Tunisia - Economic and Financial Reforms Support Loan Project

Doc= The Wo FOR OFFICI Report No. P-5636-TUN REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED ECONOMIC AND FINANCIAL REFORMS SUPPORT LOAN IN AN AMOUNT EQUIVALENT TO US$250 MILLION TO THE REPUBLIC OF TUNISIA NOVEMBER 21, 1991 This document has a restricted distribut-on and may be asel by recipients only in the performance of their ofricial duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY AND EQUIVALENT UNITS Currency Unit = Tunisian Dinar (TD) US$1.00 TD 0.8783 (average 1990) TD 1.00 = US$1.1386 FISCAL YEAR January 1 - December 31 GLOSSARY OF ABBREVIATIONS BCT Banque Centrale de Tunisle (Central Bank of Tunisia) BIS Bank for International Settlements CAVIS Caisse d'assurance vieOlesse, invalldit6 et survivants CNRPS Calsse nationale de retraite et de prevoyance sociale CNSS Caisse nationale de securite sociaie CPG Compagnie des phosphates de Gafsa (Phosphate mining) Cr4EGT CNRPS for gas, electricity and water companies SNCFT Societe nationale des chemins de fers tunislens (Railways) SNT Sociste nationale des transports (Road transport)  FOR OFFICIAL USE ONLY REPUDUC OF TUNIS ECONOMIC AND FINANCIAL Ri:5:RMS SUPPORT LOAN Lean and Pam Sum n The Republic of Tunisia. US$250 million equivalent. 17 years, including five years of grace at the standard variable interest rate. The proposed loan would support Tunisia's continued implementation of its medium-term program of economic reforms and its maintenance of macroeconomic stability while overcoming the balance of payments shock caused by the Gulf crisis. The main areas covered under the program are- (i) the virtual completion of the liberalization of external trade and prices, along with institutional reforms to assist the correct functioning of markets; (ii) reforms to promote financial markets and to bring bank regulation gradually up to international standards; (iii) reforms of the special incentives to make them economically more efficient and less costly to the budget; (iv) reform of the social security system to enlarge its coverage and to make it more financially viable, and reduce obstacles to labor mobility; and (v) the establishment of coordinated external debt management, to enable Tunisia to resort increasingly to international financial markets. Rbdua The proposed loan would support the completion in all major respects of the liberalization of external trade, prices, and the financial sector and would permit market forces to operate effectively. Also by allowing the economy to achieve sustained growth in the framework of internal and external equilibrium, the reform program would provide the basis for (i) greater employment creation; (ii) a more viable and diversified economy increasingly based on manufactured exports rather than on oil exports as in the past; and (iii) restoring Tunisia's voluntary access to commercial borrowing. Two main risks can affect the success of the reform program and the project. First, the experience of the previous SAL has demonstrated that major exogenous factors, such as severe droughts and regional tensions, can complicate the implementation of measures, particularly those that entail transition costs. This is indeed a potent risk in the medium- term, and argues for strong international support, including that of the Bank and the IMF, to enable Tunisia to implement the difficult but needed reforms. However, given the This document has a restricted distribution and may be used by recipients only L. the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  - ii - Government's com-itment to the reforms, and given the expected reduced vulnerability to exogenous factors of the economy over time, this risk appears increasingly manageabla, with adequate support from the international community. The second risk relatea to the opposition that can be expected from groups that will be negatively aftected by increased competition expected to result from the trade and financial liberalization program. Hovever, a smooth implementation of the import liberalization program is expected because of the proposed early announcement of the liberalization program, the system of temporary surcharges and access to restructuring funds to viable enterprises. Similarly, the reforms of prudential regulation and banking would need careful handling given that they may entail difficult adjustments by banks, their shareholders and some of their major clients. However, the Government's commitment in this area is very strong, and one of its highest priorities is the establishment of a banking system that meets international standards. Diebtysssnntr The proceeds of the proposed loan would be disbursed in three tranches: US$100 million upon loan effectiveness, and US$70 million and US$'0 million after the completion of a number of key actions for the second and third tranche releases respectively. Release of the three tranches is planned for end-l991, end-1992 and end-1993, respectively. None.  REPUBLIC OF TUNISIA ECONOMIC AND FINANCIAL REFORMS SUPPORT LOAN Table of Contenb PARTI-THE ECONOMY ...................................................... 1 A. BACKGROUND ..................................................... 1 S. MACROECONOMIC DEVELOPMENTS: 1988-91 ............................... 2 C. IMPLEMENTATION OF REFORMS .............. ........................... 5 PART II - THE ECONOMIC AND FINANCIAL REFORM PROGRAM .......................... 6 A. THE MACROECONOMIC FRAMEWORK .......... ........................... 7 Monitoring Macroeconomic Perfornance ................................. 8 B. TRADE, PRICES AND COMPETITION ............ ........................... 9 C. THE FINANCIAL SECTOR ........... ................ .................. 10 Financial Markets ............. ......................... 10 Supervision and Prudential Regulation of Banks ........... ................ 12 Lending Rates ...................................... 14 D. SPECIAL INCENTIVES ............. ......................... 15 E. SOCIAL PROTECTION ............ .......................... 16 Social Security Funds ....................................... 16 Consumer Subsidies ................ ...................... 17 PART III - THE PROPOSED LOAN ...................... 18 A. LOAN AMOUNT, TRANCHING AND CONDITIONAUTY ....... .................. 18 B. COFINANCING .................................................... 20 C. BENEFITS AND RISKS ................................................ 20 D. COLLABORATION WITH THE IMF . ....................................... 20 E. PROCUREMENT, LOAN ADMINISTRATION AND MANAGEMENT ..... ............. 21 PART IV - OTHER BANK GROUP OPERATIONS ........... ............................ 22 A. BANK EXPERIENCE WITH ADJUSTMENT LENDING IN TUNISIA ..... ............. 24 B. IFC INVESTMENTS ................................................... 26 PART V - LEGAL INSTRUMENTS ,AND AU`HOIii7Y ..................................... 26 PART VI - RECOMMENDATION ................................................... 26 ANNEXES: Exteral Debt Management lAter of Development Policy and Pdicy Matrices Key Macroeconomic Indlcators Supplementary Project Data Sheet MAP: IBRD No. 18707 (Attached)  REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED ECONOMIC AND FINANCIAL REFORMS SUPPORT LOAN IN AN AMOUNT EQUIVALENT TO US$250 MILLION TO THE REPUBLIC OF TUNISIA 1. I submit the following report and recommendation on a proposed Econom'c and Financial Reforms Support Loan to the Republic of Tunisia In an amount equivalent to US$250 million. I would provide financlal support for the last phase of the Govemment's structural adjustment program and the accompanying Institutlonal reforms, to enable the economy to become more modem, open and private sector-based. The loan would have a term of 17 years, includlhg five years of grace, at the standard variable Interest rate and will be ccdfinanced by Japan and the European Commission. PART I - THE ECONOMY A. BACKGROUND 2. Despite modest natural resources, Tunisia has the makings of a relatively advanced developing country, largely because of consistent emphasis over a long period on the development of the human resources and prudent macroeconomic policies. Thanks to these priorities, In 1990, Its per capita income of US$1,420 was surpassed In Africa only by some OPEC countries and Mauritius, and its social Indicators only by Mauritius. The country's infrastructure is adequate and well rmaintained, its non-oil exports were growing rapidly untii the Gulf crisis erupted, and it has never rescheduled its external debt nor is it likely to need to In the foreseeable future. 3. Nonetheless, the country did pass through a period of Imprudent macroeconomic management that brought it close to a balance of payments crisis In the mid-1980s. Although not severe in comparison to what many other countries have underjone, this experience prompted reflection In the Govemment on some of the policies that had been pursued. Events had confirmed the necessity of prudence In macroeconomic management. But the Govemment also confronted a basic Issue, namely whether the economrys efficiency did not need to Improve if future balance of payments problems were to be avolded. 4. The Issue of economic efficiency had to be confronted because the brief oil boom Tunisia had experienced In tie second half of the 1970s had been stopped In 1980 by faling worid oil prices and depletion of ott reserves, and the sequel had been large macroeconomic deficits. At the peak of the boom In 1979, oil accounted for 31.0 percent of export eamings and 17.5 percent of budget revenue. Through the late 1970s this permited Investment levels close to 30 percent of GDP and rapid wage Increases without major external Imbalancs But Investment continued unabated after 1980 and wage increases only began to slow down In 1983. For the first time, Tunisia consistently had large macroeconomic Imbalances: over 1980-86 the curnt account deficit averaged 7.9 percent of GDP and the budget deficit 5.6 percent. By 1986 a balance of payments crisis was clearly threatening and the authorities responded by restraining demand- through cutting Investment, holding wages down, and tightening monetary policy- and by deWuing the dinar In real terms by 14.3 percent over the year. These measures succeeded In forestalling a crisis, but the question had been posed: how could the Tunisian economy, In the face of declining ol exports and wth te addition of the debt Incurred in the Immediately preceding years, continue to grow at rates compable to those of the past?  .2 - 5. The Govemment's basic answer to this question was: through an Improvement in the eficiency of the economy that could be refiected In lower ICORs and, thence, In smaller resource gaps. it recognized that this could only be achieved by relying primarily on the private sector and orienting the economy increasingly outward. This necessarily Implied extensive liberalization, since the economy was too permeated with administrative contrc!s for markets to function effectively. The vislon of the Govemment went even further. It sought to assure the Tunisian ezonomy's future by attracting substantial direct foreign Investment and modem technology as an open economy with a convertible currency. 6. This set an agenda for thoroughgoinj change In almost every segment of the economy. Progress In the agenda has been broad and h;A ;,een rnade In close dialogue with the Bank and with its support through five adjustmernt operations. The agenda Is, however, larger tilan the programs supported by these operations and, because of exogenous circbmstances and Internal difficulties, its Implementation has, In cerain respects, fallen behind the tir-etable the Govemment had set itself. Even then, the main reforms carried out under the adjustment programs are substantial (for details on the Bank operations, see Part IV). The Govemment also carried out some major reforms Independently of these programs, notably the liberalization of banking, the virtual creation of the money market, and reform of stamp duties and registration fees. B. MACROECONOMIC DEVELQPMENTS: 198-B1 7. The major features of the economy's performance since 1986 have been the strong export performance and the Improvement In macroeconomic balances, which together account for a robustness that the economy had not displayed eariler. The demand restraint, devaluation, and other measures taken In 1986 and after, together with strong demand from the EEC, resulted In growth of manufactured exports and tourism that offset the loss of oU export eamings. The economy was able to weather two droughts, In 1988 and 1989, with positive growth, whereas droughts In previous years normally resulted In declines in GDP. Both the balance of payments and the budget Improved (see Table 1). 8. The Improvement In the current account was due both to the growth of non-og sxports and a fall In the level of Investment. Although oil expons stagnated, the average growth of total exports over the period was 13.5 percent per annum. With Investment a lower share of GDP and a saving rate varying between 16 percent and 19 percent, the resource gap fell from an average of 8.5 percent of GDP In 19804 5 to 3.0 percent In 1986.89. The consequent Improvement In the current account stopped the deterioration In debt Indicators; the ratios of debt to GDP and of debt service to exports, which had averaged 48.2 percent and 18.6 percent respectively In 1980-85, reached their peaks of 70.0 percent and 28.2 percent In 1987 and declined to 61.0 percent and 23.4 percent in 1990 (see Figure 1).  - 3 - FIGURE 1: TUNISIA: SELECTED MACROECONOMIC INDICATORS DEBT INDICATO.S REAL EXCHANGE RTE AND TERMS OF TRADE Q.7 ._____ _____I_______. 0*- -- l l ll- -- ' 0,4 -~~~~~~~~~~~~~~~~~~~~~~~~ DEBTINDCTOR ACCOUN ANDBUD 0TDEF00 0. . 0.1 - 19031196801 16 1986 1982 68 1968318 1980 1698 161 961987 68 198888 1986 68 199 08019 - CoboW mGP ntt WDOW-.Sctwetos Ni I- at -Emma" Rat. -'Ibfue of TiadSi CURRENT ACCOUNT AND BUDGET DEFICIT In Percent of GDP 0.02 0 -0.08 -0.1 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 Source: Ministry of Planning and Regional Development, and Bank estimates  -4- Tt3ble 1: EMSC PEF1UC 1980-85 1986-89 1990 1991 Average Average 'iorecaat) GDP Growtb Rates (2 p.a.) 4.2 3.5 7.1 3.0 Current Account/GDP (I) -7.9 -2.8 -5.3 -5.0 Non-oil Export Growth Rate (S p.a.) 4.3 16.7 5.9 -2.3 Investment/GDAP () 30.3 21.6 26.6 24.1 Budget Deficit/GDP (Z) -5.6 -4.0 -3.8 -3.4 9. Even in the most stringent times, the major social objectives were maintained Intact. The success of consistuint emphasis on poverty reduction, social development, and family planning distinguishes Tunisia from many other countries at similar Income levels. Budgetary difficulties In the mid-1980s demanded substantial cuts In food subsidies thereby threatening severe hardship for the poor. The authorities did Indeed reduce subsidles from 5 percent to 2.9 percent of GOP. However, they did so by raising most the prices of goods consumed less by the very poor and by maintaining targeted programs, such as free basic health care and school materials for the very poor. A marked reduction in population growth from 2.5 percent a year to 2.1 percent, and possibly lower, has occurred through the general effect of social development and through Incentives in the socW security system. 10. 1990 promised to be the first fully normal year since the early 1980s, until the onset of the Gulf crisis. Rainfall was good and agricultural production recovered to the level of 1987, contributing 13.5 percent to GDP growth. Expons of manufactures continued to grow strongly, apart from the loss of the growing Iraqi market, though tourism slackened, partly because the crisis affected the late season. Fixed inm.-stment began a vigorous recovery, rising 19 percent to reach 23 percent of GDP. But the lost earnings from exports to Iraq, including merchandise ready for shipment and payments on previous exports, amounted to US$184 million. Capital Inflows from Arab funds and direct foreign Investment were also Interrupted. Furthermore, because of the prospects of war, the authorities encouraged the buDd-up of stocks, which rose by the equivalent of 3.4 percent of GOP. The outcome was that GDP grew 7.1 percent that year, the current account deficit Increased to 5.3 percent of GDP, and reserves fell from 2.5 months' Imports at end-1989 to 1.7 months' Imports at end-1990. 11. The outbreak of war had immediate and severe repercussions on Tunisia, mitigated only by exceptionaily good rz!nfall. Tourism fell and, because of continulng regional tenslons, failed to recover sinificantly with time. For 1991, the volume of tourism Is expected to be 33 percent less than In 1990. Manufactured exports were also affected and are expected to grow only by 10.0 percent In 1991, compared to a 14.6 percent growth In 19. Allowing for the decline in Imports of Inputs for exports and tourism, the net loss of export eamings in 1991 is estimated at about 5 percent of GDP. That GDP Is still expected to Increase by 3.0 percent Is entirely due to the excellent harvest and the existence of large stocks. The Govemment acted quickly to restrain demand with a supplementary budget In March 1991, which Increased revenue by 1.8 percent of GDP and cut expenditures, thus limitlng the budget deficl to 3.4 percent of GDP. Nevertheless, even with IMF support, reserves at the end of 1991 are expected to be only equal to 1.6 months' Imports.  -5- C. IMPLEMENTATION OF REFORIMS 12. The reforms of the last few years have dismantled numerous constraints on private initiative and have conceded much of the State's dominance of the ecorY'my to the private sector. With the lifting In 1987 of prior authorization requirements on private Investment, the State relinquished Its most powerful Instrumenit for directing private actMty. Prior authorization Is now only required for linvestments for whlch the advanvtages of special Incentives are being sought. A number of activities that were reserved to the public sector, such as 4stribution of agricultural Inputs and Importation o' certain foodstuffs, are now open to private entrepreneurz. A privatization program has been progressing successfully and has about 30 enterprises to its credit. The private sector's share of fixed Investment has also Increased; fron. below 40 percertt In th a late 1970$ it has Increased to over 50 percent In 1988-90. 13. An essential part of the move to the private sector and market mechanisms has been the liberalization of banking since 1987. Prior authorization requirements for almost all credits have been lifted. Interest rates are free except for caps on sight deposits and a cap on deposit bank' lending rates, which can, nonetheless, reach 15 percent as compared to an Inflation of 6-7 percent per annum. One 4 the objectives of liberalizng banking was to create conditions for more effective Indirect monetary mianagemenvt. The development of a money market has been an essentia step in this direction, In 1987, the Central Bank limited rediscounting to providing liquidity at penalty rates and to preferenvtial credits, which are low interes loans accorded under the special Incentives schemes. Also the Central Bank does not normally Impose reserve requirements. Money supply is managed through the Central Bank's weekly provIsion of liquidity through an auction process on the money market, and the "money market rate", by which several other Interest rates In the economy are determined, directly or indirectly, Is the Inter-bank rate. Currently this rats Is 11 7/8 percent. The term "money market" Is used In a wider sense as well, to include certificates of deposits tind commercial paper which were Introduced In 1987-88 and may have maturities of up to five years. In 1989, Treasury bills were Introduced with yields that made them attractive t% ~he general public. These developments are creating new competition In the financilW sector and graduai.y' widening the array of financial Instruments available. 14. Reform of taxation has replaced distortionary and complicated direct and Indirect taxes with taxes that are simple and economically rational, It has already yielded widespread benefits; the removal of numerous fiscal distortions In financial transactions Is a typical example. Under the programs supported by the Bank, a multitude of Indirect taxes was gradually grouped around a few tax rates and then, In 1988, replaced by a value-added tax (VAT) on producton. The VAT was extended In 1989 to wholesale distribution, with the exception of foodstuffs. The c Id system of direct taxation, wh!ch was complicated and uneven In Its Incidence and, consequently, unjust, was replaced In 1990 by new direct taxes on personal Incomes and profits that are simple and low (the maximum rate on Incomes and profits Is 35 percent). In particular their transparency Is ensured by the absence of double taxation, e.g., of profits at the corporate level and dMdends as personal Income. Customs duties have also been towered and simplifie; from over 200 percent fth maximum Import duty has been reduced to 43 percent and the structure of rates has been rationalized, while export duties have been removed from all but a handful of items. 