Mozambique - Economic Recovery Program Project

Document of The World Bank FOR OFFICIAL USE ONLY MICROFICHE COPY Report No. P- 5775-MOZ Type: (PR) BONNEL, RE/ X34257 / J11051/ AF6CC REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED DEVELOPMENT CREDIT IN AN AMOUNT EQUIVALENT TO US$180 MILLION TO THE REPUBLIC OF MOZAMBIQUE FOR AN ECONOMIC RECOVERY PROGRAM MAY 18, 1992 Tlis document has a restricted distribution and may be used by recipients only iD the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENC'x EQUIVALENTS (April 1, 1991) USD 1.00 = MZM 2,213 (Secondary Market Exchange Rate) Special Exchange Rate for Tied Aid: 8 percent discount ABBREVIATIONS AND ACRONYMS ADB African Development Bank AGRICOM State Enterprise for Agricultural Marketing BM Banco de Mogambique BCM Banco Comercial de Mogambique BPD Banco Popuar de Desenvolvimento BSTM Banco Standard Totta de Mopambique CG Consultative Group CIRE Iner-Miisterial Commission for Enterprise Restructring CNP National Commission of Planning ERC Economic Recovery Credit ERP Economic Rehabilitation Program FIAS Foreign Investment Advisory Service ESRP Economic and Social Rehabilitation Program GCPI Department for the Coordination of Import Programs LDP Letter of Development Policy LIB Limited Interational Bidding MEDIMOC State Inport/Export Agency for Medical Supplies MOH Ministry of Health NGO Non-Government Organization NSA Novo Sistema de Abastecimento (New Supply System) OECD Organization for Economic and Cooperation and Development PFP Policy Framework Paper PHC Primary iHealth Care SNAAD System for the Non-Administrative Allocation of Foreign Exchange SGS Soci&te Generale de Surveillance UTRE Enterprise Restructring Unit MErR[C EOUIVALE 1 meter (m) = 3.28 feet 1 square meter (sq.m) = 10.76 square feet I kilometer (km) = 0.62 miles 1 square kilometer (sq.km) = 0.386 square miles FISCEAL YEAR January 1-December 31  FOR OFFICIAL USE ONLY MOZAMBIQUE ECONOMC RECOVERY CREDrr TABLE OF CONTENTS PROGRAM SUMMARY ...........................................................i PART I: COUNTRY POLICIES AND BANK GROUP ASSISTANCE STRATEGY ........ 1 A. Recent Economic Performance ...........................................................1 B. Medium-Term M roeconomic and Structral Policies ................................. 8 C. Bank Country Assistance Strategy ............................. ................... 13 Objectives and Strategy ................................................ 13 Lending Program and Economic and Sector Work ............................... 14 Aid coordinatlon ................................................ 19 Relations with the IMF .................. .............................. 19 D. Summary Assessment ................................................ 19 PART I: PROPOSED STRUCTURAL ADJUSTMENT CREDIT .............. ............... 21 A. Enhancement of Private Sector-Based Growth ......................................... 21 Foreign Exchange Allocation ................................................ 21 Improvement in Price and Export Incentives .......................... ............ 24 Reform of the Financial Sector ................................................ 25 Enterprise Restructung/Privatization .............................................. 28 B. Public Expenditure Management and Poverty Reduction ............................. 30 PART m: FEATURES OF THE PROPOSED CREDlT .......................................... 33 A. Credit Amount, Tranching, Coordination and Cofinancing ............ ............. 33 B. Disbursement, Procurement and Auditing ................................................ 34 C. Mnagement and Monitoring of the Program ........................................... 35 D. Benefits and Risks ................................................ 36 PART IV: RECO lEID'ATION ................................................ 38 This report is based on the findings of an appraisal mission which visited Mozambique in November 1991. The mission consisted of Messrs. Rend Bonnel (Mission Leader and Senior Economist), Simon Bell (Financial Economist), KJell Roland (consultant), John Graves (Lead Financial Advisor), and Ms. Neeta Sirur (Projects Officer). Mr. PrafM Patel is the managing Division Chief and Mr. Stephen Dennin is the Deparuet Director for the opeation. This document has a restricted distribution and may be used by recipienbt only in the perfmance of ter official duties. Its content may not otherwi be disclosed without Wodd Bank authorizatio  NNE I Letter of Development Policy . ................................ 39 ANNEII Policy Mrix .................................. 51 ANNEXm Balance of Payments ................................. 57 Key Macroeconomic Indicators ................................. 58 Exteroa Financing Requirements and Sources ................................. 59 Soi Indicators ...................................i. 60 ANNEX IV Statement of Bank Group Operations (IDA and IFC) ............................ 