Tunisia - Towards the 21st century (Vol. 1 of 2) : Main report

Report No. 14375-TUN Republic of Tunisia Towards the 21 st Century Country Economic Memorandum (In Two Volumes) Volume I Main Report October 1995 Country Operations Division Country Department I Middle East and North Africa Department U Document of the World Bank A >  Currency and Exchange Rates Currency Unit: Tunisian Dinar (TD) TD per US$ Period Averages 1980=0.4050 1981 =0.4938 1982=0.5907 1983 =0.6788 1984=0.7768 1985 =0.8345 1986 = 0.7940 1987=0.8287 1988=0.8578 1989=0.9493 1990=0.8783 1991 =0.9246 1992=0.8844 1993= 1.0037 1994=1.0126 (est.) Fiscal Year January 1st - December 31st Weights and Measures Metric System  ABBREVIATIONS AND ACRONYMS ANPE Agence Nationale de Protection de l'Environnement (Environment National Agency) BCT/CBT Banque Centrale de Tunisie (Central Bank of Tunisia) BNA Banque Nationale Agricole (Agricultural National Bank) CDs Certificates of Deposits (Certificats de Dep6t) CNSS Caisse Nationale de Securite Sociale (National Social Security Fund) CPI Consumer Price Index (Index des Prix a la Consommation) CTN Compagnie Tunisienne de Navigation (Tunisian shipping company) EPA Etablissement Public Administratif (administrative entity) EPIC Etablissement Public Industriel et Commercial (quasi-commercial entity) EU European Union (Union Europeenne) FDI Foreign Direct Investment (Investissement Direct Etranger) FODEP Fonds de Depollution (Anti-Pollution Fund) FTA Free Trade Agreement (Accord de Libre Echange) FTZ Free Trade Zone (Zone de Libre Echange) GATT General Agreement on Tariffs and Trade (Accord General sur les Tarifs Douaniers et le Commerce) GDI Gross Domestic Investment (Investissement Interieur Brut) GOT Government of Tunisia (Gouvernement de Tunisie) IDF Institutional Development Fund (Fonds de Developpement Institutionnel) INNORPI Institut National pour la Normalisation des Produits Industriels (National Institute for Industrial Products Normalization) INS Institut National de Statistiques (National Institute of Statistics) MEAT Ministere de l'Environnement et de l'Amenagement du Territoire (Ministry of Environment and Regional Planning) MMR Money Market Rate (Taux du March6 Monetaire) MOA Ministry of Agriculture (Ministere de l'Agriculture) MOH Ministry of Health (Ministere de la Sante) NIE Newly Industrializing Economies (Economies Nouvellement Industrialisees) OC Office des Cereales (National Agency for Cereal Marketing) OECD Organization for Economic and Cooperation Development (Organisation de Cooperation et de Developpement Economiques - OCDE) ONAS Societe Nationale d'Assainissement (National Sewerage Company) ONH Office National de I'Huile (National Agency for Edible Oil) O&M Operation and Maintenance (Exploitation et Entretien) QRs Quantitative Restrictions (restrictions quantitatives) SICAF Societe d'Investissement a Capital Fixe (closed-end mutual fund) SICAV Societe d'Investissement a Capital Variable (open-end mutual fund) SME Small-Medium Sized Enterprises (Petites et Moyennes Entreprises) SONEDE Societe Nationale d'Exploitation et de Distribution des Eaux (National Water Supply Utility Company) STAM Societe Tunisienne d'Affretement Maritime (Tunisian cargo-handling company) STIL Societe Tunisienne d'Industrialisation Laitiere (National Company for Milk Marketing) VAT Value-Added Tax (taxe A la valeur ajoutee) WTO World Trade Organization (Organisation Mondiale du Commerce)  List of Definitions Accord de place Informal agreement between commercial banks not to compete for deposits based on interest rates. Appel d'offres A weekly auction by the Central Bank of a fixed amount of seven-day funds provided to commercial banks. The appel d'offres operations are based on precisely defined collateral (loans to priority sectors, e.g. agriculture, micro-enterprises. Bon d'6quipement Treasury bonds mandatorily placed by the Government. Bon du TrOsor Treasury Bills at market-related interest rates. Bon du Trtsor nggociable Treasury Bills negotiable (NTB) on the bourse and set at maturities of five years or more. Contrat de liquiditg ou Obligation for commercial banks to repurchase the securities sold to Accord de liquiditd customers virtually on demand regardless of maturity. Emprunts nationaux "National loans", borrowing of the Government through bond issues. Prise en pension A seven-day repurchase facility at a higher interest rate than the appel d'offres, designed to provide banks with additional liquidity. The report is a product of a team consisting of Linda Likar (Task Manager), Norman Loayza (Macroeconomic Policy and Policies for Higher Growth), Aziz Bouzaher and Sarah Forster (Environmental Issues), Mohamed Lahoucl (Competition Policies), Guillermo Hakim and Martin Rama (Labor Policies), Laura Burakreis and Richard Brun (Banking and Financial Sector Reforms), and Juan Lopez (Comparator Country Analysis and Macroeconomic support). The main report was prepared by Linda Likar and Norman Loayza. Several working papers (listed in the bibliography) were prepared by staff from the sector divisions and by Tunisian consultants. Valuable inputs and comments were received by Laurie Effron and David Tarr. Fataneh Semsarzadeh provided research assistance. The cooperation of the Government of Tunisia, particularly the Ministry of Plan and the Instiafu d'Economie Quanlitalive, is gratefully acknowledged. Local consultants, Professors Mohamed Lahouel and Faycal Lakhoua of the University of Tunis and the SIDES consulting firm, made significant contributions to the report.  REPUBLIC OF TUNISIA TOWARDS THE 21ST CENTURY COUNTRY ECONOMIC MEMORANDUM MAIN REPORT Contents Page No. EXECUTIVE SUMMARY ........................................ i CHAPTER I - MACROECONOMIC POLICY .......................... 1 A - Overview ...................................... I B - Monetary Policy .................................. 1 Monetary Policy Before 1986 ....................... I Monetary and Exchange-Rate Policy after 1986 ............ 2 Interest-Rate Policy .............................. 4 Inflation and Other Monetary Developments .............. 6 C - Balance of Payments and Exchange-Rate Policy .............. 6 Savings and Investment ........................... 8 D - Fiscal Policy .................................... 9 Tax Reforms .................................. 9 Government Revenues ............................ 11 Fiscal Expenditures .............................. 12 Fiscal Deficit .................................. 13 E - Conclusions ..................................... 14 Monetary Policy ................................ 14 Balance of Payments and Exchange-Rate Policy ............ 15 Fiscal Policy .................................. 15 CHAPTER 11 - THE ROLE OF THE STATE IN THE ECONOMY .... ....... 16 A - Overview ...................................... 16 B - Public Sector Activity ............................... 16 Definition and Size of the Public Sector ................. 16 Divestiture of Public Enterprises ..................... 17 C - Infrastructure Services: Provision and Maintenance ............ 18 Deregulation and Increased Efficiency .................. 19 Other Measures ................................ 21 D - Social Policies and Expenditures ........................ 22 Education Policies .............................. 