Algeria - A medium-term macroeconomic strategy for Algeria : sustaining faster growth with economic and social stability (Vol. 1 of 2) : Main report

Report No. 26005-AL People's Democratic Republic of Algeria A Medium-Term Macroeconomic Strategy For Algeria Sustaining Faster Growth With Economic and Social Stability (In Two Volumes) Volume 1: Main Report May 2003 Social and Economic Development Group Middle East and North Africa Region Document of the World Bank  FISCAL YEAR 2003 July I - June 30 Vice President: Jean-Louis Sarbib Sector Director Mustapha Nabli Country Director: Theodore Ahlers Sector Manager Pedro Alba Task Team Leader Aristomene Varoudakis This report was prepared by a team comprising: Sandeep Mahajan, Paul Moreno-Lopez, Shane Streifel, Aristomene Varoudakis (main authors), with significant contrbutions by Punam Chuhan, Enule Finateu, Annette de Kleine, Christian Schmidt, Dimitri Vittas, and Leila Zlaoui. To the report also contributed Najy Benhassine, Caroline Farah, and Robert Keyfitz. External contnbutions were provided by Daniel Astier, Ali Bayar, Ghazi Ben-Ahmed, and Said Ighzlahnz Manuel Felix and Ingrid Ivins provided research assistance. Peer reviewers were Craig Bumside and Shahrokh Fardoust. Guidance was provided by Mustapha Nabli (Sector Director and Chief Economist), Teodore Ahlers and Christian Delvoie (Country Directors) and Pedro Alba (Sector Manager). The counterpart team in Algeria provided valuable comments in the discussion of the prelimunary report in September 2002 Support from the counterpart team in the provision of information is also gratefully acknowledged-particularly from Office National des Statistiques; Direction Gnerale des Etudes et de la Prevision, Direction Generale du Tresor; Ministere de l'Energie; Banque d'Algerie; Caisse Nationale des Retraites. The team also benefited from advice/comments from Zoubida Allaoua, Ahmed Benbitour, Regina Bendokat, Philippe Callier (IMF), Paul Duran (IMF), Olivier Hassler, Abdelouahab Keramane, Alain Laurin, Michel Lazare (IMF), Djamal Mostefai, Rolando Ossowski (IMF), Setareh Razmara, Sergei Shatalov, Kutlu Somel, Mazen Soueid (IMF). Khalid Alouane, Isabelle Chaal, Marie-Hugette Osselyn, and Brigitte Wiss contrbuted to the production of the document.  Preface This study is part of a series of analytical works on Algeria prepared in parallel by the World Bank, with the aim of laying out the framework and facilitating the dialogue for the elaboration of the Bank's Country Assistance Strategy for Algeria. Companion studies include: A private sector development strategy note; A diagnostic on foreign direct investment in Algeria (FIAS). This report builds on consultations that took place in April 2002, a review of the preliminary report with the Algerian Counterpart Team in September 2002, and a review in the context of the CAS consultations in April 2003. On private sector development issues, the report builds on the findings and recommendations of the companion studies. Please refer to each of these studies for details on the analysis, the methodology, the diagnostics and the recommendations. A policy note was also issued to synthesize the main messages and recommendations from these reports, into a coherent and comprehensive medium-term growth strategy. It should be noted that the focus of the two-pillar strategy elaborated in this report-securing fiscal sustainability and promoting a favorable investment climate for medium-term growth-is not intended to overshadow equally crucial policy agendas for long-term growth and poverty reduction in Algeria, especially in the social sectors and the rural sector. Moreover, it should be acknowledged that a number of the proposed policy measures are actually being implemented, to various degrees, by the Government of Algeria, and the proposed strategy's emphasis is on strengthening and accelerating these policies while complementing them with broader reforms. This report is divided into three parts. It first presents a diagnostic of the slow growth performance, by benchmarking Algeria's performance against other comparator countries, with the aim of identifying the key bottlenecks to better long-term growth performance in Algeria. Building on this analysis, experience from transition economies, and the diagnostics in the companion reports, the second part reviews options in structural reforms to encourage the development of the private sector, by strengthening the investment climate and furthering Algeria's transition to the market. The third part examines options to strengthen the fiscal framework, to insulate the fiscal stance from volatile hydrocarbon fiscal revenues and secure fiscal sustainability, so as to achieve a sustained acceleration of growth. More technical background material of the analysis is presented in annexes, in a separate volume.   Table of Contents Executive sulmmary . Strategic Challenges and Policy Options -- --viii CHAPTER 1 1 FACTORS OF LONG-TERM GROWTH AND MACROECONOMIC VOLATILITY IN ALGERIA- 1 1.1. Growth and macroeconomic volatility in Algeria: A comparative perspective 4 * A growth boom has been followed by a protracted bust------- ---------- 4 * -partly owing to poor totalfactor productivity growth ------- --------------- -- -----6 * Algeria has been exposed to high macroeconomic volatility ----------------- ------------ 8 1.2. Assessing Algeria's long-term growth potential: strengthening assets and removing bottlenecks to growth - 11 * Accountingfor Algeria's "missing long-term growth" ----------- -- --------------- 11 * Accountingfor the protracted "growth crash "since the mid-1980s ----------------------------16 * Resuming the growth process in Algeria: Policy challenges ------------------------------------------19 CHAPTER 2 21 SUSTAINING FASTER MEDIUM-TERM GROWTH IN A COMPETITIVE ENVIRONMENT: THE CHALLENGE OF STRUCTURAL REFORM 21 2.1. Furthering Algeria's transidon to the market: Disciplining the old sector 23 * Privatization in Algeria has been elusive ---------------- * Completing the transition to the market would bolster Algeria's potential in manufacturing ----29 * Restructuring ofpublic banks in Algeria has been costly and is stillfraught with risks----------31 * Financial clean up of public banks should go in tandem with operational restructuring and pri- - - ----- - - - - -------- - - ----------- 34 * Trade liberalization has progressed, but protection in Algeria remains high compared to other transition economies------_ - --- - ----- -____ _ __ 2.2. Making most of the market: Policies to encourage private sector-led growth 36 * Strengthening the investment climate and reducing the cost of business services --------- 37 * Improving private sector's access tofinance------------------------ ---- - - 41 * Promoting the development of an efficientfinancial sector ---------------------43 * Industrial land bottlenecks hinder private sector development ------------------------ - 46 * Fostering the role of the market in developing Algeria 's hydrocarbon and mining sectors--------46 * Labor market reforms would help improve the employment content of growth -----------------48 2.3. Rising to the challenge of competition: Fostering the competitiveness of Algeria's non- hydrocarbon tradable sector 49 * In labor-intensive industries Algeria 's cost competitiveness has improved---------- _ _-49 * -but further improving competitiveness would callfor productivity gains-------- ------ S52 * -and creating an enabling environment for exporting --- ------------ ------- -53  CHAPTER 3 55 SECURING MACROECONOMIC STABILITY AND FISCAL SUSTAINABILITY: CHALLENGES AHEAD 55 3.1. Insulating fiscal policy from the volatility of hydrocarbon revenues 56 * A boldfscal adjustment has been achieved----- -- --------------------- S6 * -but, to reduce volatility, the pro-cyclicality offiscal policy needs to be tackled ------- 57 3.2. Safeguarding fiscal sustainability in the medium term: Challenges and risks 59 * Fiscal consolidation has broadened the room of maneuver offiscalpolicy in Algeria --------------59 * Risks forfiscal sustainability ------- --------------- ------------------------63 * Managing hydrocarbon revenue windfalls to reduce the pro-cyclicality offiscal policy-the role of the Stabilization Fund ("Fonds de Regulation des Recettes ") ----------------- --------------64 * Assessing the sustainability offoreign debt---------- --------- --------- --------67 3.3. Strengthening medium-term fiscal policy management: An integrative framework 70 * Improving medium-term fiscalpolicy design: Toward a rules-basedfiscal policy, underpinned by a sound and integratedfiscalframework --------__------- 71 * Assessing the feasibility ofpermanent-income rules, the potentialfor savings, and risks for long- term fiscal sustainability --- ---- - -------- 75 * Toward a strategy of active debt andfinancial asset management --------------------78 * Improvingfiscal transparency and moving towards an integratedfiscalframework -------80 References 87 Endnotes 90 List of Figures Figure 1.1: The growth collapse since the early 1980s has been followed by a timid recovery since the mid 1990s ....................................................................................... 1 Figure 1.2: Long-term growth trends in Algeria have been shaped by oil revenues ............................................4 Figure ].3: Sectoral long-term growth trends .............................................................................6 Figure 1.4: TFP Trends ............................................................................7 Figure 1.5: Totalfactor productivity performance in Algeria has been weak ...................... ................................8 Figure: 1.6. Macro Economic Volatility has been high (1970-2000) ..................................................................9 Figure 1.7: Volatility in Sectoral Growth Rates ........................................................................... 10 Figure 1.8: Higher volatility is associated with slower growth .......................................................................... 10 Figure 1.9: Accountingfor the protracted growth crash in Algeria: Management of volatility matters .......... 18 Figure 2.1: Enabling the emergence of the new sector helps reduce the cost of the transition to the market .... 22 Figure 2.2: Public and private sector shares in economic activity .................................................................... 25 Figure 2.3: An uneven pace ofprivatization within manufacturing ................................................................... 25 Figure 2.4: Profitability ofprivate-sector companies outpaces that of public enterprises across Algerian manufacturing industries ........................................................................... 27 Figure 2.5. Contrasting performance of industrial output in Algerian private and public manufacturing ....... 28 Figure 2.6: Domestic bank credit in Algeria ........................................................................... 32 Figure 2.7: Patterns of trade protection: Algeria vs. comparators .................................................................... 36 Figure 2.8: Obstacles to doing business in Algeria-summary evidence from enterprise surveys .......... .......... 37 Figure 2.9: Foreign Direct Investment and the investment climate in transition economies ........... ................... 38 Figure 2.10: Administrative barriers to doing business in Algeria remain high ................................................. 40 Figure 2.12: Foreign bank presence in Algeria ....................... .................................................... 44 Figure 2.13: Algeria's real exchange rate has been aligned to competitive levels ............... ............................. 50 Figure 2.14: Unit labor costs in Algerian manufacturing industries .................................................................. 51 Figure 2.15: More competitive unit labor costs in private sector manufacturing .........................2.................... 52 Figure 3.1: Long run Fiscal Performance ........................................................................... 57  Figure 3.2: The non-hydrocarbon primary fiscal deficit has been affected by the cycle of oil ............ ............... S9 Figure 3.3: Foreign debt dynamics are sensitive to hydrocarbon revenues projections ..................................... 70 Figure 3.4: Algeria's non-interest public expenditures in international comparison .................. ....................... 73 List of Tables Table 1.2: Comparison ofAlgeria vis-a-vis Sample Average-volatility has been costly in terms of growth performance .............................................................. .: 13 Table 1.3: Algeria's performance on Institutional Quality/Governance has been weak ................................... 14 Table 1.4: Select Human Development Indicators in Algeria and Comparator Countries .............. .................. 15 Table 1.5: Select Macro and Structural Indicators for Algeria and Comparator Countries ............................... 16 Table 1.6: Regression resultsfor growth-crash model .............................................................. 18 Table 2.1: Comparison of average tariff rate reduction paths ........ ....................................................... 36 Table 3.1: Comparative Volatility of Fiscal Outcomes .................... ........................................... 58 Table 3.2: Analysis offiscal sustainability .............................................................. 62 Table 3.3: Debt dynamics under the base-case scenario ............................................................... 68 Table 3.4: Debt dynamics under the low-case scenario ............................................................... 69 Table 3.5: NPVof Government Hydrocarbon Income to205 ............................................. .................. 76 Table 3.6: Fiscal balance and permanent hydrocarbon income estimates in Algeria ......................................... 77 Table 3.7: Strengthening the role of the budget as an instrument for improved medium-term macroeconomic management -action plan ............................................................... 83 List of Boxes: Box 1.1: Assessing factors of long-term growth in Algeria ........................... .................................... 12 Box 3.1. Risks in the medium-term outlookfor the hydrocarbon sector ............................................................ 61   A Medium-Term Macroeconomic Strategy for Algeria: Sustaining faster growth with economic and social stability Executive summary Thanks to successful stabilization since 1994, steps taken in structural reform, and favorable hydrocarbon prices, Algeria is now experiencing a mild resumption of growth. But growth, led by the non-hydrocarbon sector, will need to accelerate further, to absorb high unemployment and help reduce poverty. Structural and macroeconomic policies will have to address a simultaneous challenge: (i) Enabling the "new economy, led by the private sector, to gain strength in the non-hydrocarbon sector, by improving the investment climate and furthering Algeria's transition to the market; (ii) Strengthening the fiscal framework, to better manage volatility and secure medium-term fiscal sustainability. Completing the transition to the market would call for removing still remaining constraints to the efficient use of resources. This will boost totalfactor productivity-whose poor performance accounts for a large part of Algeria 's "missing long-termn growth "-and encourage the growth of the "new economy". In Algeria, as elsewhere in transition countries, the "new economy" over- performs the "old economy"' dominated by public enterprises, in terms of profitability and output growth. Facilitating access to finance and to backbone productive inputs, while further lowering the administrative barriers to doing business, would encourage the emergence of the "new economy: but would have to go in tandem with reforms that enforce market discipline on the "old economy". Insulating the fiscal stance from volatile hydrocarbon fiscal revenues is equally important, as fiscal policy in Algeria has been pro- cyclical, thus exacerbating the impact of terms-of-trade volatility on the rest of the economy, and contributing to Algeria 's "missing growth ". Strengthening fiscal management would call for implementing a multi-year, integrated fiscal framework, with the aim of de-linking expenditures from the volatile hydrocarbon revenues. The fiscal framework should be underpinned by appropriate, medium-term targets for the primary non-hydrocarbon fiscal deficit. Securingfiscal sustainability would require saving part of hydrocarbon revenues, in the context of an active asset and liability management strategy. Following years of economic downturn, from the mid 1980s to the mid 1990s, due to low oil prices, slow and hesitant reforms, and civil violence, Algeria is now experiencing a resumption of growth. Successful stabilization since 1994, cautious monetary and fiscal policies in the face of volatile oil prices, and progress in structural reform, have laid the groundwork for a mild growth recovery. GDP grew by 2.5 per cent per year, on average, from 1999 to 2002, while the non-hydrocarbon, nonagricultural sector grew at a faster pace, by 2.9 per cent. The increase in the price of oil since 1999 has provided financial resources to support increased domestic demand, and helped turn current account and budget deficits into sizeable surpluses. Growth has recently been sustained also by stepped up public sector investment, directed to improving social and economic infrastructure. But private investment has yet to recover, owing to the still weak investmnent climate and the incomplete structural reform agenda.  