62  i ECONOM BWQVERY PROGRAM SUMMARY Republic of Mozambique Benecfiay: Republic of Mozambique Amount: IDA Credit SDR 132 million (USD 180 million) Switzerland SwF 10 million (USD 6 million) Terms: Standard IDA terms, 40 years maturity Desaigfti In earlier adjustment operations IDA had been supporting Mozambique's Economic and Social Rehabilitation Program (ESRP). The proposed credit will provide support for the ESRP. The objectives of the credit are to enhance private sector-based growth, redeploy budgetary expenditures towards key social sectors and small holder agriculture and provide support for drought-relief. The credit has four main components. First, it will improve foreign exchange allocation and export incentives by developing a consolidated market for foreign exchange, liberalizing prices of manufactured products and reforming agricultural marketing. Second, it will strengthen the role of the Centa bank, improve access to credit by the private sector and develop commercial bankdng services. Third, the credit wiU accelerate the restuctring and privadzation of the state enterprise sector and establish a transparent system for privatization. Fourth, the credit wiU reorient budgetary expenditures to protect a set of high-priority activities in primary health, primary and secondary education, smallholders in agriculture, and provide support for the implementaion of limited targeted direct income transfers to poor households. The proceeds of the credit would be used by Mozambique to support the enlargement of the secondary market and finance technical assistance to strengthen the Government's capacity to extend the privatization process to large enterprises and reform the banldng sector. It is also expected that up to USD 10 mllion would be used for restoring the productive potential of agriculture destroyed by the drought. BDenefits: The program would enhance prospects for economic growth and exports while alleviatng poverty. Production and exports would increase because of improved access to foreign exchange and credit, enhanced financial incentives resulting from price and agriculturd trade liberalization, and the restructuring of the state enterprise sector. Poverty alleviation would be strengthened as a result of increased efficiency of resource utilization in the social sectors and the redeployment of budgetary resources towards the social sectors.  ii Riak: There are risks associated with the program. First, the introduction of a multi-party system and the process of negotiations with RENAMO will increase the need for consultation and consensus which could make the implementation of the reforms more difficult. However, this risk should be balanced against the Government's strong commitment to the program through its acceleration of reforms concerning exchange rate, foreign and domesdc trade and privatization. Second, the technical and managerial capability to Implement the adjustment program is limited. To reduce this risk, technical assistance, both by IlDA and other bilateral donors will be provided. Third, the uncertain security situation could reduce the beneficial hnpact of the measures, particularly in the mral areas. This risk should, however, be assessed against the concerted efforts and progress achieved towards reaching a peace agreement. Disbursement: USD 175 million would be disbursed in two tranches. The first tranche of USD 82.5 million would be available upon effectiveness. The second tranche of USD 82.5 million would be available about nine months later upon satisfactory fulfillment of specified conditions. Disbursement would follow standard Bank procedures for imports. Retroactive financing would be allowable up to a maximum of 20 percent of the loan, for imports carried out during ;he four months immediately prior to credit effectiveness. Disbursements for technical assistance and consultants' services (estimated at USD 5 million) would be made on the basis of 100 percent of totl expenditures. There is no separate Staff Appraisd Report  INTERNATIONAL DEVELOPNT ASSOCITION REPORT AND RECOlMMENDATION OF THE PRESIDENT TO TE EXECtUTIVE DIRECTORS ON A PROPOSED ECONOMIC RECOVERY CREDIT TO THE REPUBLIC OF MOZAMBIQUE 1. I submit the following report and recommendation for a proposed Economic Recovery Credit (ERC) to the Republic of Mozambique for SDR 132 million (UJSD 180 million equivalents) on standard IDA terms with a maturity of 40 years. 2. Ihe proposed adjustment program would build on the reforms already undertaken by the Government of Mozambique under three IDA Rehabilitation Credits, and the Structura Adjustment Facility (SAP) and Enhanced Adjustmnt Facility (ESAF) arrangements provided by the IM. The Government's Economic and Social Rehabilitation Program (ESRP) has been descnrbed in the 1991-1993 Policy Framework Paper which was discussed by the Committee of the Whole on September 12, 1991. Support for the Government's adjustment program is being provided through a second-year ESAF approved by the IMF on September 20, 1991. IThe following bilateral donors have conformed that they would provide cofinancing: Switzerland (USD 6 million); and Germay (USD 10 million). 3. From the inception of the ESRP in 1987, the Mozambican Government has shown strong commitment to the ESRP framework and has registered a number of Important accomplishments over the past five years. These include: major real devaluation of the exchange rate (78 percent); substantial increase of agricultura commodity prices to nea-border prices; elimination of monetary financing of the budget; improvements in the composition of budgetary investment; and rapid progress on eliminaing state enterprise subsidies and priatization of about 120 sn'all and medium enterprises. 