Madagascar - Country assistance strategy

Document of The World Bank FOR OFFICLAL USE ONLY Rqmo No. 13170-MAG MEMORANDUM OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO TEE EXECUTIVE DIRECTORS ON A COUNTRY ASSISTANCE STRATEGY OF THE WORLD BANK GROUP FOR THE REPUBLIC OF MADAGASCAR JUNE 20, 1994 Country Departuent III Africa Region T7is document ha a restricted disbribuion and may be mud by recpients only in the performnce of teir official duties. Its contents may mot otherwise be disclosed withot World Bank authorization.  DATE OF THE LAST CAS May 18, 1992 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) WEIGHTS AND MEASURES Metric System MALAGASY FISCAL YEAR Janary 1 - December 31 ABBREVIATIONS AND ACRONYMS AGETIP Agency for the Execution of Public Works and E-mployment AIDS Acquired Immune Deficiency System ARPP Anual Review of Portfolio Performance BOP Balance-of-Payments CG Consultative Group CBI Cross-Border Inidative CIR - Country Impl ion Review COMESA Economic Commuity of Eastern and Southern African States CPPR Country Portfolio Performance Review EPZ Export Processing Zone ESAF Enhanced Structural Adjustment Facility ESN Economic Strategy Note ESW Economic and Sector Work GDP Gross Domestic Product GNFS Goods and Non-Factor Services GNP Gross National Product NEAP National Environmental Action Plan NGO Non-Govermental Organization OGL Open General Licensing PFP Policy Framework Paper PHC Primary Health Care PIP Public Investment Program PSD Private Sector Development SAC Structural Adjustment Credit SPA Special Program of Assistance for Afiica  FOR OFFICIAL USE ONLY TABLE OF CONTENTS MAIN TEXT A. Introduction .....................................1 B. Recent Economic and Social Performance ................ 1 C. External Environment .................................... 5 D. Development Objectives and Policies ....................... 6 E. Bank Group's Country Assistance Strategy .............. 7 F. Agenda for Board Consideration .............................. 17 TABLES IN THE MAIN TEXT 1. Key Macroeconomic Indicators, 1973-1993 ............ 3 2. Policy Goals and Instruments of Country Assistance Strategy. 9 3. Key Macroeconomic Indicators, 1994-2002 (Base Case) .15 ANNEXES Al. Selected Indicators of Bank Portfolio Performance and Management A2. Bank Group Fact Sheet, FY91-97 A3. Priority Poverty Indicators A4. Key Economic Indicators A5. Key Exposure Indicators A6. Status of Bank Group Operations in Madagascar This doamnt has a rtiod distnbution and nay be used by rocpients only in the pcformance of their offcial dutier.. Its contents may not otherwise be disclosed without World Bank authorizaton.   MEMORANDUM OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A COUNTRY ASSISTANCE STRATEGY OF THE WORLD BANK GROUP FOR THE REPUBLIC OF MADAGASCAR A. Introduction 1. Madagascar - the world's fourth largest island - is a country with significant but as yet largely unfulfilled growth potential. On the positive side, it has a low population density - it is larger than France but has only 1/5 as many people; is rich in low-wage and trainable labor; has generally good soils and climate; and has a unique environment and eco-system to attact tourism. On the downside, poor economic policies during much of the period since independence in 1960, coupled with demographic growth rates of about 3 percent, have contributed to falling per capita incomes and poor living conditions, even by sub-Saharan African standards. The country's per capita GNP in 1993 stood at only USS 235, making Madagascar one of the world's poorest nations. 2. Madagascar's economy is predominantly based on agriculture, which accounts for about a third of GDP and nearly 60 percent of export earnings, and is the main source of income for 80 percent of the population. Most farms are small and subsistence-oriented. The industrial sector is still small (about 14 percent of GDP). Owing to policy reforms which the government introduced during the mid- and late-1980s, however, the sector is undergoing a promising transition. From being largely state-owned, capital-intensive, inefficient and inward-loolcing, in the late 1980s the sector began to become increasingly privately-owned, labor-intensive and export-oriented. This shift was fueled by private investment, much of which was foreign. 3. Madagascar is one of the few African countries that have made a transition from a single party regime to a pluralistic democracy. In mid-1991, demonstrations and strikes in support of political liberalization swept the country. A transition government was put in place to lead the country to elections. The transition took two years, but was relatively peaceful. A new president, Albert Zafy, was elected in February 1993. Parliamentary elections were held in June, and a new govenment was formed in August. The long political transition paralyzed the public administration and severely disrupted financial and economic management. Although the positive response demonstrated by private investors in 1988-90 slowed, it was not halted. Labor-intensive export activities under the special regime of the Export Processing Zone (EPZ) were successful in creating jobs and expanding non-traditional exports during 1990-93. This vividly dmonsttes Madagascar's underlying potential. B. Recent Economic and Social Performance 4. Economic Policies. After independence in 1960, Madagascar enjoyed modest growth for about a decade. In the mid-1970s, the country underwent a socialist revolution which resulted in one-party, authoritarian rule and dJngiste economic policies. The state played the major role in economic matters - including ownership of public enterprises, nationalized or newly established - and the private sector was maginalzed. The result was a decade of poor economic performance and debt accumulation. During the second half of the 1980s, the govenmment embarked on a  2 reform program: the economy was stabilized, trade was liberalized, and greater leeway was given to the private sector. Economic reform was accompanied by limited political liberalization. 5. The government's reform program was supported by four IDA sector adjustment credits covering industry, agriculture, trade, and the public sector, with the objective of liberalizing the economy and withdrawing the state from productive and commnercial activities. A number of important reforms were undertaken with the support of these credits. In the external sector, the government substantially eased administrative export restrictions, greatly enhanced the country's international competitiveness through a series of devaluations of the Malagasy franc (FMG), ended quantitative import restrictions, introduced an automatic allocation of foreign exchange for merchandise imports through an open general licensing (OGL) system, and initated major tariff reform to reduce effective protection. An improved budgetary system was introduced, and the process for public investment programming was improved. Government investment, especially in large and inefficient projects, was curtailed and steps were taken to withdraw the state from productive activities. A number of long-standing projects which absorbed an inordinate amount of domestic financing were closed down. Financial institutions were partially privatized, and the sector was opened to two new privately-owned banks. In industry, the government eliminated most price controls and export taxes, reduced controls on profit rmargins, and began to dismantle the heavy administve regulations, which were a disincentive to private activity. In agriculture, it liberalized the pricing and domestic marketing of rice (Madagascar's main staple), eliminated most state monopolies, and abolished export taxes except for vanilla. Finally, a new domestic petroleum price mechanism was adopted, calling for automatic adjustment of prices based on international prices, the exchange rate, and the cost of transport and unloading. 