22 Health Care and Social Security. 25  Contents (cont'd) E - The Environment: Growth and Sustainability ................ 26 Environmental Institutions and Policies ................. 27 Paying the Price for Resource Use and Degradation .... ..... 28 F - Conclusions ..................................... 30 Infrastructure Services: Global Integration, Efficiency and Dynamism 31 Social Services: Quality, Access and Financing ..... . . . . . . . 31 Environmental Management: Analyzing Trade-offs ..... . . . . 31 CHAPTER III - STRENGTHENING MARKET FORCES .................. 33 A - Overview ...................................... 33 B - Creating an Open, Competitive Economy .................. 33 Trade Liberalization ............................. 33 Impact of Trade Liberalization ....................... 34 A Free Trade Agreement with the European Union .... ...... 35 Domestic Investment Liberalization .................... 37 Foreign Investment Liberalization ..................... 38 Off-Shore Companies ............................ 39 C - Pricing, Labor and Industrial Policies ..................... 40 Price Liberalization .............................. 40 Labor Markets ................................. 41 Policies to Promote Innovation and Quality: "La mise a niveau" . 43 D - Reforming Agriculture .............................. 45 Increasing the Role of Market Forces and Strengthening Private Initiatives ............................. 45 The Land Tenure System .......................... 46 E - Financial Sector Reform ............................. 47 The Banking Sector .............................. 47 Financial Markets--Stocks, Bonds, Mutual Funds, and Institutional Investors ....................... 48 F - Conclusions ..................................... 50 An Open, Competitive Economy ..................... 50 Pricing, Labor and Industrial Policies .................. 51 Reforming Agriculture ............................ 51 Financial Sector Reform ........................... 52 CHAPTER IV - POLICIES FOR HIGHER GROWTH .53 A - Overview ...................................... 53 B - Growth Performance, 1987-94 ......................... 53 C - Structural Reforms and Growth ......................... 54 The Determinants of Economic Growth ................. 54 Structural Reforms and Growth in Tunisia ............... 56 D - Key Maroeconomic Indicators: Medium-Term Outlook .... ..... 57 E - Conclusions ..................................... 59  Contents (cont'd) List of Tables Table 1.1 Nominal and Real Interest Rates .......................... I Table 1.2 Selected Interest Rates ................................ 4 Table 1.3 Main Monetary Indicators .............................. 6 Table 1.4 External Sector Indicators .............................. 7 Table 1.5 Fiscal Indicators ........... .. .. .. . .. .. .. . .. .. . .. .. . 11 Table 1.6 Regional Comparisons ......... .. . . .. . . . .. . . . .. . . . .. . . . 12 Table 2.1 Indicators of Public Enterprise Accounts ....... . . . . . . . . . . . . . . 16 Table 2.2 Public Sector's Share of Value Added (% Share) ...... . . . . . . . . . . 17 Table 2.3 Privatization Proceeds (1988-92) . . . . . . . . . . . . . . . . . . . . . . . . . . 18 Table 2.4 Basic Infrastructure .......... . .. . . .. . . .. . . .. . . .. . . .. . 19 Table 2.5 Demand for Telephone Connections ....... . . . . . . . . . . . . . . . . . 20 Table 2.6 Trends in Educational Attainment by Region, 1985 ...... . . . . . . . . . 22 Table 2.7 General Education Attainment Rates, 1992 ...... . . . . . . . . . . . . . . 23 Table 2.8 Comparison of Enrollment in Tertiary Education by Field of Study .... . 24 Table 2.9A Main Providers of Health Care ........ . . . . . . . . . . . . . . . . . . . 26 Table 2.9B1 Health Expenditures .......... . .. . . .. . . .. . . .. . . .. . . .. . 26 Table 2.10 Water Prices in 1994 .................................. 28 Table 2.11 Sources of Soil Erosion .................. ............ 29 Table 3.1 Average Tariff Rates .................................. 33 Table 3.2 Share of Total Imports and Exports ......................... 34 Table 3.3 Tunisia/EU FTA - Tariff Liberalization Schedule of Industrial Products . . 35 Table 3.4 Policy Distortions by Industry ............................ 40 Table 3.5 Price Controls by Sector, % share end 1994 ................... 41 Table 3.6 Job Creation (1989-1993) ............................... 42 Table 3.7 Wage Differentials (permanent workers, 1990) .................. 42 Table 3.8 Comparison of Commercial and Development Banks (1993) .... ..... 48 Table 4.1 Contribution to Real GDP Growth ......................... 53 Table 4.2 Sectoral Share in GDP at Market Price ...................... 54 Table 4.3 Determinants of Economic Growth ......................... 55 Table 4.4 Determinants of Growth Improvement in Tunisia ................ 56 Table 4.5 Medium-Term Outlook ..... ........................... 58 Table 5.OA Priority Reforms .................................... 66 Table 5.0B1 Complementary Reforms ............................... 67 List of Figures Figure 1.1 Nominal and Real Interest Rates .......................... 5 Figure 1.2 Velocity of Money and Financial Deepening ................... 7 Figure 1.3 Nominal and Real Effective Exchange Rates ................... 8 Figure 1.4 Central Government Revenue (% of GDP) .................... 11 Figure 1.5 Central Government Expenditures (% of GDP) ................. 12 Figure 1.6 Fiscal Balance (% of GDP) .............................. 13  Contents (cont'd) CHAPTER V - THE CHALLENGES OF GLOBALIZATION ............... 61 A - Overview ...................................... 61 B - Strategic Choices in the 1990s ......................... 61 Pace of Reform ................................ 61 Decisive Trade and Investment Liberalization ............. 62 Refocusing the Role of the State ...................... 63 Privatization and Deregulation ....................... 63 Growth and Environmental Sustainability ................ 64 Sectoral Impact from Resource Constraints ............... 64 C - Creating an Adaptable, Agile, Flexible Economy .............. 64 Transition from Public to Private Sector-Led Growth ... ..... 65 Proposed Reforms .............................. 65 Bibliography ................................................. 69  Contents (cont'd) Figure 3. 1 : Sectoral Distribution of Private Investments .37 Figure 3.2 Foreign Direct Investment ....... . . . . . . . . . . . . . . . . . . . . . . . 38 Figure 4.1 Standard Deviation of the Annual Growth Rate (1983-94) ........... 54 List of Text Boxes Box 1. I Monetary Policy Instruments, Government Securities, and Foreign Exchange Markets. 