Tanzania - An agenda for industrial recovery (Vol. 2 of 3) : Main report

Report No. 6357-TA Tanzania: An Agenda for Induistrial Recovery (In Two Volumes) Volume l: Main Report June 30,1987 Africa Region Industrial Development and Finance Division FOR OFFICIAL USE ONLY Document of the World Bank This report has a restricted distribution and may be used by recipients 'only in the performance of their official duties. Its contents may not otherwise be disclosed without World1Bank authorization.  CURRENCY EQUTVALENTS Currency Unit The Tanzanian Shilling (T Sh) Exchange Rates December 1983 US$l = T Sh 12 December 1985 US$1 - T Sh 17 June 1986 US31 =T Sh 40 December 1986 US$1 = T Sh 30 May 1987 us$1 - T Sh 60 Fiscal Year Jily 1 - June 30 GLOSSARY BET Board of External Trade BIS Basic Industrialization Strategy BOT Bank of Tanzania CG Consultative Group ERP Economic Recovery Program DFCs Development Finance Companies DRC Domestic Resorce Cost DSM Dar-es-Salaam GDP Gross Domestic Product MIES Miscion's Industrial Efficiency Survey NBC National Bank of Commerce NCI National Chemical Industries (Holding Corporation) NDC National Development Corporation QRs Quantity Restrictions SAP Structural Adjustment Program SIDO Small Industry Development Organization SMC State Motor Corporation SSEs Small Scale Enterprises SSIs Small Scale Industries TDFL Tanganyika Development and Finance Company Limited TEXCO Textile Holding Corporation TIB Tanzania Investment Bank TISCO Tanzania Industrial Services Corporation TLAI Tanzania Leather Associated Indu3tries This World Bank report is based on the findings of a mission to Tanzania in October 1985. The mission comprised Messrs. Daniel Kaufmann (mission chief and principal author), Ashok Khanna, Vladimir Konovalov, Sanjaya Lall, Kurt Loos, Gradimir Radisic and Antonio Tarnawiecki. Mr. Manuel Penalver (Deputy Division Chief, EAPID), joined the mission for one week. Messrs. Miguel Schloss (Division Chief, EAPID) and D. Kaufmann discussed a Green Cover draft of this report with the Government ir. December, 1986, while a draft of the Grey Cover version of the report was discussed by Mr. Kaufmann during a mission in April 1987. Mmes. Cayouette, Chacon and Thomik processed this report.  F0 RomacAL USE ONLY TANZANIA: AN AGENDA FOR INDUSTRIAL RECOVERY Table of Contents Page No. PREFACE . -.. ..............,.i.-.iii EXECUTIVE REPORT (see separate Volume) VOLUME I: MAIN REPORT CHAPTER ONE - STRUCTURE AND PERFORMANCE OF INDUSTRY IN TANZANIA 1 Introduction .................................................. 1 Data ................. . ........... .. 1 Structure and Perrormance of Industry ...................... ..... 2 Production .............................................. 2 Investment . ......... ................... . 4 Ownership Structure . ................ .;.... . ... 6 Employment and Wages ................................... 6 Manufacturing Exports .................................. . 7 Imports .................................................... a Import Substitution ....... ......................... 8 Import Dependency .......................................... 10 Small-Scale Industries ..... . .................... ...... 12 Craft Industries .......... ............................. 12 Non-Factory Industries ...... ............................ 13 Factory Industries ....,... . ...... .*. .. . 12 CHAPTER TWO - THE POLICY FRAMEWORK .......... .................... 15 Introduction ..... ........................ ............... 15 Policies Affecting Industry ... .................................. 16 The Exchange Rate .................................. 16 The Administrative System of Foreign Exchange Allocation 17 Own Funds Imports .. ............. ....................... 18 The Tariff Regime ................... ........... ... .. 19 Sales Tax .................................................... 20 Taxes on Income and Profits .. .......................... 21 Price Controls ........... ..... ... . ....................... 21 Confinement Policy .. ................................... 22 Industrial Licensing and Foreign Investment ............ 22 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  -2- Page No. CHAPTER TWO. (Cont.) Export Promotion Policies ........ .............................. 23 Export Licensing ............. *..******...... * ............ 23 Export Facilitation ...#*.*....**** *. ... ...... ....... .. 23 Export Credit Guarantee Scheme (ECOS) ................. 23 Finar ial Services to Exporters ....................... 24 Export Rebate Scheme .................................. 24 Presidential Award Scheme ............................. 24 Export Retention Scheme . ....................... . . . . . . . 24 Financial Sector and Policies . ................................ . 25 Overview .............................................. 25 Interest Rates and Credit Allocation .................. 25 Development Banks in Industry ......................... 26 Capital and Labor Costs .............. ...... ... 27 Policies Towards Small-Scale Industries ........................ 28 The Impact of Policies on the Structure of Industrial Protection . ................................. 29 CHAPTER THREE - THE EFFICIENCY OF INDUSTRY AND THE ROLE OF POLICIES ....................... 33 Introduction ......................................................... 33 Overview of Efficiency in Industry .............................. 33 The Domestic Resource Cost Methodology: A Detailed Example and Explanation ............................... ..... 34 The Survey and Assumptions of the DRC Study ................. 38 Overall Efficiency ........................................ 40 Patterns of Subsectoral Efficiency ......................... 41 Firm's Size and Economic Efficiency ........................ 41 Firm's Ownership and Economic Efficiency ................... 43 Import Content and Efficiency ........................ ... 44 Capital Intensity and Efficiency ........................... 44 Capacity Utilization and Efficiencys A Fallacy Explored ... 45 Protective Policies and Economic Efficiency ... ................. 49 Administrative Allocation of Foreign Exchange and Industrial Efficiency . .................................. . 52 Export Promotion and the Productivity of Exports ............... 53  Page No. CHAPTER THREE (Cont.) Protection and Small-Scale Development .......................... 55 Sources of Inefficiency in Tanzania Industry .................... 56 Technological Capability Development in Tanzania's Industry ..... 56 Project Preparation and Execution ....................... 58 Pre6ess, Product and Industrial Engineering ............. 59 Infrastructural Bottlenecks . .............. ......... 60 Bottlenecks in Industry, Sources of Inefficiencies and Policy Issues: A Synthesis ............................... 61 Protectionist Policies and Economic Efficiency: A Historical Comparison ....................................... 64 CHAPTER FOUR - PAST TO PRESENT: THE EVOLUTION OF INDUSTRY ...... 67 Historical Overview of the Economy .............................. 67 The Post-Independence Period ............................. 67 Agriculture ...... .............................................. 67 i9source Mobilization and External Balance Until 1978 .... 68 Internal and External Imbalance After 1978 ............... 69 The 1980ss An Economy in Crisis ......................... 70 Social Sectors Achievement4 .............. .............. 71 Industrial Strategy in the Past ................................. 71 Post-Arusha Industrial Strategy .......................... 72 The Basic Industrial Strategy ............ ............* ..... 73 Role of Foreign Aid .... ................................ 74 The Planning Process .................... **** 999999999.......... 75 The Role of the Pricing System ... ....................... 76 CHAPTER FIVE - PUBLIC INVESTMENT PROGRAMS IN TANZANIA ....... 79 overview 99999999999999999999 999....... ..99....... 79 Budget Appropriations .... ............................... 79 Investment Projects ............ Si.............9 81 Assessment of the investment Program ............................ 82 Overall Investments to Industry .......................... 82 Textiles ................................................ 83 Beer ................... 8S Leather and Tobacco ....................... 85 Chemicals and Fertilizers ............ . ............. 9... 85 Cement .................................................. 85 iron and Steel .......................................... 86 Transport ...............*...**... **..................... 86  -4- Page No. CHAPTER FIVE (Cont.) The Rehabilitation Program ...................................... 87 Assessnent of Rehabilitation Requirements ............... 89 CHAPTER SIX - THE INDUSTRIALIZATION STRATEGY AND PROPOSALS FOR POLICY REFORM ..... .................... ..... . 91 Background and Rationale for an Industrial Reorientation ....... 91 Main Elements of an Industrial Reorientation ................... 92 A. Intersectoral Reorientation ..... ........................ 92 B. Reorientation Within Industry: Channeling Resources to Productive Enterprises . .................. 93 C. Reorientation to Recurrent and Rehabilitation Needs ........................................................ 93 D. Promoting Small-Scale Development ......... .............. 93 E. Balance Between the Private and the Parastatal Sector ................................................ 93 P. Eliminating the Anti-Export Bias ........................ 94 G. Emphasizing Technological Capability Development . ................ . , ........................ * . 94 Prospects for Industry Under a Reorientatinn Effort ............... 94 Proposals for Policy Reforms ........................... ......... 96 The Rationale for Policy Reforms ........... ..................... 96 Scenario 1: Gradual Adjustment/Medium Growth Scenario ........ ... 99 A. Mechanism of Exchange Rate Adjustment ................... 99 D. The Gradual Reform of the Trade Regime .. ................ 100 Nature of the First Step ...... ...................... *. 100 Timetable for Subsequent Steps ........................ 100 C. Temporary Complementary Measures ........................ 101 Temporary Import Surcharge . ........... 101 Administrative Allocation of Foreign Exchange ......... 102 Promoting Exports . ........................... ............. 102 D. Permanent Complementary Measures ..... .................. 103 Own-Funds Imports ........................................ 103 Price Decontrol and Deconfinement ..... ............... 103 Stable Fiscal and Monetary Policies .................. 104 Interest Rate and Other Financial Sector Reforms ...... 104 Tariff Reform ....................................... 105 Agriculture Policy Reform ................. ........... 106 Other Sectors .......... ................. .............. 106  -5- Page No. CHAPTER SIX (Cont.) E. Economic Recovery Prospects of a Gradual Adjustment Program .......................... 107 F. Social Aspects of Adjustment ........................... 108 G. Prospects for Industry ......... . . . . .................................. . 109 H. Costs of Industrial Adjustment ........................ 111 Firm-Level Prospects .................. ............... 112 Industrial Employment Prospects ........ *..*............ 113 I. Risks of a Gradual Adjustment Program ...........*...... 115 Scenario II: Immediate Adjustment/High Growth Scenario ......... 117 A. Large Step Devaluation .......... . . .................................. . 117 B. Market Determination of Foreign Exchange Rate .......... 118 C. Complementary Reforms to an Immediate Exchange Rate Adjustment ............................. 120 Import Liberalization and the Tariff Regime ....... 121 Prospects for Industry .... ** ......... 121 Scenario IIIs Partial Adjustment/Low Growth Scenario ........... 122 I-ndustrial Policies ...................................................... 123 Promoting Small-Scale Enterprise Development ............... 123 Public Investment Programming ....... .................. 124 A. Preparation of a Consolidated Public Investment Program ...................................................... 124 B. Minimization of New Industrial Investments .......... . 124 C. Stopping Low Priority and Potentially Uneconomic Investments which are underway ..................... 125 D. Rationalization of Rehabilitation Investments ........ 126 E. Improved Investment Decision-Making .. ................ 126 Technological Capability Development in Industry .......... . 127 The Restructuring of Large Enterprises ......... ............ 127 Textiles ......................................................... 128 Leather .. ................................................. 128 Cement ........................... ...... 128 Iron and Steel ............................ 129 Metal Products .... 129 Chemicals ............................... 129 Pulp and Paper .......... ............. .129 Parastatal Reform .......................................... 129 Development Banks ...... .................. .................. 130 Aid Coordination ........................................... 130 VOLUME II (Separate) Annexes ............................................................ 1 Statistical Tables ....................................................... 90  PREFACE 1. Ubungo Farm Implements is a Tanzanian parastatal firm which started production in 1970 with Chinese technical assistance to make hoes, ploughs and flat shares. Following operational problems throughout the 1970s, since the early 1980s the enterprise has been able to show its real pr,ductive potential. Good management, and an infusion of technically trained personnel and of foreign exchange for imports has allowed this labor-intensive firm, employing 600 workers, to operate efficiently. By 1984, capacity utilization for hoes and flat shares exceeded rated capacity, while it supplied the agricultural sector the equivalent of US$7.5 m. in priority goods at an actual cost of inpu..s of only US$5 m. Ubungo Farm Implements is one of the most productive firms in the engineering subsector, and the main product, hoes, is produced at high levels of economic efficiency. 2. Afro Cooling is a local private firm ergaged in the manufacture of car radiators. It purchased its technology from an Indian firm which had been making radiators for 25 years and which had substantially adapted the technology to Indiaa needs. Production started in 1979 with the help of 12 expatriate experts who left by 1983 after having trained some Tanzanian counterparts. The firm can now make over 500 varieties of radiators of good quality, and is capable of meeting its foreign exchange needs from exports. Its competitive performance is the result of a technology which is simple and not scale-intensive, and of the current high quality of its managerial and skilled labor. The dynamic management has been able to assimilate and standardize the technology of a labor-intensive engineering product, adapt it, train local workers and market its products aggressively at home and overseas. The firm uses labor-intensive techniques, based on simple equipment but with an emphasis on strict quality control. It substitutes local brass and bronze fittings for imports and makes all its own toolings. The firm operates very efficiently and reached 70 percent capacity utilization in 1984, when it produced over 10,000 radiators, responding to hundreds of tailor-made orders. 3. Ubungo Parm 'Implements and Afro Cooling are two examples of well- run industrial enterprises which productively contribute to Tanzania's economy under very adverse economic circumstances. There are other effi- cient firms like these two, both in the parastatal and in the private sector. Unfortunately, the number of efficient industrial enterprises productively contributing to the economy is small. They produce only a fraction of the gross output of the sector while utilizing an even smaller share of all the resources consumed by the sector. These productive enter- prises are exceptions that provide a stark contrast to the rest of the sector, which is very inefficient. 4. Morogoro Shoe Company, a parastatal that begun operations in 1980 aided by a World Bank line of credit, was designed to be one of the largest shoe factories in the world and to export over 80 percent of its production. The project had serious design and implementation flaws and has suffered from operational problems since the plant began production. Peak capacity utilization, at 7 percent of rated capacity, was achieved in April 1982, and it has averaged about 4 percent since then. It has never exported. Poor management, lack of training, poor product design, absence of quality control and equipment deterioration, together with its inability to export, has resulted in poor financial performance and extreme economic  - ii - inefficiency. The firm is producing negative value added at world prices, i.e., the economic value of recurrent inputs (excluding labor) exceeds the economic value of the output. After subtracting the value of output, the net yearly cost to the country for keeping the firm in operation exceeded half a million dollars in 1984--not counting capital costs. 5. In contrast to Morogoro Shoe, Aluminum Africa is well rur. and, thanks to high levels of protection it is a financially profitable parastatal which has developed good technical capability in the production of aluminum products, galvanized corrugated iron sheets and steel billets. The firm exports some of its aluminium products. Aluminum Africa, however, is currently also uneconomic for the country, for different reasonss it is a capital-intensive and complex industry, using outmoded technologies, constrained by much smaller than optimal scale of operations and reliant on expensive foreign personnel and imported inputs which are overpriced for the country--due to the country's external payments situation and associated policies. As a result, most of the firm's output is being produced at negative value added, including the production for exports. The net yearly cost for the economy of operating the plant in 1984, excluding capital costs, was about four million dollars (US$3.6 m. if labor costs are excluded). In other words, if foreign exchange could have been utilized to import the final product--or to import inputs to an economically efficient operation--the country could have saved millions of dollars. 6. The causes, manifestations and extent of inefficiency vary among firms. But Merogoro Shoe and Aluminum Africa exemplify the current low economic productivity of many firms in the industrial sector, which every year results in the loss of huge amounts of resources for the country. Tanzania's industry, which at world prices produced only US$56 million worth of value added in 1984, (about 3 percent of GDP) utilized an estimated US$420 million worth of recurrent inputs, of which US$290 million were (direct and indirect) imports. In addition, the opportunity cost of labor and capital used by the sector were US$57 m. and $109 m., respectively. About one third of industrial activities are producing with negative value added at world prices. The waste of resources implied by the above figures is dramatic: this report shows tnat a reallocation of recurrent resources, from the activities that produce with negative value added to all other industrial activities (producing at positive value added, whether efficiently or not), would have resulted in US$102 million of additional industrial value added. Thus, in 1984, the sector produced only about one- third of the value added it could have contributed to the country's GDP if it had not provided scarce resources to negative value added firms. A similarly dramatic value added gain could be achieved by a reallocation of resources away from unviable negative value added activities, while at the same time transforming, through restructuring measures, potentially viable negative value added activities into positive contributors to the Tanzanian economy. 7. A more substantial reallocation of recurrent resources, from the inefficient activities whose value added does not cover the opportunity cost of labor, to productive activities where value added exceeds labor costs, could have generated at least an additional US$170 million in value added in 1984 by utilizing the same amount of resources. The existing use of recurrent resources in industry results in less than one-fourth the value added that couid have been produced by better allocation of the same amount  - iii - of resources. These estimates presume, however, capital to be immobile and its costs to be sunk. Instead, if better investment choices would have taken place--and/or capital stock in unproductive firms could have been reallocated to productive vses--the savings for the economy would have been significantly larger. Better allocation of capital and recurrent resources could have produced an additional US$250 m. in value added in 1984, i.e., about six times what industry actually produced. 