6. Economic management suffered during the political transition startng in 1991. Budgetary discipline deteriorated; monetary management was lax; intemational reserves fell, extemal arrears accumulated, and the OGL system was replaced by rationing of foreign exchange; divestiture of pubiic enterprises was slow, with only about 50 enterprises out of 170 divested and the largest, and those with the most acute financial and economic problems, remaining in the public sector; and reforms of the legal and regulatory framework to improve the business environment were discontinued. While Madagascar maintained military expenditures at a relatively low level, expenditures on general administration and indirect transfers to public enterprises represented an important burden on the economy. Because of the shortcomings in ecotomic management and the government's inability to address some of the major issues affecting the public sector, on September 30, 1993, the Association closed the FY88 public sector adjustment credit and canceled its third tranche. The unfinished reform agenda is described in Part D below. 7. The new government, which took office in August 1993, was slow to espouse reform. Ill- advised borrowing schemes were explored, and some debt may have boee contracted on unfavorable terms and for doubtful purposes; large-scale import restrictions were imposed in early 1994 as a way to address foreign exchange shortages; and the 1994 budget and public investment program went off track. In May 1994, after backsliding and inaction for several months, the government under the prime minister, Francisque Ravony, resumed the stabilization and adjustment course with a number of important actions, most significantly floating the exchange rate and abolishing import prohibitions. Moreover, the prime minister made commitments regarding more vigorous public sector management including deficit reduction and public investment. A joint Bankicff mission traveled to Madagasr in late May to review economic performance; this mission made substantal headway in negotiting a policy framework paper (PFP). Final negotiations of the PFP are expected to resume in mid-July.  3 8. Economic Performance. Table 1 provides key economic indicators. In the late 1980s, the economic reforms supported by the Bank and the Fund began to yield encouraging economic results, and over 1988-90 the country experienced modest per capita GDP growth with evidence of increased private investment, especially in labor-intensive, export-oriented ventures and tourism- related services. Table 1. Key Macroeconomic Indicators, 1973-1993 (percent) -;N hSt --~~1973- 1981M- 198- X99 199 199 ... .) - ....................... .... ..... . . .. .1 .- -3:4 Expoolume .. . ....1 . . . . . ....... . ..s . .:-.-:., ,,2 ,,.9 7,: ...- ....... 9s ... s s 13... W,, ,, ....... ,... 2! , S HO ' 9.3. . , .X.9 1... Eudgtfc .- ; -7s i.0 -10.4.............................. -1-.8 ::---:-s:-:-.6^......6 -11.... ~~~~~~~~~~~~~~~~~~~~~..... , ........... 9. During the recent political transition, economic recovery was disrupted, particularly in 199 1, when real GDP declined by 6.8 percent and per capita GDP and consumption contracted by 9.6 and 3.6 percent, respectively. During 1992-93, GDP growth resumed but averaged only about 1.S percent p.a., resulting in a. further decline of per capita GDP by a total of about 2.5 percent. Madagacrs fiscal performance deteriorated, with a widening deficit averagng 12 percent of GDP. Domestic savings averaged a low 3.2 percent of GDP. The trade deficit widened as the dollar value of imports increased by 7 percent compared to a 14 percent decrease in the dollar value of exports. The balance of payments, both on current and capital account, weakcened, resulting in a foreign exchange shortage and the build-up of arrears (amounting to about USS 700 million, equivalent to 21 percent of GDP, at the end of 1993). Reserves, which had been depleted to 1 month of imports by end-l990, remained practically at the same level thereafter. The disequilibria in the economy were reflected by the differential between the official and parallel exchange rates, which had increased to about 40 percent by the end of 1993; an increasing share of foreign exchan~ge transactions took place on the parallel markcet. 10. A bright spot in Madagascar's economic performance, despite political uncertainties, was the resiliency and growth of the private sector. Although overall levels of private investmet are still at low levels, there has been continued investment activty, particularly under the EPZ regime. The EPZ is an incentive scheme in effect since 1990, offering unlimited foreign exchange retention and much reduced regulations to firms which export 100 percent of their products. Et is modeled  4 after Mauritius' successful EPZ legislation. EPZ activity grew during the political transition, and by the end of 1993, around 90 EPZ projects had been approved, of which about 50 were already in operation. The total number of jobs already created in the EPZ is estimated at around 10,000, or 2.5 percent of total formal sector employment, with EPZ exports amounting to about USS 30 million in 1993, representing 10 percent of total merchandise exports. Since 1991, investment in the EPZ has averaged around US$ 25 million p.a.; much of it has been financed by a mixture of foreign direct investment and domestic investment, often in the form of joint ventures. A large proportion of the EPZ firms created so far are in the garments industry; others are involved in food processing and the manufacture of artisan products. Not only has this created much needed employment and growth, especially in Antananarivo, Madagascar's capital and largest city, it has also fmilianzed Malagasy entrepreneurs with new technology and managerial sklfls. The growth of the EPZ, despite the political and economic transition, and the increased role played in public debate by private sector entrepreneurs and organizations, have built a growing constituency for adjustment in the country. The private investment response is still fragile, however, and a vigorous reform program is essential to stimulate large-scale, broad-based investnent. 