Madagascar - Industry and Trade Policy Adjustment Program Project

Document of The World Bank FOR OFCIAL USE ONLY MICROFICHE COPY Report No. 10540-MAG Type: (PCR) N.AMISATO, / X31678 / T9105/ OEDD2 PROJECT COMPLETION REPORT MADAGASCAR INDUSTRY AND TRADE POLICY ADJUSTMENT CREDIT (CREDITS 1834-MAG AND A-32-MAG) APRIL 15, 1992 Industry and Energy Operations Division South Central and Indian Ocean Department Africa Region This document has a restricted distribution and may be used by recipients only (a the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS Currency Unit: Malagasy franc 1987 US$1 = FMG 1,069.2 1990 US$1 = FMG 1,494.1 1988 US$1 = FMG 1,407.1 1991 US$1 = FMG 1,835.4 1989 US$1 = FMG 1,603.4 GLOSSARY OF ABBREVIATIONS ASAC = Agricultural Sector Adjustment Credit BFV = National Bank for Trade BMOI = Malagasy Bank of the Indian Ocean BNI = National Bank for Industry BTM = National Bank for Agriculture IDA = International Development Association ISAC = Industrial Sector Adjustment Credit ITPAC = Industry and Trade Adjustment Credit LIR = Liberalized Import Regime OECP = Overseas Economic Cooperation Fund of Japan OGL = Open General License PCR = Project Completion Report PIP = Public Investment Program PSAC = Public Sector Adjustment Credit SFA = Special Facility for Africa  FOR OFFICIAL USE ONLY THE WORlD HANK Washington. D C 20433 US A OffKC of Dafectot-GenwaI Opetatnsn EValute4bn April 15. 1992 MEMORANDUM TO THE EXECUTIVE DIRECTORS AND THE PRESIDENT SUBJECT: Project Completion Report on Madagascar - Industry and Trade Policy Adjustment Credit (Credits 1834-MAG and A-32-MAG) Attached, for information, is a copy of a report entitled "Project Completion Report on Madagascar - Industry and Trade Policy Adjustment Credit (Credits 1834-MAG and A-32-MAG)," prepared by the Industry and Energy Operations Division. Country Department III of the Africa Region. No audit of this project has been made by the Operations Evaluation Department at this time. ~14 2 Attachment This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  FOR OFFICIAL USE ONLY PROJECT COMPLE-TION REPORT MADAGASCAR INDUSTRY AND TRADE POLICY ADJUSTMENT CREDIT (CREDITS 1834-MAG and A-32-MAG) Table of Contents Page No. PREFACE ................................................... EVALUATION SUMMARY ......... ...........................i PART I. PROJECT REVIEW FROM BANK'S PERSPECTIVE 1...... A. Introduction ......................1..................... Adjustment Context ................................. 1 Country Background and Performance .................... 3 B. Credit Genesis ............. ............................ 4 C. Credit Objectives and Description ........................... 5 D. Credit Component Performance .................. 6 E. Project Formulation and Organization ........................ 8 F. Project Implementation ................................... 9 G. Impact of Adjustment .................................... 10 Aggregate Supply Response ........................... 10 Supply Response in the Industrial Subsectors ..... ......... 11 The Results in Public Enterprise Reform ..... ............ 13 H. Conclusions ............................................ 13 PART II. PROJECT REVIEW FROM BORROWER'S PERSPECTIVE 16 PART III. STATISTICAL INFORMATION ...................... 17 Credit Data . .............................................. 17 Mission Data ............................................... 18 Tables 1. Selected Economic Indicators, 1965-90 ....................... 19 2. Summary Balance of Payments, 1980 and 1985-90 ..... ......... 20 3. Exports and Imports by Major Category, 1987-90 ..... .......... 21 4. Merchandise Imports, 1980-90 ............................. 22 5. Merchandise Exports, 1980-90 ............................. 23 6. Nominal Protection Rates (%), 1988-89 ...................... 24 7. Consumer Price Developments, 1980, 1985-90 ..... ............ 25 8. Government Revenue and Expenditure, 1980, 1985-90 .... ....... 26 9. Comparison of Projected versus Actual Economic Indicators, 1988-90 27 Figures 1. Real and Nominal Exchange Rates, 1982-89 ................... 28 2. Saving and Investment, 1960-89 ............................ 29 This document has a restricted distribution and may be used by recipients only in the performance Of their official duties. Its contents may not otherwise be discloseti without World Bank authorization.  PROJECT COMPLETION REPORT MADAGASCAR INDUSTRY AND TRADE POLICY ADJUSTMENT CREDIT (CREDITS 1834-MAG and A-32-MAG) PREFACE This is the Project Completien Report (PCR) for the Industry and Trade Policy Adjustment Credit (ITPAC) to Madagascar. The Credit was approved by the Board on June 30, 1987 and comprised of: IDA Credit 1834-MAG for SDR 12.5 million, Special Facility for Africa (SFA) Credit A-32 MAG for SDR 52.2 million, a Government of Saudi Arabia Credit for Saudi Rials 12 million. a Government of Japan Credit for Yen 1 billion and a Government of Japan Grant for Yen 1 billion. ITPAC was closed on March 31, 1991 and fully disbursed on February 6, 1991. This PCR was prepared by the Industry and Energy Operations Division, Country Department III of the Africa Region (Preface, Evaluation Summaqy, Parts I and HI). In September 1991, the Bank sent the Borrower Parts I and III with the request to prepare Part II by November 1991, but no reply was received. Preparation of this PCR is based, inter ala on the project brief, tne Initiating Memorandum, the President's report, the Credit Agreements, supervision reports, a special report titled Mada,ascar - Adiustment in the Industrial Sector and Agenda Lbr Further Reforms (No 7784-MAG) and correspondence between the Bank, cofinanciers and the Borrower.  - iii - PROJECT COMPLETION REPORT MADAGASCAR INDUSTRY AND TRADE POLICY ADJUSTMENT CREDIT (CREDITS 1834-MAG and A-32-MAG& EVALUATION SUMMARY Introduction i. Four adjustment Credits have been extended to Madagascar since 1985. Initially, the Government and the Bank adopted a cautious strategy and agreed to begin addressing the many structural distortions affecting the economy sector by sector. This approach was supported by two IDA sectoral Credits, beginning with the Industrial Sector Adjustment Credit (ISAC) in 1985 and followed by the Agricultural Sector Adjustment Credit (ASAC) in 1986. Building on these two operations, the adjustment process gained momentum. As it became increasingly evident that sectoral policy improvements by themselves were unlikely to lead to a significant and rapid supply response, the Government moved decisively to a broader agenda of far-reaching refc'rms supported successively by the Industrial and Trade Policy Adjustment Credit (ITPAC% .ni 1987 and the Public Sector Adjustment Credit (PSAC) in 1988. ii. The ITPAC thus marked the second phase of an adjustment policy, initiated by the Government of Madagascar with support from IDA and the IMF, to reorient the Malagasy economy towards a free market system. It comprised of IDA Credit 1834-MAG for SDR 12.5 million and SFA Credit A-32 MAG for SDR 52.2 million along with a Japanese Grant for Yen I biiiion, an OECF Credit for Yen 1 billion and a Saudi Arabian Credit for Saudi Rials 12 million. Approximately ninety-nine percent of the proceeds were quick- disbursing, providing an immediate source of foreign exchange to expand Madagascar's import potential. The remaining one percent funded consultant services for an action program to rehabilitate public sector enterprises, portfolio audits of the three state controlled commercial banks, and, subsequently, for follow-up recommendations for commercial bank rehabilitation and Central Bank supervision. Board approval was granted on June 30, 1987 and the Credit became effective on September, 21 1987 with the Japanese components becoming effective on April 19, 1988. The closinig date, originally set for December 31, 1989, was extended twice, ultimately occurring on March 31, 1991. Objectives iii. The objective of ITPAC's package of policy reforms was to deepen the policy turnaround process initiated under ISAC, thereby assisting recovery and growth. These reforms were designed to increase competition through liberalization of the international and domestic trade, thus fostering a market-based resource allocation system in Madagascar. To consolidate the gains made under ISAC, and aided by the growing consensus in favor of opening up the economy, significant additional reforms were introduced. The cornerstone of the reform program was a substantial modification of the exchange rate system in support of extensive trade liberalization. Complementary reforms were also pursued to liberalize domestic markets and reduce the role of Government. Components of the ITPAC policy  - iv - reform package fell into fve categcries: (a) liberalization of the trade and exchange rate regimes; (b) import