8. Against this background, this report focuses on analyzing the short term and longer run causes of the performance of an industrial sector whose current resource utilization is resulting in a yearly loss for the economy of well over hundred million dollars, with a view to identifying policy and restructuring actions which would substantially improve the performance of the sector, improve the allocation of investments in the future, and drastically transform industry's contribution to the Tanzanian economy. 9. This report is divided into an Executive Report, a Main Report (Volume I) and a Volume containing the Annexes and the Statistical Appendix (Volume II). The Executive Report summarizes the findings and recommendations contained in the Main Report. The first chapter of the Main Report reviews briefly the structural characteristics of the Tanzanian industrial sector and then discusses its performance in some detail. In order to understand the causes resulting in the current performance of industry, Chapter Two presents the existing set of policies and incentives affecting the industrial sector, while Chapter Three reviews the efficiency of the sector and its relationship with the policy framework. Chapter Four provides a brief historical overview of the macroeconomic and sectoral determinants of industrial investments--which led to today's industrial structure. A review of the investment plans for industry is presented in Chapter Five. The .ast chapter suggests the elements of an industrial reorientation drive and proposes policy reform alternatives, based on the findings and the diagnosis of the first five chapters. A more detailed review of some industrial subsectors as wv11 as data and analysis for a large sample of industrial firms is presented in the Annexes in Volume II. 10. This is the first industrial sector review for Tanzania undertaken by the World Bank in ten years. It constitutes an important first step in the analysis of the major problems affecting the sector today and in the identification of measures leading to industrial recovery. For that purpose, a comprehensive industrial survey was conducted by the World Bank mission and a substantial amount of information was analyzed. This report does not purport, however, to give a comprehensive historical review of the industrialization process in Tanzania, or to provide a definitive blueprint for all the measures required throughout industry. This work focuses instead on the major aspects affecting industrial performance and suggests some policy-related and subsectoral issues for intervention and identifies firm-specific areas for further study, thereby setting the stage for future collaborative work between the World Bank and the Government. The next stage in the collaboration would require a more in-depth diagnosis of particular constraints faced by industrial subsectors and enterprises, with a view to implementing industrial restructuring measures consistent with Tanzania's national objectives and the goals set under the Economic Recovery Program.  CHATE ONE STRUCTURE AND PIRlORAwICE OF INDUSTRY I TANZANIA Introduction 1.01 At the time of Independence, Tanzania had only a rudimentary industrial structure. The largest subsector was cotton ginning. Manufacturing employed about 25,000 people and accounted for a very small contribution to GDP. Without a significant break from past trends in the evolution of manufacturing sector, a somewhat more ambitious industrial program was undertaken after 1964. The major departure in terms of strategy and implementation was to take place in 1974, when the Government adopted the Basic Industrial Strategy (BIS), where industry was to be seen as the principal agent of structural transformation and self-reliance for the Tanzanian economy. The strategy emphasized import-substitution aid the production of producer goods, which were expected to use a large share of domestic resources. Implementation of the BIS resulted in very large investments in industry, generally capital-intensive, relatively large-sized and import intensive. A more detailed overview of the industrialization process in Tanzania since Independence is given in Chapter Four. This first chapter will focus on the description of the structure and performance of industry since the late 1970s. Following an explanation of the industrial efficiency survey (MIES) conducted by the mission, which formed the basis for most of the data analysis presented in this report, this chapter discusses the patterns and structure of production, investment, ownership, employment, exports, imports and small-scale industries. 1.02 Data: The analvsis presented throughout this report relies heavily on the data collected by the mission's industrial efficiency survey (MIES). This is because data analysis based on domestic prices is often misleading, when, as in the case of Tanzania, there is an over-valued exchange rate and high (end variable) levels of protection given to domestic industries, which result in large divergences between domestic and interna- tional prices. Thus, values of production measured in domestic prices include elements of protection as well as of actual production. To capture actual production trends and structure, it is preferable to measure production values at international prices since this ignores the artificial price biases induced by domestic protection. Generally, it is difficult to measure these economic variable' at world prices, since the required data is not available. For this report, however, the Bank, in collaboration with the Tanzanian authorities, conducted a detailed survey (including detailed information on inputs and outputs, domestic and world prices, etc.) of 118 industrial activities (in 48 enterprises) that account for one-half the output of the sector and which provided information for 1984. All indust- rial subsectors and types of firms were represented in the sample (public, private, large, medium and small--excluding non-factory enterprises). This comprehensive representation of all segments of industry, in addition to the large share of industrial production captured by the sample permitted the simulation of the industrial sector in 1984 to analyze in detail the industrial structure and its performance, efficiency and protection. All  - 2 - the calculations presented in this report on rates of return, Domestic Resource Costs, Rates of Protection (see definitions below in Chapter Three) and other values calculated at world prices for 1984 originated from the MIES. As expected, the results indicate that in many instances there are large discrepanzies between values calculated at world prices and values at domestic prices. Whenever relevant, both measures are reported. Structure and Performance of Industry 1.03 Production: Following a relatively strong growth from 1966 to 1978, when industrial value added grew by almost 7 percent p.a. in domestic prices--although the rate of growth was already lower by the mid-70s--, manufactu ring production has fallen sharply every year since 1979. Production fell by an average of 15.1 percent a year between 1979 and 1985, which resulted in the sectoral share of GDP declining from 13 percent in 1978 to 4 percent by 1985 in constant 1976 domestic prices. Manufacturing value added in 1985 was one third of its 1978 value (Table 1.1). Table 1.1: TANZANIA - GROWTH IN MANUFACTURING VALUE ADDED, 1978-1984 (T Sh bTllion, Constant 1976 prices) 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 Manufacturing value added (T Sh bn.) 2.8 3.0 8.1 2.8 2.3 1.8 1.6 1.4 1.2 1.0 X Change over previous year - 6.2 4.8 -10.2 -16.6 -21.2 -17.8 -8.8 -13.3 -16.0 CDP (T Sh bn.) 22.8 23.3 23.9 24.2 24.4 24.2 24.6 24.4 26.0 25.6 Mfg. share of CDP 12.4 12.8 13.0 11.8 9.4 7.6 6.1 6.6 4.7 4.0 Source: Bureau of Statistics; IMF R.E.D., February 1988, Staff Estimates. 1.04 When calculated at international prices, the share of industry in GDP, estimated to be less than 3 percent of GDP in 1984, is even smaller. The smaller share of manufacturing in GDP (at world prices) reflects the fact that protection given to industry exaggerates its contribution when calculated at domestic prices (even when holding domestic prices constant in 1976 prices, biy which time effective protection to industry was already substantial). 11 Increasing protection to industry since the mid-70s has resulted in even greater distortions when measuring industry's contribution in current terms, which in 1984 stood at 9 percent.  1.05 In terms of gross output (calculated at domestic prices). the largest industrial subsectors in 1984 were food products (20 percent of total manufacturing gross output), textiles and apparel (20 percent), beve- rages and tobacco (10 percent). chemicals and plastics (10 percent), wood and paper, metal products and transport equipment (8 percent each). Except for production increases in beverages and in tanneries and leather products, and a small drop in the relative share of transport equipment, the dramatic decline of manufacturing did not result in a significant pattern of sub- sectoral changes during the past seven years. In fact, today's structure of manufacturing production, as indicated by the share of value added calcu- lated at domestic prices, resembles the structure of the sector 20 years ago, with the exception of the small changes in the shares of consumer and capital goods (Table 1.2). Table 1.2t TANZANIA - SUBSECTORAL SHARES OF VALUE ADDED IN MANUFACTURING, DOMESTIC PRICES a/ Subsectors 1965 1973 1977 1981 1983 Consumer Goods 56.2 58.9 54.9 46.9 49.9 Intermediate Goods 39.6 33.1 36.0 45.6 40.1 Of which: Non-traditional b/ 24.0 19.2 25.5 28.7 22.7 Traditional 15.6 13.9 10.5 16.9 17.4 Capital Goods 2.7 6.9 6.5 6.7 9.3 a! Excludes enterprises with less than 10 employees. Shares are derived from current price data. b/ 'Non-traditional' intermediate goods are chemicals, fertilizers, rubber and plastic products, iron and steel, metal products. 'Traditional' ones are leather, wood, paper, printing, glass and building materials. Source: Survey of Industries, 1965; Survey of Industrial Production, various years; Economic Survey, 1984. 1.06 Measured in world prices, however, the evidence indicates a startling resultt the share of consumer goods, at 85 percent in 1984 (Table 1.3), is much larger than during the 1960s, while only 15 percent of the value added at world prices is generated by the existing investments in intermediate and capital goods--which account for two thirds of all installed capacity. 1.07 The evidence from the mid-sixties indicates that the structure of protection was relatively moderate and uniform across the main subs.ctoral categories (Chapter Three), suggesting that value added measured at domestic  prices in 1965 approximates the shares measured at world prices for that year. However, by 1984 the discrepancies between domestic and world priced value added shares were extremely large (Table 1.3), the result of the extremely high protection given to firms producing at negative value added in world prices--which are concentrated in intermediate and capital goods. The low value added produced by firms in intermediate and capital good* industries is largely the result of the very inefficient use of inputs, rather than the outcome of significant differences in capacity utilization. In fact, the share in total gross output of intermediate and capital goods production was 60 percent (compared with only a 15 percent share in value added), which is roughly equivalent to the intermediate and capital goods share in installed capacity (65 percent; Table 1.3). Table 1.8: TANZNIA - STRUCTURE OF INDUTRY AT WORLD PRICES: A COMPARISON 1986 1984 1984 1984 1984 VYlue Added Value Added Value Added Gross Output Installed at Domestic at Dom.tic At World At World Capacity Share Prices Prices Prices Pric. (World Price.) Consumer Goods sOW 40W 05W 40% 84X Intermediate Good 4OX 43X 11s 47% s1X Capital Goods Sa 11X 4% 13X 1$X Sourco: Survey of Industries, 1965; ISES, 1964. 1.08 At first glance, therefore, the evidence regarding Tanzania's structure of production, if judged by its gross output composition (or by its installed capacity), may be interpreted as being comparable to that of countries with significantly higher levels of income and industrialization, since relatively easy, 'first stage' industries (like food, beverage, tobacco, textiles, clothing and footwear) account for less than one-half the gross output of the sector. Tanzania's industry share in gross output in the more advanced equipment and chemical sectors is significantly larger than that of most Sub-Saharan African countries (see Statistical Appendix and World Development Reports). However, the low productivity of intermediate and capital goods investments--and the inefficient use of recurrent resources in these subsectors--imply that very small amounts of value added in intermediate and capital goods are generated by utilizing large amounts of resources.2 This results in an extremely low share of intermediate and capital goods production in total industrial value added, similar to that of the least industrialized Sub-Saharan African countries. 1.09 Investments Large amounts of investable resources have been channeled to the manufacturing sector particularly since the mid-1970s, when 2/ Which explain the large share in gross output.  - 5 - about one third of all investments, i.e., 7 percent of GDP, were going to manufacturing. It is estimated that over US$2 billion (in 1985 dollars) worth of industrial investments were made during the 1970s. Significant net investments continued even after 1978 when value added began to decline, both in the public and private sectors. Industrial investments reached its highest level (about US$300 million in 1985 dollars) and its largest share in total investment (37 percent) in 1979, while industrial value added was already declining by over 10 percent p.a. A temporary tapering off of parastatal "vestments took place in 1981, but they picked up in 1982 and 1983. The private sector appears to have invested substantial amounts until 1981; subsequently, a substantial decline appears to have taken place. Capital-output ratios and ICORs have been increasing sharply over the past ten years, and turned negative in the late 19709 when output began to decline. Table 1.4: TANZANIA - INCREMENTAL CAPITAL OUTPUT RATIO (ICOR) IN MANUFACTURING 1968 1971 1973 1976 1978 1979 1980 1981 1982 1983 1984 3.6 4.3 6.6 9.4 7.5 8.5 negat. negat. negat. negat. negat. Sources: CEMs and Staff Estimates. 1.10 The massive investments in industry during the 19709 led to substantial additions in installed capacity, which is estimated to have more than doubled between 1974 and 1984. Since the mid-seventies, the large increases in capacity were accompanied by a decline in capacity utilization. Subsequently, the large drop in manufacturing output since 1979 led to an even faster reduction in capacity utilization. Today, industry is utilizing only one-quarter of its rated capacity (Table 1.5). Although measured capacity utilization has declined significantly, it masks the full extent of the crisis of the sector. Measured capacity utilization did not decline nearly as much as the drop in industrial value added because: (i) gross output declined by less than value added, due to growing inefficiencies in the use of inputs and the disproportionate contraction of high value added activities; and (ii) measured capacity utilization excludes firms that have shut down and installed capacity which has been scrapped or rendered totally obsolete. Table 1.5: TANZANIA - CAPACITY UTILIZATION IN INDUSTRY 1976 1962 1983 1984 1985 53.3? al 29.42 28.2? 25.32 24.8? Sourcest Ministry of Industries and Trade; MIES; Bank Estimates. a/ Unweighted estimate.  - 6 - 1.11 Over the past 15 yeara industrial investments have been increasingly channeled to expanding capacity of intermediate and capital goods, a result of the conscious strategic decision to transform the structure of production of Tanzania's industry. Today, two thirds of manu- facturing installed capacity is in intermediate (51 percent) and capital goods (14 percent), but the actual structure of production, as indicated by the existing composition of (world priced) value added, has not changed accordingly (Table 1.3 above). 1.12 Rates of return on manufacturing investment has steadily declined since the mid-sixties, indicating the extent to which the productivity of investments has deteriorated. The financial rate of return on investments (including depreciation costs) has declinedl from 26 percent in 1966, to 15 percent in 1976 and to 6.3 percent in 1980. During this period, protection to industry increased (Chapter Three), suggesting that the decline in the economic return on investments was even steeper. Since 1980, increasing protection to industry seems to have stemmed the decline in the financial return on capital which was estimated to be 10 percent in 1984. However, by 1984 the net economic return on capital (ERC) was significantly negative at -15 percent. (The net economic return on capital is defined as annual val.ue added--i.e., revenue minus recurrent input costs, at world prices--minus the annual cost of capital and labor, shadow priced, divided by the total cost of capital. A positive ERC indicates an economically viable investment.) 1.13 Ownership Structure: The Arusha Declaration in 1967 laid the foundations for a sustained expansion in the role of the public sector in Tanzanian industry. Today 89 operating companies grouped under nine large industrial parastatal holding companies account for most public sector par- ticipation in manufacturing, but there are other, smaller, parastatal establishments involved in manufacturing. Out of 707 establishments with 10 or more employees employed in manufacturing in 1981, 196 were at least partly state-owned and 511 were private. The small-scale non-factory sector (below 10 employees) is largely private. The public sector accounts for around 55 percent of production and value idded by firms with 10 or more employees, and for 66 percent of the net fixed capital and labor employed. The public sector is spread widely through industry. For medium and large scale industry, the public sector accounts for virtually all the production in tobacco and iron and steel, and for over two-thirds in food and food products, tanneries and leather, paper, glass and cement, and rubber. Its share of output is below 25 percent in only three industries: apparel, machinery and transport equipment. (For details on the parastatal sector, see Annex on parastatals, and the efficiency analysis in Chapter Three.) 1.14 Employment and Wates: Manufacturing employment in Tanzania grew from 28 thousand in 1965, to 84 thousand in 1977, and to 105.8 thousand in 1979. Since then the employment numbers have stabilized, i.e., they comprise today about 1.5 percent of the labor force. Employment has not been affected significantly by the sharp drop in production between 1977 and 1984. The industrial sector is carrying today a large burden of surplus labor. This surplus labor hai been evenly shared among the different industries. The only important structural change in employment over the past 15 years has been the increase in the share of non-operational (manage- rial, administrative) staff in total employment from 14 percent in 1971, to 20 percent in 1978, and to 24 percent in 1983.  - 7 - 1.15 Real wages have fallen significantly since 1976. The adjustment of labor costs to the lower production levels has taken place through a real wage reduction rather than a decline in the industrial labor force. Average labor costs went down (in constant prices) from T Sh 9.9 thousand p.a. (US$1,125 at official exchange rage) in 1976, and to T Sh 3.7 thousand in 1983 (US$450 in 1976 dollars at official exchange rate). In 1984 the hourly wage for a manufacturing worker was estimated to be about US$0.35, which is low compared with countries with similar per capita income. The substantial drop in real wages since 1976 (while employment was still growing) has resulted in a drop in the share of labor costs in domestic value added (in current prices) during the period.3 The share of wages in value added per employee is not high in Tanzania. Although a comparison between Tanzania (1981) and Kenya (1980) reveals that the value added per employee was signi- ficantly higher in Kenya (42 percent), the di@crepancy in average wages was even larger (65 percent), i.e., the wage portion of value added is lower in Tanzania. Furthe-more, an international comparison among nine countries (including Ghana, Zimbabwe, Zambia, Malawi, India and others) indicates that average manufacturing earnings in Tanzania was lower than the mean even after controlling for differences in GNP per capita. 