11. Poverty and Social Conditions. Poverty in Madagascar is widespread and extreme, even by sub-Saharan African standards. Social conditions are poor as evidenced by the country's low life expectancy (51 years), under-five mortality of 15 percent, malnutrition of up to 40 percent in certain areas, and the spread of communicable diseases, e.g., malaria, sexually-transmitted diseases (including AIDS), and tuberculosis. Due to distance, inefficient markets and inadequate infrastructure, parts of the island are constantly threatened by food shortages, even when the country as a whole has a food production surplus. Food security is also a problem in urban areas, and the situation has worsened over recent years largely due to the econoaic decline. The poorest groups are also affected by deteriorating health and education services. Resources in these sectors have been poorly managed; essential drugs do not reach large parts of the population; teachers at the primary and secondary levels are unevenly distributed, with nurI areas often not served; and universities extract a disproportionately high share of education resources. From a situation of almost universal enrollment in primary education a decade ago, enrollments have now dropped, and the indicators of internal efficiency have deteriorated. Madagascar faces the prospect of producing the first generation of children who will be less educated than their parents. This has serious implications for poverty reduction efforts, as well as for aintaining Madagascar's comparative advantage in wellrained, low-wage labor. Underemployment in the country is significant - only 2.7 percent of the population are in non-agricultural, wage-eaning jobs, compared to countries lIke Malaysia and Mauritius where that figure is 20 to 30 percent. The population growth rate, though falling, is still high at 2.8 percent; this forces more people to share fewer resouces, and multiplies the strain on the envirnmnt. Annex A3 provides key social indicators. 12. Enviroment. Madagascar is facing a spiral of environmental degradation that increasingly thretens sustainable development and the country's unique ecological heritage. The forest cover has been reduced by 50 percent in the last 30 years, and in some areas erosion is decreasing agricultural productivity and itatening infasucture. Low technology use and subsistence agricuure have led to improper hillside cultivation, including slash-and-bum techniques, and agncultural encroachment on forests. As noted above, poverty and high population growth have contibuted to environmental degadation. The previous govenment recognized the importance of this issue, and Madagascar was the first African country to prepare a national environmtal action plan (NEAP), widely supported by the donor community, including IDA (enviroment project, FY90). Program start-up coincided with Madagascar's period of political transition, and progress has been slower than expected. Supervision has been intensified  5 to help the new government establish the institutional set-up envisaged, to improve coordination among agencies and to define realistic, priority annual work programs. 13. Summary Assessment. Despite significant shortcomings in economic management during the political transition and first months of the new government, the policy reforms undertaken since the mid-1980s have altered for the better the underlying economic environment of Madagascar, brought a new degree of freedom to the markets and demonstrated that faster growth is feasible. Moreover, they helped build wider support for a new approach to sustained development, with a reduced role of the state in economic affairs and correspondingly Larger participation of the private sector. Investors have started to respond, and Madagascar is a bonafide candidate for becoming, over time, an Afican success story, provided the authorities vigorously pursue their commitment to a renewal and intensification of economic reform, and to address the constraints to accelerated growth. C. External Environment 14. Madagascar is vulnerable to several external factors. Due to its geographic location, it is frequently hit by cyclones; its traditional export crops (coffee, cloves, vanilla) face volatile prices and increased competition; and it has a heavy debt burden. Most of the cyclones which hit Madagascar every year cause only minimal damage. In January and February 1994, however, several cyclones struck Madagascar, and the most violent one, Geralda, wreaked great damage to the main transport corridor linking the country's main port, Toamasina, to the central highlands, where the capital is located, and disrupted the supply of basic goods such as rice and petroleum products. A cyclone rehabilitation credit was approved by the Board on June 9, 1994. 15. The world market prices for coffee and cloves have declined steeply in recent years, and between 1980 and 1993 the share of these two products in Madagascar's total exports dropped from 61 to 15 percent. The recent recovery of coffee prices is not expected to bring prices back to their real levels of the 1970s. Adjustment measures were taken to revive these exports, but in the interim Madagascar's main buyer of cloves, Indonesia, has become self-sufficient. Current farm- gate prices for coffee and cloves are 10 and 20 percent lower, respectively, in real terms than they were in 1982, and production continues to decline. Vanilla, traditionally the country's most important export crop, accounted for only 15 percent of exports in 1988-1992, and Madagascar's share of the intemational vanilla market fell from 70 percent in the early 1970s to about one-third in recent years, due to poor state management of the sector and active competition from new entrants. Given the weak prospects for the country's traditional exports, aggressive diversification into non-traditional exports is the key to sustained, accelerated growth. This is the centerpiece of the country strategy. There has been some recent progress: shellfish have become an important export, earning as much as vanilla, for instance, and non-traditional industrial export earnings are now at about the same level as traditional export crops. 16. Madagascar's debt burden represents a severe constraint (Annex AS). The debt/GDP ratio was estimated at about 120 percent in 1993; based on debt service due, the debt service ratio was estimated at about 75 percent of exports. The country was unable to pay much of this debt service, and Madagascar is in arrears to almost all of its creditors except the Bank. The country has had seven reschedulings, recent ones on Toronto terms, but a large portion of the debt is now ineligible for rescheduling because of a cut-off date in the early 1980s. In addition, the debt rescheduling agreements related largely to onerous loans contracted in the late 1970s, a period of "all-out public invesumt" in the country, and the average interest rates in the rescheduling agreements are high.  6 As a result, the current annual interest burden is still heavy, even though new loans have been on greatly concessional terms. D. Development Objectives and Policies 17. An Accelerated Growth Vision. Madagascar can become an economic success story. Retumig to the pace of reforms of the past will not, however, enable the country to realize its full potential. At best, this would result in the modest economic growth which Madagascar experienced in the late 1980s and which barely outstripped population growth. Under this scenario, extreme poverty would continue to be widespread, and the country would only regain its 1971 per capita income levels in the second half of the 21st century. 