2 Box 2.1 Telemarketing in Ireland .20 Box 3.1 : Tunisia-European Union Free Trade Agreement: Estimated Benefits and Costs 36 Box 3.2 : Free Trade Zones: Maximizing Host Country Benefits .39 Box 3.3 : Upgrading the Competitiveness of Small and Medium-Sized Enterprises: The Case of Slovenia .45 List of Annexes Volume I Statistical Annex: Table I : External Sector Indicators .73 Table 2 Fiscal Indicators (% of GDP) .74 Table 3 : Public Sector Accounts (% of GDP) .75 Table 4 : Unemployment Rates .76 Table 5 : Country Data Sheet .77 Table 6 : GDP, Output, Government Finance .78 Table 7 Exports, Exchange Rate, External Debt, IBRD/IDA Lending .79 Table 8 Money Credit, Prices, and Balance of Payments .80 Table 9 Macroeconomic Balances, 1988-1993 .81 Table 10 : Key Economic Variables, 1987-1994 .82 Figure I : Fixed Investments by Agents .83 Figure 2 : Exports by Destination, 1980, 1992 .84 Figure 3 : Structure of Tunisia's Financial System .85 Volume II Annex I Economic Growth and Environmental Sustainability: Linkages and Implications Annex 11 : Competition Policies Annex III : The Banking and Financial Sector   REPUBLIC OF TUNISIA TOWARDS THE 21st CENTURY Executive Summary Elements of Tunisia's Success 1. In the mid-1980s, Tunisia took the strategic choice to become a modern, market-oriented, and internationally integrated economy. Tunisia's macroeconomic performance since introducing stabilization and structural adjustment reforms in 1986 has been impressive. The per capita GDP growth rate increased significantly from an average of 1.15% p.a. for the period 1981-1986 to 2.44% p.a. for the period 1987-1994. The inflation rate (4.5% in 1994) is approaching the average rate of the EU countries (4.1 %). The central-government primary balance has been in a slight surplus since 1992, and the ratio of tax revenues to GDP is higher than the respective averages for selected countries in the Latin American, South-East Asian, and Middle Eastern regions. The current account deficit averaged 4% of GDP during 1986-1993, thus improving with respect to the early 1980s when it averaged 8.5% of GDP. The economy is also becoming more diversified and more open, as manufactured output replaced the previous dominance of oil and phosphate production and as the ratio of non-petroleum/non-phosphate exports to GDP increased from 25% in the early 1980s to 35% in the early 1990s. With the implementation of monetary and financial sector reforms, Tunisia's financial market is deepening and the capital market is becoming very active (after more than 20 years of dortnancy). At the same time, the country has made impressive social advances over the past decade: the incidence of poverty is low and declining, and income distribution is improving. The progress achieved in the development of human capital, the reduction of the population's growth rate, and an increase in life expectancy are also highly commendable and are important ingredients for stronger growth. Strategic Choices in the 1990s 2. This report focuses on the policies which will influence the future growth and development of Tunisia. The report analyzes the areas expressed by the government as being strategic for Tunisia's future: achieving higher rates of growth in the context of sustainable environmental management and the enhanced competitiveness of the economy in a global market environment. In addition, the report includes key issues raised by other groups in Tunisia (the private sector and members of the academic community) on the role of the state in the economy, the development of the financial sector, and the adequacy of the education system in meeting the human capital requirements of the 21st century. Three key messages emerge from the analysis which can contribute to the country's strategy formulation: * The pace of structural reform needs to move forward more decisively, particularly in the areas of trade and investment liberalization. Although the Tunisian economy has become stronger and more sophisticated since the late 1980s, the external environment has not stood still. The rest of the world is also changing rapidly, so that countries like Tunisia need to liberalize their economy with determination and in a timely manner to maintain their growth prospects and enhance their international competitive position. * The state needs to decrease further its size and role in the economy, strengthen its actions in the provision of public goods, and encourage a higher level of private investment-domestic and foreign. Further disengagement of the state and the deregulation of public sector monopolies (for example in telecommunications, maritime transport, and in the banking sector) and an acceleration of the privatization program would promote productive and allocative efficiency in the economy and enable the GOT to focus on the enforcement of regulations that encourage profitable activities, protect the public, and preserve the country's natural resources. * Environmental constraints mean that further adjustments in growth plans must take place, particularly in agriculture and tourism. By undertaking the necessary adjustments now, the GOT will he in a better position to implement these reforms gradually.  - ii - Report Outline 3. The report is organized as follows: Chapter I (Macroeconomic Policies) covers monetary, balance of payments, exchange rate and fiscal policies; Chapter II (The Role of the State) covers the role and size of public enterprises in the economy, the provision of infrastructure services, health and education policies, and environmental management; Chapter III (Strengthening Market Forces) covers a range of policies designed to create a more competitive economy (trade, pricing, labor, industrial, financial and agriculture); Chapter IV (Policies for Higher Growth) applies the findings of the more recent growth literature and comparative country analysis to the case of Tunisia; and Chapter V (The Challenges of Globalization) proposes a strategy to maximize the benefits to Tunisia of a closer integration with Europe and the rest of the world. The following sections summarize the main points of each Chapter. Macroeconomic Policies and AManagement (Chapter 1) 4. The stabilization measures introduced after 1986 brought a significant degree of macroeconomic stability and a much improved level of efficiency in the use of resources in Tunisia. The accomplishments described in para 1 are remarkable. Nevertheless, there remain some areas in macroeconomic policy that merit further improvements. Monetary Policy 5. Further liberalization of interest rates is essential to obtain a market-driven yield curve in Tunisia. This can be accomplished by eliminating all remaining preferential rates, encouraging competition among commercial banks on the basis of both interests rates and portfolio quality, and promoting a secondary market in Treasury securities through the removal of restrictions in their clearance and settlement procedures. These changes will also allow the BCT to control monetary expansion through system-wide open-market operations in Treasury bills rather than by allocating funds on a bank-by-bank basis, provided an integrated secondary market for Treasury bills and bonds exists and provided the banks achieve stronger deposit bases in proportion to their credits. System-wide monetary expansion, market- driven interest rates, and a thriving secondary market in government securities are all necessary elements for the efficient conduct of monetary policy, whose goals consist of achieving price stability and minimizing GDP fluctuations around its full-employment level. Balance of Payments 6. Tunisia's rather sizable trade deficit and the large role of tourism receipts and workers' remittances in financing the trade deficit makes Tunisia's external position vulnerable to adverse developments in the region's economic and political stability. Faced with an adverse economic or political shock, it would be rather difficult under current international conditions to finance a larger current account deficit. This is so, because of both higher interest rates in developed countries and less optimism towards emerging markets (partly as a result of the Mexican crisis). However, Tunisian authorities have demonstrated, as in their handling of the Gulf crisis repercussions on Tunisia in 1990 and 1991, their determination to avoid serious balance of payments disequilibria. Imposing trade restrictions (as in 1991) is effective in the short run to deal with balance-of-payments imbalances, but at a high cost. In the long run, only policies that encourage competition and a diversified production structure, stimulate flexibility of wages and relative prices, induce higher public and private savings (which are all goals of the Tunisian structural reforms), and allow for a market-determined exchange rate (which is the motivation behind the introduction of the interbank foreign-exchange market) result in a socially efficient, sustainable external position. 