However, growth will need to accelerate further, in order to absorb unemployment, improve living standards, and strengthen social cohesion. Despite the resumption of growth, unemployment remains very high, at an estimated 27 percent in 2001-although the magnitude of labor market slack may be overestimated because of the existence of a large informal sector. Moreover, around 6 out of 10 young people are unemployed, and a fast growing labor force is putting additional pressure on the labor market. To reduce the unemployment rate by half in ten years, and make a significant dent on poverty, GDP would have to grow by 6 per cent per year-a significant acceleration from its current pace. A more drastic reduction of unemployment would call for faster growth-or for increasing the employment content of growth through stronger diversification to labor- intensive sectors. A sustained increase in investment in the non-hydrocarbon sectors is needed to reduce unemployment, because the hydrocarbon sector and the downstream industries contribute little to job creation. The hydrocarbon sector accounts for about 30 per cent of Algeria's GDP, more than 95 percent of export earnings, and 75 percent of fiscal revenues, but directly contributes only to 3 per cent of job creation. To reduce unemployment, growth would have to rely on the diversification of the non-hydrocarbon sector, driven by labor- intensive industries and services that are able to compete in open markets. Competitive diversification of the non-hydrocarbon sector would call, in turn, for stronger productivity growth, which would lay the ground for a sustained increase in investment, led by the private sector. Achieving faster productivity growth would only be possible if the remaining constraints to the efficient use of all production factors are reduced by furthering Algeria's transition to the market. Foregone GDP growth in Algeria over the past three decades is estimated at about 2.3 percent per year, mainly owing to weak performance of total factor productivity (TFP). TFP growth weakened since the late 1970s, and slipped into negative territory during the 1980s and up until the mid 1990s. TFP growth has somewhat improved thereafter, as a result of the structural reforms implemented since 1994. TFP performance was impaired by large relative price distortions during the command economy period; policies that often exacerbated volatility in the face of large external shocks; and limited openness to non-hydrocarbon trade and attractiveness to foreign direct investment. Part of the recent productivity improvement reflects the increasing role of the private sector in industry and services since 1994-as private enterprises in Algeria outperform public enterprises. Poor productivity performance hampers the competitiveness of manufacturing, because it -raises relative unit labor costs, while it also squeezes the profitability of the non-hydrocarbon industry. Algeria's growth collapsed for a decade since the mid-1980s, due to the adjustment to the oil price slump and disruptions associated with a difficult transition from the command economy to the market. Poor productive efficiency also contributed to the protracted collapse of growth. The drop in TFP growth accounted for about half of the 4.2 percentage points decrease in GDP per capita growth since 1985, relative to the previous 15- year period. Shrinking public sector investment in the face of the slump in hydrocarbon revenues accounted for the rest of the collapse of growth. Shortages of intermediate inputs  and imported capital, owing to the balance-of-payments crisis and the devaluation of the dinar in the late 1980s, exacerbated inefficiencies in the non-hydrocarbon sector and worsened the productivity slump. The failure to diversify non-hydrocarbon exports, stimulate domestic investment, and attract foreign direct investment also largely explain the weak resumption of growth since the mid 1 990s. High exposure to volatility has also impaired output growth and deterred private investment. Algeria has been exposed to large external volatility-among the highest in a group of oil-producing countries. The resulting swings in domestic demand have been reflected in high volatility in non-hydrocarbon output. High exposure to volatility has impaired output growth and deterred private investment. Volatility has likely deterred domestic investment in the industrial sector, because it heightened investor risk in an already weak business environment. Growth in agriculture has been by far more volatile, in large part reflecting continued vulnerability of agriculture to shifts in weather conditions, as in other Maghreb countries. However, agriculture was also the best perforrming sector during 1976- 2000, with an average annual growth rate of 3.9 percent. Volatility, weak institutions, social instability, and a large share of government in the economy, have had a mutually reinforcing adverse impact on productivity and growth. Their interaction cost Algeria an estimated 2 percentage points in average annual growth since the mid-1980s. The absence of supporting institutions, to help build social consensus, greatly reduced the government's ability to respond to volatility, due to the adverse impact of the adjustrnent to shocks on social stability. The fiscal retrenchment and exchange rate devaluation, implemented in response to the collapse in the price of oil in the mid-80s, were followed by severe social and political unrest in the country. This greatly diminished the capacity of the government to maintain policy restraint in the face of shocks, while at the same time keeping up the pace of costly reforms needed to complete the transition to the market. The delayed restructuring and privatization of public enterprises has had, in turn, adverse consequences on manufacturing activity, investment, and the soundness of the banling system-which was crippled by bad debts. Long-term growth has been also adversely affected by relatively weak development of human capital. Education indicators continue to under-perform regional and income-group averages, while, until recently, population growth and fertility rates were among the highest in the world. Despite low levels, human capital indicators are in an improving trend. However, experience-especially from MENA countries-suggests that improvements in education do not lead to higher growth in the absence of a conducive environment in which the educated labor is employed. Algeria's improving trends in human capital bode well for future growth, but they will have to be combined with concomitant improvements in other factors of growth, especially the investment climate and market institutions. With a tradition of high savings, improving educational attainment, abundance of hydrocarbon resources, and an advantageous geographic location, Algeria has good potential for growth. In the past, growth has fallen short of this potential because of large external shocks, institutional weaknesses, a hesitant transition to the market that perpetuated iii  price distortions, lack of openness to foreign trade and investment, and a large and intrusive government. Moving forward, achievement of this potential will depend on how effectively these impediments to growth are being tackled. In the medium term, promoting fast, broad-based growth requires simultaneous action on both the structural and macroeconomic policy fronts: Encouraging the development of the private-sector, by strengthening the investment climate and furthering Algeria's transition to the market. This calls for "second generation" structural reforms, to remove inefficiencies in public service delivery, as well as in the markets for credit, industrial land, and the labor market. Such reforms call for a fundamental redefinition of the role of the State in the economy: (i) ncreasing the State's capacity to regulate markets; enforce decisions; ensure a level playing field among all participants; provide effective and reliable public services and market institutions; (ii) Reducing the State's intervention in areas where private operators should progressively take over-especially in the production of goods and services that do not exhibit public good or strategic features. * Strengthening the fiscal framework, to insulate the fiscal stance from volatile hydrocarbon fiscal revenues, and secure fiscal sustainability in the face of expenditure pressures and the contingent liabilities of the public sector. Strengthening fiscal management would call for a multi-year, integrated fiscal framework, with the aim of de- linking expenditures from the volatile hydrocarbon revenues, while saving part of the hydrocarbon revenues in the context of an active asset and liability management strategy. Despite steps taken to date, Algeria's transition to the market remains incomplete. To complete the transition to a dynamic market economy, Algeria would need to establish discipline on the "old economy" managed by the public sector, while enabling the "new economy", led by the private sector, to grow. Establishing market discipline on the public enterprises is key, so that these enterprises face the incentive to restructure and become more productive and able to compete in a market-based system. This would eventually call for significantly stepping up the privatization program. Enabling new enterprises to emerge and expand is crucial for resuming growth and absorbing currently idle resources and those that could be released by the old sector-in particular offering employment opportunities to workers affected by liquidation and restructuring. Experience from transition economies suggests that, despite the costs involved, policies to encourage the emergence of the "new economy" have to go hand-in-hand with enforcing discipline on the "old economy". There is no evidence that slow downsizing of the old sector could provide a viable "cushion", until the new sector has grown enough to offset the pain of liquidation and restructuring of public enterprises. Encouragement without discipline has not worked, because often the old sector has absorbed resources that would otherwise have flown into new enterprises. In Algeria, resources of oversized public enterprises (such as, for example, industrial real estate) are not put to efficient use, while weak management incentives lead to poorly performing enterprises, unutilized resources and depreciating machinery. iv  Slow restructuring and privatization in the Algerian industry entails an opportunity cost, because private companies over-perform public enterprises in terms of profitability and output growth across all manufacturing industries. With the acceleration of reforms to encourage private sector development since 1994, industrial production of private enterprises has rebounded across all Algerian manufacturing industries-particularly so in light manufacturing. In industries where the public enterprises accumulate sizeable losses, private enterprises have been in good financial shape. Because distressed public enterprises lack the incentives and the means to modernize and expand capacity, investment in Algerian manufacturing has been low, denying the economy the benefit of a multiplier impact on non-oil GDP and slowing job creation. Distressed public enterprises also pose risks to the Algerian economy by burdening the public banks with non-performing debt. Although this appears to have been less the case recently, the financing requirements of state-owned enterprises have been largely covered by bank borrowing, despite the willingness by the authorities to severe the links between state-owned enterprises and public banks. Bank loans to state enterprises have represented sizable contingent liabilities for the Algerian government. Over 1993-97, the cost of the buy-back of bad loans to state enterprises represented close to 30 percent of average GDP-the major part of the domestic debt in Algeria. A fresh buy-back of non-performing loans, along with recapitalization of two banks, took place in 2001, to complete the cleanup of public banks' balance sheets. It cost an estimated 15 per cent of GDP. The fiscal and quasi-fiscal cost of the bailouts of public banks in Algeria is at the high end of the range seen in other transition economies. The cost is cornparable to that in Bulgaria and the Czech Republic (42 and 26 per cent of GDP) and much higher to that seen in the Baltics and the CIS. Bailouts of public banks in Algeria suffered from similar weaknesses as in the Central and Eastern European Countries, with financial cleanup de- linked from deeper operational restructuring of banks and-most importantly-restructuring of distressed public enterprises. In transition economies this approach typically led to the recurrence of not-performing loans, and it did not prove successful in reducing the risk of renewed bank failures. Because of their superior performance, accelerated development of private- sector enterprises would help Algeria rise to the challenge of international competition. The Association Agreement with the EU and the upcoming membership to WTO open a new era in Algeria's participation in global trade. Trade liberalization will call for bold adjustments in import-competing industries, in order to improve efficiency and withstand competition. But with the right business environment in place, Algeria could face competition, take advantage of export opportunities, and attract foreign direct investment in the non-hydrocarbon sector. Because of low wage costs, the Algerian manufacturing sector could be well-positioned in a number of labor-intensive industries-although unit labor costs still surpass those in potential competitors. Unit labor costs in manufacturing are, on average, lower in the private sector, reflecting a better productivity performance-especially in light industries such as textiles, leather, and footwear. v  Improving access to and lowering the cost of key productive inputs and business services-especially finance and industrial land-and strengthening the legal, judicial, and governance framework, are key elements of an enabling environment for the creation of new enterprises, willing and able to compete in domestic and export markets. Despite a recent improvement, access to finance remains a key constraint. It remains difficult, time consuming, and unreliable-especially for small and medium enterprises. While the private sector represents now approximately 50 percent of GDP and 60 percent of bank deposits, bank loans to the private sector still represent only about one-third of total credit allocation to the enterprise sector. Although lending conditions to public enterprises appear to have tightened-possibly as a result of the introduction of the "Performance Contracts" with public banks-they are still easier than lending conditions to private enterprises of comparable size. The difficult access to credit partly reflects weaknesses of the banking sector and partly shortcomings on the business side. Banks are bureaucratic, not business-friendly, and poorly equipped. The long-standing lending links between public banks and state-owned enterprises have also shaped the credit culture towards less risk taking. Economic information is scarce and unreliable, only 53 per cent of private companies have audited accounts, credit history databases are inexistent, and many SME managers lack the qualifications to present sound business plans. Moreover, the judicial system is slow, unreliable, and still dominated by judges lacking knowledge of commercial matters; making it impossible for banks to credibly secure collateral. Credit bottlenecks are exacerbated by the lack of specialized financial institutions (such as leasing, factoring) and venture capital, catering to the financing needs of Small and Medium-sized Enterprises and business start- ups. As severe a bottleneck is the high cost of industrial land in Algeria. Out of the 600 firms surveyed in 2002, 38 percent have been looking for a plot of land, for a period of time of almost five years on average, to invest and expand. About half of the industrial estate is kept unused, in the face of considerable pent-up demand. The process of acquiring industrial land is thus lengthy, costly and uncertain, hindering the growth of private enterprises. Most unused land in industrial zones is entitled to former state-owned enterprises that ceased to operate. Lack of proper land ownership titles impedes freeing unused industrial land. Despite the positive change in Government policy toward the private sector, the attitude of the public administration is often business unfriendly and the administrative barriers to doing business remain high. Entrepreneurs still face unfriendly bureaucratic behavior, red tape, cumbersome and opaque regulations and endless delays to obtain clearances and authorizations. Barriers are pervasive in all areas of business activity. Most frequently mentioned are the procedures to clearing imported goods through customs, in particular through Algiers' harbor; obtaining a building permit; registering an enterprise. Pervasive administrative barriers in doing business and weaknesses in the legal and judicial framework perpetuate what is often perceived as unfair competition (from the informal sector; illegal imports; private import monopolies), and make it hard to enforce the anti-trust legislation. vi  Foreign investors have sidestepped Algeria, owing to the lack of attractiveness of local partners, the poor overall business environment, and to security concerns. The foreign perception of the country has also been negatively affected by the perceived hesitations in implementing the reforms, particularly the privatization program. Evidence from the transition countries indicates that a strong investment climate, underpinned by a strong commitment to reforms, has been a key determinant of FDI inflows. Improvements to the overall business, environment would also strengthen the FDI climate in Algeria. In addition to bottlenecks in access to finance and industrial land, obstacles that should be addressed include: a) administrative barriers to doing business; b) weaknesses in the legal, judicial, and governance framework; c) high cost and unreliable quality of key infrastructure and business services. A ranking of Algeria's performance across 42 infrastructure indicators indicates a weak performance. Due to the dominant position of hydrocarbon revenues in total fiscal revenues, oil price swings have been transmitted to the fiscal stance. Maintaining low fiscal