4. Part I of this memoandum gives an overview of Mozambique's recent economic performance; the country's medium-term macroeconomic and structural policies for the period of the proposed credit; and the Bank's assistance strategy in Mozmbique. The proposed Economic Recovery Creddk is outlined in Part 11. Part m describes the specific features of the credit, while Part IV discusses its benefits and risks. PART I: COUNTRY POLICIES AND BANK GROUP ASSISFANCE SRATEY A. RecentEmontcfrfrmn S. DaWkround. In 1975 Mozambique was a relatively prosperous country, its economy built on a strong agricultural base and on provision of transport and labor services to neighboring countries, especially South Africa. However, during the 197545 period it suffered a major eonomic decline with the result that today Mozambique's per capita income (around USD 80) is one of the lowest of the world and its social indicators (iteracy ratt,  2 infant mortality rates, levels of acute malnutrition and life expectancy) awe among the worst In Sub-Saharan Africa. Several fators account for this deterioration, including: O) a colonial legacy of very low Investment in human resources; (ii) inappropriate (socialist) economic policies; and (iii) weak civil service capacity, exacetbated by the emphasis on centraized planning. Perhaps most debilitating has been the ongoing civil war which, since the early 19808, has devastated much of Mozambique's counride. The economic cost of the civil war has been far-reaching in all sectors: over a third of health facilities and about one-alf of all primary schools have been destroyed, and nealy 40 percent of the population has been displaced or otherwise directly affected by the insecurity. - 6. In response to the serious economic and financial difficulties, the Government launched a comprehensive adjustment program in 1987-the Economic Rehabilitation Program. The global objectives of the ERP were to: (i) reverse the decline in production and restore a minimum level of consumption and income for all the population, particularly in rural areas; (ii) reduce substantially the domestic imbalances and strengthen the extemal accounts; and (iii) establish the conditions for a return to htgher levels of growth once the security situation improves. In 1989/90, taking into account the serious and widespread poverty prevailing in the country, a Poverty Reduction Framework Papei was prepared joindy by the Government and the Bank for presentation at the 1990 Consultative Group. Following general agreement by Government and donors regarding the centrality of the need to address poverty issues, the objective of poverty reduction was incorporated into the ERP and the program was subsequently renamed the Economic and Social Rehabilitation Program (ESRP). Ihe ERP/ESRP has been supported by three IDA Rehabilitation Credits, three arrangements under the Structural Facility (SAF) and two arrangements under the Enhanced Structral Facility (ESAF) from the IMP, and assistace from multilaterd and bilateral donors. 7. The most striking feature of the ERP has been the increase in production, which is rvesing tie 1982-85 decline (see Graph below). From 1987 to 1989, real GDP growth has averaged 5.4 percent per annum. Much of this growth has come from liht industral activity which rose because of improved avadiability of foreign exchange for raw material Imports. Despite the adverse security situation, recovery was also apparent in the agricultural sector, where value added increased on average by over 5 percent per annum. A key factor was the adjustment of prices and the increased availability of incentive goods in rural areas. In 1990-91, growth slowed down to 1.1 percent per annum on average, mainly as a consequence of bad weather and renewed attacks by RENAMO, which particularly disrupted the supply of energy.  3 Evolution of Real GDP Index 1980 100 96 101. . _ .. . n- I- -1- X--- 8. Considerable isaaduhetwas carried out with domestic revenues increasing from 12.9 pretof GDP in 1986 to 23.9 percent of GDP in 1991. Budgetary deficits before gr-ants, averaging 24 percent of GDP were financed increasingly through grants with the result thfat the budgetary deficit after grants fell from 15.3 percent of GDP in 1986 to 6.1 percent in 1991 (see Table 1). Ihe most noticeable results have been a significant improvement in the comxposition and level of thie investment program as well as in social policy. Significant Inttuinal changes were implemented to transform the government budget into a key policy insrmn lor prioritzng state expenditures. In 1990, previously off-budget expenditue amontin to about 10 percent of GDP were included in the budget and an acutng system for monitoring budgetary expenditures was put in place with technical asstace. lhese imrovements were accompanied by the formulation of a roiling three-year investment and financial plan, and substantial revisions were brought to the investment program. Ihe overall size of the budgetary investment was cut from a projected 29.3 percent of GDP (at the beginning of 1990) to 24.2 percent in 1990 and the composition of the investment program was substantially improved. Large white elephanlt projects in irrigation were cut, and the investment program was redesigned to better reflect poverty reduction priorities. In particular, spport to smallholder production in agriculture and social expenditures were increased 8Uy.l~~7 X In onstat 1980 pic, per ca budgearry ex p itu omeducatien fell frem MS 409 in 1980 to Mof 128 in 1987,6antossto M2Z3 M 215 by 1990; pro Budgetary epenits before L the decned fro diZi 132ain 1980ts toZm 53 in 1987,6andi to MZM 61 by 1990.  