18. Against this background, in mid-1993, Bank staff prepared an economic strategy note (ESN), which was discussed with the Malagasy authorities and encouraged them to raise their sights and adopt a comprehensive program of policy reform to bring about high, sustained economic growth led by the private sector and fueled by diversified exports. To this end, the ESN identified potential sources of growth including: labor-intensive, export-oriented manufactring (clothing, leather, footwear, fish processing, woodworking); touris; and a diversified, market- oriented aiculture (cut flowers, litchis, other fruits and vegetables, diversified seafood) aimed at increased exports and local consumption. Under this scenario, sustained growth of about 6 percent p.a. would be possible by the end of the century, and per capita income would double within a generation. 19. The ESN discussed the unfinished reform agenda that would need to be pursued for the high-growth scenario to materialize. It underscored the importance of stabilizing and opening the economy and of launching a reform program which would remove remaining constraints to private sector development, trim back the role of the state and make govermnent more efficient and effective. Higher invstment would require significantly increased domestic savings; public savings would be generated by a rigorous budgetary policy, and private savings would be encouraged by increasing national revenue, creating appropriate savings instruments, and competiiive interest rates. An export-push drive would necessitate a competitive exchange rate (achieved since the float started on May 9), appropriate incentive policies, firther lowering of tariff protection and an efficient, active financial sector. As regards trade, Madagascar undertook a major liberalization over 1988-92, including eliminating quanfitative restrictions, reducing tariffs and simplifying the tariff rate structure; in May 1994, the govemnmt removed recently-imposed import restrictions, thereby diminating the reversals in trade reform. Additional action is still required, however, to further narrow the tariff band to achieve a more uniforn structure of incentives for exports and inport substitution. As regards the financial sector, important steps have also been taken to begin restrucuring Madagascar's banking system and financial sector. This is being supported by a FY93 financial institutions development technical assistance project. These reforms are incomplete, however, and the financial system is structurally shallow and underdeveloped by international standards. Action is needed to complete credit policy and institutional reforms, consolidate a sound, efficient banking systen, and broaden capital markets. 20. The ESN also highlighted the complex interactions among poverty, unemployment, high population growth and environmental degradation, and the necessity to taclde them through an integrated economic development strategy. It noted that poverty and population growth are the principal causes of envirornental damage, that me ntl degadation leads to lower crop yields and infiastructure deterioration, and that rapid economic growth is essental to break tiis  7 vicious circle. Under the ESN scenario, the move from subsistence to intensified market agriculture, along with reduced population growth in the longer run, would lessen the pressure from slash-and-bum agriculture on the environment. At the same time, the ESN argued that the structure of growth is as* important to ensure that economic benefits are distributed equitably, and that development must foster the use of the most abundant resource of the poor - labor. The ESN underlined the importance of: investing more resources in primary education and health care, to improve the output and ability to earn of the poor; investing more in infrastructure, to allow more efficient operation and mobility of the goods, finance and labor markets and to make it easier for expanding regions to attract labor and disseminate products to other regions; establishing non- governmental mechanisms under which small private companies can bid on labor-intensive infrastructure projects, thus improving the food security of vulnerable groups; and establishing and maintaining for the present a social safety net based on specific, targeted assistance. Furthermore, as noted in the ESN, prompt measures are needed to dynamize family planning programs and to halt the spread of AIDS. 21. The Constraints. To get on the path of sustained accelerated growth, Madagascar will have to overcome a number of constraints, especially weaknesses in macroeconomic management and policies, and in the regulatory, tax, financial and judicial regimes to facilitate the continued development of a modem private sector. Other constraints include: (i) an over-dimensioned and ineffective public administration; (ii) a large public enterprise sector, which seeks to provide goods and services which the private sector could fumish more efficiently; (iii) a still high demographic growth rate; (iv) a weak human resource base with deteriorating quality of education; (v) an inadequate infrastructure base, especially transport and telecommunications, which represent important bottlenecks to economic growth; and (vi) a threatened environment. 22. The new govemment has reacted positively to the high-growth vision articulated in the ESN. It has accepted, in principle, the sustained growth objective based on private sector involvement, export orientation, liberalization and competition, with a reduced role for the state. It recognizes the need for solid macroeconomic management with a market-based exchange rate, sound govemment finances, and a public investment program focused on priorities in infrastructure and human resources. It intends to pursue privatization, has espoused poverty alleviation programs, including projects with high labor-intensive components, and has placed environmental protection and family planning on the policy agenda. The bold measures taken by the government in Ma.y 1994 are a strong signal of its wiflines to vigorously pursue the policy reform agenda. At the same time, the country is going through a period of political apprenticeship and decision- making is diffuse. Deep-seated populist beliefs held by some leaders and political maneuvering have slowed the governments ability to taclde the country's constraints and to articulate and implement a comprehensive program of reform. While recent progress has been encouraging, there is still a risk of further delay or derailment. E. Bank Group's Country Assistance Strategy 23. The Bank Group's overarching objectives in Madagascar are to help the government promote private sector- and export-led growth, attack poverty, improve natural resource management, build local capacity, and improve project implementation. A key underlying theme is redefinition of the role of the state, improving the quality of public services, and expanding the role of the private sector in investment and the provision of services. The Bank is seeking to help Madagascar realize its full potential by providing it with a