deficits in the face of declining hydrocarbon revenues has been associated with expenditure compression, with the brunt of the adjustment bome by capital spending. By contrast, increasing hydrocarbon revenues have often boosted govemment expenditures, even though higher hydrocarbon revenues have proven temporary. Thus, the stance of fiscal policy has been pro-cyclical, as suggested by the close association between the non-hydrocarbon primary fiscal deficit and the hydrocarbon fiscal revenue. By following the cycle of oil, fiscal policy exacerbated the impact of terms-of-trade shocks on the rest of the economy. Macroeconomic policy has supported stabilization, aided by favorable oil prices, but challenges for fiscal sustainability lie ahead. Expenditure compression has been the cornerstone of Algeria's painstaking fiscal consolidation during the 1990s, which supported macroeconomic stability in the face of a volatile external environment. This has ensured a comfortable fiscal position in the medium term. On current tax and expenditure policies, if oil prices were maintained at levels similar, on average, to those seen in the 1990s, the standard foreign indebtedness indicators would perform favorably. The rising trend in foreign reserves, combined with a declining external debt portfolio, would translate into a net asset position for the country. However, the existing fiscal latitude and external debt dynamics are sensitive to the projected size of the hydrocarbon revenues. The contingent liabilities of the public sector pose a risk to medium-term fiscal sustainability in Algeria. In the current corporate and bank governance enviromnent, the bulk of contingent liabilities in Algeria will continue to originate in the non-performing loans to public enterprises, accumulated in the portfolios of public banks. Guarantees for credits extended by financial institutions and for deposits in those institutions also pose risks. Contingent liabilities may arise also from the financial situation of the pension system, with cumulative financing requirements projected at about 6 per cent of GDP over 2002-08. The current budget procedures do not faciltate a clear assessment of the Government's financial situation and the management of fiscal risks associated with contingent liabilities. There is widespread scattering of current and capital budget vii  allocations not reflected in the budget. Spending scattering dilutes public policies, provides incentives to perpetuate multiple activities for which line departments accumulate resources, and impairs prioritization of expenditures. Resource dispersion is compounded by a multiplicity of financial management instruments for public expenditure. There are over 300 active special accounts that intermediate expenditure financing, most of which are not integrated in the budget. Challenges also exist for maintaining the sustainability of the primary non hydrocarbon fiscal deficit in the face of exhaustible hydrocarbon revenues in the long run. On current fiscal trends, the non-hydrocarbon fiscal deficit would be sustainable under a high-case scenario for hydrocarbon revenues, where "permanent hydrocarbon income" is estimated at 20.6 per cent of 2001 GDP. That would not be secured in a mid-case scenario, with "permanent hydrocarbon income" estimated at about 17 per cent of GDP, in view of the upward trend in the non-hydrocarbon primary deficit. Strategic Challenges and Policy Options The interactions of policies and institutions documented in the analysis suggest the need for a wide-ranging growth strategy. To create the right framework for a sustained acceleration of Algeria's growth, policies to manage macroeconomic volatility and secure fiscal sustainability would need to go hand in hand with structural reforms to remove bottlenecks to private sector activity and improve competitiveness. Yet, the strategy would need to be focused, by addressing the key medium-term structural and macroeconomic policy challenges, and promoting measures that mutually reinforce each other. The strategy should be built around two pillars: * Fostering private sector development by improving the investment climate * Strengthening the fiscal framework, to better manage volatility and secure medium- term fiscal sustainability The Algerian Government has already taken steps in a number of these directions, but further progress would be needed to strengthen policies and reap the benefits of past initiatives. A full-fledged discussion of the options outlined below is provided in this report; the Private Sector Development Strategy; the investment climate assessment by the Foreign Investment Advisory Service; and the Synthesis Policy Note on the Medium-Term Growth Strategy for Algeria. viii  Challenge 1: Fostering private sector development by improving the investment climate 1. Establish market discipline on public enterprises andfoster the privatization agenda * Accelerate transparent privatization, based on existing legal framework and send strong, credible signals by achieving key 'success stories' * Accelerate public enterprise restructuring by selling non-performing assets, terminating non-viable activities, and concentrating public enterprises on their core business * Enforce hard budget constraints on public enterprises and replace bank credit to loss-making enterprises by transparent subsidies in the budget 2. Accelerate the comprehensive reform of the financial sector * Reduce the State's direct involvement in the financial sector by preparing for the privatization of the banking sector, while upgrading the State's regulatory role * Facilitate the development of new financing instruments that fit the needs of the private sector-especially SMEs (Leasing and factoring companies; venture capital funds; Export financing; reforn of housing finance) * Improve access to market and credit information and increase consulting and training support to SMEs * Strengthen the technical infrastructure of the financial sector * Fosterjudicial refonn (collateral legislation, banlcruptcy etc.) 3. Reform the institutional set-up of the industrial land market to increase supply of land slots at market rates * Increase the supply of available public land, while selling or conceding at auction major shares of public land to unify the dual land market * Review the institutional set-up of the land market to limit the State's involvement to its regulatory function * Foster private participation in development and management of industrial parks 4. Strengthen the business environment by reforming the institutional and regulatory frameworkfor private sector investment * Reduce administrative bottlenecks, especially to streamline customs procedures and facilitate enterprise registration * Foster business information-all laws, implementation decrees, and regulations should be published and made available to the public * Further facilitate private participation in infrastructure services; to mobilize needed capital; and, to attract management skills needed * Launch pilot Export Processing Zones ix  5. Improve the functioning of the labor market to foster formal employment and job creation * Reduce the high level of non-wage costs, due to the high rates of social security contributions, especially for the low-skilled and low-paid workers * Ease restrictive employment regulations that hurt more vulnerable worker groups and the youth and feed the informal labor market * Audit existing active labor market programs with the aim of improving targeting and facilitating monitoring Challenge 2: Strengthening the fiscal framework, to better manage volatility and secure medium-term fiscal sustainability 1. Take steps to de-link public expenditures from short-run movements in oil prices and the resulting volatility in hydrocarbon revenues * Set cautious reference prices for oil in the budget * Anchor the fiscal framework on an indicator that is unaffected by the short- run changes in hydrocarbon revenues, such as the non-hydrocarbon primary fiscal deficit, measured as a ratio to non-hydrocarbon GDP * Implement a multiyear expenditure planning, based on a rolling medium-term expenditure framework * Integrate the "Fonds de Regulation des Recettes" into the budgetary process and improve transparency in the goals, rules, and operations of the fund 2. Secure the sustainability of the non-hydrocarbonfiscal deficit in the medium and long term * Implement a savings strategy over time, to meet the challenge of long-run depletion of hydrocarbon fiscal revenues * Over the medium term, keep the non-hydrocarbon primary deficit below a prudent estimate of the "permanent hydrocarbon income stream", and save excess hydrocarbon fiscal revenues to offset the depletion of hydrocarbon revenues in the long term or help face future calls on the budget * Implement an active asset and liability management strategy with the aim of reducing net debt, giving priority in the short term to prepaying most expensive foreign debt and reducing the debt service ratio. Over the medium term, construct a portfolio of financial assets that hedges the risk of protracted declines in the price of oil * Promote efficient government debt markets through the establishment of reference interest rates and yield curves, regular debt issuance (including in the international capital market), and modernization of the regulatory framework of securities markets x  3. Strengthen the transparency of fiscal accounts and the role of the budget as an instrument for improved medium-term macroeconomic management * Step up the modeniization of the preparation and fornulation of the Budget by: a) Enhancing coordination among information collecting institutions b) Strengthening the capacity by Government agencies to formulate better projects and programs for public investment c) Establishing a fully integrated Budget framework, including a unified, multi-annual, and rolling Budget for 3-year periods d) Ensuring thorough coverage ("exhaustivit6") of all fiscal and expenditure accounts within the Budget. e) Consolidating the evaluation and monitoring of contingent liabilities * Strengthen ex-post Audit/Control of Budgetary Expenditure * Establish an independent system for impact evaluation of public policies xi   CHAPTER 1 FACTORS OF LONG-TERM GROWTH AND MACROECONOMIC VOLATILITY IN ALGERIA 1. Economic performance in Algeria since 1980 has been characterized mainly by weak growth and a large exposure to external shocks and volatility. After seeing a decade of relative prosperity in the 1970s, when GDP grew at an average annual rate of 6.8 percent, Algeria witnessed virtual economic stagnation. From 1980 to 1994 GDP grew, on average, by 1.7 percent per year-less than the rate of population growth. Thus, despite a growth revival since 1995, real per-capita GDP in 2000 (in constant US dollars and international prices) stood at about US$2,800, just 2 percent higher than in 1980 (Figure 1.la). Moreover, growth has been volatile: ten years during the past two decades saw negative per-capita growth (Figure 1.lb). External volatility arises mainly from sharp movements in hydrocarbon revenues, on which Algeria is heavily reliant: hydrocarbon revenues currently account for 95 percent of the country's exports, 30 percent of GDP, and 75 percent of fiscal revenues. Terms-of-trade volatility has been among the highest in the world. Volatility has been inadequately managed and has had a disproportionate impact on GDP growth. Figure .1.: The growth collapse since the early 1980s has been followed by a timid recovery since the 'mid 1990s Average Standard of Uving Per-Capita GDP Growth Rates (GDP Pspita) 8 3WO ~~~~~~~~~~~~~~~4 2500 - 5 -2 3000 - 4 1971 197 7 19W 1983 IBM I t 15 ____ (a) (b) Note: Per capita GDP is measured in constant international dollars, using purchasing power parity rates Source: World Bank staff 2. Since 1994, the government has successfully carried out important fiscal consolidation, adopted cautious monetary and fiscal policies in the face of volatile oil prices, and achieved some progress in structural reform. These measures have laid the groundwork for future growth. Algeria is now experiencing a mild resumption of growth, seeing 5 consecutive years of positive per-capita growth for the first time in the past two decades (Figure 1.lb). GDP grew by 2.5 per cent a year, on average, from 1999 to 2002, while the non-hydrocarbon, nonagricultural sector grew at a faster pace of 2.9 per cent. Boosted by rapidly growing domestic demand, thanks to the Economic Recovery Program implemented in 2002, growth in the non-hydrocarbon sector reached 4 percent in 2002. Consumer price inflation remained I  tamed, despite a spike to about 4 per cent in 2001. Growth was supported by rapid expansion of the hydrocarbon-sector, thanks to the increase in the price of oil since 1999. Growth in the non-oil sector has been revitalized but still remains insufficient to absorb the high level of unemployment (especially in the non-oil industrial sector-Table 1.1). The weak responsiveness in the non-oil sector growth shows that the agenda is far from complete. The increase in the price of oil has helped Algeria improve its external and internal balances. The current account switched to a sizeable surplus of 16.7 percent of GDP in 2000, which gradually declined to 9 percent in 2002. 3. Growth will need to accelerate further in order to absorb the high unemployment that was estimated at 27 per cent of the labor force at the end of 2001. Because of the existence of a large informal labor market the estimated rate of unemployment overstates the true magnitude of labor market slack. However, informal labor market jobs do not provide as productive jobs as in the formal sector, do not contribute much to the development of workers' skills, and thus do not support a strong growth of household incomes. With new entrants to the labor market growing by about 1.7 percent per year-and assuming an average elasticity of employment to output growth of 0.5-to reduce the unemployment rate by half in ten years, GDP would have to grow by 6 per cent per year. A more drastic reduction of unemployment would call for faster growth-or for increasing the employment content of growth through diversification to labor-intensive sectors as explained later. 4. Broad-based growth is also critically important to make a dent on poverty. According to the 1995 data, 14 percent of the population was below the poverty line; up from 8 percent in 1988. Although most recent estimates of poverty incidence are not yet available, preliminary evidence from national accounts data and household surveys suggests that the trend of increasing poverty may have been reversed. Per capita consumption in constant prices grew by 1.1 percent per year, on average, from 1995 to 2000. At the same time, contrary to the early 1990s, consumption growth of the low-income groups seems to have been more resilient. According to recent household survey data, while in 1988 the first five deciles of the population accounted for 24.2 percent of total household expenditures, that share had risen to 27 percent in 2000. Each of the lower deciles saw an increase in expenditure shares, in both rural and urban areas. 5. Overall, after ten years of transition to the market, inequality in Algeria does not seem to have worsened. Clearly more in depth research is needed to validate these trends and study the underlying factors of poverty and inequality. However, the recent pattern of expenditure inequality may partly reflect the maintenance of the social safety net. Moreover, the elimination of distortions (such as the realignment of prices and exchange rates, reduction of tariffs and import barriers) may have also played a role in improving the consumption possibilities of the low-income groups. Further promoting labor-intensive growth and improving the quality of public services would be a prerequisite to consolidate gains in poverty reduction. 6. By examining the determinants of long-term growth trends, and benchmarking Algeria's performance against other oil-dependent comparator countries, this chapter seeks to identify the key bottlenecks to better long-term growth performance in Algeria. The chapter 2  also draws the main linkages between growth and volatility in Algeria, by analyzing the impact of volatility on long-run growth, and identifying the channels which propagate the impact of shocks and volatility to growth.' 7. Overall, results show that long-term growth has suffered from relatively large exposure to external volatility, a low human capital base, relative price distortions, and weak institutions. Algeria's growth collapsed for a decade since the mid-1980s, due to the adjustment to the oil price slump-exacerbated by an unsustainable foreign debt-and disruptions associated with a difficult transition from the command economy to the market. The interaction between large shocks and weak institutions has greatly contributed to the growth crash, which was further worsened by the persistence of macro instability until the mid 1990s. The lack of success in diversifying exports, stimulate domestic investment, and attract foreign direct investment in the non hydrocarbon sector largely explain the weak resumption of growth since the mid 1990s. 8. As further explained in chapter 2, strengthening the investment climate and easing constraints to the efficient use of resources would foster private sector development, enhance medium-term growth, and help reduce the high level of unemployment. However, with hydrocarbons at the heart of the Algerian economy, the strategic management of the hydrocarbon sector will also shape growth potential. The impact of changes in hydrocarbon revenues on the rest of the economy will be determined in great part by the efficiency with which these revenues are intermediated by the government. Strengthening the fiscal framework, to insulate the fiscal stance from volatile hydrocarbon fiscal revenues, so as to better manage macroeconomic volatility and secure fiscal sustainability will be key in helping achieve a sustained acceleration of growth. 