4 TABLE 1: KEY MACROECONOMIC INDICA"ORS, 1986-91 I1 Rea Growtb (% p.a.) GDP Gabwtk Rate 2.3 5.3 S.5 S.4 1.3 0.9 Coosumpon per Capita -3.3 0.4 0.9 3.2 -2.8 -3.7 Goss lnvest GDP 21 9.2 24.0 33.4 35.5 38.1 42.7 Domestic Savings/GDP -1.1 -12.0 -16.S -16.6 -11.7 -11.6 Budgdary Data (% of GDP) Budgetuy Revenues 12.9 16.2 19.9 23A 22.3 23.9 Govenm t Expeninus 30.9 37.5 45.2 49.0 51.8 51.2 Overal Defict before Gats 17.6 21.1 25.3 25.5 29.5 27.3 OverallDeficitafleruant 1S.3 11.8 11.4 9.0 12.6 6.1 Shareo of GDP (%) Epos (G&NPS)GDP 3.5 12.1 15.1 1.SA S.9 24.3 Export Growth Rat (G&NFS) 3/ -1.4 8.3 4.4 8.4 10.6 31.3 Current Amount DefitX&S) Before Grnts 314 289 253 281 263 214 AfterGrants 207 159 108 138 114 78 Real EfeExch Rate (depr.=-) 22.2 -77.3 -18.3 0.8 1.2 -17.7 Inltion (averag, % p.11.) 38.7 163.3 50.1 42.1 49.2 35.0 V Due to inadequacies in national aucouts, estimates on investment and savins are distorted. The inres in ratios to GDP reflects the effects of major exchange rate adjustmn on the exteal components of Investment reat to a less ser increase hi domedo infation, and therefre, GDP. 2/ nVestet expendtu inude some re_uret expedtute (about 1S percent of invemen). 9. Following indepeence, Mozambique's finciW system was restructured with the result that Banco de Momique (BM) operated both as the central bank and the largest commercia bank, acuntn for around 95 percent of financial system assets. Through its ownerip of the two largest banks,2 the Go'erment has had direct Control of most c the financial seofr, which was largely used to fiance the government budget and the operating deficit of state enterprises until 1987. Consequently, the financial sector operated as an arm of the govemment budget rather than as a proper banking system, with the result that it provided only minimum banking services to enterprises. Starng in 1987, the Government initated a refrm of the banking sector aimed at separating the commercial banking and central bank functions of Banco de Mogambique (DM). In early 1992, BM was separated into Banco Comercial de Mopambique (BCI) and Banco de Moambique (BM). 2 Th seond largest bank, Banco Popa do Dlesevolvlmito (BPD), is stat-owned and has been mainly urvolved il agrdcultural lending. Ihe third bank, Banco Stndard Totla do MoAmbique, is t only privatly owned bak and is relauvely smail with lendimg confied to the pivate sector.  5 iO. Mong= goice were aimed at reducing the degree of excess liquidity and improving the efficiency of credit utilizadon. Monetary expansion was restrained by eliminating domestic bank financing of the budgetary deficit from a level of about 12 percent of GDP in 1986, and in 1991, the budget made repayments to the banking sector in an amount equivalent to 1.7 percent of GDP. Overall, the ratio of money to GDP fell from 63 percent in 1986 to 36.5 percent in 1991, and inflation declined from 163 percent in 1987 to 35 percent in 1991. To increase the role of market forces in the allocation of credit, interest rates were raised with a view of achieving positive interest rates in real terms. Ir April 1992, interest rates were increased substantially with the result that rates are now positive in real terms and the differentiation in lending rates among sectors has been eliminated.3 11. As economic management shifted towards a market basis, major corrections were made In administered prices and suppressed price pressures were released. Significant progress was made in restoring financial incotlye at the producer level. The number of product groups in the agriculture, industy and service sectors with price control was reduced from 46 in 1986 to 16 in 1991. The objective was to limit price controls to food products made available through food aid and essential products sold through the ration system in urban areas (9), and energy products traded through state monopolies (7). However, to ensure that prices reflect real resource costs, the policy adjustments were focused on realigning prices to international levels. In the agricultural sector, prices were either freed or set instead as minimum (floor) prices for nine products with the result that the ratio of border to domestic prices fell by over 400 percent from 1986 to 1989 for most products. By 1990, most agricultural prices (with the exception of export crops) were at about 80 percent of border prices. Fixed prices for manufacured products were replaced by a system of ex post review ("conditioned prices"), which gave enterprises flexibility in increasing prices. Overall, the share of products subject to price control fell to about 17 percent of total production in 1991, a substantial decline from the pro- ESRP level of 69 percent (Table 2). TABLE 2: PRODUCTS WTH FDIED PRICES Share of production (begl ning of period) 69% 39% 30% 