7. An examination of the behavior of national savings and investment shows that the worsening of the current account deficit from 1989 to 1993 was accompanied by a rise of both savings and investment, with the latter increasing at a faster rate. To the extent that external savings are being used to finance  - iii - higher and better quality domestic investment, the sustainability of the current account deficit is preserved. This confirms the conclusion in the above paragraph, that Tunisia's external position is secure to the extent that the structural reforms are implemented. Fiscal Policy 8. Generalizing the VAT and broadening the income-tax base will both reduce the reliance on foreign-trade taxes and increase total tax revenues. These improvements and controlling the expansion of the government wage bill are necessary not only to compensate for a likely future decline in petroleum- sector revenues but most importantly, to finance increased expenditures in infrastructure, education and public health. 9. Although the deficit of the central government seems to be well under control, there remains the question of the sustainability of the consolidated-government deficit, for which accurate information is unavailable. The GOT should prepare information on: (i) the consolidated nonfinancial public sector (consolidating the central government with local government, social security, and nonfinancial public enterprises) and on (ii) the consolidated total public sector (which adds to the first consolidation the central bank and the public banks). Some data on public banks and enterprises reveal that their profitability is considerably lower than that of their private counterparts. This, together with the distortionary effect of government direct participation in competitive economic activities, calls for an acceleration of the privatization process initiated in 1987. The Role of the State (Chapter II) Privatization and Divestiture 10. Estimates of the public sector's (government and public enterprises) share in total output and in total investment have slowly come down between the early 1980s and early 1990s from 48% to 42% for output and from 57% to 54% for investment. But this share is still quite high compared to other countries. For developing economies as a whole, the public enterprise (PE) share of GDP is around 11% (14% for the poorest countries), and it has come down to about 7% for industrial countries, compared to an estimated 20-25% in Tunisia. Privatization, namely the divestiture of state assets and public enterprise (PE) closures, have so far played a modest role in the government's restructuring and "competitiveness upgrading" efforts. Total cumulative sales since 1987 amounted to about US$180 million in 1994 (about 1 % of GDP), with roughly half of the privatizations in the tourism sector. 11. The GOT's strategy so far has focused more on constraining new PE investments and on trying to make PE operations more efficient and more autonomous. While these efforts have had a positive impact on reducing transfers to the PEs, transfers are still significant (3% of GDP), and it is unclear whether some of the transfers have been shifted to the banking system (through debts) or to the public (through higher prices charged by PEs in a protected or quasi-monopoly position). Several cross-country studies show that even in spite of improved PE performance, ownership does matter. It determines the incentive structure of the enterprise, which, in turn, is the force that promotes productivity in a competitive environment. For a variety of reasons--political and social--PEs have more difficulty than private enterprises in adapting quickly to an open, competitive, and rapidly changing international environment. Since 1991/92, the GOT has been preparing sectoral studies (in order to evaluate divestiture options) and amendments in legislation in order to create a legal environment which will facilitate stronger privatization efforts in 1995/96. Deregulation and Increased Efficiency in Infrastructure Services 12. In 1985, a law was passed that opened merchandise transport to the private sector, but the law was not applied until 1989. The GOT has also been slow to deregulate cargo handling and maritime  - iv - transport in the main Tunis ports, despite the slow and costly service. Several studies have been prepared, and the GOT is now (1995) in the process of exploring privatization/deregulation options to improve the situation. Deregulation of public bus transport has been slow, and non-charter air transport and telecommunications are both state-owned monopolies. 13. Progress has been made in reducing public sector force account for operation and maintenance (O&M) works under SONEDE and ONAS, both of which use private subcontracting for most of their O&M works. In the transport sector, recurrent road maintenance is still largely done by public sector force account. The government is now (1995) planning to open some infrastructure projects in electricity, solid waste treatment, highways and water purification to private concessions, hoping to attract foreign investment. The GOT is also raising prices for many infrastructure services with the objective of encouraging demand management and covering the full cost of operations and part of investment costs by the year 2000. The Quality, Access and Affordability of Social Services 14. The GOT has secured good quality and nearly universal access to health care through the public provision of health services. The GOT needs, however, to secure a sustainable system for financing growing costs--a problem not dissimilar from what many OECD countries face. Tunisia also needs to meet the demands of a population still growing at 2% p.a. as well as the demands of a growing older population with more chronic diseases that are expensive to treat. As the main provider and financier of health care, the GOT needs to promote the active private sector provision of health services by enhancing its own supervisory role and by reducing its widespread provision of subsidized services (nearly half the population receives free or highly subsidized care). To maintain the quality of existing services, the GOT needs to better target health care subsidies, increase some