Madagascar - A strategy for high growth and poverty allevation : an economic strategy note

Report No. 1 3274-MAG Madagascar A Strategy for High Growth and Poverty Alleviation An Economic Strategy Note June 29, 1994 Country Operations Division South Asia and Indian Ocean Department Africa Region FOR OFFICIAL USE ONLY U Docuent of lb Woid BS This documen'as a restricted distribution and may be used by recipients onty in hepe*wfance of thier officia duies. Its contents may not otherwise be disclosed without Wor- Bank autorization  CURRENCY EQUIVALENTS Currency Unit Malagasy franc (FMG) US$1.00 = FMG 1,914 (average 1993) = FMG 1,963 (Dec. 31, 1993) - FMG 2,947 (May 9, 1994 - first day of free float) MALAGASY FISCAL YEAR January I - December 31 WEIGHTS AND MEASURES Metric System BritishWUS Equivalent I meter (m) = 3.28 feet I square meter (sq. m) = 10.76 square feet I kilometer (kin) = 0.62 mile I square kilometer (sq. km) = 0.39 square mile 1 ton (metric) = 2204.6 pounds ABBREVIATIONS AND ACRONYMS AIDS Acquired Immune Deficiency System BFV Commercial Bank (Banky Fampandrosoana ny Varotra) BTM National Rural Development Bank (Bankin'ny Tantsaha Mpamokatra) BTU British Thermal Unit GDP Gross Domestic Product ILO International Labor Office LDC Less-Developed Country LIR Liberalized Import Regime NEAP National Environmental Action Plan NIEs Newly Industrializing Economies NGO Non-Governmental Organization OGL Open General Licensing OECD Organization for Economic Cooperation and Development PIP Public Investment Program STD Sexually-Transmitted Disease STIMAD Malagasy Corporation for International Telecommunications (Societe de Telecommunications Intemationales de Madagascar) UNCTAD United Nations Conference on Trade and Development UNDP United Nations Development Program  FOR OFFICIAL USE ONLY Preface This Economic Strategy Note was prepared by a team composed of Pierre Demangel (Task Manager), Daniel Tommasi (Consultant), and Louis Goreux (Consultant). Other contributors were Benoit Blarel (agriculture), Bengt Bostrom (tourism), Dieudonne Randriamanampisoa (private sector), and AF3PH staff (human resources). Nicolas Gorjestani (Division Chief, AF3CO), Eugen Scanteie (Principal Economist), Ulrich Thumm (Lead Economist), Jer6me Chevallier (Operations Advisor) and Francisco Aguirre-Sacasa (Director, AF3) gave substantial advice and direction to the work. The peer reviewer was Sudhir Shetty. Helpful comments were received from members of the Madagascar Country Team and the AFRVP economic office. The Economic Strategy Note was issued in French as a "white paper" in June 1993 and discussed extensively in Madagascar with the transition government, with political and economic groups, as well as with the press and socio-professional associations. The new government formed in August 1993 has formally endorsed the strategy and cleared the publication of the Note. In May 1994, the government took a number of important actions, most significantly floating the exchange rate and abolishing import prohibitions. The PFP prepared in June 1994 by the Malagasy government, with the joint support of the Bank and the IMF, is explicitly conceived as a first step in the implementation of the "dynamic reform for sustained growth" scenario presented in the Note. This document has a restricted distribution and may be used by recipients only in the perfornmane of their l official duties. Its contents may not otherwise be disclosed without World Bank authorization. l   Table of Contents SUMMARY AND CONCLUSIONS i 1. Introduction i 2. The sustained growth scenario ii 3. Economic policies v 4. Managing the transition vii I. INTRODUCTION I H. RECENT ECONOMIC DEVELOPMENT AND SOCIAL INDICATORS 3 HISTORY OF THE ADJUSTMENT PROCESS, ECONOMIC DEVELOPMENT AND CURRENT ECONOMIC POLICY 3 POVERTY, UNEMPLOYMENT, POPULATION GROWTH, AND THE ENVIRONMENT 4 Im. LONG-TERM PERSPECTIVES FOR DEVELOPMENT 7 BASIC OPTIONS 7 SOURCES OF GROWTH 10 National savings and foreign aid 11 Development of exports and world markets 13 Potential by sector 18 The role of human resource enhancement 23 MEDIUM-TERM SCENARIOS 24 The "do nothing" scenario 25 The "adjustment as usual" scenario 26 The "dynamic reform for sustained growth" scenario 27 CONSTRAINTS ON DEVELOPMENT 29 IV. ECONOMIC POLICIES TO ENABLE SUSTAINED GROWTH AND REDUCE POVERTY 30 AN INSTITUTIONAL FRAMEWORK CONDUCIVE TO GROWTH 30 Role of the state 30 A legal and regulatory system conducive to the development of the private sector 31 Macroeconomic policy 34 A growth-oriented human resource development strategy 37 POPULATION, POVERTY, AND THE ENVIRONMENT 39 V. MANAGING THE TRANSITION 41 PRIORITIES 4 1 Macroeconomic stability 41 International trade and finance policies 42 Eliminating the barriers to economic activity 42 Private sector development 42 Human resources policies 43 THE STEERING GROUP 43 PARTICIPATION BY THE PEOPLE 44  ii The Newly Industrializing Economies (NIEs) example' v. The example set by East Asia and Mauritius demonstrates that it can indeed be done. Since 1965, the economies of Indonesia, Malaysia, Thailand, Korea, and China have on average been growing by over 6 percent a year. More recently, Mauritius has achieved an average growth of 7 percent during the 1980s. vi. The conditions that enabled some NIEs to achieve high annual growth and join the ranks of more developed countries have a number of common features. In all cases, governments maintained rigorous and growth-oriented macroeconomic policies that included: (a) economic expansion driven by vigorous growth in exports and in the manufacturing sector, made possible by an increasingly productive labor force and an openness to the outside world; and (b) an environment conducive to entrepreneurial initiative and private investment, where the state has withdrawn from sectors unrelated to its essential responsibilities. High domestic savings helped sustain high investment rates, which in turn contributed to significant growth. Considerable resources were also invested in education and health. Private savings, private investment, and direct external investment constitute the foundations of the new approach. vii. Sustained growth is inseparable from measures to eliminate poverty and unemployment, control population growth, develop human resources, and protect the environment. Poverty and population growth are major contributors to environmental degradation. In turn, deterioration of soil and infrastructure results in declining output and impoverishment of the population. The achievement of a sustained high growth rate based on labor-intensive export activities is the best way to reduce poverty, since it gives the poor the opportunity to capitalize on their major asset, i.e. their labor. The development of education and of primary health care increases the capacity of the poorest to contribute to economic expansion, and share its benefits. Three main economic policy options viii. Madagascar is faced with choosing among three economic scenarios. The first assumes a continuation of present economic trends, without any major program of reforms. This scenario would result in a continuing decline in living standards, and represents the most probable outcome if no corrective action is taken. The second option would involve a program of partial reform similar to the one implemented in 1988-90. The result would be moderate per capita growth, where 1971 growth levels would not be attained until 2065. But in the long-term, the program would be difficult to sustain since the business climate would be plagued by uncertainties and private entrepreneurs would be hesitant to invest. The third option, "sustained growth, " is barsed on the hypothesis that given more daring and innovative economic policies, annual growth of about 6 percent could be achieved by the year 2000, and 1971 living standards restored in about 10years. Only with option three could Madagascar see a reduction in poverty by the end of the decade. This report will attempt to demonstrate that stustained annual growth of 6 percent can indeed be achieved, and will discuss the economic policies that could make it possible. Strictly speaking, the term "Newly Industrializing Economies" has been used elsewhere to refer to Thailand, Indonesia and Malaysia. In this report, it refers more broadly to the group of countries which have achieved sustained high growth through an export-onented strategy.  iii 2. The sustained growth scenario ix. The sustained growth scenario is based on Madagascar's potential in the agricultural, industrial, and tourism sectors. Its objective would be to achieve steady economic expansion with a target of 6 percent growth by the year 2000, and to subsequently maintain at least that rate. This would involve full utilization of Madagascar's natural and human resources and require over 4 percent growth in the agricultural sector, about 10 percent growth in the industrial sector, and 6 percent growth in the service sector. a. Sectoral sources of growth x. The agricultural sector currently accounts for 32 percent of GDP and employs 70 percent of the labor force. To achieve 4 percent growth, an agricultural strategy would require expanded production for the domestic market, the resumption of growth of traditional export crops, and most importantly, the diversification of agricultural production for export. Food production--the predominant component of agriculture--could be boosted significantly by increasingyields. The present low yields are a result of both not making efficient use of irrigation systems, and not exploiting comparative regional advantages. Some traditional export crops-- coffee, vanilla, pepper, cotton, and peanuts--could be developed by better organizing their production and marketing channels (particularly for quality control and export promotion), and lifting the export restrictions on vanilla and cotton. Because of Madagascar's rich diversity of natural resources, there is great potential for developing nontraditional exports. In recent years, the cultivation of nontraditional products, such as fruit (litchis), vegetables, maize, cassava, and seafood products, has risen dramatically. Actual export volumes, however, are still low due to small market shares in importing countries. xi. The industrial sector represents 14 percent of GDP Thtough originally geared to the domestic market, it has recently been boosted by new industries made possible by the free trade zone, and a new investment code. New export niches have opened up, particularly in the clothing, shoe, and wood processing sectors. Successful industrial growth will rest on Madagascar's ability to establish an economic climate conducive to both foreign and local investment. The recent relocation of Mauritiun enterprises is a good sign; however, economic policies for attracting foreign investment to Madagascar must continue to improve. xii. Tourism in Madagascar is underdeveloped, in spite of abundant natural resources. In 1990, Madagascar welcomed 50,000 tourists, compared to Seychelles' 100,000, the Maldives' 160,000 and Mauritius' 300,000. The number of tourists to Madagascar could be increased to 150, 000 by the year 2000 by exploiting the country's potentialfor beach, cultural, and ecological tourism. This would require improved medium- and long-range air access to the island and the establishment of well-targeted infrastructure on the most promising sites. Madagascar has the potential to develop other services, such as consultant services, telecommunications, insurance, and transport, faster than the overall growth rate. b. Economicfoundationsfor growth xiii. The "sustained growth" scenario is based upon a strategy of export promotion linked to production diversification and private sector development. Sectoral growth can be achieved only if Madagascar succeeds in accumulating the needed productive capital, requiring a significant  iv increase in both the investment rate and the mobilization of savings necessary to fund such investment. Also crucial to the strategy's success is further development of human capital. Savings and investment xiv. The accumulation of productive capital involves raising investment from 11 percent of GDP in 1991 to over 20 percent of GDP by the year 2000. This is a feasible goal. Successful NIEs have investment rates topping 30 percent. The investment structure must change even more dlrastically: private investment (now 33 percent of domestic investment) will have to increase to 60 percent by the year 2000. Domestic savings, virtually nonexistent today, are crucial to the financing of such high investment rates. An important step to generating public savings is using^ a rigorous budgetary policy to bring down the deficit. Private savings can be encouraged by increasing national revenue, creating a financial market, and setting positive real interest rates. Nevertheless, the country will still require considerable external savings in the form of direct foreign investment, public assistance for investment, balance of payments support, and debt rescheduling. As with the NIEs, Madagascar's ultimate success will rest on a sign ificant increase in directforeign investment. An export-oriented strategy xv. 7he economic successes of NIEs and such countries as Mauritius are founded on an export promotion policy that yielded faster export growth than the growth of GDP. These countries took advantage of periods of expanding world markets and exported their most dynamic products to coincide with those periods. In times of world recession, they boosted their exports by increasing their market share. The steady growth of their exports was sustained by ongoing diversification efforts. All these countries passed through similar stages: diversification of agricultural exports, export of labor-intensive manufactured products, and transition to high- technology products made possible by enhanced human capital. In Madagascar, the expansion of the free trade zone export industries in nontraditional sectors (vegetables, silk, leather goods, essential oils, models, bicycles, watches, jewelry, buttons, and electrical equipment) is a positive sign and bodes wellfor the country's ability to follow a similar development path. Human resources xvi. For NIEs, investment in human resources has proved to be a highly profitable undertaking. Upgrading human capital--for example training workers in improved technical and management skills-can help develop future entrepreneurs and can contribute to productivity gains across all sectors. Women's education has been shown to have a positive impact on controlling population growth and improving children's health. Rehabilitation of educationi and health services can improve the access of the poor to the benefits of growth. As with physical investment Madagascar has a long way to go before these changes can be implemented. teachitng standards have declined at all levels, and the health care system is extremely inefficient. Human resource development is beneficial in the short- and medium-term as well--the economic benefits of appreciable improvements in education, including vocational training, and health care could have an impact very quickly.  v c. Constraints on development xvii. In order for Madagascar to successfully realize its growth-oriented strategy, the government will have to eliminate the constraints that prevent the country from fulfilling its economic potential The principal constraints can be summarized as follows: (a) Inadequate infrastructure for transport, telecommunications, and electric power. In terms of the road network, Madagascar has 84 kms of roads per thousand sq. kms of territory compared with 100 kms in Malaysia, Thailand, and Indonesia. (b) Poor social conditions. Poverty, inadequate education, and substandard sanitation limit the country's ability to contribute to a strategy of sustained economic growth. Life expectancy is 50 years compared to 60 to 70 years in Malaysia, Thailand, and Indonesia. The infant mortality rate is 12 percent compared to 6 percent in Indonesia and less than 3 percent in the other two countries. (c) The inefficiency of government institutions and their inability to operate within the context of a market-based economy. Many sector-specific departments still maintain control over private sector investment and import/export activities, and the legal and regulatory framework is not conducive to private investment or initiative. (d) A shortage offoreign exchange, which limits economic activity and reflects the huge external trade deficit. The high level of foreign indebtedness will require debt relief measures so that the government can restore sound external relations, including with the donor community. 