3  1.1. Growth and macroeconomic volatility in Algeria: A comparative perspective 9. With the hydrocarbon sector at the heart of the Algerian economy, economic performance since independence has in large part been shaped by oil price movements. Algeria shares the growth pattern of other oil-producing countries and MENA countries. However, the economy's ability to respond to the reverse oil shock was impaired by the rigidities of the command economy system, while exposure to volatility has also been stronger. Contrary to patterns seen elsewhere, and largely due to the civil violence and the slow transition to the market, Algeria has lagged behind other developing countries in the growth recovery seen in the 1990s. A growth boom has been followed by a protracted bust- 10. During the 1970s, high oil prices resulted in an economic boom that benefited almost the entire group of oil producers (Figure 1.2a and Annex 1.1). In the 1980s, the growth boom came to an end, as oil prices collapsed in 1986, and falling export earnings led to a sharp contraction in domestic demand-especially in investment (Figure 1.2b). Emerging from the oil price slump in the 1980s, and experiencing persisting weaknesses in oil prices, growth performance within the group was more varied in the 1990s. Mexico and Indonesia were able to achieve reasonable growth, despite their exposure to severe financial crises. In contrast, per-capita growth remained negative in Algeria, Ecuador, Nigeria and Venezuela. Figure 1.2: Long-term growth trends in Algeria have been shaped by oil revenues Per capita GDP growth, in per cent per year percEtdGOP 7 7 00 -- _ 40 _ 7 LM ~~~~~~~~~~~~~~~~~30 5 00 J / la 5D~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~0 -2X 00 0mm 25 300 ~~~~~~~~~~~~~~~~~20 . 100 1 . 0 Algeria Mgerila Veinezuela 71.80 81-90 91-00 1970 1974 1978 1900 1#16 lo 1900 1900 (a) (b) Source: World Bank staff 11. Algeria's growth performance follows that seen in other oil producing countries, but was also shaped by the rigidities of the command economy. After the healthy growth seen in the 1970s, in the early 1980s growth was already running out of steam, as the drawbacks of the centralized planning were holding back productivity and yields in public enterprises and state farms (Figure l.lb). Growth of demand was mainly fuelled by consumption subsidies and money growth, but supply shortages gave rise to increasing rationing on the official market and a sizeable parallel market premium on the official foreign exchange rate (Nashashibi et al. 1998). With hydrocarbon revenues dropping by 50 percent in 1986, Algeria witnessed significant budget and external imbalances. Budget deficits were largely 4  monetized, while current account deficits led to the buildup of foreign debt-with the debt service ratio rising from 35 percent of exports in 1985 to 78 percent in 1988. The debt crisis triggered by the reverse oil shock was followed by a collapse of growth, which lasted for a decade. 12. Macroeconomic adjustment efforts were put in place in 1989 and 1991, and were resolutely strengthened by an adjustment program introduced in 1994. To achieve macroeconomic stabilization, the 1994 program relied on strong fiscal adjustment (see chapter 3), supported by tight monetary policy, exchange rate adjustment, and a strict incomes policy. At the same time, to revitalize growth, the government initiated structural reforms aimed at accelerating the transition to the market and improving resource allocation through the realignment of relative prices and gradual liberalization of foreign trade. Thanks to successful stabilization and debt rescheduling, foreign debt was put on a sustainable path, with the debt service ratio declining to about 30 percent of exports by 1997. 13. Growth in the industrial and services sectors has largely mirrored overall growth performance (Figure 1.3a). Growth in agriculture has been by far more volatile, in large part reflecting continued vulnerability of agriculture to shifts in weather conditions, as in other Maghreb countries. However, agriculture was also the best performing sector during 1976- 2000, with an average annual growth rate of 3.9 percent (Table 1.1). The non-hydrocarbon industrial and services sectors grew on average at about the same rate as GDP. Moreover, movements in the oil price have been transmitted to non hydrocarbon GDP growth: the simple correlation between the annual non hydrocarbon GDP (excluding agriculture) growth and changes in real price of oil during 1975-2000 was 0.4 (Figure 1.3b). Table 1.1: Growth Rates Output Components 1968-70 1971-75 197640 1981-85 198640 1991.95 1996-2000 1978-2000 GDP Growth 6.5 6.5 6.2 4.8 0.8 0.3 3.2 3.1 Agriculture Sector Growth 2.1 10.9 4.8 2.9 3 6 4.5 3 9 3 9 Industrial Sector Growth 11 1 22 7.0 4.1 11 -0.5 40 3.2 Non-Ol Industrial Sector 11.7 19.5 12.2 64 -1 6 .22 1.4 3.2 OilSector 11.1 -1.2 4.1 2.4 3.2 0.6 5.5 32 Services Sector Growth -7 4 20.5 5.2 5.9 0.9 1.0 2 2 3.0 Aggregate Consumption Growth 21 12 9 7.7 5.5 -1.8 0.9 1.2 2.7 Private Consumption 1 5 12 2 7.8 5.5 -1.8 0.6 1.1 2.6 Govemment Consumption 47 15.4 7.7 4.7 -2.1 5.3 2.8 3.7 Fixed Investment Growth 15 2 8 4 3 4 -5.0 -2 5 2.4 1.4 Private Investment . .. -1.3 1.6 *0.9 -0.7 -0 3 Public Investment .. .. 12.5 -12.7 -4.5 14 3 2.4 Exports Growth 7.8 2.5 0.6 5.0 3 5 0.8 5.8 3.1 Imports Graoth 8 7 17.1 3.9 5.8 -8.1 -2.4 -1 4 -0.4 Source: World Bank staff 14. Owing to the collapse in hydrocarbon revenues in the mid-80s, the growth of demand in the services sector, the non-oil industry, and construction, took a big hit. During 1986-90, growth fell by 5 percent in the services sector and by 8 percent in the non-oil industries relative to the previous 5 years. Growth in the two sectors has remained relatively weak since. The mild recovery in GDP growth since the mid-1990s has been led mostly by the oil 5  sector. However, the non-oil industrial sector has also seen a modest resumption of growth, after 10 years of contraction, in response to the structural reforms implemented since 1994. Figure 1.3: Sectoral long-term growth trends (a) (b) Growth in value added, in per cent per year 00 80 25 Agncultu 150 - 60 Servces r 100. .l140 -15I - 710 75 .80 8I5 90 95 00 1975 1978 1981 1984 1987 1990 1993 1998s 1999 -Oilprice Growth - Growth of Non-oil GDP -G of 0G-GP Source: World bank staff 15. On the demand side, the recent growth recovery has been driven by a large increase in public sector investment, directed to expanding the oil sector and the resulting pick-up in hydrocarbon export growth. Private investment has yet to recover, owing to the still weak investment climate and the incomplete structural reform agenda. Private consumption growth has remained subdued since the mid-1980s, reflecting the exceptionally high unemployment and the weak growth in household incomes. -partly owing to poor totalfactor productivity growth 16. Total factor Productivity (TFP) growth in Algeria was largely negative during 1979-94, recovering somewhat during the late nineties (Figure 1.4a).2 TFP growth rates are closely linked with non-hydrocarbon GDP growth rates (Figure 1.4b). Weak TFP performance and a steady decline in capital accumulation have been the main factors behind the negative growth of output per worker. The human capital measure has been improving steadily over the past 3 decades. But its impact on growth has been more than offset by slow capital accumulation and negative TFP growth, resulting in low GDP growth rates.3 6  Figure 1.4: TFP Trends Grwth In per cent per year Grwth m per cent, per year - - - ~~~~~~8 Capitalstock 6 Per capfta non-hydmcarcon GDP 4 4 - ~~~~~~~~~~~~~~~~~~~~2 -8 8 1974 1977 1980 1983 1986 1989 1992 1995 1998 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1998 1998 2000 (a) (b) Source: World Bank staff 17. Analysis later in this chapter suggests that relative price distortions, exposure to large extemal shocks and institutional weaknesses may have contributed to the weak TFP performance over the entire 1970-2000 period. Also, TFP growth since the mid-80s seems to have suffered from volatility caused by macro policy slippages (which were corrected after 1994), and lack of openness to external trade and investment. A factor of particular importance was the severe shortage of intermediate inputs and imported capital, owing to the balance-of-payments crisis and the devaluation of the dinar in the late 1980s, triggered by the collapse in the price of oil. Moreover, the debt crisis squeezed financing for investment projects, both in the enterprise sector and for public investment in infrastructure, thus exacerbating inefficiencies in the non-hydrocarbon sector and worsening the productivity slump. 18. TFP growth has shown a positive albeit subdued response to the structural reforms implemented since 1994: the average TFP growth picked up to 0.3 percent per worker during 1995-99, compared to -4.3 during the previous 5-year period. As explained in chapter 2, part of this increase in productivity may be explained by the increasing role of the private sector in industry and services since 1994. But TFP performance remains constrained by a weak investrnent climate that prevents a stronger resumption of private investment. Moreover, markets for labor and credit, as well as the delivery of public services to enterprises, all suffer from severe inefficiencies, leading to underutilization of production factors and to a growing informal sector that prevent a genuine revival of TFP growth. 19. The performance of TFP growth is consistent with the experience of other oil- exporting countries (Figure 1.5).4 The majority of countries in the group saw positive TFP growth in the 1970s: most likely due to the positive impact on productivity of increased investment in infrastructure. During 1980-85, TFP growth collapsed in all countries, as the balance-of-payments crises that were triggered by the oil price crash caused widespread disruptions in production and the efficient use of resources. But poor TFP growth also reflected the low quality of massive investments carried out during the oil boom. The fallout 7  of the oil slump since the mid eighties was more mixed. Indonesia, Ecuador, and Venezuela used the crisis period to step up structural reforms and experienced a rebound in TFP growth. Egypt and Mexico have also seen some gains from progress on structural reforms since the mid-1990s. Algeria suffered the most, with negative (and lowest in the group) TFP growth during 1986-90. Figure 1.5: Totalfactor productivity performance in Algeria has been weak Average Annual TFP Growth Rates (in per cent) 2 -2r lj -4 2i1971-79 * 80-85 El86-90 0 91-95 * 96-00 Algeria Ecuador Egypt Indonesia Mexico Nigeria Venezuela Source: World Bank Staff Algeria has been exposed to high macroeconomic volatility 20. Over the 1970-2000 period, the outcome of external shocks and domestic policy responses for Algeria was growth volatility at the high end of other oil-producing countries and transition economies-at least twice as large as the MENA average over any period of time (Figures 1.6a-1.6d, based on a methodology outlined in Annex 1.3). Out of a total sample of 144 countries, only 9 countries had higher terms-of-trade volatility than Algeria during 1971-1999. The strong impact of terms-of-trade volatility on GDP also reflects the poor diversification of the Algerian economy out of hydrocarbons. However, in the 1990s, volatility of GDP growth receded, as Algeria compares favorably with other oil-producing countries and the average (see Annex 1.3). This partly reflects the somewhat lower exposure to terms of trade variability in the 1990s, but is also attributable to strengthened macroeconomic management and successful stabilization since 1994. 8  Figure: 1.6: Macro Economic Volatility has been high (1970-2000) Inflation Volatility GDP Growth Volatility Volat(INFLATI) Volat(GROWTH1) 40 - 1- - i 30 20 Ii6iu u..11 10 3 (a) (b) Terms of Trade Volatility Terns of Trade Volatility Volat(TOT2) Volat(TOT4) 40 1000 _____ _ 30 o800 20 600 10 2 400 *flflflflfl3fl* ~~~~200 (c) (d) Source. World Bank staff 21. The Agricultural sector has been the most volatile due to its vulnerability to recurrent changes in weather conditions (Figure 1.7). Hydro-carbon output has been the least volatile, reflecting constraints imposed by production quotas. By contrast, changes in domestic demand, as a result of terms of trade volatility and policy responses, have been reflected in high volatility in non-hydrocarbon industrial output. Increased volatility is likely to deter domestic investment in the industrial sector, as it increases risks in a sector already plagued with substantial uncertainty, due to persisting violence and to increasing exposure to foreign competition. 9  Figure 1.7 Volatility in Sectoral Growth Rates Volatility (of sectoral growth rates between 1976-2000) 12 11: 12 0 Agrkcurlure Non-Nydro Services Non-ydro Hdro- GDP hdustry GDP Carbon GDP Source: World Bank staff 22. Evidence suggests that higher volatility hampers the long-run growth process (Ramey and Ramey,1995; Aizenman and Marion 1995, 1996; Serven 1998). Across a large group of countries, average growth performance over 1981-2000 is, indeed, negatively related to the volatility in the changes of terms of trade (Figure 1.8).5 Figure 1.8: Higher volatility is associated with slower growth 2ore Aorlgerlaaf CL 8 -4 0 10 20 30 40 50 Teffms of Trade Volatility Source: World bank staff 23. However, individual country performances vary significantly around the average. The impact of volatility on a country is likely to depend on govemment policies, and the quality of the underlying social and economic institutions. Stronger financial systems will be in a position to better cushion the impact of volatility, by allowing better inter-temporal smoothing of expenditure and more efficient allocation of resources across economic sectors in the face of greater uncertainty. Flexible labor markets would also help absorb the incidence of shocks to employment, thus preventing steep increases in unemployment that may amplify the impact of shocks on domestic demand and growth. Most importantly, prudent fiscal policies are key to insulating the economy from external shocks. Prudent fiscal policies provide room for absorbing the shocks, without placing excessive strains on domestic demand in order to maintain a sustainable external position. Analysis later in this chapter and in chapter 3 confirms that, because of weak institutions and pro-cyclical fiscal 10  policies, volatility has been mismanaged and has had an adverse impact on growth in Algeria. 1.2. Assessing Algeria's long-term growth potential: strengthening assets and removing bottlenecks to growth 24. Drawing on cross-country empirical evidence, this section examines the social, structural, and macro economic determinants of Algeria's long-term growth performance. The section first examines the reasons for the weak growth performance in the past, especially, for the protracted slowdown since the mid-80s. This analysis forms the basis for an assessment of Algeria's growth potential over the next decade or so, conditional on removing the key bottlenecks that have constrained growth so far. Accountingfor Algeria's '"issing long-term growth" 25. If Algeria had achieved growth performance similar to Indonesia's (another oil- dependent economy), per-capita GDP in constant US dollars would have been US$4,400, such that the living standard of an average Algerian could have been 60 percent higher. According to a more accurate empirical estimation (see Box 1 for main results and Annex 1.4. for details), based on Algeria's investment ratios, human capital, population growth, and initial level of per capita income, the country's per capita income should have grown on average by about 3.2 percent per year over the past three decades.6 However, actual growth during 1971-2000 has been only 0.9 per cent on average per year, suggesting a "growth gap" of about 2.3 per cent. What are the factors accounting for Algeria's "'nissing growth" over the past three decades? 26. Further empirical analysis (Box 1 and Annex 1.4) shows that this "missing long-term growth" is explained almost fully by Algeria's large relative price distortions during the command-economy period; weakness of its market-supporting institutions; weak human capital indicators; and exposure to large external shocks. When these factors are accounted for, predicted per-capita average growth for Algeria's is 1.3 percent, quite close to the actual performance.  