user fees, encourage an expanded use of private resources and services, and focus public funds on preventive care. 15. The GOT's Secondary Education Reform Program must succeed in increasing the completion rates of primary education (grades 1-9). A solid primary education base provides the cognitive, language and analytical skills to improve employment and earning opportunities and ensure Tunisia's ability to integrate confidently with the highly educated European labor force. The GOT is trying to make tertiary education and vocational training more relevant to the country's future development needs. A comparison of 1992 higher level student curriculum shows that the largest share of students (one quarter) are studying humanities, compared to 5% in teacher training, about 6% in business administration, and less than 10% in engineering. These percentages contrast quite sharply with such countries as Portugal, Malaysia and Chile. In order to meet the demands of growing numbers of young people seeking higher education and to provide the quality needed, more resources will be required. At present, virtually all (97%) of higher education is provided and financed by the state, which contrasts with trends in other parts of the world where private funds and private provision play a larger role in vocational training and higher education. 16. In Tunisia, regulatory reforms, including accreditation and supervisory policies, can speed up the entrance of private investors in many different service activities which have been traditionally dominated by the public sector (higher education, vocational training, medical services, agricultural extension and veterinary services). Shifts in public/private financing policies need to be introduced so that limited public funds are used to finance priority areas with high social and economic returns, for example, increasing completion rates of 9 years of basic education and further improving preventive health care. Private financing needs to increase in areas where private benefits are high: medical expenses (with public/private insurance policies) and tertiary education (with loans and scholarships for the needy).  - v - 7he Environment--Paying the Price for Resource Use and Degradation 17. The natural beauty of Tunisia, its vulnerability to climatic variations, and the important role of such an environmentally sensitive activity as tourism in the economy have heightened the need to take full account of the costs and pricing of resource use and degradation. The authorities have learned from past experience: inappropriate pricing policies which did not take into account the economic value of resources; haphazard coastal zone planning and; fiscal and financial advantages for activities which exacerbated erosion and water scarcity problems. The GOT is making good progress in correcting these policies and in organizing itself institutionally to assess the costs and benefits of development and investment initiatives with a longer term perspective. The donor community is providing budgetary assistance and technical advice to support the GOT's program. 18. Tunisia's environmental program can, nevertheless, be strengthened by: (i) ensuring that the costs of environmental degradation are borne by resource users and polluters; (ii) promoting community- based actions and developing the central and local capacity to monitor progress and; (iii) ensuring that the government's development strategy in agriculture, industry and tourism is based on the economic value of natural resources, including and in particular, those of land and water. The types of problems which Tunisia will face in the 21st Century include natural resource scarcity, solid and industrial wastes, and water and air pollution in selected areas. To tackle these problems will require additional resources (generated through pollution charges), and some reallocation of expenditures, for example away from municipal waste water treatment. Progress in Strengthening Market Forces (Chapter 111) Trade Liberalization 19. The number of import restrictions (QRs) have come down since 1990. Those which remain were estimated to cover 25% of domestic production by end 1994 (mainly some agricultural products, processed food, and textiles). Many of the restrictions, however, could be replaced with tariffs, since the estimated tariff equivalents of the QRs fall within Tunisia's legal tariff range agreed under the GATT. The average tariff rate for domestic producers is still quite high (33%) compared to 36% prior to liberalization reforms. The reason the average rate has not fallen more sharply is because the removal of many QRs after 1990 was offset by temporary surcharges of up to 30%. 20. On July 17, 1995, Tunisia became the first country in the Middle East and North Africa region to sign a Free Trade Agreement (FTA) with the EU--its largest trade partner, accounting for 75% of its imports and exports. The agreement marks another important step in opening Tunisia's economy to international competition, a process which began in 1986, and has included its accession to the GMT1 in 1990 and its signature to the Uruguay Round agreement in 1994. The elimination of the remaining trade barriers in Tunisia will largely be influenced by the pace of Tunisia's trade and commercial integration with the EU. The draft FTA provides for extensive technical support from the EU to harmonize product standards and upgrade the quality of Tunisian goods and services which brings important benefits to Tunisia. The agreement also allows for some tariffs to be removed immediately (those which do not affect domestic production), while other tariffs on more sensitive products would be removed more gradually--over the next 5 to 12 years. Discussions on market access for agricultural products and services both in the EU and Tunisian markets have been postponed tor five years (although the access for some agricultural products has been increased). The benefits ot free trade with the EU ;arc estimated to be very large for Tunisia (between 4-5% of GDP p.a.), provided Tunisia removes the high tariffs on the most protected sectors in the short term (less than five years). It would, thus, be beneficial for Tunisia to: (i) compress the schedule of QR eliminations and tariff reductions currently agreed oni with the EU; (ii) begin lower tariffs on all manufactured goods in the first year (1996); (iii) apply reductions to all of its trade partners and; (iv) seek greater access to the E;U market, rarticularlv tor services.  - vi - Investment Liberalization -- Domestic and Foreign 21. A 1987 manufacturing investment law abolished capacity licensing and removed prior government authorization for all projects not requesting investment incentives. The problem with the law, however, was that it introduced generous incentives on a sectoral basis (exceeding I % of GDP) and created distortions in the allocation of investment resources. Most investors wanted the incentives, hence GOT approvals continued to play a critical role. In December 1993, Parliament passed the Unified Investment Code which was ratified in 1994. The law reduces sectoral incentive distortions and reduces the number of investments requiring government approval. The new code is more open to foreign investment and strengthens the investment liberalization commitment begun in 1987. But investment restrictions in many support services remain in place (i.e. transportation, telecommunications, tourism, education and cultural establishments, real estate, computer and information technology, consulting and auditing) and investments in sectors not specified under the new code remain regulated (restaurants, financial services, mining, energy). 