3. Economic policies xviii To achieve sustained growth, the government will need to eliminate the above constraints, and enact new economic policies and implement them with determination. A profound change in outlook will be needed to keep the state focused on its essential objectives: establishing a coherent macroeconomic policy geared to financial stability, liberalizing the economy, improving infrastructure, and waging a comprehensive battle against poverty, environmental degradation, and the deterioration of social services. The government's role xix. The country needs a strong government that can fulfill its essential duty to the people--to guarantee security, institute a regime of sound macroeconomic management, ensure that the legal and regulatory systems function properly, and develop human resources and infrastructure. This implies that the government must abandon its orientation towards state-administered economic activity, and withdraw from productive activities, both in public enterprises and in public investment projects. It also implies a reduction in nonrriority expenditure, increased user fees, and the privatization of services in order to increase efficiency. The same principles should guide the decentralization process provided for in the August 1992 constitution. The decentralization process should aim at developing regional potential without increasing the overall weight of government administration. Public investment programs should be geared to promote economic expansion while targeting improvements in transport, telecommunications, and social services. Not only the nature but the quality of investment is critical if funding is to generate the desired growth. Although a high volume of investment was focused on the public sector and university construction during 19 79-80, it failed to stimulate economic growth. All available funding must  Tables Table 1: Economic indicators, selected years 1980-92 3 Table 2: Socioeconomic indicators for selected developing countries 5 Table 3: Madagascar exports 16 Table 4: Comparison between countries 24 Figures Figure 1 - Per capita GDP and private consumption I Figure 2 - Value added by sector 10 Figure 3 - Savings and investment 12 Figure 4 - Per capita GDP 25 Figure 5 - Adjustment as usual scenario 26 Figure 6 - Dynamic reform scenario 28 Boxes Box 1 - Economic indicators for various countries 11 Box 2 - Dynamic export products 15 Box 3 - Madagascar: Resistant exports, 1980-1990 17 Box 4 - Main tourist areas of Madagascar 21  SUMMARYAND CONCLUSIONS 1. Introduction The challenge i. Madagascar is a striking example of unfulfilled economic potential. In the last twenty years, it has experienced an economic decline unprecedented for a country which was never invaded, nor torn by civil war. Between 1971 and 1991, per capita GDP plummeted by 40 percent. Yet Madagascar has ample resources: abundant, cheap, and easily-trained labor, and a wide variety of soils, climates, and natural resources, including unique fauna andflora. Not only has the country become steadily poorer overall, but there has been a drastic widening of the gap between low- and high-income groups, and a dramatic increase in the total number of people living below the poverty line. Under the pressure of meeting the survival needs of a population growing by 3 percent, the society has used its natural resources in a nonsustainable way, causing a decline in opportunities for growth. It must find a way to shed the crippling burden of increasing poverty. ii. Now that it has completed the process of political reform, Madagascar will have to move to the economic front to combat poverty. After a two-year transition period, the country now has democratic institutions and freely-elected leaders. This peaceful changeover bodes well for the Malagasy people's ability to work together, an indication that differences can be overcome to lift the country out of poverty and support economic takeoff. This ability to compromise, set aside conflicts, and build a broad consensus will no doubt be put to the test as the elected government starts implementing the major planks of its new economic policy. iii. The start of a new political era provides a unique opportunity to rethink economic strategy. The government is facing an historical challenge: to unleash the country's immense potential, and make up for lost ground It must establish economic policies through which it can bequeath to the next generation a very different economic and social outlook. It must fulfill the vision of a democratic society with a market-based economy in which economic and social conditions improve consistently, and where the discrepancy with more advanced countries is steadily reduced To that end, one foresees a competitive economy where the government plays its usual role in a market-based system geared to private sector initiative, and where investment in human resources helps train men and women to enhance their well-being and make them better able to take advantage of economic opportunities and contribute to lower population growth. iv. Even if the 1988-90 growth rate were reproduced (0. 5% per capita), it would still take a century to realize any noticeable improvements in living standards. Only with far more daring and innovative policies can Madagascar hope to achieve economic growth high enough to significantly reduce the number of poor within one generation, and provide the means for government to fulfill people's aspirations. Is there a way of achieving 6 percent growth-the lowest rate that could double per capita GDP in 20 to 25 years-and regain the country's 1971 living standard within a decade?  vi be put to the best possible use. It is estimated that $1 billion2 in available donor funding still remains to be disbursed Macroeconomic policy xx. The adoption of a rigorous and stable macroeconomic policy is one of the main factors enabling successful countries to develop rapidly. Broadly speaking, this implies a low budget deficit, moderate inflation, a realistic exrchange rate, and a viable balance of payments. Government financial policy must be aimed at increasing public savings, controlling government expenditure (with a focus on investing in high priority sectors, such as infrastructure and human resources), and raising tax revenue and user fees. A prudent monetary an2d credit policy is required to keep reserves sufficiently high and control inflation. Positive interest rates are needed to stimulate private savings. Restructuring the financial sector and privatizing the banks are additional measures that are necessary for generating adequate financing for the productive sector, particularly private enterprise. Lastly, the liberalization of external trade-fundamental to any significant growth in exports--would require a realistic exchange rate in step with the rest of the world and with competitors in particular. The combination of moderate inflation and a competitive exchange rate would allow companies to become profitable and thereby increase their savings and ability to finance additional investment. Debt relief measures should be an integral component of any program designed to re-establish a viable balance of payments. Only thus can the economy maintain, and even increase, its competitiveness. The legal and regulatory framework xxi. In Madagascar, private investment can be developed only to the extent that potential investors believe they will operate under stable and favorable conditions. This means that the manifold contradictions that exist in current laws and regulations must be eliminated, and that a legal and regulatory framework conducive to private sector activity be established The independence and strengthening of the judiciary system provided for in the new constitution is crucial to that process. The private sector requires an environment in which there are concrete and stable parameters, and not where the whim of the current administration governs the establishment of businesses, the hiring and firing of employees, and import/export activities. Liberalizing a few of the sectors that are still regulated today, such as transport, telecommunications, and vanilla, would send the right message to business. Furthermore, healthy competition must be allowed to flourish and an attempt should be made to eliminate all public and private monopolies. Poverty, population, and the environment xxii. Among the main difficulties facing Madagascar are poverty, high population growth, and environmental degradation in the form of deforestation and soil erosion. Poverty and population growth are the principal, though indirect, causes of environmental damage. Environmental degradation leads to lower crop yields and infrastructure deterioration. Madagascar's quest fo. growth should not be separate from a strategy of poverty reduction and environmental protection. Sustained growth is the prime weapon in the battle against poverty. To achieve all these goals 2 Unless otherwise noted, dollar amounts in this paper are in current US dollars.  vii satisfactorily, the country will need a coherent program of environmental conservation, family planing programs, and specific poverty reduction measures which give the poor better access to productive and better paying jobs. This can be achieved by investing more resources in primary education, rehabilitating health care, and establishing nongovernment mechanisms to allow small private companies to bid on labor-intensive infrastructure projects. To protect the most vulnerable groups, a social safety net based on specific, carefully targeted assistance must be established and maintainedfor the present. Furthermore, prompt and dynamic measures will be needed to halt the spread of AIDS, since an epidemic would be catastrophic and compromise the country's chances for economic growth. 4. Managing the transition xxiii. An economic strategy aimed at high sustained growth will mean a crowded agenda of activities in a wide range offields. The government will also encounter considerable difficulty in changing people's attitudes and overcoming resistance. It will be forced to introduce reforms gradually, to allow time both for the administration to put them into place andfor the economy at large to assimilate them. The principal theme of the first phase of reform should be restoring confidence. Mobilizing private sector support and external investment are the cornerstones of the sustained growth strategy. To achieve this a climate of confidence will be required to encourage both local businesses to invest andforeigners to operate in Madagascar. This will also necessitate that commitments are respected and carried through to the end In order mobilize more foreign resources, for which developing countries intensely compete, confidence must be restored among the donor community. In sum, the government must redefine its priorities, set up an economic management team that can direct the iransition, and encourage the people to participate. Priorities xxiv. The priorities for action in launching the reform program fall under five broad headings: macroeconomic stability, international trade and finance policies, elimination of barriers to economic activity, emphasis on the private sector's role, and social policies such as population, education, and health. xxv. Macroeconomic stability is essential to growth, efficient utilization of resources and long-term private sector investment decisions. It means moderate inflation, access to foreign exchange and a stable exchange rate, none of which can be achieved without the following: (a) A prudent monetary policy that is based on controlling private and public credit. Credit must be extended to the private sector at the expense of government borrowing. (b) Reinforcing budgetary discipline to reduce the budget deficit and to prevent public sector borrowing from the banking system. This means raising tax revenue and bringing down public spending while continuing to protect high priority sectors. xxvi. International trade and finance policies must be geared to promote private sector confidence and investment, which will be necessary for sustained growth: (a) International trade policy must aim for a convertible current account, the first step towards total convertibility. This requires a market-determined, realistic exchange  viii rate, for example, an inter-bank foreign exchange market, if the financial sector can support it. A possible transitional measure could be the reintroduction of the Liberalized Import Regime (LIR), though an appropriate exchange rate must be achievedfirst. Prudent monetary and budgetary policies in concert with realistic management of the exchange rate should enable Madagascar to keep the exchange rate fairly stable. (b) Import liberalization will depend on rigorous budgetary and monetary management. Moreover, external debt relief will be required, along with substantial balance of payments support. (c) The financial system must be rapidly placed on solidfooting ana should include sound banking operations for the inter-bank exchange market to function properly. The state banks, BTMand BFV, should be privatized Market-determined interest rates are needed to halt capitalflight. A treasury bond market, managed by the Central Bank, will make it possible to establish competitive interest rates, which will in turn stimulate savings. xxvii. Elimination of barriers to economic activity. The government must declare explicitly that entrepreneurs are welcome and ensure that its administrative requirements do not hamper the establishment of businesses, investment, the purchase of goods, and the flow of goods andfunds: (a) Business creation and foreign investment can be stimulated by an unambiguous directive outlining the acquisition of real estate by foreigners. The one-stop shopping approach should be implemented and be the only requirement for admission to the free trade zone system and approval under the investment code. (b) Liberalization of key sectors should be pursued to make the economy more competitive and to eliminate constraints on development. These include reforms in the petroleum and telecommunications industries. Liberalizing the vanilla trade is equally urgent if 'adagascar's share of the world market is to be protected Negotiations with foreign partners are needed to open up international air transport routes to swpport business operations and give tourism an opportunity to develop. xxviii. The private sector's role in the economy should be clearly recognized By withdrawing from public enterprises and redirecting public sector activities and investment towards established priorities, the state will clearly demonstrate that its economic policies are irreversible. This will help create a climate of confidence neededfor growth. The state must withdraw from activities in which it has no comparative advantage. At the same time it must be more efficient in discharging ils responsibilities: (a) The government must make clear how, and on what basis, it will withdraw from public enterprises, and it must start that withdrawal quickly. It will also need to determine how to withdraw from medium-sized companies in the secondary sector, including textiles, sugar, cotton, oilseeds, mines, and meat processing, privatize the remaining hundred or so small- and medium-sized businesses (including the 11 currently being privatized), and deal with large enterprises including banking, oil, telecommunications, electric power, water, and port activities. The mechanisms  ix that will be established should aim to make the economy more efficient and promote competition. The state must begin by establishing the same