Morocco - Country economic memorandum : towards higher growth and employment (Vol. 1 of 2) : Main report

Report No. 14155-MOR Kingdom of Morocco Country Economic Memorandum Towards Higher Growth and Employment (In Two Volumes) Volume I Main Report September 15, 1995 Country Operations Division Country Department I Middle East and North Africa Region Document. of the World Bank  CURRENCY AND EXCHANGE RATE Currency Unit = Dirham (DH) 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 DH per US$, End of Period 9.55 9.62 8.71 7.80 8.21 8.12 8.04 8.15 9.05 9.65 DH per US$ Period Average 8.81 10.06 9.10 8.36 8.21 8.49 8.24 8.71 8.54 9.30 FISCAL YEAR January 1st - December 31st This report was supervised and drafted by Roumeen Islam. It is based on the contributions of a team consisting of Jean-Paul Azam (The Labor Market, consultant), Jacques Coudol and John Nellis (Privatization and Private Sector Development), Luc De Wulf (Financial Sector Development), Kouassi Soman (The Macroeconomic Framework, Statistical Annex), and Sethaput Suthiwart-Narueput (International Trade). Khadija Khoudari (Gender Issues in the Labor Force, consultant), Benoit Millot (Gender Issues in Education), and Anita Schwarz (Financial Sector Development - Pension Systems) also contributed to the report. Ishac Diwan, Ross Levine and Klaus Schmidt-Hebbel were peer reviewers for the report and provided guidance. Additional advice and support was provided by Rene Vaurs, John Underwood and Miria Pigato. Carine Bolou-Mansilla and Magalie Pradel desk-topped the report.  Page 1 of 3 MOROCCO - COUNTRY DATA SHEET, 1995 Population Characteristics (1993) 1987-92 Population Area & Density Total Fertility Rate (births/woman) 3.8 26,590 million (mid-1994) Area (sq. km) 710,850 Infant Mortality (per 1,000 live births) 57 Growth Rate: 2.0 % p.a. Density (pop./sq. km) 39.5 (1992) Llfe Expextancy (years) 63 Age Dependency Ratio 0.78 Access to Safe Water (% of populatilon) 61 Health 1987-92 Urban 86 Population per Physician 4,844 Rural 14 Population per Nurse 1,053 Access to Health Care 60 Population per Hospital Bed 809 Nutritional Expenditures Access to Electricity Cereal Imporls(000 metric tons) 3,095 Urban (/ of Households) 90 Food Aid In Cereals (000 metric tons) 208 Rural (% of Households) 13 Food Produclion per Capita (1987 = 100) 104 Share of Agriculture in GDP 21 (1994) Education Primary Enroll. (% of school-age pop.) 66 Secondary Enroll. (% of school-age pop.) 28 Adult Literacy Rate (% of pop. age 15+) 49 Newspaper Circulation (per thou. pop.) 13 GNP per Capita a/: US$1040 (1993) OH, billions % of Annual Rate of Change (%, constant prices) Gross Domestic Product (1994) GDP 1980-83 1984-87 1988-92 1993 1994 GDPat market prices 289924 100.0 3.6 4.7 3.9 -1.1 11.5 Gross Domestic Investment 61591 21.2 1.9 2.6 5.0 -8.4 10.5 Gross National Savings 54973 19.0 -6.9 9.6 1.6 -10.0 8.7 Exports of Goods & NFS 61353 21.2 4.4 4.6 4.0 4.8 5.1 Imports of Goods & NFS 76461 26.4 -1.8 4.8 7.3 0.4 4.8 DH, billions Annual Rate of Change (%, constant prices) Sectoral Value-Added (1994) % 1980-83 1984-87 1988-92 1993 1994 Agriculture 60486 20.9 -0.7 10.3 1.8 -6.2 63.0 Industry 85599 29.5 1.6 2.6 3.4 -2.0 2.3 (of which: Manufact.) 47578 16.4 3.8 3.9 4.4 -1.5 2.0 Services 143839 49.6 6.3 4.1 4.7 0.7 4.3 Total 289924 100.0 3.6 4.7 3.9 -1.1 11.5 (in billions of DH) (as % of GDP) Central Gov't Accounts 1992 1993 1994 1992 1993 1994 Current Revenue 63659 66194 66219 26.4 26.7 23.4 Current Expenditures 51815 54754 58043 21.5 22.1 20.5 Budgetary Savings 11844 11440 8176 4.9 4.6 2.9 Capital Expenditures b/ 17194 19597 19008 7.1 7.9 6.7 Budget Deficit. com. basis -5350 -8157 -10832 -2.2 -3.3 -3.8 - Foreign Borrowings, net 278 -957 -4858 0.1 -0.4 -1.7 - Domestic Borrowings, net 5072 6972 13638 2.1 2.8 4.8 - Privatizatlon Proceeds 0 2142 2052 0.0 0.9 0.7 Source: Officlal Country Data (Statistical Office and Ministry of Finance) a/ Based on the World Bank Atlas methodology; b/ Including capital transfers to public enterprises and local governments.  Page 2 of 3 MOROCCO - COUNTRY DATA SHEET, 1995 Period Averages Money, Credt aPilces 1988 1989 1990 1991 1992 1993 1988-90 1991-93 (in bililon of Dirhams, end-of-period) Money Supply (M2) 86659 96853 114802 134063 146507 159259 99438 146610 Bank Credit to Govemmenl 44508 50185 48556 51367 55470 60526 47750 55788 Bank Credll to Non-Govemment 35520 39422 43874 59235 66020 71753 39605 65669 (Percentage or Indices) Money (M2)/GDP (%) 47.6 49.9 53.7 55.5 60.7 64.3 50.4 60.2 ConsumerPricelndex(1987-100) 102.3 105.5 112.5 121.5 128.5 135.1 106.8 128.4 Annual Percenlage Change: -MoneySupply(M2) 14.7 11.8 18.5 16.8 9.3 8.7 15.0 11.6 - Consumer Price Index 2.3 3.1 6.7 8.0 5.7 5.2 4.0 6.3 -Bank Credit to Govemment 17.2 12.8 -3.2 5.8 8.0 9.1 8.9 7.6 -BankCrediltoNon-Government 9.2 11.0 11.3 35.0 11.5 8.7 10.5 18.4 Merchandise Exports (Avge. 1992-94) Balance of Payments 1992 1993 1994 est. US$mil. % of Total US$mil. Agriculture prod. 1,172 30.2 Exports of Goods & NFS 6454 6205 6696 Phosphate Rock 292 7.5 Imports of Goods & NFS 8287 7671 8265 Phosphoric Acid 377 9.7 Resource Gap -1833 -1466 -1569 Fertilizers 315 8.1 Manufactured Goods 1,514 39.0 Factor Services Payments 1325 1550 1635 Other Exports 217 5.6 O/w: Interest Paid 995 1069 1087 Total, fob 3,887 100.0 Net Current Transfers 2405 2251 2158 Current Account Balance -460 -542 -708 US$ mill. (as % share of GDP) -1.6 -2.0 -2.3 External Debt Stocks (DOD) 1993 % Foreign Direct Investment 503 522 776 Public & pubi. Guaranteed 20315 98.3 Nei MLT Borrowing 23 336 -265 Olw: Official 15632 75.6 - Disbursements 1769 1963 1467 - IBRD 3563 17.2 -Amortization 1746 1627 1732 Bilteral 10019 48.5 Other Capital n.e.l. (net) a/ 494 168 812 Private 4684 22.7 Private Non-Guaranteed 350 1.7 Net Credi from IMF -116 -152 -146 Total MLT Debt 20665 100.0 Change In Reserves (- Incr.) -443 -332 -469 Gross Reserves (end-year) 3819 3942 4378 Memo ntems: 1992 1993 1994 est. Memo Remns: - Debt Service/XGS 23.3 30.4 32.6 - Official Exchange Rate (DH/$) 8.5 9.3 9.2 - DOD/GDP 74.6 67.8 68.5 - Reserves (months of Imports) 5.5 6.2 6.4 (in US$ millions) IBRD Operations by FY FY90 FY91 FY92 FY93 FY94 - Commitments 483 626 325 549 412 - Disbursements, total 371 352 503 345 309 Project Lending 168 342 215 253 154 Non-Project Lending 203 10 288 92 155 (as of end-1994) (US$millions) Memo items: IBRD IDA TOTAL Disbursed 6,652 45 6,697 Repaid 1,982 11 1,993 Total Held 4,670 35 4,704 Total Undisbursed --- -- 1,506 Sources: Official Country Data; and Bank Central Databases (DRS, BESO); a/ Including debt rellet,short-term capital, errors and omissions.  Pape 3 03 MOROCCO - COUNTRY DATA SHEET, 1995 INCENTIVE INDICATORS Estim. 1988 1989 1990 1991 1992 1993 1994 1. Real Effective Exchange Rate 1.1 Index (1990 - 100) 104.9 105.2 100.0 100.8 102.3 104.0 106.9 1.2 Annual % Change (- depreclatIon) -2.0 0.3 -4.9 0.8 1.5 1.7 2.8 2. Interest Rates (applicable as of date) 1-Jan-89 1-Jan-90 31-Dec-91 1-Jan-93 1-Jan-94 2.1 Deposit Rates - Savings accounts (deposit money banks) 8.5 8.5 8.5 8.5 8.5 - Sight deposits (Insurance and SFI) 5.0 5.0 5.0 5.0 .... -6-months time deposits 10.5 10.5 free rate free rate free rate - 6-months Treasury bills (ordinary) 10.5 9.5 9.5 10.5 10.5 - Speclal T-blils (banks, SFI - up to 1 year) 4.25 4.25 4.25 4.25 4.25 2.1 Lending Rates As of December 1989 1990 1991 1992 1993 Short-term: -Discountable CMM credits (Deposit banks) 11.0 11.0 11.0 11.0 11.0 - Discountable exporls credits (Deposit banks) 9.0 9.0 9.0 10.0 10.0 - Short-term grain, rice and cotton warrants 8.0 8.0 8.0 8.0 8.0 Medium-Term (up to 10 years): - Discountable 12.0 12.0 12.0 12.0 12.0 - Nondiscountable 13.5 tree rate tree rate free rate free rate Long-Term (10 years or more): 14.0 tree rale free rate free rale tree rate 3. PublIc Sector Wages 1989 1990 1991 1992 1993 est. 3.1 Index of Real Wage (1990 = 100) 99.1 100.0 104.3 99.6 95.9 3.2 Annual % Change 9.1 0.9 4.3 -4.5 -3.7 4. Ratios of domestic/Int'l prices (moroccan crop year: November-October) 1988/89 1989/90 1990/91 1991/92 1992/93 4.1 Wheat 1.52 2.16 2.79 2.22 4.2 Barley 1.95 2.00 1.81 2.23 ..... 5. Volume Index of Malor Exports (1990 =100) 1989 1990 1991 1992 1993 1994 est. 5.1 Agriculture 102.6 100.0 115.9 97.4 98.9 103.9 5.2 Phosphate rock 106.4 100.0 78.6 78.5 75.0 83.2 5.3 Fertilizers 72.9 100.0 88.9 77.3 101.6 106.7 5.4 Manufactured goods 80.4 100.0 102.0 93.4 93.3 94.3 6.ExportSharelnWorldTradef%) 0.12 0.12 0.12 0.11 0.11 .... 7. Manufactured Exports 7.1 Real Growth Rate (%) 17.8 24.4 2.0 -8.4 -0.1 1.0 7.2 Value as share of lotal exports of GNFS 22.3 24.1 25.6 23.9 23.8 22.8 8. Commodity Terms of Trade 8.1 Index (1990 - 100) 106.7 100.0 104.0 104.0 103.7 104.0 8.2 Annual % Change -1.2 -6.3 4.0 0.0 -0.3 0.3 Sources: Official dala (Ministrles of Flnance, Agriculture; Central Bank); staff estimates.   LIST OF ACRONYMS AND ABBREVIATIONS ASEAN An Export Company BAM Banque Al-Maghrib (The Central Bank of Morocco) BCP Banque Centrale Populaire BMCE Banque Marocaine de Commerce Exterieur BOO Build-operate-own BOT Build-operate-transfer CDG Caisse de Dep6t et de Gestion (A Public Sector Bank) CEN Caisse d'Epargne Nationale (National Savings Bank) CG Central Government CMR Caisse Marocaine de Retraite CNSS Caisse Nationale de Securite Sociale DH Dirham EEC European Economic Community EU European Union FTA Free Trade Accord GDP Gross Domestic Product GOM Government of Morocco ICOR Incremental Capital Output Ratio MFA Multi Fiber Agreement NIC Newly Industrialising Country OCP Office Cherifien des Phosphates ODEP Office d'Exploitation des Ports ONCF Office National des Chemins de Fer ONDA Office National des Aeroports ONE Office National de l'Electricit6 ONEP Office National de l'Eau Potable ONPT Office National des Postes et Telecommunications ORMVA Offices Regionaux de Mise en Valeur Agricole (Regional Agencies for Agricultural Development) PAYG Pay-as-you-go PE Public Enterprise PFI Pr6levement Fiscal a l'Importation (A Tax on Imports) PSA Private Sector Assessment QR Quantitative Restriction RAM Royal Air Maroc (The National Airline) SMAG Salaire Minimum Agricole Garanti (Agricultural Minimum Wage) SMIF Societe Marocaine d'Intermediation Financiere SMIG Salaire Minimum Interprofessionnelle Garanti (Non Agricultural Minimum Wage) SNEP A Private Company TAB Taux de Base Bancaire UR Uruguay Round VAT Value-added Tax   KINGDOM OF MOROCCO COUNTRY ECONOMIC MEMORANDUM TOWARDS HIGHER GROWTH AND EMPLOYMENT CONTENTS VOLUME I: MAIN REPORT EXECUTIVE SUMMARY ...................................... i INTRODUCTION ........................................... 1 BACKGROUND .......................................... 1 CHAPTER I: THE MACROECONOMIC FRAMEWORK .................. 4 The Current Situation .......... ...................... 5 Where Morocco Would Like To Be ........................ 6 Employment Effects . ................................. 6 Fiscal Policy ...................................... 7 Public Sector Management ............................. 9 Investment and Savings .............................. 10 The Rural-urban Factor .............................. 11 Monetary Policy .................................. 11 Balance of Payments ................................ 11 The Real Exchange Rate .12 CHAPTER II: INTERNATIONAL TRADE .12 Impact of the Uruguay Round .......................... 13 Protectionist Trade Regime ............................ 14 Agriculture ...................................... 15 Lowering Trade Protection ............................ 16 Fiscal Considerations ............................... 17 Allow Employment and Relative Price Flexibility .............. 17 CHAPTER m: FACTOR MARKETS ............................. 18 A. The Labor Market ................................... 18 The Labor Force .................................. 18 The Regulatory Framework ........................... 20 Minimum Wage Policy .............................. 20 Non-Wage Costs .................................. 21  Hiring and Firing .................... .... .... .... . 22 Efficiency of the Educational and Training Systems . . ......... . . 24 Gender Issues . .. . . . .5. . . . . . .. . .. .. . .. ... . . . . .. . . . 25 Public versus Private ......... . .................... . 25 B. The Financial Sector ........... . ..................... . 26 Structure of the Financial System ........ . .......... . . . . . 26 Size of the Financial System ......... . ............. .. . . 27 Interest Rate Liberalization ......... . ............... .. . 27 Legal and Regulatory Reform of Securities and Bonds Markets ..... . 29 Increase the Use of Indirect Instrument for Monetary Policy ...... . 29 Reduce the Government's Preferential Access to Credit . ....... . . 30 Reform of the Contractual Savings System .... . .......... . . . 31 Opening the Financial System ......... ............. . . . . 32 Bank Supervision ........... . ..................... . 33 C. The Water Constraint ........... . .................... . 33 D. The Land Market ........... . ...................... . 34 CHAPTER IV: PRIVATIZATION AND PROMOTING THE PRIVATE SECTOR . 34 The PE Sector ............. .. .. .. .. .. .. .. ... .. .. . 35 First Phase of Privatization ......... . . . .. . . . . . .. . . . . . . . 35 Next steps ............... ... ... ... ... ... .. ... .. . 37 Infrastructure ............. ... .. ... .. .. ... .. .. ... . 37 The Labor Issue ............ .. .. .. .. . .. .. .. .. .. .. . 38 Public Enterprise Reform ......... .. . . . .. . . .. . . . .. . . . . 39 PROPOSED MATRIX OF REFORMS ......... .. . . . .. . . .. . . . .. . . . . 40 BIBLIOGRAPHY ...................... .... ..... .... ..... . . 42 VOLUME II: ANNEXES ANNEX I - THE MACROECONOMIC FRAMEWORK ANNEX II - INTERNATIONAL TRADE ANNEX LIA - THE LABOR MARKET ANNEX IB - GENDER ISSUES IN THE LABOR MARKET ANNEX IVA - FINANCIAL SECTOR REFORM ANNEX IVB - PENSION SYSTEM ANNEX V - PUBLIC ENTERPRISES AND PRIVATIZATION  EXECUTIVE SUMMARY Introduction 1. The purpose of this report is to identify elements of a medium-term strategy to promote higher sustainable growth in Morocco. Higher growth is essential to improve the living standards of the Moroccan people by creating much-needed employment opportunities. No country has ever made sustained progress in raising employment nor significant progress in reducing poverty without growth. Achieving growth rates of 7-8 percent from Morocco's historical average of 34 percent is possible, though not trivial. It will require the simultaneous implementation of substantial policy changes in many areas. Neither is the employment effect of higher growth trivial. Over the medium-term, the unemployment rate (at 16 percent in urban areas) could fall several points even with labor force partcipation rates rising twice as fast at growth rates of 7-8 percent. At current average growth rates of 3-4 percent, unemployment could rise to about 20 percent even without an increase in labor force participation rates. 