the end of 1985 all external payments arrears either by cash payments or through rescheduling arrangements. 2.25 In fact, despite some reduction of outstanding arrears during 1985, Somalia's current debt service problem remains extremely difficult. Even excluding the outstanding arrears at the end of 1985, current debt service obligations during 1986 and 1987 exceed US$150 million per year, or are larger than the sum of annual export earnings and remittances of Somali nationals working abroad. The current burden of annual debt service obligation is thus way beyond Somalia's capacity to bear. The current debt service obligations (excluding arrears) to multilaterals alone amount to over US$40 million in 1986 and $80 million in 1987 (of which the larger portion is owed to IMF). 2.26 The Government requested a further Paris Club rescheduling in early 1986, but following the Paris Club's standard procedure, creditors indicated their unwillingness to consider Somalia's request until a Fund- supported program was in place, covering at least the period through the end of 1986. Somalia has also approached various other creditors for debt  - 21 - relief, but no new debt rescheduling has been arranged. Meanwhile, debt service obligations to various creditors have not been paid. Therefore, Somalia's arrears at the end of 1986 have increased by over $80 million (contrary to the objective of reduction of arrears stipulated in the 1986 stand-by arrangement with the Fund). Fiscal and Monetary Developments 2.27 Notwithstanding less than comprehensive coverage and accounting of the government budget, data in Table 2.13 below indicate that the fiscal situation improved moderately in 1985 over 1984, although the current account deficit remained very large. The progress is continuing in 1986. Total revenue in nominal terms, after having decreased by 8 percent iti 1984, grew by 31 percent in 1985. But this rate of increase was still substantially lower than the rate of inflation. The increase in total recurrent expenditure in 1985 (22 percent) was much smaller than in 1984 (73 percent). 2.28 However, domestic revenues remain grossly inadequate to finance recurrent government expenditures. Despite wide margins of error in estimates, available data indicate that domestic revenue as a proportion of GDP in 1984 and 1985 was a record low (5-6 percent) compared to 13-15 percent in earlier years. There are several factors contributing to this problem. The primary reason has been the valuation of imports for duties and taxes (from which comes half of Somalia's domestic revenue) has been carried out at an artificially low price of foreign exchange which is roughly half of the legal free market rate. Extensive tax evasion and weak tax administrations are also important factors.  - 22 - Table 2.18 SOMALIA:. Summary of CentralI Government Financ*. 1981-86 (in Mill. of So"ait Shillings) 1981 1982 1988 1984 Prolim 1986* Domestic Revenue 1 2262.6 2759.8 4252.6 8978.7 5220.0 9401.0 of which Tax Revenue 2967.8 2477.9 U848.6 2979.9 4582.4 8418.0 Recurront Expenditure 1 2295.9 2906.0 4716.0 8140.0 9918.0 15898.0 Curront Balance -32.4 -145.4 -468.5 -4161.8 -4698.9 -6998.0 Dovelopment Expenditure 1424.8 2400.6 1920.0 3181.5 7940.0 12296.0 of which: Dovelopmeont Budget 286.8 847.6 498.1 661.5 1872.0 2609.9 Overall Balance -1457.2 -2606.0 -2888.5 -7842.8 -12688.0 -18289.0 Financing 1457.2 2606.0 2388.5 7842.8 12688.0 18269.0 Foreign 1116.2 2780.0 2678.5 4720.8 11698.0 18850.0 Loans 081.2 1724.1 1572.5 2797.8 4978.0 99911.0 Grants 485.0 1066.0 1106.9 1989.0 620.0 9849.9 Domeatic 841.0 -174.0 -295.0 256.0 1046.0 -81.0 Banking System 847.9 -150.0 295.0 2678.0 875.60 -61.0 Other -4.0 -24.0 0.0 -8.0 170.0 090 I/ Includes transfer. to and from local governoente. Source: Annex Tablo 6.1. - estimate. as of December 1986.  - 23 - 2.29 As a consequence of an inadequate domostic resource mobilization in the public sector, the budget deficit in the last few years has continued to be large. This deficit was financed mostly from foreign grants in the form of shillings generated by commodity aid. Current deficit increased from So.Sh. 4.1 billion in 1984 to So.Sh. 4.7 billion in 1985. In 1984 budgetary support in the form of external grants was So.Sh. 2 billion and by 1985 it had jumped to So.Sh. 6.6 billion or about 7 percent of GDP. Despite this high level of external budgetary support, the Government's net borrowing from the banking system was So.Sh. 2.6 billion in 1984 and So.Sh. 875 million in 1985. (The Government had to recourse to bank borrowing in 1985 because it paid off So.Sh. 1400 million in arrears it had accumulated in 1984). No net borrowing from the banking system has been made in 1986 primarily because of a 41 percent increase in external grants. 