15. These measures have gone far to remove impediments to private enterprise, but the opening of the domestic market to foreign competition has been slower, In 1988 over 90 percent of domestic agricultural and manufacturing production was protected by non-tariff restrictions on Imports. The Govemment has long recognized that Improved economic efficien.cy presupposes that restrictIons on Imports be removed, and had set itself the objective of removing all these restritions, excepting those on .1/ There are I. deposit banks and 8 development banks.  -6 - certain subsidized items of basic consumption and a few luxury goods, by end-1992. But, with the proiciged sluggishness of Investment, the rising unemployment and the effects of the droughts In 1988 and 1989, Its progress haa been hesitant. At present about 70 percent of agricultural and nianufacturing production remains protected by Impon restrictions. The removal of quantitative Import restrictions constitutes one of the most ambitious components of the program supported by the proposed loan. PART II - THE ECONOMIC AND FINANCIAL REFORM PROGRAM 16. The proposed loan would support Tunisia's efforts to restore the economy qu!ckly to adequate and sustained economic growth on the basis of macroeconomic stability, and to formulate and implement reforms tc remove the major remalailng obstacles to the efficient operation of markot forces, while ensuring basic protection to the poor. There wouid be five main areas of reform: (1) One of the major obstacles to efficient markets Is the high level of protection through Import restrictions. Producer prices have been mostly freed but distribution margins are mostly controlled. The reforms will liberalize Imports and most prices. (11) Financial markets are mainly limited to the short term, and the reforms will remove the fiscal distortions and Treasury borrowing practices that obstruct the markets In long-term bonds and equity. The loan wil also support the strengthening of the regulatory framework of banking and the gradual application of higher prudential standaro4. The remalning llmits on lending rates will be removed. (i)ii Tunisia has a system of special Incentives that is Inefficient and costly to the budget. It will be replaced by a unified code that accords a limited set of fiscal and financial advantages for a few clearly defined cases of market failure. (iv) The social security system is costly to the budget ano fails to cover a substantial part of the population, which depends on targeted assistance. The reforms will broaden coverage in a financially viable manner, while providing basic cover to tie needy. The present system of consumer subsidies has been a costly way of helping the poor since all consumers benefit from it, regardless of their needs. The Govemment has formulated a program for reducing its cost, while targeting the subsidies better to the poor. (v) Tunisia will, In the coming years, resort to international financial markets since it has an unblemished debt service record. The loan will support its efforts to create the requisite skills and institutional arrangements to manage these more complex debt transactions. 17. Up to now the emphasis of reforms has been on removing obstacles to the private sector. The reforms supported by the proposed loan will aim at making the private sector more efficlent and ensuring that It Is supported by a sounder and more market orlented financial system. Increasing external competition wHil Improve the efficiency of existing enterprises, and remove the excessive protection that diverted Investment to economically Inefficient activities. Since Tunisia encourages direct foreign investment, the reforms wIll Increase the attractiveness of the economy to foreign capita', especially as a base for exports to Europe. The expected outcome will be a further strengthening of the outward orientation of the economy with the private sector Increasing its z,le and gradually moving to technologically more advanced activitles. At the same time the reform of the social security system will remove some of the hindrances to labor mobility. Reforms of the education sector that the Bank would support through a Higher Education Project would increase the supply of suitable skills. Although some enterprises are likely to close because of the external competition and jobs will be lost as a result, the Increasing growth led by exports is likely to reduce the unemployment rate gradually from its present level of around 15 percent.  -7 - A. THE MACROECQNOMIQ FRAMEWO8K 18. The nacroeconomic objective of the Loan is to support Tunisia In overcoming the effects of the Gulf crisis and enable it to return to the pattem on which it was settling: annual GDP growth rates of around 5 percent with the non-interest current account close to balance and the govemment deflcit dedining from 3.4 peruent of GDP In 1991 to 2.0 percent by 1996. Tables outlining the framework for 1991- 96 are in Annex iii. As already stated, the feasibility of this objective depends on continued Improvement In the efficiency of the economy. 19. Export-led growth. A good part of the efficiency galn would result from the growing importance of non-ogl exports, whose ratio to GDP is expected to Increase from 37 percent to 46 percent over the decade. Although both private and public consumption will be growing slower than GDP, per capita private consumptio Is expected to grow 2-3 percent a year after 1992. Gross domestic saving will Increase modestly from aroundi 19 percent of GDP In recent years to around 22 percent in the second half of the 1990s. The share of Investment In GDP will be lower In 1991 and 1992 than In 1990, but w0i then rise to around 25 percent, well below the levels of the late 1970s and early 1980s, but adequate given the expected higher economic efficlency. 20. A viable balance of payments. By balancing the non-Interest current account, Tunisia would slowly reduce the ratio of debt to GDP from 61.3 percent In 1991 (and about 70 percent In 1987) to around SQ percent by 1997, and the debt service ratio from 25.5 percent to around 15 percent. The current account deficit would decline over the same period from 5.0 percent to about 2 percent. The adjustment to the balance of payments shock of the Gulf crisis wIll occur in 1991 and 1992. In 1992, restriction of consumption growth, through restraints on wages and salaries, wUi permit a reduction of the current account deficit to 2.9 percent of GDP and an Increase In reserves to 1.8 months' Imports. After that reserves wiil grow gradually to 2.9 montis Imports in 1996, not a high level, but within the limits of prudence. Borrowing would be above the exceptionally low average of 1987-89, which was due to specil factors, but the net transfer of resources would be oniy i.6 percent of GDP In 1991 and would decline to zero at the end of the decade, whereas commitments would be In line with past trernds. An Increasing part of the financing would need to come from private sources since official sources will be llmited notably by demands from other countries. Tunisia is well placed to attract direct foreign Investment and Is actively encouragilng it, but a prudent forecas 's that it will remain roughly equal to 1.4 percent of GDP rising from US$185 mllon in 1990 to US$262 million In 1996. 21. Greater reliance on financing from private sources will entail Improved management of extemal debt. Tunisia has never needed to reschedule its extemal debt and has had a good track record of timely servicing. However, greater access to financial markets, by the Central Govemment as well as the domestic banks and enterprises, will require a new level of skills and Institutional capabilities. The proposed Loan would support measures for better coordination of debt management among the various govemment entities, creation of a unified data base, and modemization of legislation to facilitate normW hedging and borrowing (see Annex 1). While no specific tranche conditionality is being attached to this component, It wuil be part of the overall review of the development policies. 22. Relative decline of the public sector. The shares In GDP of the govemment's revenue, expenitures, and deficits will decline steadily. Expenditures will fall from 31 percent of GDP In 1991 to about 26 percent In 1996 anci the deficit from 3.4 percent to 2 percent. The trend of recent years d an Increasing priate sector share In fixed Investment by enterprises will continue, while fixed investments by the central govemment wil, decline modestly as a share of GDP.  -8 - 23. The budgetary cost of the reform program. The projectlons of the Govemment budget take into account the Implementation of the reforms supported by the loan, whose net effect, on present estimates, will be a marginal loss. Large costs due to some measures are almost offset by gains due to others. Most of the losses are likely to arise from the reform of the banking system (see paragraph 45). The remaining significant losses will arise from the Treasury's transition to borrowing on market terms, !nstead of at the low Interest rates on its bons d'eauloement, and its eariy redemption of most of the outstanding stock of the bons d'4auioement. The main offsetting gain will be the revenue generated by temporary surcharges as Imports are liberalized (see paragraphs 25-26). A smaller saving will be obtained from the reform of special incentives, through reduction of tax advantages and Increases in the costs of preferential credits (see paragraphs 49-51). At this stage these estimates are tentative. Reliable date on the costs of banking reform will only be available once the prudential reforms this loan would support are In place. Similarly the extent to which the Treasury recoups the costs arising from the reform in its borrowing practices wIll deperid on the effects the reform program has on the behavior of the financial Institutions that hold its paper. Estimates of revenue gains from Imports are based on econometric analysis, but are sensitive to changes In a number of economic parameters. Because of these uncertaintles, the banking reforms and macroeconomic program give particular emphasis to monitorlng the budgetary Implicatlons of the reforms. Monitoring Macroeconomic Performance 24. Macroeconomic performance would be monitored through reviews on the basis of a periodilcaiy updated framework and selected economic Indicators (see Table 2). The framework will be next updated after the establishment of the program for 1992 with the IMF. These indicators would not be performance criteria, but deviations from forecast values would be the basis for discussions between the Tunisian authoritles and the Bank on corrective measures. Such corrective measures would Indude demand management through policies on credit to the economy, government expenditure, wage and salary movements, and exchange rate policies. The indicators would be updated every six months on the basis of data fumished In advance of the discussions by the authoritles. Table 2: A C INDICACRS (in percent) l99n 1991 1992 1993 1994 1995 1996 GDP Growth 7.1 3.0 2.8 4.8 5.2 5.2 5.1 Current Account/GDP 5.3 5.0 2.9 2.9 2.5 2.5 2.2 Budset Deficit/GDP 3.8 3.4 2.7 2.5 2.3 2,2 2.0 Debt Service/GDP 11.2 11.1 10.3 9.1 8.5 8.3 7.6 Net Transfer of Resources/GODP 1.1 1.6 0.5 0.9 0.8 0.7 0.6 Manufactured Exports Growth 14.6 10.0 7.9 7.8 7.5 8.0 8.0 Private Borrowing/ Total Borrowing 71.9 61.9 64.5 68.3 70.6 71.3 71.9 Budgetary Interest Payments/ Government Revenue 10.9 10.7 13.6 13.4 12.9 12.5 12.0  -9v Viability of the balance of payments. Tunisia Is In the position of being able to reduce its external debt burden gradually, without recourse to debt relief, while avoWing a net transfer of resources out of the country. This Is the path taken In the macroeconomic framework. But the plth Is narrow. Hence, to monitor whether the economy is moving along or off the path, the two appropriate Indicators are: (a) the ratlo of total external debt service to GDP, and (b) the net transfer of resources. Export performance. Part of the outward orientation of the economy consists In tiie growth of non-oil exports. But, since of the two major non-oil exports, manufactures and tourism, tourism Is more subject to external Influences and less to domestic policy, the Indicator most suitable for policy decisions Is the growth of manufactured exports. Private sector access to resoutrces. To ensure that the private sector Is not crowded out, its access to resources needs to be monitored. The most appropriate Indicator, which is the one that will be monitored, Is the share of the private sector In total net domestic and external borrowing. The viability of the govemment budget. Since budget deficits are almost entirely financed without recourse to the Central Bank, the accumulation of Govemment debt needs to be monitored to ensure long-term stability, especially since the cost of domestic borrowing wfll be Increased by the reform program (see paragraphs 31-32). One indicator would be monitored: the ratio of budgetary interest payments to Govemment revenue. B. TRADE. PRICES AND COMPETITION 25. Import liiberallzatlon. An essential conditlon for achieving the improvement In economic efficiency that the Government Is aiming for will be a substantial reduction in the degree of protection of domestic prodbuction from external competitlon. At present, about 70 percent of production In manufacturing and agriculre Is protected by Import restrictions. There is, however, no black market premium on foreign xchange, which indicates that the figure of 70 percent may overstate the protection. One reason mnay be that restrictions apply to production categories that weigh heavily In domestic production, but are mostly export oriented. Another is that the authorities readily permit Imports where shortages or monopolistic behavior might occur. Under the program supported by the loan all Import restrictions will be lifted by the end of 1993, except for goods accounting for two thirds of textile production, subsidized artides of basic consumption, a few luxury goods not produced In Tunisia, and security related items. Yam Imports will, however, be free in 1993 and the Government Is committed to liberaltzing all textile Imports In 1994. 26. Before the gains from this rapid liberalization of Imports can be reaped, many segments of the economy will go through a difficult transition since the level of tariff protection Is moderate. The highest Import tariff is 43 percent and the unweighted average Is 28 percent. The authoritles are especleily concemed about unemployment that could result from enterprise closures caused by liberalization. Urneployment has crept above 15 percent and the authorities feel they have gone to the brink with job losses from dosures and restructuring of public enterprises. These concems and the temporary job losses caused by the droughts delayed trade liberaization In the past. The authorities, therefore, propose to ease the transition for enterprises that wHil face Increased external competitlon by instituting a system of temporary surctwges for a nwdmum period of about three years. They will also follow a detaied timetable that wlil be announced In advance to remove uncertainties that might arise over the timing of the liberalization for indvdual products. The Bank's proposed Industrial Finance Loan would support enterprises In  - 10- Implementing plans to adapt their production and products to Import competition, and also support the acquisition of the technical capabilities needed to design and carry out such plans. 27. Distulbution margins. Calculated using domestic production weights, only 29.8 percent of distribution margins are free. The Government aims to free all distribution margins, Including those on imports, by end-1994. The choice of date Is determined by the lack of competition In distribution. The number of wholesalers In any product Is small because of administrative restrictions on entry, which have recently been lifted through legislation prepared under the SAL program, and the authorities believe that a year Is needed between the liberalization of the Import of a good and liberalization of Its distribution margins to give time for the growth of competition In its distribution. Given this objective, 60 percent of distribution margins, measured using absorption weights, will be freed by end-1993. This would be equivalent to 72.5 percent measured using production weights if all the goods concemed were domestically produced. 28. Producer prices. Over 70 percent of production prices are free and the remainder will be freed during 1992, w:'th t.he exception of natural monopolies and subsidized articles of basic consumption. C. THE FINANCIAL SECTOR 29. Having made substantial progress in liberalizng banking and developing the money market, the Tunisian authoritles are taking steps to extend the role of market mechanisms in the financial sector and to strengthen the supervision and prudential regulation of banks. As outlined In paragraph 13, prior authorization requirements on bank lending have been lifted and Interest rates are largely free. Moreover the money market Is an effective short-term market and has been the scene of financial innovation. The next step will be to develop other financial markets. The Government's program will remove the obstacles to the effective operation of markets in fixed Interest securities of all maturities and In equity. Tunisia's system of banking supervision and prudential regulation is more complete than in most developing economies, but the authorities recognize that it needs to be strengthened to meet the needs of a liberalized banking system. Hence, the Govemment's program will, In stages, bring the supervislon and prudential regulation of banks Into conformity with international standards. The program will also remove the last administrative control on lending rates. Financial Market 30. The two maln steps In developing financial markets are to remove obstacles to the avaiablity of bonds (maturities of more than one year) and shares for trading, and to reduce the fiscal advantages of certain liquid bank accounts that attract savings away from bonds and shares. To remedy the dearth of bonds and shares that can realistically be traded, which prevents the development of secondary markets, the authorities will reform the Treasury's borrowing practices, replace most of the stock of bonds Issued by the Treasury at below-market yields, and remove the fiscal distortions that discourage resale of bonds or shares. The mark3t framework is satisfactory, as a result of recent reforms and training programs In the bgurse. on which bonds and shares are traded, and these measures will extend the operation of market mechanisms beyond the confines of the money market. A successful first step beyond the money market occurred In 1989 wlth the introduction of Treasury bills (maturities of less than a year, which offer yieds of around 10 percent, enough to make them attractive to the general public and enterprises, and which are freely bought and sold through the banks. For comparison, inflation is 6-7 percent per year and the current money market rate is about 12 percent.  - 11 - 31. Treasury paper. The emphasis on Treasury paper Is due to its preponderance among bonds. The total stock of bonds, Treasury and corporate, was about TD 1,565 million at end-1990, and TO 1,276 million consisted of bons d66aulpment, ten year bonds with coupons of 8 1 /8 percent, whose yields are too low to attract voluntary purchases.2 But deposit banks are obliged to hold up to 20 percent of their deposits In these bonds, and held TD 964 million at end-1990. Virtually all the rest were held by insurance companies, which must place 50 percent of their technical reserves in these bonds, and social security funds according to agreements with the Treasury. The low yield represents a tax on the financial system ancd, if the bonds were to be resold, it would be at a big discount entailing a realized capital loss. Because of this and tax distortions affecting the resale of other bonds, the face value of bonds that can realistically be traded on the bourse is only TD 120 million. 