2. The last decade in Morocco has been one of mainly adjustment and stabilization. Morocco has made progress: the budget and current account deficits fell from about 12 and 9 percent of GDP in the early 1980s to just over 3 and 1 percent respectively, in 1990. The debt stock to GDP, and debt service ratios fell somewhat from about 100 and 36 percent to about 90 and 21 percent respectively, over the same period while inflation stabilized at around 4-5 percent p.a. Stabilization was accompanied by liberalization of the economy with greater emphasis on private sector-led growth. With the help of the international financial community, these improvements in macroeconomic indicators were achieved while maintaining growth rates of 3-4 percent p.a. on average. 3. However, progress achieved on the stabilization front remains fragile. This fragility is demonstrated by the deterioration of macroeconomic indicators in the first half of the 1990s. Budget and current account deficits have been rising. Debt to GDP and debt service ratios, at just under 70 percent and around 33 percent respectively in 1994, are still high. GDP growth remains extremely vulnerable to weather conditions because of the importance of agriculture in the economy: the period of structural adjustment was not accompanied by diversification of production away from agriculture. Manufacturing growth has not been very high (an average of 3.5 percent in the 1990s), exports are concentrated in low value-added activities, and private investment (at around 13 percent of GDP) and domestic savings (at around 16 percent of GDP) rates remain low. In addition, unemployment is on the rise and around 13 percent of the population lives in poverty and many others live in near-poverty. During drought years these numbers increase significantly. Moreover, under the current policy framework and the changing international environment, the sustainability of the public sector deficit over the medium-term is in doubt. 4. To meet this dual challenge of rising unemployment, and a possible worsening macroeconomic situation, Morocco will need to deepen macroeconomic stabilization efforts and at the same time, implement a series of measures to allow it to achieve higher growth. Specifically, higher growth will depend on Morocco's ability to raise physical and human capital accumulation, to increase domestic savings to finance these investments, to increase factor productivity and efficiency, and to use its natural resources rationally. Over the medium term, overall domestic investment, fueled by rising private investment, will need to rise to about 30 percent of GDP from its current level of around 21 percent. National savings will need to rise substantially to reach roughly a third of GDP with domestic savings at around 27 percent compared to its present level of 16 percent. Moreover, higher rates of investment  ii will need to be associated with increasing efficiency of investment. Export growth will have to be the driving force behind higher investment and sustained growth. 5. This report lays out specific policies that could, as quickly as feasible, achieve these objectives of higher savings and higher and more efficient investment. The strategy is drawn from world-wide best practice, various analyses of the Moroccan economy, and discussions with the Moroccan authorities. To ensure sustained increases in savings, investment and investment efficiency, Morocco's future development strategy will need to be centered around: (i) supporting faster private sector development; (ii) human resource development andpoverty alleviation; (iii) and sustainable use of its natural resources. Essential to the implementation of Morocco's development strategy will be improved public sector management. 6. Faster Private Sector Development. Though Morocco has a relatively strong private sector accounting for over 80 percent of value added, private investment has not grown much during the last decade. Several constraints to private sector development remain. These have been identified in the Private Sector Assessment and consist of underdevelopment of and rigidities in factor markets, legal, judicial, and regulatory constraints (for example, the bureaucratic procedures involved in establishing a new business in Morocco are overly cumbersome; in addition, foreclosure on non-performing business entities is a very slow and difficult process due to underdevelopment of the judicial system, and rigidities in the labor code. Thus both entry and exit costs are very high for private firms.), continued distortions in the incentive framework (such as price controls at the local levels) and a continued preponderance of the public sector in many areas of economic activity. Many of these key issues are covered in greater depth in this report. In addition to the alleviation of the above constraints, further development of the private sector will depend to a large extent on improved public sector management, and a changed role for the Government. 7. Poverty Alleviation. During the period of stabilization, poverty in Morocco declined: by 1991 the percentage of people below the poverty line had fallen to 13 percent from its level of 21 percent in the mid 1980s. However, this improvement remains fragile: an estimated 1.7 million individuals have expenditure levels just above the poverty line. Though overall social indicators have improved in Morocco during the last twenty years, they are still far below achievements in the average lower-middle income country. In addition, there are wide variations in living conditions and welfare indicators among the poor, and between urban and rural areas. As noted in the Poverty Assessment, a two-pronged approach to poverty reduction is needed: (a) higher economic growth is essential as are (b) efficient and well-targeted government expenditures in the social sectors. Progress on this front will have a positive payoff in terms of growth. Efforts to reduce poverty and thus enhance equity will ensure that labor productivity rises along with support for growth enhancing policies. This report concentrates on the policies necessary for higher growth. Other Bank reports, including the Poverty Assessment and the Public Expenditure Review discuss possible targeted interventions. 8. Sustainable Use of Natural Resources. The most pressing concern in Morocco regarding its natural resources is the fast depleting per capita water supply and the degradation of water quality. By the year 2020, per capita water supplies in Morocco are expected to decline by 50 percent and Morocco will be a chronically water-stressed economy. The importance of centralized management of Morocco's water resources in accordance with Government priorities cannot be overemphasized. A National Water Strategy to deal with these issues needs to be developed as soon as possible to ensure that Morocco's growth strategy is sustainable and to ensure that potable water is accessible to both rural and urban  iii populations. The Water Sector Review discusses issues related to water resources in detail. Other issues related to natural resource use include (i) soil erosion, aggravated by overgrazing and deforestation (soil erosion can affect the viability of existing water infrastructure); (ii) air pollution in certain urban areas; and (iii) management of waste. A national environmental action plan, to follow the national environmental strategy needs to be defined and implemented quickly. 9. Under the above framework, the main policy instruments available to the Government to promote higher and more efficient investment as well as a large increase in domestic savings will be (a) greater macroeconomic adjustment, (b) a more open trade regime to access larger markets for Moroccan exports, and to increase competition in the economy, (c) development of the financial sector, (d) labor market reform consisting of faster human capital development, progress in the social sectors, and greater labor market flexibility, (e) policy and regulatory changes to ensure rational use of natural resources, and (f) much greater emphasis on private sector development through privatization, reform of the legal, judicial and regulatory frameworks, and in general by reducing the costs of doing business. These policy instruments are interdependent and will promote the desired objectives best if implemented together. A few of the many strong interlinkages are highlighted below. What Will Policy Refonn in these Areas Achieve? S First, deepened macroeconomic adjustment is essential to the growth of private investment since it will reduce the still substantial crowding-out by the public sector of private investment. Higher public savings is an important part of the effort to raise overall domestic savings to finance investment. Worldwide experience shows that sustained low public sector deficits have been a key factor in promoting private investment. Conservative fiscal management will also improve Morocco's debt indicators and raise its creditworthiness in international markets. Improved management of public sector finances is closely linked to development of the financial sector: current fiscal policies impose an implicit tax on the financial sector and constrain its development. Financial market development can be expected to reduce the cost of Government debt. Fiscal reform (to reduce the budget's reliance on trade related taxes) will also be necessary if Morocco is to sustain further trade reform in order to compete in the changing international marketplace. Reforms to rationalize public expenditure patterns will be necessary to ensure that (a) government resources are allocated (within a tighter envelope) in accordance with medium-term priorities and that (b) essential investments are not cut to meet the immediate goals of deficit reduction. * Second, increasing outward-orientation by liberalizing the trade regime will be necessary to promote new sources of export growth (it will remove the anti-export and anti-labor bias of the current regime) and to access larger markets for Moroccan goods. This will be particularly important in view of the negative implications of the Uruguay Round (UR) international trade agreement for many of Morocco's traditional exports. Neutral trade liberalization (the type that does not discriminate between sources of imports and markets for exports) would be the most effective in increasing the efficiency of production (and investment). Trade liberalization can also have a positive effect on employment and poverty reduction as shown by Morocco's recent experience. Trade liberalization is more likely to raise employment and exports if there is accompanying labor market reform and financial sector reform. * Third, labor market development in Morocco, specifically higher and more efficient investments in human capital formation and the reduction of rigidities in the market will promote growth and  iv employment creation. It will do this first, by raising labor productivity and, second, by enabling labor reallocation to more productive activities. More targeted investments in the social sectors will not only raise labor productivity but will also raise equity. More equitable growth will, as worldwide experience shows, ensure the sustainability of higher growth by ensuring public support for reform. Moreover, labor market reform will reduce entry and exit costs for formal sector firms and thus (a) raise employment and investment, (b) reduce informalization of the economy and the penalization of the most vulnerable and (c) increase Morocco's competitiveness in international markets. The latter is a particularly pressing issue since there will be greater competition for Morocco's traditional exports (textiles and clothing) in international markets, implied by the Uruguay Round. Excessive labor market rigidities can also encourage the use of capital-intensive technology. Labor market reform will, in addition, lower the adjustment costs of privatization and public enterprise reform. * Fourth, financial sectordevelopment will assist in mobilizing investment resources and allocating them to their most productive use. Hence, it will raise both the efficiency and magnitude of investment and overall domestic financial savings. Over time it can lower the cost of financial resources to the Government and facilitate the conduct of monetary policy. An improved allocation of financial resources will make labor reallocation easier. Efficiency raising resource reallocation effects of trade liberalization will be enhanced with financial sector reform. In addition, the success of public enterprise reform and privatization (public enterprises may be sold on the stock market and newly privatized firms will access financial markets) is closely tied to the development of financial markets. * Fifth, faster and bolder privatization and more aggressive private sector development, (through legal, regulatory, and judicial reform) will both boost private investment and raise the efficiency of investment. Privatization will, in addition, help the Government achieve its goal of ensuring a sustainable public sector deficit while enabling the financing of much needed infrastructure to support higher growth. Moreover, it will boost capital market development. It also provides a means of reducing Government debt: privatization receipts should ideally be used to retire debt. Better public enterprise management will help contain the public sector deficit and promote private sector development. _ Sixth, rational use of Morocco's natural resources (mainly water, phosphates, and land) through regulatory and institutional reform will ensure a growth pattern that is sustainable. The Instruments 10. Chapter I: A Prudent Macroeconomic Framework. There are a number of actions that the Government could take to reduce the consolidated public sector deficit. Central government expenditures in Morocco, at about 29 percent of GDP are high relative to comparable countries and should, as a proportion of GDP, be reduced. Generally, wage expenditures are high, particularly relative to recurrent spending on goods and services and capital expenditures. This fact suggests that to reduce overall expenditures, the authorities could consider a freeze of the wage bill in the Government, leading to more comprehensive civil service reform over the longer run. There are many goods and services currently provided by the Government (at a loss) which could be transferred to the private sector. Where public provision remains (either temporarily or indefinitely), cost recovery could be implemented immediately. The Public Expenditure Review (PER) identifies these areas and Chapter IV discusses some options in  v detail. Significant improvements in the efficiency of public expenditures (better intra-sectoral and inter-sectoral