24% 17% 12. Despite this progress, there are still significant distortions and impediments in the domestic trade regime. Although Government has decontrolled agriculural prices and improved price incentives, the available evidence indicates that state agencies are procuing agriculural commodities at below market prices. Such a pricing policy is facilitated by the restrictions affecting the importation and marketng of incentive goods in rural areas.4 As the purchase and trade of agricultural products by private traders is limited by registration 3 As a result, both th lowest (39 pect) nd th highes (44 percent) leding rates ar now substanially above the inflation rate achieved in 1991 (35 percent). The second important change was to reduce the number of lending rates from 54 in 1987 to 18 in 1991 and 6 in 1992. 4 Import and distrbtion of conomer goods financed by official aid are administatively managed by Govemment and state enterprise  6 procedures,5 state enterprises face little competition when purchasing agricultural commodides. This monopoly was strengthened by the allocation of imported consumer goods to state enterprises for distribution in rural areas. These enterprises, being nearly the sole legil source of incentive goods in rural areas, are able to buy agricultural products at low prices in exchange of consumer goods. Realizing that the legal barn 3rs to marketing were resulting in substantial taxation of agriculture, the Government has initiated an overhaul of pricing and domestic marketing of agricultural commodities. 13. Foreign e2change allocation Until the introduction of the System for the Non-Administrative Allocation of Foreign Exchange (SNAAD) in October 1989, most of Mozambique's foreign exchange was administratively allocated with the price of foreign exchange having no allocative role. To establish a more efficient system of foreign exchange allocation, the Government decided that, for those products selected for inclusion under the SNAAD, enterprises would be accorded automatic access to foreign exchange and import licenses. The range of products eligible for SNAAD financing was initially restricted to three product groups, but was further enlarged in mid-1990 and 1991. The gradual increase in the SNAAD was reflecteC both in the mimber of firms applying to the SNAAD and in the value of imports.6 About 80 percent of the SNAAD funds were distributed to private firms. 14. The initial expectation was that the SNAAD would become a significant market-based system for allocating foreign exchange. For several reasons, however, this objective was not achieved. First, the SNAAD was financed only by official aid as exporters' earnings were srrendered to Banco de Mogambique.7 The consequence was that available funds for financig the SNAAD were limited to donor aid provided as undad balance of payments support. Typically, they were provided in a 'lumpy" fashion during the year, which resulted in periods of excess demand, which were managed through a queuing process rather than through exchange rate adjustment. As the official exchange rate was overvalued until mid-1991, significant implicit import subsidies vere provided through the SNAAD. Once the initial rest i'tions applying to the SNAAD were lifted, the demand rapidly exceeded available resources, and the SNAAD ceased to function as a market. 15. The creation of the secondary market for foreign exchange in October 1990 was aimed at establishing a market through which economic agents could obtain access to foreign exchange without administratve restrictions. Initially limited to service earnings (tourism, etc.) and the savings from the import entitlement sceme for exporters, the secondary market was expanded in mid-1991 to include earnings from non-traditional exports. Nevertheless, it remained small amounting to about USD 40-50 million in 1991, pardy becase of the segmentation of foreign exchange windows. As a reflection of the demand and supply of 5 Traders have to reostr with the Ministry of Comnmrce before the begining of the agrculturl marketing campaign so that each tader can be assigned to a specific area. While the init objective of this measure was to estimate the credit to be provided by the baniing sector, the reslt was to limit competition among tladers. 6 Import licenses rse from USD 16.6 million in 1990 to USD 67 million by end-1991. 7 These funds were in tum used to meet pre-d_termined payments such as debt sevice.  7 foreign exchange, the secondary market exchange rate has fluctuated between the official and the parallel market exchange rate. 16. Exchange rate adjust. The major conclusion that emerged from the experience gained from the operation of the SNAAD was that a substantdal devaluation of the official exchange rate was required. It Is a credit to the Government that exchange rae devaluation accelerated in 1991 with the result that the official exchange rate is now at a level broadly consistent with the establishment of a market-based allocation of foreign exchange. From end- 1990 to April 1, 1992, the premium of the parallel exchange rate over the official exchange rate fell from 97 percent to about 14 percent (see Graph below). Similarly, the premium of the secondary market exchange rate over the official exchange rate fell from 80 percent to 5 percent from end-1990 to March 1992. 