22. Foreign investment in Tunisia has not been well-integrated into the rest of the economy. Already in the 1970s, a dichotomy developed between the "off-shore" companies (which produce for export) and the "on-shore" companies (which produce for the domestic market). The former face a completely liberalized trade regime and pay little or no taxes, while the latter group were heavily protected, but faced more controls with respect to import duties, taxes, and other regulations. The new code attempts to place domestic companies on a more equal footing with export companies. Continued efforts, perhaps with the support of the EU, to improve infrastructure services, rationalize tax laws and incentives, and ensure that the tariff protection system is applied in a streamlined and uniform manner for all enterprises--direct and indirect exporters alike--would promote a closer integration of domestic companies in off-shore activities and promote higher levels of private investment. Price Liberalization 23. Considerable progress has been made in reducing producer price controls and regulated distribution margins in the agricultural and manufacturing sectors. By end 1994, only 13 % of producer prices in agriculture and manufacturing were still regulated and 30% were regulated at the distribution stage. The two main sectors where controls account for a significant share of production are agroindustries and construction materials and, at the distribution stage, for machinery and equipment. Regulated distribution margins for fresh fruits and vegetables should be removed, given the extent of domestic competition in this subsector and the need to transmit clear price signals back to producers. Cereal prices are not included in the price liberalization calculation, but are set by the GOT, and the prices of many services and non-manufactured goods continue to be regulated. Labor Markets 24. The population growth rate of 2% (and the young age structure of the population), the entrance of more women into the work force, and rural to urban migration flows are increasing the urban labor force at the rate of an estimated 5% p.a. Unemployment is estimated by the Bank to be between 11-12%, with the main unemployment problem being for first-time job seekers. The growing size of the urban work force puts pressure on the authorities to increase economic growth and create more jobs. Between 1989-1993, job creation has been faster than the average for the economy in the services sector (4.3%) which accounts for the largest share of total employment (24%). Employment in government administration is high (18% of total employment and 25% of total wage earners), and it has also been growing faster than the economy's average (3.2% compared to 2.1 %). The authorities may wish to introduce quarterly or annual labor surveys which are used in many countries to give policy-makers more up-to-date information on labor market changes. The GOT is currently preparing a strategic study of labor issues for the IXth Plan covering labor legislation, costs, productivity and wages. In particular, the GOT is reassessing labor legislation with the objective of increasing employer flexibility to adjust the size of the work force.  - vii - Reforming Agriculture 25. Input subsidies have been reduced significantly, but the GOT should reassess its agricultural policies which hinder private sector participation in marketing some agro-industrial products. Policies which entail price supports and credit subsidies to maintain or increase cereal production need to be reassessed in light of trade integration with Europe and the expected impact of the Uruguay Round agreement. The land tenure system (characterized by poorly defined property rights) hinders the use of market mechanisms as a means of ensuring that land and agricultural inputs are used as efficiently as possible. The state, as a major owner of prime crop land (11 % of total cultivable land) should consider expanding its program of leasing land to the private sector and reassess the costs and benefits of selling state lands to the private sector. Banking Reform 26. Tunisia has come quite far in creating a healthier and more efficient banking sector. Prudential regulations were reinforced in 1994, including stringent capital adequacy requirements, and the supervisory role of the Central Bank has been strengthened. The most notable feature of the banking sector is the predominance of public sector banks, which account for 70% of the banking sector's total assets and whose performance is significantly weaker than that of the private banks. 27. The GOT's efforts have focused on recapitalizing the public sector banks and improving the quality of their portfolios. In order for these efforts to succeed, the policy environment has to encourage competition--based on the provision of services and on interest rates. A gradual divestiture of these banks (through selling some shares on the stock exchange) would be an ineffective substitute for selling a controlling interest to a core group of shareholders that can appoint key board members and managers that can run the banks after divestiture. With respect to the government-owned development banks, the GOT should explore options with its partners (the governments of other Arab states) to reorient the development banks' activities towards investment banking, restructure some, and/or link some of them up with commercial banks. Financial Market Development 28. After being dormant for more than 20 years, since 1989, the GOT has strengthened the necessary laws and regulations which have encouraged the stock and primary bond markets to begin functioning. Between 1990 and 1994 primary bond market activity grew steadily, while stock market activity increased dramatically. Over this period, the stock index increased 350%, the capitalization of the 20 listed companies on the Tunis stock exchange jumped from TD 543 million to TD 2.4 billion, and the demand for stocks exceeded the supply by 200-500%. The average price/earnings ratio on the Tunisian stock market is high (25), compared to average ratios in other emerging markets that range between 10-15. The GOT should consider: (i) speeding up the privatization program to increase the supply of stock offerings and help to satisfy the excess demand for stocks and; (ii) removing fiscal distortions in the form of large tax benefits that encourage investors to oversubscribe to initial stock offerings. It will, nevertheless, take time for many of Tunisia's traditional, family-owned companies to go public. The GOT has overseen the development of an increasingly sophisticated financial sector. With the implementation of reforms to strengthen institutional investors, and by ensuring market-driven interest rates and an active secondary market for government securities, the financial sector will be significantly strengthened. Policies for Higher Growth (Chapter IV) 29. In the mid-1980s, several prominent economists began focusing their attention on how long-run growth is enhanced by socio-economic developments and government policies. This theoretical and empirical research uses cross-country data to measure to what extent different structural reforms promote  - viii - economic growth. Their main conclusion is that economic growth is maximized when the incentives to invest in physical and human capital as well as in technological innovation are determined by free-market forces. Governments assist this process by providing an environment of macroeconomic and political stability and the appropriate public infrastructure. 