Box 1.1: Assessingfactors of long-term growth in Algeria Following Mankiw, Romer and Weil (1992), we ran a regression of the average per-capita GDP growth (1971-2000) (y) on the average investnent rate (INV), the initial inicome in 1970 (IN1), the average population growth rate (POP), and the average level of secondary school enrollment during this period (SEC) as a measure of human capital. Results are reported below with the relevant t- statistics in parenthesis. The signs are as predicted: the sign on initial income is negative, suggesing conditional convergence. y = -6.2 + ln(SEC)*0.77 + n(InNV)*3.3 - lo(IN)*0.6 - POP*4 (-3.3) (3.0) (6.4) (-2.2) (-2.0) Adjusted R2 0.44 According to this estimation, the average per-capita growth rate in Algeria during the 1971-2000 period should have been 3.2 percent, and not the 0.9 actually seen. This is mainly driven by a high average investment ratio in Algeria: one of the highest in the sample. These gains from capital accumulation are offset to some extent by the relatively high population growth rate and weak average human capital indicators-although these have improved significantly in rec.ant years. To account for the "missing growth' of 2.3 percent in Algeria we extend the regression to include broader measures of growth determinants, drawing on the empirical growth literature. y = 4.5 - SEC*0.02 - MORT*0.01 + ln(INV)*2.3 - in(MI)*l.1 - FERT*0.4 - VOLAT*0.05 + ICRG*0.04 - BM*0.001 (1.2) (-1.6) (-3.0) (-5.0) (-2.8) (-1.7) (-2.5) (2.2) (-2.5) Adjusted R2 0.64 where, SEC, MORT and FERT are human capital indictors and stand for the average secondary enrollment rate, the average mortality rate, and the average fertility rate respectively, VOLAT is a volatility measure (calculated as standard deviation of annual terms of trade growth during 1971- - I999), ICRG is the average rating of political institutions over 1984-2000 by the ICRG, and BMP is the average black market premium. The relevant t-statistics are in the parenthesis. All signs are as expected, except for enrollment to secondary education-wlich is not significant and has the wrong sign once additional measures of human capital are included. This framework predicts an average per-capita growth of 1.3 percent for Algeria, which is much closer to the actual performance of 0.9 percent. Therefore, much of the "inissing growth" is accounted for by including proxies for market distortions, volatility, and institutions. Source: World Bank staff 12  Table 1.2: Comparison ofAlgeria vis-a-vis Sample Average--volatility has been costly in terms of growth performance Algeria Sample Contribution to Average Growth TOT Volatilitv 24.4 11.1 -0.7 ICRG Ratings for Political Institutions 52.6 61.9 -0.4 Average Fertility Rate 5.4 4.0 -0.5 Average MortalitY Rate (under-5, per 1,000) 92.8 81.3 -0.1 Average Black Market Prenlium 201.1 66.4 -0.1 Initial Per-Ca ita GDP (natural log) 7.5 7.7 0.2 Av. Gross Dom Investment Rate (natural log) 3.5 3.1 0.9 Source: World Bank staff 27. Comparisons with sample averages suggest that excessive volatility may have been the biggest contributor to Algeria's "missing growth" (Table 1.2). Excess volatility cost Algeria close to 0.7 percentage points in average annual per-capita growth, while a loss of close to 0.4 percentage points may be attributable to weak institutions, 0.6 percentage points to poor human capital indicators and 0.1 percentage points to 7price distortions (captured by the "black-market" premium on the official exchange rate). The impact of these factors has been transmitted to growth through the weak or negative total factor productivity growth documented earlier. By contrast, comparatively large investments by the public sector have provided some limited support to growth, although insufficient to offset the drag of weak productivity on growth. 28. The role of institutions. Algeria's performance with regard to institutional/governance variables is generally recognized as being weak (see also Dillman, 2000). The economic system has for long been characterized by an extensive state patronage system fed by distribution of oil rents and, until recently, a myriad of state controls and price distortions. This has typically provided more incentives for rent-seeking and predatory behavior by the private sector than for engagement in productive activity. The positive change in Government policy toward the private sector over the 1990s has not translated yet into significant change in the attitude of the public administration towards entrepreneurs, who still often face unfriendly bureaucratic behavior and red tape (see chapter 2). Simnmering discontent with economic and political weaknesses, against a backdrop of lacking institutions that could provide people with voice and participation to enable the needed change, has contributed to a pernicious civil strife since 1992. 29. Two sources were used to benchmark Algeria against comparator countries on the performance of governance institutions: ICRG, and a compilation of rankings by various agencies (Kaufrnan et al; 2002). It should be stressed that such ratings convey the image of a country's governance as perceived by foreign investors, but do not necessarily convey a fully accurate sense of ongoing reforms, as investors' perceptions may be slow to change-due to entrenched perceptions and credibility concerns-or may be blurred by external events. It is thus important to strengthen the credibility of reforms so as to improve the country's image on governance, as this is an important determinant of the attractiveness to foreign investors. The use of these ratings in the empirical estimates reported in this study is not meant to imply that The World Bank necessarily endorses their accuracy. The FIAS report provides more 13  evidence and explores policy options to strengthen the foreign investor climate on Algeria (World Bank, 2002d). 30. Algeria is perceived as performing poorly on most measures considered (Table 1.3). According to the ICRG ratings, among the 14 countries compared, Algeria's rankings are particularly low on the Rule of Law and Order, and Democratic Accountability, while they are close to average on Corruption and Quality of Bureaucracy. On all indicators, but the Quality of Bureaucracy, Algeria's score is below that of the MNA average. According to compiled rankings, (Kaufinan et al, 2002), of the 14 countries compared, Algeria's ranking varies between 9 and 14, while its performance is significantly worse than the MNA average along all six dimensions. On the two dimensions which arguably are the most critical for private investment, Regulatory Quality and Rule of Law, Algeria ranks last and second-last respectively. Table 1.3. Algeria's performance on Institutional Quality/Governance has been weak InternatIonal Country Risk Guide (ICRG) Ratings Kaufman, Kraay, Zoldo-Lobaton (2002), "Governance Matters II: Scaled to a Score of 110D) Uj dated Indicatorsor 200011" World 8ank WP. Bureaucracy Law and Corruption Democratic Voice and Politcal Govermnmnt Regulatory Rule of Control of _a_ QualRy Order Accountablly Accountability Stabilty Effectiveness Quality Law Corruption 1998-2000 1998-2000 1998-2000 1998-2000 2000/01 2000101 2000101 2000/01 2000/01 2000/01 Algeria 3.33 3 38 3 33 3 52 -119 -1 27 0.81 4 79 -0 97 -0.62 Azerbaijan 1.67 6 80 3 33 4.07 -0 70 -0 70 -0 95 -0.14 0.78 -105 Colombia 3 33 2 87 3 06 5 00 -041 -1 36 -0.38 0.02 4.77 4.39 Ecuador 3 33 519 5.00 6 67 -014 -0.80 -0 94 0.00 -0.76 -0 98 Egypt 3 33 6 67 3 33 3 33 40.65 0 21 0.27 0.13 0.21 -0.16 Gabon 3.33 5.00 1.67 5 09 -0 40 -0.44 -0.45 -0.12 4 44 -0 58 Hungary 6.67 9 07 8 29 10.00 119 0 75 0.60 0.88 0 76 0.65 Indonesia 4 35 3 61 236 4.21 - 40 -1.66 -0.50 -043 -0 7 -1.01 Mexdco 5.00 3 56 4 35 8 56 0.12 0 06 0 28 0.58 -0.41 4.28 Nigeria o.83 5 00 1.94 3 61 -0 44 -1 36 -1.00 -O 39 -1.13 -105 Poland 6 00 7 66 6 48 10 00 1 21 0.69 0 27 0.41 0 55 0.43 Saudl Araba 3 33 8.33 3 33 0.00 -1.07 0.51 0.00 -4.11 0.19 -0 35 SyrlIa 1.67 8 33 6.02 1.67 -1 40 -0.28 -0.81 4.66 -0 52 -0.83 Venezuela 1.67 6 67 6 00 7.45 -0 34 -0.33 -081 4.30 - el 40.69 MNA Average 2.86 7 46 4 76 3 64 4 64 0.07 0 07 0.16 010 -009 Source: World Bank staff 31. The role of human capital Long-term growth in Algeria has been adversely impacted also by relatively weak human capital indicators. Education indicators continue to underperform regional and income-group averages (Table 1.4), while, until recently, population growth and fertility rates were one of the highest in the world. However, despite low levels, human capital indicators have considerably improved in recent years. For example, during the 1975-2000 period, the average years of schooling more than doubled while the fertility rate fell by more than half and life expectancy increased by 15 years. Primary enrolment is now almost universal and relatively equal across urban and rural areas (World Bank 1999). 32. Considerable scope for improvements in human capital remains nonetheless. In health, infant and child mortality rates, albeit considerably lower than in the 1970s and 1980s, have stagnated since the 90s. Improving the quality and targeting of health care services would 14  help expand health coverage to include poorer and rural sections of the society. Although the illiteracy rate is less than half its level in the 1970s, it remains considerably above the level in comparator countries and Algeria's income group. In addition, the recent trend of increasing repetition and dropout rates, especially at the secondary education level, needs to be reversed. Also, the quality of the education system needs major upgrading: there appears to be a serious mismatch between skill requirements of the market and skills being imparted by the system: this also lowers the returns to education and contributes to the high drop-out rates. Moreover, experience, especially from MENA countries, suggests that improvements in education do not lead to higher growth in the absence of a conducive environment in which the educated labor is employed (Pritchett, 1999). Therefore, the improving trends in human capital bode well for future growth in Algeria, but only if combined with concomitant improvements in other important growth determinants, especially the investment climate and market institutions. Table 1.4: Select Human Development Indicators in Algeria and Comparator Countries Life Fertllty Rab Under-4 Gross Primary Gross Secondary Av Years Illiteracy rate Expectancy (births per Mortality (pe Enrollment Rate (% Enrollment Rate Y ea o ho r adult (% pop _(years) woman) 1,000 live births) of school-ge pop.) of ago group) oling 15 and above) 1975 2000 1975 2000 1980 2000 1975 1995 1975 1995 1975 2000 1975 2000 Algeria 56 71 7.3 3.2 139 39 93 107 20 63 2.0 5.4 72 4 33.3 Colombia 63 72 4.6 2.6 58 23 118 109 36 81 4 3 5.3 18.9 8.3 Ecuador 60 70 5.6 3 0 101 34 104 123 40 52 4.6 64 21.7 8 4 Gabon 46 53 4.3 4.2 89 102 . .. .. Indonesia 51 66 5.0 2.5 125 51 86 113 20 51 30 50 371 13.1 MexIo 64 73 5.8 2.e 74 36 109 115 35 61 3.9 72 21.3 86 Nigeria 44 47 6.9 5 3 196 153 51 93 8 32 1.4 3.5 74.1 381 Venezuela 67 73 4.7 2.8 42 24 97 90 44 35 3.6 6 6 19.6 7 4 MNA Average 55 68 6.8 3.9 131 46 71 96 32 52 2.4 5 3 62.6 34 0 Lower-middle- 63 69 36 21 81 41 114 112 44 67 ,, 5.6 34.8 15.3 Income countrles Source: World Bank staff 33. Factors affecting efficiency. Benchmarking also shows that exchange rate distortions, as reflected by the black market premium on foreign exchange and real overvaluation of the exchange rate, have been large in Algeria (Table 1.5). Algeria had the highest average black market premium and average real overvaluation during 1971-2000.8 These price distortions impaired the efficiency of the price system in guiding resource allocation. Hence, they impeded investment due to higher uncertainty, while reducing its efficiency as they artificially boosted the viability of industries making intensive use of imported intermediate inputs. Excessive distortions in the foreign exchange markets have been removed in recent years, although the black market premium still remains significant. 15  Table 1.S: Select Macro and Structural Indicators for Algeria and Comparator Countries Gross Dom. Inv. GovL Cons. Budget Balabnce CPIInflaUon Trade (X + M) FDI, net Inflows Black Mkt Premium Real (% of GDP) (% of GOP) (% of GDP) (annual %) (% of GDP) (% of GDP) N Overvaluataon 1971-2000 1971-2000 1971-2000 1971-2000 1971-2000 1971-2000 1911-2000 1971-2000. Algeria 34 4 16 3 >52 121 55 0 0 2 201 158 colombia 191 117 -1 8 21.8 316 1.3 8 66 Ecuador 21 4 11.5 -0 7 31 3 53 3 20 22 85 Gabon 35 3 15.6 -2.9 7 7 96.5 0 9 2 149 Indonesia 25 9 9 0 -14 13.4 50 2 0 6 5 71 Mexdco 22.6 9.8 -41 34.9 34.0 1.4 7 70 Nigeria 20.0 13.1 -31 22 9 54.8 2.5 125 187 Venezueia, RB 241 9.9 -0 9 22 3 481 0.9 38 90 MNA Average 24 7 19 6 -5 4 95 72.0 1 1 39 120 Lower-.niddle- 29 7 12.7 . 39.8 1 41 income countries . Source: World Bank staff 34. International evidence has also shown that openness to trade and foreign direct investment are important determinants of productive efficiency and, hence, long-term growth. Algeria is in the middle of the group of comparators with respect to the trade-to- GDP ratio, while its ratio of FDIVGDP is the lowest in the group. The impact of trade on GDP growth may be weaker in Algeria however, as non-hydrocarbon exports are limited. Both trade and FDI shares of GDP fell significantly in the 1980s and 1990s relative to the 1970s, owing to the faltering performance of the oil sector and the lack of diversification. Oil exporters such as Mexico and Indonesia, that were able to diversify their economies away from oil, were more successful in taking advantage of the rapid growth in global trade and investment, and achieved higher per-capita growth as a result. Accounting for the protracted "growth crash" since the mid-1980s 35. The changes in the macroeconomic and structural policy variables mentioned in the previous sections provide an incomplete explanation of the protracted growth crash in Algeria since the mid-80s. The average annual per-capita growth rate dropped by over 4.2 percent during 1986-2000, relative to the 15-year period before. This is a much larger drop than changes in the variables identified in the previous section would suggest.9 36. International evidence suggests that external shocks are likely to be imrportant drivers of "growth crashes" (e.g. Easterly et al 1993; Rodrik, 1999). Accordingly, a growth model was estimated to explain the growth differences between the periods 1971-1985 and 1986- 2000, while accounting for the role of external shocks. The analytical framework is outlined in Annex 1.5 and the main results are presented in Table 1.6. The growth model explains about 70 percent of the variations in growth across countries over the two periods, and applies well to Algeria. Using alternative measures for terms-of-trade volatility, (VI and V2 respectively, in regressions 1 and 2),1o and accounting for changes in openness and the inflation rate, the predicted drop in per-worker GDP growth in Algeria is about 4.0 percentage points-very close to the actual drop of 4.2 per cent seen during the period." 37. Next, a synthetic indicator (V3-see regression 3) was constructed to account for the interaction among terms-of-trade volatility, improvements in institutions, and degree of political stabilitY and violence in the society. The same caveats apply concerning the 16  interpretation of the indicators of institutional quality.12 The drop in per capita growth rate predicted for Algeria was estimated at 4.6 percentage points. According to this estimation, Algeria lost about 2 percentage points in average annual growth relative to an average country due to this interaction effect (Figure 1.9). Thus the adverse interaction of volatility, weak institutions, and social instability was by far the biggest contributor to the growth crash since the mid-80s. 38. Because of institutional weaknesses, the government's ability to respond to volatility was been greatly reduced, due to the adverse impact of the adjustment to shocks on social stability. This has delayed restructuring and privatization of public enterprises, with adverse consequences on manufacturing activity and on the soundness of the banking system which was overburdened with bad debts (see chapter 2). Moreover, the fiscal retrenchment and exchange rate devaluation, implemented in response to the collapse in the price of oil in the mid-80s, were followed by severe social and political unrest in the country. This greatly diminished the capacity of the government to continue with policy restraint in the 1990s: while reducing capital expenditure, the government increased current expenditure by over 10 percentage points of GDP between in the 1990s. Overall, growth suffered not only from external shocks, but also because of the resulting social strife and increase in unproductive government consumption, largely reflecting the lack of supporting institutions.13 17  Table 1.6: Regression results for growth-crash model D'P and na Variabl: Average Per-W orker aroawth In 1986-2000 m Inus Av- rage Per-Workor Growth In 171.1 086 (1) (2) (3) (4) Ind pen d ant Variables L.g ed Growth -0 ea o075 .0 71 -0 7 (-tt 2).. (. 4).. (-8 ai)... (.91 Votle tility Terms v i -0 0 e (-2 4) V 2 -0 002 (-3 7 )* synthetiC Indicators V3 -0 61 (-4 1) V4 -0 42 (-2 .6)- DecadelChange. In Avorage FDIIODP Ratio 0 32 0 24 0 34 0 25 (2 8)... (2 4)" (4 0)... (2 4)" AvoIags TradIlGOP Retlo 0 05 0 05 005 005 (4 Q)- IS 3) - (4 9 )... (5 1).. Ave regs Inflation Rato -2 71 2.3 e -2 40 -2 40 (-3 7). (-2 9)- (-4 2)... (-2 9). umrn my for Oll-exporting countrles -0 77 -0 43 -0 07 -0 63 (-2 2)" (-1 1) -0 1 (-1 6) Adjusted R' 0 68 0 72 0 75 0 7 O b 74 70 62 70 Value Predicted for Algeria -386 -3 906 -4 50t -4 03 . -, ' Impile that the coefticlent Is significant at the 10, 5 and 1 percent levels Figure 1.9: Accountingfor the protracted growth crash in Algeria: Management of volatility matters Contribufion of various factors In Growth Crash of 1986.2000 0 -0.2 -044 -06 .12 S.4 -1.6 -1.8 -2 VotlyTTen1 Itcrese inreasehI kIreein Tradg(GP FWG Wi8bcn Note: The Volatility I term reflects the interaction effect between terms of trade volatility, improvement in political institutions, and social stability. Source: World Bank staff 18  Resuming the growth process in Algeria: Policy challenges 39. With a tradition of high savings, improving educational attainment, abundance of hydrocarbon resources, and an advantageous geographic location, Algeria has good potential for growth. In the past, growth has fallen short of this potential because of large external shocks, institutional weaknesses, and a hesitant transition to the market that perpetuated price distortions, lack of openness to foreign trade and investment, and a large and intrusive government. Moving forward, achievement of this potential will depend on how effectively these impediments to growth are being tackled. 40. The Government has pursued fiscal consolidation and followed a prudent monetary policy that contributed to stabilization, and at the same time has taken steps on the front of structural reforms. As a result, price distortions have eased, inflation has been tamed, and internal and external balances have improved. However, the incomplete transition to the market and weaknesses in market-supporting institutions still act as a break on growth of the non-hydrocarbon sector. These shortcomings have also prevented the economy from responding sufficiently to the reform measures taken thus far and also from benefiting from improvements in human capital. To tackle persisting social problems, especially high unemployment, it is imperative that the Government takes quick actions to facilitate private sector growth in the non-hydrocarbon sector (see Chapter 2), while continuing the efforts at fiscal consolidation, to preserve macroeconomic stability and secure fiscal sustainability in the medium term (see Chapter 3). 