full range of development banking services. At the same time, the Bank's assistance program will be selectiv and concentrate on  8 areas where the Bank has comparative advantage, avoiding direct involvement where either the private sector or other donors can more effectively take the lead. The Bank program has been developed keeping in mind the lessons learned from the past and the findings of recent ESW, including the ESN referred to above, a report on financial policies for diversified growth, and four sector reports: a private sector assessment (prepared jointly with IFC), an agricultural sector strategy paper, a poverty assessment, and a report on the quality of primary and secondary education. In the case of possible adjustment lending, conditionality wil be carefully sequenced and concentrae on key policy levers. Investment lending wil continue to be strewmlined, with simple operations covering limited time frames. Portfolio perfomnance will continue to be carefully monitored. Public expenditure reviews wiU be conducted regularly as process-oriented tasks to feed into the govermnent's budget preparation cycle in a timely manner. Institution and capacity building wiU be important aspects of the program, as wil donor coordination to mobilize the international community to provide well-focused and adequate financial assistance, including debt relief. The key elements of the Bank's program are discussed below, and the specific Bank vehicles, which are proposed to address the stategic objectives, are listed in Table 2. 24. Promotion of Private Sector- and Export-Led Growth. The Bank's dialogue will focus on the primordial importance of maintaining a sound macroeconomic framework which will stabilize the economy and provide the impetus for investment and an export drive. This includes fiscal restraint, prudent monetary, credit and foreign borrowing policies, quality public expenditures, domestic resource mobilization, trde liberalization, and maintenance of a competitive, market-deterrinid exchange rate. Govenment perfonnance permitting, the Bank will support the return to sound macroeconomic management with a resumption of structural adjustment lending, starting with a structural adjustment credit (SAC) in FY95, and a possible capacity building project for public expenditure management. The macroeconomic dialogue, including negotiation of the PFP, is being conducted in close coordination with the IMF. 25. In addition to establishing a sound macroeconomic framework, the SAC would support a new phase of carefuly-selected refomis aimed at promoing private sector development (PSD). This would include improving regulatory and domestic competition policies through amendment of the Investment Code to make its provisions more automatic; tax changes to harmonize incentives to entrepreneurs; further lowering of tariff protection and narrowing of the tariff band; and eliminating "red tape" and simplifying procedures, for example in obtaining operating licenses, registering companies and titling land. An important goal is to extend the benefits already applicable to EPZ exporters to all exporters. Depending on progress in implementing reforms, the SAC could be followed by other policy-based lending focused on continuation of reforms needed for PSD, export development, and financial sector development. Further measures in the financial sector would include completion of credit policy and institutional reforms; encouraging competition in banking, which would help achieve lower market-based real interest rates; restructunng and privatization of the. remaining large state-owned banks; stegtheng the Central Bank and banking supervision; stmlnn banking legislation; and deepening and broadening capital markets, with attention to increasing the attractiveness of longer-term savings instruments and expanding and stengthening the equities market, contracal savings, exporter financial services and financial services markets in rural areas. A privatized financal sector, with interest rates detemined by market forces and comprising a wider variety of financial institutions and instruments, would improve Madagascar's poor savinp performance and provide a greatly increased volume of finance to meet the needs of an expanding market economy. A global line of credit is envisaged to support private investment, to be provided by the Bank and/or IFC depending on circumstanc. In addition, the Bank's program would include a strong focus on investment  9 Table 2. Policy Goals and Instruments of Country Assistance Strategy Polky Goas Instruments And -.nin. A, Pto -if -priv atp e sector- -an.d (i) macroecon~~~~omOXfmWOrk :BCOArioC 03tragy nOte(FY914); polk fraew6rtppt n tnictiral adj'tm ntcredits (first in FY95); aact ui4n : . :-................. ....... : ~ prjec fo pblic t eaditumprk AeMen (F.9R~aa .....-- ....: -Mo iniato ntaspr FY95) an thepbic n mmi) 9__ 2 !bX~~~~ppe (FY4) astrutra _4utmn cdisj an osbesc XX.~ ~ ~ ~ ~~~~~tldn~'D fiac adarcutr; edn g...... ... r i.n (FY95 i ,,,.....- ...g,.......'.''.'". "' t 'F i~~~~~~~~~~rvtzto ol ke utlts per:u (FY94): .ij ji j .... - j. j. jj -j:. .. . . . . . . . . j. ii . f l 5t.. .. . . . ...................................9 :'. : '. ' :i.i .'. ' , , : . ' ' " '''''"'''''.' '. ' j. ' ................. .. . .a . .... , ii) irax etr tning tar A tl*i *rivo*si irib i wtrk 'F~ ) '' '''''to*n>*<>*i , ~~~~~~~~~~~. . . . . . .. . . . . .. . . . . . . . . as'''s*i *i < 8iaszis* -.-i'.i.S.' :iR a RiSa jiajRjrij RR . iR,aR,... ,,.RidjRR-R ijj S..,. S... ..... - .................... . .. . .. . BBB~~~~~~~~~~~~~~~~~~6 . i. . s ...... ervices (FY96). .....=,anspo' t ....... iR8a siRaasia a a Ria.jSBaB -.S"" ".'.R',i.. -~~~~~~~~....... . . ___.. .. . .. . . . . . ..S;','ij.4, -hi4twati ...... . al (fY97) s al d S; 'a pi*t (FY96)........ p .. PCXuoat(Y 5;atde rqial~ .sR.Bass ~ ~ ~ ~ pzmw arid aooday4uao (F9) A03 WY9$), BisSsrBRRSi R9 aaOlprlvate delivery 4)tSia~lal servifc. aaa96)~lient r.. . . .. ...*...*.......*...........*.*...*.*...*....on .ociatsen4cc* (FY97); dialogue on pp lion ~~~~~~~~~~~~~~~~~~~~~~~~... .......... (ongoing =ealib sector Iniprcwnmnent prt~ject); labor-I .t.ns .. . . (.... c. a l .... ad d ....... . ii s oi ......... .A. VOW " ~ m~a I 101 .. 477mala ...OnII ... ...~ . ........... ........ ..W,ii .en lzr (F Y.....i..tra se ...t. eg a er ( Y 4)  10 operatons-in infrastructure, ulities and agiculture - which combine market liberalization (removal of remaining price controls, freeing up entry for private investors) and divestiture of public enterprises/privatization with much-needed investments for rehabilitation and private business support services. In order to stimulate resumption of privatization, the possibility of providing technical assistance and of developing a privatization trust fund to hold a portion of the shares of divested public enterprises and later sell these stocks either individually or via a mutual fund, will be explored. 