30. This work has been applied to the case of Tunisia, by comparing per capita GDP growth improvements between 1981-1986 (the period prior to undertaking adjustment reforms) and 1987-1994 (the period during which structural reforms have been under implementation). The analysis compares the predicted improvement with the actual improvement, and it estimates the growth impact of several policy measures, as determined by the cross-country empirical analysis. The main elements which contributed to improved growth in Tunisia were estimated to be: (i) an increased openness of the economy; (ii) a reduction in price distortions; (iii) improvement in population health indicators; (iv) advancement in the level of education; and (v) financial deepening. All these elements significantly increased the economy's total factor productivity. Given that physical capital investment as a ratio to GDP was lower in 1987-94 than in 1981-86, the rise in total factor productivity was the main source of the improved growth performance in the reform period. 31. Conditional on a timely completion of the reform program, real GDP is projected to grow at an average of 6.2% over the next 9 years. It is estimated that about one third of the growth improvement with respect to the period 1987-94 would be explained by a larger investment rate. Thus, most of the growth improvement would come through a further rise in total factor productivity, generated by both stronger market incentives for private activity and more efficient public services. Given the environmental constraints facing Tunisia, agriculture's share in total production is projected to decrease in the coming years at the same time as manufacturing and non-government services (with a slightly decreased role for tourism) become the leading growth sectors. Tunisia's external position would remain sustainable, particularly under the high-growth scenario, as private savings respond favorably to financial sector reforms and as exports/GDP rises due to Tunisia's enhanced international competitiveness. The Challenges of Globalization (Chapter V) 32. Successful economic performance will be increasingly determined by a country's adaptability to accelerating change in the rest of the world. A strong human capital base, transparent rules and regulations, and private sector dominated enterprise management structures offer Tunisia its best chance to compete successfully in the globial economy. The government plays an enormous role in creating an environment that promotes entrepreneurial agility, strong human resources, and labor force flexibility. 33. Tunisia has been liberalizing its economy for nine years, and in many respects it has gone quite far. But past sources of growth are diminishing and/or face growing environmental resource constraints (hydrocarbons, mining, agriculture, tourism). New investments and new sources of growth need to be developed with the private sector taking the lead in a competitive environment. At this advanced stage in the adjustment process, the remaining reforms which need to be undertaken are all important and complement each other, and therefore should, ideally, be pursued concurrently. Although undertaking numerous reforms simultaneously may be economically desirable, it may be politically difficult. For this reason, the report places a particularly strong emphasis on trade liberalization measures, since the pressure of international competition will require Tunisia to follow a comprehensive adjustment strategy to respond to that pressure. By adhering to well-known and straightforward reform timetables, the GOT shows strong political commitment towards competition, and economic agents--entrepreneurs, local and foreign investors, civil servants--become convinced that the system has changed irreversibly. 34. Tunisia has much to gain from accelerating retorms in trade liberalization, the deregulation of state monopolies, and a reduction in the predominance of the state in the provision of goods and services. The goal of high sustainable growth is achievable in Tunisia, but requires strong determination to maintain macroeconomic stability and push ftorward the implementation of structural reforms.  I. MACROECONOMIC POLICY A. Overview 1.01 The mid-1980s marked a turning point for the Tunisian economy. Since 1986, the economy has been undergoing a transformation which has combined the elimination of macroeconomic disequilibria with gradual but important structural reforms aimed at refocusing the role of the state (see Chapter II), and transforming a highly regulated and protected economy to an open, market-oriented one (see Chapter III). Stabilization measures launched the reform program in 1986. Structural reforms have been applied throughout the period, but gained increasing importance after 1990. This chapter looks at the macroeconomic developments and policies pursued from the mid-1980s to today, tracing the shifts in monetary policy, balance of payments and exchange rate policy, and fiscal policy. The analysis of Tunisia's growth performance and its sources, particularly in relation to the reform program, is undertaken in Chapter IV. B. Monetary Policy Monetary Policy Before 1986 1.02 Prior to 1986, the main objective of the Tunisian Central Bank (BCT) was to provide credit to support the Government's economic development plan. The Government's control of the commercial banking system allowed the BCT easy management of financial markets. The BCT controlled the growth and distribution of credit as well as various interest rates (Table 1.1). The spread between the rate paid on deposits and that charged to the private sector bore little relationship with the excess demand for credit. Furthermore, to enforce the distribution of credit according to the rationing scheme imposed by the BCT, commnercial banks needed the Central Bank's approval for most of their operations. Priority sectors (mainly agriculture, tourism, manufacturing of heavy equipment, exports, and small enterprises) had preferential access to credit and paid lower interest rates. In fact, the real interest rate on loans to priority sectors was negative for most of the period from 1972 to 1985. Heavily subsidized credit createcl an incentive to invest in low-return projects and crowded out investment in other areas of the economy. 