rules for everyone to ensure that public enterprises do not receive preferential treatment in any industry. (b) Enough work has been done to enable the Public Investment Program (PIP) to be restructured quickly. Given the new focus on infrastructure and human resources, this will also help support economic growth. Production-oriented government projects, particularly in agriculture, all projects financed with nonconcessional funds, and all projects requiring excessive state contributions should be halted or suspended Resources should be applied to expediting the implementation and follow-up of priority projects relating to infrastructure, human resources, and the social assistance safety net. Implementation of other projects should be phased in accordance with the priorities, strategies and availability of local counterpart resources. With the help of donors, part of the project portfolio should be restructured to reflect sectoral strategies. (c) Reorganizing the civil service to serve as an instrument of support for the country's development is a long-term prospect. The action plan for civil service reform adopted in 1992 requires the state to reflect upon its essential functions, and the best means of discharging them in the context of a move towards decentralization and an enhanced role for the private sector. xxix. Human resources policies will have an impact mostly over the long term. But efforts to tackle demographic, educational, and health care problems must begin now in order to play a major role in helping Madagascar achieve its goals in the next 15 to 20 years. Family planning support programs need to be strengthened Most pressing--in fact the key to long-term development--are improvements in primary and technical education. The steering group xxx. The success of the reform program will depend on the people who carry it through. The government will have to forge a steering group of politicians and economists with a coherent vision of the overall strategy, and the abilities needed to guide the reform process. The team must draw on the country's best intellects and be given all the technical resources it needs. Though South Korea, Malaysia, Thailand, and Mauritius may serve as examples and sources of inspiration, Madagascar will have to find its own way of achieving sustained growth and reducing poverty. Policies will be dictated largely by economic realities; however, the steering group can tailor implementation schedules and management approaches to take into account Madagascar's specific needs, and the Malagasy people's particular aspirations. Participation by the people xxxi. The reform program is broad in scope and cannot succeed without the confidence and acceptance of the Malagasy people. There must be broad consensus on economic policies, and politicians must take great care to keep economic issues untainted by political controversy. Confidence will also be restored if the government complies rigorously with its laws and regulations, ceases to act arbitrarily, and strongly supports an independent and revised judiciary  x system. To gain widespread acceptance, the government's economic program must be broadly disseminated, explained, and discussed The stakes are very high. Knowledge of the program's objectives and rationale cannot be confined to a limited group of technocrats, but must be shared with all citizens. In this way, the Malagasy people can come to understand that everyone must make sacrifices so that the benefits of growth and a better standard of living can be shared by all.  I. INTRODUCTION 1. Madagascar is a striking example of unfulfilled economic potential. In the past twenty years, its economy has deteriorated in a way unprecedented for a country which was neither invaded, nor tom by civil war. Its GDP per capita plummeted by 40 percent between 1971 and 1992 (Figure 1). In the same period, countries such as South Korea and Malaysia--which formerly had living standards lower than Madagascar's--now have a per capita income 10 to 30 times higher. Not only has Madagascar grown steadily poorer overall, but there has also been a drastic widening of the gap between low and high income groups. Moreover, there has been a dramatic increase in the total number of people living below the poverty line. Under the pressure of meeting the immediate survival needs of a population growing at 3 percent, the country has used its natural resources at a nonsustainable rate, causing a degradation of the environment and a decline in opportunities for growth. Filgure 1 - Per capita GDP and private consunption 250 ~230 170 I150 130 I i o N N N N N ~~~ ~~~00 00 co0 0 Source: World Bank data 2. Is there a way for Madagascar to escape this cycle of poverty? The structural adjustment program introduced in the mid-1980s seemed to offer some hope. Measures to lift price controls and liberalize internal and external trade, coupled with better management of the exchange rate and foreign exchange allocation, resulted in real GDP growth between 1988 and 1990. However, on average, this represented an annual increase per capita of only 0.5 percent. At that rate, Madagascar would need 70 years to regain its 1971 living standard and 139 years to double its per capita GDP. Is it possible to envision a more promising goal--for example, a growth rate that would boost the country to its 1971 living standards in 10 years and double its per capita GDP in 25 years? That goal could be achieved if annual GDP growth reaches 6 percent by the end of the decade. Economic expansion in East Asia and Mauritius is evidence that such rapid growth is  2 possible. Some countries, such as South Korea, Thailand, and China, are expanding at rates that will double their citizens' per capita income in 10 years. 3. Analysis of the conditions that have enabled several countries of East Asia, and the countries of Chile and Mauritius to achieve such high annual growth and leave the ranks of the lower-income countries reveals a number of common features. In all these countries, the government maintained sound macroeconomic management; economic expansion was driven by vigorous growth in the manufacturing sector, and in agricultural and industrial exports. That growth was enabled by a greater openness to the outside world, recognition of private sector development as a priority, and the liberalization of economic activity including disengaging the state from sectors unrelated to its essential functions. By contrast, despite the adjustment efforts initiated in 1987, Madagascar's institutions and regulatory framework are still under the government's pervasive pressure in the economic sphere of activity. Significant reforms are needed to create a climate conducive to expansion based on exports and private sector activity. 4. An essential objective of economic policy is to significantly reduce poverty. If per capita growth remains below 3 percent, it will be virtually impossible to bring about a perceivable reduction in the percentage of the population living below the poverty line. Rapid growth is therefore a crucial weapon in the battle against poverty. No country has significantly reduced poverty without considerable and sustained growth. But rapid growth is not enough: the structure of growth is crucial if the poor are to participate in the process and escape poverty. Those countries that have succeeded in reducing their poverty rates have fostered development that uses the most abundant resource the poor have: labor. They also emphasized enhanced government expenditure programs in health and education, improving the poor's output and ability to earn. In addition, population control policies have succeeded in significantly reducing the population growth rate. 5. The purpose of this report is to review available economic policy options to meet the Malagasy government's goal of eliminating poverty. Chapter II describes recent economic developments and illustrates the formidable challenge presented by the extent of poverty in Madagascar. Chapter III discusses medium-term perspectives, based on an analysis of macroeconomic and sectoral foundations for growth. Chapter IV outlines the economic policy options associated with the "dynamic reform for sustained growth" scenario, and Chapter V discusses the factors that must be considered in setting priorities for implementing selected policies and managing the transition.  3 II. RECENT ECONOMIC DEVELOPMENT AND SOCIAL INDICATORS HISTORY OF THE ADJUSTMENT PROCESS, ECONOMIC DEVELOPMENT AND CURRENT ECONOMIC POLICY 6. Madagascar's economic history in the 1980s was largely the result of the "all-out investment" approach of 1977-80, preceded by nationalization and economic control policies which discouraged development of the private sector, including farmers. Massive investment in the productive public sector was supposed to drive growth, in turn leading to a rapid increase in domestic savings. Instead the budget deficit rose from 1.5 percent of GDP in 1977 to 13 percent in 1980. The banking system's net assets rose from $8 million1 in 1977 to $20 million in 1980, and the Central Bank exhausted all its reserves. External public debt, which was $250 million in 1977 (13 percent of GDP) rose to $1 billion (32 percent of GDP) in 1980. Automatic adjustment was inevitable and brutal. 7. As a result of foreign exchange shortages, imports fell between 1980 and 1983, causing a decline in output, particularly in industries that were unable to obtain supplies (Table 1). The govemment was forced to adopt a stabilization program designed to contain demand; this led to a general shrinkage of GDP, exports, imports, and public expenditure and revenue. By 1986, the stabilization program had achieved its objective. The current account deficit had dropped from 16 percent of GDP in 1980 to 6 percent in 1986, while inflation had dropped from 30 percent in 1980 to 15 percent in 1986. Drastic spending cuts had brought the public deficit down to 8 percent of GDP. Table 1: Economic indicators, selected years 1980-92 Indicator 1980 1983 1986 1989 1990 1991 1992 GDP (1984 = 100) 109.9 98.3 103.1 112.3 115.6 108.8 109.7 Per capita GDP (1984 = 100) 122.3 101.1 97.2 96.3 96.2 87.4 86.2 Percentage of GDP: Imports 29.7 17.5 14.1 21.4 26.9 26.2 24.5 Exports 13.3 10.6 12.0 18.0 15.9 17.3 16.1 Investment 15.0 8.4 9.0 13.4 17.0 10.6 8.8 Domestic savings -1.4 1.4 6.9 10.0 6.0 -0.8 0.4 Current account balancea -15.7 -8.6 -6.3 -8.7 -12.9 -11.4 -10.1 Budget deficitb -12.8 -4.7 -8.0 -14.0 -9.3 -12.6 -13.1 a. Excluding grants b. Excluding grants and including interest after rescheduling. Sources: Government of Madagascar, and World Bank staff estimates. 8. In 1987, the government launched a macroeconomic adjustment program to revitalize supply and enhance competitiveness. The program rapidly boosted output by introducing a series of measures to liberalize domestic trade, deregu!ate prices, devalue the currency, and liberalize the import system. These measures covered the external sector, taxes, government spending, public I Unless otherwise noted, dollar amounts in this paper are in current US. dollars  4 enterprises, the financial sector, the regulatory framework, the environment, and human resources. For the first time in several years, Madagascar saw a modest increase in per capita GDP--about 0.5 percent annually between 1988 and 1990. Private and foreign investment also increased, particularly in the export-oriented industries. 9. Despite its success on the democratic front, the 1991-93 transition exacted a heavy economic price. The slight 1 percent rise in GDP in 1992 was not enough to recover from the substantial 7 percent drop in 1991. GDP growth in 1993 was only around 2 percent. The macroeconomic problems still overshadow the accomplishments, and have led to a decline in Madagascar's competitiveness. Tax revenue, excluding grants, has flattened out at 9 percent of GDP, public debt is 13 percent of GDP, and the current account deficit is 10 percent. Arrears on external payments reached $700 million by end-1993. The investment climate is greatly depressed. The news is not completely bad, however, since the government was able to eliminate taxes on coffee and cloves, relaunch privatization efforts, and successfully manage an expanding free trade zone. 10. The new government is at a crossroads. It is faced with an impoverished country, in which the constraints en growth are formidable, it must devise a new recipe for growth. The adjustment program has left a respectable legacy: most of the economy has been liberalized and productive forces are better able to react to world market or economic policy incentives. But most of the major reforms have yet to be enacted. The adjustment program had the right approach, but it was not implemented effectively enough, and the reform measures were incomplete. The limited success of the years 1988 to 1990 shows that the program was not sufficient to reverse the inexocable slide towards; poverty. POVERTY, UNEMPLOYMENT, POPULATION GROWTH, AND THE ENVIRONMENT 11. Madagascar has great development potential. However people live at standards which are below average levels in Sub-Saharan Africa: the chronic malnutrition rate is 40 percent, infant mortality represents 11 percent of live births, endemic malaria has become a major problem, the incidence of tuberculosis and other contagious diseases is rising, and educational standards are declining. Productive assets are unevenly distributed, and neither urban nor rural areas can offer equitable access to economic opportunity. Due to distance, inefficient markets, and inadequate infrastructure, the southern tip of the island is constantly threatened by food shortages, even when the country as a whole has a food production surplus. 12. The poorest groups are affected by deteriorating health and educational services. Even though a healthy and wvell-educated population is more productive, rapid population growth has forced more people to share fewer resources. The deterioration in the services and coverage at all levels in the public health sector was caused by inefficient sectoral management, and a real decline in resources allocated to this sector during the 1980s. The education level among the population is declining. Teachers at the primary and secondary levels are unevenly distributed, with large urban centers receiving more and better qualified teachers. Funds for nonpersonnel expenditures are not adequately managed. Finally, universities extract an exceptionally high share of the education resources, especially fo: students' room and board.  5 13. The severity of poverty is reflected in the employment situation, population growth, and the degradation of land and infrastructure. Acquiring a wage-earning job is the best way of leaving poverty behind--yet the data for Madagascar reveals significant underemployment. Only 2.7 percent of the population are in nonagricultural, wage-earning jobs, while in countries like Malaysia, Thailand, the Philippines, Indonesia, and Mauritius, that figure is 20 to 30 percent (Table 2). In order to absorb the expanding labor force, the development of salaried employment is essential. Madagascar's labor force is projected to grow by 3.1 percent annually between 1995 and 2000; this means that some 220,000 people--more than half the total number of existing nonagricultural jobs--will be joining the labor force each year. Table 2: Socioeconomic indicators for selected developing countries Country Population GDP GDP Non- Life Adult Km of growth per growth agricultural expectancy literacy roads capita rate jobs (percent) ($) (percent) (percent of (at birth) Men Women (per 1, 000 population) km2 of territory) 1980-91 1991 1980-91 1991 1991 1991 1991 1991 Malaysia 2.6 2,490 5.6 27.0 71 87 70 122 Thailand 1.8 2,580 7.8 17.4 69 96 90 143 Indonesia 1.8 610 5.8 18.5 60 84 68 115 Chile 1.7 2,160 3.4 n.a. 72 94 93 105 Mauritius 1.0 2,420 7.2 21.5 70 86 76 966 Madagascar 3.0 210 0.5 2.7 51 88 73 84 n.a. - not available Sources: World Bank, International Labor Office (ILO), UNDP 14. The problems of poverty and employment are linked to those of population growth. From 1985 to 1989, the average annual population increase was 3.1 percent. The rate for 1990-94 is down to 2.8 percent, apparently as a result of lower fertility rates. If the downward trend in the fertility rate (now 6.1 percent) can be confirmed, population growth should stabilize at approximately 2.75 percent for 1995-2000. This represents an annual increase of 400,000 people, who will have to be absorbed by the health and educational systems. If the downward trend in the fertility rate is maintained, Madagascar will have 26 million inhabitants in 2025, more than double the 1990 population. If the fertility rate does not fall, however, the population will reach 32 million by 2025, elimirating any hope of improving living standards appreciably. Rapid growth countries (Table 2) have succeeded in bringing population growth down to 1-2 percent. These countries can be certain that their populations in 2025 will be less than double the 1990 level. Population growth in Madagascar multiplies the strain on the environment, already severely degraded in recent decades. Deforestation, caused by clearing new farmland and harvesting fuelwood, has already led to soil erosion on slopes, and silting in the irrigation systems, reservoirs, ports, and infrastructure. These conditions exacerbate the survival problems of the poorest members of society. 