26. Achievement of the country's accelerated growth objective will require improved performance of the important, but underdeveloped, agricultural sector. The Bank has recently prepared an agricultural sector strategy paper which identifies the main constraints to achieving this goal, and the Bank's program aims to address the constraints through projects focused on fam support services and infrastructure, including the second irrigation rehabilitation project proposed for the Executive Directors' consideration, as well as on institutional and policy reforms needed to promote exports. At the request of the government, the Bank will help it develop a more coherent sector policy and help to rationalize the agricultural public investment program. A sector adjustment or investment credit may be developed to support this effort as well as key policy reforms to remove remaining distortions. 27. For lack of adequate maintenance, infrastructure has deteriorated badly and constitutes a major constmint to development in Madagascar. The cyclones of January/February 1994 exacerbated the situation, and the Bank is offering emergency assistance to help repair damaged infiastructure fcilities. More generally, priority attention needs to be given to maintenance and rehabilitation, with new investmt focused on expanding the infrastructure base taldng a back seat. The rationaliation of sector spending is being addressed through the Bank's regular public expenditure review process, which is also the basis for increased local ownership of sector policies, and donor coordination. Limitations in execution capacity require that the govenment establish an appropriate institutional framework and aggressively pursue expanded participation of the private sector in investment and services delivery. In transport, a sector resource mobilization study by the Bank is underway. Madagascar's road network has badly deteriorated, and the focus of Bank intervention in this subsector is to ensure coordinated donor support of a program of rehabilitation and sustainable maintenance of the core network, with carefully planned extension of the network taking place only as the fiscal, managerial and technical capacity of maintenanc is stngtheed. The Bank will highlight the use of local capacity, sramlined procuremnt and cost recovery. It will also support liberalization, deregulation and privatization in the transport sector. In the water sector, the Bank will support institutional strengthening and expansion of access to potable water and sanitation services, particularly outside the capital. In telecommunications and power, it will help upgrade infrastructure, accompanied by efforts to liberalize the regulatory framework and promote privatization and private sector participation. 28. Human Capital Development and Poverty Afleviation. The poor quality of education and health services in Madapscar is a serious constaint to the countrys development. Government stategy in education is to improve the provision of facilities and quality at the primary and secondary levels, to promote the relevance of vocational and technical education to employers, and to control the expansion, while promoting greater efficiency and quality, of higher education. The govermem s strategy in the health sector is to deliver a comprehensive program to control communicable diseases, introduce upgraded family planning services in primary health care (PHC) clinics, improve and expand delivery of PHC services including essental drugs, and  11 strengthen the efficiency of the health delivery system. The Bank has, over recent years, given greatly increased attention to these sectors; taken together with the poverty projects discussed below, human resources projects represent one-third of the outstanding Bank portfolio. This includes an education sector reinforcement project, focused on primary and secondary education (FY90); a manpower training project (FY92); and a health sector improvement project (FY91), which includes a family planning component. In the short term, the challenge for the government and the Bank is to ensure that these projects are implemented effectively. IDA resources will also be focused on sharpening priorities in national sector policies, ensuring adequate allocations of public expenditur, and donor coordination. Wherever possible, partnership with the private sector/NGOs is being promoted, and issues of cost recovery are being addressed. Follow-up projects in education and health are envisaged as soon as needed. The Bank will soon issue a report on ways to improve the quality of primary and secondary education, whose recommendatios will be implemented both through the ongoing education sector reinforcerent project and a follow-up project. The Bank is also studying the danger posed by AIDS in Madagascar, and plans work on NGO/private delivery of social services, and client feedback on the quality and effectiveness of social services. 29. Given the magnitude of Madagascar's poverty problem, a prerequisite for the sustainable reduction of poverty is increasing per capita income and consumption levels through labor- intensive growth, which the Bank will support as described above. The Bank's focus on increasing growth, productivity, and incomes in the agricultural sector, the primary employer of the poor, will contribute to poverty alleviation. Likewise, the emphasis on PSD will stimulate employment generation. An equally important element of the Bank's poverty reduction strategy is the development of human capital, both as an essential input into generating growth and to improve the ability of the poor to participate in growth. The adjustment dialogue will provide an appropriate fimework through emphasis on a priority public expenditure program in oducation, health and safety nets; this will be a prime focus of public expenditure reviews. As noted above, the Bank is supporting existing projects aimed at developing human resources, and plans follow-up operations (primary and secondary education, health projects). The Bank is also supporting specific projects aimed at attacking poverty directly and creating safety nets. Two ongoing projects - conomic management and social action (FY89) and food security and nutrition (FY93) - address, in close collaboration with NGOs, the need for enhanced food security and nutrition in the most vulnerable zones, and for employment generation through labor-intensive schemes. The food security and nutrition project represents a model for other projects, not only in terms of its poverty focus, but also in terms of rapid project start-up. Strong government commitment to the project and attention given to preparatory development of management capacity led to a short time for project effectiveness and disbursements which are in line with projections. The government has requested that consideration be given to extending the project beyond its originally targeted provinces of Antananarivo and Toliary to meet urgent needs arising in other parts of the country. A foUow-up operation (social fund project) is planned. Other Bank-financed projects will anphasize labor- intensive methods wherever possible; an example is the recently-approved Antananarivo urban works project. Bank transport projects wil help improve access to markets, another important element of poverty alleviation. A Bank poverty assessment (FY95) wil provide further information to guide fiuture Bank activities, and attention wil be given to improving the statistical database, to allow improvod targeting of assistance. 