allocation) are needed with better targeting to reduce poverty and enhance equity. For example, though expenditures on education at 5 percent of GDP are high relative to other middle income countries, education outcomes do not reflect this level of expenditure. A relatively greater emphasis needs to be put on the provision of basic education. Expenditures on health, though comparable to other middle income countries, could also be better targeted. A longer run issue would be reform of the social security system whose deficits should be counted as part of the overall public sector deficit. This subject is covered in Chapter III. 11. On the revenue side, Morocco's past performance has been promising; particularly in light of the various tax reforms that have occurred including the establishment of the value-added tax (VAT). Trade taxes however, continue to account for a substantial portion of total tax revenues. Given the changes that will be occurring in the international trade arena, this reliance on trade taxes will be neither a feasible nor a desirable alternative in the future. Thus, (a) improvements in non-trade related tax collection are needed; (b) current exemptions (sector specific as well as cross sectoral), such as for the agriculture sector and tax advantages such as for the housing and land markets, should be reconsidered; and (c) an assessment of the VAT system including a possible adjustment in its rates as a transition measure, may be desirable to maintain tax revenues as a proportion of GDP. 12. To support a scenario of high growth, the budget deficit will need to be falling as revenue sources and expenditures are adjusted. During this process, the deficit of the (non-central government) public sector should also decline as efficiency increases due to improved governance and faster privatization. If Morocco continues with economic policies consistent with its historical 3-4 percent average rate of growth, the budget deficit can be expected to deteriorate as a result of (a) the worsening financial situation of the public enterprise (PE) sector, (b) increasing inefficiencies in the expenditures of the government and (c) somewhat lower tax revenues as a proportion of GDP. As a result, it could become unsustainable over the medium-term. The current account deficit will be falling over the medium-term as domestic savings will be increasing. The current account deficit under a low growth scenario would have to be contained by lowering imports and constraining growth in per capita consumption. 13. Chapter II: Interational Trade. As a result of the Uruguay Round of the GATT, Morocco will face increased competition for its main exports to the European Union (EU): textiles and clothing and agricultural products. Currently 86 percent of its textiles and clothing exports and 76 percent of exports in three main agricultural items go to the EU. However, there will probably be gains from increased access to other countries' markets as a result of the UR. The increasing openness of world markets will lead to market and product diversification, greater access to technology and quality improvements over the longer run: an export based growth strategy will have better prospects with a more liberal international environment. 14. To increase its outward orientation, Morocco is currently engaged in negotiations that would lead to the conclusion of a Free Trade Accord (FTA) with the EU. Such an accord would open the Moroccan market to competition from European imports and increase the efficiency of Moroccan production. Morocco already has duty-free access to the markets of the EU for its manufacturing exports, and the FTA will not affect these exports. The trade agreement for agricultural products will be concluded separately from the FTA. Free access in agriculture is only available under full EU membership. This implies that the direct (strictly trade-related) effects of a FTA for Morocco depends on its import market.  vi The net welfare effects of such an accord depend on the relative magnitudes of trade creation (increase in trade volumes), and trade diversion (if Morocco imports more goods from the EU for which the latter is a higher cost producer than other trading partners). There are no other agreements granting special benefits to Morocco which are tied directly to the signing of the FTA. The estimated trade revenue losses of a FTA are high at around 68 percent of 1993 customs revenue. Large trade creation effects would offset these effects. There are, of course, potential gains from a FTA that are not directly related to the volume of trade (these include signalling the commitment of the government to a particular policy path, and increased investor confidence, and improvements in quality). These will also be attainable with non- discriminatory trade liberalization. 15. To encourage new sources of export growth, non-discriminatory reduction of trade protection consisting of lowering tariff dispersion and the overall level of trade protection, (which will lower the current regime's anti-labor, anti-export bias), is recommended. To maximize net welfare gains associated with the FTA, Morocco should also undertake non-discriminatory reductions in trade protection. This could accompany the implementation of the FTA. However, given Morocco's high dependence on trade related taxes (25 percent of total 1993 tax revenues), trade liberalization in general must be synchronized with fiscal reform for it to be sustainable. 16. To avoid high adjustment costs, to raise exports and to maximize employment gains, trade liberalization should also be accompanied by labor market reform. In the presence of labor market rigidities, trade liberalization could result in more unemployment rather than in rising exports especially in the short-run. Contracting firms would release labor, but growing sectors would be more likely to create (more) employment if the current regulatory framework were modified. 17. Chapter III: Factor Markets. A. Labor Market Reform. Labor market rigidities in the form of a high and apparently binding real minimum wage in the formal non-agricultural sector to which are added high social charges and rigid restrictions on worker dismissals contribute to unemployment and slow growth. Worldwide evidence indicates that workers, and particularly the poor, are better protected through increasing employment opportunities, market determined wage increases and low labor market rigidities. Generally, fast employment creation has been followed or accompanied by real wage increases. The efficient provision of basic education, targeted social services and infrastructure could be effective direct interventions to raise labor productivity and equity. 18. Several labor market related actions are suggested. It is recommended that the non-agricultural minimum wage be allowed to fall in real terms, and that the agricultural minimum wage be allowed to increase only in line with increases in agricultural productivity. The 36% gap between the two wages is unwarranted for cost-of-living reasons. Reduction of the differential by a decline in the former will tend to reduce formal urban unemployment both by increasing labor demand, and by reducing rural-urban migration (which is probably higher because the differential is so high). To reduce the disincentive effects of high social charges and to reduce informalization of the economy (which can have negative effects on long-run productivity, and tax revenues), reform of the social security system is needed. This reform will also boost growth through capital market development. Simple economic analysis and empirical observation indicate that overall job creation is not possible without some job destruction and that overly rigid systems can reduce employment growth. They can also encourage the use of more capital-intensive technology by firms than would otherwise be the case. The restrictions on worker dismissals should also be modified: this will enable firms to more easily adjust to the skill mix desired for their operations and encourage employment creation, as incentives change with trade liberalization.  vii Greater flexibility in the labor market will also enhance Morocco's competitiveness in international markets. 19. Human capital development in Morocco requires improvement if the labor force is to support higher growth. Morocco has a very low literacy rate at around 49 percent (38 percent for women) and low enrollment rates (only 55 percent). However, Government expenditures on education at around 5 percent of GDP are high compared to other middle income countries with higher literacy rates. Inefficiencies in public expenditures, if corrected, could lead to substantial improvements in educational achievement. One suggestion is to reallocate Government expenditures on education toward basic education and to increase overall expenditures in this segment. It is particularly important that progress is made in educating women in rural areas for whom literacy rates are the lowest. There are significant externalities associated with educating women in terms of the positive effects on labor productivity, family health, reductions in fertility and environmental protection. While overall increases in enrollments and literacy are the best way to raise female literacy, in conjunction with these, more targeted interventions are needed. 20. There is an apparent mismatch in the demand for, and supply of, various skill types in the labor market. At present, much of the job-related training in Morocco is publicly provided; the evidence indicates that there is under-provision of training by the private sector. Much greater private sector provision of/participation in training should be encouraged. As a first step, the mandatory payroll tax used to finance public sector provision needs to be revised and private provision encouraged. Steps should be taken to facilitate the growth of private training institutes hy levelling the playing field between the private and public sectors. These could include setting up an independent certification council, recognizing equivalency with public training institutes and equal tax treatment. These measures would enhance the quality and increase the supply of much-needed technically trained (middle management) labor. The expenditure of public resources on vocational training and public management of this training should be reassessed. This training does not seem to increase employment opportunities for most recipients and only seems to significantly affect opportunities for employment in the public sector. 21. B. Financial Sector Development. To support the high growth scenario, financial policy in Morocco should be geared towards promoting the provision of services essential to accelerated private sector activity. These services include (a) the provision of information on the productivity and riskiness of alternative investments (through market determined interest rate changes, and stock market prices, for example), (b) the provision of instruments to help firms and individuals hedge against the risks of investments (such as a forward foreign exchange market or well developed stock and bond markets), (c) the mobilization of resources from a multiplicity of savers (small and large) to finance investments, (d) lowering the costs of transactions for investors (by pooling resources for the economy and by providing information, for example), and (e) (within a well-designed regulatory system) improving corporate governance through the provision of credit on the basis of firm and project quality. 22. The main elements of financial sector reform should be the following: (a) liberalization of interest rates, to allow financing of riskier (often small and medium enterprises) investments by raising the expected returns, and to signal market developments; (b) the promotion of the capital market, (notably stock and bond markets), through the adoption and implementation of the necessary legislation, will help mobilize resources for investment; (c) the increasing use of indirect instruments for a more efficient conduct of monetary policy; (d) the elimination of the government's preferential access to credit which will reduce taxation of the financial system and the private sector, and (e) allowing capital account  viii convertibility, in order to provide investors with the best possible financing choices and risk-hedging mechanisms. Moreover, (fJ the promotion of institutional savers will help mobilize financial savings and promote capital market development. Pension system reform will be particularly important in this respect since it will help reduce labor market distortions and also reduce the drain on Govermnent resources. As the financial sector develops (g) bank supervision will need to be strengthened. It is important that all financial sector reforms, to be sustained, be conducted in the context of a sound macroeconomic framework. 23. Chapter IV: Privatization and Private Sector Development. The higher growth path requires a substantial change in the role of the Government. Its main role should be to support private sector led growth rather than to be involved directly in productive activities. The public enterprise (PE) sector still accounts for about 20 percent of GDP, higher than in most middle-income countries. To accelerate growth, Morocco will need to move faster on privatization of public enterprises, in reform of the regulatory system to promote private sector development and towards better public sector management. In addition, the revenues from privatization should be used to finance debt reduction, rather than to finance additional current expenditures. Privatization represents asset sales. Selling assets to support current expenditures, while postponing necessary adjustments in expenditure patterns is an unsustainable strategy. 24. The first step is to complete the privatization of the 112 PEs on the first list of privatizables. The second step is to privatize the remaining PEs in industrial and commercial activities. The Government could also take measures to increase the participation of the private sector in the management, financing, and especially the ownership of infrastructure firms. To encourage greater private sector participation the Government would need to simultaneously provide an appropriate competitive and regulatory framework. The approach that has been initiated in energy and water distribution should be extended to the telecommunications, mining, port and transport sectors and industrial branches of the phosphates industry. In addition, it is essential that the regulatory and supervisory framework for those PEs, or parts of PEs, that will temporarily or indefinitely, remain under state control, be overhauled. Inter-enterprise, and PE-government arrears will need to be cleared to complement reform of the regulatory framework. Under the current regulatory framework, the financial condition of many PEs has been deteriorating and the public sector deficit could worsen substantially as a result.  