tariff reform; (c) price decontrol; (d) public investment program rationalization; (e) restructuring and privatization of public enterprises; and (f) reforms in the bankdng system. Implementation Exnerience iv. InPAC was disbursed in three tranches. The first two phases of the adjustment program were implemented as planned, although a three-month delay in releasing the second tranche was necessary to allow for a waiver on specific project conditions. Conditions for third tranche release were met thirty months after the originally s Neduled date. The delays were caused by difficulties in the privatization and/or liquidation oI the ten targeted public enterprises. These comprised ten ill-conceived industrial firms chosen because of the burden they imposed on the budget and on the financial system, that clearly presented little immediate interest to the private sector. The program design lesson from this experience is that when multiple objectives are to be achieved, the pace is dictated by the slower actions to be implemenited. Public enterprise reform, although an important objective, had an impact on trade reform which was advancing on a faster track. Lapses in macroeconomic management and lower than expected export expansion, together with the delay in tranche release, contributed to the reemergence of foreign exchange constraints and threatened the sustainability of the program. V. Beyond the Government's hesitancy in defining the role of public enterprises in the economy and in taking decisive action thereof, several unforeseen factors caused the implementation of the program to suffer. Private sector capital available for the purchase of public enterprises was scarce and Government's receptivity to foreign investment for this purpose was less than complete. Rising energy import costs became a substantially greater burden on the economy. Due to changing economic conditions, many provisions of the investment code, which was in cffect at the inception of the adjustment effort, were not particularly effective and a broader version was only announced in December 1989, relatively late in the implementation of this particular program. Project Impact vi. The core objective of ITPAC - to implement trade policy reforms increasing competition and efficiency of the industrial sector and enhancing its contribution to the economy - was substantially realized. Industrial capacity increased in many of the more competitive sectors, with the largest gains achieved in the garment industry. Product line rationalization was a result of lower protection from imported goods and increased competition from abroad. This required a significant adjustment in production patterns and the response from parts of the sector was quite positive. Pricing policies increasingly incorporated market signals. The reorientation of the industrial sector came not only from rationalizing production of existing plant but also from new investment responding to incentives favoring exports. A feasibility study on free trade zone policy environmen., and development was completed with promising prospects for Madagascar. The comparative labor advantages offered by Madagascar, coupled with a liberalized access to foreign exchange and a more positive Government attitude towards foreign investment, have already induced foreigners to consider and undertake foreign direct investments.  vii. As expected, the impact of reforms on specific industrial subsectors varied in line with the subsectors' cnmparative advantage, relative labor and capital intensity and import requirements. Textile production ha. enefitted from pressure by exporting garment manufacturers foc quality and consistency improvements. New entries in the sector are gearing then.Aclves to sell directly into export markets. Existing specialized garment manufacturers are also becoming increasingly export oriented. The structure of the footwear subsector hes changed from a quasi-monopoly, prior to the adjustment process, to a multi- enterprise activity in which many small individual enterprises are subcontractors to the major producer. The seafood processing subsector has felt the greatest impact and the shrimp industry has grown to represent seven percent of the total exports of Madagascar. Vertical integration of shrimp fishing and farming has led to aquaculture pilot projects, which could further enhance export prospects. Sustainability and Conclusions viii. Project-supported reforms, togetherwith parallel Bank adjustment operations, had a major impact on reversing the economic decline and laying the foundation for the recovery of the Malagasy economy. Specific gains were made in GDP growth levels: starting in 1988 GDP per capita has grown in real terms for three consecutive years for the first time in almost two decades. Despite the encouraging progress noted in the previous section, the sustainability of the recent recovery will depend on the expansion of private sector investment and exports. The objective is to reduce the excessive dependence on external aid flows, which threatens the viability of Madagascar's external position and, in turn, could lead to comopacency in t.e reform process. ITPAC, and other adjustment programs, represent si nificant steps in this direction but a sustaineA diversification and expansion of Madagascar's export require additional efforts to improve the environment for private investment. The Government's reform agenda and Bank lending strategy are focussing on this objective. ix. ITPAC was successful in carrying forward the reform effort in Madagascar and setting the stage for renewed interest in Madagascar by domestic and foreign private investors. This achievement was helped by the following features of the operation: (a) the implementation of trade reforms was conditioned on a credible fiscal program that achieved and maintained internal balance; (b) currency devaluation made the elimination of quantitative restrictions consistent with tne balance of payments objectives; (c) the tariff reduction stage was phased to come after stabilization and was coordinated with the stabilization program; (d) accompanying domestic regulatory/institutional reform, which focussed on reducing Government discretion and facilitating business entry and exit, increased the effectiveness of the reforms; (e) implementation and monitoring of the trade reform was facilitated by the specificity of conditionality in terms of removal of quantitative restrictions and of reduction of both maximum and average nominal tariffs and the dispersion around the average;  - vi - x. Neverthelcss, recent developments (such as continuing concern with the weak performance of domestic taxes and heavy reliance on foreign aid, lack of currency convertibility for non-trade current account transactions and lack of momentum for further reform in the trade of services), suggest that the adjustment could have been more effective if: (a) trade reform had been directly linked to domestic tax reform, in particular excise and value added taxation. Poor revenue performance is generating pressures to raise revenue from trade taxes; (b) consideration had been given to whether the large amount of financing was sustaining the real exchange rate at an artificially high level (thereby perhaps hindering a better export performance), especially given that free access to foreign exchange was essentially limited to trade in goods; (c) a timetable had been agreed at an early stage for achieving full convertibility of the Malagasy franc for all current account tr3iisactions--this would have given more incentives for private investment and facilitated the privatization process that hindered disbursements under the Credit; (d) the eventual end-point of trade reform had been discussed explicitly: is the current 35 percent average tariff with 15 percent dispersion adequate when industrialized countries have tariffs of about 5 percent and high performing developing countries now have average tariffs of about 10 percent; and (e) during implementation more emphasis had been placed on the need for rapid reform in regulations controlling private investment and incentives to private investors, including foreigners, so as to get the full supply response and efficiency gains generated by the trade reforms. Xi. These design improvements, with the lenefit of hindsight, would probably have increased MAC's effectiveness. More generally, it is Possible to argue that the authorities could have managed the program better by implementing reforms in a more determined and less gradual manner. Their hesitancy, particularly with respect tu defining the role the the State and of PEs in the economy, sent mixed signals to the private sector and caused it to adopt a wait and see attitude. With hindsight, it is clear that actual results, in the form of supply response, could have been much more impressive if the reform program had been carried out with greater vigor. As noted in this report, however, the Madagascar reform program is generally considered as a relatively successful adjustment experience in Sub- Saharan Africa and ITPAC had an important contribution to this achievement.  