Tanzania - An agenda for industrial recovery (Vol. 1 of 3) : Executive summary

Report No. 6357-TA Tanzania: An Agenda for Industrial Recovery (In Two Volumes) Executive Report June 30,1987 Africa Region Industrial Development and Finance Division FOR OFFICIAL USE 04LY 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 World Bank authorization. 0)-  CURRENCY ?QUIVALENTS Currency Unit The Tanzanian Shilling (T Sh) Exchange Raten December 1983 US$1 = T Sh 12 December 1985 US$1 = T Sh 17 June 1986 US$1 = T Sh 40 December 1986 US$1 = T Sh 50 May 1987 us$1 = T Sh 60 Fiscal Year July 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 Resource Cost DSM Dar-es-Salaam GDP Gross Domestic Product MIES Mission'3 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 Industries 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 in 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.  FOR OMCIAL USE ONLY 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 19709, since the early 19808 the enterprise has been able to show its real productive 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 ard 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 inputs 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 engaged 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 Indian 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 I brass and bronze fittings for imports and makes all its own toolings. Eirm operates very efficiently and reached 70 percent capacity ization in 1984, when it produced over 10,000 radiators, responding to nundreds of tailor-made orders. 3. Ubungo Farm Implemants 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 credi., 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 operationaf 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 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.  - ii inefficiency. The firm is producing negative "Alue added at world prices, i.e., the economic vtlue 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. S. In contrast to Morogoro Shoe, Aluminum Africa is well run and, thanks to high levels of protection it is a financially profitable parastatal which has developed good technical capability in tha production of aluminum products, galvanized corrugated iron sheets and steel billets. The firm exports some of its aluminium products. Aluminum Africa, however, is current .y also uneconomic for the country, for different reasons: 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 Morogoro 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 atworld 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 dramatics this report shows that a reallocation of recurrent resources, from the activities that produce with negative value added to all other industrial aetivities (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 finms. 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 could have been produced by better allocation of the same amount  - iii - of resources. These estimat3s 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 uses--the savings for the economy would have been significantly larger. Better allocation of cspital 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. Agal.nst 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 'Co understand the causes resulting in the current performance of indus:ry, 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 ovotrview 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 last 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 well 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.  TANZANIAs AN AGENDA FOR INDUSTRIAL RECOVERY EXECUTIVE REPORT Introduction i. 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 and 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 of the Main Report, which is not included in this Executive Report. This first chapter of the Main Report, summarized here, focuses 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. ii. Data: The analysis 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, ns in the case of Tanzania, there is an overvalued exchange rate and high (and variable) levels of protection given to domesti, industries, which result in large divergences between domestic and international prices. Thus, values of production measured in domestic prices include elements of protection as well as 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. In general, however, it is difficult to measre: these economic variables at world prices, since the data are not available. The Bank, in collaboration with the Tanzanian authorities, conducted a detailed survey (including detailed information on inputs and outputs, domestic and world prices, etc.) on 118 lines of production in 48 enter- prises, that account for one-half the output of the sector. All industrial subsectors and types of firms were represented in the sample (public, private, large, medium and small). This comprehensive representation of all segments of industry, permitted the simulation of the industrial sector in 1984 to annlyze in detail the industrial structure, performance, efficiency  - ii - and protection. All the calculations presented in this report on economic rates of return, Domestic Resource Costs, Rates of Protection and values calculated at world prices originated from the MIES. The results indicate that in many instances there are large discrepancies between values calculated at world prices and values at domestic prices. Whenever relevant, both measures are reported. Structure and Performance iii. Production: Manufacturing 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 (in constant 1976 domestic prices) declining from 13 percent in 1978 to 4 percent by 1985. Manufacturing value added in 1985 was one-thitd of its 1978 value. When calculated at international prices, the share of industry in GDP, at less than 3 percent, is even smaller. In domestic prices, except for production increases in beverages aud in tanneries and leather products, and for only a small drop in productiorn of transport equipment, the dramatic decline of manufacturing did not result in significant subsectoral changes during the past seven years. When calculated in domestic prices, today's structure of manufacturing production resembles the structure of the sector 20 years ago, with the exception of the small changes in the shares of consumer and capital goods. Measured in world prices, bowever, the evidence indicates a startling result: the share of consumer goods, at 85 percent in 1984, is izuch larger than during the 19609, 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. iv. Investment: Large amounts of investable resources have been channeled to the manufacturing sector particularly since the mid-1970s. It is estimated that over US$2 bn. (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 sector. 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 investments took place in 1981, but they picked up again in 1982 and 1983. The private sector appears to have invested substantial amounts until 1981; subsequently, a decline appears to have taken place. Capital-output ratios in the private and parastatal sectors have been increasing sharply over the past ten years, and ICORs turned negative in the late 1970s when output began to decline. Relatedly, rates of return on manufacturing investment have steadily declined since the mid-sixties, indicating the extent to which the productivity of investments has deteriorated. By 1984 the net economic return on capital was significantly negative at -15 percent. v. The massive investments in industry during the 1970s 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.  - iii - 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. Industrial investments have been increasingly channeled to expanding capacity of intermediate and capital goods over the past 15 years. This has been the result of the conscious strategic decision to transform the structure of production of Tanzania's industry. Today, two thirds of manufacturing installed capacity is in intermediate (51 percent) and capital goods (14 percent). But as seen above, the structure of production has not changed accordingly: only 15 percent of the value added (at world prices) of the sector originates in intermediate and capitel goods subsectors, the result of the high concen- tration of negative value added firms in these sectors. vi. 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 participation 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. The small-scale non-factory sector (below 10 employees) is largely private. The public sector accounts for about one-half the production and value added by firms with 10 or more employees, and for almost two-thirds 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 another 6 sectors. Its share of output is below 25 percent in only three industries: apparel, machinery and transport equipment. Its establishments tend to be larger than comparable private ones. In spite of the importance of parastatals in Tanzania industry, however, the private sector also plays a key role in medium- and large-scale manufacturing, as it accounts for half of the output. vii. Small-Scale Enterprises: The last census of manufacturing, conducted in 1978, recorded about 1,600 small-scale enterprises (between 5 and 49 workers) which employed a total of about 24,500 people (21.5 percent of employment in manufacturing) and contributed about 10 percent to manufacturing value added. These enterprises, comprising crafts, non- factory industries and small factories, were engaged in the production of 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. In 1972 there were 278 factory small-scale factory establishments; by 1978 the sector had grown to 973 firms. However, by 1981, the number of establishments and employment had decreased to less than half of that in 1978. But labor productivity in SSIs did not decline and consequently 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. By 1981, total factor productivity (of labor and capital) had become higher in SSIs than for medium- and large-scale enterprises. Furthermore, the small-scale sector is not very depenaent on imported inputs.  - iv - viii. EMlo9rne_t and Wasess Ha1tufacturing employment in Tanzania in enterprises with 10 or more workers grew from 28 thousand in 1965, to 84 thousand in 1977, and to 105.8 thousand in 1979, i.e., about 1.5 percent of the labor force. Since then employment levels have stabilized. Employment has aot been affected significantly by the rharp drop in produc- tion between 1977 and 1984, and today the sector carries a large burden of surplus labor, which is evenly shared among the different subsectors. Real wages have fallen significantly since 1976. Average labor costs per employee went down, in constant prices, from T Sh 9.9 thousand p.a. (US$1,125 at the official exchange rate) in 1976, to T Sh 3.7 thousand in 1983 (US$450 in 1976 dollars at the 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. ix. (anufacturins EzDorts: 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. Total manufactured exports in 1984 werc US$65 m., of which two-thirds were petroleum products, tobacco, textiles and sisal products. A significant proportion of exports are produced very inefficiently and exported at a net foreign exchange loss for the country. Based on the MIES sample, (which excluded petroleum products and sisal), over one half of the exports in 1984 were exported at a net foreign exchange loss for the country, even after assuming capital costs as sunk. X. Import Substitution: The share of domestic production in total manufacturing supply has been steadily 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 domestically for exports. By 1983, 59 percent was produced in Tanzania for domestic consumption, and the export share was less than 5 percent, implying a 36 percent share of imports. The contraction in the import share since the late 19709, however, has been the result of the large drop in the country's import capability. xi. lmort Depaencv. 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 economic self-reliance. Import dependency has been growing steadily over the past 20 years, and is extremely high today. The share of imported inputs in the total inputs of Tanzanian industry today is 70 percent. 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. A comparison with four other countries in Eastern Africa which have followed import substitution strategies indicates that Tanzania had the highest import dependency. xii. Imported raw materials, spare parts and other inputs utilized by manufacturing in 1984 were estimated to be US$290 m., of which about 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 amortiza-  - v - tion. The total direct foreign exchange consumption of the manufacturing sector in 1984 was therefore estimated to be about US$365 m. In spite of the significant decline in the capacity utilization since the early 1980s, there is no evidence of a concomitant decline in imported inputs to manufac- turing, which '8 the most frequent justification for the fall in capacity utilization. In fact, the data suggests that industry has been absorbing an increasing amount of foreign exchange since the early 19809. xiii. The discussion above indicates that the performance of the manu- facturing sector has been very poor, particularly over the past decade. Both output and value added have declined dramatically, while large invest- ments continued to be channeled to industry. The massive investments have resulted in a sector whose installed capacity was intended to produce US$1.9 billion worth of gross output in 1984 but only produced a total output of US$480 m. utilizing US$423 m. in inputs, which resulted in a very small manufacturing value added contribution to GDP. Severty five percent of capacity lies idle and in disrepair. The sector is highly capital-intensive and import-dependent, 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 timen the value of industrial exports. This overall performance, however, masks significant differences among subsectors and even among firms, which are described below in more detail. The Policy Framework xiv. The policy regime affecting the manufacturing sector since the 19708 has been dominated by the mechaniems 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 thrcugh administ.'ative 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 producers, on the other, a comprehensive price control system was also established. This was complemented by restricting wholesale domestic and foreign trade operations to parastatal agencies--known as the confinement policy. 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, had major implications for the performance and efficiency of the sector.  - vi - Policies Affecting Industry Zv. The Exchange Rate. The Tanzania shilling (T Sh) was introduced in 1966 and was originally pegged to the SDR. From 1966 to 1974 the exchange rate was T Sh 7.14 = US$1. Subsequently, the shilling had minor nominel fluctuations until January 20, 1979, when it was devalued by 10 percent (to T Sh 8.22 - US$1). Successive devaluations in 1982, 1983 and 1984 brought the shilling to T Sh 17 to the dollar. During the first half of 1986, the exchange rate was first allowed to slide to T Sh 25 to the US dollar, and then further depreciated to T Sh 40 - US$1 on June 20, 1986. In spite of the recent devaluations, the currency remains significantly overvalued. The available evidence suggests that the exchange rate that could clear the market for foreign exchange in the absence of trade restrictions would be substantially higher than the official rate, which at T Sh 50 to the U.S. dollar by end-1986, was about one-third of the parallel market rate. Zvi. Foreisn Exchange Allocation: There are two levels at which rationing occurs--at the import licensing stage and at the point of externalizing funds. Until the early 19809 the licensing process wes virtually the sole