1.16 Manufacturing Exports: Exports of manufactures, defined broadly to include first stage processing items such as petroleum, chemical compounds and animal feed, have constituted a steady 7 percent of manufacturing output in recent years and between 17 percent and 20 percent of total exports. The stability of these shares is due to the decline of total and manufacturing exports at the same rate as output, i.e., about 15 percent per annum in real terms between 1978 and 1984. Total manufacturing exports in 1984 were US$65 m., and nine items constituted more than 80 percent of Tanzania's manufactured exports. Of these, petroleum products (US$16.5 million) and tobacco, textiles and sisal fabrics (about US$10 million each) contributed two thirds of exports in that year. Export industries have lacked diversi- fication: the same main products have been the dominant items for the past fifteen years (although some new items have been exported lately in small qutntities as a result of export promotion schemes, see Chapter Two). Processed raw materials--sisal ropes, spun textiles and cured tobacco, go to developed countries and manufactured items--canned food, bakery products, cigarettes, apparel, cement, non-ferrous metals and batteries, go to developing countries, particularly to other Sub-Saharan African countries. Export earnings have declined every year since 1980, a good year for manu- facturing due to the reopening of the Uganda market. Export earnings in 1984 were 43 percent of the 1980 value in spite of the many export promotion policies that have been implemented during this period. There has been a particularly large decline in the export of tobacco products, electrical machinery and animal feed stuff. 3/ The share of profits (in current prices) has increased as the manufacturing sector received increasing levels of protection in recent years. 4/ The wage structures in the two countries, however, are relatively similar, particularly for larger, 'modern' establishments, which use similar technologies (see Statistical Appendix).  1.17 Statistical analysis5 indicates that Tanzanian manufacturing exporters differ from non-exporters in that the former are associated with (i) less import intensity of inputs; (ii) predominantly medium-sized firms; and (iii) firms that have foreign management contracts. There is no signi- ficant difference, however, between exporters and non-exporters regarding (i) capital intensity; (ii) import intensity of capital; (iii) public vs. private firms; and (iv) unit labor costs. Among exporters, the more labor- intensive, larger firms with lower unit labor costs have penetrated the OECD and LDC (other than Sub-Saharan) export markets more than exporters that do not share these characteristics. Sub-Saharan exports penetration is not significantly associated, however, with these characteristics. Exports to neighboring countries appear to be produced by relatively capital-intensive, import substitution consumer goods industries and may be due to policy distortions in the economy, particularly the result of high effective exchange rates faced by import intensive exporters (see below on retention schemes). 1.18 A significant proportion of exports are produced very inefficiently and exported at a net (direct and indirect) foreign exchange loss for the country. Based on the MIES sample, (which excluded petroleum products and sisal), 56 percent of exports in 1984 were exported at a net foreign exchange loss for the country, assuming capital costs as sunk (otherwise the losses are much higher.) In fact, 6 out of the 14 surveyed export activi- ties (43 percent) were producing at negative value added at world prices, and only one activity (cigarettes) had a positive economic return on capital. The average economic return on all export activities in the sample was -11 percent. Imports 1.19 Imyort Substitution: The share of domestic production in total manufacturing supply has been steadily--and significantly--increasing over time. Less than 30 percent of domestic consumption of manufactured products was produced in Tanzania in 1961, when 62 percent of the supply was imported and 8 percent was produced donestically for exports. By 1983, 58.7 percent was produced in Tanza.iia for domestic consumption, and the export share was 4.7 percent, implying a 36.6 percent decline in the share of imports (Table 1.6). 1.20 There were four distinctive periods in this process of import substitution. During the 1961-1965 period, there was a decline of the import share due to expansion of domestic production (particularly consumer goods) for the domestic market; in contrast, during the second half of the 19609, the growth of output was not accompanied by import substitution. The main sources of growth during the late sixties were growth in domestic demand and, to a lesser extent, manufacturing exports (see Gulhati and Sekhar). The import substitution drive was renewed in the early seventies but not through consumer goods: from 1971 to 1978 import substitution took place mostly in intermediate goods (the share of domestic production in total supply increased from 33.8 to 72.2 percent during the period; Table 1.7). Between the late seventies and early 1980s there was an unintended import substitution process, resulting not from growth but from the decline 5/ Based on regressions from the 1984 MIES sample  -9- Table 1.6: TANZANIA - IMPORT SUBSTITUTION, EXPORT PROMOTION, AND DOMESTIC PRODUCTION IN TANZANIAN INDUSTRY (in current T Sh million) Source of Manufoaturing Supply (Share) 1981 165 1971 1976 1981 1983 1984 Production for Domestic Market/ Total Manufactured Supply 29.6 86.0 85.4 46.7 66.8 68.7 58.9 Production for Exports/Total Manufactured Supply 6.2 7.6 10.5 8.7 4.9 4.7 6.0 Manufactured imports/ Manufactd Sypply 02.2 568.2 $4.1 49.0 88.8 38.8 41.1 Tote I 198. 1Us.$ 10.8 190.6 198.0 19.0 100.0 Source.: Trade Statistics of Tanzania; Ministry of Industry, Budget Speeche. - :U1984/86 an 1986/06 Economic Surveys 1961, 1962, 1968 and 1984; Tanzanla: Basic Econole Report No. 1610-TA, World Bank, Deceber 1977; World Bank Estimates. in import of manufactured goods: during 1978-1983 the import share declined due to the drastic cutback in import capacity of the country, which particu- larly affected consumer and capital goods imports. Intermediate goods imports to industry, however, underwent a smaller decline between 1978 and 1981, and rebounded after 1981, explaining the relative lack of substitution during the period (see para. 1.25). 1.21 A partial reversal in the import substitution trend appears to have taken place in 1984 in spite of the continued severity of the crisis (Table 1.7). This development is consistent with the liberalization of 'own funds' imports, which, since 1984, have allowed a significant influx of previously restricted imported goods into the country. Table 1.7: TANZAIA - IMPORT SUBSTITTION IN MUNFACTURIN 1961-1988 (In current T Sh million) 1981 les 1971 1976 1981 1983 1984* l'otal Man7acturing D lWMe Frodaction/ Total Supply MO 87.6 48.6 45.9 60.4 61.2 68.4 58.9 Consumer Goode Domestic Production/ Total Supply (M) 60.0 59.5 76.6 66.8 79.4 77.0 N/A Intrmediate Good DomestEc ProducIton/ Total Supply (3) 25.7 82.1 88.6 72.2 90.8 75.1 N/A MWre? -F roduction/ Total Supply (M 16.4 16.6 15.8 17.4 28.9 26.4 N/A Source.: Trade Statistics of Tanzania; Ministry of Induatry, Budget Speeches 1964/65 and 1985/86 Economic Surveys 1961, 1062, 1968 and 1984; Tanxania: Baslc Economic Report No. 1616-TA, World Bank, Doeember 1977; World Bank Eati..t... * Preliainary  - 10 - 1.22 Iwnort Dependencys The process of import substitution has been associated with the emergence of an extremely import-dependent manufacturing sector which has made it increasingly difficult for Tanzania to achieve the objective of self-reliance (however defined). Import dependency has been growing steadily over the past 20 years, and is extremely high today. The dependency on imported inputs of Tanzanian industry in 1984 was estimated to be 70 percent (calculated at shadow prices; 52.5 percent at domestic prices, which is a less accurate measure due to significant overvaluation of the currency; see Table 1.8). The dramatic increase over-time in import dependency is as significant an indicator of industrial performance and structure as the extremely high levels of import dependency todays import dependency of the sector has more than doubled since 1973, when the Basic Industrial Strategy was about to be launched and the import substitution drive was intensifying. 1.23 An increase in the import content of industrial costs can, in many cases, be associated with expected structural changes resulting from a healthy industrialization process. Indeed, the 7 percentage points increase (from a very small initial share) in the imported input share between 1961 and 1973 may well have reflected such an industrialization process, and not any underlying structural weakness per se. However, a 30 percentage point increase (from an already larger share) during the subsequent dozen years appears to have been associated with the emergence of an increasingly vulnerable and inefficient sector whose import needs significantly exceeded its export generation capability. Table 1.8t TANZANIA - IMPORT CONTENT OF MANUFACTURING PRODUCTION Import Dependency Ratios (X) 1961 1973 1984 Imported Input Costs/Gross Output At Domestic Prices 10.2 14.6 27.8 At Shadow Prices n.a. n.a. 62.0 Imported Input Costs/Total Input Costs At Domestic Prices 15.1 22.9 52.5 At Shadow Prices n.a. n.a. 70.0 NOTEs Computations exclude oil. Sources: Census of Industrial Production in Tanganyika 1961; Survey of Industrial Production 1973; An Input-Output Table for Tanzania, 1969; MIES 1984; Staff Estimates.  - 11 - 1.24 Imported raw materials, spare parts and other inputs utilized by manufacturing in 1984 are estimated to have exceeded US$290 m., of which over US$250 m. were non-oil imported inputs. In addition, US$75 m. was estimated to have been the foreign exchange component of capital equipment amortization. The total direct foreig:& exchange consumption of the manufac- turing sector in 1984 was therefore esdInated to be about US$365 m., i.e., about six times the value of export earnings. Manufacturing exports meet 17 percent of import needs only, and as discussed--over half of these exports are estimated to be made at a net foreign exchange loss for the country. 1.25 Since the early 1980s the import capacity of the economy has declined significantly. Surprisingly, however, there is no evidence of a substantial parallel decline in imported inputs to manufacturing, which is the most frequent justification for the continuing fall in capacity utiliza- tion. Excluding oil and transport equipment, imports to manufacturing were US$87 ,. in 1975. During the higher import capacity years of 1980-81, they averaged slightly less than US$200 m. During 1982-83 manufacturing imported inputs were US$210 m, whi e they are estimated to have increased to almost US$230 m. during 1984-85. The Bank of Tanzania's foreign exchange allocation to 48 manufacturing firms is also consistent with this trend: it allocated an average of US$82.4 m. a year to these firms during 1984 and 1985, which was 25 percent higher than the 1982-1983 allocation. The efficiency of use of the foreign exchange (and imported inputs) channeled to industry appears to have deteriorated during the period (Chapter Three). 1.26 A cross-country comparison provides another measure of the high import dependency of Tanzania manufacturing. A comparison with four other countries in Eastern Africa which have followed import substitution strate- gies, (for which recent data was available), indicates that Tanzania had the highest import dependency (Table 1.9). Table 1.9: TANZANIA - CROSS-COUNTRY COMPARISON OF IMPORT DEPENDENCY Country Tanzania Zimbabwe Uganda Ethiopia Zambia Year of Survey 1984 1982 1982 1980 1981 Share of Imported Inputs ir Total Costs At Domestic Prices 52.5 25.3 42.5 45.5 49.4 At Shadow Prices 70.0 35.1 a/ 49.0 a/ 52.0 a/ 58.9 a/ Source: World Bank Industrial Sector Reports; Bank Estimates of Shadow Prices. a/ Preliminary estimate. 6/ Sources: Customs for 1976, 1980, 1981. MIES for 1982-85.  - 12 - 1.27 The very high average import dependency of manufacturing disguises some substantial variation in the import dependency ratio, both across sub- sectors and among activities. Imported input dependency in the MIES sample range between 4 percent (cotton yarn) and 100 percent (ball point pens, galvanized corrugated iron sheets, fertilizers, etc.). Small-Scale Industries 1.28 The last census of Manufacturing, conducted in 1978, recorded about 1,600 small-scale enterprises which employed about 24,500 people (21.5 percent of employment in manufacturing) and contributed 9.8 percent to manufacturing value added.7 These enterprises were engaged in textiles, garments, furniture, building materials, printing and packaging, shoe manufacture, blacksmith services, food processing, beverages and handicrafts. They were located mainly in urban areas, with over 50 percent in Dar-es-Salaam alone. The discussion in this section is based on the definition of small-scale industry (SSI) used by the Small Industries Development Organization (SIDO). The definition includ.s: (i) craft industries, generally non-factory; (ii) very small industries, also non- factory, which employ less than 10 people; and (iii) factory industrial units that employ between 10 and 49 persons. 1.29 Craft Industries: Tanzania is rich in traditional arts and crafts based on wood, ivory, textiles, leather, fiber, metal and clay. Artisans produce cane, and bamboo products (10,200 producers),8 pottery and ceramics (6,500 producers), wood and ivory carving (4,700 producers), furniture and textiles (4,500 producers). They also render tailoring, carpentry, cobbling, vehicle repair, blacksmith, plumbing, toolmaking and machining services. Surveys suggest that about 150,000 people are engaged in craft activities; about 70 percent of the artisans live in rural areas and are also engaged in agriculture; about 90 percent of handicraft production is on an individual basis and 5 percent in cooperatives. The sector is the primary source of income for many households and made a modest contribution to foreign exchange earnings, amounting to a cumulative total of T Sh 13 million between 1976 and 1984. 1.30 Non-Factory Industriess According to the 1978 Industrial Census, non-factory establishments (5 to 10 people) constitute 34 percent of all manufacturing establishments; they employ 3.8 percent of the industrial labor force and contribute 1.1 percent to value added in the manufacturing sector. The subsector appears to be small in comparison with either the craft or the factory sectors. The four most important activities are food 71 The census covered only those enterprises employing between 5 and 49 people in the small-scale sector (crafts and enterprises employing between 1 and 4 people were excluded). 8/ Data are from the National Handicrafts Survey, 1976-77, conducted by SIDO.  - 13 - products, textiles, wood products and metal products; they account for 88 percent of value added and 75 percent of employment. Recent official data indicate that the non-factory industrial sector declined in the 1978-84 pari passu with the manufacturing sector as a whole, likely the result of a significant decline in the availability of domestic input supplies. 1.31 Fact.ory Industries: In 1972 there were 278 factory small-scale establishments employing 6,704 people. By 1978 the sector grew to 973 establishments employing 20,141 people, a growth rate of about 20 percent per annum. In 1978, factory small-scale establishments constituted 76 percent of all factory establishments, employed 18 percent of all factory employment and contributed 9 percent to the factory sector's value added. The major activities were consumer products in food and b..verages, textiles and wood industries. Table 1.10: TANZANIA - A COMPARISON FOR ALL FACTORY INDUSTRIES: 1978 AND 1981 1978 1811 Estabilhmeate EstablishmentEs Estab ishments Establishmotes with 10-49 with 50 a over with 10-49 with 60 & over Employees Employees Employ... Employ.es Number of Establishments 978 808 407 299 Percentage Distribution of EstablIshments 708 24% 58% 42X Number of Persons Employed 29,141 89,831 9,269 95,588 Percentage Distribution of Value Added 8% 81% 18% 84X Average Value Added per Employee 18,80 23,480 13,780 11,7U0 (T Sh Constant 1976 Prices) Sourco:Industrlal Census 1978 and Survey of Industrial Production 1981, Bureau of Statistics. 1.32 During 1978-1981 the small-scale factory sector experienced a very significant decline, when the number of establishments and employment decreased from almost one thousand establishments to about four hundred (Table 1.10). Although all sectors were affected by firm closures, activities like textiles, that require imported inputs, suffered a somewhat greater decline than those such as wood products that utilize domestic resources. Labor productivity in SSIs, has not declined, however: since employment decreased by about as much as value added in real terms, the value added per employee in the small-scale factory sector was about the same in 1981 as in 1978.  - 14 - 1.33 The performance of the small-scale factory sector was in sharp contrast to the experience of the medium- and large-scale enterprises for the same period. While value added in the latter also declined quite drastically, by about 50 percent in real terms, the number of medium- and large-scale establishments remained the same and employment actually increased by 7 percent. By 1981 value added per employee in real terms decreased to about half of its 1978 level. Value added per employee in medium and large firms was 75 percent greater than the small-scale sector in 1978, by 1981 it was 15 percent below that of SSIs. These changes in employment and number of enterprises show that the small-scale factory sector adjusted to the changed economic conditions very differently than the medium- and large-scale sector. The number of establishments and employment was substantially reduced for SSIs, either through voluntary closure or bankruptcy, commensurately with the decline in value added, and thus productivity per (surviving) enterprise was maintained until 1981, by which time total factor productivity (of labor and capital) was higher in SSIs than for larger enterprises. Among SSIs, there was also some adjustment in production towards activities that used domestic resources (wood products) and against those that required imported inputs (textiles). In contrast, the medium- and large-scale sector has continued operating with virtually no structural adjustment, a result of the increasing protectionist policies (C'Lapters Two and Three). 1.34 The scant evidence available since 1981 suggests that the further decline in the small-scale factory sector (pari passu with the medium- and large-scale sector) may not have eroded productivity substantially for surviving firms, because of the continuous decline in the number of small firms and in employment. The further reductions in output are due to the fall in demand induced by decreasing real incomes and by the lower availabi- lity in the supply of domestic inputs. The small-scale sector is not very dependent on imported inputs; the import content of recurrent inputs for factory SSIs with 5 to 25 workers is about one-half (37 percent) the overall industrial sector's import intensity (MIES). 1.35 This chapter's discussion indicates that the performance of the manufacturing sector has been very poor, particularly over the past decade. Both output and value added have declined dramatically. The poor performance took place while large investments in manufacturing were incurred. Even as manufacturing production began to decline sharply, investments continued to be very large and thus ICORs became negative. The massive investments have resulted in a sector that has an installed capacity intended to have produced US$1.9 billion worth of gross output in 1984. However, only US$480 m. of gross output was produced, utilizing US$423 m. in inputs, which resulted in a very small manufacturing value added contribution to GDP. Seventy five percent of capacity lies idle and in disrepair. The sector is import-dependent and appears to be capital- intensive, and subject to low and declining labor and capital productivity. Exports are small and often do not result in a net foreign exchange contribution for the country. Imports to support the 25 percent capacity utilization in manufacturing are about six times the value of industrial exports. This overall performance, however, masks significant differences among subsectors and even among firms, which will be described in more detail in Chapter Three.  - 15 - CHAPTER TWO THE POLICY FRAMEWORK Introduction 2.01 The causes of deterioration in the Tanzanian economy have been both external and internal. During the past decade, Tanzania was hit by a number of external shocks: two oil crises, the war with Uganda, drought, the break up of the East African Community and a sharp deterioration in the terms of trade. Exchange rate management, agricultural sector policies, the size and quality of industrial investments, over-protective industrial poli- cies and significant delays in starting a process of macroeconomic adjust- ment exacerbated the deterioration in the economic situation. (A more detailed account of macroeconomic development.s since independence is provided in Chapter Four.) 2.02 Between 1982 and 1985, the Government made some attempts at restructuring the economy under their structural adjustment program. While the measures (e.g. some cuts in the budget and imports, increase in agricul- tural producer prices by 30-35 percent in 1983-84, 40 percent nominal deva- luation and some trade liberaiization in 1984) represented a movement in the right direction, they were insufficient to improve resource allocation and generate economic recovery. Most recently, in its 1986/87 budget speech, the Government has announced a number of policy measures, the most important being an exchange rate to T Sh 40 - US$1 on June 20, 1986, and a 30 to 80 percent increase in agricultural producer prices. (See discussion in the section on policy recommendations in Chapter Six.) 2.03 The policy regime affecting the manufacturing sector since the 1970s has been dominated by the mechanisms introduced by the Government to deal with the excess demand for foreign exchange at an increasingly over- valued exchange rate. The main instrument has been a system of foreign exchange rationing through administrative allocation on a firm by firm basis. This system, together with import licensing, was used to restrict competing imports into the country and to channel foreign exchange to the importation of raw materials for industry. In order to limit the resulting monopoly power for domestic producers (and protect consumers), on the one hand, and to provide satisfactory financial profitability to existing produ- cers, on the other, a eomprehensive price control system was also estab- lished. This was complemented by restricting wholesale domestic and foreign trade operations to parastatal agencies--known as the confinement policy. As we shall see below, this set of interrelated policies (overvalued exchange rate, rationing of foreign exchange, prohibition of competing imports and price controls), together with the objective of keeping all existing industrial enterprises alive by spreading the available foreign exchange as thinly as necessary, has had major implications for the performance and efficiency of the sector.  - 16 - 2.04 During the two years preceding the 1986187 budget speech announce- ments, there was one substantive tRaee below) and some marginal policy improvements (small devaluation, granting of export retention schemes, some price decontrol aaid deconfinement) in the situation described above. The most important change was the legalization of "own funds" imports, i.e., allowing the importation of competing goods not requiring foreign exchange from the Bank of Tanzania (i.e., utilizing foreign exchange from repat- riation, smuggling, or acquired in the parallel market). These poliLy changes, however, did not improve industrial performance significantly because of the remaining policy distortions. Against this background, this chapter reviews in detail the existing set of policies affecting the industrial sector and then discusses the impact of the policies on the structure of industrial protection. Policies Affecting Industry 2.05 The ExchaanRe Ratet The Tanzania shilling (T Sh) was introduced ini 1966 and was originally pegged to ti.e SDR. From 1966 to 1974 the exchange rate was T Sh 7.14 = US$1. Subsequently, the shilling had minor nominal fluctuations until January 20, 1979. At that time, the peg to the SDR was discontinued, the T Sh was devalued by 10 percent (to T Sh 8.A2 - US$1) and pegged to a basket of currencies of Tanzania's main trading partners. The shilling remained stable until March 8, 1982, when it was again devalued by about 10 percent. A 20 percent devaluation on June 6, 1983, and a further 20 percent devaluation on June 15, 1984 brought the shilling to T Sh 17 to the dollar. During the first half of 1986, the shilling was allowed to slide to T Sh 25 to the dollar, and in June it was further devalued to T Sh 40. Additional small devaluations have resulted in an exchange rate of T Sh 50 to the dollar by end-3986. 2.06 During the mid- to late-1960s Tanzania maintained a balanced external trade account. By 1970/71, however, a significant trade deficit had already emerged. From 1970 to the end of 1978 the real exchange rate appreciated by 56 percent as a result of higher domestic inflation while terms of trade deteriorated by 17 percent during the period and external debt increased rapidly. The various devaluations between 1979 and 1984 did not slow down the continuing overvaluation of the currencys faster domestic inflation, additional deterioration in the terms of trade, increasing debt accumulation and build-up of arrears resulted, by 1985, in the official exchange rate being more overvalued than ever before. The real effective exchange rate appreciated by 120 percent between January 1979 and December 1985 while the terms of trade further deteriorated by 27 percent. By the end of 1985, the parallel market rate was T Sh 150 (i.e., 9 times the official rate). 2.07 By early 1986, just to restore the 1970 parity would have required a rate of about T Sh 50 to the US dollar. However, this would have been far from sufficient to eliminate the substantial excess demand for foreign exchange because of the decline in the terms of trade and the enormous increase in debt service and arrears. The available preliminary evidence suggests that, under the present circumstances, the exchange rate that would clear the market for foreign exchange (in early 1987) would be significantly  - 17 - more depreciated than the official exchange rate. Three pieces of evidence, in particular, point to this conclusions (i) the gradual appreciation, over time, of the real effective exchange rate (see above); (ii) the 45 percent decline in the terms of trade since 1970, and the large increases in debt service and in arrears (estimated to be currently US$900 m.); and (iii) the parallel market rate, which ranges between T Sh 130-160. 2.08 The Administrative System gf ForeiMn Kichante Allocations The administration of the regime for foreign exchange control and allocation rests with the Bank of Tanzania, which has approved outward payments although in effect many of the final decision on externalization of funds is made nowadays at the National Bank of Commerce (NBC). Control over exchange operations in Zanzibar is exercised by the People's Bank of Zanzibar. Import licenses in the mainland cre administered by the Imports Controller in the Bank of Tanzania and export control by the Exports Controller in the Ministry of Trade. 2.09 The average annual foreign exchange availability over the period 1980-84 was US$1,038 million, of which US$497 came out of exports of goods and services and US$541 million from external sources (aid and concessionary lending). Most of the foreign exchange available through aid and loans has been tied to particular projects, although an increasing share has become untied, i.e., it is fungible across commodities, albeit it may still be tied to country source. Authorities have therefore distributed through the general foreign exchange allocation system proceeds from exports of goods and services and import support aid which have comprised over one half of the total foreign exchange available. 2.10 There are two levels at which rationing occurs--at the import licensing stage and at the point of externalizing foreign exchange funds. Until 1983 the initial process of licensing was the main source of foreign exchange rationing; virtually all licenses issued became actual imports, although there were some lags. However, since then the foreign exchange authorizations by the Bank of Tanzania became an equally important constraint on imports, the result of the growing overestimation of foreign exchange availability. Expected availability of foreign exchange is estima- ted in the foreign exchange plan and balance of payments projections. The broad direction of the allocation is made following objectives set out in various policy papers. In particular, the emphasis on industrialization since the 19703 has resulted in a significant share of foreign exchange resources being channeled to the importation of inputs for industry. 2.11 In the process of foreign exchange rationing from free resources, the Governor of the Bank of Tanzania is assisted by an Advisory Committee on Imports, comprising representatives of key ministries, NBC, and the State Motor Corporation. The Directorate of Import Licensing in the BOT works as the Secretariat to this committee--its role is to assess applications from a technical angle and make initial recommendations. In so doing, the secreta- riat refers to sub-committees on agriculture, industry and transport. The Directorate of Import Licensing assesses the foreign exchange to be set aside for imports of petrol, medicines, food grains and defense needs. Capital goods are mainly financed by the use of loans and grants made available to the Government. Consumer imports (other than those financed by 'own funds'; see below) have been given less priority and are examined on a  - 18 - case-by-case basis. Imports competing against locally produced goods can only be imported with official foreign exchange after verifying that there is a shortfall in local supply, or that the local product does not meet specific properties. The remaining applications are then classified into broad groupings, which in turn are classified by end use. Inputs into the agricultural sector, such as fertilizers, bags and tractors are supposed to be given priority, followed by industrial inputs and transport equipment. Activities are also classified according to their local content, whether they are "essential" commodities, export industries, and remaining imports. However, no detailed guidelines exist to resolve the various intersectoral competing claims. In effect, aside from the broad development strategy guidelines, the actual allocation of total import licenses between sectors is in large measure the result of a bargaining process at the sub-committee level, which in practice takes into consideration past import patterns, the need to alleviate perceived short-term crisis and particular representa- tions. In this process, the political strength of the various Ministries and the size of existing installed capacity in the sector--and its import dependency--also plays an important role. As a result of this process, complemented by the direction and magnitudes of foreign aid, industry has always received a significant share of the available foreign exchange. 2.12 Once an import license is granted an importer requests to NBC to open a letter of credit. An import license is valid for six months, but may be renewed every three months thereafter. All the requests for letters of credit are again assessed on a weekly basis by the Advisory Committee on Imports within the Bank of Tanzania, with reference to their actual holdings of foreign exchange at the time. If there is sufficient foreign exchange available, the decision to externalize funds is made and the letter of credit is confirmed. 2.13 Growing awareness that such a system of foreign exchange alloca- tion was not effective led (following the Structural Adjustment Program ir. 1982) to an attempt to further prioritize among foreign exchange users at the Bank of Tanzania. Preliminary lists have been made by the BOT using criteria such as: linkages in the economy, basic consumer requirements and export orientation. These criteria, however, are broad enough to apply to most industrial activities. In practice, assessments of priority industries have simply resulted in lists of foreign exchange needs of existing industrial activities. Attempts to prioritize among industrial firms by the Ministry of Commerce, Industry and Trade have fared similarly and have not become operational. Since 1983, the import licenses approved have signifi- cantly exceeded foreign exchange available, rendering the various guidelines and technical criteria for allocation much less effective in practice. In effect the allocation of foreign exchange to industry by the BOT has been driven by the objectives of supporting fiscal revenue earners (beer, cigarettes) and keeping most existing enterprises alive, on the one hand, and by particular pressures, representations and ad hoc decisions, on the other. 2.14 Own Funds ImDorts: Under the 1983/84 budget a provision was made for allowing the importation of a limited number of items purchased with external sources under what is referred to as own-funds import licenses, i.e., the importer uses foreign exchange from other than official sources. The number of items permitted under own-funds imports has increased signifi-  - 19 - cantly since 1984, and by now include transport equipment, some consumer goods, building material and equipment, electrical goods, fishing equipment and a large number of industrial goods and inputs for manufacturing. The scheme has been administered flexibly and thus, in effect, a wide range of consumer goods and inputs can now be imported under own-funds licenses, which are provided automatically. 2.15 The funds utilized under own-funds imports comprise returning capital, recycling of parallel market proceeds, remittances and direct investment. Imports under own-funds licenses are not subject to price controls or confinement. Own-funds imports have grown very rapidly. During the first six months of 1984 they comprised about 16 percent (US$94 million) of total imports; they rose to 22 percent (US$155 million) during the second half of the year and to at least an estimated one-third (about US$300-350 million) during 1985. 2.16 During the first half of 1984 about one quarter of own-funds imports were consumer goods and the remaining three quarters were interme- diate goods (20 percent), machinery and equipment (40 percent) and spares, accessories and building materials (16 percent). The share of consumer goods has increased significantly (to 44 percent) since then, reflecting the increasing liberalization in the administration of the scheme. Although the share of intermediate and capital goods has declined accordingly, the dollar amounts of imports in these categories have increased significantly (by about 30 percent) since June 1984. Trucks and vans dominate the equipment category; textiles, clothing and to a lesser extent soap and detergents are important consumer goods. Own funds imports are estimated to have grown rapidly; by 1985 they exceeded one third of all imports to Tanzania. 2.17 The "own-funds" imports scheme has already caused some price reductions and quality improvements in items that now face import competi- tion, but it has not led to increases in manufacturing production or capa- city utilization. The small effective demand for 'own-funds' imports of industrial inputs has been mainly due to the high price of these imports. Since an industrial firm which purchases its inputs at the implied parallel rate would effectively face very low protection on the final good, only firms that operate very efficiently and are competitive in a free trade situation are expected to be able to afford such imports. The low protection on a final good for a firm that purchases its inputs in the parallel market is largely the result of the negligible effective tariff on parallel market transactions (see below), and in some cases also due to price controls. (Price controls generally do not, however, play an important role in reducing protection or rents because many categories of goods are not subject to controls any longer--whether officially or in practice--, and for those where controls apply they are calculated on a generous 'cost-plus' basis). 2.18 The Tariff Regime: The importance of Tanzania's tariff structure in determining the pattern and efficiency of resource allocation has been inversely related to the prominence given to quantitative restrictions (QRs), prohibitions, and to the centralized allocation of foreign exchange. Since the late 19609 Tanzania increasingly relied on import licenses (QRs and prohibitions), both to control the overall use of foreign exchange and to protect domestic industry. Under these circumstances manufacturing  - 20 - output and input prices were not influenced by the structure of tariffs but became mainly determined by the monopolistic power given to the local producer through QRs on competing imports, the nature of price controls and confinement, and the exchange rate. 2.19 The recent introduction of own funds imports and the de facto relaxation of quantitative restrictions for many commodities has increased the potential role of tariffs in influencing prices and protection. At present, however, the huge discrepancy between the official and the parallel exchange rates limits in practice the role of tariffs. For goods imported under the own-funds import scheme, protection to local production activities depends on the parallel exchange rate (T Sh 150, which applies to own funds imports and therefore is a main determinant of the price of competing domestic products) the average rate at which inputs are imported and the structure and level of tariff duties on inputs and final goods. Since tariffs are levied on imports valued at the official exchange rate, however, their impact is considerably diluted. An own funds importer who faces a tariff duty of 60 percent levied on imports valued at the official exchange rate (T Sh 40 - US$1), effectively pays only about 16 percent on the actual import price (at the parallel market rate, T Sh 150). The role of the tariff schedule will, however, become significantly more pronounced the closer the exchange rate moves towards an equilibrium rate (or alterna- tively, if tariffs are eventually levied on the basis of an equilibrium--or parallel--rate). 2.20 Tanzania's current tariff schedule is relatively simple v/ith a few basic rates used throughout. The bulk of imports are subject to a tariff of 20 percent, which applies to most tariff items, particularly intermediate and capital goods, followed by a 60 percent tariff rate, which applies to most consumption items. A duty free list includes agricultural inputs, petroleum distillates, pharmaceutical products, spare parts, educational and packing materials. Exemptions from duty include goods used by the Govern- ment and diplomats. Virtually all duties are ad valorem, and range up to 120 percent. Since finished consumer goods carry higher tariff (60-120 percent), than intermediate and capital goods (generally 20 percent duty, and in some cases no duty), considerable potential protection would be provided to a domestic producer in the absence of an overvalued exchange rates the effective rate of protection to domestic production would be of the order of 150 to 200 percent on average. 2.21 Implicit tariff rates (obtained by dividing actual duty collections by the FOB value of import value) declined from 19 percent in 1970 to 7 percent in 1982183 (among the lowest in Sub-Saharan Africa), largely due to a progressive reduction in duties collected on imports of mineral fuels and lubricants. The absolute increase in duty collections in 1984/85 (to 13 percent of import value) partly reflects the lowering of high tariffs (which ranged up to 500 percent, encouraging widespread evasion and smuggling) to 120 percent or less, and also the opening up of own-funds imports that led to higher imports of consumer goods. 2.22 Sales Ta:s All imports and most locally produced goods are also subject to a sales tax. Inputs are subject to taxes of up to 25 percent (the most common rate), and final goods are taxed at higher rates, ranging between 50 to 300 percent. Exemptions include educational articles, some  - 21 - food stuff and pharmaceuticals and Government imports. Some locally produced final goods (such as textiles) are exempt from sales tax when sales tax was paid on imported materials used in the production process (effectively encouraging the use of imported materials), while the same imported final goods are subject to the sales tax. In these cases, the local production activity is provided with additional protection. However, since the official exchange rate is used as the base for the valuation of imports, the additional protection granted through discriminating sales tax is also small at present. Also, the use of the official exchange rate, and the various exemptions, keep custom duty and import sal.es tax collections to only about 20 percent (10 percent each) of total Government revenue. 2.23 Taxes on Income and Profits: Income tax is charged on income accrued or derived from Tanzania in respect of any basiness, employment or service rendered, any rent dividend, interest, alimony, and similar allowances, any pension or annuity. Provision is also made for undistri- buted dividends to be taxed as if they had been distributed. For parastatal and private corporations taxes amount to 50 percent of corporate net income. For individuals, annual income is taxed according to a steep progressive marginal rate schedule which, since mid-1986, ranges from 20 percent for annual incomes over T Sh 10,000 (US$250) to 75 percent for incomes above T Sh 240,000 (US$6,000). 