41. Findings in this chapter suggest that improvements in state institutions offer great potential in terms of higher growth. This is particularly important for Algeria given its large exposure to shocks and presence of social conflict that has manifested on numerous occasions in the recent past. Analysis suggests that by improving the quality of its institutions to the levels achieved by an average economy in the world, Algeria can add an additional 0.4 percent to its long-term growth. The per-capita growth bonus that would come with institutions at par with: * Mexico, would equal 0.7 percentage points; * A successful transition economy, such as the Czech Republic, would equal 1 percentage point; * Developed country standards, would equal 1.5 percentage points. 42. Better economic diversification could, also bring a high growth dividend, by reducing Algeria's vulnerability to external volatility. If exposure to external shocks could be brought down to the levels faced by Indonesia and Mexico (that used to be also disproportionately dependent on oil), growth could be enhanced by 0.5-0.7 percent. The steady improvements in human capital, which-under the right conditions-could potentially add about 1.3 percentage points to Algeria's long term growth relative to past performance. Greater openness to foreign trade and investment in the non-hydrocarbon sector has the potential of adding another 1.5 percentage points to medium-term growth. These gains are only suggestive, based on cross-country evidence, but do point to areas that can bring the highest gains in terms of growth. Summing up, improving performance along these dimensions could increase Algeria's long-term growth rate by about 3.8 percentage points. 19  43. Finally, because hydrocarbons are at the heart of the Algerian economy, the strategic management of the hydrocarbon sector may also shape long-term growth. Simulations suggest that, under the right conditions, the intermediation of hydrocarbon windfalls through the household and business sectors might produce superior economic performance in the long run (see Annex 1.6). When a temporary windfall is intermediated by the government, the impact is likely to die out almost completely in the long term, while with intermediation by the household and business sector the long-term increase in GDP might be sustained. This is because when the hydrocarbon revenues are exclusively intermediated by the state the pattern of expenditures and the amounts allocated to savings and investment are different from the patterns that would prevail under disbursement of rents to households and business. Hydrocarbon windfalls may be transferred to households and businesses through different channels-such as lower personal and corporate income taxes; lower indirect and payroll taxes; or direct transfers. Although these instruments have a different impact, when temporary hydrocarbon windfalls accrue to households and businesses savings may also increase concomitantly, funneling investment and directly expanding productive capacity and output in the long term. When the windfall accrues to the government, productive capacity increases only indirectly, to the extent public investment in infrastructure boosts private sector productivity, thus producing a more limited impact on output in the long run. 44. However, though increased private intermediation of hydrocarbon revenues could work for growth better, it would call for strengthening the investment climate. In real economic circumstances, higher household and business sector savings out of hydrocarbon windfalls would not be spontaneously converted into productive investment. This is especially so in Algeria, where weaknesses in the investment climate, constraints to the efficient use of resources, and still poorly functioning institutions hinder domestic investment. Shifting to a different model of intermediation of the hydrocarbon revenues would, thus, not be enough by itself to unlock the economy's long-term productive potential. Encouraging private sector investment and the efficient use of resources would not only promote the diversification of the non-hydrocarbon sector, but would also improve the capacity of the economy to make hydrocarbon revenues work for growth in the long term. 20  CHAPTER 2 SUSTAINING FASTER MEDIUM-TERM GROWTH IN A COMPETITIVE ENVIRONMENT: THE CHALLENGE OF STRUCTURAL REFORM 45. Achieving faster GDP growth for a sustained period of time is a prerequisite to significantly reduce unemployment in Algeria. However, as long as the hydrocarbon sector remains the main driver of growth, it will be hard to significantly reduce unemployment, because the hydrocarbon sector and the downstream industries contribute little to job creation. To reduce unemployment, growth will have to rely on the diversification of the non- hydrocarbon sector, driven by labor-intensive industries and services that are internationally competitive. 46. To respond to competitive challenges, growth would need to be led by the private sector, by encouraging both domestic and foreign investment in labor-intensive non- hydrocarbon industries and services. This would call for a comprehensive program of mutually reinforcing structural reforms, with the aim of furthering Algeria's transition to the market so as to remove the remaining constraints to the efficient use of resources. Indeed, since 1994, Algeria has embarked on a program of reforms, with the aim of promoting private sector development and addressing the structural bottlenecks at the origin of slow growth and high unemployment. 47. But despite steps taken to date, Algeria's transition to the market remains incomplete. To be sure, the Algerian private sector's share in non hydrocarbon value-added increased to an estimated 76 per cent in 2000, from about 62 per cent in 1992, comparing favorably with the private sector's share in other transition economies, especially in oil-rich countries in the CIS (Figure 2.la). However, private sector participation in Algeria remains much lower in the non-hydrocarbon industry. Moreover, the sizeable hydrocarbon sector remains in public hands, so that the private sector's share in total GDP remains compressed at below 50 per cent. 48. The shift from planned to market economies is a social and economic transformation of unprecedented magnitude. Although the specific design of policies, their sequencing and their speed are still subject to debate, there is a broad consensus that at the heart of the transition process are two major challenges: (i) Disciplining the "old economy", and (ii) enabling the "new economy" to emerge (World Bank, 2002b). The challenges faced by Algeria are examined in the first two sections of the chapter. Measures to strengthen the investment climate and remove bottlenecks to private sector development in Algeria are examined in more detail in the Enterprise and Private Sector Development Note (World Bank, 2002c) and in the Assessment of Foreign Investor Climate (World Bank, 2002d). 49. Establishing market discipline on the enterprises inherited from the command system is key, so that these enterprises face the incentive to restructure and become more productive and able to compete in a market-based system - with failure to restructure successfully leading to liquidation. Enabling the creation of new enterprises that are willing and able to 21  compete in the market place is crucial for resuming growth and absorbing the resources released by the enterprises from the old sector-in particular offering employment opportunities to workers affected by liquidation and restructuring. Experience suggests a large performance differential between the old and new sectors in transition economies during 1996-99 (Figure 2.lb). 50. Experience suggests that the transition economies that have created an enabling environment for the emergence of the new sector have witnessed stronger overall growth and lower transition costs, because enterprises in the new sector are more productive, and they also invest and export more than enterprises in the old sector. In retrospect, it is the effectiveness of policies in disciplining the enterprises inherited from the old production system and enabling the emergence of a critical mass of new enterprises that best explains the wide disparity in growth, social welfare and resilience to shocks, across the transition countries of the Central and Eastern Europe and the CIS. Figure 2.1: Enabling the emergence of the new sector helps reduce the cost of the transition to the market A faster speed of privatization may alleviate . . .because new enterprises outperform the costs of the transition... the state-owned enterprises Sh Al p&. -r b, GOP Vbw W-rA) 100 I Sues 15. 0o 10 eo 0~ AZ.lbDel -ebNeetis| a/~~~ K ,'~~~ Tnl*,'l 20 21 *992 _ _ - - - - - _. 6qxSsi t 100I2 IM0 9004 IM IM0 1007 100 AM000 (a) (b) Source: World Bank staff; based on data from EBRD and Algerian National Acrounts (ONS) 51. But at the same time, Algeria needs to rise up to the challenge of international competition, as the transition to the market inyolves lowering the protection of incumbent firms from foreign competition. The Association Agreement between the EU and Algeria opens a new era in Algeria's participation in global trade. With the' right business environment in place, Algeria could take advantage of export opportunities and attract foreign direct investment' in the non-hydrocarbon sector-which would help Algeria participate in cross-border production networks. Algeria's competitive potential in manufacturing is examined in section 3. 22  2.1. Furthering Algeria's transition to the market: Disciplining the old sector 52. Experience from transition economies suggests that disciplining the old sector calls for imposing hard budget constraints on enterprises, providing exit mechanisms for insolvent enterprises, monitoring managerial behavior, and increasing product market competition- also by liberalizing foreign trade. Imposing hard budget constraints on enterprises and banks is not only a sine qua-non condition for restructuring the old sector but also for macroeconomic stability (Annex 2.1). This section looks at progress and challenges still to be met by Algeria in privatization of public enterprises, bank restructuring, and trade policy reform. 53. Managing the political economy of reforms is perhaps the single most important determinant of the success of transition to the market (Annex 2.2). This is because the transition to the market entails costs and benefits which are unevenly distributed. Disciplining the "old economy" entails short-term costs, while gains from the emergence of the "new economy" will require a longer term horizon to accrue. Moreover, winners tend to be a diffuse constituency (because of the longer term horizon of the gains from reforms), while losers are concentrated. The uneven time profile of costs and benefits, along with the uneven distribution of winners and losers, may reduce the pace of reforms needed to discipline the old sector. 54. However, experience from transition economies suggests that, despite the costs involved, policies to encourage the emergence of the "new economy" have to go hand-in- hand with enforcing discipline on the "old economy". There is no evidence that slow downsizing of the old sector could provide a viable "cushion", until the new sector has grown enough to offset the pain of liquidation and restructuring of public enterprises. On the contrary, encouragement without discipline has not worked, because often the old sector has absorbed resources that would otherwise had flown into new enterprises. The emerging economy may be impaired in various forms. For example, in Bulgaria and Romania using the banking sector to prop up state-owned enterprises led to a sharp increase in non-performing loans in the 1990s, which prevented the expansion of credit to new enterprises and eventually triggered a banking crisis. In a number of CIS countries (Georgia, Kyrgyz Republic, Moldova, Russia, Ukraine), protection of state-owned enterprises through tax and utility arrears meant that new and more efficient enterprises were penalized by higher taxes or charges to offset foregone revenues of the state (World Bank, 2002b). In Algeria, resources of oversized State Owned Enterprises (SOE) are not put to efficient use (such as, for example, land), as suggested by their sub-par economic performance documented in the following sections. 55. Moreover, weak discipline of the "old economy" and lack of development of the "new economy" may be mutually reinforcing. Lack of a vibrant new economy, led by the private sector, limits product competition, an essential element of a disciplining environment. It also limits opportunities that may attract workers and potential entrepreneurs from public enterprises. This situation may typically lead to a "low equilibrium trap", characterized by a protracted transition to the market, slow growth, high unemployment, and worsening income distribution. A "reform freeze" scenario may then unfold, breaking the transition to the 23  market. To avoid "reform freeze" scenarios, it is important that reforms lead to a rapid establishment and effective flmctioning of the institutions that encourage entry and competition. It is also important to implement policies that offset the costs of the transition to vulnerable groups-such as social protection programs, including social insurance (pensions and unemployment benefits) and social assistance (family and poverty benefits). Civil society participation in the policy making, monitoring and evaluation is invaluable to the success of reforms in transition. Key among components of a vibrant civil society are NGOs, consumer and producer associations, and the media. Their participation tends to foster a public debate whereby the nature of the costs and benefits of reforms, as well as their respective horizons, are unveiled. Broad and genuine representation is also key to constrain the power of interest groups to capture the state during the transition (Annex 2.2). Privatization in Algeria has been elusive 56. The presence of a command economy was overwhelming in Algeria up until 1994, with resource allocation governed by administrative decisions on prices, investment, and credit of state-owned enterprises and public banks. Government disengagement from commercial activities gained momentum in 1994 (IMF, 1998). However, until 1998 the main emphasis of reforms was on public enterprise restructuring, with the closure of more than 900 non viable enterprises. Between 1996 and 1998 the labor force of public enterprises was cut by 320,000-or by about 40 per cent. But financial rehabilitation of public enterprises that were deemed viable cost to the budget an estimated DA 840 billion over 1991-98 (about 20 per cent of 2000 GDP). The cost of restructuring was high, as out of 800,000 jobs in public enterprises only 480,000 were saved in 1998 (World Bank, 1999). 57. Labor force shedding, as a result of the restructuring of public enterprises, was reflected in a significant decrease in the wage bill paid by public sector, which was cut by half as a proportion of non-hydrocarbon GDP from 1989 to 2000 (Figure 2.2a). However, the public sector still distributes half of the total wage bill, despite the increase in the share of the private sector to 76 per cent of non-hydrocarbon GDP in 2000. Wages distributed by the private sector rose by only about 2 percentage points of non-hydrocarbon GDP since 1994, offsetting just about half of the decline in the public sector wage bill over the same period. This partly reflects the still anemic private sector economic activity, and partly the significant size of the informal sector. 58. Despite the downsizing of public employment, the process of privatization has been very slow to date. Significant progress was achieved only in commerce, transport and communications, and construction and public works (Figure 2.2b). Exploration and investment in the hydrocarbons sector remains dominated by the public sector, despite some opening to private sector investments. In the non hydrocarbon industry, the share of the public sector in value added still remained at about 65 per cent in 2000, after hovering around 80 per cent for most of the 1990s. 24  Figure 2.2: Public andprivate sector shares in economic activity Despite the rise of the private sector, half of the A slow retrenchment of the public sector wage bill is still distributed by the public sector from productive activities Wage bill, in per cert taf on4riorocarbon GOP b O y d . 35 _ e W 1 {s ~~~~Publicseodor * Prtvateaecfzr 30- 25 aa, 20 - 1 5 10 .. 0q 4 4 4 4 4 14 ____________P l (a) (b) Source: World Bank staff, based on National Accounts datafrom ONS 59. However, in industry the disengagement of the public sector was uneven. In a number of manufacturing industries-such as food industries, textiles, leather and footwear- divestiture was swift, so that by 2000 the public sector accounted for between 20 and 40 per cent of value added (Figure 2.3a). But in capital intensive industries, private sector participation was slow, with the public sector accounting still for more than 70 per cent of value added in 2000 (Figure 2.3b). Figure 2.3: An uneven pace ofprivatization within manufacturing Public sector divestiture has been more swif Public enterprises remain entrenched in labor-intensive manufacturing in capital-intensive industries Value added of public enteipitses on per cent of value added by industry) Value added of publicentarpfsas (in per cent of vakue added by Indusby) 100 *--eTextes and dot-ng Metal and Machine Leather and fotwear 80 60 70 qzz~~~~~~~~Chennicals~~~7 eo 9 ~~~~~~~9s^_ 70 t;7~~~~~~~~~~~ and plastc oo n a 40 zooolndustCas + 60 Oiher tndusbolsr Consfucionmatalais 20 40 0 30 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 (a) (b) Source: World Bank staff based on National Accounts datafrom ONS 25  60. Main bottlenecks to privatization have been the scarcity of domestic savings that could be mobilized for privatization operations, in association with the weak investment climate- which has been also plagued by security concerns. However, privatization was also hindered by the administrative and legal framework for the operation of the holding companies, which was cumbersomne and ineffective. A new legal framework was adopted in August 2001, aimed at streamlining and stepping up the privatization process. 