source of foreign exchange rationlng although some lags in externalizing funds took place. Since then, however, the import licenses approved have significantly exceeded the foreign exchange available, further reducing the importance of the various guidelines and technical criteria for allocation. In effect the administrative allocation of foreign exchange to industry has been driven by the objectives of supporting fiscal revenue earners such as beer and cigarettes, and of keeping most existing enterprises alive, and by particular representations and ad-hoc decisions. xvii. Own Funds ImDort8s Since 1984, the importation of a number of items purchased with external sources of finance has been permitted, under what is referred as own funds imports, where the importer uses foreign exchange from other than official sources. The number of items permitted under own funds imports has increased significantly, and now covers a wide range of consumer goods and inputs. Imports under own funds licenses are not subject to price controls or confinement. Own funds imports are estimated to have exceeded US$300 million during 1985. Although the own funds imports scheme has caused some price reductions and quality improvements in items that now face import competition, it has not led to increases in manufacturing productiou or capacity utilization. xviii. The Tariff Regime: The importance of Tanzania's tariff structure In determining the pattern and efficiency of resource allocation has been relatively small due to the prominence given to quantitative restrictions (QRs) and to the centralized allocation of foreign exchange. The role of tariffs will become significantly more pronounced the closer the exchange rate moves towards an equilibrium rate. Tanzania's current tariff schedule is relatively simple with a few basic rates used throughout. The bulk of imports are subject to a tariff of 25 percent, which applies to most tariff items, particularly in intermediate and capital goods, followed by a 60 percent tariff rate, which applies to most consumption items, and a list of duty free exempted goods. The highest tariff rate is now 120 percent. A  - vii - significant list of goods is subject to zero duties, while exempted categories include goods used by Government and diplomats. All imports and most locally produced goods are also subject to a sales tax. Since finished c.onsumer goods carry substantially higher tariffs than intermediate and capital gonds, the present tariff structure would still provide considerable protection to domestic producers in the absence of an overvalued exchange rate and QRs. xix. Price Controls: The number of price-controlled items has declined from about 3,000 in 1978 to I8& items (or 47 products) in 1985. Items such as cooking fats and oils, salt, milk, sugar, beer and soft drinks, radios, soap and detergents and agricultural products are still subject to price controls. Controlled prices are set by the National Price Commission on cost-plus basis, to allow for a pre-tax 30 percent rate of return on assets (i.e., for a 15 percent after-tax rate of return). xx. Confineent Polic:t Under Tanzania's policy of confinement, wholesale trade for some domestic and imported commodities is 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 designated parast.tal trading firms. 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 compakies 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 outcomer to that followed by the price control authorities. Since the process of own funds import liberalization and price decontrol has gathered momentum, more goods have become deconfined in practice. xxi. Exbort Promotion: Since its inception, the Board of External Trade has helped to launch the Export Rebate, Presidential Award, Concessional Rate of Interest, Export Credit Guarantee and various Export Retention schemes, which are explained in detail in the report. 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 Bank of Tanzania. These schemes allow manufacturing exporters to retain between 50 and 100 percent of their foreign exchange earnings for the importation of inputs and spares, while traditional exports get to retain at most 5-15 percent of their earnings. xxii. Policies Towards Small-Scale Industriess Tanzanian industrial strategy has intended to assign an important role to the SSI sector, comple- mentary to that of the medium- and large-scale sector. To that effect, a number of promotional policies favoring SSIs have been implemented, including the creation of the National Small-Scale Industry Corporation which was started in 1965 and was superseded by Small Industry Development Organization (SIDO) in 1973. SIDM is in charge of coordinating all policies and programs to promote small-scale industries. The more important programs to promote SSI development have beens (i) industrial estate program; (ii) financial support program; (iii) technology transfer; (iv) extension and training services; and (v) handicraft development programs.  - viii - xxiii. Financial Sector and Policies: The banking system of Tanzania comprises a Central Bank, the Bank of Tanzania (BOT), and ten financial institutionst two commercial 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. Tanzania has no private capital market. Interest rates are determined administratively. A detailed structure of depo..it 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. Interest rate adjustments have been small and have not kept with inflation. Thus, throughout the 1970s until now, real interest rates have been significantly negative. This negative level of interest rates has resulted in reduced savings, lending rationing and capital leaving the country. Recently real interest rates have become less negative due to more frequent upward adjustments in the nominal rate. xxiv. 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, partly the result of a decline in the demand for funds and partly the conscious Govern- ment policy 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 private firms turn to the informal private credit network, where they pay very high interest rates in real terms. 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 allocation of foreign exchange which exists. The allocation of a large share of credit resources to very unproductive activities is the result of the institutional weaknesses and rigidities at NBC and at the Central Bank, the remaining macroeconomic, trade and pricing policy distortions and the inadequate financial and economic assessment in the provision of credit overdrafts at NBC. Relatedly, and similar to foreign exchange allocation decisions, the objective of keeping many large unviable activities afloat result in the provision of large amounts of credit overdrafts to unviable activities. Under these circumstances, the monetary restraint objective of keeping within certain of aggregate credit ceilings for the economy has the unintended effect of leaving many efficient firms out of the official credit allocation system--in effect precluding many of them from access to foreign exchange. xxv. 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. The diffi- cult economic environment of the past several years has had a significant impact on the performance of these institutions. With the benefit of hindsight, it is clear that during appraisal inadequate attention was paid  - ix - to project design and implementation issues affecting sub-borrowers and to the economic and financial viability prospects of many of the enterprises financed by these financial institutions. These problems have resulted in a serious deterioration in the portfolio of the two institutions. As a result of the economic problems in the country, they have also had difficulty in mobilizing new foreign exchange resources. 