INTRODUCTION 1. The purpose of this report is to identify elements of a medium-term strategy to promote higher growth in Morocco. Higher growth is essential to improve the living standards of the Moroccan people: it will create much-needed employment opportunities and it will make Morocco's social objectives easier to fulfill. Improvements in social conditions will in turn, ensure that growth is sustainable over the longer-run. Lack of concerted action at this time and continuation of past policies could lead to a worsening and eventually unsustainable macroeconomic situation as well as to higher unemployment rates over the medium term. 2. To address the goal of achieving higher growth this report focusses on four critical cross-sectoral issues: (a) the importance of a more prudent macro-economic framework to raise domestic savings and to encourage private investment; (b) increasing growth in international trade and the importance of an outward orientation in gaining access to larger markets and in raising product and factor market efficiency; (c) factor markets: ensuring that labor, financial and natural resources are allocated efficiently so that productive domestic investment rises (as well as savings) and provides increasing employment opportunities; (d) continuing privatization of the large public enterprise (PE) sector and promoting the private sector through regulatory reform to raise efficiency in production, to ensure that investments crucial for the acceleration of growth are funded and to achieve a better allocation of scarce government resources in essential areas. BACKGROUND 3. The Challenge. To raise growth rates in the medium term in Morocco to an average of 7-8 percent p.a. from its historical average of 3-4 percent p.a. is not trivial. It will require time, concerted action on a variety of fronts and interim adjustment costs. However, the impact on employment generation over the medium-term would be significant; given the existing high urban unemployment rate (16 percent), the pressing need to improve social conditions, and its natural resource constraints, Morocco must strive to move towards this goal. Failure to do so will exacerbate current problems and make changes harder to implement down the road. 4. The past decade in Morocco has witnessed a great deal of progress in the area of macroeconomic stabilization with budget and current account deficits falling from 12 and 9 percent of GDP in the early 1980s to about 3 and 2 percent of GDP in the early 1990s, respectively. Morocco increased its outward orientation and manufacturing exports grew in importance relative to traditional exports (mainly phosphate based). Manufacturing exports in real terms have grown at an average of 4 percent p.a during the early 1990s; real growth is much lower if 1990 is excluded, due to the recession in the EU." The increase in employment related to rising exports, growth in GDP per capita, as well as government efforts to reduce poverty have resulted in better living standards for its population so that the percentage of people with average consumption below the poverty line has fallen from 21 percent in 1984/85 to 13 percent in 1990/91. 5. However, the stabilization and adjustment achieved remains fragile as demonstrated by the deterioration of macroeconomic indicators in the first half of the 1990s with budget and current account deficits rising, and as demonstrated by continuing high debt to GDP and debt service ratios at just under Real growth in manufactured exports was 24.4 percent in 1990 but dropped to 2 percent in 1991 and -8.4 percent in 1992.  - 2 - 70 percent and around 33 percent respectively in 1994. There has been little diversification in the production structure of the economy; GDP growth remains extremely vulnerable to weather conditions due to the extreme variations in agricultural output and the relatively large share of agriculture in GDP. The public sector continues to play an important role in many sectors. Export growth in the manufacturing sector has come from low value-added activities and in sectors for which, in the new international environment of the Uruguay Round, future growth seems unlikely. In addition, the overall levels of domestic savings and investment remain low at 16 and 21 percent respectively in 1994. 6. These facts suggest that the first policy priority, as Morocco moves towards higher sustained growth, will need to be a substantial deepening of past stabilization efforts. The public sector deficit will need to reduced and the Government's role in the economy will need to be changed further: along with better public sector management there will need to be a greater focus on the social sectors, such as education and health. This will need to be complemented by further structural reform in key areas. 7. The Determinants of Higher Growth. Higher growth in Morocco will depend on faster total factor accumulation, i.e. higher rates of investment and human capital formation, as well as on increases in total factor productivity.3' Empirical evidence demonstrates that there exists some key elements which can affect factor accumulation, factor productivity and growth. First, cross-country work has demonstrated the overriding importance of prudent macro-economic management to growth. Macroeconomic stability and in particular sustained small budget deficits (and preferably surpluses) play a significant role in raising domestic savings and in signalling the Government's commitment to reform. (Chile and Thailand for example, both fast growers, have preserved persistent budget surpluses in the after reform period). While Morocco has undertaken significant macroeconomic adjustment and as a result has attracted significant foreign investment, recent economic developments indicate that progress in this area remains fragile and needs to be deepened. 8. Most countries that have grown in the post-reform period have undertaken structural reforms in various areas along with macroeconomic stabilization. One such area is the financial sector. Cross- country work has also demonstrated that there exists strong correlations between growth and financial sector development. In fact, financia' sector development has been found to be a robust predictor of long-run growth.4' Financial sector development entails both deepening and liberalization of financial markets and the implementation of a suitable regulatory and supervisory framework. While Morocco has begun financial sector reforms, a great deal remains to be done to ensure a financial system capable of supporting and promoting high growth. The financial sector plays an important role in improving the allocation and magnitude of investment and savings, and in influencing the success of nonfinancial policy reforms (trade and price liberalization, fiscal and public enterprise reform; pension reform can also reduce 21 For example, the growth rate of real GDP was -4.4 percent in 1992, -1.1 percent in 1993 and 11 percent in 1994 due to variability in agricultural output. Growth rates for agriculture were -36 , -6.2 and 65 percent respectively. The share of industry in GDP remains around its level in the early 1980s at about 30%. The fast-growing East Asian economies has demonstrated that in fact factor accumulation (both labor and capital) has been an important source of growth and in many cases have been more important (even in the manufacturing sector) than increases in total factor productivity. See Alwyn Young (1993). See bibliography for various cross-country studies on policies affecting growth.  labor marker distortions). It has also been associated with falling costs of capital, and increased access to private international capital."' 9. 7he East Asian experience, as well as general country experience, has demonstrated the importance of human capital in promoting growth. In fact, some studies cite the initial conditions related to higher literacy/education levels (which also raised equity) as the single most important factor contributing to higher growth. This underlines the necessity of preparing the labor force as well as the labor market for growth in Morocco by investing directly in human capital and by facilitating labor mobility and employment growth. Country experience has also shown that growth that is shared, for example, through efficient investments in health, education and social services, tends to be sustainable while rising inequalities in the standard of living will be an obstacle to growth (often due to low labor productivity and thus low labor mobility and rising social tensions). Morocco needs to make a greater effort in the development of human capital and in the social sectors in general. One way to achieve greater efficiency in human capital formation would be through the reorientation of government expenditure priorities6' and a better public-private mix in the provision of training and education. It is important to ensure that at the very least, the income distributional consequences of the policy framework (of which government expenditure is an element) is not regressive in the long-run. 10. Efficient allocation of labor and therefore more productive use of the labor force requires labor market flexibility. Most countries that have sustained high income and employment growth have done so by promoting labor mobility and market based pricing for labor. Income growth has first been followed predominantly by employment growth and then by wage growth (which of course has also been tied to the rising skills of the labor force). Greater labor market flexibility can raise investment rates by reducing the entry and exit costs of investment; it also can mitigate the adjustment costs related to privatization and public enterprise (PE) reform. i1. Trade reform, of the non-discriminatory kind, has also been undertaken by many countries that have successfully stabilized and raised their growth rates. In fact, empirical studies have shown that low distortions in international trade are positively correlated with growth and in fact, high levels of international trade are positively correlated with investment. Chile and Thailand are examples of countries where trade reform has led to a spectacular rise in trade volumes; Argentina and Poland are examples of countries where more recent trade reform is having strong results on trade volumes. Increasing outward orientation not only raises efficiency in production but will also provide a large market for Moroccan exports. Though Morocco has liberalized progressively over the last few years, far deeper policy reform is needed to encourage new sources of growth and to compete effectively in the new international environment of the Uruguay Round (UR). 12. Increasing reliance on the private sector for the provision of goods and services, accompanied by large reductions in public spending, privatization, and the establishment of a legal and regulatory framework conducive to the growth of private business (including streamlining of business regulations)7", 5/ The experience of Latin American countries provides a good example. 6/ See "Kingdom of Morocco,- Preparing for the 21st Century- Strengthening the Private Sector in Morocco", (PSA), Public Expenditure Review, (PER), and Costs, Efficiency and Financing of the Education System- MOR. 71 See PSA for details.  - 4 - has also characterized successful reformers. An increase in the magnitude of private investment both in absolute terms and relative to public investment has been associated with improvements in the efficiency of investment both during and after reform. Moreover, privatization can provide a significant boost to capital market development as Morocco's initial experience and that of other countries (such as Chile and Argentina for example) has shown. Many countries have successfully used the proceeds of privatization to enhance long-term fiscal adjustment by reducing public sector debt. Argentina is a good example of this. Such a policy increases fiscal flexibility, essential in Morocco, where increased attention to social priorities is needed. Privatization and private sector development in general would provide the means to finance essential investments in infrastructure to support higher growth in Morocco.8' 13. Each of these main areas of reform are essential inputs to an entire policy package. Accelerated growth will require the simultaneous deepening of reform in these areas since many of the policies suggested are either complementary or interdependent. For example, trade reform will not be sustained in Morocco without fiscal reform. The success of trade reform in reallocating factors will depend on development of the financial system and labor market. Labor market development through faster human capital formation will make Morocco better able to compete in the international arena. Financial sector reform which will aid labor reallocation will to some extent depend on fiscal reform. The efficient conduct of monetary policy depends on financial sector development which in turn will promote privatization, and private sector development. Labor market reform will also reduce the costs of unemployment related to privatization, and will lower the entry and exit costs of private firms. 14. Changes in the policy framework are often accompanied by adjustment costs in terms of temporarily falling output or increasing unemployment. Morocco's past adjustment experience did not, on average, result in either (partly due to the aid provided by the international donor community). The implementation of a comprehensive reform package would help in reducing the duration as well as the magnitude of possible adjustment costs in Morocco. CHAPTER I THE MACROECONOMIC FRAMEWORK 15. Conclusion. The essential elements of higher sustained growth will be more efficient and increased investment and productivity increases which will raise output, particularly exports. To finance this, higher domestic savings will be necessary. A stable, rational macro-economic framework with greater attention to decreasing the public sector deficit will be essential to both elements, as will policy changes in product and factor markets.9' To accelerate growth the most important prerequisite will be a prudent macroeconomic framework. Specifically, past stabilization efforts need to be deepened so that the public sector deficit reaches a surplus over the medium-term in order to raise domestic savings and To ensure the success of its policy framework, Morocco must strengthen its legal and judicial framework. For greater detail, see PSA. There are several policy reforms focussed on private sector development that have been developed in the PSA; not all of these reforms are discussed in detail here.  promote private investmnent. Such a scenario will require cuts in the overall government expenditure to GDP ratio, and an increase in the efficiency of expenditures within the reduced envelope as noted in the Public Expenditure Review (PER) including a more rational structure of capital expenditures. Rationalization of expenditures will increase the government's ability to safeguard essential investments in the face of deficit reducing expenditure cuts. In this regard, expenditure allocations should ideally be determined within a multi-year framework and in accordance with government priorities over the medium-term rather than in annual allocations. The maintenance of revenues as a proportion of GDP through better tax collection, the adoption of a regulatory framework which will encourage the formalization of production (and raise the tax base), and the implementation of various measures to rationalize the current tax structure will also be required. To ensure consistent implementation of a forward-looking macroeconomic strategy, the current management of public finances needs to be strengthened and decentralized. The consolidation of expenditures and revenues for all levels of government would help in determining total financing needs. The maintenance of the current strategy towards public sector finances could eventually lead to an unsustainable fiscal balance and continued crowding out of the private sector. 