PROJECT COMPLETION REPORT MADAGASCAR INDUSTRY AND TRADE POLICY ADJUSTMENT CREDIT (REDITS 1834-MAG and A-32-MAGj PART I: PROJECT REVIEW FROM BANK'S PERSPECTIVE A. Introduction Adjustment Context 1. The Industry and Trade Policy Adjustment Credit (ITPAC), was the third in a series of adjustment operations attempting to increase efficiency in resource allocation through liberalization of product and factor markets. These operations laid the foundation for the recovery of the Malagasy economy, which had been deteriorating rapidly since the early 19P.'s. The ITPAC Credits provided balance of payments support of approximnately US$100 million, in three equal tranches, disbursed in accordance with a pre-established schedule of economic reforms undertaken by the Government of Madagascar in the context of an ongoing dialogue with IDA and the IMF. 2. Four IDA adjustment Credits have been extended to Madagascar since 1985. Initially, the Government was not ready to implement a broad based structural adjustment effort. Instead, it adopted a cautious sector-by-sector strategy to address the many structural distortions in the economy. This approach was supported by two IDA sector Credits, beginnine with the Industrial Sector Adjustment Credit (ISAC) in 1985 and followed by the Agricultural Sector Adjustment Credit (ASAC) in 1986. Building on these two operations, the adjustment process gained momentum and, the Government, recognizing that sectoral policy improvements by themselves were unlikely to lead to significant and rapid slipply response, moved decisively to a broader agenda of far-reaching reforms supported successively by the Industrial and Trade Policy Adjustment Credit (ITPAC) in 1987 and the Public Sector Adjustment Credit (PSAC) in 1988. 3. The ISAC (US$60 million) became effective in July 1985. This operation was ct nceived as a first step U1 reducing distortions in the industrial sector and the economy as a whole. Specifically. ASAC focused on (a) freeing most ex-factory industrial prices; (b) eliminating export taxes on manufactured prod ucts; (c) removing some merchandise import prohibitions, thereby initiating import liberqlization; (d) improving the quality of the industrial public investment program; and (e) promu.,ating a more private sector-oriented investment code. A PCR' for this project has already been prepared, and it concludes that this operation, although perhaps modest in its specific conditionality, played a key role in setting the political economy stage for a comprehensive reform program. 4. The ASAC (US$100 million, including cofinancing) became effective in September 1986. Its objective was to increase the market orientation of the agricultural sector. ' PPAR on Industrial Assistance Project (Credits 1541-MAG and A-7-MAG), Report No. 10405, February 27, 1992.  -2 - Specifically, it focused on: (a) progressively reducing e need for Government rice imports by eliminating direct Government intervention in the rice market; (b) reforming the pricing system for major export crops and rice; (c) gradually reducing subsidies paid to agricultural trading companies and eliminating subsidie's on agricultural inputs; (d) transferring the responsibility for input supply to private comniercial interests; and (e) improving the quality of public investment in the agricultural sector. The implementation of ASAC has generally been satisfactory, and early results, particularly in the rice sector, have been encouraging. The second tranche was released in April 1989. The credit was closed in June 1990. 5. The ITPAC (US$100 million, including cofinancing) became effective in September 1987. Its objective was to increase the openness and efficiencv of the economy. The policy package supported by this ope-ation focused on: (a) . lizaEion of the foreign trade and foreign exchange allocation regimes; (b) tariff reform; kc) fw-r'.er price decontrol; (d) restructuring of public enterorises; (e) initiating reforms of tile banking system; and (f) improvine, the quality of the national public investment program (PIP). Analysis of experience with the implementation of this Credit and of its impact on the economy is the subject of this report. 6. The PSAC (US$180 million, including cofinancing) became effective in December 1988. This operation was geared to support additional actions aimed at reducing the heavy direct involvement of the state in the economy and improving public sector management. It focused on: (a) eliminating administrative export restrictions and the state stabilization funds' monopoly on pepper, cloves and coffee; (b) restructuring the banking sector; (c) restructuring and privatization of public enterprises; (d) introducing a new public sector budgeting system; (e) extending the annual public investment program into a rolling three-year PIP process and preparation of annual public expenditure programs; and (f) initiating a comprehensive civil service reform. After substantial upfront actions, implementation slowed in the public enterprise and budgetary reform areas, but since late 1990, the pace has quickened, allowing the second tranche release to occur in March 1991. 7. In addition to these adjustment Credits, financial sector and business environment reforms designed to stimulate bank competition, facilitate the conduct of monetary policy, and encourage private sector investment were puki.led under the APEX I Credit which was approved in March 1990. This project provides a line of credit through the banking system to support private sector investments necessary for the supply response envisaged under the policy framework fostered by the adjistment Credits. 8. Overall, ,c pite slower than expected progress in policy areas dependent on Madagascar's limited administrative capacity (i.e., budgetary and public enterprise reforms), the cumulative implementation of the package of sectoral and macroeconomic reforms enacted since 1985 has been satisfactory and has contributed to the r-sumption of growth. In response to the liberalization measures in agriculture for example, both the 1986 and 1987 crop seasons yielded substantial production increases in the rice secto? As a result, despite bad weather in 1988 and 1990, Madagascar has now significantly reduced its dependency on imported foodstuffs. For the economy as a whole, it was not realistic to expect a supply response much before 1989 because most of the crucial struc.ural adjustment reforms (price decontrol, exchange regime, external trade, restructuring of the banking sector and improved allocation of public expenditures) took place on;y beginning in 1987. Nonetheless, initial  3 - indicatioios of the positive impact on the industrial aector are encouraging, as summari7z in Section 0 belowY Country Background and Performance 9. Madagascar, a large islanu off the southeastern coast of Africa in the Indian Ocean, has a vast range of natural resources and a wide assortment of ecological and climatic variations. Madagascar's 570,000 sq km is home to a popAliation of about 11 million with a density of 20 people per sq km. While most of the island is rural, the widely dispersed urban centers have a unique multi-cultural and ethnic configuration. The country enjoys a blend of traditional values rr.ixed with an emerging modern outlook. 10. With a per capita income of US$230 in 1989, Mauagascar is one of the 15 poorest countries in the world. The agricultural sector accounts for about 41 percent of GDP, and employs approximately 90 percent of the work force. Coffee, vanilla and cloves are traditional exports and account for 28 percent of total exports. The industrial sector accounted for 13 percent of GDP in 1989. Rice, Madagascar's main staple, is grown in the central high!and plateau by small and medium-sized producers. 11. At the time of independence in 1960, Madagascar was a net exporter of rice and had a thriving private sector which operated in a relatively liberal economic environment. Depressed rice prices, as a result of Government interventions in the rice market, substantially reduced production incentives. As a result, the country has become a net importer of this commodity. More generally, the country's economic record is one of modest growth to 1970, stagnation from 1970 to 1980, sharp deterioration between 1980 and 1982, and financial stabilization with limited economic growth from 1983 through 1987. Since 1988, economic results have been encouraging. 