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--as currently structured--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's and TDFL's clients have been encouraged to over-invest in fixed capital. Furthermore, the controlled level of interest rates charged by these DFCs has not been adequate to cover their administrative costs, including adequate provisions for default risk. xxvi. Policies Affecting Capital and Labor Costs: Capital has been subsidized, both through the overvalued exchange rate and the negative real interest rates. 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, however, in a commensurate decline in the share of the wage bill in value added, since employment levels have been maintained at its 1979 peak level. The significant surplus employment in manufacturing implies that labor--even at the current very low real wages-- is not an inexpensive factor of production for the industrialist. This, combined with the low cost of capital, have been important factors affecting the choice of technology in industry. xxvii. The Impact of Policies on the Structure of Industrial Protection: The system of import licensing and QRs (and the concomitant cost-plus price controls) which has accompanied the overvaluation of the currency has provided protection and market power to the local producer. Thus, manufac- turers have been able to charge prices significantly above equivalent border prices: average nominal protection on manufacturing output was found to be 70 percent. 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. For the average manufacturer, purchasing these imports at the official exchange rate implies a 45 percent effective subsidy on inputs. Capital is purchased by the firm at only a fraction of the actual cost to the economy. xxviii. The data indicates that an extremely high average level of effec- tive protection on domestic manufacturing production of about 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 producing a good at almost 5 times the international cost, and still be financially profitable. 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 (ranging between T Sh 50 and 140) depending on their source of foreign exchange, and relatedly, different degrees of trade protection, price controls and confinement. Different exporters face also different degrees of protection, depending on their retenticn schemes. Many industrial activities enjoy virtually unlimited protection, while others are effectively disprotected. Heavily protected firms have had a huge financial incentive to produce and expand its activities, at the expense of activities that have less protection. The Efficiency of Industry and the Role of Policies xxix. Efficiency Overview: The MIES data from 1984 indicates that only 11 percent of manufacturing activities are operating efficiently in that their value added cover labor and capital costs, when both inputs and output were measured at world prices, i.e., these activities had a long-run Domestic Resource Cost--DRC--ratio of less than one. (The DRC methodology is a useful tool for providing an indication on the efficiency of resource allocation and on the economic productivity of industrial investments. It can also give a preliminary indication on the efficiency of a firm's operations. However, particular caution and additional information are needed if a DRC is to be used as a guideline for firm-level decision- making.) Eighty nine percent of the activities are inefficient in the lon& run sense at present levels of capacity utilization. In addition, over one third of all activities were also absolutely inefficient in that they generated negative value added in production--while most of the other inefficient activities have DRCs significantly higher than one. Even when all capital costs are disregarded and treated as sunk costs, two thirds of the activities are still inefficient at actual capacity utilization levels, i.e., their output measured at world prices was less than the input and labor costs, also measured at world prices--short-run DRC was well above one. Every day that these inefficient enterprises remain in operations without undergoing substantial changes results in additional net losses for the country. The large share of inefficient activities results in yearly losses for the economy of well over one hundred million dollars (see preface). xxs. Patterns of Subsectoral EfficLency: Currently only food processing, beverages, tobacco and rubber activities are being undertaken efficiently in the short-run sense, i.e., they contribute positively to the economy assuming capital costs as sunk. Textiles, glass, wood and paper (excluding Mufindi Pulp and Paper, which was not part of the sample), 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.  - xi - xxxi. Absolutely inefficient--negative value added--activities are concentrated in intermediate and capital goods. Forty five percent of intermediate and capital goods activitits produce at negative value added. Within these, over one half of the activicies in tanneries and l,ather, pharmaceuticals, chemicals and fertilizers, and transport have 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 Lvplying that the textile subsector, in spite of including a large number of efficient activities, does not generate sufficient value added to cover its labor costs. Food products, beverage and tobacco seem to have a very swull share of inefficient activities, resulting in a positive net contribution for the country. xxxii. Firm's Ovnershib and Economic Efficiency: Parastatal firms which operate extremely unproductive activities are significantly over-represented in industry: 56 percent of all parastatal activities have negative value edded at actual levels of capacity utilization, as opposed to only 14 percent in the private sector. Gross inefficiencies are thus dispropor- tionally represented in the parastatal sector, although a very significant proportion of private activities are relatively 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 oi 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 on the average about 3 units of the economy's factor resource in order to produce one unit of value added. xxxiii. Firm's Size and Efficiencys The economic efficiency of Tanzanian manufacturing firms is closely related to their size. Smaller firms, employing less than 100 employees, are significantly more efficient than larger firms employing up to 1,500 employees. Well-run natural monopolies (cigarettes, beer), which employ over 1,500 workers, are economically efficient. Among smaller sized firms, small-scale factories employing 5 to 25 workers are the most efficient in the sampie, with the highest levels of labor and capit&l proauctivity, and lowest capital intensity and import dependency. xxxiv. Imort Content and Efficiency: There is also a very significant inverse relationship between the import content of inputs and industrial efficiency: firms with an import content in total input costs of less than 30 percent are on the average more than twice as efficient in terms of DRCs and labor productivity than firms that import 30 to 90 percent of their inputs. Activities with import dependency higher than 90 percent, which comprise one third of all activities, on the average produce at negative value added. xxxv. Calital Intensity: 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, on average, a 15 percent lower factor productivity than activities below average capital intensity--even at *attainable' capacity levels. The difference is significantly enlarged when the employment variable in the capital intensity ratio is adjusted for labor skill differentials, suggesting that skilled labor may be complementary to unskilled labor and substitute for capital.  - xii - xxXVi. Capacity Utilization and Efficiency: Low capacity utilization resulting from the lack of foreign exchange is by far the most common explanation given for the poor performance of Tanzania's industrial sector. A widely held 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. xxxvii. First, even if sufficient resources could be mobilized and channeled across-the-board to industries in order to reach attainable capacity, the performance and efficiency of the sector would improve only marginally from an economic return on capital of -15 percent to a still highly negative -11 percent--while uitilizing an additional US$360 million in imported inputs. As described in the Report, a hypothetical reallocation of resources from large inefficient enterprises to--small, medium and large-- productive firms would have a substantially larger impact on efficiency than across-the-boarl increases in capacity utilization, while freeing resources for allocation to other sectors. xxxviii. Second, it is clear that the magnitudes of additional foreign exchange required to reach attainable capacity in industry will not be available. Tanzania's economy, even under the most optimistic import capability assumptions, cannot adequately support its present industrial capacity: if additional resources are made available to the economy through higher levels of exports and aid, and these additional resources are evenly distributed between sectors and within industry, average capacity utilization in industry could be expected to increase only from 25 to about 33 percent. This across-the-board additional allocation (with no reallocation among activities) would have a very limited impact on industrial value added, which would increase from US$56 to US$78 million. Negative value added activities would marginally decline from 37 to 33 percent, while long-run efficient activities would increase from 11 to 14 percent. If these same additional resources were allocated to efficient firms only, they could generate instead an additional US$68 million in value added, instead of the US$21 million additional value added resulting from the indiscriminate increase in capacity utilization. An increase in utilized capacity will 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. xxxix. Policies. Structure of Protection and Industrial Efficiency: Africhem, a fictitious name for an existing industrial firm producing inter- mediate goods which was surveyed in the MIES sample, is typical of many of the inefficient firms in the sector. In one of its activities it produced gross output worth $1.8 million at world prices in 1984, using a total amount of inputs worth $2.2 million. Thus, it had a negative value added of $-0.4 million. Labor costs amounted to $0.25 million. However, this activity was financially profitable for Africhem due to the high protection on its domestic production, which allows it to sell its output domestically at US$4.1 million equivalent, while spending $2.6 million for inputs. Examples like Africhem, although not as extreme, are prevalent throughout the industrial sector. About 90 percent of all industrial sector activities are profitable on an operational basis, i.e., excluding depreciation or capital costs. Yet two thirds of all the profitable activities are uneconomic in the short-run, i.e. even when assuming capital costs as sunk.  - xiii - xl. The wide dispersion in protection and efficiency implies that efficient manufacturing industries are denied scarce resources which are flowing disproportionally to inefficient firms. An entrepreneur will not have an incentive to invest in unprotected industries, where the financial rate of return is very low--and where the economic return for the country is high. In addition, unprotected but efficient industries will not generate sufficient financial surplus to attract additional resources. Instead, investment and recurrent resources will continue to flow to financially profitable enterprises, even if they are very inefficient for the country. xli. The evidence from the data indicates that the degree of financial protection (defined as the difference between financial and economic profitability) provided to a firm is strongly and inversely associated with the efficiency of the firm's operations. On the average, 10 percentage points in additional financial protection are associated with a 6 percentage point drop in the economic return of the firm. Similar results were obtained by analyzing the relationship between Effective Rates of Protection and economic efficiency. The data show that effective protection is substantially larger for firms that are: (i) larger; (ii) more import dependent; and, (iii) more capital-intensive, while efficiency is lower for firms with these same attributes. In the private sector, higher protection results in higher financial profitability for inefficient firms as compared with efficient private enterprises. In the public sector, protection allows all firms to maintain similar profitability levels regardless of their efficiency. xlii. Administrative Allocation of Foreign Exchange and Industrial Efficiency: Data from the MIES indicate that the administrative allocation of foreign exchange has favored economically inefficient firms at the expense of efficient ones. This means that the foreign exchange allocation guidelines have not been effective in practice. Random resource allocation would have resulted in a larger share of foreign exchange allocated to efficient firms than at present. Slightly over one quarter of the gross output of the industrial firms in the sample is produced at negative value added, utilizing 42 percent of all imported input costs. Yet the system of administrative allocation provided 50 percent of foreign exchange to these activities. Efficient firms receive a disproportionally small share as a result. Furthermore, the allocation of foreign exchange has worsened between 1982 and 1985. The data also suggest that the intersectoral allocation of foreign exchange may have worsened, since industry appears to have received an increasing share. These unfortunate results highlight the difficulties associated with attempting centrally to allocate foreign exchange efficiently to thousands of producers in the economy (there are over 500 demanders of foreign exchange in industry alone) on the basis of efficiency considerations, even when technical guidelines are developed. The results also highlight the existing pressures to keep the industrial sector functioning, at whatever cost and however thinly resources have to be spread. xliii. Export Promotion and the Productivity of Exports: As noted earlier, a plethora of policy instruments aimed at promoting exports have emerged in the past few years in an effort to compensate for the over- valuation of the currency. With one major exception--the export retention  - xiv - scheme--export promotion policies implemented by :.he Government to compensate for the anti-export bias do not significantly affect the profita- bility of exports. The export retention scheme provides a significant financial incentive to the industrial exporter under the current policy framework. Manufacturing firms are entitled to retain between 50 and 100 percent of export proceeds, implying an effective exchange rate significantly higher than the official exchange rate, ranging between T Sh 100 to the dollar (50 percent retention) to T Sh 140 (100 percent retention). Conversely, traditional agricultural exports are entitled to only a 10 percent retention, implying the much lower effective exchange rate of about T Sh 50. xliv. The large financial incentive provided to manufactured exports, however, introduces additional distortion and encourages exports to take place at a foreign exchange loss for the country. Economic losses result from production switches away from low export-retention commodities (like cotton lint) to additional processing and exporting of high-retention commodities (like knitted fabrics made of cotton yarn). In fact, the MIES sample indicates that only 44 percent of the exported output was produced efficiently in the short-run. For the remaining 56 percent, the value of inputs and the labor costs exceeded the value of the exported output. xlv. Sources of Inefficiency: In addition to the relationship between efficiency and the choice of technology and input mix, this section in the main report discusses