16. Key Objectives: (a) Reduce Expenditures as a Proportion of GDP; the overall level of expenditures seem to be high relative to other middle-income countries including the fast-growers; (b) Increase the Efficiency of Public Expenditures Within a Reduced Envelope generally in line with the recommendations made in the Public Expenditure Review (PER) and by conducting a review of the investment budget and implementing multi-year programming of expenditures. This will involve the redirection of expenditure, towards the social sectors with better targeting towards the poor within the sectors. Improving social indicators can help sustain growth by raising the productivity of labor (by improving literacy, health and nutrition indicators) and by helping to maintain social consensus for reform; (c) Reconsider Present Tax Exemptions and Improve Tax Collection partly by reducing incentives to greater informalization of the economy; (d) Improve Management of Public Finances by adopting a medium-term framework in allocating expenditures and implementing decentralization of Government. 17. The Current Situation. As Table 1 shows Morocco has reduced its budget and current account deficits since the early eighties. During this process of stabilization, growth rates were on average positive and of the order of 3-4 percent p.a. Inflation has also fallen from its level in the 1980s. However, both budget and current account deficits have increased during 1993-95. In addition, Morocco remains a highly indebted country: the debt to GDP ratio is just under 70 percent in 1994-95 and debt service around 30 percent. Investment as a proportion of GDP remains low as does domestic savings. GDP growth has been very volatile in the 1990s due to changing weather conditions and has contributed to the deteriorating budgetary situation. The average growth rate during 1990-94 has been about 3.3 percent; (2% if 1995, a bad drought year, is included). The average growth rate of merchandise exports has been over 4 percent, unless 1990 is excluded (growth was high in 1990 and made up for the sharp decline in 1989) when it falls to under 2 percent p.a. partly due to a recession in the EU. (In fact the growth rate of manufactured goods exports between 1991-94 was -0.9 percent).  - 6 - Table 1. Historical Macroeconomic Indicators Averages Actual 1980-1983 1984-1987 1988-1992 1992 1993 1994 Rates of Change (% p.a.) Gross Domestic Product 3.6 4.7 3.9 -4.4 -1.1 11.5 Agriculture -0.7 10.3 1.8 -36.0 -6.2 63.0 Industry 1.6 2.6 3.4 1.9 -2.0 2.3 (0/w manufacturing) 3.8 3.9 4.4 1.8 -1.5 2.0 Services 6.3 4.1 4.7 5.1 0.7 4.3 Exports of GNFS" 4.4 4.6 4.0 0.9 4.8 5.1 Imports of GNFS -1.8 4.8 7.3 7.7 0.4 4.8 Ratios to GDP (%): Gross Investment 25.6 24.1 23.1 22.7 21.2 21.0 Domestic Savings 13.5 16.5 18.3 16.2 15.7 15.9 National Savings 16.1 20.3 22.0 21.1 19.1 18.7 Current Account Balance -9.6 -3.7 -1.1 -1.6 -2.0 -2.3 Government Revenue 21.6 20.3 23.7 26.4 27.6 24.1 Government Expenditure 33.8 29.2 27.6 28.6 30.0 27.2 Fiscal Deficit, commit. basis -12.2 -8.8 -3.9 -2.2 -3.3 -3.8 ICOR (5 years) 5.2 6.1 4.7 5.8 14.7 6.5 External Debt Burden (%): Debt Outstanding (DOD/GDP)w 74.6 113.0 85.7 74.6 80.5 68.3 Debt Service (TDS/XGS)v 37.7 31.3 25.7 23.3 30.4 32.6 Inflation (GDP deflator) 8.0 8.1 5.1 4.5 3.8 2.7 Real Effective Exchange Rate - 114.4 102.6 104.1 105.1 107.9 (1990= 100) Real GDP per capita (in 1980 US$) 958 1021 1120 1097 1063 1162 i/ GNFS denotes Goods and Nonftctor Services; 2/ External debt includes MLT, IMF, and short-terrn; 3/ XGS denotes export of goods & services; includes workers' remittances. 4/ This is the IMF's definition and is obtained from the International Financial Statistics 18. Where Morocco Would Like to Be. Table 2 shows two possible paths that Morocco could follow in the future depending on the policy framework adopted. The high case scenario is based not only on improved management of public sector finances (a budgetary surplus, improving debt indicators, better budgetary procedures) but also the implementation of various structural reforms discussed elsewhere in the report. These include the structural reforms suggested for the financial sector, the labor market, international trade, the PE sector, and the establishment of a regulatory, legal, and institutional framework conducive to private sector development. These reforms will be essential to raise investment, and savings to the levels necessary for higher growth (see para. 25 for discussion). The low case scenario is based on the continuation of the existing policy framework. The numbers in the low case scenario indicate that, if present policies continue, the budget deficit could continue to grow with increasing crowding out of the private sector. This will eventually lead to an unsustainable situation.'0' 19. Employment Effects. Estimates show that only under a high growth scenario of the type envisaged here, can Morocco achieve substantial reductions in unemployment. If Morocco continues on ID/ Annex I has details.  - 7 - its historical growth path of 3-4 percent on average p.a., the rate of unemployment can be expected to worsen considerably. The current rate of unemployment at 16 percent in urban areas would probably rise to over 20 percent by the end of the decade even without rising labor force participation rates. However, it could decline several points under the high growth scenario even with labor force participation rates rising twice as fast over the medium-term. "' 20. Fiscal Policy. To provide a boost to private investment, and to raise public savings, the consolidated public sector deficit would need to be falling over the medium-term and the Central Government deficit would need to move towards a surplus. A lower public sector deficit will be associated with reduced crowding out of the private sector and will also signal the continued commitment of the Government to reform. The experience of other countries suggests that the magnitude of the budget deficit is important for investment. (Both Chile and Thailand for example had budget surpluses during and after reform and have high private investment rates). A budgetary surplus will allow debt indicators to improve: this will also encourage private investment. Moreover, the current fiscal policy of the Government could, over the longer run, lead to an unsustainable public sector deficit, currently estimated at 4-5 percent of GDP (a lower bound), particularly if (a) revenues are not maintained as a proportion of GDP due to declining trade taxes, (b) expenditures do not fall and (c) the financial conditions of PEs, of the local governments and of the public social security system worsen.'2' 21. On the expenditure side, several measures to raise efficiency have been noted"'. Central Government expenditures at 29 percent of GDP are high in Morocco relative to comparable countries including the fast growers, and expenditures as a proportion of GDP will need to be reduced. Under a high growth scenario, overall expenditures are assumed to decline to about 24 percent of GDP over the medium-term. Greater reductions in expenditure will be needed however, if revenues fall more than assumed (see below). Key measures include reduction of the high wage bill of the government (which amounts to about 10 percent of GDP; non-wage recurrent spending is low by international standards. In the past decade the drop in overall expenditures has been borne mostly by reductions in non-wage recurrent spending and capital expenditures), implementing cost recovery for publicly provided goods and services, and reducing the size of the public enterprise sector by encouraging the private provision of many goods and services currently produced solely or primarily by the public sector. Increased efficiency of expenditures within sectors will also be needed. For example, public expenditures on education and In times of high unemployment, there are many who are not counted as unemployed since they have stopped searching for jobs. However, as times improve, they can be expected to re-enter the labor force; this will prevent the unemployment rate from falling as fast as would be expected in the absence of such a reserve labor force. The rural unemployment figures are very low at about 5 %; however there is a lot of under-employment (estimated at around 20-25 % on average in a normal year. This number is higher during drought years) and disguised unemployment in rural areas. See Poverty Assessment (PA). 121 Current projections of the viability of the financial condition of the two main social security organizations in Morocco indicate insolvency over the medium-term. Pension system reform is discussed in Chapter III and Annex IVB. Chapter IV deals with the financial condition of PEs. It is not possible at this stage to determine the implicit debt of the government resulting from the current pay-as-you go system of social security though this number should ideally be added to the public sector deficit cited above to get a true picture of the overall deficit. 13/ See PER for details.  - 8 - health would need to be better targeted to the poor.'4' III In addition, to pursue a high growth scenario, goverrnment expenditures will need to be directed relatively more towards capital expenditures (to provide investments complementary to private investment) and away from current expenditures within the reduced envelope. Rationalization of the public investment program will thus be necessary to improve the efficiency of government expenditures. Table 2. Key Macroeconomic Indicators Medium-Tenn Outlook and Resource Allocation lHigh Case Scenario Low Case Scenario 1995 1996-2000 2000-2003 2004-2005 1996-2000 2000-2003 2004-2005 Rates of Change (% p.a.) Gross Domestic Product -5.1 5.2 6.1 7.5 4.2 3.8 3.8 Agriculture -36.5" 9.1 4.0 4.0 8.9 3.5 3.5 Industry 3.8 6.3 8.6 9.0 4.1 4.2 4.2 (0/w manufacturing) 4.0 7.4 9.5 10.0 4.0 4.0 4.0 Services 1.8 3.6 5.4 7.6 3.0 3.6 3.7 Exports of GNFS' 4.8 7.9 8.8 8.9 4.8 5.0 5.1 Imports of GNFS 8.6 5.6 7.0 6.7 3.7 4.0 4.2 Ratios to GDP (%): Gross Investment 21.6 24.5 28.3 31.8 21.8 22.5 22.1 Domestic Savings 1S.0 18.1 23.2 28.0 15.8 17.5 18.1 National Savings 18.3 22.4 27.3 31.0 18.4 19.4 19.3 Current Account Balance -3.4 -2.2 -1.1 -0.8 -3.5 -3.1 -2.8 Government Revenue 24.4 23.6 24.2 24.1 22.9 22.9 22.9 Government Expenditure 28.6 25.8 24.3 23.6 27.5 27.4 27.2 Fiscal Deficit, commit. basis -4.2 -2.2 -0.1 0.5 -4.7 -4.5 -4.3 ICOR (I year) -4.0 4.7 4.3 4.0 5.6 6.2 6.2 External Debt Burden (%): Debt Outstanding 69.8 58.7 46.6 37.2 54.4 44.0 36.3 (DOD/GDP)" Debt Service (TDS/XGS)4' 26.5 22.7 21.2 18.2 25.5 28.7 29.6 Inflation" 5.6 2.6 2.0 2.0 5.7 6.2 7.0 Real GDP per capita (1980 US$) 1082 1224 1388 1621 1194 1275 1362 1/ The numbers for 1995 reflect policy adjustments that should be made under the high case scenario. The figures for the fiscal deficit do not include privatization receipts; 2/ GNFS denotes Goods and Nonfactor Services; 31 External debt includes MLT, IMF, and short-term; 4/ XGS denotes export of goods & services; includes workers' remittances. 5/ The inflation figure is derived from the GDP deflator. 22. Revenues at around 24 percent of GDP (they have fallen somewhat due to recent changes in the tax regime) are high in Morocco compared to other fast growers (for example Thailand at 19 percent and 141 Expenditures on health in Morocco at I % of GDP are low compared to other middle-income countries and are also skewed towards the richer in society. 15' Central government investment in the social sectors should increase overall relative to other sectors.  - 9 - South Korea at 17 percent). Under a scenario of increased trade liberalization, Morocco could face substantial trade-related revenue losses.'6' Morocco has undertaken tax reform in the last decade with the introduction of a value-added tax (VAT) and the lowering of various income taxes; though tax collection has improved and tax reform was implemented without revenue losses, this was partly aided by supplementary taxes imposed on external trade. Given the developments in the international trade arena the heavy reliance on trade-related taxes will be neither a feasible nor a desirable alternative. Continuing improvements in tax collection will be needed as will a re-evaluation of the tax system. Simplification of the various investment codes and eliminations of some tax exemptions may need to be considered to boost revenues. For example, the implicit subsidy for agriculture (which is tax exempt) may not be justified either on economic grounds or for poverty alleviation reasons.'7' Similarly for taxes in the housing and land markets. In addition, as a temporary measure, an upward adjustment in the VAT may be an option to consider to replace trade revenues.'8' Unification of the various investment codes and simplification of business procedures, labor market reform and greater private sector development can play an important role by encouraging the formalization (for tax purposes) of production and employment and by broadening the tax base. 23. The privatization of a large part of the PE sector should have a beneficial effect on public finances on two fronts: future loss-making investments will be avoided by the government and revenues will be generated for the Treasury. Receipts from privatization if used to reduce the debt stock will enable the Government to further improve debt indicators. Financial sector development, while temporarily increasing the costs of borrowing for the Government will, in the long-run, allow more flexibility in the financing of fiscal deficits, and lower the cost of borrowing for the Treasury, as evidenced by the experience of many Latin American countries that have undertaken financial sector reform. Improvements in the overall management of public finances will in turn be needed to complement financial sector reform. 