15. The emergence of AIDS is a threat to Madagascar's economic prosperity and future welfare. Until now the island's isolation has protected it. Though few cases have been declared to date, medical experts estimate that several thousand people are infected by the virus, which has a 5-15 year incubation period. Other countries in Asia and Africa with health conditions comparable  6 to Madagascar's experienced an explosive spread of the disease once the virus had taken hold. Many governments waited for the problem to become acute before taking decisive preventive measures. At this late stage, controlling AIDS becomes very difficult and much more expensive If Madagascar takes rapid, comprehensive action now, it still has a chance of minimizing the impact of the disease on its economy and society. Calculations have shown that, in many African countries, the AIDS epidemic will cause GDP to fall by some 0.6 percent annually. These figures suggest that a massive escalation in prevention efforts would be cost-effective in strictly economic terms. 16. The complex interactions between poverty, unemployment, population growth, and environmental degradation make it imperative that they be tackled through an integrated economic development strategy. In East Asia and Mauritius, rapid economic expansion made it possible to break the vicious circle. However their experience makes it clear that the structure of growth is as important as the growth itself in ensuring that economic benefits are distributed equitably among social groups and regions. There are two preconditions essential for equitable distribution: first, the efficient operation and mobility of the goods, finance, and labor markets, making it easier for expanding regions to attract labor and disseminate products and wealth to other regions, second, the availability of education, primary health care and infrastructure throughout the country. With abundant, high-quality infrastructure, market segmentation, which blocks the spread of growth, can be prevented. Education and primary health care enable the poor to take better advantage of opportunities created by accelerated growth. 17. The difficulties are numerous, and the obstacles appear insurmountable. It seems that no problem can be tackled without exposing a host of associated barriers or encountering contradictions. However, East Asia demonstrates clearly that a country can be rescued from apparently desperate straits and achieve a brighter future. NIEs have made the breakthrough because their leaders distanced themselves from immediate, day-to-day concerns and conceived a long-term vision of the future. They also made the people understand and share that vision.  7 III. LONG-TERM PERSPECTIVES FOR DEVELOPMENT 18. When we try to imagine what Madagascar will be like in 2010, we realize that our vision depends on the ability of its government and society to liberate itself from the constraints preventing it from fulfilling its potential. Assuming the constraints are overcome, the vision will show the advantage of a competitive labor force being translated into a number of small- and medium-sized export firms, and diversified, expanded production in the agricultural, industrial, and service sectors. In that context, poverty is reduced, and better education and health services help establish a foundation for greater human productivity and even further progress in the battle against poverty. 19. What type of society, and what type of economic system, can be envisioned for Madagascar? A politically and economically liberal system presupposes making certain choices between short- and long-term benefits. This chapter provides an outline of the basic options, followed by a review of the macroeconomic and sectoral basis for growth that could generate appreciable benefits in the medium term. The "scenarios" corresponding to possible economic strategies are reviewed, and finally the constraints Madagascar will have to overcome to fulfill its long-term development objectives are summarized briefly. BASIC OPTIONS 20. Although everyone will benefit from a well-managed economic policy in the long term, the government will inevitably be forced to make some initial choices between certain groups' short-term interests. These choices include trade-offs between: savings and consumption, wages and jobs, protectionism and exports, looking outward and looking inward, playing by the rules and acting arbitrarily, and the poor and the less poor. Savings and consumption 21. With memories of the "all-out investment" policy of the late 1970s still fresh, the government might have second thoughts about any proposal to increase the investment rate appreciably. However, some facts cannot be ignored: high growth cannot be achieved without significant growth in the investment rate. Even without attempting to attain comparable rates to NIEs (30 to 40 percent of GDP), the current rate of 11 percent will have to be raised significantly. High investment rates in turn require a considerable increase in national savings, thereby postponing the expansion of private consumption in response to growth. An "all-out consumption" policy would have the same disastrous results as the "all-out investment" policy. Such alternatives make it incumbent on the government to accept only economically-justified public investment projects and ensure they are rigorously implemented. They also entail greater private sector involvement in investment, mechanisms enabling public savings, and foreign aid to contribute to the funding of private investment. Wages and jobs 22. Per capita income has been dropping almost continuously for the past 20 years, and wage earners have not escaped. Civil service wages have fallen in constant francs, as have private sector  8 wages. Since unions are demanding that wages catch up, a new government will find it difficult to resist the temptation to make a popular decision in resolving a difficult problem. Yet this would risk further compromising the re-establishment of a macroeconomic balance which is so desperately needed. In particular, it could jeopardize the availability of a cheap, hard-working labor force, so attractive to investors. Quite simply, this could mean abandoning the perspective of rapid growth and its corollary benefits: an increase in the number of wage-paying jobs and a reduction in poverty. A different approach would seem more reasonable: to make benefits for wage earners flow from a general expansion of the economy and base real wage increases on increases in productivity. Once the economy has taken off, wages should rise more quickly than average income, as the East Asia example has shown. Protectionism and exports 23. The government and private businesses might consider protectionism a tempting, even legitimate, means to achieve growth in the industrial sector. This is a temptation to which industrialized countries succumb easily. However, when the policy "succeeds," higher costs for consumers and industries that use the protected goods as raw materials are the result Protectionism has also kept nonprofitable enterprises afloat, thus delaying and even exacerbating the inevitable outcome. Protectionism is even more dangerous for a small developing country since it does not have a domestic market for its domestic producers to capture. In Madagascar, the domestic market is at such a low economic level that it cannot bring about the development of sectors geared solely to import substitution. 24. New and existing businesses that want to survive must capture a share of the world market--the size of which dwarfs every sector of the Malagasy economy. The enterprises created for import substitution, which have remained inefficient under the protectionist umbrella, are demanding that protection be maintained. Export-oriented companies, such as the garment industry, would like to see protectionism eliminated in favor of an open system, an environment which fosters, rather than hampers exports, where supplies could be easily obtained at optimal cost and goods subsequently sold outside the country. Looking outward and looking inward 25. Should Madagascar look outward and participate in world economic activity, with all the risks and profits it would involve? Or should it prevent foreigners from "getting their hands" on its national assets? Government policy has often given in to an instinctive suspicion of foreigners, sometimes even nationals of foreign origin, the result is lost opportunities. But production is increasingly organized along global lines: for example, a US company may have its production facilities in Hong Kong, with the Hong Kong subsidiary in turn subcontracting to Malaysian suppliers, In light of this globalization, Madagascar must decide whether it wants to be part of the new system and become another Thailand or Mauritius, or just sink deeper into the trap of underdevelopment. Eventually, foreigners' investment can contribute to growth, or they tnay become partners in opeiling new markets and bringing in new technology. 26. Another aspect of an inward-oriented policy is the movement of monetary capital. No government has succeeded in controlling capital flight by regulating foreign exchange. These controls have merely discouraged foreign investment and prevented the repatriation of any capital transferred outside the country. Economic expansion requires considerable investment by nationals  9 and foreigners--investment that itself requires a climate of confidence in which each party knows it can freely dispose of its profits and capital. Playing by the rules and acting arbitrarily 27. For many years, the authorities believed the state should be omnipresent in the economy and control as much of it as possible--including taking on the role of producer where necessary. Instead of protecting the weak and promoting the country's best interests, this approach has led to the proliferation of fiefdoms where officials impose their decisions and frequently benefit personally. A liberal economy cannot exist in such a setting. Economic agents cannot be efficient if they are subject to arbitrary action. The rules of the game must be clear and respected by all parties. To that end, the justice system must be independent, as Madagascar's constitution stipulates it is. The judiciary system must be strengthened along with legislation governing its structure, and economic activity must be revised. This represents a tough choice for future decision makers, bearing in mind that progress will be contingent on eliminating the privileges of an administrative class with which they frequently have close ties. The poor and the less poor 28. Envisioned adjustment programs are often accompanied by governmental comments on the sacrifices the people will have to make. First it should be made clear that the downward spiral of poverty has been caused by the ill-conceived policies of the past, rather than by adjustment measures. Second, the overall impact of the measures, not only their impact on a particular group, should be explained. For example, liquidating nonprofitable public enterprises will mean layoffs. But to continue to operate them would force the country, including its poorest citizens, to continue subsidizing an activity that gives them nothing in return. The taxes, foreign aid, and bank credits used to keep them afloat could be put to more profitable use. Another example is the allocation of resources in education. While the primary education system is at an appallingly low standard, the nation spends a great deal on lodging and feeding university students whose academic performance is mediocre at best. Families are supposed to pay part of the cost of primary education, but not of higher education. This leads to an incongruous transfer of funds from the poorest families to those who are less needy. 29. While the connection is less obvious, devaluating the artificially-high exchange rate affects income distribution. This often translates into higher living costs for urban wage earners and better incomes for farmers and other producers in the short run. In this case, the purpose of devaluation would not be to effect a transfer of income but to expand the total output of goods and services in the long run. Its impact on income distribution should be fully analyzed to avoid decisions geared to the welfare of any given segment of the population. 30. The new government will be faced with many such economic choices that will weigh the interests of some groups against those of others. Often it will be the more privileged classes, those closer to the government, who will be the most vocal. The government will have the difficult task of making decisions that are in the best interest of the country as a whole, and will help the poor survive in the short term and emerge from poverty in the long term.  I0 SOURCES OF GROWTH 31. In formulating an overall vision with the potential to mobilize the people, it is important to reflect upon the type of growth that would enable that vision to become reality.2 Growth needs to be high: to regain the 1971 living standard within 10 years, annual economic growth will have to be over 6 percent. The structure of growth is important too; we are assuming that the government will strive for sustainable, long-term growth, while reducing poverty and protecting the environment. What are the economic foundations for sustained growth? Emphasis on the development of diversified, labor-intensive export activity would seem the best course to take. An essential contribution to growth would involve all economic sectors. The combination cif over 4 percent growth in agriculture, 10 percent in industry, and 6 percent in services would enable total economic activity to expand by more than 6 percent (Figure 2). Figure 2 - Value added by sector Dynamic Reform Scenario 9 8 7 6 3- 2- I_ r 00 oo g 0% 0% 0% 0% 0\ 0% 0 x o g oo 0% 0%0% as0 % 0 % % 0 % 0 | * Agficulture I Industry E[ Services Source: World Bank data. 32. This increase in growth cannot be achieved without an increase in production capacity-- that is an increase in investment. Despite the willingness of donors to assist Madagascar in its development, foreign aid, or external savings, will not be sufficient to finance the requisite investment level. As in NIEs, domestic savings will therefore have to grow significantly. To generate higher domestic savings means a rapid growth in exports. Given Madagascar's debt (120 percent of GDP), the continuation of external savings should be more oriented toward the flow of non-debt-generating capital, such as direct investments and grants. 2 Henceforth the term 'scenario' will denote a quantitative description of the progress towards future econornic conditions.  