12. The disappointing growth performance of the 1970s stemmed largely from inappropriate economic policies. These emphasized a much increased public sector role, with import substitution in industry as the central objective and agriculture in a support role, and pervasive controls on private economic activity. Between 1978 and 1980, the Government embarked on an "all-out" public investment policy which included large and economically non- viable projects. These policies, combined with declning terms of trade, led to an 11 percent decline in real GDP from 1980 to 1982 and a large external debt burden, which still severely constrains economic growth. 13. During the 1980s, the focus of economic managemen. moved from the urgent need of financial stabilization with IMF assistance in the first part of the decade to supply-oriented measures supported by the Bank and the Fund in the second part. Between 1983 and 1987, the economic decline of the preceding three years was arrested, and the economy grew at a modest average rate of 1.4 percent per annum. The improved policy environment contributed to an acceleration of economic growth starting in 1988, when GDP grew faster than population at 3.4 percent. The economy continued to grow by another 4.1 percent in 1989 ' A detailed analysis of the initial supply response to reforms in the industrial sector is contained in a gray-cover report "Adjustment in the Industrial Sector and an Agenda for Further Reforms" dated October 29, 1990. The economy-wide impact of the overall adjustment effort is assessed in the 1991 Country Economic Memorandum.  -4- and by 3.5 percent in 1990. Investment has also begun to recover. The composition of public investment has been slowly shifting towards activities which support rather than replace pri-ate economic efforts and its quality improved markedly. The recent investment recovery was largely associated with some initial pick-up of private investment, from a trivial amount until 1987 to around 5 percent of GDP in 1988 and 1989. B. Credit Genesis 14. Sector Dev lopment Objectives. The Government's strategy for the industrial sector was to continue the adjustment process that was initiated under the first adjustment operation in Madagascar, the Industrial Sector Adjustment Credit (ISAC). The reforms introduced with support fromr ITPAC were conceived to increase the productivity and efficiency of the industrial sector and of the econor. as a whole, and to gradually increase its capacity to generate foreign exchange and expand output, reversing the contraction of the past decade. These objectives would be achieved through the liberalization of product and factor markets. Free movement of relative prices would induce the reallocation of resources to more productive sectors, the greater use of domestic inputs and the transformation of the more efficient industrial units towards export-oriented production. The cornerstone of this policy package was the continuation and full implementation of international trade liberalization measures, supported by domestic deregulation. The quick-disbursing proceeds of the Credit were to increase the amount of foreign exchange available to finance imports by all economic agents under a liberalized import regime, thereby supporting the movement towards a market- determined exchange rate. 15. Policy Context. ITPAC was the third in a series of economic adjustment programs aimed at reversing previous policies. These policies emphasized state control of the economy and the allocation of resources by the Government rather than in response to market signals. This gave rise to inward-looking policies protecting domestic enterprises through an administered foreign exchang-.. allocation system, import licensing requirements, quantitative restrictions and high import tariffs. Stabilization efforts to correct the resulting internal and external imbalances were proving unsustainable and increasingly painful without a reversal of the policies of the previous decade. The Government, reluctant to venture into the unknown, was initially not inclined to inaugurate across-the-board corrections, although it was, in principle, committed to the process of reform. The positive results obtained under ISAC helped convince the Govemment that it was on the right road, opening the door for MAC and other reform programs. 16. Credit Design. ITPAC was designed to cover many problem areas with decisive action where half measures would not do (exchange rate, foreign exchange allocation and price controls) and with caution where a gradual approach seemed more appropriate (tariff protection and public enterprise reform). The policy reforms under MAC were to achieve increased competition in the domestic market. By quickly liberalizing foreign trade and the allocation of scarce foreign exchange resources, the economy moved a long way towards this objective. In order not to subject the local industry too abruptly to foreign competition, some protection was maintained through the system of ad valorem tariffs. Tariff protection was rationalized but was designed to remain high in the first year of the reform period when quantitative restrictions were eliminated for almost all products. Nominal protection was gradually decreased in the course of a four year reform program.  -5 - 17. Domestic cost-plus pricing controls were removed in parallel with increased competition from abroad. Price controls were formally maintained for five basic necessities. These, too, became redundant in practice soon after the implementation of the trade liberalization, and were removed shortly after the elimination of quantitative restrictions. In order to reduce pressures for increased trade protection to public enterprises and to moderate the burden on public finances, ITPAC called for the privatization/liquidation of ten major industrial public enterprises. Also included in the Credit was agreement on measures for dealing with several public projects of doubtful economic merit and on the Public Investment Program (PIP) for 1987, 1988 and 1989. Finally, the ITPAC program also envisaged increased competition in the financial sector. Policy measures to this end included reform of the banking law and plans for liberalizing entry in the domestic banking sector for new institutions drawing their equity base from the private sector, local or foreign. C Credit Objectives and Description 18. Credit Objectives. The Credit contained a policy package to remove barriers to efficient allocation of scarce resources. Its main features were expected to result in economy- wide benefits. With respect to the industrial sector, the objective against which success would be judged was to stimulate the revival of its more efficient segments and to provide strong incentives for the creation of efficient enterprises able to compete effectively in the domestic and foreign markets. 19. Credit comoonents. lTPAC included the following components: (a) Trade and Exchange Regime. To ensure the efficient allocation of foreign exchange, the Government agreed to establish a non-discriminating foreign exchange allocation regime and to introduce an Open General License (OGL) system covering all goods imported to Madagascar. This was supported by a real exchange rate adjustment which was expected to be followed by an active exchange policy to reestablish and maintain Madagascar's competitiveness. (b) Tariff Reform. So as to increase the outward orientation, competitiveness and efficiency of the industrial sector, the Government agreed to elinminate quantitative restrictions and to simplify the tariff system, finishing with all product-specific tariffs and tariff treatment by end use, and reducing tariff brackets to a maximum of ten. Tariff ceilings were immediately brought down to 80 percent and floors were set at 5 percent. Under a four-year program, average nominal protection would be reduced to 35 percent and the dispersion around the average to 15 percent. The program would also eliminate all exemptions and required that nominal and effective tariffs (revenues divided by imports) not deviate by more than 10 percent. (c) Price Decontrol. To make the Malagasy economy more responsive to increased competition, and in line with the international trade Lberalization, the gradual removal of price controls and cost-plus pricing was agreed. (d) Public Investment Program (PIP). To rationalize the PIP process and to improve the quality of public p.ojects, an agreement on the 1987 PIP at the  -6 - national level (not limited to just the industrial sector), was achieved during project preparation. This was to be followed up with agreements on the 1988 PIP and 1989 PIP. (e) Public Enterprise Reform. To reduce the Grovernment's role in productive activities, the Government identified ten public, sector manufacturing enterprises to be privatized, rehabilitated or liquidated (making a total of 26 since inception of public enterprise reform under ISAC). The preparation of an action program for these public enterprises was agreed. (f) Financial Sector Reform. A two-stage approach would be adopted. Initially, portfolio audits of the three state-owned banks would take place. Thereafter, portfolio restructuring plans would be formulated and implemented. Bank supervision would also be strengthened while a study would provide the analytical underpinnings for further financial sector reforms. D. Credit Component Performance 20. Trade and Exchange Regime. The import liberalization phase of the Credit introduced and developed a market-based system of foreign exchange allocation. In January 1988, a law eliminating quantitative restrictions on imports and import licenses was enacted. The list of prohibited items was left only with items that could present a risk to national security and health. A temporary surcharge of 30 percent was applied on previously prohibited items, while agreement was reached on a schedule to eliminate this surcharge in three years. In July 1988, foreign exchange policy reforms were widened with the introduction of a full-fledged Open General License System (OGL). This meant that unlimited foreign exchange became available at the prevailing exchange rate for import of goods by any economic agent. The 1987-88 overhaul of the foreign exchange regime was made possible by a cumulative 53 percent depreciation of the Malagasy franc in trade- weighted foreign currency terms. As a result of these actions, the overvaluation of the exchange rate was largely corrected by end-1988 and the OGL system could operate satisfactorily. 21. Before the initiation of the adjustment program, Madagascar had in place an extensive system of export controls, that included prior authorization to export, export price controls, minigum value requirements and trial periods for exporters. In September 1988, all export controls, with the exception of those applicable to vanilla and coffee, were eliminated. Beginning with the 1988/89 crop year, coffee producers were also allowed to negotiate and execute export contracts freely. With the exception of the foreign exchange repatriation obligation that still remains in force and the case of vanilla, virtualiy all other export controls have been eliminated. 22. Tariff Reform. The elimination of quantitative restrictions, import prohibitions and cumbersome licensing requirements pursued under ITPAC, coupled with the establishment and thereafter maintenance of competitive exchange rates, still left in place a high and dispersed level of tariff protection. A program of tariff rationalization was introduced in January 1988, when specific tariffs were substituted by ad valorem rates; tariff categories were reduced from 69 to 21, with a minimum rate of 5 percent scaling up to a maximum of 110  -7- percent. The maximum tariff rate has been gradually reduced and reached 60 percent in the 1991 Budget Law, leaving only 12 categories. The surcharge introduced for the previously prohibited products was phased out a year earlier than originally envisaged, in January 1990. in February of 1988 the Government also eliminated "end-use' taxation applicable to approximately 500 products. The 1989, 1990 and 1991 tariff reforms went a long way towards reducing the dispersion of the tariff distribution, eliminating cascading to a very large extent. The unweighted mean tariff rate reached 32 percent in 1990 and is expected to go down to about 29 percent in 1991, while the dispersion was 20 percent in 1990 and would be about 17 percent in 1991. This in turn had a major impact towards reducing effective protection. (see table 1) 23. Price Decontrol. Under ISAC, the decontrol of the ex-factory price of all manufactured goods was initiated. By late 1986, the number of goods under price control was further reduced to ten. The Government had nevertheless maintained controls on profit margins between ex-factory and retail prices for all industrial products. These controls were maintained in an effort to curb inflationary pressures resulting from the protection of monopolistic local industry existing in an environment of import-substitution. To meet ITPAC's conditions of effectiveness, the Government eliminated all profit margin controls. However, maximum price guidelines remained on all but 16 industrial goods. Decree No. 989/89 of the Ministry of Commerce, dated February 20, 1989, removed all price controls and recognized a free market system for the production and sale of all goods. 24. Public Investment Program. The Government of Madagascar sought to rationalize the public investment program which had reached unsustainable levels due to the uneconomic nature of the projects undertaken prior to 1982. Under ISAC, the quality of industrial projects had improved and the size of the program had been trimmed back. Project appraisal capabilitik, were also improved at the Ministry oF Industry level. In 1986 an agreement was also reached on an agricultural sector investment program. Under ITPAC, the overall PIP process was improved and agreement was reached for the 1987 national PIP during project preparation, followed by agreements on the 1988 PIP before second tranch disbursement. Agreement on the 1989 and 1990 PIP was reached in the course of reviewing the implementation progress on ITPAC and PSAC. 25. Public Enterprise Reform. Prior to ISAC the Govermment controlled about 170 companies or 97 percent of domestic industrial output. The majority of these received subsidies from the Government and suffered from managerial, technical and financial problems. The 1983 IMF stabilization program sharply reduced these subsidies. Following this reduction, the fully Government-owned banking sector continued to keep these enterprises alive. ITPAC's objective was to liquidate or privatize a definite number of public enterprises. At appraisal, a list of ten enterprises was identified for the preparation of diagnostic studies, but there was a three-month delay by the Govemment in presenting the Bank with the result of these studies. At second tranche release, it was agreed that completion of the divestiture or liquidation phase was to occur by December 1988 In fact this was only partially achieved by December 1990. By this date six companies had been liquidated, three were sold to private sector investors and the sole remaining company was given an extension for its sale or liquidation until May 1991. The ITPAC conditions were substantially met only after considerable delays. Indeed, difficulties linked to implementation of the privatization/liquidation of the ten public enterprises largely explain the delays in the release of the third tranche of the credit.  26. The public enterprise reform program has been cxpanded and continued within the Public Sector Adjustment Credit (Cr. 1941-MAG) approved on July 18, 1988. A comprehensive multi-year program has been formulated and is being implemented, with dissolution or divestiture actions having been initiated for about 50 public enterprises. An indefinite moratorium on the creation of new public enterprises was established in 1988, a ceiling on total credit to the parastatal sector has been included in the monetary programs since 1985, new credit to 'high risk" public enterprises has been prohibited and the Government has frozen at the 1987 level the budgetary transfers to all these public enterprises. The most important recent measure has been the c- ation in late 1990 by the Government of a single autonomous Special Unit reporting to the Prime Minister's Office with the responsibility to manage in its entirety the parastatal reform program. The Bank will continue the monitoring of the public enterprise reform program under the Public Sector Adjustment Credit and subsequent adjustment operations. 