2l6- 1.4 - Ra 2 ~ ~ I t 18 17. In line with the objective of establishing a more open trade regime, a major buff reform was completed in 1991 involving the eliminz ion of all specific import duties and the simplification of the tariff schedule. Ihe number of tariff rates was reduced from 34 to only six ad valorem rates, and the maimum tariff rate was lowered from 100 percent to 35 percent, thus reducing excessive protection, incentives to smuggling and pressure for tariff exemption. At the same time, a harmonized system of tariff nomenclature was introduced. To unify the treatment of domestic and imported goods and eliminate some cases of negative protection, the coverage of the urnover tax was extended in mid-1991 to consumer goods imports at a rate of 5 percent and the rate for domestic manufctiu was reduced from 10 percent to the same level. I8. uffent Account Deffi. With an external debt of USD 4.9 billion in 1991, and a debt service ratio (before debt rescheduling) amounting to 146.5 percent of exports of goods and sevices in 1991, Mozambique is one of the world's most indebted countries. The Government has take importa steps, including exchange rate devaluations to respond to this siation. As a consequence of these policy changes, the rate of growth of exports of goods and non- factor services accelerated to 10.6 percent in 1990 and 31.3 percent in 1991 in real terms with the rest that the share of exports in GDP has doubled since 1987 (Table 1). Nevertheless, extal Imbalances remained substantial. ITis disequilibrium was the consequence of  8 Mozanbique's low levels of production, which implied that large volumes of imports would remain necessary, at least in the medium-term, to provide incentive goods for the agricultural and industrial sectors as well as the capital goods required for the rehabilitation of key economic and social infrastructure. This strategy was reflected in the widening of the current account deficit before grants from 47.8 percent of GDP in 1987 to 61.2 percent in 9i. Because of strong donor support for the ESRP (see below), the current account deficit after grants fell from 26.8 percent of GDP in 1987 to 22.1 percent of GDP in 1991. 19. A key component of the ESRP was the mobilization of extemal aid on more concessional terms and under conditions more conducive to its efficient utilization. In this respect, emphasis was placed not only on the relaxation of centralized administrative controls, but also on the provision of untied external aid within the context of the Special Program of Assistance for Sub-Saharan Low-Income Debt-Distressed Countries. Substantial amounts of exteirna assistance have been made available by bilateral donors, both as cofinancing for IDA credits and as parallel operations. In aggregate, gross inflows of loans and grants increased from USD 497 million in 1986 to USD 700 million in 1990 and the share of grants increased from 43 percent to 64 percent over the same period. 20. Following two traditional debt rescheduling with the Paris Club in 1984 and 1987, Mozambique concluded a new rescheduling on Toronto terms in June 1990 covering the period 1990-92. A number of donors have already converted their outstanding loans into grants or have canceled their loans, thus bringing closer the prospect for balance of payments viability. In addition, about 64 percent of Mozambique's commercial debt was retired at a discount in December 1991, utilizing fiuds from the IDA Special Debt Reduction Facility and donor finacial support. The overall effect was to reduce the debt service ratio from 146 percent (beore debt relief) to 42 percent in 1991. 21. In summary, since the initiation of the ERP in 1987, the Government has made steady progress in improving the incentives system, strengthening government's capacity to prioritize investment and alleviate poverty, and addressing the most important causes of domestic and external imbalances (external indebtedness, low production, inadequate tax revenue, and high rate of credit expansion). Compared to the situaion of four years ago, progress is significant. The combination of improvement in policy, rehabilitation investments, and strong donor suport has led to the restoration of economic growth despite continued domestic insecurity. B. Medium-Term Macroeconomic and Structural Polcies 22. Given the progress achieved over the last five years, the stage is now set for the Government to place greater emphasis on addressing stmrtural impediments to deal not only with critical short-term problems (particularly as concerns inflation and the difficult balance of payments situation), but also to establish sustained economic growth and alleviate poverty. The Government's medium-term macroeconomic framework and structura policies for the next three years, as outlined in the Policy Framework Paper (1991-93), were discussed and supported by donors at a CG Meeting in December 1991. Ihe key features of this program are: (a) reduction of the fiscal deficit after grants coupled with prudent monetary policy; (b) establishment of a relatively large market for foreign exchange; (c) improvement in export and productin mcentives; (d) privatization and restructuing of the state enterprise sector, (e) poverty alleviation and redeployment of budgetary expenditures towards key social sectors  9 and support to smallholders in agriculture; and (f) strengthening of Government's institutional capacity. The main aspects of the program are summarized below. 