ii National savings and foreign aid 33. Strong economic growth will require higher domestic investment rates than the current ones. During 1987-92, investment in Madagascar represented only 11.8 percent of GDP, lower than the African average rate of 19 percent. Countries currently experiencing rapid growth have much higher investment rates (Box 1). Private investment in Madagascar represents only 30 percent of total investment, in comparison to 60 percent in high ,rowth countries. Any economic target of 6 percent annual GDP growth by the year 2000 must be based on an expansion of investment, reaching above 20 percent of GDP during 1997-2000 (Figure 3). By 2000, private investment should represent 66 percent of total investment. Box 1: Economic indicators for various countries Country GDP/capita Growth rate Investment rate Exports 1991 ($) (1980-91 mean) (as % of 1991 GDP) (as % of 1991 GDP) High-income countries Hong Kong 13,200 6.9 29 141 Singapore 12,890 7.1 37 185 Middle-income countries Korea 6,340 10.0 39 29 Malaysia 2,490 5.6 36 81 Thailand 1,580 7.8 39 38 Mauritius 2,420 7.2 28 64 Low-income countries Indonesia 610 5.8 35 27 China 370 9.4 36 20 Madagascar 210 0.5 11 17 The South-East Asia NIEs in this table have applied the same strategy of sustained, export-based growth. Since they started at different times, they are at different stages of development. Hong Kong and Singapore have joined the ranks of high-income countries. Korea has reached upper-middle-income level, while China and Indonesia are still low-income countries. Nonetheless, they all share common features. high growth, high investment rates, and a high export volume. They differ in the forms of industrial development they have achieved. While Thailand and Malaysia still have numerous labor-intensive industries, Hong Kong, Korea, and Singapore have moved on to the use and creation of leading-edge technologies, built on the industrial base of previous labor-intensive development. Source: World Bank 34. Low national savings is one of the main obstacles to the scenario. Others include the deficit, the decline in private consumption, and inefficiencies in public investment. Between 1987 and 1992, national savings, excluding foreign grants, represented only 1.2 percent of GDP. The contribution of national savings to investment has plummeted from an annual average of 33 percent of total investment in 1988-89, to 18 percent in 1990 and into negative figures in 1991 and 1992.  12 The lack of national savings can be explained by the negative figures for public savings. This meant that private savings had to be mobilized, indirectly through the banking system, to finance the budget deficit. Another obstacle is the current account deficit. Excluding grants, it rose to 10.6 percent of GDP during 1987-92. Because equipment may need to be imported, the investment required for high GDP growth will tend to increase the current account deficit. Without a substantial rise in national savings, the deficit would reach a nonsustainable level, thus dashing all hopes of achieving sustained long-term growth on schedule. A rise in the savings rate is therefore essential to sustained growth. Thirdly, private consumption per capita persistently declined during 1980--92. By 1992, it had fallen to 62 percent of the 1980 level. If the emphasis is on raising private consumption and increasing tax revenue, it will be difficult to increase the private savings rate. Measures to increase national savings will initially have to focus on boosting public savings, by increasing the difference between government revenue and operating expenditures. Figurv 3 - Savings and Investnmrnt Dynranic Refonn Scenario 25 20 iz 15. *10 A.0 -S _ i I I .. .. I I .... I I I I 00 i - a, e 0 r o 0' 0' 0' 0' 0' 0' 0' C ] -ia- Nationalsavings -Eemal savings -4-- Investnetn Isource: World Bank data. 35. Finally, the need to increase investment rates to achieve high growth should not mean repeating the mistakes of the "all-out public investment" program of the late 1970s Two measures that make it possible to avoid those errors are: making private investment a priority, and carefully selecting public investment projects. High-quality investments are essential if they are, indeed, to result in high, sustained growth. The high investment volume of 1979-80 focused on the public sector industrial enterprises and universities, and failed to improve the economy. Furthermore, the government will have to put available funding to the best possible use. It is estimated that $1 billion of the funding currently available for all donor-financed projects has remained unused Public investment from 1987 to 1992 represented 59 percent of total investment volume. In 1993, the Public Investment Program (PIP) still covered some production-oriented projects with a low  13 economic return. Adequate public investment in social sectors and infrastructure must be maintained, and can serve as justification for a modest rise in public investment volume. However, any investment increase in these sectors should result primarily from a redirection of the PIP. 36. The sustained growth scenario provides for dynamic growth in the industrial sector. The growth is based on the establishment of small, labor-intensive export industries. Success will depend largely on Madagascar's ability to attract foreign investment in the sector, and thus to extend the scope of its free trade zone activities. To some extent, this model also makes it possible to eliminate some of the constraints associated with inadequate domestic savings, due to the net inflow from foreign investors. Mauritiun investors have expressed a lively interest in relocating in Madagascar, provided that the economic and regulatory framework is favorable. In addition, contacts with South-East Asian and European business delegations may lead to more prospects. This is a prime opportunity for Madagascar to forge ahead with industrial development. In addition to these external funding sources, a rise in the national savings rate will be needed to finance the current account balance. Pursuing the sustained growth scenario will double the current account deficit by the year 2000, since initial export expansion will not be enough to compensate for the escalation in equipment imports. This is true even if the deficit is kept at nearly the same percentage of GDP as during 1987-90. Development of exports and world markets 37. High export growth rates are a common feature of most newly-industrialized countries which have developed rapidly. This applies not only to the four "dragons"--Singapore, South Korea, Taiwan, and Hong Kong--but also to such countries as China, Indonesia, Malaysia, Mauritius, and Thailand. In Malaysia, GDP has grown by an annual average of 6 percent in the last 25 years, driven by an annual 8 percent expansion in exports. Parallel figures for Thailand are 7 percent and 10 percent, respectively. In these countries, export growth has been the engine of economic expansion. Exporters faced with international competition were forced to boost their productivity by adopting the appropriate technologies, and improving management and quality control. They quickly discovered that rapid growth required a large investment in foreign-made equipment, and therefore rapid export development to generate the necessary foreign exchange. 38. Madagascar would do well to study how these countries have succeeded in developing their export industries so rapidly. A common initial feature in the rapid development of exports is growth in agricultural exports, especially through ongoing diversification. In the 1970s, average annual growth of agricultural exports in Indonesia, Malaysia, and Thailand was over 20 percent. These countries also used the resulting surpluses in a system of resource mobilization to diversify into exports of manufactured goods. In a second phase, the South NIEs' export strategy emphasized export of labor-intensive manufactured goods. They geared their export development efforts to increasing their share of developed countries' import markets for labor-intensive goods. They attracted foreign firms to invest in production facilities for export, and benefited from the international division of labor evolving from the operating strategies of large multinational corporations. NIEs have now reached a third stage: they are capitalizing on skilled labor and the comprehensive development of their industrial base to export a growing proportion of high- technology products. The export development strategy focused on market penetration in developed countries. Given their size, even a small share of those markets represents a large  14 export volume. Bv forming ties with companies in the target markets, NIEs succeeded in smoothing out difficulties and gaining a part of the market. Exports blossomed almost entirely through the efforts of private companies, which were encouraged by a policy of open competition and less protectionism within the country, and clear and well-defined administrative regulations. 39. In recent years, growth in world trade has occurred predominantly in manufactured goods, which account for over half of less-developed country (LDC)s' exports. Between 1970 and 1990, exports to the Organization for Economic Cooperation and Development (OECD) countries of goods manufactured by developing countries grew by an average of 20 percent a year. The three principal markets for industrial exports from developing countries are the United States. Europe, and Japan. The US market is still the largest, though Europe and Japan are growing steadily. In the 1980s, the dollar volume of Europe's industrial imports from developing countries rose on average by 10 percent a year. The Japanese market expanded at a rate of 19 percent. The Lome agreements have made Europe an especially promising market for a growing Madagascar export industry.3 The expansion of trade in finished products is reflected in a steadily rising volume of trade in parts, components, and partially assembled products, all driven by direct foreign investment in developing countries. Companies in industrialized countries are relocating their production facilities to developing countries, and exporting their products to their country of origin or to a third country. Some 20 percent of US imports come from overseas subsidiaries of US companies. Japanese firms also encourage trade expansion by importing consumer goods and raw materials, and subcontracting industrial activity overseas. As companies in South Korea, Hong Kong, Taiwan, and China find their operating costs rising, they are relocating to LDCs. The Mauritiun textile company, Floreal, has already begun to relocate to Madagascar. Madagascar's best prospect is to be the relocation site for small- and medium-sized companies based in OECD), East Asian, and neighboring countries. 40a These trends reveal a number of common features: (a) A small number of developing countries dominate export trade. Four--South Korea, China, Hong Kong, and Taiwan--are Japan and Europe's principal LDC partners. However, other countries, such as Turkey, Malaysia, Indonesia, Thailand, Pakistan, and the Dominican Republic, have established a significant presence in industrialized markets. For all of these countries, annual growth in industrial exports to OECD countries in the 1980s was 14 to 35 percent. (b) A small number of "traditional" products, such as textiles, clothing, and shoes, continue to account for a significant share of exports from LDCs, even the relatively advanced ones. (c) Among the most imported products are steel, jewelry, semiprecious stones, chemicals, and construction materials to Japan; steel, electrical equipment, office equipment, and vehicles to the United States, and steel, electrical equipment, jewelry, semiprecious stones, and chemicals to Europe. More recently, such products as computer hardware, vehicles, and heating and cooling equipment have appeared in those markets, 3 In 1990, most of Madagascar's exports were destined for the European Community (51 percent) and North America (27 percent). Exports to Sub-Saharan Afnca represented only 5 percent of total volume.  '5 41. The prime factor for export development in newly industrialized countries has been the capture of a large share of world markets in the most "dynamic" products: those for which there has been a faster than average expansion in total world trade, Dynamic products are particularly attractive, in that it is easier to acquire a large share of a rapidly growing market. Box 2 contains a Box 2: Dynamic export products Product Expansion in global value of expors 1980-1990 1970-1990 percent percent Computers, office equipment 18.6 18.4 Plastic items 14.7 15.7 Travel equipment 13.9 17.3 Cassette players 13.5 16.9 Silk 13.3 7.3 Toys, sports, and hunting equipment 13.3 14.8 Manufactured leather 13.1 15.6 Leather 12.9 12.6 Perfume, cosmetics 12.7 16.2 Clothing 12.6 14.7 Electrical equipment 12.6 15.9 Art 12.3 15.0 Telecommunications equipment 12.0 14.1 Furniture 11.7 15.5 Fresh fish 11.7 13.9 Pigments, paints 10.9 13.4 Office stationery supplies 10.5 13.2 Dyes, indigo 10.5 9.7 Shoes 10.4 14.1 Jewelry 10.3 17.5 Hides 10.1 9.8 World trade 5.9 11.5 Rates indicated represent average annual growth in current dollars Source: United Nations Conference on Trade and Development (UNCTAD) list of the major dynamic products that could be profitable for Madagascar. The average growth in dollars of world trade between 1980 and 1990 was about 6 percent. In volume terms, this is virtually stagnate. By increasing their market share of dynamic products, however, the countries  16 involved boosted their exports rapidly. Today it is clear that, among developing countries, the newly industrialized countries are world export leaders in dynamic products.4 42. For some nondynamic products, exports were boosted by increasing market share. Analysis of comparative advantages shows that most countries can find "niches" in which a comparative advantage allows them to increase their market share substantially. Between 1980 and 1990, this is what Madagascar succeeded in doing for cinnamon, quartz, semiprecious stones, textiles and processed wood (Box 3). 43. Madagascar's exports over the last 20 years have reflected the country's general economic decline. After increasing by 25 percent between 1971 and 1979, export volume plummeted to less than 70 percent of the 1971 level by 1983, where it languished until 1988. After 1988, exports picked up in response to trade liberalization measures, regaining real 1971 levels in 1991. In 1991, per capita exports were at 50 percent of the 1971 level, covering only 65 percent of imports. The 20-year stagnation in export volume considerably reduced Madagascar's share of the world market. In 1971 Madagascar's exports represented 0.05 percent of the world market. By 1980 this figure had fallen to 0.025 percent, and by 1990 to 0.011 percent. This plunge had the greatest impact on Madagascar's major exports: coffee, vanilla, pepper, shellfish, graphite, and mica (Table 3). Table 3: Madagascar exports Percent of world market Product 1970-72 1980-82 1988-90 Coffee 1.4 1.1 0.7 Vanilla 77.0 61.6 56.3 Other spices 8.6 7.6 2.5 of which: pepper 1.9 1.7 0.8 cinnamon 3.6 0.4 2.1 cloves 38.6 44.4 36.8 Shellfish 0.7 0.6 0.4 Mica 5.7 4.9 3.2 Graphite 17.6 12.4 7.3 Source: UNCTAD 4 World leaders in exports arnong developing countries of certain products are as follows: computers and office equipment: l'aiwan (() percent), llong Kong (3 percent), Korea (2 percent); travel equipment: Korea (19 percent), Taiwan (17 percent), I long Kong (3 pcrcent); toys, sports, and hunting equipment: Taiwan (21 percent), Korea (8 percent), Hong Kong (3 perccnt), jeitelvn: I long Kong (7 perccnt), Thailand (4 percent), Korea (2 percent).  