24. Public Sector Management. The current system of public finance management hinders the efficient allocation of expenditures in Morocco. First, management within the central Government is over-centralized. Expenditure decisions for each ministry are decided a priori and individual expenditures must be approved. Second, local governments do not have control over expenditures due to lack of effective decentralization. Third, a definition of medium-term priorities is lacking (and thus hinders continuity in fiscal policy) in the allocation of expenditures; financing for longer-run sectoral objectives is determined on an annual basis and is too dependent on year-by-year ad hoc deficit containment attempts. Fourth, the current management of PEs does not ensure efficient resource use. To promote greater efficiency in the allocation of Government resources and to ensure continuity in the financing of activities in accordance with Government priorities, it is recommended that the budgetary process be made more flexible. One suggestion would be to prepare 3-4 year investment programs. The same strategy would be required for recurrent expenditures. Efficiency in decision making would be increased if there were effective decentralization of Government. This can be implemented only gradually and will require the strengthening of the administrative capacity of local governments and the implementation of 16 Trade taxes are very distortionary sources of revenue and should in any case, be replaced by less distortionary taxes. 171 A very rough estimate of the possible revenue gains from eliminating the tax exemption for agriculture was provided in the PER at 1-2 percent of GDP. Similarly for the housing sector at .2-.7 percent of GDP. 18/ However, this is one possible option and the tax system should be reviewed before any action is taken.  - 10 - an efficient resource transfer system to local Governments from the central Government. The regulatory system governing PEs will also need to be overhauled to reduce the drain on Government resources. (See Chapter IV on PE management issues). 25. Investment and Savings.'9' To support high growth there must be a significant increase in both investment and savings in Morocco. Gross investment at around 21 percent of GDP, and private investment in particular at just over 12 percent, is low compared to fast growing countries even though Morocco's reform program began several years ago. In addition to an increase in overall investment, a shift in investment from the public to the private sector will be needed. "'To boost private investment a substantial deepening of reform is needed. One of the key ingredients is a much tighter budgetary policy aimed at near balance to reduce crowding out and to signal Government commitment to continued reform as mentioned above. Other elements that will encourage increases in the magnitude and efficiency of private investment include (a) levelling the playing field between the public and private sectors in all sectors of the economy, and accelerating privatization, (b) reform of the legal, judicial and regulatory systems, and generally reducing the cost of doing business (including excessive administrative requirements; these will also encourage formalization of the economy and have been detailed in the Private Sector Assessment), (d) reducing entry and exit costs of private businesses (such as by increasing labor market flexibility, privatization) (e) providing a competitive environment, and access to larger markets (such as by trade liberalization), (f) allowing better allocation of resources and better risk management through financial sector development, (g) improvements in human capital formation through more efficient public sector provision and encouragement of private provision of education and training;21' (h) the substantial development and maintenance of infrastructure through higher private sector provision (privatization, foreign direct investment) and a redirection of central government expenditures towards capital expenditures and away from current expenditures to complement private investment. These reforms should raise foreign direct investment (FDI) as well, which in turn could raise productivity by contributing to inflows of foreign technology. The implementation of the entire package of reforms will be important to raise private investment to 20-22 percent of GDP over the longer run; together they will not only signal the commitment of the Government to sustained liberalization but also raise the returns to investment. This ratio would be comparable to that in many countries which have sustained high growth rates (some examples are Chile and Malaysia). Increases in private investment in this scenario can be expected to be associated with productivity gains and a falling ICOR. (Many countries have shown significant improvements in productivity during and after reform leading to low ICORs, for example Chile at 3 and China at 3.7). 26. Domestic savings are very low in Morocco at around 16 percent of GDP and particularly so compared to fast-growing countries. The reduction in the total public sector deficit, and eventual balance in the Treasury budget (and the corresponding increase in public savings) should have a significant positive effect on domestic savings. Private savings will also be boosted by income growth and lower unemployment. In addition, financial sector reform, by changing the incentive structure for financial intermediaries and by increasing confidence in the financial system should increase domestic financial 19! Details of the macroeconomic background, and growth under a low and high case scenario are in Annex 1. 20/ The ratio of public to private investment in Mcrocco is high relative to other middle-income countries and particularly the fast-growers. Annex I has details. 211 Many of the issues which are not covered in the CEM in detail, particularly pertaining to legal, administrative and regulatory obstacles to private sector development, have been covered in the Private Sector Assessment.  - 11 - savings. Financial intermediaries will become more aggressive resource mobilizers and promoters of savings through capital market development, interest rate liberalization, reduction of preferential credit to Government, and reform of the contractual savings institutions. Direct action to reach savers, particularly small savers can also help (such as the development of the postal savings system). As the performance of the financial sector improves, as income grows, and as active policies to attract savings in financial institutions are undertaken, domestic savings are expected to increase as a proportion of GDP. At around 31% of GDP, national savings would be comparable to that in many fast-growing countries (all the East Asian countries for example). (See Table 2). 27. Under an accelerated program of privatization, improvements in the fiscal position of the overall public sector, financial sector, labor market and trade reform, FDI is expected to increase to reach about 3 percent of GDP over the longer-run (comparable to the level in Thailand though much below that for Malaysia). However, even if FDI remains below this level under the high growth scenario, Morocco could borrow more externally to finance its expenditures and still maintain debt indicators at an acceptable level. 28. The Rural-urban Factor. Development and growth has historically entailed redistribution of factors from lower to higher productivity activities, generally a move away from agriculture to industry, and increasing urbanization. In Morocco too, the agriculture sector as a percentage of GDP can be expected to fall. Efficiency increases and technological improvements may lead to faster and more intensive growth in agriculture (e.g., through the development of drought-resistant varieties of crops)' than in the past but slower growth relative to industry and services, which can be expected to rise as a proportion of GDP. These changes need to be accompanied by appropriate government policies in rural areas regarding social infrastructure and the regulatory framework in agriculture. Any increases in agricultural value-added must come under market conditions and keeping in mind Morocco's very serious water constraint if it is to be part of a sustainable growth strategy. The future of irrigated crops and the net additional benefit from investments in irrigation need to be reconsidered. Currently, the incentive structure, including trade policy in agriculture is very distortionary." Sustained, efficient growth and alleviation of poverty in the rural sector will not be possible as long as this prevails. 29. Monetary Policy. Monetary growth in Morocco has been conservative leading to low inflation at around 4-5 percent in the early 1990s; the continuation of similar policies will be important for the growth of investment and savings. Financial sector development will facilitate the conduct of monetary policy by providing the authorities with indirect instruments and lessening their reliance on direct controls on the financial sector. 30. Balance of Payments. Increasing outward-orientation should have positive effects on exports and on the composition of exports. Growth in manufacturing exports and services is expected to average 8-9 percent p.a. in the longer-term as trade reform reduces the anti-export bias and macro-stability promotes investment. Increasing integration with the international community should also promote the tourism sector. (The share of agricultural products is expected to decline as the country diversifies under a high 22/ See Agriculture Sector Strategy Paper-MOR for details on modernization/productivity enhancement of agriculture. 231 For example, agricultural products (e.g. oilseeds) that use water intensively, may not be profitable to produce once trade reforms are underway and price distortions in the economy are corrected.  - 12 - growth policy regime). Trade liberalization and rising investment needs will be associated with rising imports particularly, of investment goods and the trade balance can be expected to deteriorate somewhat in the short-run. 31. The Real Exchange Rate. The Moroccan dirham is pegged to a basket of currencies. Since 1990 the real effective exchange rate in Morocco has appreciated by about 8 percent to end 1994 (and is appreciating further in 1995 as a result of the higher rate of inflation in Morocco). Such an appreciation undermines external competitiveness and its reversal will help raise exports. CHAPTER II INTERNATIONAL TRADE 32. Conclusion. To realize its growth objective and given the small size of its domestic market, Morocco will have to turn more aggressively to its export sector, but especially to new sources of export growth. The direct effects of the Uruguay Round (UR) will be negative for Morocco's traditional exports and will erode the benefits that Morocco currently reaps from preferential access to the European Union (EU) market. However, over the longer run, there will be gains from increased access to other markets and technology, and trade volumes will rise. Morocco is engaged in negotiations concerning the formation of a Free Trade Accord (FTA) with the EU. Such an association will increase competition for domestic producers in Morocco; there will also be gains from the harmonization of standards. The net trade-related welfare effects of such an agreement depends on the relative magnitudes of trade creation with the EU, trade diversion and the drop in tariff revenues.' Currently, there are no other agreements directly tied to the successful conclusion of the FTA. There may be non-trade gains from forming a FTA; for example, the magnitude of total grants from the EU to Morocco may increase; it may result in greater investor confidence as the FTA would signal the commitment of the government to reform and could raise FDI. It may also result in quality improvements for Moroccan goods. These gains would also be obtained with non-discriminatory liberalization. Other benefits to Morocco could include lower trading costs if the EU finances improvements in infrastructure to facilitate trade. The current trade regime continues to be significantly protective which engenders a bias against exports and also favors capital-intensive production. Thus, further trade liberalization measures are desirable and to maximize welfare gains for Morocco, it is recommended that non-discriminatory liberalization accompany the FTA with the EU. 33. Key objectives. (a) Lower trade protection in a non-discriminatory fashion: Both the average level of protection and the dispersion of tariffs should be lowered to reduce the anti-export and anti-labor bias and to encourage outward-oriented growth. This reduction in tariffs could accompany the signing of the FTA; (b) Synchronize trade liberalization with fiscal reform: to ensure the sustainability of both trade and public sector reform (see Chapter I); (c) Allow employment and relative price 241 Trade diversion occurs when countries import more from a higher cost producer as a result of preferential tariff reductions; trade creation occurs when the total volume of trade rises as a result of falling prices for imported goods. Tariff revenues can be replaced either by increases in consumer surplus for the importing country or in producer surplus for the exporting country. The net welfare gain to the countries involved depends on the sum of these effects.  - 13 - adjustments: a decline in real labor costs and higher labor market mobility will boost exports and maximize the gains from factor reallocation." 34. Impact of the Uruguay Round. Morocco will benefit relatively less from the worldwide reductions in developed country tariffs on industrial products under the UR since it already enjoys essentially duty free access to the EU markets for its industrial exports under a 1976 agreement." However, there will probably be benefits associated with increasing exports to other geographical areas and overall increases in trade volumes over the longer run. Under existing trade patterns, the primary and direct implications for Morocco of the UR stem from * the dismantling of the Multifiber Agreement (MFA) and * the liberalization of trade in agriculture. These developments could effect Moroccan textile, clothing and agricultural (especially fruits and vegetables) exports to the EU negatively; the former two accounted for over 25% and the latter for II % of total exports in 1993. 