2.30 External loans and grants continue to finance fully the development expenditures undertaken through the Public Investment Program (PIP) which remain outside the budget. (The PIP expenditures have been included in the Table 2.13 to get a better overall estimate of the total government spending.) The local counterpart requirements of the development expenditures are included in the budget as 'development budget' and are also financed externally by counterpart funds generated through the commodity aid program. Table 2.13 indicates that development expenditures have been large, and increased 66 percent in 1984 and further 150 percent in 1985. In 1986 total development expenditures have increased 55 percent to So.Sh. 12.3 billion or about 48 percent of total (recurrent and development) expenditures and 80 percent of recurrent expenditures. 2.31 At the same time, recurrent expenditures on social and economic services have been grossly insufficient. Recurrent budget expenditures have primarily gone towards meeting rising expenditures on general public services (i.e. Defense, Interior) and maintaining an overly large civil service as will be discussed in Chapter III. 2.32 Recent monetary developments largely reflect the modest budgetary improvement in 1985 over 1984. The rate of expansion of domestic credit slowed down to about 18 percent in 1985 from over 82 percent in 1984. This was entirely due to a sharp reduction in credit to the Central Government (see Table 2.14), as Central Bank financing of the budget was reduced from So.Sh. 2.6 billion in 1984 to about So.Sh. 0.9 billion in 1985. Credit to public entities was somewhat higher in 1985 than in 1984, whereas credit to the private sector was drastically lower -- with only 8 percent increase in 1985 compared to 62 percent increase in 1984. 2.33 Broad money (M2), i.e., currency plus demand deposits and time deposits, increased sharply in 1985 despite the reduction in the rate of expansion of domestic credit. Domestic credit expansion only accounted for about one-third of the budgetary expansion. The large increase in monetary  - 24 - liabilities reflects in particular the increase in foreign currency deposits by the private sector and their revaluation given the rapid depreciation of the shilling, and the build-up of counterpart funds from the comodity aid program. Data available for early months of 1986 indicate that monetary expansion may have slowed down to some extent. 2.34 With moderation in the expansion of domestic credit, inflation (as measured by Mogadishu Consumer Price Index) slowod down to 38 percent in 1985 from 92 percent in 1984. But further progress does not seem to have been made in 1986. During 1986, domestic inflation was about 37 percent. However, the share of the private sector in domestic credit declined from 39 percent in 1984 to 35 percent in 1985, and was even lower in 1986 (See Table 2.14).  - 25 - Table 2.14 SOMALIA: fngo and Crodit, 198W (mlill. of So.5h., OngdO Prio) Items 19 19e IOU 198 1984 19e C .e. 2 For.lin Asnets, Net1 145 72 -441 -28JW -4465 -591U8 -8259 Domestic Credit 8gm 4546 5024 5261 9616 11347 1ism Claims on Govt., Not 1902 22W0 2100 1S65 4J78 5252 6196 Claims on Public Entities 1651 1722 1300 1163 1511 2071 8257 Claims on Private Sector 426 575 1624 2293 8727 4024 4227 Money Supply (MI) 2788 3619 8911 4167 6078 0117 11887 Mon y Quasi-Money (M2) 8081 4866 4995 5849 6678 11938 16111 Other Itume, Not 1 648 251 -612 -248 -1797 -6428 -10888 Memo Items Ratio of M2 to GOP 27.4 22.9 20.8 16.6 10.8 12.8 11.6 X Increase of M2 20.2 29.1 14.4 7.1 24.9 78.2 86.8 X Incroese In DOM Credit 81.12 17.2 10.5 4.7 82.8 18.0 20.6 U Increose In Mo4gdishu CPI 59.0 44.6 22.6 86.4 92.1 87.9 87.0 J/Includes valuation adjustomnt. Data for 1966 ore as of September 1986. M2 Includes money supply (currency and demand deposits) and tim deposits. Source: Annex Tables 6.1 and 9.2.  - 26 - Key Performance and Incentive Indicators 2.35 Table 2.15 attempts to provide an overview of some incentive indicators, in order to show to what extent distortions in the policy framework are being corrected over time. The real effectivo exchange rate (REER) - the nominal effective exchange rate adjusted for the differential in domestic inflation and partner countries' inflation - applicable to exporters (Table 2.15), has declined moderately but unsteadily since 1980, except for 1984, the year of setback of policy reform. The index of REER depreciated substantially and rapidly to reach about 60 in mid-1986. A depreciation of the REER raises the domestic prices of exportables relative to non-tradables, provides incentives to producers/exporters, and also improves the competitiveness of exportables abroad, and helps to rectify the balance of payments deficit. Thus, except for 1984, Somalia has been correcting the earlier exchange rate distortions and improving export incentives since 1981, and specially during 1985 and 1986. Somalia needs to sustain a depreciation of the real effective exchange rate to expand and diversify exports and to encourage import substitution towards reducing the large external imbalance. However, because of multiple exchange rates, the real effective exchange rate relevant for imports has still not moved adequately in the right direction to provide strong incentives to import savings, domestic production of import substitutes and thus to correct distortions in the policy framework which we shall discuss in the ne-', chapter.  - 27 - tabIl 2 1S Soeall Keo