17 Box 3: Madagascar: Resistant exports, 1980-1990 Product Value exported in 1990 Comparative resistance Share of world market (millions of ) index a in 1988-89 (percent) Fresh fish 0.3 5.4 0.005 Maize 5.1 19.4 0.056 Fresh fruit 15.5 4.8 0.058 Fresh vegetables 7.7 1.9 0.035 Sugar and honey 12.8 2.9 0.176 Cinnamon 1.9 8.3 2.070 Hides and skins, unprocessed 0.9 6.0 0.016 Oil-bearing nuts 2.0 3.9 0.013 Processed wood 1.9 17.0 0.006 Cotton 2.2 3.6 0.019 Quartz 2.1 8.1 1.640 Chromite 15.2 2.0 3.740 Crude animal products 0.9 2.7 0.020 Wood manufactures 0.6 6.8 0.007 Fibers (sisal-hemp) 0.6 201.2 0.800 Yarn and thread 1.3 7.1 0.221 Other textiles 0.9 14.6 0.010 Nonmetal mineralsb 2.1 14.8 0.035 Precious and semi-precious stones 5.2 4.8 0.140 Furniture 0.6 10.7 0.002 Travel equipment 0.1 2.1 0.001 Clothing 11.6 5.0 0.006 Toys, sports, and hunting equipment 0.8 6.3 0.003 Zoo animals 0.3 11.3 0.086 Total 92.6 a. The comparative resistance index for a given product is the ratio of its relative market share in 1988-90 to its relative market share in 1980-82. (Relative market share is the ratio of Madagascar's market share for the product to Madagascar's total share of the world market.) b. Does not include cla) A comparative resistance index higher than I for a given product indicates that Madagascar's market share for the product held up better than did exports as a whole. Since Madagascar's share of the world market fell almost by half between 1980 and 1990, an index higher than 2 indicates that its market share for the product increased. Many products important to Madagascar have a comparative resistance index lower than 2, indicating a drop in market share. They are: coffee, cocoa, vanilla, cloves, pet food, shellfish, graphite, vegetable oils, mica, essential oils andperfumes, leather, cotton textiles and shoes. Source: UNCTAD  18 44 How can Madagascar hope to reverse these catastrophic trends and stimulate rapid growth in exports? First, it must regain its former share of markets for traditional products by instituting appropriate economic policy measures. Second, it must diversify its agricultural and industrial exports through partnerships with producers and distributors in consumer countries, or with investors seeking to relocate production facilities. In spite of the overall collapse, the structural trends in exports observed in the 1980s are encouraging in this regard. Though its exports declined overall, Madagascar was able to maintain or increase its market share for many products, thus showing there is potential for new production. Box 3 shows the major products that were still profitable during the recession in the 1980s. In particular, growth in the market share for "dynamic" products like luggage, sport and hunting equipment, furniture, clothing, and hides is evidence of the export industry's still embryonic potential for diversification and development. Exploitation of this potential and accelerated diversification of exports offers a chance of achieving "sustained growth." Potential by sector 45. Agriculture and fishing. The agricultural sector has considerable potential for growth. Since agriculture can pull the rest of the economy upwards, it will play a major role in any national development strategy aimed at accelerating economic expansion, reducing poverty, and eliminating food shortages, while protecting the environment and the sustainable use of natural resources. 46. In view of Madagascar's geography, population distribution, and the extent of the sociological barriers to migration and development in areas of low population density, the best approach to boosting the agricultural sector in the short- and long-term is to develop it in densely populated areas with high agricultural potential. Primarily, this would mean improving yields, diversifying farming operations, and shifting towards market-based rather than subsistence farming. In addition, greater regional specialization geared to both export and domestic markets should be a part of this strategy. This development would be enabled by the expansion of both export and domestic agricultural markets, private sector growth, and the decentralization of agricultural support services. 47. The potential for growth in all agricultural subsectors is considerable. With regard to foodstuffs, the economic and financial analysis suggests that Madagascar has a regional comparative advantage for producing enough food to meet almost all its requirements. The potential for intensification is significant and financially attractive to farmers. Agricultural yields are consistently low, and have seen practically no improvement since Independence. However, the sector has considerable productive capital in the form of high-density irrigation systems covering 40 percent of the cultivated land. In those areas, exploitation and yields are both low , there is little or no crop diversification, and the emphasis is on subsistence farming. Despite the fact that paddy fields represent 40 percent of the value of total production, and they take up almost all the irrigated land, less than 15 percent is commercialized. The marked comparative advantages of individual regions underline the driving role that interregional and external trade can play in the intensification and diversification process by giving farmers access to profitable markets for their products. 48 Potential demand for food products is significant for two reasons. First, national output falls short of current food requirements, particularly for grain (annual shortfall: 180,000 tons) and  19 vegetable oils (annual shortfall: 13,000 tons). Second, consumption levels are low: rice availability per capita fell by 35 percent between 1982 and 1992, and 35 percent of the country's population are food insecure (42 percent in urban areas and 34 percent in rural areas).5 Projections for 2005 indicate that, on the basis of past crop yields and a 1 percent rise in per capita income, shortfalls in grain (rice: 215,000 tons, wheat: 150,000 tons) and vegetable oils (42,000 tons) will increase.6 49. The growth potential of agricultural exports for both traditional and nontraditional products is noteworthy. In the foreseeable future, traditional export products (vanilla, coffee, pepper, lima beans, cotton, and peanuts) will continue to contribute to the development of exports, generation of foreign exchange, and higher incomes in rural areas. There is significant potential for the intensification of such products; however, that potential continues to be underexploited because marketing channels are highly disorganized and constitute a barrier to quality enhancement and product promotion. Furthermore, there are restrictions to export policies for vanilla and cotton, marketing costs are pushed up by dismal means of communication and insufficient credit, and prices for producers are unattractive. 50. Despite their recent and spectacular development, nontraditional exports7 still have a narrow base. This does not include shrimp which is the second largest source of foreign exchange. The expansion and diversification of the other exports are essential to sustained agricultural growth because they will boost and stabilize exchange revenue, and provide access to profitable outlets and employment in many areas of Madagascar. New export industries will capitalize on the wide variety of conditions and natural resources in the country, and thus have an impact on almost every region. They have enormous potential for development: in the fishing sector alone, a wide range of resources are currently underexploited, including crab, green crawfish, tuna, and seaweed. There is also considerable potential for expansion and diversification of animal and vegetable products. The development of this resource should be managed carefully. Experience in other basins illustrates the hazards of overexploitation and its negative impact on the resource. The Indian Ocean has not yet reached the point of overexploitation, but the situation could deteriorate rapidly with indiscriminate use. 51. Industry. Madagascar's industrial sector is fairly small, accounting for approximately 14 percent of GDP. It consists mainly of public enterprises which were geared toward import substitution. The main subsectors are textiles, clothing, preserves, beverages, shoes, and pharmaceuticals. Smaller private sector enterprises have demonstrated a greater capacity to make the change towards exports, particularly in clothing and shoes. New enterprises, established in the free trade zone and under the investment code, have opened up new export niches. For example, free trade zone certification was obtained for exporters dealing in silk, leather goods, essential oils, models, bicycles, watches, jewelry, buttons, and electrical equipment. S A household is considered to be food insecure if its income does not enable it to maintain a minimum nutrition level of 1680 calories per person per day. 6 The income elasticity demand has been estimated at 0.4 for rice, 0.7 for wheat, and 0.9 for vegetable oils. 7 In volume, from 1985 to 1990, corn, cassava, fish, trepang, shark fins, squid, and octopus rose over 200 percent, fruit and vegetables 100-200 percent, and beans, potatoes, cashew nuts, shellfish, and livestock 50-100 percent.  20 52. For industrial expansion, Madagascar will rely less on developing existing production than on positioning itself in world markets with highly dynamic products. However, as experience has shown, it is also possible to increase market share in less dynamic products. The industrial sector's current dependence on locally-produced primary materials, such as cotton, hides, fruit, and vegetables, will decline insofar as a skilled, highly competitive workforce can enable the country to import primary materials to process for export. In Southeast Asian countries with rapid expansion, the industrial sector has grown even more quickly than the economy, attaining a concomitantly larger percentage of GDP. Thus Malaysia, with an annual growth of 7 percent between 1973 and 1981, saw its industrial sector expand by 9.5 percent. Between these dates, the share accounted for by the industrial sector grew from 15 to 20 percent of GDP. Thailand experienced 7 percent growth between 1963 and 1987, together with an industrial growth rate of 9.5 percent. In that period, industry's share rose from 14 percent of GDP to 25 percent. The lessons for Madagascar from the East Asia examples are clear. First, industrial expansion in all countries seems to proceed in the same successive stages: (a) an initial stage of labor-intensive, unskilled production, based on local raw materials and geared to import substitution; (b) rapid replacement of such production by export-oriented industries comprising an increasing proportion of skilled labor, initially focusing on assembly of imported components, and (c) a broadening of the productive base, through the intensive application of imported technologies and utilization of competent foreign managers. 53. Companies and investors in the most advanced economies (Taiwan, Hong Kong, Japan, and the United States) have been approached and actively encouraged to establish production facilities in partnership with local private entrepreneurs. Madagascar could develop its industrial sector successfully. It has the major asset the NIEs began with--plentiful, cheap labor, which is easily trained in production methods. However, this potential cannot be realized unless the legal and regulatory framework of economic activity unfetters productive energy by facilitating the establishment of new businesses, foreign investor activity, and job creation. Furthermore, it cannot be realized without suitable physical infrastructure, and the development of human capital. Only by developing a labor-intensive export industry can Madagascar hope to bring down its catastrophically high unemployment, which could well become a source of political and social unrest. Developing the industrial sector will by no means be an easy task. Markets for manufactured goods and financial services are increasingly globalized, while technology, marketing, and business management are forging rapidly ahead. In industrial markets, produci quality and on-time delivery are becoming the dominant factors. This means that it is increasingly important for Madagascar to seize opportunities for investment and trade with its neighbors, particularly Mauritius and South Africa, as well as with the industrialized countries of East Asia. 54. Tourism and other services. Tourism has become a dynamic component of Madagascar's economic diversification. Between 1985 and 1990, the number of foreign visitors rose from about 23,500 to almost 53,000--unfortunately it then fell to 35,000 in 1991. Certified hotels offered 1,597 rooms in 1985 and 3,040 rooms in 1991. Gross tourism earnings, though they fell from $40 million in 1990 to some $29 million in 1991, were in both years higher than export earnings from coffee.  21 Box 4: Main tourist areas of Madagascar The high plateau region The high plateau is centered on the capital, where economic activity and a significant administrative and political presence are conducive to international and domestic business tourism. The region is also important as a hubfor travel to other areas. Furthermore, it offers many opportunitiesfor tours and exploration. A wide range of activities is available, such as the hot springs in Anisirabe and scopefor outdoor activities in Ampefy and Mantasoa. The region's total long-term capacity is estimated at 6,800 rooms (over 12,000 beds). Current utilization is less than 13 percent. The Virgin Island Coast (Northwest) This region comprises the northwestern coast from Soalala to Cap d'Ambre and a portion of the northeastern coast, including Antsiranana (Diego Suarez) and Sambava. The emphasis will be on beach tourism; the climate is very pleasant, except during the hurricane season, which lasts from January through April. Beach activities could be complemented by a wide range of land and sea tours. Three sites stand out: Nosy Be, Antsiranana and Mahajanga (Majunga). Due to its outstanding qualities, Nosy Be would be the prime site. The region's total long-term capacity is estimated at more than 8,000 rooms (over 15,000 beds). Current supply represents only 5 percent of capacity; this underscores the region's tremendous potential. The Capricorn Coast (Southwest) This region offers two types of possibly complimentary activities. beach tourism around Ifaty, where the lagoon has outstanding flora and fauna; and discovery activities through land tours on the Isalo Massif where the scenery andflora reflect the "island continent's" immense diversity. In the long term, secondary sites could be established for beach tourism (Morondava and Morombe) or discovery (Ampanihy). The region's total long-term capacity is estimated at more than 3,700 rooms. Current utilization is less than 5 percent. The Spice Coast (Southeast) This region has 650 km of coastline, extendingfrom Mananjary to Taolaflaro (Fort Dauphin). It has many stretches of straight coastline and a steep hinterland leading up to the mountains. This site can be promoted as a dual destination (sea and mountain). The region's total long-term capacity is more than 3,500 rooms. Current utilization is less than 5 percent. The Rosewood Coast The northern continuation of the spice coast is referred to as the Rosewood Coast. It stretches for 700 km from Vatomandry to Antalaha. One of the region's prime sites is the island of Sainte Marie. Tourist activities in the entire region focus on natural beauty: the flora are particularly luxuriant, and there is extensive scope for beach, lake, and river tours. Toamasina, Madagascar's second largest city, is the region's second site. The region's total capacity is estimated at some 2,000 rooms. Current utilization is 7 percent.  