23. Crdiplicy is focused on reducing excess liquidity and improving credit allocation to sustain economic growth. Currently, the range of commercial bank deposit facilities offered in Mozambique is very limited; the majority of the deposit base is in the form of demand deposits (95 percent), and banks are reluctant to accept time deposits in the current context of excess liquidity. The objective of reducing excess liquidity is reflected in the 1992-93 credit program, which is set on the basis of increases in broad money significantly lower than those projected for nominal GDP. However, to sustain economic growth the non-government sector will benefit from the entire amount of domestic credit expansion compatible with the monetary targets. 24. The second objective of the Government's credit policy is to improve the allocation of credit. Although agriculture continues to receive most bank credit, this proportion has declined since 1987 as credit is increasingly being allocated to commercial activities. This changing pattern is, in part, the result of the lending interest structure which remains administratively managed. With no discretion to set rates, banks have moved away from lower yielding agricultural lending (where rates are lower and risk is higher) into higher return and less risky commercial activities. To improve banking services and lending, structural reforms have been initiated to increase domestic competition among banks, develop the procedures and regulations for new commercial banks to operate in Mozambique, and reform the structure of interest rates (see paragraphs 72-77). 25. Fiscal policy is aimed at reducing the fiscal deficit after grants and prioritizing government expenditures. The overall deficit after grants will be reduced from 6.1 percent of GDP in 1991 to about 4 percent by 1993. These targets are to be achieved by restoring revenues to about 26 percent of GDP by 1992 and mobilizing counterpart funds. As local currency resources available to the budget have been limited by the under-collection of counterpart funds generated by external commodity aid, particularly food aid, increased efforts will be made to enhance the collection of counterpart funds through the harmonization of valuation, reporting, and administrative procedure and mobilizing additional counterpart funds. Agreement with donors is also being sought on the use of these funds so as to provide the Government with greater flexibility on expenditure decisions. The reform and streamlining of the customs tariff introduced in October 1991 is to be accompanied by a rationalization of customs operating procedures, while the turnover tax and ad valorem excise taxes are being modified to harmonize the tax treatment of domestic and imported goods and facilitate collection. 26. The Government intends to continue making significant improvements to the devastated economic and social infrastructure. This includes making adequate provisions for the rehabilitation of rural roads and storage infrastructure-which are crucial for agricultural recovery and exports. The Government recognizes the need to redeploy government expenditures to increase the human capital of the poor and increase the effective participation of the poor-who constitute over half of Mozambique's population-to the recovery process. It therefore intends to make significant improvements in the quality of, and access to basic social services-primary health care and primary and secondary education-and to strengthen agricultural research and extension services to support smallholder agriculture. The allocation of reurrent budgetary resources to priority sectors, in particular, health, education and  10 agrliculture, wMI therefore be increased so as to raise investment productivity and accelerate progress in reducing poverty. Government, with assistance from bilateral donors, is also actively developing a program for the demobilization of military personnel once a peace accord is reached, and intends to reallocate savings on military expendiures to programs aimed at poverty reduction. Technical assistance in this area is being provided by bilateral donors. 27. Foreign Exchange Allocation. Following the significant reduction in the overvauation of the official exchange rate (see paragraph 16), the Government intends to create a relatively large market for foreign exchange by drastically reducing the number of 'foreign exchange windows' and simplifying the administrative procedures and requirements applying to Import support finds. In 1991, there were about five official windows under which foreign exchange could be made avalable. These included: the foreign exchange fund of Banco de Moganbique ('Fundo Cambial'); the import entitlement scheme for exporters ("Novo Sistema de Gestao Cambial"); the secondary market for foreign exchange; the SNAAD; and other import support funds managed by the Ministry of Commerce. As the degree of administrative intervention, the cash cover required at the time of opening a letter of credit, and the procedures required by donors varied greatly among windows, the structure of import costs was greatly different from that of exchange rates.