27. Financial Sector Reform. The financial sector was highly inefficient and unable to meet the challenges of a liberalized economy. ITPAC aimed at introducing the basis for liberalizing the banking sector and paving the way for private sector participation. The portfolios of the three state-owned banks were in need of major write-offs, mainly as a consequence of the previous public enterprise funding policy. The restoration of sound portfolios ind improvements in credit decision formulation seemed urgent and were included as conditions in ITPAC. As a consequence of the portfolio audits initiated in 1986, loans in the high risk category were immediately written down to the maximum allowable under accumulated provisions. Additional provisions for the rehabilitation of the portfolios were undertaken in April 1988 and again in February 1989. The Central Bank ensured that the prescribed provisioning and write-offs were fully implemented. The Banking Law of May 1988, enacted in the context of the negotiations for the PSAC and APEX credits, further established supervisory guidelines for the Central Bank and also allowed, for the first time, the participation of private capital in existing banks and provided for the creation of new private financial institutions. A new private bank called Banque Malgache de l'Oc6an Indien (BMOI), with 75 percent foreign and 25 percent local ownership started operations in mid- 1989. Cr6dit Lyonnais, a French bank, now owns a majority share in BNI, and an Italian bank, Banco de San Paolo, owns a minority share in BFV. Although the wording of the specific conditionality on the IPAC credit was ambiguous, staff interpretation during implementation was restrictive in the sense that tangible progress in the privatization process had to be achieved for tranche release. E. Project Formulation and Organization 28. The conceptual foundation for this project was jointly established by the Government and the Bank with the full support of the Fund. The Government of Madagascar, encouiaged by progress under the IMF-supported stabilization efforts and the Bank sector adjustment programs, requested IDA's help to continue and broaden the adjustment process through measures partly based on the findings and recommendations outlined in the studies initiated under ISAC. During the three supervisory missions of ISAC, a package of policy reforms was developed and thereafter discussed with the Govemment both during a preparatory mission in July 1986 as well as at the 1986 Annual Meetings. MAC was thus the logical progression as the second phase in the structural adjustment process. The project was designed to channel approximately 99 percent of the quick-disbursing proceeds of the Credit to increasing foreign exchange availability for imports, thereby supporting the opening  - 9 - up of the economy. The remaining proceeds were allocated to funding a study for the restructuring of 10 pre-identified public sector enterprises and to develop audits of the portfolios of the three state-owned banks (BNI, BFV and BTM). 29. The public enterprise reform component of the MAC was in retrospect not well designed. Almost all the enterprises included in the program were unprofitable and economically non-viable and did not attract foreign interest. Private sector interest was, in general, minimal. The Government was reluctant to liquidate them and feared that the privatization would benefit the local Indo-Pakistanis. Delays in the implementation of the public enterprise reform program cast doubt on the Government's commitment to liberalization and discouraged private investors. 30 ITPAC was jointly financed by IDA (Credit 1834-MAG, for SDR 12.5 million), the Special Facility for Sub-Saharan Africa (Credit A-32-MAG, for SDR 52.2 million), the Saudi Fund (Credit for Rials 12 million), and the Japanese Government (OECF Credit for Yen 1 billion and Grant for Yen 1 billion). Disbursements were made directly to the Government and administered through the Central Bank. Three tranches were foreseen for the IDA and special facility credit, while the OECF Grant and Credit and the Saudi Fund Credit had no tranching. F. Project Implementation 31. The operation was declared effective on September 21, 1987 as scheduled. The second tranche, released on 18 April 1988, was three months behind schedule, partly due to delays in import tariff reforms, but mainly because of serious difficulties on the privatization and liquidation of public enterprises. A waiver was requested and the rel ase was done only after three enterprises were liquidated and an action plan for the privatization or liquidation of the other seven by December 1988 was agreed. 32. Satisfactory implementation for the release of the third tranche in a timely manner was achieved in five out of six areas of reform: (a) adoption of a four-year program of tariff reform; (b) implementation of rules and procedures to be applied by the Central Bank in supervising the banking sector; (c) imrnlementation of the portfolio restructuring plans for the three fully Government-owned commercial banks (BNI, BTM and BFV); (d) introduction of an open general licensing system for imports; and (e) elimination of all restrictions on profit margins. However, actions taken on behalf of the ten targeted public enterprises for privatization and/or liquidation encountered significant delays, in spite of the agreements for second tranche release. The target date of July 1988 was extended to December 27, 1990. By that time, six of the public enterprises have been liquidated, three were sold to the private sector, and the remaining enterprise was granted a postponement of 3 months for its sale or liquidation. 33. The Malagasy legal environment was not favorable to privatization and/or foreign ownership. Foreign ownership definition, dividend payment provisions, capital repatriation, foreign currency denominated local bank accounts and employee retention provisions were serious obstacles to privatization. The original investment code, enacted in 1973, provided for some fiscal and other incentives but proved to be ineffective in its implementation. The National Assembly approved a new code in 1985, but this was not very helpful. The investment code was further discussed under PSAC and a broader version, more in tune with  - 10- the Government's reform efforts, was published in December 1989. However, the implementing decrees have reestablished some of the cumbersome bureaucratic procedures. The absence of a well functioning capital market, including private placements, issuance and dispersal of stock and an orderly secondary market, was also a serious drawback to an efficient dispersal of public assets. G. Impact of Adjustment Aggreiate Supply Response 2' 34. The overall impact of the turnaround of the Malagasy policy environment has not been spectacular in terms of per capita growth and supply response has been neither unexpectedly slow nor uniformally sluggish. In the rice sector, for example, the response to the 1986 liberalization measures was practically immediate, with the 1987 season showing a substantial production increase. The increase was slowed in 1988 by bad weather, but resumed at an accelerated pace in 1989. Helped by liberalization and good weather, the country has moved away from heavy import dependence in this key staple. In the manufacturing sector, investment for export production is beginning to gather momentum, but this is not yet reflected in aggregate export statistics. With regard to the timing of the response in the economy as a whole, it was not realistic to expect much before 1989 because the fundamental structural adjustment changes did not begin in earnest until 1987-88 with the reforms in the tariff and exchange regime. But around mid-1988 a response started to appear. 35. The twelve months between the large devaluation of June 1987 and the introduction of the Open General License (OGL) import system on July 1, 1988 was a key transition period to the beginning of recovery. For the first half of 1987, the tight administrative import regime required by the overvalued exchange rate continued to be an obstacle to sustained economic expansion, but it provided short-term insulation against sharp reductions in imports of intermediate goods. The June 1987 devaluation was an essential prerequisite for moving the economy to a higher growth path, but it temporarily reduced domestic absorption, and the economic situation consequently did not improve through early 1988. Indeed, exports and imports continued their decline through the middle of 1988, along with private sector credit and GDP. 36. The impact of the devaluation, both on prices and on domestic demand, was absorbed relatively quickly. In April 1988, inflation began to decelerate rapidly and economic activity began to recover. Real GDP grew by 3.4 percent for 1988 and by 4.1 percent in 1989. Growth in 1990 continued at a slower pace (3.5 percent), yielding the third consecutive year of per capita GDP increase. Thes.e changes in the level of major aggregates gain added credibility from concomitant improvements in their composition, with imports of capital goods and long-term credit growing especially fast. Employment data in Madagascar cover less than 10 percent of labor force and show some stagnation. However, partial information suggests that the informal sector has been an important and growing source of employment opportunities. ? This section draws from the 1991 Country Economic Memorandum  - 11 - 37. Since 1984, the poor performance of total exports has mainly reflected the price and volume declines of the "traditional" export crops of Madagascar, namely, coffee, cloves and vanilla. The relative share of these three products in the Malagasy exports declined from a maximum of 68 percent in 1984 to 48 percent in 1989. Because of the decline in aggregate exports, it would be misleading to call this "diversification". Actually, in value terms, exports other than coffee, cloves and vanilla collapsed from US$171 million in 1980 to US$114 million in 1987. In 1988 and 1989, however, non-traditional exports picked up markedly, spurred by the liberalization measures and by the devaluation. (see table 2) 38. Overall, the impact of the exchange rate devaluation on Malagasy exports was disappointing. For the 1980-89 period, the elasticity of exports with respect to the real effective exchange rate was very low. However, this low elasticity does not diminish the importance of maintaining a competitive exchange rate to develop and diversify exports. First, the low elasticity of total exports reflects the inelasticity of traditional Malagasy exports. In turn, this is partially explained by the Government policy of severing farmgate prices from border prices, thereby preventing a pass-through of the exchange rate adjustment. Second, the supply response to exchange rate variations was better for non-traditional exports. 