22 55. Obviously, tourism could be a rich source of revenue for Madagascar. But demand forecasts in this sector are always uncertain, particularly in cases like Madagascar where the industry's base is weak and initial expansion would have to be rapid. The country can best be compared to the Maldives and Seychelles, though it is much bigger and more diverse. In the Maldives, the number of tourists rose from 33,000 in 1979 to 158,000 in 1989. In the Seychelles, tourism showed less expansion, rising from 55,000 visitors in 1977 to 104,000 in 1990.8 These figures indicate that Madagascar could receive at least 100,000 to 150,000 visitors a year in the comning decade. Two extensive studies on tourism have been conducted in recent years. The first supported an ambitious project to build hotels on three sites (the islands of Nosy Be and Sainte Marie, and near Fort Dauphin in the south) and concluded that the annual number of visitors could reach 140,000 by 1995. The second study, conducted for the United Nations Development Program (UNDP) in 1992, concluded that in ten years the number of visitors could rise from 70,000 to around 460,000. These figures indicate the scale of Madagascar's tourism potential, though estimates are widely varied (Box 4). Madagascar's natural resources, low wages rates, and the emphasis the Malagasy place on quality of service are all factors conducive to tourism development. The beauty and variety of Madagascar's landscape, its natural riches and its diversity of flora and fauna9 are further assets in tourism development. "Ecological" tourism is showing the fastest growth. It is estimated that the number of tourists who visited Madagascar especially for its natural beauty rose from 4,000 to 8,000 during 1988-90. Thus environmental protection is as essential to the development of tourism and associated jobs as it is to agriculture. Keeping sites and beaches clean, pollution free, and protected from environmental degradation, will have a positive impact on traditional tourism. 56. To fulfill the more ambitious projections, Madagascar would need accelerated development of hotel infrastructure and equipment. This means private foreign financing, at least for the hotel component. Only very limited projects have been implemented to date: a new hotel project for Antananarivo and some sites south and north of Toamasina, and financing for some access roads to tourist areas in the south. In the short- and medium-term, limited operations would seem to be more viable than the construction of groups of hotels with over 100 rooms apiece. With existing infrastructure, Madagascar could start receiving approximately 70,000 low- cost individual tourists a year. It will be some time before the country can support high-value- added tourism. Thus, it is most likely that growth will be primarily generated by beach tourism organized through charter companies and travel agents. 57. Development is also hampered by the distance from major markets, and high transportation costs. Air access is limited by restrictions on both charter and regular flights to and from Europe, Nairobi, Mombassa, and Reunion Island. The projected liberalization of domestic flights will facilitate the transfer of tourists from Antananarivo, now the principal point of arrival to other tourist destinations. In conjunction with the medium-term development of air traffic, direct international access to Nosy Be could be another means of developing regional tourism. Tourists from Southern Africa and the Indian Ocean region could quickly grow to 20 percent of the total This is a small increase compared to Mauritius, where tourism rose from 115,000 visitors in 1980 to 300,00() in 1991 Thc figures for the Seychelles could have been much higher, but the governmcnt is deliberately limiting thc number of visitors through a luxury tourism policy, pnrmarily as en,ironmcntal protcction. 9 Madagascar has an estimated 150,000 .pecies unique to the island  23 number of tourists visiting Madagascar. Direct access already exists for Toamasina. With limited development, potential tourism is estimated at 100,000 to 150,000 foreign visitors annually by the year 2000, generating $80 to $120 million a year in gross foreign exchange earnings (in comparison with $50 million from vanilla and $45 million from shrimp), with $53 million-$80 million in value added. The hotel capacity required is double the number of rooms now available (about 3,000) in certified hotels. Other constraints on tourism development are inadequate infrastructure in the tourist areas, especially telecommunications, electricity, and water. 58. In addition to tourism the overall development of other services is linked to general economic activity; they should therefore grow at the same rate as the economy as a whole. However, Madagascar does have the necessary human potential to develop certain services even faster, including: consultants and chartered accountants, computer services, telecommunications, insurance, transportation, and export services. The role of human resource enhancement 59. The experience of high growth countries, which initially faced the same limitations as Madagascar, has shown that the quality of a country's human resources is an essential factor in short-term development and sustained long-term growth. The enhancement of human resources contributes to growth by: a) generating an educated, healthy labor force which can rapidly expand productivity, and thus raise the average income; b) providing the management, technical, and business skills needed for growth; c) making farmers less reluctant to implement modern, high- yield agricultural methods; and d) creating an environment that will foster the development of new entrepreneurs. Qualified, healthy labor is one of the prime factors that will attract investors to Madagascar, insofar as they are seeking not only cheap labor, but cheap productive labor. Investing in human resources will contribute to increased productivity in the agricultural sector, where crop yields are very low. Experience has shown that farmers who have had some primary education achieve higher yields, because they are more receptive to modern methods and are better able to communicate with their suppliers. With specialized training, they can achieve even higher yields. Health also has obvious impacts on productivity--healthy farmers can work harder, go further to markets, and so forth. Industry and commerce have everything to gain from access to skilled labor. Any modern labor force must have technical and business skills. Moreover as analysts have noted, the dearth of qualified managers constitutes one principal constraint on development. The fact that workers with technical, management, and business skills find employment faster shows that these workers are in high demand. However these skills are unusual in Madagascar. 60. Table 4 uses two indicators to illustrate the profound impact which investment in human resources has had in East Asia and Mauritius. In a rapidly changing economy where technological innovation is constant, the importance of general primary education cannot be overstated. The NIEs had attained almost universal primary education before they started on the path to industrialization. Though Madagascar has made significant progress, it still lags behind all the comparison countries, except Thailand. There are also disparities in education quality. It is acknowledged that certified primary school teachers in Madagascar have minimal qualifications. The impact of investment in basic health care is even more remarkable. In all the comparison countries, infant mortality in 1990 was down to at least a third, and in some countries even a fifth,  24 of its 1960 rate. By contrast, in the same period Madagascar only cut its infant mortality rate in half The 1990 infant mortality rate in Madagascar was still higher than the 1960 rates in all comparison countries except Indonesia. Table 4: Comparison between countries Country Primary school attendance rate Infant mortality rate (percent of school age children) (per 1000 births) 1960 -65 1970 -75 1985-90 1960 -65 1970 -75 1988 -90 Hong Kong 103 119 105 27 15 7 South Korea 101 107 108 62 40 17 Malaysia 90 91 96 55 37 16 Thailand 78 83 88 88 55 27 Indonesia 72 86 118 128 109 61 China 89 126 135 90 46 29 Mauritius 101 107 103 65 45 21 Madagascar 65 95 92 201 159 114 Source: World Bank, 1992 Economic Development Trends 61. Investment in human resources must be accompanied by measures to ensure that each group has the opportunity to fulfill its economic potential. Special consideration of the role of women in development is essential. There is a close correlation between women's education and economic and social development. Countries that invest in women's education reap the benefits of higher economic productivity, lower infant and childbirth mortality, longer life expectancy for men and women, and lower birth rates. Better educated women can also earn more. The children of educated women are healthier, and stay in school longer and learn more quickly, both of which are positive feedbacks to development. Madagascar is certainly making an effort: women now represent 39 percent of the labor force, a level higher than that in some comparison countries (see Table 2 in Chapter 2). However, literacy among women (73 percent) is still significantly lower than among men. MEDIUM-TERM SCENARIOS 62. The scenarios described below were developed to illustrate the medium-term impact of the various economic strategies the new government could adopt. They should not be interpreted as an exercise in prescriptive planning, but rather serve to reveal links and macroeconomic constraints associated with the strategies, reminding us that everything is interconnected. Three scenarios are discussed, The first is based on the premise that current economic trends will be maintained and no major reform program implemented. This is the "catastrophe" scenario; no details are provided here except that its repercussions would be disastrous for the Malagasy. It illustrates the crippling cost of relying on a day-to-day management strategy, and instituting no reforms. The major consequences would be a continuing slide in the living standard and ongoing degradation of the environment, infrastructure, and health conditions. If the Malagasy government fails to take corrective action, this scenario--economic stagnation--is the far most likely to occur. The two other scenarios discussed in this report are based on an entirely different premise: that  25 Madagascar can restructure its economy and achieve sustainable growth. Both scenarios have the ultimate objective of increasing GDP per capita and reducing poverty, and both assume the enactment of measures to arrive at a more balanced budget, keep public investment high, and mobilize relief for the balance of payments to allow financing of its imports. The scenarios involve the formulation and implementation of a sound reform program. The "adjustment as usual" scenario is based on a reform program similar to the one instituted in 1988-90, and provides for limited GDP growth. The "dynamic reform" scenario--sustained growth--entails generous private investment and accelerated export development. The three scenarios are illustrated in Figure 4. Flgue 4 - Per caita GDP 110 "1W5 ~95__ _ __ -85 75 l l 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 - [yInanic Refo-n- Adjustnrnt as usual D)D nothing Source. World Bank data. The "do nothing" scenario 63. Madagascar's economy has been in decline for twenty years, with only brief interruptions in the downward slide. In 1992, per capita GDP was 40 percent lower than in the early 1970s. The slight gains achieved during the period of limited growth in 1988-90 ended in the exhaustion of Madagascar's foreign exchange reserves in 1990, and were ultimately wiped out by a fresh contraction of the economy in 1990 and 1991. The 1991 losses were not made up in 1992. In early 1993, Madagascar encountered difficulty in meeting external payments, a high budget deficit and an inefficient public sector. Potential foreign investors hesitated to commit themselves, wary of uncertainties associated with the political transition and worried that the rigidly-planned, state- controlled economic system might persist after the changeover. In this scenario, economic decline is unavoidable. The country would become even poorer, with a 10 percent drop in per capita GDP by the year 2000, leading to more generalized poverty.  26 The "adjustment as usual" scenario 64. The "adjustment as usual" scenario is based on the economic policies implemented between 1988 and 1990, although they followed the right approach, they lacked sufficient energy and were incomplete. The scenario involves. (a) a prudent government finance policy, (b) better management of the Public Investment Program, enabling it to be implemented faster and to mobilize more assistance, (c) reintroducing the Open General Licensing (OGL) or some other open foreign exchange allocation mechanism, as well as maintenance and expansion of the free trade zones, (d) higher productivity in the agricultural sector, measures to promote traditional exports, particularly vanilla, (e) reform of the regulatory framework to encourage increased private investment, somewhat higher in real terms than GDP growth, and (f) mobilization of assistance for the balance of payments and debt restructuring. The scenario assumes these policies will lead to 4 percent annual growth in the industrial sector by 2000, and as high as 3 percent annual growth in the agriculture sector by 2000. 65. Under these circumstances, and assuming that the 1990 level of economic activity can be restored by 1994, Madagascar could attain its 1988-90 growth rate by 1995-96. Average annual GDP growth would be 3.2 percent between 1993 and 2000, reaching 3.6 percent by 2000. Private consumption per capita should begin to rise by 1996. Real annual growth in exports would be 4.4 percent, and in imports would be 3.9 percent. The investment ratio would be fairly stable, representing 12 to 13 percent of GDP (Figure 5), with public sector investment continuing to predominate. Domestic savings would represent, on average only 4 percent of GDP. Madagascar for the first time in many years, would see an increase in GDP per capita for more than two or three years running But this scenario does not provide for an absorption of the external trade deficit, and maintaining it beyond the year 2000 would leave little hope of regaining even the 1971 per capita GDP before 2065. Flgue 5 - Adjustnmnt as usual scermiuo 160 -- 1401 120 - 100 ----------I 60- 40 \,,- 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 WDP - Investent a tport |Source. World Banik datal  27 The "dynamic reform for sustained growth" scenario 66. In the recent elections, the people of Madagascar clearly expressed their aspirations: they elected new leaders, not to see them "do nothing," but to have them do something concrete to lift the country out of the seemingly inexorable poverty which is slowly suffocating it. This scenario provides for full realization of Madagascar's potential. It assumes that the formidable obstacles currently blocking it will be overcome by means of a dynamic economic policy, aimed at raising living standards through sustained growth. This requires a profound change in people's conception of economic development, and the adoption of a new paradigm integrating the basic choices outlined in the first part of the third section, "Long-term perspectives for development." All of Madagascar's economic sectors will need to expand (see earlier Figure 2). Sustained growth cannot be achieved without a dynamic private sector, and significantly accelerated growth in exports; this will enable the country to reduce the trade deficit--the major obstacle to balance of payments viability. A first objective of the policy could be to restore the 1971 living standard within 10 years. As things stand, this is already a major challenge. Once the 1971 living standards are reached, the physical and human investments made to foster growth should help begin to close the gap with countries like Mauritius. Calculations show that if this scenario were implemented, annual growth of at least 6 percent should be possible by the year 2000. Its implementation involves all the economic measures described in the "normal adjustment" scenario, as well as a determined focus on the development of exports and private investment. The measures required are described below. 