the dynamic process of technological capability development in Tanzanian industry. It focuses on the country's techno- logical, skilled labor and managerial constraints, their causes and ramifi- cations. In addition, a general synthesis of the bottlenecks and problems affecting industry, which in turn determine the low efficiency of the sector, is provided in the main report. The variety of factors explaining the inefficiency of many activities suggest that the identification of a high DRC in itself cannot provide a guide for a firm-specific action. Isolation of the sources of inefficiency in each activity is required in addition to the DRC information. xlvi. The relatively small domestic market, an inadequate infrastructure, a limited entrepreneurial cadre and a scarce skilled labor could have called for technologies which, besides being less import- and capital-intensive, would have been less demanding of advanced labor and managerial skills, and more capable of being assimilated with limited technological adaptation. Industry today is significantly over-extended in relation to the country's technological, skilled labor and managerial capabilities. The capabilities constraint began to 'bite' earlier than the plant size, capital and import dependency: the sector had problems running even its simpler manufacturing concerns throughout the 1970s. Tanzania embarked on industrial activities which demanded more advanced skills and know-how than it possessed and it did not develop new skills and capabilities to meet growing industrial demands. This led most industries to remain uncompetitive during the early 1970s and to suffer substantial deterioration in the quality of their production and equipment later in the decade. As a result, serious weaknesses exist in (i) project preparation and execution; and (ii) process, product and industrial engineering. These two aspects, in turn, have contributed to the inefficient performance of the sector today.  - xv - xlvii. Against this background, the role of enterprise-specific and industry-wide bottlenecks and constraints is emphasized in the main report. These constraints and firm-specific problems, which account for the high DRCs of many activities, include: (i) scarcity of raw materials and spare parts; (ii) inadequate infrastructure (power, water and transport); (iii) equipment inadequacy; (iv) inadequate technological, skilled labor and managerial capability; (v) incorrect plant scale, inappropriate import and capital intensity; (vi) insufficient demand; and (vii) wasteful utilization of inputs. The analysis in the main report strongly suggests, however, that these enterprise-specific bottlenecks cannot be addressed in isolation of the policy framework. For instance, provision of roads and of new industrial machinery, raw materials and spares may increase the resource waste in activities which, due to the particular technological charac- teristics and their skill requirements, are not economically viable for the country. xlviii. Resource allocation aimed at removing the existing constraints should therefore be selective and concentrate on viable industrial activi- ties and assess the costs and benefits of removing a particular constraint. Adequate selectivity necessitates an appropriate policy environment, however, to ensure that viable activities are the ones facing adequate incentives to solve their problems. Nevertheless, some underlying structural factors, which are not directly related to macroeconomic, trade or pricing policies are also important per se. Inadequate infrastructure and lack of technological capability development are important bottlenecks in Tanzanian industry and deserve particular attention in themselves. xlix. Protection and Inefficiency Over-Time: In addition to the evidence presented on the effects of high protection on productivity in today's industrial sector, the available data--from 1966 and 1984--suggests that protection has increased significantly over time (a four-fold increase in effective protection), and that this rise in protection has been associated with a very significant deterioration in efficiency over the past 20 years. 1. This comparison over a long period of time suggests that important changes in the structure of protection and industrial performance have taken place in Tanzania over the past two decades. Policies increasingly protective of industry became more prevalent over time. The historical process which became largely responsible for the sector's growing structural weaknesses, which in turn, resulted in today's lack of manufacturing productivity, is the main issue addressed in Chapter Four of the Main Report. li. The discussion of Chapter Four focuses on the roles of the following factors in the emerging structural weaknesses of the economy in general, and of industry in particular during the 1970s: (i) increasing foreign financing; (ii) deteriorating agricultural incentives; (iii) increasing exchange rate overvaluation; and (iv) growing internal and external imbalances, brought about by exogenous events and defective economic management. The section on industrial strategies reviews the roles of the Basic Industrialization Strategy (BIS), foreign aid, the internal planning process and the policy framework in determining the weak structure and performance of industry today. Chapter Five of the Main Report, which is not summarized in this Executive Report, provides a review of the public investment programs for industry, covering ongoing projects, planned investments and rehabilitation plans (see also section on Public Investments in policy recommendations below).  - irvi - LTowards Industrial Reorientation and Revival lii. Since the late 1960s, and during the seventies in particular, Tanzania emphasized the objectives cf self-reliance, equitable development, growth, structural transformation o06 the economy towards industrial production--and within industry towards intermediate and capital goods. The means utilized by the Government, however, have not been effective in achieving the stated objectives. In industry, the combination of external shocks, inadequate policies, and the very low productivity of the massive investments expended have resulted in; (i) low levels of industrial production, with manufacturing contributing only about 3 percent to GDP, although for much of the seventies as much as one third of all investments were channeled to industry; (ii) a "traditional" structure of production within industry, where the share of consumer goods in manufacturing value added, at 85 percent, is much larger than during the 1960s in spite of investments having been channeled disproportionally to intermediate and capital good production; (iii) an extremely inefficient and import dependent manufacturing sector, which exports little and in many instances produces at a loss to the economy; and (iv) insufficient investments and incentives in other sectors, particularly agriculture and infrastructure, which has been associated with a weak structure of agriculture, a decaying infrastructure and the sharp decline of the economy. liii. The emerging conclusion is that the implementation of any industrial strategy in the future ought to emphasize efficiency and produc- tivity as instruments to attain the social and economic objectives of the Government. Economic growth, industrial transformation and the provision of basic goods will not be achieved if industrial efficiency considerations are neglected. Investments intended to change an economic structure and achieve self-reliance and equitable growth, are bound to be ineffective if these investments are not productive. Furthermore, the more specific goals of increasing production, productivity and utilization of capacity in industry, which have been emphasized by the Government under the ERP, will also necessitate an increased emphasis in the efficiency of resource allocation and use. The required emphasis on efficiency of resource allocation and use implies