2.24 Price Controls: The Government's price control system was first introduced in 1973 and is administered by the National Price Commission. The number of products subject to price controls was initially 1,000, but increased to about 3,000 by 1978. Since then, the number of product groups and individual items under price controls has been significantly reduced, so that by 1983/84 only 50 locally manufactured product groups containing 226 individual items, in addition to 6 imported product categories containing 9 items were still under control. In 1984/85, the price controls were further reduced, as the number of domestically produced items subject to controls was reduced to 179 items (or 44 products), while the number of imported items under price controls fell to 5 (equivalent to 3 products). Price controls have in general been imposed on food, other consumer goods and intermediate inputs deemed to be essential to consumers and producers. Items such as cooking fats and oils, salt, milk, sugar, beer and soft drinks, radios, soap and detergents are subject to price controls. Price controls are also imposed on intermediate agricultural products such as fertilizers, hoes, other farm implements, and on construction materials, including iron sheets, rolled steel and cement. Prices of a list of commo- dities considered basic ne:essities are also controlled. These include prices of petroleum products, and, until recently, maize and maize flour. In these cases, the Government has either directly subsidized the item or has allowed for cross-product subsidies to guard against large increases in retail prices. 2.25 On the basis of costs and price reviews by the NPC, which are held at least once a year, the controlled prices may be adjusted to reflect addi- tional costs. Following a review of production costs, audited final accounts, and projected financial statements, the NPC allows for a pre-tax 30 percent rate of return on assets (i.e., for a 15 percent after-tax rate of retumn). ;Thereafter, profit margins are fixed for the wholesale and retail levels depending on the turnover rate. For products with a high  - 22 - turnover rate, the margin for wholesale prices ranges between 5-15 percent, while for retail prices it is 5 percent. For products with a low turnover, the wholesale margin is 20 percent, while the retail margin is between 10 and 20 percent. For most imported products, the price is 'set' by importers under a scheme, whereby the importer presents the cost structure and the planned retail price for the product to the NPC for approval. Price controls are administered at the national, regional and district levels. At the national level, the NPC sets the same price for essential commodities regardless of location and the cost of transportation. At the regional level, the Regional Advisory Committees set the retail prices on other goods so as to reflect the differences in transportation and other costs. Finally, the District Advisory Committees are responsible for setting prices for essential commodities locally. 2.26 Confinement Policy: Under Tanzania's policy of confinement, wholesale trade for some domestic and imported commodities are restricted to parastatal organizations. Industries are required to sell certain specified goods through national and regional trading companies and to purchase many of their imported requirements and some domestic inputs through designed parastatal trading firms. The Board of Internal Trade (within the Ministry of Industries and Trade) and the Bank of Tanzania administer the confinement policy. Over fifty goods are subject to internal confinement, comprising mainly consumer goods, building materials and agricultural implements. There is no total concordance between the list of price controlled goods and those subject to confinement, although there is significant overlap. Trade companies negotiate prices with their suppliers for items which are not subject to price controls, generally on a cost-plus basis, a process which results in similar outcomes to that followed by the price control authorities. 2.27 Irn practice, the evidence suggests that confinement policy has been associated with poor service, lack of payments to suppliers and high marketing costs. Parastatal companies have not been successful in developing adequate marketing strategies and have often been unresponsive to consumer demand. Furthermore, confinement has not been effective in making some scarce consumer goods (such as textiles) available in remote districts. 2.28 Since 1984, when own funds imports became important (thus exempting many goods, in practice, from deconfinement) and the process of price decontrol gathered momentum, there has been a shift towards deconfine- ment with producers increasingly permitted to distribute their products directly. Nowadays, many industrial inputs and outputs are not subject to confinement, although some important items are still subject to the confinement scheme. 2.29 Industrial Licensing and Foreiln Investment: Manufacturing firms are required to be licensed under the National Industrial Licensing and Regulation Act. The Industrial Licensing Board within the Ministry of Industries and Trade is in charge of implementing the Act and takes into account in the decision process the financial viability of projects and some economy-wide implications. In general, the Board attempts to emphasize projects that are labor-intensive, located in rural areas and which have a favorable impact on foreign exchange earnings.  - 23 - 2.30 Foreign investors are not required to obtain local equity, but they are advised to associate with Tanzanian entrepreneurs to help them set up. In general, foreign investors have certain guarantees over their investments under the Foreign Investment (Protection) Act, including compensation in the event of nationalization and entitlements to transfer out profits. In practice, however, there has been limited repatriation of profits allowed in recent years, a result of the deteriorating balance of payments. ExDort Promotion Policies 2.31 The major institutions involved in the formulation of trade policy are the Ministry of Industries and Trade, Bank of Tanzania and the Ministry of Finance. Advise on export promotion and policy formulation have been given to the Board of External Trade (BET), formed in 1978 under the aegis of the Ministry of Industries and Trade. The BET has been actively involved in designing and implementing many export incentive schemes and providing export promotion services. Since its inception, the BET has helped to launch the Export Rebate, Presidential Award, Concessional Rate of Interest, Export Credit Guarantee and various Retention schemes. The BET has provided services through the Trade Facilitation Council and Export Facilitation Committee, launched market studies and marketing missions and participated in trade fairs. The main export policy instruments are described below. 2.32 Export Licensing: All manufacturing exports are subject to licensing, although in practice manufactured exports are not.subject to restrictions. Until recently, the process of obtaining export licenses was slow and excessively bureaucratic, yet it has been streamlined so that in most cases licenses are issued on-the-spot. 2.33 Export Facilitation: The Trade Facilitation Council at the BET is entrusted with rationalizing procedures for export documentation such as export licenses. The Export Facilitation Committee at the Ministry of Industries was established to help solve ad hoc problems faced by exporters such as transportation bottlenecks, shortage of domestic inputs, water and power. BET has also a Contact Promotion Program organized to promote exports of cement, canned fish, and aluminum household goods to neighboring countries. A market survey was conducted to explore possibilities of increasing exports to Western Europe and a number of sales missions were launched to promote yarn, textiles and household goods. In addition, BET annually establishes export targets in cooperation with about 40 major exporters of manufactures. 2.34 Export Credit Guarantee Scheme (ECGS)t Institutional arrangements for ECGS have recently been put in place at the National Bank of Commerce and the Board of External Trade and are expected to start functioning soon. They offer two types of guarantees--for pre-shipment finance and compre- hensive. The pre-shipment finance covers the lending institution up to 75 percent of any loss resulting from insolvency or default of the exporter. The comprehensive shipment guarantee covers the exporter between 45 percent and 95 percent of any loss (depending on the cause) against the commercial risk of non-payment by the buyer and the political risk of restrictions on remittances.  - 24 - 2.35 Financial Services to Exporters: There are several financial services provided to exporters. First, since August 1985, exporters of manufactured goods pay a preferential interest rate of 11 percent on short- term loans from the National Bank of Commerce, a concession of two and a half points. However, by mid-1985 the outstanding loans to manufacturing exporters were estimated to be only about T Sh 25 million (US$1.5 million equivalent). Also, the Bank of Tanzania allows exporters to extend credit facilities to overseas buyers for a period of sixty days. 2.36 Etgort Rebate Scheme: The scheme was established in July 1981 to replace the Duty Drawback Scheme and covers about 60 horticultural, processed %nd manufactured products. The rebates range from 5 to 25 percent of the FOB value of exports, depending on a detailed analysis of duties and sales taxes levied on inputs for the products exported. There are about 80 companies enrolled in .he scheme covering a diversity of manufactures, mainly textiles, garments, sisal products, engineering goods, leather and processed food. Improvement in the processing of claims has led to a maxi- mum of two months wait for rebates. The amounts disbursed under this scheme have increased from T Sh 35 million in 1982 to T Sh 81 million in 1984, which constitutes less than 8 percent of manufacturing export value. The main product claimants were sisal products and blended tea. Rebate claims are made quarterly for exports valued at T Sh 10,000 or more and payments are approved by an inter-ministerial Export Rebate Committee. 2.37 Presidential Award Scheme: This scheme was introduced in 1981 to reward exceptional export performance in five major export subsectors, including manufactures. Government agencies are required to give priority and preferential treatment to the winners for the year e.g. foreign exchange allocation, transportation, local inputs, working capital, etc. The crite- ria for selecting the best exporter include export target achievement, percentage of production exported, market and product diversification and export growth. 2.38 Export Retention Scheme: The export retention scheme is the most significant export incentive provided to exporters because of the large differential between official and parallel exchange rates and the rationing of foreign exchange by the BOT. The scheme allows exporters to retain some of their foreign exchbuge earnings for the importation of inputs and spares and, in some cases, to cover foreign debt service. The first export retention scheme was initiated in the 1983/84 Budget and expanded in the 1984/85 Budget. Under this scheme a number of exporters, mainly parasta- tale, negotiated a retention percentage, ranging froyi 10 to 100 percent, on an ad hoc basis with the Bank of Tanzania. In most cases the retention was for the purchase of inputs and spares although in three cases it was to cover foreign debt service of companies. 2.39 The second retention scheme, the Seed Capital Revolving Scheme, was started early in 1985 with funding from the Swedish International Development Agency. The Seed Capital Fund provides the initial foreign exchange required for imports of inputs to get companies started in the export market. The participating companies then retain a pre-detenmined percentage of their foreign exchange earnings to finance the next round of input imports. The retention percentages, varying between 50 and 80 percent, are based on the imported input requIrement of the export product.  - 25 - In addition, the companies retain 35 percent of any excess foreign exchange earnings over the revolving seed amount to expand their production. Currently, thirty-four companies are operating under this scheme and another eighteen are under consideration. 2.40 A third retention scheme, which may eventually supersede both schemes mentioned above, was announced in the 1986/87 Budget, and after some modifications it has begun to be implemented. This scheme, which for the time being applies to all exports heretofore subject to small or no retention, differentiates between traditional and non-traditional exports. Traditional agricultural exports (eight main commodities), constituting 68 percent of total exports, will be eligible for their present retention percentages, usually about 10 percent (and no retention in some cases), while non-traditional agricultural exports, which account for 14 percent of total exports, and other non-traditional exports, mainly manufactures and processed raw materials, accounting for 18 percent of total exports, will be eligible to retain 50 percent of their export earnings. In addition, limited transferability of retained currency by exporters to other producers has recently began to be sanctioned. Financial Sector and Policies 2.41 Overview. The banking system of Tanzania comprises a Central Bank, the Bang of Tanzania (BOT), and ten financial institutionss two conmmercial banks (the National Bank of Commerce--NBC--and the People's Bank of Zanzibar), four development banks (specializing in medium- and long-term financing for manufacturing, agro-business, tourism and transportation), a savings bank, a housing bank, an insurance company and a national provident fund. All the institutions are fully state-owned except for the (i) East African Development Bank (EADB), (ii) Tanganyika Development and Finance Company Limited (TDFL) which is jointly owned by the Tanzania Investment Bank (TIB) and three development finance institutions from the U.K., the Federal Republic of Germany and the Netherlands; and (iii) Cooperative and Rural Development Bank (CRDB) which is owned by the Government, cooperatives and BOT. Tanzania has no private capital market. Interest rates are determined administratively. A detailed structure of deposit and lending rates for all financial institutions is prescribed by BOT. In addition, more detailed sectoral lending rates are established for NBC borrowers according to priority status. Currently the favored sectors in terms of lending rates include the Government budget, agricultural activities and production for export. 2.42 Interest Rates and Credit Allocation. A modest change in interest rates took place in July 1982 when deposit rates were increased on longer- term deposits fron 6 percent to 7.5 percent, with a 0.5 percent increase allowed on 9 to 12 month deposits, from 5 percent to 5.5 percent, and no change on short-term deposits. Lending rates were raised by 0.5 percent from 7.5-12 percent to 8 to 12 percent. In spite of 30 percent inflation, further increases did not occu: until October 1985 when the general level of interest rates was adjusted by 1 to 4.5 percentare points. Twelve month deposit rates were increased to 7.5 percent and savings rates to 10 percent; the maximum lending rates were increased to 14 percent for comercial banks and to 16 percent for specialized financial institutions. Throughout the  - 26 - 19709 until now, real interest rates have been significantly negative. As of late, real interest rates have become less negative due to more frequent upward adjustments in the nominal rate. 2.43 The negative level of real interest rates has resulted in reduced savings and lending rationing. Saving deposits in real terms have declined since 1980. Furthermore, negative interest rates have also resulted in capital leaving the country. The sectoral distribution of credit outstanding has remained quite steady over the past five years for the major sectors in the economy. Manufacturing has been receiving about 9 percent of all commercial bank lending since 1980, down from about 25 percent between 1975-79. This dramatic decrease in manufacturing bank credit coming to the sector is partly the result of a decline in the demand for funds (concomitant with the sharp drop in industrial production and in investments), and partly the deliberate policy of the government to extend a more substantial share of credit to the agricultural sector. The evidence suggests that most of the credit to industry accrued to the parastatal sectors, with the private sector receiving a rather small share. Many such firms turn to the informal private credit network where extended families of entrepreneurs, residing in Tanzania or abroad, lend funds at market clearing interest rates, which are positive in real terms (i.e. significantly above the 30 percent inflation rate estimate). 2.44 The allocation of credit throughout the economy, which is mainly determined by NBC, is extremely inefficient. The current channeling of financial resources is both an outcome and a cause of the wasteful alloca- tion of foreign exchange which exists. The allocation of a large share of credit resources to very unproductive activities is the result of the insti- tutional weaknesses and rigidities at NBC and at the Central Bank, the remaining macro-, trade and pricing policy distortions and the inadequate financial and economic assessment in the provision of credit overdrafts at NBC. Relatedly, the objective of keeping many large unviable activities afloat result in the provision cf large amounts of credit overdrafts to unviable activities. Under these circumstances, the imposition of aggregate credit ceilings for the economy have the unintended effect of leaving many efficient firms out of the official credit allocation system. 2.45 Development Banks in Industry. TDFL and TIB are the two main financial institutions in Tanzania specializing in medium- and long-term financing for manufacturing, agro-business, tourism and transportation. TDFL provides funds mainly to medium-sized private enterprises, whereas TIB finances mainly larger scale enterprises in the public sector. TIB is owned by the Government (60 percent) and two parastatals: the '!ational Bank of Commerce (30 percent) and the National Insurance Corporation (10 percent). As of December 31, 1985, TIB's loan portfolio amounted to T Sh 1,366 million in 99 projects, and its equity portfolio amounted to T Sh 84 million in 10 companies. TDFL is owned by foreign governmental development agencies (73 percent) and TIB (27 percent). As of December 31,1985, TDFL's loan port- folio amounted to T Sh 227 million in 49 projects, and its equity portfolio amounted to T Sh 85 million in 53 companies. The sectoral distribution of activities financed is similar for the two institutions with manufacturing being the main activity accounting for about 60 percent of the loans, followed by agriculture and fishing which account for about 17 percent.  - 27 - 2.46 The difficult economic environment of the past several years has had a significant impact on the performance of these institutions. In line with Tanzania's industrial strategy of the past, which emphasized domestic production for domestic needs, both TDFL and TIB financed projects which were oriented towards import substitution, yet they were import dependent in terms of raw materials and spares. By the end of 1985, about one-half of the loan portfolios of TIB and TDFL were in problem projects, including projects incurring heavy losses and others under litigation. With the bene- fit of hindsight, it is clear that during appraisal inadequate attention was paid to design issues and to the longer-term prospects of many of the enter- prises financed, especially in the face of deteriorating economic conditions in the country. Relatedly, the economic viability of many of these invest- ments was not fully assessed. These problems have resulted in a steady deterioration in the portfolio of the two institutions, which are now beginning to face a solvency problem. As of December 31, 1985, 58 percent of TDFL's loan portfolio and 74 percent of TIB's loan portfolio was affected by arrears. Furthermore, as a result of the economic problems in the country, both institutions have had difficulty in mobilizing new foreign exchange resources. Their levels of operations have thus steadily declined over the years, and there has not been adequate funds to finance the rehabilitation of existing projects. The uncertainty of future operations has created staff morale problems in both institutions. 