32. To permit the resale of its paper, without capital losses, the Treasury will issue new bonds at market yields and redeem all bons d'6quipement issued after 1988 by 1996. Wth the simultaneous maturing of the older bons d&6auipement, at most 33 percent of the present stock would be outstanding at the end of 1986. The additional cost to the Treasury from the redemption will rise gradually to TD 53.4 million in 1996. No bons dcl'uiDement will be issued after 1991. To facilitate the redemption of these bonds deposit banks will, for the time being, continue to be obliged to place 20 percent of their deposits in Treasury paper (including short-term bills), but they will be able to purchase the paper on the secondary market if they choose. The possibility of reducing the 20 percent requirement will be reviewed before third tranche. The obligations of Insurance companies and social security funds will be addressed under the Investment guidelines that will be adopted as part of the reform of the social security system (see paragraph 55). 33. Taxation of bonds. The removal of fiscal distortions that discourage resale of bonds will also accelerate the supply of bonds available for trading. These distortions have held back trading, although the Treasury has allowed corporations to issue bonds more frequently In recent years and the need for its approval was lifted in June 1991. The Government has also twice issued bonds at yields that attracted the general public, the Emprunt National, amounting to TD 112 million outstanding at end-1990. But roughly half of every boncd Issue Is designated 'A' bonds, meaning that primary purchases can be deducted from taxable Income up to a limit of 35 percent, provided they are held five years (Law 62-75). They have lower coupons than "B" bonds, which are taxed normally. In addition sectoral Investment codes also offer tax Incentives for the reinvestment of eamings In certain primary Issues. Consequently, the only bonds that are Issued at near market terms and hence avallable for trading are the "B' bonds. 34. Taxation of shares. The removal of fiscal distortions caused by the Law 62-75 will also Increase the availabiity of shares for trading since the law offers the same advantages for the primary purchases of shares as for bonds, provided the shares are held two years. Another stimulus to the supply of shares wUi come from the reform of the sectoral Investment codes (see paragraphs 47-50). These codes encourage debt financing and reinvestment of eamings In equity, thus reinforcing the propensity In Tunisia for families and small groups to maintain control over firms. Hence they llmit the supply of shares and deter the public from buying them. Nonetheless, the mobilization of financing through share Issues will only develop gradually since pattems of ownership and financing will not change quickiy and since the public wil take time to gain confidence In Investments In shares. 2/ dons d'4auliement Issued before 1989 carried coupons of 6.5 percent but carried tax advantages that made their yield the equivalent of the later Issues. They are not being redeemed before maturky because of legislative complications that would arise from the tax advantages. At end-1991 they will account for about 40 percent of the face value of all bons d'gauloement.  - 12 - 35. TaXation of mutual funds. Reform of the taxation of bonds and shares will make it easier to solve the tax problems that have obstructed the Issue of open-end mutual funds. A few closed-end funds (StCAFs) have been issued on the basis of special tax arrangements with the authorities, but open-end funds (SICAVs) face two problems. One problem arises from the transparency of the new direct tax laws Introduced in the Loi de Finances for 1990, whereby profits taxed at the corporate level are not again taxed as personal Income. This means that the dividends paid by a SICAV would either not be taxed as personal Income, thus permitting the SICAV's eamings on bonds to go untaxed, or the SICAV's earnings from equity would be taxed twice. The other problem is that SICAVs would be at a disadvantage compared to directly held shares In that they could not benefit from the Law 62-75. Two alternatives are to separate dividends arising from fixed Interest securities and shares, or to apply a moderate withholding tax. 36. The tax treatment of special saving accounts makes it difficult for secondary markets to compete against banks for savings. These accounts are sight deposits, using passbooks and not checks, intenided to attract small savings to banks by offering Interest at two points below the money market rate, though the cap on sight deposits Is otherwise 2 percent. There are no other administrative controls over Interest rates, but the liberalization of sight deposits rates Is Inadvisable before the program of reform of prudentla regulation of banking Is carried out (see paragraphs 39-40). These deposits are llmited to TD 5,000, but banks accept much larger deposits since they are cheaper sources of funds than the alternatives and since an Individual can have an account in each of the twelve deposit banks. Their attraction to big savers was that they were tax exempt until 1990, and even now the first TD 1,000 of Interest remains tax exempt and the retention at source of 10 percent is lower than the 15 percent for other Instruments. Other less liquid Instruments cannot easily compete. Since the authorities wish to maintain the original pur,jse of helping small savers, they are considering reducing the fiscal advantages of these accounts. Hiwever, since this requires more controls to ensure that the limits on the accounts are observed, they are also considering the alternative of reducing the Interest on savings deposits by one point. 37. Fiscal reforms. A new law on taxation of savings and financiainstruments will be promulgated In the Lol de Finances for 1992. Among other things, it will: (1) maintain the transparency of direct taxation and avoid multiple taxation; (ii) encourage net investment In financial instruments, without distinction between primary and secondary Issues; (Ii) remove obstacles to the Introduction of open-end mutual funds; and (iv) bring taxation of bank deposits Into line with taxation of other Instruments. SuRoerislon and Prudential Regulatlon of Banks 38. Although not up to Bank for Intemational Settlements (BIS) standards, the supervision and prudential regulation of banks In Tunisia are moderately good and have enabled the Central Bank to manage the recent liberalization smoothly. They also give reasonable assurance that the danger of a financial crisis In the near future Is minimal, despite the considerable number of loans made In eariler years with Inadequate attention to financila viability. Nonetheless there are major shortcomings and some banks have Inherited problems from the past. The program to address these Issues will have four components. One will strengthen the Central Bank's prudential regulations. The second will strengthen on-site examination and surveillance of banks. The third wili introduce amendments to banking legislation. And the fourth wvil consist of auditing, Inspection and action programs to bring banks gradually up to BIS standards of capital adequacy. The first three components will occur during the loan period, though further Improvements can  -13 - be expected after that. The fourth Is likely to take several years and, therefore, will stretch out after the loan Is closed. 39. Prudential regulation. The reforms will build on the existing regulations. The present loan dassiflcation system (substandard, doubtful, losses), which was introduced In 1987, has subjective criteria that have functioned well. its objective criteria will be made more stringent by shortening the seniority of arrears to international norms (90, 120, 360 days). Minimum provisioning rules, also corresponding to Intermational norms (20 percent, 50 percent, 100 percent) and Interest suspension will be Introduced for all categories of classified loans. Tax exemptions for speciflc provisions will be raised from 20 percent to 26 percent and the advisability of a higher exemption will be studied. The calculation of t.ne seniority of arrears will not be affected by loan renewals, extensions, or rescheduling, unless interest Is effectively paid. Reschedulings will be closely monitored and any Interest capitalization will be subject to new guarantees and a satisfactory respect of the new terms. Furthermore, any lack of information to evaluate a loan or a deterioratlon In the borrower's capacity to generate cash flows will also affect the classification of the loan. The new rules will also apply to overdrafts. 40. The rules governing lending limits and capital adequacy will also be made stricter. The present exclusion rules regarding lending limits will be abolished and a satisfactory definition of groups of related borrowers will be introduced to include other financial or commercial relations that may affect final repayment. The maximum lending limit will Initially be fixed at 40 percent of capital and progressively reduced to 25 percent by third tranche, at which point excesses over the limit will be penalized by an additional charge on capital. In most respects the present welghting of a.'sets follows BIS recommendations, though capital adequacy Is set at 5 percent of risk, not at the 8 percent of the BIS. The shortcomings In the welghting will be addressed by weighting fixed assets and off-balance sheet risk, and by ralsing the welghting of equity holdings to 100 percent. 41. On-site examination and surveillance. The Central Bank will Increase the emphasis on on-site inspection, which has up to now been less concemed with asset qualitv and more with the observation of administrative controls. To strengthen its capabilitles in this respect, the present Inspectlon and control departments will be reorganized, with detailed specifications of their respective functions and modes of collaboratlon. The Inspection Department staff will be organized Into groups, each of which will be In charge both of examination and off-site surveillance of a number of banks. The groups wiil work according to recurrent targeted examinations of the quality of assets, sufficiency of capital and loan provisioning, the accuracy of eamings figures, and the quality and weaknesses of the management processes. Written examination methodologies are being prepared for them. To enable the Inspection Department to fulfl its Increased responsibilities, new Inspectors wHl be recruited and training programs Instituted. The Control Department will develop a new set of prudential returns Introducing more rigorous accounting practices, and develop a new data base with a financial analysis model to detect anomalies and shifts In performance trends. It will receive the reports fumished by the banks, auditors, and Inspectors and will make them avalable to the Inspectors In appropriate format. 