61. In the new framework, the privatization strategy is laid out by the "Conseil des Participations de l'Etat" (CPE), with the operational. support of the Ministry of State Participations. The privatization strategy is implemented by the 28 newly created "Societes de Gestion des Participations" (SGP) that manage, on behalf of the CPE, the equity of the public enterprises eligible for privatization. The SGPs encompass 674 public enterprises, according to a classification by economic sector, with the aim of improving the consistency of the privatization process within each sector and broadening the scope of privatization to sectors not eligible so far. Eligible for privatization are also eight industrial groups that have been singled out of the portfolio of the 28 SGPs, either because of their key economic role (Air Algerie), or because further restructuring is called for. The privatization process is also to encompass banks and insurance companies still in public hands, but according to a procedure specific to the realities of the financial sector. 26  Figure 2.4: Profitability ofprivate-sector companies outpaces that ofpublic enterprises across Algerian manufacturing industries odustr,t otmialo . rubb-r *i 01d platoc pLduCt S BO rutoitlt m_ _ _ _ _ _ _ 70 so~~~~~Plwas - ~~~~~~~~~~~~~40 30p 6 / / PLtlc ~~~ ~~~ ~~~~20 / ~ . 10 PubUc -10 / 0 . .30 -20 --- -- 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 1989 1990 1991 1992 1993 1994 1995 1998 1997 1998 1999 2000 (a) (b) Na proS of pdlo end pI MS ct0 opito On pr Cot Of vahug addedttlr by - r . d . s Qn pm MM of WM added ty sect(dl 0 Fu a d tabom eo W iNW. p w eXpl eid p odidps (tioyty C __ todod) 60 - 2ut __ _ - F = F =;0 = _ 80 1989 1990 1991 1992 1993 1994 1995 IM9 1997 IM9 ION9 2080 1989 1990 i991 199 1993 19S4 IM9 IM9 1997 i99 I99 2000 (c) (d) tXtprtdpttikndpSto urWeedrt. asPa (In poew r it *f ^d oby strN ptit poft dpjbc tr pAf siicb wtpites ani pw r" ant WANr by wtor ToW NbWt AM" s o-zr nend bottr a0 5=\ /-40 -10 tv 9 | | . . . 20 7 .~.~. .-- . . r60 \20 -, -110 -240 , 20~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~0 -160 -.-80 -- 19s8 1990 1991 1992 1993 1994 1995 1998 1997 199 1999 2000 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 (e) (d) Source: World Bank staff n based on National Accounts dataftom ONfS 27  Figure 2.5: Contrastingperformance of industrial output inAlgerianprivate andpublic manufacturing Vakmlidesk by $1=r (1989=1W) VOake added mr0s by sector (1989=100) tam~cu* rtt n min oIler p109k lbu8 Ghflksctrpn nEbr 3140 i21 10D O 80 SO- 60 0_ , 200 4 40 - ~--~RiOk 100 _ _ _ 20 0 0 1989 1990 11 1992 1903 104 1Iti 1911 IW 1990 199s 2W0 190 1 990 1991 19S2 i9 1994 1996 1080 1897 1980 190 2W0 (a) (b) alue added indics byseodor (1999=100) Va dde a bsouo ysWeotor (is0 180) Food PredtkR l pr mo r 1i200.. _._ - - ~- - - - - - - -----_................................... ___10 z0 \140>ao< / 120 100 206 Rtrata P"~~~~~~~~0 150 .4 Public 4 so 20 0 s i M 19 03 104 I M 16 0 M 2M1989 1990 1091 IM 1993 1994 1995 19199997M 1898 19809 (c) (d) 'Mue added Iedicgq byosectr (1989WO1) Vakbia edindcas by adior (1999=100) Te,file and Apparel L08198 podu dol 999108116 120 IGO1 9---- 10D ~~~~~~~~~~~~~~~~~~~~~~140 120 -dv w ~ ~ ~ ~ ~ ~~Pwa 40 40C 2D~~~~~~~~~~~~~~~~~~~~~C 40~~~~~~~~~~~~~~~~~~~~~ i9o9 low 1o 1902 1900 1904 1995 199 1997 1099 I00 200 I" I I IM 1091 0 92 1994 Iou 1099197 Iou IM 2DD (e)(f Source: World Bank staff, based on National Accounts data from ONS 28  62. The new framework recognizes three categories of public enterprises-namely viable, potentially viable, and distressed-and aims to step up the disposal of financially viable enterprises and those that have been successfully restructured. The authorities have taken steps in the right direction, to extend privatization and streamline the divestment procedures, in line with the procedures that have proven more successful in the economies in transition (Annex 2.2). The new framework aims to streamline administrative procedures for the participation of strategic foreign partners in the capital of key industrial enterprises and public banks. This will help in the modernization and further development of the enterprise sector. At the same time, privatization through the public offer of equity on the stock market is to be limited to a small number of key enterprises, given the low absorption capacity of the stock market and the need to identify strategic partners. However, the privatization program still extends over a relatively long, ten-year horizon. The main progress to date was the sale to foreign investors of two-thirds of the equity in the steel corporation (and linked iron ore mines). 63. Public enterprises in a healthy financial position can be found in three Algerian manufacturing industries: (i) Chemicals and plastics; (ii) Construction materials; and (iii) Food industries. The profitability of public enterprises in chemicals and construction materials has been in line with that of companies in the private sector-though it fell significantly short of private-sector profitability in food industries (Figures 2.4.Xa,b,c). 64. By contrast, public enterprises in metal products and machinery; textiles and clothing; leather and footwear, have been accumulating sizeable losses since the mid 1990s, amounting to as much as their value added-and even surpassing it by far in the case of textiles and apparel (Figures 2.4.d,e,f). In 2000, distressed public enterprises in these three industries accounted for about 15 per cent of total value added in manufacturing, and they were employing about 110,000 persons (2 per cent of the labor force). 65. The sizeable losses accumulated by public enterprises in these three industries have been induced by a collapse in their output, which in the late 1990s fell to levels as low as 20 per cent compared to the beginning of the decade (Figures 2.5.d,e,f). The output of public enterprises was also halved in food products (Figure 2.5.c). By contrast, industrial production of public enterprises remained constant in chemicals and construction materials, thus helping to maintain a decent level of profitability (Figures 2.5.a,b). Completing the transition to the market would bolster Algeria's potential in manufacturing 66. Contrary to the weak performance of public enterprises in most manufacturing industries, industrial production in the private sector held up well in the 1990s, suggesting that the collapse of Algerian manufacturing is not destiny. With the acceleration of reforms to encourage private sector development since 1994, industrial production of private enterprises rebounded across all Algerian manufacturing industries (Figure 2.5). The private- sector led industrial recovery was particularly sharp in light manufacturing-food products, textile, leather, and footwear-and in construction materials. By contrast, in capital-intensive industries the recovery was more modest. 29  67. Moreover, profitability of private companies over-performs that of enterprises in public hands across all manufacturing industries (Figure 2.4). Most notably, in the three industries where the public enterprises are accumulating losses, private enterprises are in good financial shape, with profits surpassing 40 per cent of value added (Figures 2.4.d,e,f). And while the losses of public enterprises have been soaring, the financial performance of private enterprises has been improving in the recent years, especially in labor-intensive industries such as textiles, leather and footwear. This pattern suggests that, with the right business environment in place, there is significant scope for growth in labor-intensive Algerian manufacturing-a finding also supported by evidence on relative international competitive positions examined in section 2.3. 68. The differences in performance between private and public enterprises-despite the existing bottlenecks to private sector development in Algeria-suggests that the troubles of public enterprises arise from their limited ability to meet the competitive challenges of the markets, rather than from competitive disadvantages of specific Algerian manufacturing industries. Creating an enabling environment for the growth of private enterprises holds thus the key to improving the overall performance of Algeria's manufacturing. Stronger output growth and better profitability in private manufacturing would stimulate investment and job creation-as private enterprises fare better in labor-intensive industries. Given their superior performance compared to public enterprises, private companies would also stand a better chance to meet the challenges of reduced protection in the free-trade zone with the EU. 69. Restructuring and privatization of viable public enterprises would help accelerate the recovery of Algerian manufacturing because in all industries output performance and profitability of private companies over-performs that of enterprises in public hands. Lack of restructuring entails an opportunity cost, as the unprofitable public enterprises burden the Algerian economy in, at least, two ways: First, they saddle the public banks with non performing debt, as their financing requirements are largely covered by bank borrowing. At about DA 21,5 billion in 2000, annual losses of public enterprises in the three problematic industries, if compounded over a five-year period, would amount to a financing requirement of 2.5 per cent of GDP. Second, capacity utilization in distressed public enterprises is low, while these enterprises also lack the financial means to modernize and expand capacity. This results in a low level of investment in Algerian manufacturing, denying the economy the benefit of a multiplier impact on non-oil GDP and weakening job creation. 70. Given Algeria's lag in privatization in industry and the differences in performance between private and public enterprises, the planned ten-year time horizon for privatization of enterprises still in public hands appears too cautious. The slow pace of privatization in Algeria also negatively affects the credibility of the Government reform agenda-especially for foreign investors. Privatization should go in tandem with establishing hard budget constraints on public enterprises, so as to facilitate restructuring. Hard budget constraints entail eliminating a wide range of explicit and implicit mechanisms to channel public resources to enterprises and banks, including tax exemptions, fiscal and financial subsidies, budget and tax offsets and directed credits. 71. During privatization, a coherent strategy should be put in place to manage public enterprises. Though this strategy should be worked out carefully, and in consultation with the 30  main stakeholders, international experience suggests that main directions in that process should be the following: * Enforce hard budget constraints on public enterprises 1. Accelerate public enterprise restructuring by selling non-performing assets and terminating non-viable activities, while liquidating the non viable enterprises 2. To facilitate restructuring, concentrate public enterprises on their core business, in particular by transferning responsibility for social services and management of social assets to small enterprises that may be created out of staff downsizing 3. Replace directed credits to public enterprises by transparent fiscal subsidies, and establish a timetable for a quick phasing out of such subsidies * Accelerate privatization of financially viable enterprises, preferably through the participation of strategic foreign partners who will help modernize and further develop the enterprise sector 72. The lessons from transition countries (see Annex 2.1 and World Bank, 2002b) suggest that small enterprises under state ownership (generally enterprises with fewer than 50 employees) should be sold quickly and directly through an open auction with no restriction on who may bid for the shares. Medium-size and large enterprises should be targeted for sale to strategic outside investors. The evidence indicates that privatization to concentrate outside owners such as investment funds, foreign strategic investors, and blockholders has facilitated restructuring. In contrast, privatization to diffuse owners and to enterprise employees has not been conducive to enterprise restructuring. However, enterprises controlled by strategic investors have performed better than those controlled by investment funds, holding companies or other financial institutions. Strategic investors are indeed able to provide more resources and skills for restructuring, and are better connected with intemational markets for technologies, inputs and products. The selection method of strategic investors also appeared to matter significantly. Enterprises sold through transparent tenders or auctions have generally attracted better owners, outperforning enterprises sold directly to politically connected parties, frequently at highly subsidized prices. Restructuring ofpublic banks in Algeria has been costly and is sdillfraught with risks 73. Algeria has one of the few remaining financial systems in the world that is largely dominated by the state, in terms of both credit allocation and ownership of financial institutions. The six state-owned banks are the hard core of the Algerian financial system. They represent more than 90 per cent of the banking system's assets. Up until 1999, the public enterprises were absorbing more than 80 percent of domestic credit. More recently, the access of the private sector to credit was on the rise, with the share of the public sector to domestic credit declining to 65 percent in 2001 (Figure 2.6a). Preliminary estimates for 2002 attest to a further decline in the share of public sector to about 56 percent. Credit to the private sector increased thus to nearly 7 percent of GDP in 2001. Although the allocation of credit to the public sector (as a ratio to the GDP) is not significantly higher compared to other 31  countries in MENA, the share of the private sector remained compressed, on average over 1996-2000, to lower levels than those seen elsewhere in MENA (Figure 2.6b). Figure 2 6: Domestic bank credit in Algeria The public sector still gets a major share ... and credit to the private sector of bank credit ... remains compressed h per cent of GDP Dornmsc ba* crdit In per cert of GDP (avrmgo, 19962000) 30 _1._ ._ _ ._ ___._._._ _ 25 DCrednto -ubllcenterprlses acredlttothepriv r Pubic se e P Pifvate sectr 120 20 1 5 80 40 5 0 - ' - - -- - - - 0 1994 1995 1996 1997 1998 1999 2000 2001 lb~ locreditto public enterplises U Credftto theprivate ectr /j (a) (b) Source: World Bank staff based on data from Bank ofAlgeria; IMF, and Arab Monetary Fund. 74. For the Algerian government, bank loans to state enterprises have represented sizable contingent liabilities, which have raised government financing needs to levels well above budget deficit financing requirements over the last ten years. Financial restructuring of banks and public enterprises came in two rounds in the past, in 1991-94 and 1995-98. The total cost of this cleanup, including the bank recapitalization of 1996 and the recapitalization of CNEP in 1997, came to an estimated than DZ 840 billion.'4 The cumulative buy-back of bad loans to state enterprises represented more than 50 percent of the average amount of outstanding loans to the economy, and gave rise to a significant domestic public debt. In total, about 90 per cent of the domestic debt in Algeria (about 20 per cent of GDP) is composed of government bonds issued for the repurchase of non performing loans, in order to rehabilitate the financial position of public banks. (World Bank, 2000). 75. A new buy-back of non-performing loans was carried out in 2001 to complete the cleanup of public banks' balance sheets. Bad loans were swapped for Treasury bonds with a 20 year maturity, carrying a 6 per cent interest rate. The repurchase of non-performing loans amounted to DZ 346 billion. An additional DZ 167 billion was spent to repurchase bad loans in real estate held by the CNEP, while consolidation of past operations cost DZ 224 billions. The total cost of the last clean up amounted thus to about 15 per cent of GDP, spread over 20 years. In order to meet the capital adequacy ratios, two banks were recapitalized in 2001 (BEA and BDL), and the recapitalization of a third one is planed for 2002 (BNA). The cost of these operations is estimated at DZ 50 billions. The authorities estimate that this last cleanup has completed the financial restructuring of public banks. According to staff's estimates-which, however, were not confirmed by a detailed examination of the public 32  banks' balance sheets-additional amounts of about DZ 130 billions may need to be committed, to cover still existing non-performing loans and improve provisioning, especially for the BADR, BEA and BNA. 76. The fiscal and quasi-fiscal cost of the bailouts of public banks in Algeria is at the high end of the range seen in other transition economies-comparable to that in Bulgaria and the Czech Republic (42 and 26 per cent of GDP) and much higher to that seen in the Baltics and the CIS. Bailouts of public banks in Algeria suffered from similar weaknesses as in the Central and Eastern European Countries, with financial cleanup de-linked from deeper operational restructuring of banks and-most importantly-restructuring of distressed public enterprises (Annex 2.3). Experience from transition economies suggests that this approach typically led to the recurrence of non-performing loans, and it did not prove successful in reducing the risk of renewed bank failures. 