35. Multifiber Agreement. Morocco was not party to the MFA but benefits from preferential access to the markets of the EU.27' Under the UR, export quotas on MFA-restricted goods will be freed and import tariffs reduced over a ten year period. Outstanding import quota restrictions (QRs) will also be expanded. This will cause prices of textiles and clothing to fall in currently MFA-restricted markets and to rise in other markets. Since Morocco sells 86 percent of its total textiles and clothing exports to the EU, a MFA quota-constrained market, while facing no quota constraint itself, it will unambiguously lose from the dismantling of the MFA through a significant loss of quota rents on its textile and clothing exports to the EU. While much of the quota phaseout occurs in the tenth year, Moroccan competitors party to the MFA will benefit from significantly expanded quota growth rates to the EU in the interim under the UR agreement. Moroccan exports may be particularly vulnerable since its cost competitiveness relative to the countries with expanded quotas is not favorable. Its unit labor costs in the sector are estimated to be 58, 100, and 262 percent above those for Malaysia, Thailand, and Indonesia, respectively, for example.7' 36. Agriculture. The UR provides for the tariffication of agricultural imports and a reduction in these tariffs. While there is likely to be a limited impact on Moroccan imports (see para. 32), the terms of the EU offer at the UR would erode Morocco's preferential access to the EU market consisting of duty free quotas for fruits and vegetables (notably tomatoes, clementines, and oranges). Moroccan exports to the EU in 1993 represented 76 percent of total exports for these products. Morocco was also subject to 251 A real exchange rate depreciation through suitable demand management and exchange rate policy would have the same effect as decline in real wages in termns of boosting exports. However, real exchange rate depreciations are not always sustainable as they can induce wage-price increases which erode the initial depreciation. 26/ Under the UR, there is a 40% cut in import-weighted average bound tariffs on all industrial products by industrial countries and an increase in tariff bindings to cover 98 % of all imports. For details on the UR and the MFA and other issues covered in this chapter see Annex 11. n7l While there are several items of clothing and textiles subject to voluntary export restraints (VERs), these do not appear to have been binding in practice and have been surpassed by 200-300% without corrective actions being taken (Kingdom of Morocco, Republic of Tunisia, Export Growth: Determinants and Prospects, World Bank, 1994). 28/ Ibid.  - 14 - various minimum selling prices (prix de reference) during the year which excluded it from the market during certain periods. 37. The EU offer to the GATT consists of (i) the replacement of reference prices by higher and more binding minimum entry prices (prix d'entre'e); (ii) the imposition of customs duties29'; and (iii) application of the maximum tariff equivalent (equivalent tarifaire) in case the selling price drops below 92 percent of the entry price. (In many cases, it appears that these minimum import prices have been set so high, i.e., above the internal EU price, that Morocco would be excluded from the market). Moroccan estimates show that under the original terms of the EU offer to the GATT, they would lose approximately 90 percent of their tomato and clementines exports and 40 percent of their orange exports."'' Morocco reached a temporary agreement with the EU for its tomato and zucchini exports for the 1994/95 season. While the impact of the final agriculture agreement reached will depend upon its specific terms, the prospects for further growth of agricultural exports to the EU appear very limited. 38. Protectionist Trade Regime. The trade regime still exhibits a significant degree of protectionism. In the non-agricultural sector, Morocco has no quantitative restrictions (QRs) in place and has eight tariff rates ranging from 0 to 35 percent with an unweighted average of 23 percent in 1993. To these must be added the Prelevement Fiscal a I'Importation (PFI), an import surcharge, ranging from 12.5 percent to the normal rate of 15 percent.3"' (The PFI, intended as a revenue collection rather than protection device, hardly varies across sectors). Nominal statutory protection rates therefore run up to 50 percent. The sectors benefitting from higher nominal protection are clothing and textiles, food and drink, and metal- working. The actual tariff collection rate is around 12.8 percent; with an average PFI around 14-15 percent the actual (average) nominal trade protection rate is around 27 percent.32' Table 3 presents tariff and PFI rates. Note that if the 19 percent VAT were applied on the tariff-exclusive rather than the tariff- inclusive price of imports, the nominal protection afforded to domestic production would be lower.33' Additional protection is provided by reference prices. The reference price system establishes minimum import values for a range of industrial goods, mostly textiles, clothing, and white goods (e.g., washing machines and refrigerators).34' These are used largely as a means of providing additional protection for industrial goods whose tariffs are already at the maximum 35 percent rate. In principle, they cover no more than 10 percent of industrial production. 291 Morocco faces tariffs of 11-18 percent for tomatoes and clementines; and 4 -20 percent for oranges under the EU GATT offer. 30{ See Annex 11 for method of calculation. 311 The PFI has been 12.5 percent for medical products and 10 percent for products which fall under the investment code. However, the Loi de Finances 1995 abolishes the PFI for investment goods, and also provides exemptions on import taxes for some investments. 32/ The fiscal effect of the conversion of agricultural quotas to tariffs will not be known for some time. 331 Domestic prices under a VAT imposed on the tariff inclusive price of a good are higher by tv percent (a cascade effect), where t is the tariff rate and v the VAT rate. 341 These reference prices are to be removed in 1998 in accordance with the GAT7. The system seems to provide significant protection for specific products. A previous study noted that one in four products subject to reference prices were not imported in 1990 (P. Messerlin, "The Moroccan Reference Price System," 1991).  - 15 - Table 3. Total Protection Rates at 15% PF135' Tariff* PFI** Total 0.00 15.00 15.00 2.50 15.00 17.50 7.50 15.00 22.50 12.50 15.00 27.50 17.50 15.00 32.50 25.00 15.00 40.00 30.00 15.00 45.00 35.00 15.00 50.00 *Excludes some rates cited in circular, but not found in other data sources. Tariff rates on some consumer goods not produced domestically were reduced in 1995; these changes are not reflected in this table (see para 47). In addition tariff rates on some agricultural commodities remain at 40 or 45 %. **See Footnote 31. Source: Admninistration des Dousnes et Imp6ts Indirects; Circulaire No. 4320 du 17/3/1994. 39. Agriculture remains by far the most highly protected sector. QRs in place are to be removed in 1995 and replaced with tariffs in accordance with the UR. However, unless Morocco sets its actual tariffs significantly below the tariff ceilings submitted at the UR, there are likely to be few import liberalization benefits even after the GATT-required 24 percent tariff reduction over 10 years. This is because the ceilings were set very high, e.g., 190 percent for soft wheat; 171 percent for barley; and 221 percent for sugar. These levels exceed current protection levels: the tariff equivalent on soft wheat in 1994 is estimated at 123 percent.36' 40. Imports under the admission temporaire (imported inputs used in exports) and investment code categories are exempt from tariffs. The overall tariff collection rate, i.e., excluding exemptions, was 12.85 percent for the first six months of 1994. Tariff collection rates tend to be significantly higher on final consumption than other (raw materials and semi-finished) products. While such a tariff pattern is frequently observed and used as a means to encourage high value-added activities, it tends to create high and dispersed effective protection rates. 41. The most recent study of effective protection which was conducted in 1991 may still be roughly indicative.37' This study showed that though export incentives significantly reduced the negative effective protection on exports (from -23 percent to -5 percent), the anti-export bias--given by the difference between local and export incentive rates--remained significant at 35 percent. Since Morocco already 351 Tariff rates on some consumer goods which are not produced domestically were lowered in November 1994 but these new rates are not reflected in this table (see para. 47.) 36/ Based on 1990-94 prices, the base plus marginal tariff structure under consideration for soft wheat would have yielded a tariff rate of 126 percent. While lower than the 190 percent tariff binding, it is no lower than the estimated 1994 tariff equivalent of 123 percent. 371 Van de Wetering, Belghazi, and McDermott, "Incentives and Protection in Morocco's Industrial Sector in 1991," 1993. Prepared for USAID. This paper is based upon the same survey and study as Ministere du Commerce, de l'lndustrie, et de la Privatization (1993), "Les Incitations et la Protection dans le Secteur Industriel en 1991."  - 16 - grants substantial export incentives, it should further reduce this anti-export bias by lowering import protection levels.38' 42. Lowering Trade Protection. To boost exports and growth Morocco should (a) lower tariff dispersion, which will result in positive welfare and efficiency gains and (b) lower the average level of protection (inclusive of tariffs, PFI, and reference prices) in a non-discriminatory fashion. 43. A Free Trade Accord with Europe. The creation of a FTA with the EU is currently under negotiation. Under the current terms, the free access of EU goods into Morocco would be phased in over a period which remains to be determined.39' Since Morocco already gets duty-free access to the EU for its industrial exports, these exports will not be affected. Trade in agricultural products will not be part of the FTA. The agriculture agreement will be concluded separately; Morocco is unlikely to get any improved access beyond what it already has."' Moroccan imports from the EU, on the other hand, will be affected as Morocco will import more from the EU than previously. 44. The welfare impact therefore depends largely on the effects within Morocco's domestic market. The net effect depends on the sum of trade diversion, trade creation, the drop in tariff revenue, and the extent to which domestic prices fall after the creation of the FTA. Foregone customs-related revenue would be quite substantial, on the order of 8.5 billion DH.41' Large trade creation effects would offset the above and have a positive net welfare impact.42' Though no other benefits are directly tied to the conclusion of a FTA, there are expected to be non-trade benefits such as higher grants from the EU. The association with Europe is viewed by the Moroccan authorities as more than a closer commercial linkage; it is viewed as bringing the two parties closer, technologically, culturally and sociologically as well. 45. Next Steps. The above analysis suggests Morocco could maximize its welfare gains and promote exports through further non-discriminatory liberalization of the trade regime. The FTA will be phased in gradually over the next several years. Morocco could start a process of non-discriminatory liberalization: the first step would be a reduction in the number of tariff rates from the current eight rates 38/ It is far better to target and reduce the original source of distortion than compensate by increasing a countervailing distortion. Tax incentives for exporters, for example, increase the incentive to export but create additional distortions. By raising the after-tax return to capital (profits), they may bias production away from more labor-intensive methods. In any case, new export incentives are not permitted under the UR. 39/ The Moroccan authorities would prefer a phasing in period of around 15 years. 40/ Free agricultural access to the EU is available only under full membership 411 See Annex 11 for details. 4V A study by T. Rutherford, E.E.Rutstrom, and D. Tarr (1993) using a computable general equilibrium model for Morocco estimates net welfare gains to Morocco of 1.5 percent of GDP. This model has 39 production sectors, is based on a 1980 input-output matrix of the Moroccan economy and assumes among other things, that there is an accompanying real exchange rate depreciation (to ensure current account sustainability) which boosts exports and that there are no terms of trade effects.  - 17 - to perhaps no more than four and in average tariffs to first 20 percent, followed by further reductions to 10-15 percent."' 46. Fiscal Considerations. Further trade liberalization should take place in the context of overall fiscal reform. Tariff and PFI revenue accounted for 25 percent of total tax revenue in 1993. This is almost as much as total value-added tax (VAT) revenue (29 percent), a high proportion of which was from imports (52.7 percent). This large proportion is partly due to the existence of an informal sector. Broadening the domestic tax base for the application of the VAT needs to be high on the reform agenda. 47. In an attempt to curb smuggling, the authorities have lowered tariffs to 5 percent on about 500 goods which are not produced locally. However, since the remaining taxes (15 percent PFI and 19 percent VAT) on these products will not be lowered, this is not likely to divert trade substantially to formal channels while leading to an immediate loss of about 203 million DH in tariff revenue. The elimination of the PFI on equipment imports under the Code d'Investissement is estimated to result in a 500 million DH revenue loss."' This is in addition to the 8.5 billion DH revenue loss from the proposed FTA which represents 68 percent and 17 percent of total 1993 customs and tax revenue, respectively. 7he best strategy may be for Morocco to first lower dispersion in trade taxes in the context of revenue- neutral reform and as a next step lower average tariffs further. 48. Allow Employment and Relative Price Flexibility. Many of the benefits of trade liberalization are predicated upon freely-functioning factor markets which permit ready resource reallocation. The high levels of urban unemployment and underemployment in Morocco, however, indicate that significant labor market rigidities exist.45' Further import liberalization in such a context could increase unemployment rather than exports (see Annex II) and would therefore raise adjustment costs."' 