30. Women play a significant role in the social and economic fabric of Madagascar. In addition to having major responsibilities for household activities, women are important producers of food crops and contribute significantly to cash crop production. Women-headed households are  12 disproportionately represented among the poor, particularly in the urban areas. Generally women suffer less discrimination in Madagascar than in most sub-Saharan African countries, either in access to jobs or education. Female and male school enrollment rates are broadly similar, and training institutions accept female students alongside males. Still, literacy among women is lower than among men. The ESN highlighted the importance of giving special consideration to the role of women in development, and the Bank's assistance strategy already includes enhancement of women's access to health services and ability to choose the size of their families (health sector improvement project, FY91), access to agricultural extension services (agricultural extension pilot project, FY90), access to financial services in the rural areas (rural finance technical assistance project, FY93), and targeting of women in the food security and nutrition project (FY93). The Bank will continue to be mindful of this issue under fiture projects. For example, the proposed second irrigation rehabilitation project accords special attention to the potential role of associations for women producers, and in preparing a proposed water and sanitation project, women will be consulted regarding the location of water sources, technology and cost recovery, and will be involved in management of water sources. 31. Natural Resource Management. As the first phase of its NEAP, Madagascar is implementing an extensive environmental program (establishment and protection of national parks and reserves, introduction of sustainable production systems in environmentally-sensitive areas, accelerated titling of agricultural land, and improved managment of forests). This program is being supported by a broad coalition of donors, including IDA (environment project, FY90). Given the size and comprehensive nature of the program, the novelty of the proposed activities, the establishment of new institutions and the large number of national, bilateral and intemational agencies and NGOs involved, there is a need for special coordination and close supervision. Start- up of the program was slow due to institutional and political problems, but execution is now improving. Ensuring that progress continues and that the desired objective of protecting Madagacar's fragile environment is achieved represents a major chaUenge for the Bank and the entire donor community over the next few years. This has becn and wil contnue to be a prime focus of the Bank's supervision activities. A folow-up operation is also planned. Agricultural projects aimed at transforming subsistence agriculture would contibute, in the longer term, to lessenig land degradation. Thc cyclone rehabilitation project (FY94) will help develop appropriate methods to probte the environment in the immediate area of transport infrastucture, and energy sector lending contains a component to promote improved charcoal techniques. Continued dialogue on the need for population control will also, in the'long term, help address the environmeal problem. Sector work covers woodfuels, enviomental impact of energy and capacity building for environment maagment. 32. Local Capacity Building and Improvement of Project Implementation. An important priority of the country's development strategy is fostering local capacity and ownership, and improving econonic management at the macrocnomic and sector levels, as well as enterprise/agency/project management. Madagascar's civil service must shift from a control attitude to one of fcilitation and contracting out, and be subject to stricter performance criteria. A civil service action plan, 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 decentbrzation, mandated by the new constitution, and an enhanced role for the private sector. Bank dialogue with the governmnt wiU focus on ways to make the civil senrice more responsive and better perfonring. Local ownership of possible solutions wil be built through workshops. The Bank has also undertaken a study to help guide implementation of the decentralization of govemment in a fiscally reponsible manner. In conjunction with the SAC, consideration is being given to the development  13 of a capacity building project aimed at improving public expenditure management. The Bank will make greater use of local talent in carrying out its ESW; this has already been done, for example, in preparation of the private sector assessment, the poverty assessment, and the study on quality of primary and secondary education. Building up of private sector capacity is also a goal of Bank assistance. The Antanananvo urban works project (FY94) is an important pilot effort to test the AGETIP concept of delegating to a specialized agency the contracting-out of rehabilitation and naintenance of labor-intensive infrastructure works to small and medium enterprises; the proposed second irrigation rehabilitation project promotes the transfer of operation and maintenance of irrigation systems to water users' associations; an agricultural exports promotion project is planned to promote farmer associations and interprofessional trade organizations; and a private sector competitiveness project would support an expanded private sector/government dialogue to design and promote ownership of reforms, and pilot efforts to improve private sector institutions, support services, export marketiing and foreign investment. 33. Bank Portfolio. Project execution in Madagascar has been hampered by weak project management, cumbersome procedures for procurement and disbursement, lack of counterpart flnding, and slow deivery and poor quality of audits. These problems were compounded by the virual paralysis of government administration during the political transition. Portfolio performance reached a low in FY92, when the disbursement ratio for investment projects dropped to 7 percent and six projects representing 30 percent of the portfolio were rated as problem projects. 34. In recent years, the Bank has launched a major effort to improve Madagascar's portfolio performance. Country Implementation Reviews (CIRs) were held in Decanber 1990 and March 1992. Following these reviews, the government agreed to use standard bidding documents for procurment and to make special accounts accessible to project managers. Both of these decisions have been followed up aggressively and applied to all IDA-financed projects. A number of additional actions have been tken: Bank staff discussed the Fall 1993 Annual Review of Portfolio Performance (ARPP) in detail with the new Malagasy authorities, and send them monthly updates of project-by-project disbursement performance; the public invstment review held in November 1993 focused on allocating adequate counterpart resources for priority projects; action plans were developed and monitored for all problem projects; a procurement seminar was held in Madagascar in Noverber 1993; and a dialogue has been instted with the Malagasy auditing finns with a view to improving the quality of audits. Supervision has been intensified, with the average supervision resources per project increasing from about USS 41,000 (14.8 staff weeks) in FY91 to an average of USS 51,000 (17.7 staff weeks) over FY93-94. High levels are expected to be maiained in FY95. 