77. Until recently, in Algeria the majority of loans to state enterprises took the form of bank overdrafts. They were for the most part undocumented, and were not based on explicit loan contracts with binding maturity dates. Efforts since 1996 have been devoted to reducing the use of overdrafts and fostering more transparent and objective loan practices. The recapitalization of banks was thus accompanied by the introduction of "performance contracts" between the government and bank managers. Performance contracts intend to hold the bank managers responsible for respecting the capital adequacy ratios established by the Bank of Algeria, thus separating the management from the ownership of the public banks. By granting public banks increased leeway with respect to the allocation of credit according to commercial criteria, the performance contracts could be a step towards improving bank incentives to actively seek new market niches away of public enterprises. 78. However, the transparency of these "performance contracts" is open to question, as is their effectiveness in permanently redressing incentives in public bank lending to state- owned enterprises and minimizing the fiscal costs of bad loan repurchases. Since the introduction of the performance contracts, when public banks extend directed loans to public enterprises, these loans are provisioned by a transfer of funds by the Treasury to the bank. Though the link between the banks and the public enterprises is not yet severed, there is some progress, because the new procedures convert the government's implicit contingent liabilities into an "off-budget" subsidy to public enterprises, intermediated by the state- owned banks. If certain loss-making public enterprises were to be kept in operation for social or other sectoral policy reasons, it would be important that public bank loans (even provisioned by the Treasury) be replaced by transparent subsidies in the budget, so as to effectively severe the links of these enterprises with the banks and help restore the soundness of the banking system on a permanent basis. 79. Eventually, the quality of the public banks' loan portfolios will not improve unless the financial situation of their largest customers-mostly state entexprises-is significantly improved. As documented earlier, a significant part of public enterprises in Algerian manufacturing are still financially distressed. A rough estimate puts the current indebtedness of the major state enterprises at about DA 200 billion-but this figure is increasing due to the large operating losses documented earlier. Once more, some of the outstanding bank loans to 33  state enterprises may have to be repurchased by the Treasury in the coming years, either due to insolvency, or as part of restructuring plans for state enterprises or public banks prior to privatization. Therefore, reform of the financial sector must be accompanied by a sustained effort to restructure and privatize state enterprises, in order to reallocate their resources to profitable investments and allow the emergence of sound private enterprises. Financial clean up of public banks should go in tandem with operational restructuring and privatization 80. Along with public enterprise reform, the Algerian banking system must undergo a radical operational restructuring in order to restore its soundness on a permanent basis. Strengthening corporate governance of Algerian public banks, and upgrading information on financial performance to stock market disclosure requirements would help reduce the risks of recurrence of non-performing loans. Financial institutions must be granted full responsibility for their credit allocation and investment decisions. This would require strengthening the role of the supervisory authorities, to preserve the integrity and soundness of the banking system-especially in view of the increased presence of private banks. 81. However, the ability of the existing banking system, dominated by public banks, to cater to the needs of an economy that relies increasingly on the private sector should be strengthened, notably by improving the risk assessment capabilities of banks. This calls for a significant revision of the role and size of the state presence in the financial system. It is unlikely that the overall efficiency of the banking sector will change much in the short term without a sale of one or more state-owned banks to a private group or to foreign strategic investors. 82. Bank restructuring may lead to closing down public banks, or to privatization-partial or total. Privatization may involve two basic approaches: (i) a market flotation; (ii) sale to a strategic investor. Market flotation allows participation by small investors but raises concerns because of weak governance structures. In most developing countries, stock market privatizations have led to poorly performing banks. Bank managers have tended to take excessive risks, manipulated credit policies, favored related parties, and often used the resources of the banks to interfere in the political system. The failure of the OTP (former national savings bank) of Hungary is a well-known example of such practices. Privatization through a sale to strategic investors with managerial control would be more promising and should be used for some of the state banks. The use of a fully transparent process with experienced international advisers, competitive bidding, and "due diligence" is key to successful privatization. Trade liberalization has progressed, but protection in Algeria remains high compared to other transition economies 83. A number of reforms were recently introduced to Algeria's tariff policy (in the complementary budget for 2001 and the new tariff regulation introduced in August 2001). Tariff reform measures aimed at rationalizing the tariff system. This led to reducing the 34  number and level of rates, and to dismantling administered values. 15 The measures intended to improve the consistency of the tariff system, promote competitiveness, remnove the anti- export bias of the foreign trade regime, reduce high rates of effective protection of many import-substitution industries, and narrow the considerable variation of effective protection across industries. Reforms also aimed to prepare for the negotiations on Algeria's Association Agreement with the EU (AAEU-signed in December 2001) and facilitate ongoing efforts to gain WTO membership.16 84. The complementary budget for 2001 has three main provisions. First, it provided for reduction of the maximum rate from 45 to 40 percent and eliminates administered values. The average tariff rate-including the Temporary Additional Duty-declined slightly, from 23.9 to 22.1 percent. Second, in order to facilitate adjustment among local enterprises, a Temporary Additional Duty on imports ("Droit Additionel Provisoire", or DAP) was introduced. The DAP was set at 60 percent from July 1, 2001 with a phase-out timetable of five annual reductions (of 12 percentage points each) for its eventual complete elimination on January 1, 2006. The first reduction of the DAP to 48 percent was made on January 1, 2002. Third, the law eliminates the ad hoc Specific Additional Tax (TSA) and replaces it, for a limited number of goods, with the existing Internal Consumption Tax (TIC). 85. The 2002 budget and the complementary budget law for 2002 introduced further tariff changes, while broadening the list of products subject to the DAP. The second reduction of tariff rates, introduced in early 2002, brought about a more significant decline in the maximum tariff rate from 40 percent to 30 percent, and correspondingly reduced the average tariff rate (excluding the DAP) to 17.3 percent. 86. Despite these reforms, protection in Algeria remains high, compared to other transition countries-though not higher than elsewhere in the region (Figure 2.7; see also Annex 2.4). This is so particularly due to the DAP, and to a lesser extent to the TIC. The DAP was extended to other products (mainly to equipment goods), subsequent to the initialing of the EU association agreement in December 2001. The recently signed Euro-Med Association Agreement with the EU provides for the gradual elimination of tariffs on most industrial goods between Algeria and the EU over a twelve-year period. However, as the reduction in tariffs for final goods is back-loaded while tariffs on intermediate imports and equipment will occur in the early stages of the process, the effective protection of Algerian producers is likely to increase over the medium term. Effective protection will decline in the later stages of the association process, when the tariffs on final goods are eliminated. 87. Compared to the average tariff rate reductions (unweighted) achieved in the early years of transition in Hungary and Poland, Algeria's pace of trade liberalization has been more gradual and spread out over a longer period, as opposed to large one-off reductions, at least in the initial years (Table 2.1; see also Annex 2.4). This has delayed adjustment, as it prolonged the life of inefficient public enterprises without providing strong enough incentives for more ambitious restructuring. 35  Figure 2.7: Patterns of trade protection: Algeria vs. comparators A-r. P.,lgh dl , ..In p.n.nt 19HJ X 0 Em.lod Pngsry Polan d &ill EWyPI Mo.on NAign Tola. Source: World Bank staff Table 2.1. Comparison of average tariff rate reduction paths Unweighted, in percentages 1993/1998 2001 2002 2003 2004 Algeria 1 24.8/24.2 23.9 22.1 17.3 n.a. 1985 1991 1992 1993 1994 Poland n.a. 11.7 11.7 8.5 8.5 Hungary 24.0 12.6 n.a. 8.5 8.5 DC Average 27.2 24.3 21.5 19.4 18.7 Sources* World Bank staff 88. On the fiscal front, the loss of tariff revenue has to be compensated by new tax income, requiring a better tax collection and tax base broadening by containing the scope of the informal sector. The loss of tariff income from the Association Agreement with the EU is estimated at between 1 percent of GDP and 2.5 percent of GDP. 2.2. Making most of the market: Policies to encourage private sector-led growth 89. Market discipline is a necessary condition for the transition to the market but does not guarantee steady growth. Market discipline forces uncompetitive public enterprises (or sheltered private ones) to release assets and labor, which then can be potentially absorbed by restructured enterprises and business start ups. Creating an enabling environment for the growth of restructured and new enterprises is the key for improving growth performance and reducing the costs of the transition. This requires a strong investment climate, along with companion policies that that remove bottlenecks and encourage the creation of new enterprises willing and able to compete in domestic and export markets. Improving access to and lowering the cost of key productive inputs and business services-especially finance and industrial land-and strengthening the legal, judicial, and governance framework, are key elements of such an enabling environment for private sector development. 36  90. The diagnostics draw on the findings of the investment climate survey carried out for the Report on Private Sector Development and the FIAS (World Bank 2002c; 2002d). Fully- fledged policy options are provided in these reports and the companion synthetic Policy Note. Key findings and policy options are also highlighted below, as they constitute the backbone of the medium-term strategy for a sustained recovery of growth in Algeria based on private-sector development. The investment climate survey conducted on 600 firms in nine Wilayas, together with the interviews of 56 potential European investors, convey a sense of the main constraints identified by economic operators-whether private, public, foreign, or local firms. Overall, limited access to credit and to industrial land, and unfair competition from the sizeable informal sector appear to be key constraints to growth (Figure 2.8). Figure 2.8: Obstacles to doing business in Algeria-summary evidence from enterprise surveys Mstsewre obtaKe to nlneaa X t jC t 1 1 ~~~~~~1 ilArdqoost severe i Secoud most _ Most sewfs Source: World Bank staff Strengthening the investment climate and reducing the cost of business services 91. A strong investment climate is key to attract foreign direct investment. Geography (proximity to the EU) has been an important factor of FDI flows to the Central and East European Countries during the early years of transition. However, over time, other factors became more significant, and countries that were first neglected during the initial stages of transition due to their greater distance to the EU, also became significant recipients of FDI (Annex 2.5). 92. Survey data across the transition countries indicate that countries with high institutional performance ratings captured the highest cumulative net FDI inflows in per capita terms (Figure 2.9a). But FDI is footloose, and thus especially sensitive to risk. The greater the degree of perceived risk in a given country, the lower the cost of delaying entry in the country. As uncertainty is often driven by government policies, strong commitment to reforms greatly improves the investment climate. 37  93. Improvement in the perceived investment environment is also observed in the ratings for Algeria in the second half of the 1990s, according to a pattern that follows closely that of Bulgaria (Figure 2.9b). However, despite its size and market potential, Algeria has been to date sidestepped by foreign investors, contrary to other countries in the region, like Tunisia and Morocco, that have taken advantage of their proximity to the European market and of their Association Agreement with European Union. FDI inflows to Algeria have been notoriously concentrated in the oil sector. Figure 2.9: Foreign Direct Investment and the investment climate in transition economies In transition countries FDI has been boosted by Algeria's investment environment has high-quality institutions started catching up the lost ground FOI Inflewe. Ranked by EB RD In-titUtl-o1a Pe-lo nm0ne I -tdlo,t rmm lowesttohtlshwetOhv Ottbo y louAcng bwes MRmj: 190M *e, ao st cow olotlo net P1 inFlow, por napits (1D990-2000)7 10 10 - e so tt .... u go a -.--Hy -a-oPda -PA&f --EsIa so $5W 1=Q500 S21M taO ioo s2oi00 (a) (b) Source: Various issues of the EBRD Transition Reports, WDI, and the Institutional Investor, 1990-2001. 94. The limited FDI inflows to the Algerian non-hydrocarbon sectors partly reflect security concerns and partly the lack of attractiveness of local partners and the poor overall business environment. In addition to these, the foreign perception of the country is negatively affected by the perceived hesitations in implementing the reforms, particularly the privatization program. other issues are a source of particular concern for foreign investors-such as the practical impediments that they often face in transferring dividends abroad, in spite of a clear guarantee of transfer in the Algerian legislation; or the negative attitude and restrictions to foreign investment in the service or distribution sector. Constraints and restrictions that do not correspond to best international practices should be urgently addressed (World Bank, 2002d). 95. improvements to the overall business environment would also strengthen the FDI climate and support the Goverment's objective of FDI promotion. In addition to improving access to finance and industrial land as discussed separately below, areas were reforms would contribute to strengthening of the overall business environment include: a) reducing administrative barriers to doing business; b) strengthening the legal, judicial, and governance 38  framework; c) lowering the cost and improving the quality of key infrastructure and business services. 96. The positive change in Government policy toward the private sector has not translated yet into a significant change in the attitude of the public .administration and a lowering of administrative barriers to doing business. Entrepreneurs still face unfriendly bureaucratic behavior, red tape, cumbersome and opaque regulations and endless delays to obtain clearances and authorizations. Barriers are pervasive in all areas of business activity. Most frequently mentioned are the procedures to: clearing imported goods through customs, in particular through Algiers' harbor; obtaining a building permit; registering an enterprise; etc (Figures 2.1Oa and 2.1Ob). Tax harassment is also frequently mentioned. These difficulties are compounded by difficulties to access information, such as about laws, regulations and procedures, statistics, market information, etc. Although evidence is hard to come by, corruption is also reportedly present, possibly spurred by the administrative barriers and cumbersome procedures that make service delivery by the public sector slow and unreliable (Figures 2.10a and 2.10b). Some reforms are underway and should be scaled-up (for example, in customs and the tax authority), but major efforts of simplification and e-enabling of administrations are needed. Some of these, including faster business creation and improved access to information, should materialize via the ongoing roll-out of ANDI. 97. The Algerian legal framework is progressively being more attuned to the requirement of a market economy. However, it is far from functioning smoothly because of the shortage of qualified commercial judges and of the lack of understanding, by the business community, of methods that proved successful in other market economies (e.g. collateral legislation; bankruptcy; alternative dispute resolution). Also, there is limited trust within the business community in the impartiality of the judicial system. It is still widely seen as slow, inefficient, partial, and best avoided. In the short-term, there is a need to speed-up the implementation of the judicial reform on commercial matters, in particular the setting-up of independent commercial courts. As important is the need to urgently scale-up the ongoing training program of commercial judges to a much larger number of beneficiaries. 39  Figure 2.10: Administrative barriers to doing business in Algeria remain high Delivery of business services is slow ... ... while cumbersome customs procedures are a key bottleneck Ave r33e dela.. in the de&ieyr ofrpdl. senkes bmprng dip to deewetoo, 34 94 1ff0 111 il _ [ 11 | 12 S46S I | Isngut30 2t1 1715 8 Diq ilo 1636 *AVtloystdeueor jus 100 ~~~~~~~~ ~ ~~~~~~~~~~~~~~12 54651 11n1 jtgitndclaylo ear o '~ dUg 2 6ea 1 . C . 0 5443316 1 leah ,l sa C d .... C- . I)A