1.03 Loan repayment was low, because of the highly cumbersome judicial process Table 1.1 which slowed down payment collection Nominal and Real Interest Rates through legal means. The BCT had to give prior approval for most loans. BCT Preferential Money Market Rate Knowing that the BCT would bail them out, er Inflation Rate (end of period) Knowing that he BCT wouldbail them Ou, Years (CPI) Nominal 1Real Nominal Real banks were mainly concerned with expanding loans, with little consideration to 1981 8.9 n.a. n.a 8.50 -0.40 their portfolio quality. The real interest 1982 13.7 n.a. n.a. 8.25 -5.45 rate on term deposits was also mostly 1983 9.0 n.a. n.a. 8.38 -0.62 negative during the period 1972-1985, 1984 8.5 n.a. n.a. 8.89 -0.39 hence generating financial disinter- 1985 8.0 n.a. n.a. 10.28 2.28 mediation. Thus, the reduced amount of 1986 5.8 5.13 -0.68 10.25 4.45 savings channeled through the banking 1988 6.3 5.31 -0.99 9.63 2.33 sector could not satisfy the large demand 1989 7.7 5.31 -2.39 11.31 3.61 for loans that the artificially-low interest 1990 6.5 6.50 0.00 11.81 5.31 rates had generated. The excess demand 1991 8.2 6.50 -1.70 11.81 3.61 for loans created the need for an expansion 1992 5.8 8.50 -2.70 11.31 5.51 in money supply, which in turn led to a 1993 4.0 8.50 4.50 8.81 4.81 significantris in inflation (8-9 . . 1994 4.5 8.50 4.00 8.81 4.31 significant rise In inflation (8-9%). Source: Central Bank of Tinisia, er cept MMR from 1981 to 1985 _ MF Financi Statistics.  - 2 - Monetary and Exchange-Rate Policy After 1986 1.04 Given a nominal exchange rate fixed with respect to Tunisia's main trading partners, a relatively high domestic inflation hindered the competitiveness of Tunisia's products in world markets and, by 1986, led to an unsustainable current account deficit. To deal with the short-run balance-of-payments crisis, the BCT sharply devalued the Dinar and, more importantly, changed its monetary and exchange-rate policies in accordance with a comprehensive package of economic reforms. 1.05 With the goal of improving the efficiency of credit allocation, decreasing inflation, and muaintaininig equilibrium in the external accounts, in 1987 the Government initiated two major imiprovements in monetary policy: (i) a shift of emphasis from direct control of credit and monetary expansion to indirect management through refinance facilities and (ii) a gradual elimination of preferential interest rates and quotas (Text Box 1. 1). 1.06 Since 1987, monetary policy in Tunisia has been directed at reducing inflation and strengthening the external reserve position of the Central Bank. On both accounts, the BCT has been quite successful. There are a few aspects of interest-rate policy that warrant further discussion and improvement. F Text Box 1.1: Monetary Policy Instruments, Government Securities, and Foreign-Exchange Markets' Monetary Instruments The control of monetary expansion is conducted on a bank-by-bank, rather than a system-wide, basis through two instruments: the appel d'offres and the pnise en pension. The appel d'offres is a. weekly auction of a fixed amount of seven-day funds. The prise en pension is a seven-day repurchase facility at a punitive, higher interest rate, designed to provide banks with additional liquidity to that obtained through the appel d'offres. Whereas for prise en pension operations the BCT accepts as collateral all refinanceable papers (except Treasury bills), appel d'offres operations are conducted on the basis of precisely defined collateral (certain loans to priority sectors, e.g. agriculture, micro- enterprises). The appel d'offres and pension rates maintain a fixed spread between them: 1.5 percentage points through 1991 and 1992, and 1 percentage point since December 1992 (see Table 1.2) Since 1990, the interbank (money-market) interest rate has stayed fairly constant for long periods of time, changing discretely when the appel d'offres and the pension rates are changed by the Central Bank; since December 1990, the interbank rate has remained at 1/16th below the pension rate. Interbank trading, which on average amounts to only one-third of the liquidity obtained through the Central Bank facilities, has remained low because of the lack of easily tradeable financial instruments and the banks convenient access to the pension. As explained below, banks have been virtually unable to trade government securities with each other in the secondary market. I/ Also see Annex Ill, "Banking and Financial Sector Policies," R. Brun and L. Burakreis, 1995.  -3 - Government Securities Prior to 1991, non-bank domestic financing of the fiscal deficit consisted of the forced placement of 10-year Treasury investment bonds (Bons d'equipement) at below-market rates. As part of the financial liberalization program, the Government has, since 1991, relied mainly on Treasury bills (Bons du Tresor) at market-related interest rates to finance the deficit. Treasury bills were first introduced in 1989 and modified on several instances. These securities are placed through weekly auctions to the banks, which then sell them to the public at a slightly lower interest rate. The rates for Treasury bills bid by the banks have remained virtually constant with respect to the appel d'offres rate, and the interest rates for the shortest maturities are only slightly lower than for the longest-maturity Treasury bills. Treasury bills have been quite successful as a means to finance the budget deficit. In principle, Treasury bills may also serve as the basic instrument of open market operations and interbank trading. However, a secondary market on Treasury bills has not developed in Tunisia due to (i) the lack of competition among banks on the placement of government securities and (ii) restrictions in clearance and settlement procedures. In fact, transactions have been limited to those between each bank and its customers because property rigbts cannot be transferred from one bank to another in the accounts of the BCT. The market-making responsibility assigned to the banks by the BCT has been thus interpreted as an implicit "contrat de liquidite," by which banks are obligated to repurchase government securities virtually on demand, regardless of maturity. Consequently, the term structure of interest rates (yield curve) has been basically flat. In order to obtain a suitable, longer-term debt maturity structure, the Tunisian authorities introduced in late 1993 the option of having banks convert a Treasury bill (bon du Tri4sor) into a negotiable Treasury bond (bon du Tresor negociable), which would be traded solely at the Bourse. At first, due to problems in the settlement procedure, trading in the new securities did not take place. In June 1994, the authorities changed the bon du Tresor negociable into a bond with maturities of five years or more, to be issued through and traded at the Bourse. Correspondingly, the maturities of the simple bon du Tresor were limited to four years or less. It is expected that this change, together with improvements in the settlement procedure, will increase the attractiveness and marketability of the negotiable Treasury bonds, thus increasing their share in domestic public debt. Foreign Exchange Markets Until recently, the BCT has tightly controlled the determination of the nominal exchange rate. In March 1994, the BCT introduced an interbank foreign-exchange market with the purpose of obtaining a more flexible and market-determined rate. During the launching period, the BCT sets a central exchange rate on a daily basis around which banks trade among themselves within a