35. These efforts are paying off. Disbursmernt for investment operations increased by nearly 80 percent in FY93, i.e., from USS 23 million in FY92 to USS 41 million in FY93. In FY94, the upward trend continued, with disbursements projected to be about USS 48 million, representing a disbursement ratio of 14 percent. Regular use of special accounts has been significantly improved. The number of problemn projects has been reduced to two as of April 1994; of these, one was restructured and downsized in April 1994 and the other will be the subject of a nid-tem review during Fall 1994. There is still roorn for improvement, however, and the Bank will continue its efforts to consolidate the gains mnade and address further issues. A Country Portfolio Performance Review (CPPR) was held in April 1994 and developed an action plan to address remaining issues, including speeding up procedures for efictiveness, establishing time limits for the bid evaluation process for each contract and for the replenishment of spcial accounts, ensuring timely availabiliq  14 of counterpart funds, and putting in place the needed systems and training to improve the quality of accounting and audits. A department in the Ministry of Economy and Plan has been empowered to monitor implementation of the action plan and report regularly, both to the govemment and the Bank. Perfonnance against the action plan will be a factor in deciding the level of new IDA lending to Madagscar. Under the cyclone rehabilitation project, the government agroed to use simplified proment procedures, which might be extended, as appropriate, to other projects. In addrion, a Bank implementation specialist will be assigned to the Resident Mission in early FY95. The specialist will train local staff and help project managers to develop and use appropriate tools for accelerating project implementation. 36. Growth Prospects and Fmancing Requirements. The Bank will make every effort to help the govenment implement the accelerated growth strategy outlined in the ESN aimed at achieving at least 6 percent annual growth. Given the complexity of the political landscape and the slowness of decision-naking in Madagascar, however, the base case (based on the most likely outcome) assumes a return to sound macroeconomic management, with structural reform (e.g., deregulation, privatization of public enterprises, etc.) resuming at a moderate pace. Under the base case (Table 3), annmal GDP growth would accelerate gradually to reach 4.5 percent by 2002, allowing private per capita consumption growth of about 2 percent p.a. The ratio of gross investment to GDP would increase from 12 percent in 1993 to about 16 percent in 2002, with greater participation by the private sector. The budget deficit (capital grants excluded) would drop to about 5 percent of GDP by 2002, and domestic savings would increase to about 13 percent. 37. Under the base case, the 1994-96 financing gap is estimated to be USS 1.4 billion. This assumes gradually increasing disbursements for ongoing investment projects, including an average of USS 50 million p.a. from the IDA portfolio. Exceptional balance-of-payments (BOP) rIeqireetsA for 1994-96 would amount to USS 377 million, even before considering debt service obligations with official and commercial creditors in excess of USS 1 billion. Assuming that agreement is reached on an adjustment program satisfactory to the Bank and Fund, Madagascar is ex;pected to mobilize the required concessional BOP support over the three-year period (including up to USS 150 million from IDA). In that context, all major donors have indicated that they would be prepared to consider providing the BOP and/or other support (including highly concessional debt relief) necessary to bridge Madagascar's extemal financing gap. The Bank would help mobilize this support through the Specal Program of Assistance for Africa (SPA) and a Consultative Group (CG) meeting. Grants would continue to be an important financing source. Financing by gants or on highly concessional terns is critical, and the Bank and Fund have strmny advised Madagascar against borrowing on commercial terms. 38. IDA Assistance Program. In view of the recent political, administrative and economic disruptions, IIDA lnding during past years has been limited to a core mode (seven projects totaling about USS 137 million over FY92-94). ITere is still uncerinty as to how ambitious the government's future reform program will be, i.e. how far and how fast it will be ready to undertake the refonns needed to achieve the accelerated growth vision outlined in the ESN, and how aggressive it will be in implementing a comprehensive package of reforms. The Bank's assistance to Madagscar will be modulated based on the depth and speed of rdefrm, as well as on pefrmance of the existing portfolio. Based on the corageu economic measures taken by the governnt in May 1994 and the likelihood that a satisfactory PFP will soon be in place, the Bank proposes to move beyond the core lending mode to a base case lending program totaling between USS 300-375 million over the FY95-97 period, for 3 to 4 projects p.a.; this includes adjustment lending, starting with a SAC in FY95 which would support a basic package of reforms to establish  15 Table 3. Key Macroeconomic Indicators, 1994-2002 (percent, except where indicated) (Base Case) .....-. .... 1994 1995 1996 2002 1994- 1997- - G -~~~~~~~~. .. ....-. _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1996 ~2 0 02 Growth RarW real 3.1 ~~~ ~~34 . . . . GD? 'at, re0 0. - 5 --. .j4 13 Piv t-.e~piauunipti , -l 2 2 i-0i:: - .2, . 0. - . : Eport(GNPS)vehime .6 4.4 1~~~~~~~~4-.....3 .... :ic AA A. -*4 . - " .P N'' ' ''... ,': .................................. ': .'' , '.'-.S,{...:,..v." '''''' ' ..,,. ... ...,. .. e~~~~~. .. .. ...,. ... .. ~~~~. .. '.I',' ... ..............',"'":..... ,. '....... . .','...''''.. P s1 1zivate1z 4.6 4yB.:'8s 4 Gev ~~~peu4iture2,. = 2 X1. '''20.S 19. a sundmacroecononi framwor and 4t0 4.8 e haeo euatr,dmsiccmeiin ad .incntiwpoulsaimed at7 siln private s alsondin maouldonoresentwr aboud4 pretof start newnding owr tehregultoy,a donesticod.pThelrest would be invesftmet lending, focused on infrastructure, hunian resource development, poverty alleviation, agniculture, private sector developnment, and environrnent. Continsuation of the base case would depend on maintenace of a sound mnacroeconomic fiwnework and continued progress in execution of the portfoio. 39. On the downside, if the govermnmnt backtacks on basic macroecononic reforms and/or portfolio implementation is poor, dernonstraling inability of the country to absorb the investnmet resources proposed under the base case, the Bank would return to a core prograrn mode, with projects focused wanly on human resouces, poverty alleviation, and environment. Total lending in the low case would be about half that under the base case. I