67. In this scenario, the 1990 economic level of GDP will be restored by 1994, GDP growth would then be approximately 4 percent around 1995, and reach 6 percent towards the end of the decade (Figure 6). Initially the necessity of increasing private savings will limit private consumption. However private consumption per capita should begin to grow by 1996. Domestic savings, virtually negligible in 1990, should expand to 14 percent of GDP by 2000. The increase in the savings rates would make it possible to establish the conditions required for sustained, long- term growth. The development of export-oriented activities could enable exports to expand by a real annual average of 10 percent between 1992 and 2000, and 12 percent thereafter. The promising success of free trade zones is evidence that such results can be achieved. Through the enhancement of a competitive labor force, the country can develop agricultural and industrial exports, as well as tourism. Exports, which currently represent only 15 percent of GDP, would expand to over 20 percent of GDP by the year 2000 and over 30 percent of GDP after 2005.  28 Figure 6 - Dynamic reform scenario 250 - 8 200k .' 50 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 r. ~GDP Investnnt Exponis Source. World Bank data. 68. The experience of countries with high economic growth nas proved that a high investment rate is essential. According to this scenario, the investment rate should attain 22 percent of GDP by 2000 (see earlier Figure 3). The increase will be generated by strong growth in private investment. By the end of 1995, real private investment would be restored to the 1990 level and would then grow at an average annual rate of 22 percent. This may be an ambitious goal, but it reflects the need to invest in activities which only the private sector can develop. In 2000, private investment will represent 14 percent of GDP, in comparison with 7 percent in 1990 and 4 percent in 1992. The increase in private investment will involve a far more open attitude to foreign investment. In addition, an appropriate credit policy which shifts sectoral credit distribution to favor private sector instead of public sector credit should be put in place. Credit to the private sector should go up by an average of 22 percent a year. If the government finance policy makes it possible to expand public savings as expected, then private sector credit can be increased in the context of a prudently managed money supply. Public investment, which could be mairtained at about 8 percent of GDP, would be focused on infrastructure and human resources, enabling the state to make the best possible contribution to economic development. 69. To launch itself on a path of sustained growth, Madagascar will need an approach radically different from that of the late 1980s. An investment rate which is higher than 20 percent of GDP and generates sustained growth cannot reasonably be attained unless the government can offer foreign investors appropriate legal and political conditions, entrepreneurial freedom, ansd liberal transfer, settlement, and property rights. Financial stability is a prerequisite for such a high investment rate, as is the generation of national, public, and private savings. National savings net of external grants, now a negative figure, should thus increase to 12 or 13 percent of GDP by the end of the decade. As with investment, any measures to generate savings will place a burden on both the private sector and the state. Since balance of payments deficits will be inevitable during  29 the period in which investments grow, an expansion in the volume of external financing, as well as a reorientation of its structure, will be essential. CONSTRAINTS ON DEVELOPMENT 70. The purpose of this chapter has been to provide an overview of Madagascar's potential for growth and the means by which that potential can be fulfilled. As we have indicated, the potential has been there for some time, but its fulfillment has been blocked by numerous constraints, which must be eliminated before Madagascar's ,government can make any strides in achieving its goals for the coming decade. The constraints are related to infrastructure, human resources, the macroeconomic and regulatory environment, and the balance of payments. Infrastructure for transportation, telecommunications, electricity, urban networks and markets are inadequate for an intensive development plan. Telecommunications are not sufficiently extensive, while roads, the electric power distribution grid, and urban networks are deteriorated. The Malagasy's ability to contribute to high economic growth is limited by poverty, low quality education and inadequate health conditions. Macroeconomic and regulatory constraints include the government's lack of institutional capacity to run the state in the context of a liberal economy, the uncertainties engendered by current economic policies, and the lack of depth and consistency in the reform measures introduced in recent years. To eliminate these constraints, the government needs to make good use of its basic resources and focus on its essential functions, abandoning direct intervention in the economy. Finally the dearth of foreign exchange, a major obstacle to economic activity, reflects the huge imbalance in external trade. The balance of payments is no longer sustainable in its present form. To date, the accumulated debt, including arrears, stands at 120 percent of GDP. Debt relief is an absolute prerequisite if relations with other countries, including donors, are to be restored to a sound footing.  30 IV. ECONOMIC POLICIES TO ENABLE SUSTAINED GROWTH AND REDUCE POVERTY 71. This chapter mill explore the economic policy options through which Madagascar could, in the medium term, rrmake full use of its economic potential and significantly reduce poverty. Among the scenarios set forth in Chapter III, the "dynamic reform" option is the only one which makes it possible to redulce poverty within a reasonable time and, as a first stage, restore the 1971 living standard within a decade. The goal is to implement economic policies which achieve sustained growth, redu.ce poverty, and protect the environment, in the medium term. The challenge resides in elirninating the serious constraints set forth at the end of Chapter III. This chapter will study three major courses of action: achieving an institutional framework conducive to growth, reducing poverty, and protecting the environment. AN INSTITUTIONAL FRAMEWORK CONDUCIVE TO GROWTH Role of the state 72. The establishment of the rule of law took concrete form in August 1992, when MOadagascar adopted a new and far more liberal constitution. The process has been completed by the democratic implementation of discrete, yet complementary, executive, legislative and judicial powers. Moreover the new constitution provides for political decentralization with local elections. The new government has an excellent opportunity to reflect upon the ways in which it can move away from direct intervention in economic activity and take on the role of "facilitator," with the motto: "less government but better government." The functions assumed by the state must reflect the new constitution's liberal orientation and the financial means available. The state will have to reinforce some of its core functions: maintaining security, enforcing the law, ensuring that the judiciary system works as it should, formulating and implementing macroeconomic policy, and levying and collecting taxes. Other expenditures--those related to the control of economic activity and "management" of the agricultural sector--will become superfluous, since they will no longer have a raison d'c&re once a market-based economy has been established. 73. Logically, the genesis of economic growth through private sector development requires that the state withdraw from direct production activities by privatizing industrial and commercial enterprises and liquidating nonviable public enterprises. The state must direct its efforts towards establishing a physical and institutional environment conducive to the development of a competitive private sector; the experience of newly industrialized economies has shown that this is the most effective way of achieving a sustainable reduction in underemployment and poverty. This cannot be accomplished without substantial improvements to infrastructure and the enhancement of human capital, particularly in the areas of health and basic education. Since needs will far exceed available budgets, the state will need to assume its responsibilities in cooperation with private organizations. These could include: churches and local nonprofit organizations for teaching, Non-Governmental Organizations (NGOs) and local organizations for health services, and private companies and NGOs for technical training and infrastructure maintenance.  3] 74. The planned decentralization policy provides for the decentralization of federal staff and/or reallocation of administrative services to local authorities. This would bring local communities closer to development activities, and make it easier to adjust programs in accordance with the different resources and comparative advantages of individual regions and subregions. One option is to decentralize the central administration by relocating personnel to outlying areas. Another option is to reallocate administrative services by transferring many of the central government's primary responsibilities to local authorities--with some activities, particularly in teaching, health, safety, and infrastructure, eventually shifting to the private sector. With the second option, local authorities will need access to adequate financial resources, including cost recovery from households willing to pay for better services. 75. The overall direct and incidental taxation effort will have to be intensified to mobilize the savings to finance investment growth, which is the essential precondition of sustained growth. However, before raising taxes or levying new ones, the central government must decide how local govemments are to be funded, and how the public and private sectors are to divide responsibility for delivering essential services. One option is to implement a local tax system strong enough to collect a substantial portion of total tax revenue and finance most of the local governments' needs. Another option is for the central government to increase tax revenue and share it with local authorities. To choose between these options, the government must decide how much financial autonomy it wants to allow local communities, and determine how efficient the central tax system is in comparison with local systems. Most likely the local systems will be established gradually and with the assistance of the central tax department, so transfers from the central government would initially represent the major portion of local revenue. Transfers could be reduced as local tax systems are strengthened. 76. Local tax system reform is one component in a much-needed comprehensive tax reform plan. The plan's objectives must be twofold: to provide more incentives for economic activity, and to increase fiscal revenue--a prerequisite for adequate public savings. Reform must be geared toward a value added tax as a primary source of revenue, while direct taxation must be reduced as much as possible. The main reason the tax system is unfair is that tax evasion and tax exemptions are significant. By waging an effective campaign against tax evasion, the government would see its tax revenues rise and dispel the sense of injustice felt by those who actually pay their taxes. A legal and regulatory system conducive to the development of the private sector 77. The legal and regulatory framework. Private investment in Madagascar can develop only insofar as potential investors are confident they can operate under well-defined, stable conditions. Furthermore, the legal system must be effective in enforcing contract compliance. At present, this is far from the case. There are many contradictions between statutes that are still in force, between statutes and their corresponding regulations, and even among internal government directives which are not legally binding but have a significant impact on decision making within the government. Businesses already operating in Madagascar have often succeeded in overcoming government-imposed constraints, but they represent a major obstacle to new entrants. 78. The commercial, industrial, and agricultural activities of individuals and groups are in principle still governed by the Commercial Code (Code de Commerce), enacted in 1960. It is no longer appropriate to the demands of modern business, and has been amended many times. Its  32 application is frequently complicated by the large number of decrees and circulars that at times complement it, but at others contradict it. Bankruptcy laws make it very difficult for a failing business to terminate its activities. Property rights must be better defined and easier to verify. There is no mechanism for settling civil liability conflicts in the absence of a contract. A series of new statutes was enacted during the recent period of economic liberalization. Foremost amongst these is the new Constitution adopted in 1992. It is a liberal document, very different in nature from the dirigiste approach of the Socialist period. But the practice remains, from the dirigiste period, where an administrative note may supersede the implementation of new legislation. For example, foreigners are now legally permitted to purchase buildings in Madagascar, but such transactions cannot take place because a memo exists prohibiting them. Foreigners' inability to acquire real estate constitutes a major obstacle to both the privatization of public enterprises and the development of direct foreign investment. 79. These examples show how necessary it is to review the legal and regulatory framework goveming economic activity. Existing contradictions between statutes, the regulations implementing them, decrees and internal directives, and memoranda must be eliminated. There must be no conflict between the commercial code, business code, mining code, and legislation governing competition, real estate ownership, the free trade zones, and other areas. Collectively these instruments must be consistent and reflect the government's liberal approach, as set forth in the Constitution of August 1992. Furthermore they must be enforced through an effective legal system, which requires profound restructuring. The possibility of establishing arbitration procedures should also be studied. It is not enough for private investors to know the rules of the game, instead the rules must be such that compliance does not require a huge investment in time and effort to wade through the bureaucracy. Incorporation procedures should be simplified, giving all entrepreneurs access to the one-stop facility implemented to deal with certification applications under the investment code. To ensure that certification mechanisms are open to scrutiny, a recourse procedure could be instituted for cases that were denied certification, or had received no response within two months of submitting the application. Mexico has enacted such legislation. The one-stop facility must serve as the single decision-making entity: sector ministers should not be responsible for approving applications as they were under the Second Republic's interventionist approach. 80. Pursuing the course of liberalization. The expansion of external trade will require improved air transport and cheaper shipping, and telecommunications facilities. The high cost of air transport is a significant obstacle to tourism. Air Madagascar has a monopoly on both domesticl and intemational routes. Since domestic airfares for residents are set by the company at far below cost, Air Madagascar's international flights subsidize domestic flights. On international flights pooled with Air France and Air Mauritius, rates are higher than they would be in a more cornpetitive regime. The end result is that capacity for domestic flights is far below demand, in spite of the higher domestic fares paid by nonresidents. Capacity on international flights is artificially limited to ensure full occupancy. Thus tourism and exports are penalized in two ways: by fares that are too high, and by the inadequate transportation capacity. The best way of eliminating these constraints would be to deregulate domestic flights and open the international routes to other carriers. The later would involve entering into an agreement with Air France. t