2.47 These term lending financial intermediaries have yet to fully recognize the large losses incurred by the lack of productivity of many of their client firms. The economic reform program underway is already exposing the unproductive reality of many of the industrial and agro-related projects in the portfolio of these institutions. In addition, the level of on-lending interest rates imposed on TDFL and TIB have also affected their financial performance and their ability to efficiently allocate resources. With negative real interest rates TIB and TDFL clients have been encouraged to over-invest in fixed capital in the past. Furthermore, the level of interest rates charged by the financial intermediaries has not been adequate to ccver their administrative costs, including adequate provisions for default risk. Capital and Labor Costs 2.48 In general, capital has been substantially subsidized in Tanzania, both through the overvalued exchange rate and the negative real interest rate. On the other hand, real wages were high by international standards until the mid-seventies. The significant drop in real wages since the late seventies has not resulted, hovever, in a decline in the share of the wage bill in value added (in current prices), since: (i) value added declined commensurately with real wages; and (ii) employment levels increased. Hence, the share of wages in value added per employee has not declined over time, mostly as a result of limited labor mobility and strict regulations regarding redundancy of surplus labor. The significant surplus employment in manufacturing today implies that labor--even at the very low real wages of today--is not an inexpensive factor of production for the industrialist. The combination of a low cost of capital and the limited flexibility to adjust employment levels when production declines (effectively raising the expected wage costs per unit of value added), are important factors in determining the entrepreneur's investment decisions, which has promoted capital-intensive technology.  - 28 - Policies Towards Small-Scale Industries 2.49 Tanzanian industrial strategy has intended to assign an important role to the SSI sector, complementary to that of the medium- and large-scale sector. To that effect, a nuwLber of promotional policies favoring SSIs have been implemented. For that purpose, the National Small-Scale Industry Corporation was started in 1965, to be superseded by the Small Industry Development Organization (SIDO) in 1973. SIDO is in charge of coordinating all policies and programs to promote small-scale industries including (i) aid with project preparation; (ii) financing at concessional terms; (iii) two year exemptions from income, sales taxes and customs duties; and (iv) provision of services at subsidized rates (rental of sheds in industrial estates, access to workshops and foundries, extension services, electricity, water and roads). 2.50 The more important programs to promote SSI development have been: (i) Industrial Estate Program comprising 16 industrial estates with 154 sheds of which 58 percent have working units, 23 percent are in the process of being occupied and 19 percent are unoccupied. Industrial Estates have not been particularly successful. Many sheds remain unrented and the recovered rental income is 10 percent of expected recovery. Other problems faced include scarcity of experienced entrepreneurs; design problems with some industrial estates and sheds; problems with water, power and raw materials availability; and a resulting low capacity utilization. (ii) Financial Supports Rural and Urban Hire Purchase Schemes have been administered by SIDO since 1974 to finance machinery, equipment and tools for small-scale industries. Up to 90 percent of the estimated value of the machinery can be borrowed at 8 percent interest and are repayable in one to seven years after receiving the machines. Loan approvals for the rural scheme were T Sh 53.3 million by June 1984 and the urban scheme had T Sh 256.5 million by 1982183. These schemes have experienced high and increasing default rates. Because of SIDO's poor performance in administering the hire purchase schemes an agreement was reached to transfer the loan finance responsibility to NBC, who has recently begun disbursing funds. (iii) Technology Transfers There are two major programs that support transfer of technology to Tanzania. The Sister Industry Program (SIP) establishes a long-term technology transfer relationship between a company in Sweden and a start-up SSI in Tanzania. SIDA provided investment funds and the Swedish Companies provided training for entrepreneurs, managers and workers, helped select machinery and raw material sources. The link between the Swedish and Tanzanian companies are maintained after project implementation. Between 1976 and 1984, twenty five ventures, at an investment cost of T Sh 180 million and employing 600 people, have been established under this program to produce consumer goods, agricultural implements, equipment and tools. The projects are operating pr.>fitably, as a result of the high domestic prices for their products atid the subsidized foreign exchange they receive. It is very unclear, however, whether most of these projects are economically efficient. In a more competitive  - 29 - environment they would encounter serious difficulties because they employ fifteen times more capital per employee than the average SSI in Tanzania, are operating at 30 percent capacity and are very import dependent for inputs. The Indo-Tanzanian Program, started in 1977, supported 48 projects by providing machinery and training in India and Tanzania. The implementation was, however, poorly managed in that there were incomplete deliveries of machinery and logistical problems in the training arrangement. The assessment of the program is that 18 projects are functioning without major problems, 14 projects have significant problems (missing items, breakdowns, poor product quality) but are salvageable and the remaining 16 have problems (missing items, poor choice of technology, inadequate training, faulty shed design) that cannot be solved in the near future. Extension and Training Servicess SIDO provides, through a network of regional offices, training and production centers and other related organizations, many extension and training services including tech- nical studies, economic surveys, feasibility studies, raw material sourcing, marketing advice, management consultancy, entrepreneur and worker training. While SIDO has been successful in delivering these services to many SSIs, they have not reached handicraft producers in rural areas due to transportation difficulties, and many services to factory and non-factory SSI's have suffered due to inadequate tech- nical capability and extension network anid poor communication within the SIDO organization and with the entrepreneurs. Handicraft Development: SIDO has supported craft production with technical and economic services, credit for tools and raw material, training and marketing assistance to prepare the ground for rural industrialization among other objectives. The major part of the support has been directed towards ten lines of handicraft production and to blacksmiths. The impact of the technical support has been limited because the effort was diffused over too many activities and the marketing organization has performed less well than private curio shops and handicraft dealers. * , * * * The Impact of Policies on the Structure of Industrial Protection 2.51 The system of import licensing and QRs (and the concomitant cost- plus price controls), which have accompanied the overvaluation of the currency, have provided protection and market power to the local producer. Thus, manufacturers have been able to charge prices significantly above equivalent border prices: average nominal protection on manufacturing output was found to be 70 percent (after accounting for the existence of 'cost-plus' price controls on many items). Moreover, the price of imported inputs and capital is also affected by the overvalued currency since the great majority of imported inputs and capital for industry are purchased at the official exchange rate (i.e., prices paid are only a fraction of border  - 30 - prices equivalent, implying a significant subsidy to the local producer). For the average manufacturer who imports 70 percent of its recurrent inputs needs, purchasing these imports at the official exchange rate implies a 45 percent effective subsidy on inputs. Similarly, capital is purchased by the firm at only a fractiov of the actual cost to the economy. 2.52 Consequently, significant protection continues to exist (even as the parallel market window continues to widen) as long as imported inputs and capital continues to be purchased at an overvalued official exchange rate, (while competing imports transact at the implied parallel market rate, or higher). A firm that used to enjoy protection through QRs which now faces competition from own-funds imports may still enjoy very substantial effective protection if it receives heavily subsidized official foreign exchange allocation for the purchase of imported raw materials and spares. 2.53 The following example illustrates the magnifying impact--and its implications--of a 70 percent nominal protection on the output side and a 45 percent effective subsidy on the inputs side. A firm produces US$100 (equivalent) worth of world priced gross output utilizing US$80 (equivalent) in domestic and imported inpults, appropriately border priced. The resulting US$20 in value added suffices to pay the wage bill, which is assumed to be US$20 (capital costs are presumed to be sunk). However, a 70 percent nominal protection on the output side would allow the firm to sell its product at US$170 equivalent, while a 45 percent effective subsidy on inputs implies that the firm, (if it maintains its efficiency levels), pays only US$44 in inputs, instead of the real cost for the economy, US$80. The domestic market value of the firm's output would therefore exceed its input costs by US$136, i.e, its gross financial surplus would be over 6 tJmes higher (or over 500 percer.t larger) than the actual value added tEat the firm generates for the economy. 2.54 A firm like the one above enjoys more than a 500 percent Effective Rate of Protection (ERP, formally defined as the ratio of value added at domestic prices over value added at world prices, minus one; see Chapter Three for details). Such high effective rate of protection could allow the firm to enjoy a financial surplus many times the actual economic surplus it generates, andlor be extremely inefficienct in the use of its inputs and factors of production, yet maintain a minimum level oi profitability. Even if this example enterprise were to become extremely inefficient for the economy and utilize 4 times the previous amount of inputs to produce the same amount of output, it would still generate sufficient financial surplus (US$24) to more than cover the labor costs. However, at world prices the firm would be producing significant negative value added (by utilizing US$320 in recurrent inputs to produce US$100 in output, i.e., value added of minus US$220). If the firm is inefficient, substantial effective protection given to a firm could, therefore, keep the enterprise financially afloat while draining the economy of large amounts of scarce resources. 2.55 In fact, the data indicates that an extremely high level of effective protection on domestic manufacturing, averaging 470 percent, results from the cascading combination of a 70 percent nominal protection on the output side and a 45 percent effective subsidy on the inputs side (mostly due to the low price paid for imported inputs). A 470 percent effective protection means that the average industrial activity could be  - 31 - producing a good at almost 5 times the international cost, and still be financially profitable, or else be relatively efficient and thus able to transform the protection into very high profits. The actual patterns of efficiency of the firms in industry (as provided by the MIES data), and the relationship between the patterns of efficiency and the structure of protection, will be discussed in detail in the next chapter. 2.56 A different measure of the protection subsidy provided to industry by the policy regime is arrived at by calculating a financial profitability effective subsidy, defined as the difference between the (after-tax) financial return and the net economic return on capital. A positive difference between the financial and economic returns on capital would indi- cate that effective protectionjsubsidy is provided by the policy regime; the larger the difference the more significant the protection being given. Our data indicates that the average activity receives a (net of taxes) protective financial subsidy equivalent to 25 percentage points, since the average net financial return on capital (at 10 percent) exceeds economic return on capital (at -15 percent) by 25 percentage points. 2.57 Not every manufacturing firm is similarly protected, however. Although average protection in industry is high, the variation within industry is also very large. Policy incentives affect different firms very differently because manufacturing firms face different effective exchange rates, and relatedly, different degrees of trade protection, price controls and confinement. Some activities enjoy virtually unlimited protection (like many large firms producing intermediate goods), others are effectively unprotected (like some smaller consumer goods enterprises; see Chapter Three). 2.58 This widely dispersed protective structure is in large measure the result of a multiplicity of different effective exchange rates faced by producers. Each firm's effective exchange rate will depend on the combina- tion of sources of its foreign exchange which include; (i) official foreign exchange currently provided by the BOT at T Sh 40; (ii) suppliers' credit provided at a price above T Sh 40 (to compensate for credit risk on forward contracts); (iii) retained foreign exchange from export proceeds;' (iv, foreign exchange acquired in the parallel market, (or any other source of 'own funds') for which the effective price is around T Sh 150; and (v) lack of access to any source of foreign exchange, which implies that the firm effectively faces an infinite price for foreign exchange. In addition (and related) to the exchange rate regime, trade restrictions (i.e. QRs and confinement, or own funds), the pricing structure (i.e. "cost-plus' price controls or liberalized prices), and foreign exchange allocation decisions affect different firms very differently. 1/ If the retained foreign exchange were transferable the effective price would be the weighted average between the parallel market rate (T Sh 150, the opportunity cost of utilizing a retained dollar for import needs) and the official exchange rate; while retained foreign exchange is not transferable the effective price is the weighted average between the marginal cost of producing a dollar worth of exports and the official exchange rate.  - 32 - 2.59 Most industrial firms manage to get foreign exchange by utilizing a combination of the four sources mentioned above. The diversity of these sources and the associated differences in the effective exchange rate result in a multiplicity of average effective exchange rates facing manufacturing. Different industrial firms receive different effective subsidies on their imported inputs, depending on which effective exchange rate they paid. Heavily subsidized firms, which have access to an artificially low effective exchange rate, have a huge financial incentive to produce and expand its activities, at the expense of activities that have to pay an effective price of T Sh 100-160 for a US dollar unit.  - 33 - TEE EFFICIENCY OF INDUSTRY AND TEE ROLE OF POLICIES Introduction 3.01 The discussion in Chapter One indicated that the performance of the manufacturing sector has been disappointing, particularly over the past decade. Both output and value added have declined dramatically, while very large industrial investments were implemented. During much of the period, investments continued to be very large and ICORs became negative. The massive investments have resulted in negative ICORs and--combined with the declining ability of the economy to generate foreign exchange--in a sector utilizing only 25 percent of installed capacity. The sector is capital- intensive and import-dependent, and subject to low and declining labor and capital productivity. This overall performance, however, masks significant differences among subsectors, among firms and even among activities within firms. Some firms and subsectors are relatively productive, while others are very inefficient. The efficiency level of a firm is associated with particular attributes of the firm (subsector, size, import dependency, etc.). As importantly, the productivity of an industrial firm is related to the degree of protection provided by the policy framework. Furthermore, the level of technological capability development and the nature of infrastruc- tural bottlenecks also affect the productivity of industrial firms. This chapter gives an overview of the efficiency patterns in industry and discusses its sources, and analyzes the relationship between industrial efficiency and the policy framework. 3.02 Overview of Efficiency in Industr,t The evidence collected by the mission (MIES), based on detailed questionnaires covering 118 activities, indicates that the sector is operating very inefficiently and that most activities are currently very unproductive. A quantitative approach to assess the degree of efficiency or inefficiency of resource allocation and use in an industry is the Domestic Resource Cost (DRC) methodology. l The DRC measures the cost of domestic resources (factors) that are necessary to save or earn one unit of foreign exchange by producing a (border priced) unit of value added. If the economic value of the domestic factors required to produce a unit of output is less than the net foreign exchange savings (or earnings) generated by domestic production of the product, the process is economically profitable. In that case the DRC ratio will be less than one, implying that the domestic costs (in the numerator) are less than the net benefit of earning or saving the unit of foreign exchange (denominator). 1/ In addition to the methodological explanations provided in paras. 3.02- 3.20, a detailed discussion of the DRC methodology and of the data base of the MIES is presented in Ann-ex 3.  - 34 - 3.03 A DRC ratio significantly higher than one will reflect that the costs for the economy of producing a good that will save a unit of foreign exchange will be much higher than the net benefit of saving such a unit, which means that the economy is incurring in losses from the activity's operations. The reasons for a high DRC ratio in an activity could be many, and would determine the appropriate course of action to improve the effi- ciency of operations. Extreme (or absolute) economic unprofitability will occur when there is negative value added (at world prices) in that process, meaning that the value of tradeable inputs exceeds the international value of the good produced. In this case the net benefit of 'saving' a unit of foreign exchange is negative, i.e., the DRC is infinitely large. 3.04 Conversely, a DRC less than one implies that the economy profits from producing such a good, and thus the original investment and the alloca- tion of recurrent resources to the activity is economically justified. A DRC less than one is equivalent to the activity having a positive (net) economic return on capital (ERC, defined as annual economic benefits minus costs--including annual costs of labor and capital--divided by the total cost of capital). Consequently, computing DRCs for different subsectors of manufacturing provides an indication of the relative efficiency with which resources have been allocated and are being utilized. (However, DRCs alone cannot be used as a guideline for firm-level decision-making. In-depth information on the sources of inefficiency, and on the cost vs. benefits of removing the bottlenecks would also be required.) 3.05 An economically unprofitable activity (high DRC) may be the outcome of any of the following scenarios: (i) excessive factors of production are allocated to the activity (including too many recurrent inputs); (ii) an incorrect technological choice has been made (e.g. overly capital- and import-intensive); and, (iii) correct allocation of resources and correct technological choice has been made, but the factors of production are not being utilized to their full potential, i.e., capital, labor or managerial ability are being under-utilized. Each of these scenarios, is in turn, related to particular 'sources of inefficiency' (infrastructural, managerial and technological capability, etc., see pages 56-64). The Domestic Resource Cost Methodoloavi A Detailed Example and Explanation Z 3.06 The DRC measures the domestic cost necessary to save or earn one unit of foreign exchange through the production of one (border priced) unit of value added. As we shall see below, a low DRC reflects economic efficiency in the firm's operations, while a high DRC (significantly exceeding one) suggests economic inefficiency in the industrial activity, resulting in resource losses for the country. The DRC concept will be illustrated by providing an example of four hypothetical firms (A, B, C and D), operating in 1984, which produce the same good, valued internationally at US$1,000, and can be sold domestically at T Sh 50,000. All four firms 2/ The reader familiar with the DRC methodology can skip this example without loss of continuity and proceed to para. 3.15 on the assumptions of the DRC study.  - 35 - use the same amount of labor and capital. However, they utilize very diffe- rent amounts of recurrent inputs: Firm A uses US$1,500; B: US$900; Cs US$700; and Ds US$500 (all recurrent inputs are imported in this example). 3.07 The average official exchange rate during 1984 was US$1 = T Sh 15, while shadow (or equilibrium) exchange rate is assumed to be US$1 - T Sh 40 for that year. Thus, the output, input and capital costs values have to be adjusted to reflect the discrepancy between the shadow and official exchange rate. For instance, (as seen in the Example Table) although Firm A pays T Sh 3,750 for annual capital costs, (at US$1 - T Sh 15), the true cost for the country is T Sh 10,000, since the shadow exchange rate is significantly higher than the official exchange rate. (Alternatively, all values could be denominated in dollars, and only local costs would have to be translated to dollars at the shadow exchange rate. The end result of the value added and DRC computations would be the same in either case.) Each firm earns T Sh 50,000 revenue from domestic sales of the product, which is protected from external competition. The border price equivalent (or international price) of the good is T Sh 40,000, since the country is saving US$1,000 in imports by producing the good locally, and the true scarcity value of each unit of foreign exchange saved is T Sh 40. EaWule Table : 1XfESlC KSCRUCE MMS (DIU) FOR ROR P01EMCWAL FIlS (s1) (2) (3) (4) (5) (6) (7) (8) (4+5)/3 (4/3) (3-4-5) Aumial (Values In Gross Recurmnt Value Labour Capital Laig-fm Short-1m Financial 't00 T Sh) Oitput Inpit Added Costs Costs xC DRC &plus FimA Offical Values 50 22.5 27.5 10 3.8 - - 13.7 ShadowValues 40 60 -20 8 10 Ininite Infinite - Fim B Offiaa HT"ahies 30 13.5 36.5 10 3.8 - - 22.7 Shadow Values 40 36 4 8 10 4.5 2.0 - irm C Offidal Values 50 10.5 39.5 10 3.8 - - 25.7 ShadowValues 40 28 12 8 10 1.5 0.66 - Firm D Official Vale 50 7.5 42.5 10 3.8 - - 29.7 Shadow Values 40 20 20 8 10 0.9 0.4 - Ihe parameter's values utilized here wer as follows: Official exchan rate: US$1 = T Sh 15. Shadow exwe rate: US$1 - T Sh 40. Shadow costs of labor are below narket osts to allow for airplms eaplcmmt ani other labor maket inperfectias.  - 36 - 3.08 Firm A, which utilizes US$1,500 worth of recurrent inputs, has to pay T Sh 22,500 for them, since it acouires foreign exchange through offi- cial channels at US$1 - T Sh 15. However, the true scarcity value (shadow cost) of these inputs for the economy is T Sh 60,000 (US$ 1,500 x T Sh 40). The firm is receiving a large implicit subsidy by not paying for the real economic price of foreign exchange. At official prices and values, firm A posts a handsome financial profit, the result of the high protection and subsidy it enjoys. Its value added at domestic prices is T Sh 27,500 (revenue minus recurrent inputs), and since labor and annual capital costs total T Sh 13,750, the firm still generates T Sh 13,750 in financial surplus. However, the firm is extremely inefficient for the economy, since the true cost of the recurrent inputs consumed exceed the benefits from the output produced, i.e., the firm produces with nexative value added (revenue minud input costs, excluding factor costs at world prices is negative). If we also add the economic costs of labor and capital, the losses for the economy are magnifieds since its value added is negative T Sh 20,000, and the shadow priced labor and capital costs total T Sh 18,000, the economy loses T Sh 38,000 from this investment. Even if capital costs are considered as sunk, the economy is wasting T Sh 28,000 by keeping this firm in operation, i.e., a reallocation of resources to more productive uses in the economy would have resulted in T Sh 28,000 of additional value added for the country. 3.09 Firm B is not as inefficient as firm A, since it does generate a minimal amount of positive value added at world prices (T Sh 4,000), yet the valued added does not even cover the low opportunity cost of labor (T Sh 8,000), let alone the cost of capital (T Sh 10,000). Firm C is more efficient, since its value added (T Sh 12,000) exceeds the opportunity cost of labor, but it is not efficient enough to cover the cost of capital as vell, i.e., it would not be regarded as a viable investment if capital costs were not regarded as sunk. Firm D is the most efficient one: its high productivity in the use of inputs results in a (border priced) value added (T Sh 20,000) which exceeds the cost of labor and capital, i.e., it is a viable investment and an efficiently operating firm. 3.10 As noted above, a quantitative measure that summarizes the effi- ciency level of an activity is the Domestic Resource Cost (DRC) ratio. Since the DRC measures the cost of factors of production utilized by the country to generate one unit of value added, it is calculated by dividing the sum of labor and capital costs by value added, all appropriately shadow (or border) priced. In our example above, Firm D, which is efficient for 31 Ideally, the DRC's could attempt to measure the social value of an activity by introducing non-efficiency objectives of the Government. In that case, the adequate shadow prices to be used might differ from the above, as the imputed value of the non-efficiency objectives should be explicitly reflected in the shadow price+. The difference between border prices and the modified shadow prices would provide a measure of the costs of non-efficiency objectives. Examples of such non-efficiency objectives can be security, self-reliance, equity, satisfaction of merit wants and political expediency. It is clear, however, that almost any project can be justified through appeals to such non-efficiency objectives, thereby underscoring the need for restraint in this area. At any rate, for the puirpose of our study caution was exercised whenever the measured DRCs did not siganificantly exceed the value of one.  _ 37 - the country, nttilized T Sh 18,000 in labor and capital to generate T Sh 20,000 in value added, i.e., each unit of value added (or unit of foreign exchange saved or earned) produced by firm D costs the country only 0.9 units in capital and labort its DRC is therefore 0.9. Firms C and B are more inefficient, since their value added does not cover labor and capi- tal costs and thus have DRCs exceeding one (1.5 and 4.5, respectively). Firm C could possibly become efficient without significant restructuring, if the problems affecting it are easily solved or the shadow and border price values were to change some. Firm B is quite inefficient, however. Firm A is extremely inefficient since it does not even generate positive value added, and therefore no finite amounts of labor and capital could produce a value added unitt its DRC is thus infinitely large. 3.11 A DRC ratio which is less than one, the outcome of labor and capi- tal costs (in the numerator) being less than the value added (in the denomi- nator), implies that the activity is economically very productive. The original investment and the allocation of recurrent resources to the activi- ty is therefore economically justified. Firm D, with a DRC of 0.9, repre- sents such a case. Conversely, a much higher DRC ratio suggests that the costs for the economy of producing a good exceed the benefits of producing such a units the opportunity costs of labor and capital are higher than the value added generated (which saves or earns foreign exchange). Firms which have DRCs significantly higher than one are inefficient in the use of resources (Firms A, B, and--marginally--C). Extreme (or absolute) economic unprofitability occurs when there is negative value added (at world prices), as in the case of firm A. 3.12 Another related measure of the efficiency of operations of the firm, which is relevant in the short-run, is the economic profitability of an activity (DRCs) assuming the existing investments as sunk costs. This short-run DRC is calculated by dividing the opportunity cost of labor by the value added of the firm. If the short-run DRC is high, the activity is not operating efficiently in the short-run, since its value added does not even cover the appropriately shadow priced labor costs. Firms A and B have high short-run DEIC, significantly exceeding one (infinite and 2.0, respectively); their value added is significantly below the opportunity cost of labor. Conversely, Firms C and D have short-run DRCs lower than one (0.66 and 0.4, respectively), implying that they can still productively contribute to Tanzania's economy, whether investments were well chosen (Firm D) or not (Firm C)--as long as all investments are sunk costs and the salvage value is nil or very low. 3.13 When assessing the operating efficiency of an industrial seotor it is important to calculate the short-run DRC measure as well, since invest- ments have already been incurred. Long-run DRC measures provide guidance on the adequacy of past investment decision-making (and on possible lessons for improving decision-making in the future). Short-run DRC measures, coupled with in-depth information on the sources of the activity's inefficiency, would be more reliable for assessing the viability of operating enterprises. 3.14 On the basis of the above example, it is also possible to see the close relationship between DRC measures and the net economic return on capita! (ERC; defined as annual economic benefits minus cost--including  - 38 - annual costs of labor and capital--divided by the total cost of capital). On one extreme, Firm A, the most inefficient, operating with an infinitely large DRC, can be seen to have an extremely negative ERC, while on the other extreme, Firm D, the most efficient (with a very low DRC) has a very positive ERC, and firms B and C fall in-between. In fact, a (long-run) DRC less than one is equivalent to having a positive ERC, while a DRC higher than one (signalling inefficiency) is equivalent to having a negative (net) ERC. The Survey and Assumptions of the DRC Studs 3.15 A comprehensive questionnaire (see Annex III) was originally distributed to 56 firms involved in about 135 productive activities, During the October 1985 mission each firm subject to lengthy visits by World Bank and Ministry of Industries and Trade staff in order to complete the questionnaire with the help of the enterprise's chief accountant, his staff, and the firm's proforma invoices and other supporting materials. All questionnaires were subject to a preliminary review in the field. When gaps or inconsistencies were detected (e.g. missing information on inputs, or, conversely, over-reported costs), the firm was visited again. Following the data coding and a comprehensive computerized consistency analysis done at the World Bank, a small mission visited the field in Tanzania during January/February 1986 to complete remaining data gaps, resolve inconsistencies and ensure data accuracy. In eight out of the original 56 firms chosen the comprehensiveness and quality of the data was not sufficient to include them in the data analysis, while the final consistency tests conducted on the remainder 48 firms (118 activities) indicated that the data was complete and of high quality. (The preliminsry evidence gathered by the mission suggested that the excluded firms may have had lower productivity levels than average. Since data inferences were drawn from the remaining sample of 48 firms, the possible resulting sample bias would thus have been in a "conservative" direction; see also paragraphs below on other 'conservative' biases). 3.16 The DRC results (or economic return of capital) in any efficiency review is bound to be sensitive to certain assumptions on key values. In particular, the shadow exchange rate, relevant border prices, and opportu- nity costs of labor and capital are important parameters in the DRC calcula- tions. As explained in detail in the methodological annex, particular care was exercised in choosing the key parameters. Since each parameter could fall within a range (of different values), the chosen value for the main set of calculations reported here was always "conservative," i.e., choosing other values within the plausible range would have resulted in higher DRCs for the surveyed activities, implying larger inefficiencies than reported here. For instance, the shadow exchange rate for 1984 was estimated to be T Sh 40 to the US dollar, based on purchasing parity comparisons, terms of trade changes, debt and arrears accumulation. Admittedly, dependin& on the assumptions used and the base year, a shadow exchange rate estimate around T Sh 35 could also have been chosen for 1984. However, such a shadow exchange rate (or any other which is lower than T Sh 40) would lead to a higher DRC, i.e., it would imply higher levels of inefficiency than actually estimated in this study.  - 39 - 3.17 Similarly, the choice of border prices for each output was made 'conservatively' so thatt (i) if there were alternative import sources and prices, the higher price was selected (e.g., many Kenyan prices, which are higher than average international prices); (ii) quality adjustments were only made very conservatively, if at all, and, (iii) some international prices, which were presumed to be temporarily depressed, were adjusted upwards. Conversely, a conservative approach was taken in the calculation of the economic costs of raw material inputs. 3.18 Regarding shadow wages, the substantial adjustment from the offi- cial to the shadow exchange rate implied a significant downward adjustment in labor costss the overall conversion factor for labor costs was 0.53. This is a rather low figure considering the depressed levels of manufactu- ring wages in Tanzania, and that in many instances semi-skilled and skilled workers are very scarce. The fact that many firms carry large numbers of excess workers for its present levels of capacity utilization was also factored in by having minimal or no adjustments (depending on the data pro- vided in the questionnaire) in labor costs when calculating efficiency levels at attainable capacity levels--as opposed to actual capacity. Conservatively, no additional capital (or rehabilitation costs) were assumed to be needed to increase capacity utilization from existing to attainable levels. On the other hand, efficiency of input use wa& presumed to increase as capacity utilization increases, i.e., a proportional increase in recurrent inputs would generate a more-than-proportional increase in output, even for a given level of capital and labor (if surplus employment was present). The real opportunity of capital was assumed to be 10 percent. 3.19 In sum, the choice of parameters was done in such a way that possi- ble margins of error (which always exist in this type of studies) would bias the 'basic' results reported here in the direction of higher efficiency. Sensitivity analysis suggested that the results are relatively responsive to the assumptions regarding the shadow exchange rate and border prices for outputs and inputs, while less sensitive to shadow wage assumptions. At any rate, few of the inefficient enterprises had DRCs close to one; instead, inefficient activities tended to have very high DRCs, which were not subject to a qualitative change when performing sensitivity analysis--i.e. their DRCs would not become close to one. 3.20 One of the methodological drawbacks of the DRC methodology is that it is a "static" indicator providing an efficiency measure at a point in time. A high DRC for an activity at a point in time has different implica- tions if the trend is improving over time than if it is stagnant or dete- riorating. Infant industry and dynamic comparative advantage considerations cannot be ignored, since an inefficient industry (high DRC) at a point in time may become productive later on. It is important, therefore, to comple- ment the current *static" DRC information with some over-time efficiency compdrison and with qualitative firm and sub-sectoral specific information in order to establish possible dynamic trends that may be present. This will be done in later sections of this chapter. Given the low level of capacity utilization in recent times during the survey was collected infor- mation to calculate "attainable' capacity DRCs (in addition to actual capa- city utilization DRCs). Actual as well as 'attainable" capacity DRCs are reported below in order to provide an indication of the importance of cycli- cal and temporary factors affecting industrial performance--such as the low availability of inputs--as compared to structural factors--such as policy distortions, managerial and skill constraints, infrastructural bottlenecks and technology.  - 40 - Results of the Study 3.21 Overall Efficiency: The DRCs calculated on the basis of MIES measured the economic efficiency of an enterprise or activity in 1984. Of 118 activities surveyed in the sample, (covering about fifty percent of the gross output produced by the industrial sector), only 11 percent are operating efficiently in that their value added (foreign exchange saved or earned) are sufficient to cover the costs of domestic factors of production (capital and labor), i.e., their long-run DRC is less than one. Eighty nine percent of the activities in the sample are inefficient in the long-run sense. Over one third of the sample activities were found to be absolutely inefficient in that they generated negative value added in production (at world prices). Compared wit*h five other large countries in East Africa where the World Bank has beeh conducting studies with recent data and the same methodological approach (Ethiopia, Zambia, Uganda, Kenya and Zimbabwe industrial reviews), Tanzania's industrial sector is the least efficient-- even at attainable levels of capacity utilization. 3.22 Another measure of the efficiency of operations of the sector is the economic profitability of an activity assuming the existing investments as sunk costs, i.e., calculating the DRCs without including the costs of investments already incurred.4 If this DRC measure is higher than one, the activity should be regarded as unprofitable in the short-run, since its value added does not even cover labor costs. The results of the survey show that two thirds of all industrial activities are operating inefficiently in the short-run, i.e., their short-run DRC is higher than one. For most of them, the DRC is very high. The implications of such widespread (short-run) inefficiency are dramatic: every day that these enterprises continue to operate at the same level of efficiency, substantial additional net losses for the country occur. A reallocation of resources from inefficient to efficient activities in industry and other sectors would have generated in 1984 over US$170 million in additional value added, i.e., it would have quadrupled the amount of value added actually produced by industry, which in 1984, stood at US$56 m. Next, we discuss the relationship between efficiency and: (i) subsectoral patterns; (ii) firm size; (iii) ownership; (iv) import dependency; (v) capital intensity; and (vi) capacity utiliza- tion. It is important to bear in mind, however, that the patterns of effi- ciency to be discussed reflect averages, which, while having general impli- cations, do mask important differences among firms and activities within a category--thus, firm-specific decisions cannot be taken on the basis of the efficiency patterns reported below. A more detailed discussion on the sources of inefficiency and on firm-specific problems will be presented in later sections. 41 The previously described DRC measures did include the sunken investment costs.  -41 - 3.23 Patterns of Subsectoral Efficiencys Currently only food processing, beverages, tobacco and rubber activities are being produced efficiently in the short-run, i.e., they contribute to the economy assuming capital costs as sunk (in the long-run efficiency sense, only beverages and tobacco have DRCs less than one, however). Textiles, glass, wood and paper (excluding Mufindi Pulp and Paper, which was not part of the sample, although the evidence suggests that it is operating very inefficiently), cement (excluding Mbeya Cement), metal products and machinery are on the average marginally inefficient subsectors, i.e., they have a small negative contribution to the economy assuming capital costs as sunk. Tanneries and leather, plastics, pharmaceuticals, chemicals, fertilizers, iron and steel and transport are, on the average, very inefficient subsectors, i.e., they are a significant drain to the economy, and a large share of the activities in these sectors produce at negative value added (see Table 3.1 for the results of the sample survey). Table 8.1: TANZANIA - EFFICIENCY OF INDUSTRIAL ACTIVITIES IN MIES SAMPLE BY SUBSECTOR At Actual Capaelty Utlization (Percentage Share) (1) (2) (C) (4) (6) Total Number Long-Run Long-Run Short-Run Negative of Activities Efficient Ineffi CIen Ineficient Valuo Adde In Sample Activities !I Activities, J ivities Activities 1. Food Proceslng 9 22% 70% 11% llX 2. Beverage end ToWcco 5 80X 205 20X eX S. Textiles 23 ox 91% 48% 17% 4. Leather and Tanneries 12 a 1OOX lox 9s2 S. Rubber 4 26% 76X ex 0X 0. Glas, Wood & Paper, Cont 10 eX 19 00% 0% 7. Pl Stics A Pharmceuticals 10 0% 1011% 75X sx 3. Chemicals end Fertilizer 9 0X 100% 100% 50X 9. Iron, Steel A Metal Product 22 14X 86% sex 41X 19. machinery 8 aax 07% s8x aax 1t. Transport Equipment 4 e% 100% 100X 100X TOTAL -TR -_ "I __M --178 .~~m m - m.. NOt: By definitlon, long-run inefficlent ectivitles includo (mong others) all short-run lnefficient activities and negative value added ectivittes, while short-run lnoff icient acetvities include all neative value added activitles. Hence, column 5 Is a subset of column 4, while column 4 Is a subset of column 8. S/ Percentage share of activities In subsector with long-run ORC ratio lee than one. k/ Percentage share of activities In subsoctor with long-run DRC ratto greater than one (includlng ngative value added). c/ Percentage *hare of activities In subsector where value added at world prices not cover labor cost (Including negative value added).  _ 42 - 3.24 Absolutely inefficient activities--producing at negative value added--are concentrated in intermediate and capital goods. Forty eight percent of intermediate and capital goods activities produce at negative value added. Within these, over one half of the activities in tanneries and leather, pharmaceuticals, chemicals and fertilizers, and transport have negative value added. Furthermore, many large enterprises in machinery, iron, steel and metal products also produce at negative value added. Conversely, only 14 percent of consumer goods activities are producing at negative value added. Some large textile companies, however, are very inefficient implying that the textile subsector, although having a large number of efficient activities, does not generate sufficient valuie added to cover its labor costs. Food products, beverage and tobacco seem to have a very small share of inefficient activities, resulting in a positive net contribution for the country. 3.25 Firm's Size and Economic Efficiencys The economic efficiency of Tanzanian manufacturing firms is closely related to their size. Smaller firms are significantly more efficient than larger firmss the average economic return on capital for firms employing between 5 and 100 workers at their attual level of capacity utilization is 18 percentage points higher than for firms employing between 100 and 1,500 workers. At attainable capa- city, the efficiency difference between smaller and larger firms is signifi- cantly higher (33 percentage points), since increases in capacity utiliza- tion would not substantially alter the efficiency of larger enterprises,5 while smaller firms would benefit from an increase in capacity utilization (see below). Among smaller sized firms, small-scale factory enterprises employing 5 to 25 workers are the most efficient: they have a positive return on capital even at present levels of capacity utilization, have the highest levels of labor and capital productivity, and the lowest capital intensity and import dependency. The smaller scale of operations and the low capital and import intensities have given SSEs much needed flexibility in the face of economic adversity, which has been essential for those firms that have managed to survive--since SSEs have not enjoyed the very high protection given to its larger and less flexible counterparts. Those SSEs that have survived have higher levels of capacity utilization (51 percent for firms with less than 25 workers) than larger firms (22 percent). In contrast to smaller scale enterprises, many large scale activities were allowed to emerge and then kept afloat by substantial protection and subsi- dies, in spite of inadequate technological choices and inefficient production. 3.26 Although there is an inverse relationship between efficiency and size for firms which employ between up to 1,500 employees, extremely large enterprises (for LDC standards) exceeding 1,500 employees are relatively efficient (Table 3.2). In fact, their efficiency levels are not signifi- cantly below the small firms (5 to 100 employees), reflecting the fact that this large enterprise category include a few well run natural monopolies (cigarettes, beer) which, similarly to small-scale firms, have relatively low capital intensity and high domestic input content. The import dependency and capital intensity of firms employing over 1,500 workers is roughly one-half the overall sectoral dependency. S/ Economic return on capital would only change from -20 percent to -19 percent.  - 43 - Table 3.2: TANZANIA - FIRM SIZE, OWNERSHIP AND EFFICIENCY Number of Employees Domestic Resource Cost a/ in Firm All Public Private 5 to 100 1.07 0.66 1.71 100 to 250 5.54 Neg.V.A. 3.03 250 to 1,500 20.54 45.01 12.12 More than 1,500 1.22 1.05 1.96 All Industry 2.91 2.73 3.09 a/ Domestic Resource Cost: cost of domestic factors (labor and capital, shadow priced) for generating one unit of world priced value added calculated at actual levels of capacity utilization. Source: MIES. 3.27 Firm's Ownershig and Economic Efficiencys Parastatal firms with negative value added (extremely unproductive activities) are significantly over-represented in industry: 56 percent of all parastatal activities have negative value added at actual levels of capacity utilization, as opposed to only 14 percent in the private sector. On the other hand, only 32 percent of activities in the parastatal sector are economically inefficient yet producing at positive value added, while the private sector has 70 percent of its activities in this category (short-run DRCs higher than one but finite). Gross inefficiencies are thus disproportionally represented in the parastatal sector, although a very significant proportion of private activi- ties are generally unproductive--but producing at positive value added. In fact, the average efficiency of parastatals is not significantly below that of the private sector, the result of the coexistence of very efficient and extremely inefficient parastatals on the one hand, and the more uniform, yet less extreme, inefficiency of the private sector, on the other. Both the private and the public sectors utilize about 3 units of the economy's factor resource in order to produce one unit of value added (Table 3.2 above).6 6/ As seen in Table 3.2, grossly inefficient parastatals are concentrated among firms whose size ranges between 100 and 1,500 employees. Private firms fare substantially better in that size categorv, although on the average they are not economically efficient. Conversely, parastatals are very efficient among small firms (less than 100 employees) and among very large firms (more than 1,500 employees). Private firms are also relatively efficient in these two categories, but not as efficient as parastatals. The highly efficient parastatals in these two categories boosts the average DRC for parastatals in the sector to bring them to the average for the private sector. It is also interesting to note that the firm's age structure is not correlated with its efficiency. In fact, the prominence of negative value added activities in the parastatal sector is not due to their age.  - 44 - 3.28 The data analysis indicates that whether the parastatal is under a management contract or managed by local parastatal personnel has no signifi- cant effect on the economic efficiency of the firm. This finding is related to: (i) the variable quality of managerial skills, in many cases, even for firms under management contract; (ii) the high economic cost for the country, in hard currency, of management contracts; and, as discussed later, (iii) the distorted incentive structure provided by the policy framework, where better management may at times be translated into higher financial profits but not necessarily into higher economic returns. In fact, in purely financial terms, on the average parastatals under management contract are more profitable than others although the difference is not large. 3.29 ImDort Content and Efficiency: There is a very significant inverse relationship between the import content of input costs and the efficiency of a manufacturing activity in Tanzania (Table 3.3). Firms with import content of less than 30 percent on the average are more than twice as efficient than firms that import between 30 and 90 percent of their inputs. Activities with import dependency higher than 90 percent--one third of all activities--produce on the average at negative value added. The economic return on capital (ERC) for this highly import intensive category is -21 percent, which compares unfavorably with the ERC of 5 percent for activities with an import content of less than 30 percent. This same inverse relationship between import content and efficiency exists whether measurements are taken at actual or at attainable capacity utilization, indicating that it is not related to the scarcity of foreign exchange and imported inputs. Table 3.3: TANZANIA - IMPORT DEPENDENCY AND MANUFACTURING EFFICIENCY Domestic Resource Cost (DRC) Economic Return At At on Capital at Actual Attainable Attainable Import Content Capacity Capacity Capacity Less than 30? 1.23 0.84 5Z 30? to 901 2.65 1.46 -lo1 More than 90? Negat. V.A. a/ Negat. V.A. a/ -21? a/ Negative value added, implying an infinitely high DRC. Source: MIES. 3.30 CaDital Intensity and Efficiencys Efficiency of manufacturing is also negatively affected by higher capital intensity, although its impact is not as large as in the case of firm size and import dependency. Activities with a capital-labor ratio higher than average have a somewhat higher DRC-- even at attainable capacity levels. The difference is significantly enlarged, however, when the employment variable in the capital intensity  - 45 - ratio is adjusted for labor skill differentials. Activities with an above average capital/adjusted labor ratio have a DRC of 3.99, as compared with a DRC of 2.45 for activities below average capital intensity. In general, skilled labor appears to be complementary to unskilled labor and substitute for capital, which would explain the positive magnifying impact on efficiency for activities with lower capital intensity. Caiacity Utilization and Efficiencyt A fallacy Explored 3.31 Low capacity utilization resulting from the lack of foreign exchange is by far the most common explanation _iven for the poor perform- ance of Tanzania's industrial sector. A widelyrbeld perception is that an inflow of sufficient foreign exchange would go a long way to solving the performance bottlenecks of the sector. This view, however, is not supported by the evidence and analysis, as reported below. let the long-held belief on its validity has helped justify the lack of implementation of difficult measures required to address the real roots of industrial inefficiency. It is important, therefore, to analyze in detail the data and to assess the relationship between foreign exchange availability, capacity utilization, and industrial performance. 3.32 First, if sufficient resources could be mobilized and channeled across-the-board to industries in order to reach attainable capacity in the sector, would the performance and efficiency of the sector improve signifi- cantly? The answer is negative. Under this hypothetical scenario, which would require US$657 million in imported inputs (i.e., US$360 million above current levels), in order to attain about 55 percent capacity utilization, the average improvements in efficiency of the sector would be marginal, from an economic return on capital of -15 percent to a still highly negative 11 percent. At attainable capacity, the sector would thus still operate very inefficiently, following an across-the-board increase in capacity utiliza- tion. It is illuminating to compare this small change in efficiency induced by more than doubling capacity utilization (through the addition of US$360 in foreign exchange plus the required complementary domestic inputs and factors of production) with the significant increase in productivity resulting from an hypothetical reallocation of resources from a large to a smaller sized firm. On the average, a dollar of resources reallocated from a large firm (where it has a negative 20 percent economic return on capital) to a small firm could earn a substantial positive economic return (14 percent, see Table 3.4 below).7 Similarly, reallocation of resources-- imported inputs in particular--from negative added activities to efficient medium (and large scale) industrial enterprises would result in dramatic increases in productivity. Reallocation of resources within industry is likely to have a much larger efficiency impact than across-the-board capacity utilization increases. 7/ Similarly, a dollar of resources reallocated from a high import content activity to a domestically based line of production would, on the average, earn a significantly higher economic return on capital.  - 46 - Table 3.4: TANZANIA - CAPACITY.UTILIZATION AND EFFICIENCY Actual CaPacity Attainable Capacity Employment Size Economic Return Economic Return of Enterprise on Capital on Capital 5 to 100 employees -21 14Z 100 to 1,500 employees -20? -191 All Activities -15% -11? Sources MIES. 3.33 Second, it is unrealistic to expect that the magnitudes of addi- tional foreign exchange required to reach attainable capacity could be mobi- lized. Tanzania's economy, even under the most optimistic import capability assumptions, cannot adequately support its present industrial capacity. The significant over-capacity of the sector has been a perennial problem since before the mid-1970s, i.e., even before most of today's existing capacity was added and during times of significantly higher import capability. Under an optimistic (yet more realistic) scenario, assuming that Tanzania's import capability could be restored to the level of the late 1970s, imported inputs to industry could eventually increase across the board by one-third. Under this scenario, average capacity utilization in industry could increase from 25 to 33 percent. 3.34 An additional one-third in imported inputs, if made available to industry would not, however, have a significant effect on sectoral value added and efficiency if it were to be spread thinly across the industrial sector. Manufacturing value added would marginally increase from US$56 to US$78 million. Negative value added activities would marginally decline from 37 to 33 percent, while the proportion of (long-run) efficient activi- ties would increase from 11 to 14 percent. These same resources, which would generate an additional US$22 million in value added, if allocated to efficient firms only could generate instead US$68 million in value added. The economy loses an additional US$46 million in GDP if it follows an across-the-board capacity utilization drive.8 3.35 Foreign exchange inflows and capacity utilization increases, per se, thus cannot be expected to resolve the performance problems of the industrial sector. First, resources will be limited--even under optimistic assumptions--so that only modest increases in overall utilized capacity would be achieved. Second, the limited increase in utilized capacity will 8/ While the required additional US$90 million of foreign exchange influx for increasing capacity utilization (if complemented by domestic inputs) generates US$22 million in value added, a resource reallocation--without any additional resource inflow--from negative to positive value added firms would generate over US$100 million in additional value added.  - 47 - not be associated with substantial improvements in efficiency performance, as long as the large unproductive segment of industry continues to absorb a lion share of the resources. Some categories of activities could significantly benefit by an increase in capacity utilization (like smaller enterprises, firms with low import content, some selected subsectors; see below), but this performance improvement would be negated if negative value added firms also receive resources and continue producing at negative value added. A negative value added activity is extremely inefficient regardless of the cost of labor and capital. With few exceptions, therefore, increases in capacity utilization by themselves would not transform a firm from negative to positive value added. 3.36 The importance of increasing industrial capacity utilization in a selective manner is also suggested by the data analysis on subsectoral efficiency. If each subsector could obtain sufficient foreign exchange and domestic inputs to increase capacity utilization until attainable capacity is reached--and no other complementary measures were taken--only food products, rubber and possibly glass would substantially increase their average productivity levels. With the exception of beverages and tobacco, which would be able to maintain their relatively efficient performance, the average economic return on capital for all other subsectors would at best improve marginally or would still be substantially negative (see Table 3.5 for details). 3.37 Subsectors which would not benefit, on the average, from an across-the-board increase in capacity utilization, do include, however, potentially efficient activities, which could become productive contributors to the economy. For instance, assuming capital costs as sunk, 14 percent of the activities surveyed in the sample in the iron, steel and metal product subsector could become efficient at attainable capacity and complement the 36 percent of activities which is already efficient at actual capacity utilization. Similarly, 12 percent of activities in plastics and pharmaceu- ticals could become efficient at attainable capacity and join the 25 percent which is already efficient. The conclusion that emerges is that some activities could indeed benefit significantly from increases in capacity utilization, but selectivity in resource allocation to manufacturing activi- ties is essential to achieve productivity and growth objectives in industry. 3.38 In sum, a large number of industrial activities are currently structurally inefficient, and, in most cases, cannot be made productive by simply increasing capacity utilization. Instead, a more fundamental restructuring may be required in many industrial activities--however, the nature of the corrective measures for each specific case cannot be determined on the basis of a DRC indicator alone. As we shall explore in the next section, macroeconomic policies, particularly the exchange rate regime, the systems of protection and price controls, policies towards para- statals, coupled with the lack of technical manpower, led to many incorrect technological choices at the time investments were made. These large scale investments, which were characterized by high capital and import intensity over time experienced a worsening in industrial productivity in its operations, which in addition to poor investment choice and implementation, has been associated with lack of technological learning and the absence of incentives to productively use inputs. The sources of inefficiency will be addressed below in some more detail.  TP&E 3.5-t 9UUA: f1EU IFF3IfV a IUWIRY 393 I : :~~~~ ~ ~~~~~~~~~~ ~ : 2 3 : * : 3 I : ! o ! It : 12 133 : u Indutrial Subsectors R ate : dtual Acdtual 3ktuat Attai.bte :Attaindde Mttaiale I:Opeatigeal:. Bross Nelt I ktsal :btalobie Wieamcul :ktual Iron,: :of weKtive 3Showt-uNo MLug-Rom :apacity 3Capacity :11hort-hm.1 tong-Run Rate of :rarca:ietiu.t I ceesic t re"it ! (cumic 1 ~ ~ ~ ~~~~~~~~~~~:Protection OKU I Ut :utilizat IUtalazat OI l I NC Profit I Rtors : Rotors I Net. I bt.t.a ttigtectu. brpltu * * 1 * ,1 I , . *. :i1 FaudPradut Tobcc : 4.20 *.~s 30? m s&I : 0.221 0.65 1 m3 M1 1 492 IM 3Kn : i 111391190 ;IV T~if$ ad LeatherInfioite afiaft* :1finitt* 2 S ST S tSIfiit 411 14 St -2 -3 S I t S 5 Mnliii t w etli tatti A sin to 1.34: 3.92 tof n t: w :4 a.s1I: *.73s *n : oz M -21 I -IS Su 13? : 2,136): * , ls, Wa a ,co t 3 .2 3.4 1 5 , , S S In it . 1. -in (m m I S - ~~~~~~~~~~~~~~~~~~~~~~ S~~ 1 - - - ------ ------ - - -- ------ ----- --- -- ------ --- -- ------ ----- --- -- ------ - -.-- -- I-- ----- In Sulw o rnpr q4 " 4 .1I 71 In SMt t310S m n t -m . S tSn - ----------------- -----------. -. S -- - -- I------- _ : - -I - - , - - - - IV Plstcsan hL aecuici 72? : 40 20.279 39t 45? 3m 3.43 1.02 321 3 51 : n -20M -tit : U : 6,329 *