4' 431 Annex 11 provides some rough estimates of revenue losses from tariff reduction. However, due to the absence of import demand elasticities (the calculation is done assuming constant import levels) these estimates must be used with caution. 44/ The fonner estimate was calculated by the Ministere du Commerce Ext rieur and can be thought of as a lower bound on tariff revenue losses since they assume no response in import demands. The latter figure is from customs (Administration des Douanes). cited in L'Economiste (11/17/94). 45/ They are too high to be explained simply by frictional or search unemployment, for example. See Annex IIIA. 46/ Estimates show that with labor mobility and a non-binding minimum wage trade liberalization (especialy reducing tariff dispersion) can lead to an increase in employment and wages. Studies also show that trade reform in Morocco had a small impact on aggregate wages and employment in the formal manufacturing sector. (Currie and Harrison, 1995). This may be partly explained by the rigidity of the labor market. 471 In the absence of labor market reforms, export expansion is better accomplished by a sustained real exchange rate depreciation rather than tariff reduction. However, real exchange rate depreciations are often hard to sustain.  - lx - ChIAbTER III FACTOR MARKETS A. The Labor Market 49. Conclusion. Significant rigidities exist in the way the labor market functions due primarily to the enforcement of stringent labor regulations; these could hinder growth in output and exacerbate urban employment, weaken Morocco's ability to compete in international markets and increase the informalization of employment (which has regressive effects on income distribution). While improvements in the educational/training system are absolutely necessary to develop human capital efficiently and to raise employment, they should be accompanied by changes in the regulatory framework for labor to maximize gains in employment. Trade liberalization and the changing international market- place will have stronger positive effects on employment creation, wages and (new sources of) export growth if labor market rigidities are removed. Greater labor market flexibility can also reduce the adjustment costs associated with privatization and public enterprise reform. By reducing entry and exit costs for enterprises in the formal sector in Morocco, labor market reform can promote investment. High entry and exit costs also provide strong incentives for the informalization of production and puts large formal sector firms at a disadvantage in a competitive environment.48' Labor market reform, by encouraging the formalization of production and employment will also raise the tax base. This will be an important element of the high growth scenario: it will help to maintain budget revenues as a proportion of GDP as trade liberalization proceeds. Formalization of the labor market will also encourage firm-level (or on-the-job) provision of training and a better allocation of financial capital. In the presence of labor market rigidities, further trade liberalization or any negative change in market conditions could raise unemployment, and will also have regressive income distributional consequences. 50. Key Objectives. (a) Increase the differential between the non-agricultural minimum wage (SAIG) and the average urban wage and reduce the differential between the SMIG and the agricultural ninimum wage (SMAG) by holding the SMIG fixed in real terms. This will encourage employment creation in the formal sector, could reduce the rate of rural-urban migration, raise Morocco's competitiveness in international markets, and encourage the formalization of employment; (b) Make the current system of social security more efficient by separating the distributional component of the high social charges on labor from the savings component. Non-wage costs of labor are high and also have distortionary effects in the labor market. Lower total labor costs will reduce disincentive effects in the labor market and encourage formalization of the economy; (c) Make regulations governing dismissals less stringent so that firms are able to change the skill mix of labor employed as well as the total number employed. Develop an unemployment compensation system over the longer-run and ensure more rational implementation of the current severance payment scheme; (d) Increase the efriciency of the educational and training systems to produce the "right" skill mix for growth, and to raise the overall productivity of the labor force. In particular, take active measures to remove the gender bias from the education sphere. 51. The Labor Force. Of the total population of just over 26 million, 48.6 percent live in rural areas and 51.4 percent in urban areas. Overall population growth continues to be high at just over 2 percent; urban areas have had average annual growth rates of about 3.7 percent, and rural areas of .79 percent 48/ The informal sector in Morocco is not well known. There is also a definitional problem: firms that are often referred to as informal may pay taxes and the minimum wage. There are also firms, part of whose activities, may be considered to be in the informal sector (due to under invoicing for example).  - 19 - during 1987-1992 putting enormous pressure on the urban labor market. The gross labor force participation rate is 39 percent with 44 percent in rural areas and 33 percent in urban areas, the difference stemming from variations in the labor force participation of women (33 percent in the rural sector and 17 percent in the urban sector). 52. The rate of unemployment is very high at 16 percent in urban areas; those in the age group 15-24 years and with no education have the highest rates of unemployment (see Tables 4 and 5). Though rural unemployment is low at around 5 percent the evidence indicates the existence of substantial under- employment.49' In urban areas, 62 percent of the labor force is classified as wage earners, while only 17 percent of the rural labor force work for a wage (only 5.2 percent of rural women work for a wage, versus 25.4 percent of men). The figures for rural areas probably underestimate the fraction of the labor force working for a wage since many earn a large part of their income from more than one occupation and are classified only according to their main activity. Hence, labor market conditions in rural sectors affect a substantial proportion of the population. Table 4. The Unemployed by Educational Achievement and Age Educational Achievement Age Total Percentages 15 - 24 25 - 34 35 -44 45- 59 60 & t Toa_ecnae No Education 109,868 92,318 32,242 18,650 2,467 255,545 37.5% Certificate of Primary Education 78,220 43,701 9,093 1,988 - 133,002 19.5% Certificate of Secondary Education or equiv. 35,303 54,539 3,089 601 - 93,532 13.7% Baccalaureates or equivalent diplomas 8,998 25,373 1,197 172 - 35,740 5.2% Degrees of higher education except Medicine 6,679 32,095 2,382 - - 41,156 6% Degrees of higher education incl. Medicine 633 1,830 370 - - 2,833 .4% Technical Diplomas 9,799 29,685 1,713 538 - 41,735 6.1% Other professional diplomas 31,622 41,760 3,600 276 - 77,258 11.3% Total 281,122 321,301 53,686 22,225 2,467 680,801 Percentages 1 41.3% J 47 % 8 % I . SD .4J Source: Urban Labor Force Survey, 1993. Table 5. Labor Force Participation & Unemployment Rates Rates by Age Participation Unemployment Rate 15 - 24 years 32.2% 30% 25 - 34 years 63.1% 20.3% 35 - 44 years 63.6% 5.5% 45 - 59 years 50% 3.4% 60 + years 20.6% 1.9% 53. The quality of the Moroccan labor force needs substantial improvement: the adult literacy rate at 49 percent (38 percent for women) is very low compared with other middle-income countries and 491 See Poverty Assessment.  - 20 - particularly the fast-growers. Moreover, employers face shortages of certain skills particularly management and technical skills. However, Government expenditures on education at over 5 percent of GDP is relatively high. In addition, the Government is intensively involved in vocational training. This indicates that significant inefficiencies exist in the manner in which the Government provides for the development of human capital."t' One striking example is the fact that the Government spends a very high proportion of its expenditures on education in the provision of higher education; it could have a greater impact on raising literacy by concentrating its resources on promoting basic education.5"' 54. The Regulatory Frainework. Morocco has fairly well enforced labor regulations. The administrative framework is strong with a very active enforcement department, and labor unions play an important role."v The three main aspects of the regulatory system that have contributed to the rigidity of the labor market are the following: (a) minimum wage policy, (b) mandated non-wage labor costs, and (c) regulations governing hiring and dismissals. 55. (a) Minimum Wage Policy. The SMIG which has been rising in real terms, has a strong impact on the formal urban private sector and appears to be one of the reasons for the high rate of unemployment in urban areas. By raising total labor costs (see para. 58 and 59) informal sector firms, it also encourages the informalization ofproduction, the use of relatively more capital-intensive techniques and lowers Morocco's competitiveness in international markets. It may also play a role in accelerating rural-urban migration and thus in affecting urban unemployment. This policy is also regressive in its effects. International comparisons in fact show that Morocco's unit labor costs in its main manufactured exports (textiles and clothing) are much higher than in competitor countries; over the last decade, it has declined much less than in these countries. This can be seen in Table 6 below. Table 6. Cost Competitiveness in Textile, Clothing and Footwear, 1991 Share of EU imports Real Wages Value added Unit Labor Cost in ECU per worker (in ECU) 1985 1991 (1985 = 100) Morocco 58 89 88 0.9 1.6 Tunisia 62 105 76 1.0 1.6 Turkey 92 145 82 2.6 4.2 Malaysia 55 142 50 0.3 0.7 Indonesia 51 154 43 0.2 1.6 China 53 126 55 2.3 4.9 Source: World Bank: Kingdom of Morocco, Republic of Tunisia - Export Growth: Determinants & Prospecta, October 1994, Annex m 56. A large share of the labor time employed in the urban sector is paid at or just above the SMIG, as can be seen by the wage distribution in Figure 1 which is unimodal around the SMIG, suggesting that the latter is well enforced. Empirical evidence shows that SMIG revisions have followed the average 50/ See n Costs, Financing and Efficiency of the Education System."-MOR 51/ This expenditure pattern is also regressive since it is usually the better-off that have access to higher education. s2/ To some extent, the strength of the labor unions results from their strong links to political parties.  - 21 - wage, more than proportionately; in fact, these revisions have overcompensated for changes in the average wage.53' This has led to a shrinking margin between the two and a compression of the lower (and given the average wage, upper) tail of the wage distribution.5' In fact, this shrinking margin has contributed to the high urban unemployment rate and further changes in the SMIG should not occur until unemployment is restored to an acceptable level. It is in fact, the wages of the lowest paid workers, and their employment opportunities that are adversely affected by the SMIG.55' 56/ As Table 3 shows, the unemployment rate is the highest for those with no or little education, precisely the category for which the minimum wage would be binding.57' 57. The SMAG is about 36 percent lower than the SMIG, and is well enforced; labor unions seem to be active in rural areas as well. The large differential between the agricultural and non-agricultural minimum wages has probably accelerated the rural-urban migration that would normally occur with increasing industrialization, raised urban unemployment and put pressure on urban services. "' Such a large differential is not warranted for cost-of-living reasons.59' Further ad hoc real wage increases could have negative effects on employment in the rural sectors. To avoid aggravating unemployment in rural areas, the future evolution of the SMAG should be determined by making its growth conditional on improvements in agricultural productivity. In conjunction with the above SMIG policy, this should have the desirable effect of compressing the gap between the two. 58. (b) Non-Wage Costs. The social charges levied by the main (mandatory) social security organization for the urban private sector, the Caisse Nationale de Securite Sociale (CNSS) amount to 18.6 percent of the take home pay. Firms must also pay a 1.6 percent levy for vocational training. In addition, firms pay for various types of insurance (accident) which are not compulsory. These charges drive a wedge between the cost of labor and the net take-home pay that varies between 20.2 percent and 35 percent. This, particularly in conjunction with the minimwn wage policy has negative effects on formal sector employment that could be significant. For example, with a 60 percent elasticity of the demand for labor6' with respect to the cost of labor, it is estimated that the wedge results in a level of employment (for the lower tail of the distribution, i.e. for those for whom the minimum wage is binding) sit Though the process of revisions of the SMIG is not completely clear, it is apparent that labor unions, and employers' associations play an important role. 541 This has been occurring at a time when the gap between the minimum and average wage has been increasing in most countries, due to falling real minimum wages. See Annex III-A. 551 I Note however that compression of the upper end of the distribution also has negative incentive effects. 561 Annex IIIA provides details on this issue including regression analysis which supports this view. 571 The new draft labor code suggests the possibility of establishing different minimum wages for different types of economic activities: such a move would complicate the existing system and may introduce new rigidities into the labor market. 58/ Demographics in Morocco, with a large share of the population around the age of 15-30 has exacerbated youth unemployment. 591 MTere do not appear to be any systematic price differences between urban and rural areas. See Poverty Assessment. 601 This is a relatively conservative figure. Other figures (Annex III-A) show similarly large effects.  - 22 - that could be lower by 18 percent. Many countries with high social charges in fact have non-binding minimum wages keeping the total costs of labor low."6 62/ Figure 1: Urban Priveite Sector Wage Distribution (Number of Hours) 7000 f 6000 t Total 1992 5000- ,,Men 3000 // 2000 1000 ' -Waomen Wage 0