39. Given the stagnation of exports, merchandise imports bore the brunt of the external adjustment in the 1980s. At constant prices, Malagasy imports fell by more than 60 percent between 1980 and 1989. Over the decade, the major instrument used to compress imports shifted from quantitative restrictions to exchange rate policy. The major devaluation of 1987 enabled the dismantling of the quantitative restrictions, the implementation of the tariff reform, and the move to a free foreign exchange allocation system for imports. Quick disbursing resources from external assistance, including ITPAC, made possible a substantial increase in imports, especially in 1989 and 1990. (see table 2) Supplv ResRonse in the Industriai Subsectors 40. The core objective of this project was to implement trade policy reforms which would in turn stimulate increased efficiency in resource allocation. Because the long-term nature of the liberalization process, it is too early for a full assessment of the project's impact. However, certain trends are manifesting themselves and support the hypothesis that the private industrial sector in particular is responding positively. The most satisfactory change in the economy that resulted from the ongoing reforms in the increased outward orientation of the historically import-substituting industry. The successful macroeconomic stabilization and, in particular, the devaluations and liberalization of the import and export procedures, have stimulated private sector development of the garment, knitwear and food processing industries. 41. Until 1986, firms operated well below capacity, at rates averaging 45 percent and never exceeding 60 percent, owing primarily to the uncertain and discriminatory allocation of scarce foreign exchange. Since 1987, industrial capacity utilization has gradually risen by about 15 percentage points to 60 percent on average, even in the face of weak domestic demand. The increasing profitability of exports due to the 1987 devaluation, and the non- discriminatory allocation of the increased foreign exchange supply since the adoption of the Liberalized Import Regime, are major contributors to the rising capacity utilization. The garment subsector, which is driven by export demand, made the most impressive gains in industrial capacity utilization, reaching a rate of 85 percent in 1988, from a 1986 utilization  - 12 - rate of 50 percent. So rapid was the expansion that some firms had to bring into productive use for the first time idle equipment that had been in storage for ten years. 42. The liberalization of imports and the increased access to foreign exchange also created a new pattern of stock management. Heretofore importers maintained a six-month to a year's supply of imported spare parts and inputs so as to sustain current production requirements. This has been cut back by half, generating savings of between six and eight percent of total proauction cost. The reduction in aggregate import demand was temporary because the additional capacity utilization and expansion required increased imported inputs. 43. A trend towards rationalization in production was another significant behavioral adjustment which resulted from having an increased availability of imported goods in the domestic market. Market forces have required firms to rethink their production patterns as well as their pricing policies. This rationalization has, however, not taken place in sectors where distribution is restricted, such as tobacco and pharmaceuticals. Significant gains have been achieved in raising the level of quality control and reducing production costs. Product quality levels in the export sector are still lagging behind international standards, even though substantial progress has been made. Specific subsectors, such as the garment industry, have met the stringent international requirements and are producing high quality labor-intensive goods. 44. Smaller private sector enterprises have been reacting more rapidly to the rationalization process. This is primarily due to lingering attitudes prevalent under past monopolistic and protectionist practices that the large capital-intensive firms enjoyed for many years. In some areas, adjustment is also slower due to the built-in financial inefficiencies, the prevailing but outmoded employee retention schemes, and the continued use of inefficient capital-intensive technologies. In some areas adjustment has now firmly taken hold, as is illustrated by the shoe manufacturing subsector, which trimmed its work force through normal attrition and streamlined its product line by reducing from two thousand to two hundred the styles it is producing. The shoe industry has also increased the use of locally produced intermediate inputs by 50 percent. 45. Enterprises that rely on labor rather than fLxed assets are more flexible in adjusting to the Malagasy reform measures. Although labor is almost a fixed production cost because of the strict regulations regarding lay-offs, labor is more easily adjusted than technology, and it is cheaper than capital. Averaging only 5-8 percent of production costs (15 percent for smaller enterprises), Madagascar clearly has had a competitive edge over the Asian miracle countries by a factor of five, in terms of hourly compensation rates for workers, since the 1987 devaluation. This margin is considered sufficient to compensate for the skill differentials. 46. A 1988 study on free trade zones, financed under MAC, concluded that such zones could bring positive results in the near term. Encouraged by the economic success that Mauritius has had in the past decade with the establishment of the free trade zones, the Malagasy Government established the legal framework with Law 89-027 of 1989. Recently an agreement was signed with a group of Chinese investors, where the Government granted a free trade zone clearance for the port of Toamasina and delivered a fifty-year renewable lease. The investors have agreed to make a US$650 million investment in the Zone over fifteen years and it is estimated that 78,000 jobs will be created over this period.  - 13 - 47. Madagascar has been able to exploit its comparative labor advantage in the garment and knitwear subsectors. Firms in these subsectors can be identiried as pre-liberalization, mostly import-substituting, and the post-liberalization, export oriented entrepreneurs catering to the "higher volume--lower price" segment of the international market. An interesting exception to this pattern is the export oriented producer of hand crafted, high quality children's wear. The footwear subsector had traditionally been quasi-monopolistic, with one firm controlling 64 percent of the domestic mark-et and the remaining 36 percent covered by artisanal small producers. In 1988, sixty-three percent of primary materials had to be imported by the main producer, but by 1989 this had fallen to 50 percent. Reliance on subcontracts for some of the production also became more cost effective for the major producer. The subcontracting aspect had a very stabilizing effect on smaller producers who were beginning to face severe competition from imports. New entries in this subsector are positioning themselves as exporters. 