$ Overall, taking into account these various factors, it was estimated ta the effective cost of tied import support funds was about 8 percent higher than untied aid and exporters' earnings. 28. Taking into account these differences, the Government has initiated a program of strucural reforms aimed at unifying the foreign exchange windows applying to untied aid and exports within the secondary market. To develop that market, steps are being taken to facilitate the participation of commercial banks in the foreign exchange market. While the secondary market exchange rate would be determined on the basis of the demand and supply of foreign exchange in that market, the official exchange rate-applying to tied aid-would be set slightly lower (about 8 percent) to offset the higher finalnci cost of tied aid to firms. Because Mozambique's tied aid is large relative to export earnings, the unification of exchange rates requires the effective support of donors in untying eemral aid both in terms of the countries from which goods can be procured and in terms of the use of funds. 29. Ente=rise Restu,cindg. 'MThe Government recognizes that a priority in the coming phase of the economic reform is to deepen and accelerate the reform of state enterprises. At the time of independence in 1975, Mozambique's industi sector was relatively diverse in compaison to other African counries, with most production in the private sector. Following independence, two significant events occurred that dramatically changed the ownehip structure and adversely affected the performance of the sector. First, the exodus of more than 90 percent of the Portuguese settler population, which constuted the majority of the skilled labor, forced the Government to take control of most industrial enterprises in order to maintain 8 Xbe elapsed ime beween to initiation of te import process and the receipt of the mercandise ramged from 432 days in the case of one donor to 167 days for LIB imports to 54 days for imports throuh th secondary market, and to 24 days for own-fund import  11 production. These enterprises became known as intervened enterprises.9 Second, the shift to a centralized economy, was associated with the creation of a relatively large state sector, consisting of 575 nationally registered enterprises in 1989, of which about half were publicly owned and controlled.10 Because enterprise reform is a key condition for injecting dynamism in the economy, the Government has decided to accelerate the privatization/restructuring of state enterprises. Some 120 firms, mostly small- and medium-scale enterprises, have been privatized until 1991 and some management contracts and joint ventures have been completed. Ihe Government now Intends to move ahead with the privatization or restructuring of the largest state or intervened enterprises. 30. To facilitate the privatization process, the Government is taking steps to improve the investment climate. The Government recognizes that the pool of domestic capital and skills is limited, and is therefore keen to attract foreign investment. Support to strengthen the investment climate is being provided through IFC's FIAS, which recendy carried out a diagnostic mission at the request of the Government. 31. Finally, the Government is taking actions to address serious capacity constraints on economic management and development administration stemming from an especially acute shortage of skilled manpower. To alleviate this constraint, the Government is emphasizing capacity building through education and training, and improvements in public pay. Following the completion of a study in early 1992, the Government has identified about 3,000 key positions within the Government which are deemed essential for the effective implementation of the ESRP. Recommendations for increasing wages were adopted by Government in March 1992. Given the long lead time involved for development of human resources, Government intends to devote particular attention to utilizing existing capacity more efficiently by focusing the role of ministries on key strategic issues, simplifying internal government review/clearance procedures and delegating decision-making to lower levels of authority. 32. Macroeconomic Pro.= and External Finanemg R m ens Mozambique is well placed for experiencing increased economic growth to about 5-6 percent during the second-half of the 1990s. Assuming the Government continues with its planned reforms, a major source of growth would be the agricultural sector which is projected to grow at around 5-6 percent per annum. in the mid-1990s, as millions of currently displaced persons are gradually reintegrated into the rural economy following improvement in the security situation. A major boost to industrial growth would come from an enlarged role for the private sector coupled with the 9 'Tttervened enterprsos are entepres that wee abandoned by their prous owners, and which were controlled by Govemment in order to maintain production. Intevention was mandated by a 1977 law of intervention. Formal nationaliation was limited to petroleum refining and shing. 10 Iho 575 nonally registed enwteprises conised of: