Algeria - Country economic memorandum : the transition to a market economy (Vol. 1 of 2) : Main report

Report No. 12048-AL The Democratic and Popular Republic of Algeria Country Economic Memorarndum: The Transition to a Market Economy (In Two Volumes) Volume l: Main Report May 25, 1994 Middle East and North Africa Region Country Department I Country Operations Division FOR OFFICIAL USE ONLY MICROGRAPHIICS Report No: 12048 DZ Type: ECO Document of the World Bank This document has a restricted distribution and may be used by recipients only in the perforrnance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  DEMOCRATIC AND POPULAR REPUBLIC OF ALGERIA CURRENCY EOUIVALENTS Currency Unit: Algerian Dinar (DA) Official exchange rate: Dinar (DA) per USS Period End of Period Period Averane 1990 12.191 8.958 1991 21.392 18.473 1992 22.781 21.836 1993 24.120 23.345 1994 - 36.000 (April 1994) FISCAL YEAR January 1 - December31 GLOSSARY OF ABBREVIATIONS AND ACRONYMS ANFM : Agence Nationale de l'Emploi (National Employment Agency) BA : Banque d'Algdrie (Central Bank) BAD : Banque Algdrienne de Developpement (Algerian Development Bank) BADR : Banque de l'Agriculture el du Ddveloppement Rural (Bank of Agriculture and Rural Development) CAH Comite Ad Hoc (Ad Hoc Interministerial Committee) CCP : Centres de Cheques Postaux (Postal Checking Centers) CDC : Cahier des Charges (Import License) CNAS : Caisse Nationale des Assurances Sociales (Social Security) CNEP : Caisse Nationale d'Epargne et de Pr6voyance (National Savings and Loan) CNP Conseil National de Planification (Nationai Planning Council) CNR : Caisse Nationale des Retraite (National Pension System) DAS : Domaines Agricoles Socialistes (Socialist Farms) DIPJ : Dispositif d'Insertion Professionnelle des Jeunes (Youth Employment Program) EAC-BAI : Exploitations Agricoles Collectives et Exploitations Agricoles Individucles (Private Cooperatives and Individual Farms) EPE : Entreprise Publique Economique (Autonomous Public Enterprise) FA : Ponds d'Assainissement (Restructuring Fund) FC : Fonds de Compensation (Compensation Fund) FP : Ponds de Participation (Participation Funds) IBS Impot sur les Ben6fices des Socidt6s (Corporate Income Tax) ICAF : Imdemnit6 Compl6mentaire d'Allocation Familiale (Complementary Family Allowance) ICPR Indemnite Complementaire de Pension et de Retraite (Allowance for Pensioners) ICSR : Indemnite aux Cat6gories Sociales sans Revenu (Allowance for Households without Income) IPSU Indemnit6 pour Salaire Unique (AUowance for Single Income Households) IRG Imp6t sur le Revenu Global a'ersonal Income Tax) ISP : Importations sans Paiement (Unofficial Imports) LMC Loi Relative k la Monnaie et au Credit (Money and Credit Law) ONS Office National des Statistiques (National Statistical Office) PTG : Programme de Travail du Gouvernement (New Economic Program) SGT : Statut Gen6ral des Travailleurs (National Worker Statute) SMA Salaire Minimum d'Activit6 (National Minimum Wage) SNMG : Salaire National Minimum Garanti (National Minimum Guaranteed Salary) SONATRACH : Societ6 Nationale pour la Recherche, la Production, le .'ransport, la Transformation et la Commercialisation des Hydrocarbures (National Company for the Exploration, Production, Transportation, Processing and Marketing of Hydrocarbons) TC : Taxe Compensatoire (Compensation Tax) UGTA : Union Generalc des Travailleurs Alg6riens (National Union of Algerian Workers)  FOR OFFlCIAL USE ONLY THE DEMOCRATIC AND POPULAR REPUBLIC 3F ALGERIA COUNTRY ECONOMIC MEMORANDUM: THE TRANSITION TO A MARKET ECONOMY TABLE OF CONTENTS Summary and Conclusions CHAPTER I - ADJUSTMENT AND REFORM SINCE 1987 1 A. Background 1 B. The Adjustment Program 2 C. Support from the IMP and World Bank 7 D. The Economic Crisis 8 E. Externai Resource Constraints 11 F. The Program of September 1992 12 G. Recent Developments 13 CHAPTER II - MACROECONOMIC POLICY FRAMEWORK AND MEDIUM-TERM OUTLOOK 15 A. Policy Objectives 15 B. The Near-term Stabilization Program 16 C. Medium-term Policy Framework 19 D. Medium-term Balance of Payments Outlook 21 E. Downside Risks 22 F. Deepening Structural Reform 23 CHAPTER III - REFORM AND RESTRUCTURING OF THE ENTERPRISE SECTOR 25 A. Introduction 25 B. Structural Reform Priorities 26 This report is based on the findings of an economic mission in February 1993. The mission was composed of: Mr. Jim Parks (mission leader and main author); Ms. Roumeen Islam (trade and exchange regime, and productive sector); Ms. Setsreh Razmara (social protection system); Ms. Elizabeth Ruppert (statistics); Mr. Philippe Planchon (enterprise restructuring); Mr. Kuttu Somel (agriculture); Mr. Richard Lalonde (financial sector); Mr. Guillermo Hakim (labor market); Mr. Hamid Alavi (analysis of the industriaL sector); and Mr. Louis Goreux (macroeconomic framework). The analysis of the externaL environment for Algeria was done by the International Economics Department (IEC). The draft report has been substantially revised to incorporate developments through April 1994. At the time the report was written, Mr. Mahmood Ayub was the Division Chief. Hmes. Huguette Osselyn, Helene Talon and Brigitte Petit provided invaluable support in preparing the report. This document has a restricted distribution and may be used by recipients only in the performce of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. l  C. PE Restructuring: Summary 29 D. PE Restructuring: Conclusions 31 CHAPTER IV - AGRICULTURE 35 A. Introduction 35 B. Structural Issues 36 C. Marketing and Distribution 37 D. The Incentive System 39 E. Environmental Issues 45 F. Other Agricultural Issues 45 0. Conclusions 48 CHAPTER V - THE FINANCIAL SECTOR 51 A. Introduction f1 B. Structure of the Algerian Financial System 52 C. Financial Intermediation 59 D. Credit Allocation 64 E. Operating Performance 68 F. Legal and Regulatory Framework 69 G. Conclusions and Recommendations 71 .HAPTER VI - LABOR MARKETS 75 A. Introduction 75 B. Features of the Algerian Labor Market 75 C. The Incentive Structure: Wages 81 D. Labor Code Reform 83 E. Youth Employment Programs 85 F. Labor Market Intermediation 86 G. Towards an Employment Generation Strategy 87 CHAPTER VII - LIBERALIZING THE EXCHANGE AND TRADE REGIME 89 A. Introduction 89 B. The Foreign Exchange Regime: Overview and Evolution 89 C. Trade Policy: Overview and Current Regime 92 D. Exchange Liberalization during the Transition 95 E. Trade Policy during the Transition 98 F. Summary 99 CHAPTER VIII - REINFORCING THE SOCIAL PROTECTION SYSTEM 101 A. Introduction 101 B. The Social Insurance System 102 C. Consumer Price Subsidies 111 D. The Social Assistance Programs 113 E. Conclusion 117 Statistical Annex  SUMMARY AND CONCLUSIQNS 1. The Algerian economy is in transition from centralized planning to markets. At this critical juncture, the country's economic policy-makers face a dual challenge. Urgent measures are needed to pull the economy out of recession and address pressing social demands. At the same time, the program of macroeconomic stabilization and structural reform initiated in 1987 must be deepened in order to establish the conditions for sustainable long-term growth. The over-riding objectives of the macroeconomic stabilization program are to restore growth, correct macroeconomic imbalances and price distortions, and contain inflat on. The priority objectives of structural reform include: (i) promoting private sector development; (ii) reforming and restructuring public enterprises; (iii) deepening agricultural reform; (iv) developing a competitive financial sector, and a well-functioning labor market; (v) strengthening the social safety net, and adapting it to the needs of a market economy; and (vi) integrating the economy into world markets. 2. After a period of limited progress, the present Government has restored the momentum of the stabilization and reform program. In response to the sharp fall in oil prices in late 1993 (which generated severe pressure on the balance of payments and led to the accumu.ation of substantial arrears over the first quarter of 1994), the authorities have developed a short-term stabilization program in collaboration with the IMF. Negotiations on a new, 12-month combined Standby and Compensatory Financing Facility to support the program have been concluded. Under the program, the authorities have decided to seek a multilateral debt restructuring arrangement, involving a Paris Club rescheduling of eligible debt, and a refinancing or restructtvring of medium- and long-term commercial debt. At this point, the authorities are defining the specifics of urgent structural -eform measures with the full cooperation of the World Bank and the IMF. The main issues to be aduressed by the stabilization and structural reform program are presented below (paras 14-36). 3. The authorities are aware that the key to successfully managing the transition is to address the immediate crisis with growth-oriented policies that maintain the momentum of structural adjustment and the emergence of markets. Responding to the crisis with short-term measures that are inconsistent with expanding market forces would draw out the transition, risk reducing confidence in the reform program, and raise adjustment costs. On the other hand, failing to address the immediate crisis would risk stalling the transition process and aggravating social discontent, which would have negative consequences for the advancement of the longer-term economic reform program. While pursuing adjustment will not be without costs and risks, even higher costs and risks are associated with delaying the structural changes needed to restore a level of sustainable growth sufficient to ensure steady improvement in living standards. This report outlines numerous policy measures that can lower the risks of adjustment and reduce its social costs. A. Adjustment since 1987 4. Back8round. For 25 years after gaining independence in 1962, Algeria followed a socialist growth model emphasizing centralized planning and heavy industrialization. By the late 1970s, however, the drawbacks of the socialist modei were becoming apparent, most clearly in the case of state farms which accounted for the major part of Algeria's agricultural potential. In an attempt to satisfy the most pressing demands in an economy where incomes and employment policies were only marginally linked to productivity and output, a complex system of taxes and subsidies was progressively established. However, demand continued to outstrip supply, which initially resulted in large increases in imports, and then widespread, informal rationing. Rationing and price distortions led to a build up of excess liquidity in the economy, and promoted parallel market activity. After the collapse of oil prices in 1986, the  ii Inefficiencies of the system became untenable. Output stagnated, unemployment and inflation increased, and per capita consumption declined. T1nis precipitated an acute social anid political crisis. in response, the authorities initiated a broad-ranging trogram of macroeconomic stabilization and structural reform. 5. The Stabilization Program. Stabilization efforts began in earnest in 1989. Tighter fiscal and monetary policies were accompanied by adjustments in the exchange rate and interest rates. Supported by tight fiscal policy, the Central Bank slowed money growth, enabling excess liquidity to be absorbed. The ratio of broad money to GDP fell from a peak of 84 percent in 1988 to 52 percent by 1991, largely absorbing the "money overhang". Liquidity absorption allowed domestic prices to be progressively liberalized without unmnanageable increases in inflation. However, the pace of adjustment slackened in 1992. Financial restructuring costs, wage increases, and higher social spending generated a sharp increase in Treasury expenditures, while revenues stagnated in real terms, notably because of a decision to stabilize the nominal exchange rate. After surpluses in 1990-91, the Treasury's overall balance registered a deficit of 6.8 percent of GDP in 1992. 6. Structiral Reforms. Since its inception, the fundamental objective of the structural reform program has been to improve economic efficiency and generate a supply response. Reform has transformed the legal and institutional framework of the productive sector and the factor markets. To stimulate the supply response and provide a source of competition for public enterprises (PEs), the reform program has included a broad range of institutional measures to promote the private sector and ensure a level playing field. A program to restructure the PE and banking sectors has been initiated to complement legal and institutional reforms. Within the framework of this restructuring program, a multi- year effort has been launched to clean up the large amount of non-performing PE debt held by the financial system. Through the end of 1993, the debt clean up had cost the Treasury nearlv DA 400 billion (over US$11 billion). However, the implementation of physical restructuring to ensure long-term profitability has so far lagged behind. There are indications that the banks have continued to finance PE lo'ses, which adds to the pressures for money creation. While the institutional framework for the financial and labor markets has been modernized, to date, the reforms have had a limited impact on financial intermediation and labor mobility. The main causes of the limited reform progress are the prolonged recession, and the structural rigidities and uncompetitive business practices ingrained during 25 years of centralized planning. 7. Structural reforms have encompassed an overhaul of the incentive framework, including price, tax, and trade reforms. By the beginning of 1994, the share of free prices in the consumer price index had reached 78 percent, compared with only 10 percent before the adoption of a new price law in 1989. In January 1992, a major tax reform was enacted; a VAT was introduced to simplify the indirect tax structure, while unified corporate and individual income taxes replaced a series of schedular taxes and special tax regimes. The tax reform included a significant tariff reform component, including a reduction in the maximum tariff from 120 percent to 60 percent, and a unification of the Compensation Tax rates on imports and domestically produced goods. Nevertheless, the incentive framework has suffered from significant distortions which have limited the benefits derived from the reforms. The key distortions have been the overvalued exchange rate and negative real interest rates. In addition, the remaining price controls (concentrated on basic commodities and public services) are distorting relative prices and hampering the development of competitive distribution channels for subsidized products. The 1992 tax reform notwithstanding, marginal domestic tax rates are high. While the tariff structure has been made more neutral, it continues to distort border prices and accord a relatively high rate of protection to domestic producers. This distortion has bepn exacerbated by the administrative allocation of official foreign exchange and external credit, creating an opaque pattern of non-tariff barriers. Tackling the  iii remaining incentive distortions is one of the Government's priorities, and major steps to correct distortions were taken in early 1994 (see para. 15). 8. Social Saft Ne. Reforms have also affected the social safety net. Historically, the safety net relied heavily on secure PE employment and generalized consumer price subsidies which distorted prices and entailed high budgetary costs. Substantial progress has been made in reforming consumer price subsidies. Only three food staples remain subject to explicit price subsidies: bread, semolina, and milk. An innovative program of targeted cash transfers has been introduced to compensate vulnerable groups for price increases in subsidized food staples. However, the social protection iystem has continued to rely on price subsidies, including for housing, transport, and certain energy products. 9. Support from the IMF and World Bank. Algeria's stabilization and structural reform program has benefitted from IMP and World Bank support. The first IMF Facility was a SDR 471 million (approximately US$600 million) combined Standby Arrangement and Compensatory Financing Facility approved in May 1989. A second, SDR 300 million Standby, covering the period through March 1992, was approved in June 1991. Support from the Bank has involved both investment projects and adjustment lending, in addition to economic and sector work. Investment lending has been concentrated in public infrastructure, agriculture, and the social sectors. Between FY87 and FY93, 26 investment projects, with associated commitments of nearly US$1.9 billion, were approved. Adjustment lending began with the US$300 million Economic Reform Stpport Loan (ERSL), approved in August 1989. The ERSL was followed by the US$350 million Enterprise and Financial Sector Adjustment Loan (EFSAL), approved in June 1991. Release of the second tranche of the EFSAL, which had been delayed by the slowdown in the implementation of the stabilization and reform program, is expected soon. 10. Economic Cris. Despite the progress achieved in implementing adjustment, the economic crisis has persisted. Weak economic growth has lowered per capita consumption and exacerbated unemployment. Over the 1985-92 period, aggregate GDP growth averaged a disappointing 0.4 percent p.a., and preliminary data indicate that the recession continued in 1993. Agriculture has been the bright spot of the economy, averaging an encouraging 5.4 percent growth rate. In contrast, the value added by the core 'enterprise sector" (i.e., industry, construction, and services) has declined by an average of about 3.2 percent p.a. Limited output growth translated into a decline in per capita private consumption of some 3.0 percent p.a. on average over the 1985-92 period. The recession has worsened unemployment. The number of unemployed workers tripled over the period, and the official open unemployment rate reached an estimated 21 percent. The younger population has been particularly affected; two-thirds of the unemployed were under 25 years old in 1990. 11. Social Dimensions of the Crisis. The economic crisis has had other social repercussions. Demographic pressures and extensive urban migration enconraged by past agricultural and industrial policies have sent housing demand soaring. However, the supply of new housing has faltered, largely as a result of the severe shortages of construction materials and the general inefficiency of the construction sector which is dominated by PEs. The overall housing shortage is estimated at two million units, and the occupancy ratio of 8.5 persons/unit is one of the world's highest for middle-income countries. The compounded pressure of demography and economic recession is straimng education and health services, despite years of heavy public investment. While there is little evidence ef absolute poverty today, if inflation persists and average living standards continue to fall, substantial pockets of absolute poverty could begin to develop. Without a return to growth and an improvement in the efficiency of the Government's social policies, there is a risk that the impressive improvement in social  iv indicators achieved over the past 30 years will erode as incr9sses in the quality and availability of social services are unable to keep pace with the demands of the rapidly growing population. 12. External Resource Constraints. The authorities' long-standing determination to service Algeria's external debt in full, even at the cost of tightening trade and payments restrictions, helped prolong the recession. Persistently tight external resource constraints have been a major contributing factor to the economic crisis. For many years the authorities consistently rejected formal debt rescheduling, relying instead on increased multilateral lending, voluntary bilateral refinancing agreements, and controls on shorter-term borrowing and imports. This approach mct with limited success. Based on the most recent Bank data, the stock of medium- and long-term (MLT) external debt fell from a high of US$27 billion in 1990, to below US$24 billion in 1993, and the net debt service ratio (i.e., excluding refinanced principal) dipped from a peak of 72 percent in 1988, to 56 percent in 1992. Nevertheless, this progress came at substantial economic and social cost, and the debt service ratio has risen steeply over the past eighteen months. The controls notwithstanding, Algeria has continued to depend heavily on shorter-term trade credits which carry relatively high interest charges, sometimes aggravated by additional surcharges (or 'sweeteners"). In effect, postponing rescheduling has increased the debt service burden, exacerbated the economic and social c;sis, and probably contributed to capital flight. The debt problem has been compounded by external shocks. Because Algeria's external debt service and imports are denominated mainly in European currencies and yen, while its oil revenues are in US dollars, th. depreciation of the dollar from its highs of the mid-1980s offset the modest recovery in oil prices in 1990. 13. Recent Developments. According to preliminary data, GDP contracted by some 2 percent in 1993. This drop is attributable in part to a further reduction in imports brought on by a combination of austerity and tighter external resource constraints. The external resource constraint became particularly severe following the sharp drop in oil prices in October 1993. The current account registered a surplus of 2.2 percent of GDP in 1993, and MLT debt service exceeded US$9 billion. Lower oil prices contributed to an increase in the net debt service ratio to 68 percent in 1993. This, in parallel with the administrative controls, led to a fall in imports of goods and services to US$9.5 billion, compared with US$10 billion in 1992. Internally, increased public spending in conjunction with stagnant petroleum tax revenues resulted in an increase in the Treasury deficit to 9.2 percent of GDP (according to a new definition agreed with the IMF). Nevertheless, money supply growth eased, and inflation slowed to sowy.. 21 percent. However, the crowding out of the productive sector by the Treasury contributed to the fall in GDP. In addition, the exchange rate became increasingly overvalued. According to mdrket observers, the ratio between the parallel and official exchange rates reached 3:1 by late 1993. B. Macroeconomic Policy Framework 14. Policy Objectives. Macroeconomic policymakers must simultaneously pursue short- and long-run objectives at this critical point in the transition. Clearly, stabilization is an urgent priority. At the same time, deeper structural reforms are needed to promote increased economic efficiency and the emergence of markets. If successfully implemented, stabilization and further structural reform would pave the way for a medium-term macroeconomic framework in support of structural adjustment and sustained growth. 15. Short-term Stabilization Program. The overriding goals of the short-term stabilization program to be supported by the IMF Standby are to restore growth and contain inflation. This is to be accomplished by alleviating the external debt service burden, reducing macroeconomic imbalances, correcting price distortions, and pursuing exchange and trade liberalization (see paras. 29-32). A series  v of measures to stimulate employment and cushion the impact of the program on vulnerable groups are also planned. The program targets GDP growth of 3 percent in 1994, increasing .o over 6 percent in 1995. This is to be made possible through a significant increase in imports. Given lower Gil prices, hydrocarbon export revenues are projected to fall, leading to significant current account deficits. Program financing requirements would be met largely through a combination of continued flows of trade- linked credits (albeit at a diminished level) and multilateral debt restructuring, which would significantly reduce external debt service. Measures to reduce macroeconomic imbalances include devaluation, fiscal adjustment, and tighiter monetary and incomes policies. In mid-April, the exchange rate was adjusted to 36 DA/US$, a nominal devaluation of some 50 percent. Other incentive reforms under the program include interest rate adjustments, further price liberalization, and reductions in subsidies. Given the impact of these measures, inflation is projected to increase to nearly 40 percent in 1994. However, the pass-through effect of most of the measures should occur during 1994, and inflation is projected to fall sharply in 1995. 16. Medium-term Macroeconomic Framework. If successfully implemented and accompanied by a deepening of structural reform, the stabilization program will provide a solid basis for a medium- term macroeconomic framework geared to supporting structural adjustment and setting the economy on a permanent, high growth path. A key objective is a sustained reduction in the debt service ratio to 40 percent or less. In this regard, the large increase in gas exports projected over the medium-term will complement further debt restructuring efforts (see para. 2.17). The medium-term macroeconomic framework must ensure that resources, in particular the foreign exchange freed up by lowering the external debt service burden, are used efficiently. The authorities' commitment to a progressive approach to adjustment entails a careful sequencing of measures on a broad range of fronts. If the proper preconditions are established, channelling foreign exchange through the future interbank market will ensure an efficient allocation. Maintaining positive real interest rates will facilitate exchange rate unification by reducing the excess demand for domestic credit. Continued tight fiscal policy will provide additional resources to cushion the costs of structural adjustment md ease inflationary pressures without crowding out productive activities. The comprehensive review of public expenditures being conducted in cooperation with the Bank will support this effort. As long as macroeconomic stability .s maintained and the foundations of a market economy are securely established, Algeria has the potential to sustain high growth over the medium term (see para 37). 17. Risks. The extent of Algeria's vulnerability to external shocks highlights the urgent need for further economic reform to increase economic efficiency and diversify the country's export base. Algeria's dependence on hydrocarbon exports, together with the size and structure of its foreign debt, make it highly exposed to external shocks, particularly fluctuations in world oil prices and in the US dollar. Estimates indicate that every US$1 fall in the oil price reduces hydrocarbon exports by about US$500 million on an annual basis. Delays in implementing necessary structural reforms would dissipate the immediate gains from external debt restructuring without ensuring the resources to service the restructured debt in the future. This would risk a reappearance of foreign exchange shortages and a return to recession over the medium term. C. Deepening Structural Reform 18. Reform and Restructuring of the Enterprise Sector. Improving the efficiency and competitiveness of the enterprise sector is integral to the adjustment effort. Ach.eving this will depend on a dual effort to deepen structural reforms and intensify the PE restructuring program. The main objectives of structural reform in the enterprise sector are: (i) to promote accelerated development of the  vi entrepreneurial (i.e., non-rent-seeking) private sector, (ii) to ensure the withdrawal of the public administration from direct intervention in economic activity and to strengthen its capacity to regulate a market economy, (iii) to encourage increased competition among firms, and (iv) to ensure a market- oriented ownership and management structure in the PE sector. The basic objective of the PE restructur- ing program is to increase productivity and profitability through, inter alia, a reorganization of management, a reorientation of production, and a reduction in unit labor costs. A well managed program of privatization (including opening the capital of PEs to foreign and domestic private investors, and joint ventures) will be a key instrument in reaching these objectives. 19. An entrepreneurial private sector is at the core of every well functioning market economy. In Algeria, the private sector is likely to be the main source of growth and employment generation during the transition period. Measures to promote the private sector include: (i) correcting macroeconomic distortions, (ii) eliminating p'ublic sector deficits which reduce the investible resources available to the private sector, (iii) translating dejure equal access to resources into defacto equality, and (iv) opening up the existing capital of PEs to private investors. Equally important, however, is the evolution of the role of the State involving a continued withdrawal from direct intervention in decisions of investment, production and commerce, and a strengthening of its regulatory functions in the context of a market economy. In additlln to civil service reform and an extensive training effort, this evolution will require a change in the perception of the role of administration on the parts of the civil service and other economic agents. 20. To promote competition among firms, the authorities have enacted a series of structural reforms aimed at lowering the barriers to entry and exit, including an extensive revision of the Commercial Code. A new law on competition is under preparation. Nevertheless, competition within the enterprise sector continues to be limited. Probably the most important step is to facilitate the ease of entry for domestic private firms. Although opening the economy will take time, foreign investment and imports represent two additional potential sources of competition. Convincing foreign investors to commit major resources to Algeria requires decisive action to ensure the credibility of the reform program. The new Investment Code, adopted in 1993, will help in this regard. The new Code notably authorizes the establishment of free-trade zones and guarantees the repatriation of the capital and profits of foreign investors. 21. Establishing an ownership and management structure in the PE sector that supports profit- ma4imizing behavior and encourages competition is a fundamental condition for improving efficiency. In this regard, the present structure, based on the grouping of autonomous PEs by sector under Participation Funds (which act as fiduciary agents for the State) has not been particularly successful. In mid-1992, the authorities announced their intention to replace the Participation Funds with corporate holding companies. International experience shows that, if they are established, such holding companies are likely be more successful if they pursue joint ventures with the private sector as well as privatization. Moreover, allowing PEs to sell off assets to private firms can facilitate PE restructuring and lower the barriers to entry and exit. The authorities have decided to authorize privatization, and legal amendments are being enacted to permit private investors to participate in the existing capital of PEs, as well as to permit the latter to sell off assets to the private sector. 22. Substantial progress has been made in the financial clean up of non-performing enterj'rise debts. However, a more coinprehensive PE restructuring program at the national level is needed to organize and guide restructuring efforts at the firm level. PE managers often have a good grasp of the problems; however, there is a need for a better understanding of how to develop and implement solutions.  vii Given the magnitude of the restructuring task, the passage to true enterprise autonomy in the operational sense will take time; and successfully implementing restructuring will ned the full, active support of the Government at the highest levels. Restructuring will not be costless. While layoffs and some plant closures are inevitable, there are safety net measures which can be taken to cushion the shock and redeploy redundant workers. 23. Agriculture. The transformation of the state farms into private farms holding long-term usufruct rights has changed the basic structure of the agricultural sector. After this encouraging start, considerably more work lies ahead in deepening agricultural reform in order to increase the role of market forces and enhance the agricultural supply response. A key issue is the rationalization of agricultural subsidies. These subsidies involve: (i) producer price supports for cereals, pulses, and other selected crops; (ii) preferential interest rates; and (iii) explicit and implicit subsidies on agricultural inputs. Ag,ricultural subsidies raise fundamental issues of efficiency, transparency in implementation, and clarity of policy objectives. The effectiveness of the existing subsidies in stimulating sustainable increases in production and rural employment should be studied carefully. A major policy shift on subsidies was signalled with the liberalization of a wide range of agricultural prices, including fertilizer, in April 1994. The high degree of variability of agricultural production, particularly cereals, imposes constraints on self- sufficiency. Improving stability will depend on the development and effective extension of adapted technologies that are economically viable and complement market-based incentives. Adapting the research and extension organization to this approach can produce tangible results within a reasonable timeframe. 24. Further actions are needed to liberalize agricultural markets, consolidate land tenure arrangements, and develop the institutional framework for the agricultural sector. The markets for input and output distribution, and other agricultural services, have to be liberalized and restructured to serve the private farms and farmers under competitive conditions. Presently, these markets are dominated by monopolistic PEs, which once served the socialist farms and are still used to implement agricultural subsidies. This situation represents a serious constraint for private sector entry into the marketing of agricultural inputs and cereal crops. The formalization and stabilization of ownership rights is a basic issue for private farmers. Adequate policy signals must be given to the farmers that they are permanent landholders. Three key institutional issues concern the role of the State, the development of private cooperatives, and the reorganization of research and extension services. The State must strengthen its policy analysis and regulatory role, while furither diminishing its direct involvement in the production and marketing of agricultural products. The development of private cooperatives in input provision and product marketing requires a reduction of the dominant role played by PEs in these areas. The main challenge to the research and extension system is to reorient its actions to the needs of private farmers guided by profit motives and facing real constraints and risks. 25. The Financial Sector. The financial sector is entering a critical phase in its transition toward a market-based system, and there are a number of obstacles to overcome. Macroeconomic stabilization is needed tn permit interest rates to be progressively determined by the market. However, the financial sector lacks sufficient institutional capability to respond effectively to interest rate liberalization. While much of the legal and regulatory framework has been created, implementation of the new framework is just beginning. Tne first priority is to train competent bankers, accountants and inspectors. It is also important to restructure the existing banks, to stimulate competition, and to establish the preconditions for developing financial markets. 26. The restructuring program for the commercial banks aims to ensure their ability to supply funds across the range of maturities under market conditions, and without undue risk. This implies a  viii major strengthening of the banks' capability to conduct appraisals of medium- to long-term investment projects, and to generate a stable, long-term deposit base. Probably the single most difficult challenge is to change the behavior of agents in the financial sector, particularly given the vested interests of the present financial institutions in t.eir existing clients. This is why the success of financial sector reform is contingent upon the simultaneous restructuring of the PEs, which constitute the bulk of the sector's client base. Equally important is a clear policy stance ciat, henceforth, the banks will be responsible for managing risk, and that the Government will not use the banking system to prop up failing PEs. As part of the restructuring process, there may be opportunities to create new private banking institutions either with Algerian, foreign, or joint capital, on the basis of the sound portions of the portfolio(s) and branch network(s) of one or more of the existing institutions in order to create a lead bank. In concert with restructurinr 1 increased supervision, it may be useful to introduce a modest deposit insurance scheme for small, unsophisticated depositors. 27. Stimulating competition and establishing the prerequisites for developing capital markets are additional priorities. A prudent reduction in the degree of segmentation of the financial sector and efforts to attract new privately owned financial institutions into the banking system would stimulate competition. Actions to ensure a favorable enivironment for establishing affiliates (or branches) of foreign financial institutions are also needed. The creation of capital markets for debt and equity securities is essential in the longer run. While the preconditions for well functioning capital markets are not yet in place, the growing stock of Treasury overdrafts with the Central Bank should be converted into securities bearing attractive interest rates in order to promote financial deepening and reduce inflationary pressures. Credit unions are potentially promising institutions, particularly in geographic areas where deposit mobilization has been weak or where cultural values are not conducive to expanding commercial banking. 28. Labor Markets. To promote the development of the labor market, the main challenge is to expand the scope of recent labor reforms and integrate them into the overall agenda for economic reform. International experience indicates that the only sustainable engine of growth and new jobs during the transition period is the private sector. Therefore, encouraging development of the entrepreneurial private sector is of strategic importance for lowering unemployment. The extent of unemployment argues for labor-intensive growth; however, the overvalued exchange rate, negative real interest rates and generous wage agreements have blocked an adjustment of relative factor prices in favor of labor in the past. A sustainable shift in relative factor prices toward labor depends on combining macroeconomic price adjustment with the translation of de jure reforms into changes in labor practices, and an intensification of PE restructuring in order to raise productivity, and lower real unit labor costs. Other complementary actions include: (i) making existing youth employment and public works programs more cost effective; (ii) promoting the establishment of private labor intermediation agencies; and (iii) adapting vocational training programs more closely to the needs of enterprises. D. Liberalizing the Exchange and Trade Regimes. 29. The Foreign Exchange Regime: Overview and Evolution. Reform of the foreign exchange regime has proceeded unevenly. The reform took a big step forward in April 1991, when a new system of dejure open access to official foreign exchange was announced in an effort to introduce convertibility for merchandise import transactions. Given insufficient foreign exchange reserves, however, commercial banks were required to ration available foreign exchange and external credit among importers on an ad hoc basis, and exchange rate adjustment was temporarily halted.  ix 30. Exchange Liberalization during the Transition. The Government is renewing the move towards convertibility and unification of the Dinar. In April 1994, the ad hoc interministerial committee (CAH) overseeing the allocation of official foreign exchange and external credit was abolished in parallel with the devaluation of the Dinar. Exchange fixing sessions between the Central Bank and the banks are to be introduced during the second half of 1994. The establishment of an interbank foreign exchange market is foreseen within the framework of the Extended Fund Facility expected in 1995. As long as the preconditions for efficient operation are met, channelling foreign exchange through the interbank market will promote higher growth and accelerated structural reform. While the authorities remain concerned about the potential social and economic consequences of exchange liberalization, convertibility and unification should be achieved as soon as possible. Under the IMF-supported stabilization program, an explicit increase in budgetary allocations for the social safety net has been provided to alleviate the effects of exchange liberalization on the most vulnerable groups of the population. 31. Trade Policy: Overview and Current Regime. From 1987 through mid-1992, the trade regime was gradually liberalized in parallel with exchange liberalization. Since mid-1991, all registered operators have been atuthorized to export and import for own use or resale. However, certain trade restrictions were imposed starting in mid-1992. Import restrictions covered two groups of products. The first group consisted of "luxury" imports which were suspended regardless of the financing source. The second group of restricted imports were no longer eligible for official foreign exchange or external credit. 32. Trade Policy during the Transition. The Government is reviving the trade liberalization process. Many administrative trade restrictions were lifted in April 1994, and most remaining restrictions are to be eliminated over the course of the IMF Standby. There is some concern among Algerian policymakers that lifting the restrictions will shift the composition of imports excessively in favor of consumer goods and expose domestic enterprises undergoing restructuring to unmanageable levels of foreign competition. It is important that quantitative restrictions not be re-introduced. If compensating measures are eventually required, temporary tariff surcharges would be a superior option. A tariff surcharge targeted to non-essential consumer goods would limit the shift towards these imports. A temporary surcharge on selected consumer products would provide additional protection during the restructuring phase to those potentially viable enterprises which face severe competitiveness problems. While tariff surcharges may pose certain difficulties in practice, their price-based nature makes them consistent with the transition to markets. Posting an up-front, explicit schedule for the phasing out of any surcharges would be important in order to maintain the incentives to pursue restructuring and increase competitiveness. In the longer run, progress towards an open economy will require deeper reform to increase the neutrality of the tariff structure. E. Reinforcing the Social Protection System 33. The challenge facing the social protection system is to better use the limited resources available, and move from a dependence on secure public sector employment and distortionary price subsidies to a reliance on private sector job growth and more neutral income transfers, such as social insurance and social assistance schemes. To ensure adequate coverage and financial stability, the existing income transfer programs need to be strengthened through efforts to improve the provision of adequate but affordable benefits, increase the capability to reach the most needy groups, reduce the budgetary costs, and support efficient functioning of the labor markets. 34. The main concern with the social insurance system is its precarious financial status. Correcting the structural sources of the system's financial imbalances is a more sustainable alternative  x than increasing contribution rates. Efforts should focus on: (a) creating a stronger link between benefits and contributions in order to reduce costs unrelated to the coverage of affiliates and their dependents, and encourage the expansion of the contributor base; (b) allowing the system to achieve a positive real rate of return on its reserves; and (c) separating family benefits from other, insurable benefits. Another important step in improving the social protection system in general is to introduce a national scheme to protect redundant workers for a limited period while they search for a new job. The authorities are preparing the introduction of a national unemployment insurance scheme. If it is well conceived, financially solid, and efficiently run, such a scheme would support PE restructuring. However, a clear distinction should be made between the transitional problem of a safety net for redundant workers, and the longer-term issue of unemployment insurance to support labor mobility in a market economy. While any national scheme to protect laid-off workers will require budgetary support during the restructuring phase, a longer-term unemployment insurance system should become self-financing. 35. The consumer subsidy reform program has three objectives: (i) to eliminate gradually the remaining price subsidies on consumer products; (ii) to introduce less distortionary and better targeted cash transfers to compensate vulnerable groups for the elimination of price subsidies; and (iii) in the interim, to increase the transparency of the subsidy system. Despite substantial progress, the reform program is incomplete, and the explicit and implicit costs of consumer subsidies remain significant. The authorities are pursuing the subsidy reform program, in conjunction with the strengthening of the existing programs of targeted direct transfers. 36. The principal concern with the social assistance system is that some programs are not sufficiently targeted to needy groups. There is no well defined poverty line, and the relationship between the threshold income levels used for the assistance programs and poverty is not sufficiently established. Limiting social insurance benefits to affiliates and their dependents and phasing out consumer subsidies must be complemented by a reinforcement of the social assistance programs, with the ultimate aim of ensuring a minimum living standard for those unable to support themselves in a market economy. There is no universal prescription for improving the targeting and integration of the social assistance system. The upcoming Living Standards Measurement Survey will provide valuable information on the status of needy groups which will help refine the safety net's orientation. F. MediumnLam Cutlok 37. Provided structural adjustment continues at a sustained pace, the longer-term prospects for Algeria are excellent. In fact, Algeria has the potential to become a major engine of growth for the Mediterranean basin. As the transition to a market economy proceeds, the country's strategic location in the heart of the Maghreb, and as a bridge between Europe and Sub-Saharan Africa, will attract many investors. Algeria enjoys other advantages as well, including plentiful energy resources, a relatively well educated workforce, an extensive physical infrastructure, and a large industrial base. Investments in expanding hydrocarbon exports, particularly natural gas, together with further debt restructuring and continued capital inflows, will help ease external resource constraints considerably. Macroeconomic stability and further structural reform will promote non-hydrocarbon investment and exports, as well as ensure increases in the efficiency of resource allocation. As a result of adjustment, a sustained recovery can be expected over the medium term, with projected annual growth rates in the 5-6 percent range. This growth should be sufficient to ensure steady improvements in per capita consumption and a reduction in unemployment.  CHAPIER I ADJUSTMENT AND REFORM SINCE 198 A. Background 1.01. For 25 years after gaining independence in 1962, Algeria followed a socialist growth model emphasizing centralized planning and heavy industrialization. On the one hand, substantial resources were devoted to education and basic health care; on the other, the labor force thus upgraded was provided with modern, publicly owned factories and an extensive infrastructure was built up. While the private sector was always present, it suffered from restricted access to domestic credit and foreign exchange, and it was excluded from strategic industries. This socialist model was seen as well adapted to the underdeveloped state of the country following independence, and as offering a fast track for developing the economy. The 1974 oil price boom was perceived as an opportunity to accelerate the industrialization process. The ratio of investment to GDP was raised from one-third in 1970-73 to a!most one half in 1976-79. 1.02. By the late seventies, however, the drawbacks of centralized planning were becoming apparent, most clearly in the case of state farms which accounted for the major part of Algeria's agricultural potential. Despite large government investments in the state-farm sector, production and yields were not improving and Algeria's dependence on food imports was rapidly increasing. The time lags required for completing large public investment projects also became unduly long, notably in the housing sector, which meant that capital was immobilized for long periods without generating any return. Moreover, most of the new industrial plants were running substantially below capacity. For all these reasons, the incremental capital-output ratio became abnormally high (Table 1.1), indicating the inefficiency of investment. With investment reaching nearly 50 percent of GDP according to national accounts figures, real per capita output would have been expected to grow rapidly. In fact, the average annual growth rate of per capita GDP declined from over 3 percent during the seventies to about 2 percent during the first half of the 1980s. TABLE 1.1: THE DRACU OF CENTRAIZED PLNUING 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 Gross Investment/GDP 45% 43X 47X 521 431 391 371 37X 381 351 331 ICOR (5-year average) 4 3 5 4 5 6 7 7 8 8 6 Per Capita GDP growth 1.91 5.11 2.01 5.7X 4.6% -2.1X -0.1X 3.2X 1.91 2.21 2.3% SOURCE: Algerian authorities and WS estimates. 1.03. In an attempt to satisfy the most pressing demands in an economy where incomes and employment policies were only marginally linked to productivity and output, a complex system of taxes and subsidies was progressively established. However, demand continued to outstrip supply, which initially led to large increases in imports, and then to widespread informal rationing. Many consumer goods became scarce or unavailable on the official market despite the large inflow of petro-dollars. At the same time, real interest rates were negative and money was abundant. The combination of excess liquidity (or "money overhang") with commodity shortages helps explain why the discrepancy between  2 the parallel and the official foreign exchange markets increased steadily until 1985, when the price of the dollar was five times higher on the parallel market than on the official one. Such a divergence was enormous for a country earning one-third of its GDP (equivalent to about US$600 per capita) from exports of oil and gas. In the context of widespread defacto rationing, price controls repressed inflation and led to a further build up of the money overhang. This situation promoted vigorous growth of parallel market activity, known as trabendo. 1.04. After the collapse of oil prices in 1986, the inefficiencies of the system became untenable. The 1986 oil shock caused a 50 percent drop in Algeria's terms of trade. Although the Government borrowed heavily abroad to maintain consumption levels, imports were cut by almost one-third in volume terms from 1985 to 1987. This reduction not only adversely affected investment and the consumption of imported consumer goods, but also reduced the level of activity of domestic industries which became starved of imported inputs and spare parts. As a result, output stagnated, with the exception of the hydrocarbon and agriculture sectors. In parallel, unemployment and repressed inflation increased, and per capita consumption declined. This precipitated an acute social and political crisis. B. The Adjustment Program 1.05. In response to the crisis, the authorities initiated a broad-ranging program of macroeco- nomic stabilization and structural reform. At first, the pace of adjustment was sluggish, and macroeco- nomic imbalances worsened. Treasury revenues (as a share of GDP) fell sharply once oil prices collapsed in 1986 (Table 1.2). While Treasury expenditures were also cut, revenues fell faster, and the overall Treasury balance' registered a record deficit of 12.8 percent of GDP in 1988. Given the undeveloped financial system, the higher Treasury deficits were largely monetized. In the presence of extensive price controls, increased monetization resulted in greater rationing in the goods markets and a further buildup of excess liquidity. By 1988, the ratio of broad money (M2) to GDP had increased to 84 percent. TABLE 1.2: FISCAL AND MONETARY BALANCES 1985 1986 1987 1988 1989 1990 1991 1992 a/ Treasury Revenues/GDP 37.2X 31.2X 29.6% 26.9% 27.8X 28.4X 31.1X 31.6X o/w PetroLeun Tax 16.0X 7.21 6.5X 6.9% 10.9% 14.2X 20.21 20.0X Treasury Expenditures/GDP 47.0% 43.01 37.1K 39.7% 29.9X 25.3% 30.11 38.6X Current Expenditure 18.41 21.5K 20.91 21.91 19.21 16.5% 19.21 26.7% Public Investment 15.51 14.01 12.21 12.5X 10.6K 8.91 7.3X 7.5X Net Loans to PEs 7.9% 5.91 5.1K 6.01 1.6X -0.1% 0.01 0.91 other 5.11 1.61 -1.2X -0.7K -1.51 -0.11 3.61 3.41 Treasury Balance w/o FA/GDP 9.71 11.91 7.5% 12.81 2.01 -3.2X -4.21 0.71 Restructuring Fund (FA)/GDP - -- -- --- --- -.- 3.2X 6.1K Overall Trea. Deficit/GDP 9.7K 11.91 7.51 12.8% 2.0X -3.2% -1.01 6.8X K2 Growth 15.0K 1.4% 13.61 13.6K 5.2% 11.31 21.31 24.01 M2/GDP 77X 77X 821 84K 74X 64% 521 53X CPI Inflation 10.4% 12.4% 7.41 5.9% 9.31 16.6% 22.81 31.8% a/ preliminary. SOURCE: Algerian Atuthorities and WB estimates. I/ Ttds overl baan (solde gl10 dui Tsor) is equivalent to the Trasry's gross bormwiug requirem  3 1.06. Macroeconomic stabilization efforts began in earnest in 1989. Both current and capital spending were restrained, and the Treasury stopped directly financing new public enterprise (PE) investments. Treasury revenues were bolstered by increases in petroleum tax receipts as a result of exchange rate adjustment (para. 1.07) and the modest recovery of world oil prices. Combined with expenditure restraint, these revenue increases transformed the overall Treasury balance into a surplus of 3.2 percent of GDP in 1990 and 1.0 percent in 1991 (Table 1.2). Supported by tight fiscal policy, the Central Bank (Banque d'Algerie, BA) slowed money growth, permitting excess liquidity to be absorbed. The ratio of broad money to GDP fell to 52 percent by 1991, largely absorbing the money overhang. Liquidity absorption allowed domestic prices to be progressively liberalized without destabilizing increases in open inflation. 1.07. Tighter fiscal and monetary policies were accompanied by adjustments in the exchange rate and interest rates. Depreciation of the real effective exchange rate actually began in 1985, as the rate of inflation of Algeria's main trading partners outpaced domestic inflation. Following the decision to devalue the Dinar, the pace of depreciation accelerated. Overall, the real effective exchange rate depreciated by almost 75 percent between 1985 and end-1991. Together with the absorption of excess liquidity, exchange rate adjustnent reduced the excess demand for foreign exchange; by June 1991, the ratio of the parallel and official exchange rates had dropped to 1.7:1, its lowest level in a decade. Interest rates were also adjusted. In 1987, the maximum bank lending rate was increased to 10.5 percent, three percentage points above the CPI inflation rate for that year. In 1990, the complex grid of fixed interest rates was replaced with a unified ceiling of 20 percent. However, efforts to restrain real wages met with limited success. As exchange rate adjustment proceeded and domestic price controls began to be lifted following the passage of a new price law in 1989, repressed inflationary pressures were freed. CPI inflation began to converge to the higher underlying rate measured by the national accounts consumption deflator (fable 1.3).2 CPI inflation reached 23 percent in 1991, and ex post real interest rates fell. 1.08. The pace of adjustment slackened in 1992. Financial restructuring costs (including exchange rate losses on external debt service), civil service salary increases, and higher social spending generated a sharp increase in Treasury expenditures. However, revenues stagnated in real terms following a decision to stabilize the nominal exchange rate. Including financial restructuring expenditures of 6.1 percent of GDP, the overall Treasury balance recorded a deficit of 6.8 percent of GDP in 1992, and the money supply expanded by 24 percent (Table 1.2), which helped sustain inflationary pressures. Other factors contributing to greater inflationary pressures were: (i) the substantial wage increases granted on the eve of national elections in late 1991; (ii) the large increases in household direct transfers in early 1992, combined with the delays in planned increases in subsidized food, energy and transportation prices, which were not implemented until the middle of the year; and (iii) the liberalization, in April 1992, of the prices of industrial equipment, construction materials, household appliances, and a range of other manufactured goods. As a result, CPI inflation climbed to 32 percent in 1992. Given the stable nominal exchange rate and the interest rate ceiling of 20 percent, the real effective exchange rate began to appreciate, and real interest rates became sharply negative (Iable 1.3). The resulting increase in the rationing of foreign exchange and domestic credit was reflected in a rise in the ratio of the parallel market to official exchange rates to over 2:1. a' In Algeia, the conswnption deflator is a bmder meaue of inflation than the CPI because it includes an explicit paelld madcet component.  