48. The seafood processing subsector has a high capacity utilization rate and ninety percent of production is exported. Offshore fishing is a growing industry and specific agreements have been signed with Japan and the European Community. Major gains, since 1987, have been noted in shrimp fishing and farming. Aquaculture pilot projects have been established in the coastal regions for shrimp and oyster farming. Shrimps now account for approximately seven percent of total exports and the farming operations could substantially raise that figure as they near full capacity. The Results in Public Enterprise Reform 49. A "score card" of public enterprise reform from 1988 through mid-1991 shows the following: (i) credit to parastatals fell from 47 percent of total non-government credit at end 1987 to 30 percent at end 1990; (ii) dissolution or divestiture actions have been initiated for 70 public enterprises (out of the total of 170) and fully completed for 34 of them; (iii) the important textile industry, in particular, is in the process of going from almost entirely state- owned to fully privatized; (iv) restructuring plans have been formulated for the six largest agricultural and commercial parastatals; (v) encouraging improvements have been made in the financial situation and management of certain important public utilities, particularly the electricity and water company (JIRAMA) and the national railroad; and, as noted in paragraph 26, (vi) a single entity to manage the reform process has been established. Because of the heterogeneity of the parastatal sector in Madagascar, it is impossible tco "measure" on a precise uniform yardstick the economic importance of the actions taken. Nonetheless, a combination of criteria (value added, employment, invested capital, etc.) leads to the conclusion that the reform actions already completed or underway affect about one third of the parastatal sector as a whole. H. Conclusions 50. Madagascar has made significant progress in its shift from a command economy, with almost two decades of economic decline, to a market oriented economy. From 1988 to 1990, economic recovery continued at a reasonable pace, although Madagascar still remains highly dependent on external aid. Efforts must be made to stimulate private savings and investment among both households and enterprises and to expand exports.  14 - 51. IT.PAC was successful in carrying forward the reform effort in Madagascar and setting the stage for renewed interest in Madagascar by domestic and foreign private investors. This achievement was helped by the following features of the operation: (a) the implementation of trade reforms was conditioned on a credible fiscal program that achieved and maintained internal balance; (b) currency devaluation made the elimination of quantitative restrictions consistent with the balance of payments objectives; (c) the tariff reduction stage was phased to come after stabilization and was coordinated with the stabilization program; (d) accompanying domestic regulatory/institutional reform, which focussed on reducing Government discretion and facilitating business entry and exit, increased the effectiveness of the reforms; (e) implementation and monitoring of the trade reform was facilitated by the specificity of conditionality in terms of removal of quantitative restrictions and of reduction of both maximum and average nominal tariffs and the dispersion around the average; 52. Under IITAC, Madagascar built on the first tentative steps under previous operations to firmly put Madagascar on the path to becoming an open market oriented economy. Nevertheless, ITPAC was not able, on its own, to underpin such a radical transformation. Parallel and successor operations addressed imbalances in the public sector (PSAC), mitigated the social costs of adjustment (PASAGE) and provided resources to encourage private productive investment (APEX). Furthermore, remaining distortions in the labor market, in restrictions on currency convertibility for current account transactions and civil service reform are expected to be tackled in future adjustment operations. 53. Nevertheless, recent developments (such as continuing concern with the weak performance of domestic taxes and heavy reliance on foreign aid, lack of currency convertibility for non-trade current account transactions and lack of momentum for further reform in the trade of services), suggest that the adjustment could have been more effective if: (a) trade reform had been directly linked to domestic tax reform, in particular excise and value added taxation. Poor revenue performance is gerAerating pressures to raise revenue from trade taxes; (b) consideration had been given to whether the large amount of financing was sustaining the real exchange rate at an artificially high level (thereby perhaps hindering a better export performance), especially given that free access to foreign exchange was essentially limited to trade in goods; (c) a timetable had been agreed at an early stage for achieving full convertibility of the Malagasy Lranc for all current account transactions--this would have given  - 15 - more incentives for private investment and facilitated the privatization process that hindered disbursements under the Credit; (d) the eventual end-point of trade reform had been discussed explicitVy is the current 35 percent average tariff with 15 percent dispersion adequate when industrialized countries have tariffs of about 5 percent and high performing developing countries now have average tariffs of about 10 percent; and (e) during implementation more emphasis had been placed on the need for rapid reform in regulations controlling private investment and incentives to private investors, including foreigners, so as to get the fuli supply response and efficiency gains generated by the trade reforms. 54. These design improvements, with the benefit of hindsight. would probably have increased ITPAC's effectiveness. More generally, it is possible to argue that the authorities could have managed the program better by implementing reforms in a more determined and less gradual manner. Their hesitancy, particularly with respect to defining the role the the State and of PEs in the economy, sent mixed signals to the private sector and caused it to adopt a wait and see attitude. With hindsight, it is clear that actual results, in the form of supply response, could have been much more impressive if the reform program had been carried out with greater vigor. As noted in this report, however, the Madagascar reform program is generally considered as a relatively successful adjustment experience in Sub- Saharan Africa and ITPAC had an important contribution to this achievement.  - 16 - PROJECT COMPLETION REPORT MADAGASCAR INDUSTRY AND TRADE POLICY ADJUSTMENT CREDIT (CREDIT 1834-MAG and A-32-MAG) PART II: PROJECT REVIEW FROM BORROWER'S PERSPECTIVE The Government of Madagascar typically comments on PCRs. Indeed, it had provided extensive comments on the PCR for the Industrial Sector Adjustment Credit, the first adjustment operation in Madagascar, which was sent to OED in June 1991. Due to the current political transition, the Government was not able to comment on this PCR by the end of November 1991, as we had requested in September 1991. We do not believe that the Government will be able to comment in the near future and we, therefore, decided not to delay the processing of the PCR.  - 17 - PROJECT COMPLETION REPORT MADAGASCAR INDUSTRY AND TRADE POLICY ADJUSTMENT CREDIT (CREDIT 1834-MAG and A-32-MAG) PART III. STATISTICAL INFORMATION CREDIT DATA Amounts (SDR million) As of June 30, 1991 Original Disbursed Canceled Repa&d Outstanding IDA 1834-MAG (SDR) 12.5 12.5 0.00 0.00 12.5 SFA A-32-MAG (SDR) 52.2 52.2 0.00 0.00 52.2 SUB-TOTAL (SDR) 64.7 64.7 0.00 0.00 64.7 SALIDI LOAN (RIALS) 12.0 12.0 0.00 0.00 12.0 OECF LOAN (YEN) 1,000.0 1,000.0 0.00 0.00 1,000.0 JAPAN GRANT (YEN) 1,000.0 1,000.0 0.00 0.00 0.0 SU-B-TOTAL (YEN) 2,000.0 2,000.0 0.00 0.00 1,000.0 Original Credit Dates Revised Initiating NMeorandum. 30 October 1986 Letter of Development Policy 5 June 1987 Negotiations April/May 1987 Board Approval 30 June 1987 Signature: IDA, SFA, Saudi Loan 10 July 1987 Japanese Loan/Grant 10 July 1987 20 October 1987 Credit Effectiveness: IDA, SFA, Saudi Loan 21 September 1987 Japanese Loan/Grant 19 April 1988 First Tranche Release 21 September 1987 Second Tranche Release January 1988 18 April 1988 Third Tranche Release Juty 1988 27 December 1990 Closing Date 31 December 1989 31 March 1991 CUWUIATIVE CREDIT DISBURSEMENT FY87 FY88 FY89 FY90 FY91 IDA 1834-NAG (SDR) Planned 4.17 12.50 12.50 12.50 12.50 Actual 2.78 8.50 8.51 8.51 12.50 SFA A-32-MAG (SDR) Planned 17.40 52.20 52.20 52.20 52.20 Actual 12.50 29.68 29.85 29.85 52.20 TOTAL (SDR) 15.28 38.18 38.36 38.36 64.70 Actual Total as Planned Total 71 59 59 59 100 OECF CREDIT (YEN) N.A. N.A. 250.25 475.77 1,000.00 JAPAN GRANT (YEN) N.A. N.A. 1,000.00 N.A. N.A. SAUDI LOAN (RIALS) N.A. N.A. N.A. N.A. N.A.  - 18 - MISSION DATA Month/Year No. of Weeks No. of Persons Staff Weeks Report Date Preparation June 1986 10/30/86 AppraisaL Nov/Dec 1986 3 8 16 12/16/86 Post-Appraisal February 1987 1 3 3 03/02/87 March 1987 2/3 2 5 04/03/87 Supervision September 1987 2 2 4 10/07/87 January 19