42. Banking legislation. The liberalization of banking will require substantial changes in banking leglslation. Tne Central Bank has extensive generally defined powers, which are backed by the prestige it enjoys because of the quality of its staff. These have proved adequate so far In managing the changing banking sector, but, with the sectores further evolution and the entry of torelgn capital, some of the rules wlil need to be made explicit and some modified. The existing Banking Law will be considerably amended to endow the Central Bank with powers to enforce sound prudential practices, and impose financial discipline on banks, as well as on their boards and managers. The amendments will Include a new regime for licensing banks; a definition of the responsibilitles of bank directors; powers for the Central Bank to regulate and Inspect banks and to enforce compliance with regulations; powers for the Central Bank to issue orders to banks, to Impose penalties on banks, and to Initiate the process of Imposing sanctions on  - 14 - bank managers or directors; the definition of the different stages of deteroration of bank capital and the corresponding actions that the Central Bank would undertake; and, finally, the rights and powers of the Central Bank to intervene and resolve complicated problem cases. 43. Auditing and strengthening banks. As prudential regulations are revised and supervisory capabilities improved, the authorities will implement a program for auditing and inspecting banks; and for formulating and carrying out actions to strengthen banks where necessary. Accounting principles and rules for minimum Information that banks need to disclose to the public will follow international norms. This will be aided by the new supervisory reporting requirements for banks, which will ensure greater frequency of reporting and provide a frame of reference for achieving more homogeneity between banks in internal accounting. These reporting requirements will also lead banks to improve their internal information systems so as to enable managers and the supervisory authorities to monitor better credit and market rlsk. International auditing standards and practices will be adopted as well. In addition to following defined accounting principles, they will cover, through "long reports", Issues such as Internal controls, the types of adjustment carried out or recommended, and the Integrity of the bank's capital. The Central Bank's inspection department will have the authority and responsibility for monitoring the quality of auditing and have access to the auditors and their working papers. At present there is a shortage of auditors who can meet the guidelines regarding qualifications and experience, so that there will be reliance on international firms, training and creation of partnerships. 44. The objective of the Tunisian authoritles is to attain BIS standards for capital adequacy over a number of years. With the more stringent rules governing provisioning, interest arrears, lending limits, off- balance sheet risk, and own funds, it is likely that some banks will not meet the present 5 percent capital adequacy requirements. To meet the 8 percent requirement of the BIS, the authorities are adopting a medium-term program to strengthen the banks. At the same time they will address the Issues of loan concentration and exposure to subsidiaries, which may be substantial In some cases. Initially banks that cannot meet the new prudential requirements will be granted except' ins on condition that they formulate and Implement satisfactory action plans to make the exceptions unnecessary. The prudential requirements, notably capital adequacy, lending limits and exposure to subsidiaries, will be progresstvely made more stringent. 45. The costs cannot be estimated until the new accounting rules are applied, but they will Inevitably be widely borne. As far as possible capital increases and provisioning will be used. The State may contribute capital In some cases, but private shareholders and some of the bilateral agencies that provided some of the capital of development banks may hesitate, having Incurred losses on loans that were made at the behest of the State when lending was regulated. On the other hand, Tunisia has had some initial success In attracting foreign banking capital. The cost of provisioning Is partly bome, through larger bank spreads, by depositors and partly by borrowers, Including the State, which will pay higher IntE .est on its bonds. The State will also assume the costs of some loans to public enterprises. Finally, some banks may be merged or taken over. Lending Rates 46. The last remaining administrative constraint on bank lending rates, a cap of three percentage points on the spread between the Interest rates on loans of deposit banks and the money market rate, wiil be lifted by endi-1993. The cap Is applied out of concem that collusion between banks might raise lending rates unjustiflably t.igh. The authorities had committed themselves, under the SAL program, to removing the cap as soon as competition In lending was adequate. Recent data confirm that action should be taken soon. Competition between banks In lending has Increased, spurred on by the rapid growth of the commercial paper market. Moreover, the current high money market rate presents a good opportunity;  - 15 - since only 30 percent of loans are close to the cap rate, the likelihood of a significant Increase In lending rates Is small. Nonetheless, even though Tunisian banks have so far tended to caution, there is the possibility of risky lending by banks before the new prudentia controls become effective. To guard against this possibUiity, the complete removal of the cap will be preceded by a transition phase in which the cap will be applied to the average spreads of each bank's lending rates over the money market rate. D. SPECIAL INCENTIVES 47. An Important component of the Improvement that the Govemment Is bringing about in the structure of Incentives Is the reform of the system of special Incentives. This reform will be a major change, since ft will break from the sectoral basis on which these incentives have been designed. These incentives are provided by a number of sectoral investment codes, and a system oT rediscounted preferentiW credits, both originating mostly from the period of economic dirigisme. The Govemment will limit special Incentives to a few clearly defined objectives, replacing the vertical, sectoral approach by the use of horizontal criteria, and wiil reduce their substantial cost. Among the objectives most likely to be chosen are the promotion of exports and of regional development, the trar9fer and assimilation of technology, and the protection of the environment 48. At present the special Incentives are offered on a sectoral basis, which renders them costly and Inefficient, while making it difficult to focus them on a few cross-sectoral objectives. At present there are several investment codes: industry, Agriculture anid Fishing, Services, Intemational Trading Companies, Tourism, and Housing. Since each pursues numerous objectives, most activities are eligible for their advantages. Consequently, although they may affect the form of financing, they probably have little effect on the decision to Invest but merely compete among themselves. The minority of activities not covered by such codes, however, are disadvantaged and create pressure for more codes. For instance there was a recent proposal for an Artisan's Code. 49. The advantages available under the present investment codes are also overly generous. Since Tunisia's domestic market is small, there has been a tendency to try to compete with other countries in providing incentives to encourage Investments that can help diversify and expand output and exports, and this has affected all sectors. The fiscal advantages amount to a parallel tax system that greatly reduces the benefits of the excellent reform of direct taxation that took effect In 1990. The extreme case Is that of exports which can be exempt from all taxes and, since income from prois is only taxed at the corporate level, dividends also escape tax. In other cases tax exemptions can be for as long as ten years. Tax reductions are also given for reinvested earnings (see paragraphs 33-34). The codes provide financial advantages in the form of financing at below market rates mainly through preferential credits that can be rediscounted at the Central Bank. These preferential credits, which currently represent about 13 percent of total credit to the economy, are granted at Interest rates as low as 8-11 percent. They are available for a number of narrowly defined activites, such as expoft prefinancing, and roughly 45 percent are short term. They are almost always fully recovered. 50. Recognizing that the Incentives had become too generous, especially since the reform of direct taxation had removed much of the justification for certain fiscal advantages, the Tunisian authorities have already taken measures to reduce them. All enterprises, excepting those that export all their output and financial institutions, are subject to a minimum tax of 10 percent on eamings since 1990 and the tax deductions on reinvested eamings has been substantially lowered. The generosity of preferential credits has also been reduced: since 1987 the share of these credits In total credit has been roughly halved and their Interest rates have risen on average by over two poirnts.  - 16 - 51. The major reform will be the abrogation of the existing sectoral investment codes and their replacement by a unified code offering a llmited set of special Incentives aimed at the oblectives defined by the Govemment. The unified code will be formulated In 1992 on the basis of a study to be carried out by the Tunisian authorities, and will be adopted, with its implementing legislation. in 1993. Measures to reform fiscal advantages will take effect in 1993. This will limit the duration of the advantages, with a tapering off in the last years of the exemptions, and will narrow the basis for eligibility for tax exemptions on the basis of the objectives of the unified code. The code will Include a reform of financial advantages. It will determine what types of financial advantages, if any, will be available. If the system of rediscounted preferential credits Is retalned, on account of the advantages of these credits being fully recovered, the allocation of these credits will be determined by the new criteria of the code. To ensure Impartial and consistent application of the unified code, final decisions regarding eligibility of Investment proposals will be taken through a centralized procedure, which would be Independent of the sector ministries, most likely under the auspices of the Ministry of Planning. If the sectoral agencies applying the present codes remain, their role will be to clear investment proposals in their sectors before submission to the centralized procedure. During 1992 the Tunisian authorities will follow their usual practice of preparing for the reforms by extensive consultations and public information efforts. E. SQCIAL PROTECTION Social Securiy Funds 52. Among the benefits of consistent emphasis over a long period on socA development is the relatively low Incidence of poverty. Less than 10 percent of the population lives In absolute poverty, and signs of grinding poverty are strikingly rare. Social development was accompanied by the creation of an extensive system of social protection consisting of a number of social security fundis covering major lifecycie risks ancd a system of targeted assistance. Almost every Tunisian can, In theory, be covered by the former. However, the social security system has certain major Inefficiencies. One consequence Is that lower Income groups receive little cover for major lIfecycle risks, with the result that too many people avail themselves of the targeted programs at a substantial cost to the budget. Another consequence is that the system Is too Inflexible to provide even the well-to-do with much choice In the coverage available. The need for reform has become more pressing In the eyes of the authorities because of the decline In population growth (see paragraph 9) and the possibDlity that budgetary outlays for social protection will Increase In the medium termn as the proportion of the costs of social protection bome by the social security funds decines. Since the reforms will be complex, being Intertwined with long-standing contractual obilgatlons and thie consensus on which labor relations are based, they will need to be prepared carefully and, as with all major reforms In Tunisia, wIll be preceded by extensive discussions with all affected parties. Hence, the desire of the authoritles to begin now the process of determining the possibilities and elaborating the reforms. 53. The social security system Is highly fragmented, and one preliminary step to the rain reforms will be to introduce a single identifying social security numbering for the whole system. There are several furnds (cisse-s; the CAVIS provides pension and Invalidity benefits to about half the population; Xt CNSS provides health care, disability, and, through the CAVIS, pension benefits for the private sector and some public enterprise employees; the CNRPS provides the same benefits for most of the public sector, and the CREGT the same for workers In gas, electricity and public transport Benefits and contributions vary widely from fund to fund and, In addition to creating Irequalities, complicate the movement of labor. Procedures are In place for transferring beneflts with changes in employment, but they are necessarily cumbersome. A unified Identification numbering will help simplify such transfers and is, In any case, necessary for creating a more flexible and homogeneous system In the future.  - 17 - 54. The Govemment's reforms wUi draw more people into participating in and contributing to the social security system by linking benefits more closely to contributions. A major inefficiency of the system Is that, although virtually every citien can participate In a fund, the Incentive may be lacking for the person and for the fund. This Is especially the case for health care, which roughly haff the population Is able to obtain free or at reduced cost. It Is also true of pensions, since the young, especially if they have good family support, tend to neglect providing for old age. In both cases the funds have littie Incentive to seek those not yet particIpatIng, since they are likely to attract high risk groups. The consequences are that the CNSS finances only 20 percent of the cost of publicly provided health care and the budget the rest, while the CAVIS Is running deficits. 65, The reform would also Institute guidelines for the Investment of the reserves of the funds. Another Inefficiency has been that the reserves of the funds (and of the Insurance companies) have been used for a variety of purposes that are not normally the function of social security systems nor for what the contributlons were Intended. In particular, until recently, funds and insurance companies had to Invest malnly in bons d'4auIUement as part of their obligations to support the flnaneing of economic dwelopment. Other uses of the fundis' resources have Included "social housing' rented to low income groups. As a consequence, the reserves of the funds are Illiquid, unremunerative, and are being depleted. The reform of the guidelines will ensure prudent and remunerative Investment of the funds' reserves, which will be facilitated by the reform of the Treasury's financing (paragraph 32). 66. These reforms will lay the ground for a system proviiing optional Insurance, while assuring a baslc minimum cover for the poor compatible with budget constraints. The first step will be to revise the structure of contributions and benefits, which would be done on the basis of analyses to be carried out by the Tunisian authorities. Backed by the new Investment guidelines, these revisions will aim at making the funds financily viable. The need to keep the cost of labor in line with productivity will set the limits on contributions and, hence, on benefits. The revisions will also allow the introduction of more choice in the types of cover avaiable. The establishment of a financially viable optional system will allow private sector entry, both through participation In the existing funds and through expansions of the Insurance system. 57. By drawing a larger population Into voluntary participation In the social security system, the reforms will release budgetary funds that can be used for protecting the really needy. At present this protection comes from a variety of sources, but is largely confined to sustenance, health care, and some school materials. One source has been food subsidies, which will be maintained with better targeting to reduce their cost (paragraph 58). Similarly the poor can obtain free health care, as referred to above, and direct assistance through several programs, some of which depend on external grant financing. But they are not covered against other major lifecycle risks, such as Invalidity, disability, unemployment, and old age. As a first step, the poor will be protected through a basic minimum cover to be Introduced In 1993. The exact form of the cover wDi be determined In the light of studies of the needs and budgetary constraints. This could lead to a universal system of basic cover, to which all would contribute, unless needy or unemployed, ancd which would provide benefits on proof of contribution or exemption from the obligation to contribute. The Tunisian authorities will also examine the possibility of Introducing unemployment insurance to cover losses of jobs, especially as it will reduce pressure to restructure or close enterprises. Conscume Subsidies 58. The present system of consumer subsidies is an Inefficient way of helping the poor since It subskizes prices and, hence, benefits the better-off to the extent that they consume more of the same products than the poor. The items subsidized consist of basic articles of consumption such as certain wheat prodlucts, milk, sugar, and vegetable oil, and some agricultural inputs such as fertilizers and animal food. Since these Items are widely consumed, their subsidies have high budgetary costs and are politically sensitive. The authorities have been reducing the subsidies In numerous smnall steps, taking care that the  - 18 - effects are greatest on items consumed more by the less poor. By eliminating some subsidies, e.g., meat, increasing prices gradually, and cutting the operational costs of the system, they have brought the tota of these subsidies down from 4.2 percent of GDP In 1984 to 2.9 percent in 1990. The SAL of 1988 supported the preparation of a study on alternative strategies and the formulation of a medium-term government program. The program was adopted In 1990 and envisaged (i) continuing price increases, (li) cost reductions, and (II1) targeting through quality dierences by subsidizing only quaiities of bread, vegetable oil, sugar, and milk consumed by the poor. PART IlIl - THE PROPOSED LOAN A. LOAN AMOUNT. TRANGHING AND CONGITIONALITY 59. The proposed loan to the Republic of Tunisia Is for US$250 million equivalent. This amount has been determined oni the basis of the country's balance of payments needs and prospects for 1992-93, as well as the avallability of cofinancing. The proposed loan and Its cofinancing constitute an Integral part of the country's external financing program. 60. The proceeds of the proposed loan would be disbursed In three tranches: US$100 million upon loan effectiveness, and US$70 million and US$80 million after the completion of a number of key actions for the second and third tranci ;e releases respectively. Release of the three tranches is planned for end-1991, end-1992 and end-1993, respectively The specific actions to be monitored and their implementation program sre described below: 61. As conditions for first tranche release: (a) Trade and prices: (i) 15 percent of imports subject to quantitative restrictions, and (ii) 10 percent of distributlion margins, both measured In terms of 1989 domestic production weights, wil be liberalized. (b) Financial markets: (i) the adoption of a 4-year program (1993-1996) for redemption In equal amount of the bons d'6guIlement not benefiting from tax advantages; (ii) issue of a Central Bank circular to permit banks to hold up to 20 percent of their deposits In any Treasury securities and not Just bgLig d'&guioement; (ill) Inclusion In the Finance Law for 1992 of satisfactory provisions on the taxation of financiainstruments; and (iv) replacement of the cap on the spread of deposit banks' lending rates by a cap on the average spread. (c) Bankng suprvision and prudential regulation: (I) adoption by the Central Bank of a program to reinforce its supervision services, (il) adoption of satisfactory provisioning and classification rules to be applied from January 1, 1992; (iQi) fixation of loan concentration ceiling at 40 percent of banks' own funds and adoption of a satisfactory definition of the concept of group of related borrowers; (iv) definition by the Central Bank of audit practices for financial institutions and elimination of the ceiling on the costs of audits for the long report; and (v) adoptlon by the Central Bank of measures requiring the banks to communicate to the BCT quarterly profit and loss accounts. (d) Special Incentives: a 1 percentage point Increase In the rates of the preferentia credit rediscourted at the Central Bank.  -19- 62. As conditions for second tranche reae: (a) Economic performance: Satisfactory macroeconomic framework. (b) Trade and prices: A 30 percent reduction in imports subject to quantitative restrictions, weighted by 1989 domestic production, with respect to M;ay 1991. Reach liberalization of distribution margins for at least 40 percent of goods based on their 1989 domestic absorption value. (c) Financial markets: Promulgation of the law on the taxation of financia Instruments and Implementation. (d) Banking supervision and prudential regulation: (i) tax exemption of specific provisions and Interest suspension to be raised from 20 percent to 25 percent; (ii) reduction of the loan concentration limit to 35 percent; (iii) adoption of auditing principles conforming to intemational practices to be used by banks' auditors; (iv) presentation of a satisfactory draft banking law to the Chamber of Deputies; (v) Issue of a Central Bank circular on accounting and statistical documentation to be fumished by the banks starting on January 1, 1993; (vi) joint revilew of the situation of each bank, and action plans aimed at strengthening banks already audited; and (vii) adoption of a program of special audits and diagnoses for at least 2/3 of the assets of the banking system. (e) Special incentives: (i) adoption of satisfactory measures regarding (a) the limitation of the duration and the selectivity of tax advantages, to be included In the Finance Law for 1993, and (b) the financial advantages; and (li) a further 2 percentage points Increase In the rates of the preferential credit rediscounted at the Central Bank. 'f) Social security: issue of guidelines for the Investment of fund reserves. 63. As conditlons for third tranche release: (a) Economic performance: Satisfactory macroeconomic framework. (b) Trade and prices: (i) liberalization of all imports with the exception of certain agreed items; and (Hi) reach liberalization of 60 percent of distribution margins based on 1989 domestic absorption (equivalent to 72.5 percent of domestic production If all the goods in question were domestically produced). (c) Financial markets: (i) implementation of the program of redemption of the bons d'iqulpement; and (Hi) elimination of the cap on the spread of lending rates. (d) Banking supervision and pruderitial regulation: (i) reduction of the loan concentration limit to 25 percent and obligation for the banks to Increase their capital accordingly if such limit is exceeded; (ii joint review of the situation of each bank and implementation of the action plans taken to strengthen banks already audited; and (iiiJ special audits of banks to complete the coverage of the banking systerm (e) Special incentives: adoption of a satisfactory Unified Code of Investments and implementation of measures to reform the preferential credit system. (M Social security: adoption of a satisfactory program to reform the soia security system.  -20 - B. CQFINANCING 64. Given TunisLi's external financing needs, cofinancing is being sought. The European Commisslon will decide on providing cofinancing of around US$50 mililon at the end of November 1991. The Govemment of Japan Is expected to provide cofinancing of US$80-100 million. The Govemmant of Germany Is also examining the possibility of providing cofinancing. C. BENEFITS AND RISKS 65. The proposed loan would support the completion in all malor respects of the liberalization of the Tunisian economy and would permit market forces to operate effectively. The Eighth Plan and the discussions with the Govemment attest to Tunisia's commitment to these objectives. However, the experience with the SAL has shown that exogenous factors, such as severe droughts and regional tensions, can complicate the Implementation of measures that cause unemployment or hardship for the poor. Leaming from the past, the likelihood of smooth implementation of the import liberalization program is being maximized by the early announcement of the liberalization schedule, the system of temporary surcharges, and by gMng viable enterprises access to restructuring funds (including through the Bank's proposed industrial Finance Loan). The reforms of prudential regulation and banking will require careful handling b)' the authorities. First, the true situation of each bank and hence the costs and timetable of an eventu i restructuring program will only be known with confidence as the new prudentW and reporting regulations become operatlonal. Second, the reforms might be painful for banks, their shareholders, and some of their major clients. However, the Gov,mment's own commitment Is strong, since, In view of Its medium-termn oblective of attaining full convertibility of the dinar, it attaches the highest pririty to having a banking sector that meets International standards. 66. Almost every sector of the economy will be affected by the reforrn program and there wHil be losers, as well as gainers. Thus, the task being unoertaken by the Govemment should not be underestimated. Strong Bank support at this juncture will greatly contribute to the country's success In carrying out the structural changes that the Govenmment plans. The successful implementation of the program will make Tunisia a highly outward-oriented economy, attracting substantial direct foreign Investment, especially in activities requirlng technical skills. D. COLLABORATION WiTH THE IMF 67. After successfully completing a Stand-by Arrangement with the IMF that ended In May 1988, Tunisia entered Into the current Extended Arrangement on July 1988. Total purchases under the EFF were anticipated to be SDR 218.3 million, equal to 158 percent of quota. However, Tunisia refrained from drawing, until May 1991. In July 1991, the EFF was extended to a fourth year to support the program prepared by the Government In response to effects on the economy of the Gulf crisis. 68. Coordination between the Bank and the IMF has been excellent. During the preparation of the propose EFRSL reguar exchanges of viw with the IMF staff took place and the varos components of the proposed loan have been discussed at different stages.  - 21 - E. PROCUREMENT. LOAN ADMINISTRATION AND MANAGEMENT 69. Eligible expenitures. The proposed loan of US$250 million would finance the forein exchange cost of imported goods. Not eligible for financing under the loan are goods financed from other sources; military or para-military goods; nudear reactors and parts; or luxury goods such as toacco, precious stones, jewelry. and gold. 70. Procurement The proposed adjustment operations would be carried out through three catgories of procurement based on the value of the contract. For each, different methods of procurement. documentation rer'ilrements, and Bank review procedures apply: (a) For large value contracts (exceeding US$5 million) of the pubilc and private stors, simpilfied ICB procedures would be followed. (b) Public sector procurement valued below the ICB threshold may be carried out following the standard procedures of the public sector In Tunisia which are acceptable to the Bank. (c) Private sector purchases valued below the ICB threshold may follow established commercial practice. Wherever possible, quotations from eligible suppliers from at least two countres would be sought except where direct contracting is permissible. (d) Direct contracting wlthout competition (sole source procurement) would be penritted under appropriate circumstances In accordance with the Bank's Procurement Guidelines. to) Subject to prior approval of the Bank, commorny traded commoditie may be proured through organized international commodity markets or othr channels of competitive procurement In accordance with procedures acceptable to the Bank. In partular, they wi not be eligible if they were single source purchases or Ii they were arranged under bilateral agreements. 71. The use of the loan for petrdeum products would be limited to US$50 mllion. Retroactive financing would be permitted up to the amount of US$87.6 million (35 percent of the loan amount) for expenditures made after June 1991. 72. The Govemrnent may seekdisbursements for Imports under editing cornractsforthe supply of certain goocds such as fertilzers, commocities ancd petroleum products. Goods imported under such contracts are eliglible for Bank financing only H the contracts were awarded through the procedures prescribed herein or those deternined to be acceptabe to the Bank. They will not be eligible If they were single source purchases or f they were arranged under bilateral trade agreements. 73. Disbursement. The Central Bank wMii be responsible for the administration of the loan. Disbursements from the loan account wiil be made against 100 percent of the cost of eligible Imports. Witdraal appiications for disbursements on eligible contracts above the equivalent of US$5 million wMi be fully documented. In all other cases, disbursements will be made on the basis of Statemnwt of Expendiures (SOEs) from the Centra Bank detailirg indidual trnsacrti In a ghien perlod, and cerfication of payment and d eligibility of the tansactions for loan flnancing. Supporting documentato for disburents under SOEs wOil be retalned by the Central Bank untl at least 12 months after the closing of th loan account. Retroactive financing llmited to 35 percent of the loan amount wl be alowed for expnitures Incurrecd after June 30, 1991. The loan is expected to be fully disbed 30 months aftr effectveness. The Closing Date would be December 1994.  - 22 - 74. Accounts and audits. The Central Bank wll maintain records re di transactions under the loan In ac