4 TMA 1.3: PACROECOWMIC PRICE ADJUSTMET 1985 1986 1987 1988 1989 1990 1991 1992 a/ . .............. ........................... ................ ................... Average Noominal ER (DA/USS) 5.0 4.7 4.8 5.9 7.6 9.0 18.5 21.8 Reat Eff. Exchange Rate Index 100 92 81 66 58 52 27 35 (1985 = 100) b/ Ratio of ParalLeL to Official 4.9 4.5 4.9 4.9 4.9 4.0 1.7 2.4 Exchange Rates Maximum Real Interest Rate c/ -4.31 -6.5X 3.2X 4.6X 1.2X 3.51 -2.81 -11.81 Real Wage Index (1985 =100) 100 102 97 100 108 105 110 111 CPI Inflation 10.41 12.4X 7.41 5.92 9.31 16.61 22.8X 31.8% Consumption DefLator 6.81 13.9X 10.41 21.0X 17.9X 17.42 26.4X 31.71 a/ preliminary; b/ mid-year, except for 1991 & 1992 which are end-year; c/ defined as maximum conmerciat bank Lending rate minus CPI inflation. SOURCE: ALgerian authorities and WS estimates. 1.09. Structural Reforms. Since its inception, the fundamental objective of the structural reform program has been to improve economic efficiency and generate a strong supply response.3 This is being accomplished by decentralizing decision making and gradually increasing the role of market forces in the economy. Reform has transformed the legal and institutional framework of the productive sector (i.e., agriculture, industry, and services). The first measures took place in agriculture with the dissolution in 1987 of the 3,400 state farms, which averaged about 700 ha each. These lands have been converted into 80 ha private cooperatives and 6 ha individual farms holding long-term usufruct rights. In the enterprise sector, nearly 400 PEs have been transformed into autonomous Economic Public Enterprises (EPEs). Under the revised Commercial Code promulgated in early 1993, EPEs operate according to commercial law and are subject to bankruptcy procedures. The equity of EPEs has been vested in eight 'Participation Funds", which are mandated to manage their portfolios for the State and maximize returns. In principle, however, EPE managers have control over operational decisions, including production and investment.' 1.10. Private Sector Development. To stimulate the supply response and provide a source of competition for Pks, the reform program has included a broad range of measures to promote the private sector. All formal controls on private sector access to foreign exchange and domestic credit have been removed. The revised Commercial Code ensures a level playing field between public and private enterprises, and authorizes the creation of private joint-stock companies. Legislation is being enacted to open up the capital of autonomous PEs to private investors. The economy has been opened to foreign investment, including the authorization of production-sharing arrangements in the hydrocarbon sector. In order to clarify the investment regime and attract more direct foreign investment, a new Investment Code was promulgated in mid-1993, which notably authorizes the establishment of free-trade zones and guarantees the repatriation of the capital and profits of foreign investors. International oil companies, accustomed to dealing with risk, have responded strongly. A substantial number of other potential investors have already been accredited by the Money and Credit Council. However, in general, foreign 3/ In technical tenns, a supply respons is defined as the expansion of production in economically viable activities and the contation of production in uneconomic activities. Therefore, a strong supply response could result in a temnpomiy contraction of aggegate output during an initial phase of adjusment. i/ lThese principles are laid out in Laws 8-8t, which defined EPEs, and 88404. PPs are defined by Law 8843.  5 investors have hesitated to commit major resources to Algeria, partly because of the uncertainties surrounding the short-term outlook for the economy during the present transition period. 1.11. PE and Bank Restructuring. Efforts to restructure the PE and banking sectors have complemented legal and institutional reforms. In 1990, the authorities launched a multi-year program to clean up the large number of non-performing foreign and domestic debts of PEs, which had accumulated over the years of direct state control, and to recapitalize the commercial banks. The program is financed by a special Restructuring Fund (Fonds d'assainissement, FA) established in 1991. The FA is supported by budgetary allocations. The FA disbursed DA 26 billion in 1991 and DA 60 billion in 1992 (3.2 percent and 6.1 percent of GDP, respectively), mainly to cover foreign exchange losses on external debt service. The FA disbursed a further DA 84 billion in 1993. Moreover by the end of 1993, the Treasury had assumed some DA 275 billion in non-performing PE debts, converting the majority into equity and quasi-equity, a type of permanent bond with a profit-linked rate of return. In exchange, the banks received restructuring bonds from the Treasury, of which about DA 85 billion had been repaid with cash (DA 51 billion from the FA in 1993 and the remainder in the form of advances).5 The capital base of the banks is also being strengthened to ensure that they are able to meet the capital adequacy ratios established by the new prudential regulations (see para. 1.13). The FA disbursed DA 9 billion in 1991 to initiate the recapitalization of the commercial banks. 1.12. On the other hand, the physical restructuring of PEs to ensure long-term profitability has so far lagged behind. Most PEs have yet to develop comprehensive restructuring plans. In September 1992, it was announced that the Participation Funds would be replaced by another form of PE owner- ship/management structure (see Chapter o). However, delays in implementing this decision have created substantial uncertainty about the authorities' industrial restructuring strategy. Combined with the lack of a comprehensive safety net for redundant workers, the result has been delays in the implementation of those PE restructuring plans which have been worked out. In the interim, many PEs continue to run losses because of under-utilization of capacity, overstaffing, and the perpetuation of uncompetitive product lines. In the law enacting the 1993 National Plan,6 the authorities clearly indicated their intention not to extend the financial restructuring program beyond PE debts contracted after end-1992. Nevertheless, there are indications that the banks have continued to finance PE losses, which swell the public sector deficit and add to the pressure for money creation. 1.13. Financial Sector Reform. The legal and regulatory framework for a modern financial sector has been established, in particular through the 1990 Money and Credit Law (LMC).7 Under the new framework, the responsibility for monetary policy and oversight of the banking system has been devolved formally to the Bank of Algeria, and the Treasury is required to disengage from directly financing PEs. The LMC binds the Treasury to repay its stock of overdrafts to the BA. The new legal I/ The repuxhases have been armed out using the dinar cowupat of the exna debt efinancing operations (pam. 1.27). Under these operations, enterprises d bank have contnued to repay (in dinars) the debt according to the original maturity schedule, and the Tresy assumed responibily for repaying the refinanced extenud debt in the future. By using the dinar counwreat of the debt refinaming opetions to repurchase restructuring bonds, the Treasuy has exchanged in effect domestic liabilities (restructuring bonds) for foreign Liabilities (refinanced debt).