that an industrial reorientation has to take place: the current inefficient structure of production has to be altered to allow a more productive and streamlined sector to emerge. A restructured sector, with a hetter allocation of recurrent resources and investments, would make a significantly higher contribution to the economy, while consuming less resources. Resource savings would be freed for productive uses in agriculture, infrastructure and other sectors. liv. As a result of an industrial reorientation, the industrial sector could play a dynamic role in Tanzania's future. In parallel to the importance to be ascribed to agricultural development, Tanzania industriali- zation efforts deserve strong support in order to further the Government's objectives. The industrial reorientation drive proposed below consists of seven main elements, many of which the Government has begun to emphasize since the early 1980s, and which are described in detail in Chapter Six of the Main Report: (i) intersectoral reorientation, where agriculture, the most productive sector and the higher foreign exchange earner, together with  - xvii - infrastructure would receive a larger share of resources while industry would have a substantive supportive role; (ii) reorientation within industry towards productive firms and away from inefficient industries; (iii) reorientation of resources towards recurrent and rehabilitation needs, away from new investments; (iv) reorientation of some additional resources towards smaller scale firms; (v) balance between the private and parastatal sectors; (vi) reduced import-substitution and increased--and more efficient- -export orientation; and (vii) technological capability development. General Prospects for Industry Under a Reorientation Drive lv. Given the current low levels of efficiency of Tanzania's industrial sector, the first objective for the sector is to increase its productivity, rather than maxinizing short-term sectoral response in gross output. Maximization of industrial supply response, which could be attempted by across-the-board increases in imports of raw mate.ials and other inputs, would imply a very high opportunity cost to the .ountry. Many inefficient-- particularly negative value added--industrial enterprises would absorb resources at the expense of other efficient users in industry and other sectors, particularly agriculture, and would perpetuate the present inefficient structure of production. lvi. On the other hand, an improved allocation of resources, even with levels of imports similar to those of the recent past. would generate substantially higher manufacturing value added. In the short-run, fewer industrial firms would be able to operate than at present but they would be the most efficient firms and, in addition, they would reach higher levels of capacity utilization. In the very short-run, by reallocating resources from negative value added activities (which does not necessarily imply the closure of a firm), industry could produce at least US$85 m. in additional annual value added--conservatively assuming that displaced labor cannot be used elsewhere in the short-run. This would more than double the value added currently produced by the sector. In the short- to medium-term, as displaced labor becomes productive elsewhere, as additional resources are reallocated from inefficient firms to efficient users throughout the economy, and as some inefficient activities restructure their operations, the additional annual value added generated by industry and other sectors from the improved resource allocation in industry would exceed an estimated US$170 m. These amounts do not include the additional improvement6 in output and productivity that would be generated from the appropriate rehabilitation expenditures and from the emergence of new and more efficient enterprises in the medium run.  - xviii - ProRosals for Policy Reform The Rationale for Policy Reforms lvil. To achieve significant reallocation of resources and to provide all activities with the incentives to become more productive through cost- reduction measures, restructuring, etc., in a sector with more than 700 factories, major additional policy reforms are required in the exchange rate, trade and pricing regimes. In addition, important subsectoral and firm-specific rehabilitation and restructuring measures in industry would be needed to complement the macroeconomic and trade reforms. lviii. The system of quantitative restrictions and administrative allocation of foreign exchange and the concomitant system of price controls and confinement, which have accompanied the substantial overvaluation of the currency, have provided considerable protection and market power to the local producer. On the average, an industrial firm enjoys a 470 percent Effective Rate of Protection, allowing the enterprise to survive financially while it vaes resources very inefficiently, resulting in large losses for the economy. In addition to the high average level of protection to industry, the variation in the levels of protection within industry is also very large. The exchange rate regime, trade restrictions, pricing structure and foreign exchange allocation decisions affect different firms very differently. Some activities enjoy virtually unlimited protection (like many large firms producing intermediate goods) while others are effectively unprotected (like some smaller consumer goods enterprises). The degree of protection enjoyed by an industrial firm is inversely related to its economic efficiency: while an unprotected firm had, on the average, an average economic return of 11 percent, the highly protected firms had an economic return of -33 percent. The high degree of protection enjoyed by the more wasteful firms was in large measure the direct result of the administrative allocation of foreign exchange at the official price, which channeled a disproportionally large share of foreign exchange to the more inefficient firms, while efficient firms received a small share. lit. Against this background, a clear rationale emerges in support of the broadening and deepening of the process of major reforms in the exchange, trade and pricing regime. Exchange rate adjustments are essential in order to: (i) reduce significantly the implicit subsidy to many inefficient enterprises, thereby providing an incentive for transforming unproductive activities into productive ventures and for reallocating resources from inefficient to efficient uses; (ii) put in place the necessary balance of payments framework to move away from the ineffective system of administrative allocation of foreign exchange and QRs; (iii) provide incentives for afficient exports to expand, reducing the anti-export bias, particularly for agriculture; (iv) improve the intersectoral alloca- tion of resources, by providing additional incentives and resources to the agricultural sector (which in turn will strengthen industry); and (v) reduce the losses to the economy resulting from the large administrative and managerial costs of allocating foreign exchange centrally, and from the amount of resources wasted in rent-seeking activities.  - xix - lx. Consequently, the industrial reorientation process recommended in this report, which, consistent with Tanzanian objectives, would result in the strengthe.Ang of industry and in the value added and efficiency increases outlined below requires the continuation of the implementation of substantial policy reforms in the exchange rate, trade and pricing regimes. In addition, some industrial policies and public investment planning issues will need to be addressed and firm-specific interventions will be required. lxi. The Government, which has been trying to reverse the recent economic decline by implementing various policy changes since 1982, when it initiated the Structural Adjustment Program (SAP), has recently restated its commitment to embark Tanzania's economy into a recovery path. Accordingly, the Government has prepared a new Economic Recovery Program (ERP) aimed at remedying some of the shortcomings of earlier policies. In its 1986/87 Budget Speech, the Government announced important policy measures: (i) the exchange rate, which had been allowed to slide from T Sh 17 to T Sh 25 to the US dollar during the first half of 1986, was set at T Sh 40 = US$1 on June 20, 1986, and subsequently it has been allowed to slide further to about T Sh 50 to the dollar by end-1986; (ii) agricultural producer prices were increased between 30 and 80 percent; (iii) personal income taxes were reduced; (iv) petroleum prices were increased by 50-60 percent; and (v) other price increases (beer, cigarettes, etc.), and small changes in customs duties were implemented. lxii. These measures are important initial steps in the process of eliminating current distortions and laying the foundations for economic recovery. They will immediately result in some decline in the huge excess demand for foreign exchange and improve incentives for some agricultural crops. Better resource allocation in industry and throughout the economy will only take place, however, when the process of policy reform which has just been launched is strengthened by additional changes. At this point in time, the Government has chosen to follow a policy of gradual adjustment, which if adequately implemented, has good prospects for recovery. Consequently, the gradual adjustment scenario is presented first, and in some detail, pointing out its possible benefits and risks and the necessary complementary policy measures to enhance its chances of success (Scenario I). In terms of speed of economic recovery and of industrial reorientation, an optimal set of policies is presented as scenario II below, where the policy adjustment would be much faster, or immediate (high growth scenario). The other scenarios would result in substantial, but slower recovery (scenario I, gradual adjustment), or may even fail altogether to achieve the rn.eded economic recovery (scenario III, partial adjustment). A crucial element that differentiates among the three main scenarios discussed here is their treatment of the exchange rate issue and the elimination of the remaining overvaluation of the shilling, which is still substantial. lxiii. Scenario I: Gradual Adiustmentl/edium Growth Scenario: The objective under this scenario would be a gradual exchange rate adjustment to attain full equilibrium over a period of one and a half to two years, i.e., by about mid-1988. An equilibrium exchange rate would be the rate that would equate the demand with the supply--thereby eliminating the excess demand--of foreign exchange in the absence of trade restrictions. For the exchange rate to be in equilibrium at the end of the period, that rate would  - xx - have to be consistent with the dismantling of the systems of quota restrictions and centralized allocation of foreign exchange for imports, while ensuring that the current account balance is consistent with the level of net capital flows--accounting for aid flows, debt relief and other financial flows. The four main issues to be addressed in a gradual adjust- ment to an equilibrium exchange rate are: (i) the mechanism of exchange rate adjustment; (ii) the gradual program of trade liberalization; (iii) ..he temporary complementary measures during the transition period, and (iv) the permanent complementary measures to the exchange rate reform. lxiv. A. Mechanism of Exchange Rate Adiustment: The mechanism could either include frequent mini-devaluations or discrete step adjustments, or a combination of both. In either case, in order to reach equilibrium by mid- 1988, the chosen mechanism would have to result in significant average quarterly devaluations. Once an equilibrium exchange rate is attained, a mechanism would have to be in place to ensure that the equilibrium exchange rate is maintained, which would require regular reviews likely to result in nominal devaluations. lxv. B. The Gradual Reform of the Trade Regime: A program of exchange rate reform, which would result in an equilibrium exchange rate by mid-1988, would allow the gradual introduction of an import liberalization program for those imports currently subject to centralized allocation of foreign exchange. Currently, a significant share of imports into Tanzania have been effectively liberalized by the introduction and broadening of the own-funds imports schemes. However, a large portion of imports is still subject to administrative allocation. The main issues to be faced under a gradual process of trade liberalization are: (i) nature of the first liberalization step; (ii) timetable tor subsequent steps; and (iii) complementary measures. The initial trade liberalization step ought to be significant enough for the program to gain credibility and momentum. A substantial proportion of the foreign exchange at the Bank of Tanzania would have to be set aside and allocated accordingly to supply and demand forces. In the case of Tanzania, a possible candidate for the initial liberalization step could be the imports for the transport sector. lxvi. The pre-announcement and commitment to a timetable of subsequent trade liberalization steps is also fundamental in the deslgn and implemen- tation of a successful trade reform program. The eventual objective of the reforms, once the exchange rate reaches equilibrium, would be a trade regime where industrial protection will be given by the tariff regime and wILere foreign exchange will not be administered centrally. Prohibitions, import and foreign exchange licensing would be expected to be removed by the end of the reform program, with the possible exception of a short negative list responding primarily to health and security concerns. Consumption items deemed socially undesirable would be discouraged mainly via the appropriate set of excise and sales taxes. Furthermore, the timing of further liberalization steps would have to proceed pari passu with the exchange rate realignment: as the exchange rate approaches equilibrium, the trade liberalization process could be intensified. The removal of QRs and centralized allocation of foreign exchange should be virtually complete once the exchange rate reaches equilibrium. The implementation of a gradual trade liberalization process requires some temporary complementary measures to ensure that external equilibrium is maintained if the exchange rate is still overvalued.  - xxi - lxvii. C. Temoragr Copiementarv Measures: Under a gradual exchange rate adjustment, the currency would remain overvalued for some time. Temporary measures would thus be required to ensure better resource allocation during the transition period, and to avoid additional external imbalances, particularly if the Governvient embarks on a gradual program of trade liberalization. On the import side, unless the official exchange rate is close to equilibrium, measures would be needed to (i) increase the price being paid for (non-"own funds") imports and (ii) improve the administrative allocation of foreign exchange for that portion of foreign exchange which will continue to be centrally allocated for some time. On the export side, (iii) measures would be needed to provide sufficient incentives to efficient exporters. The temporary measures would reduce the remaining distortions in the economy until the market determined exchange rate is achieved. lxviii. TeaDorary Import Surcharge: Initially, an import surcharge would be needed unless the exchange rate is sufficiently devalued to be close to a market clearing rate. The temporary import surcharge would be needed for soaking the excess demand for imported goods in general, and for the categories of goods to be liberalized in particular, in order to avert additional pressures on the balance of payments. The import surcharge would have to compensate for the difference between the actual exchange rate and the estimated equilibrium exchange rate. lxix. Administrative Allocation of-Foreian Exchange: Since a compre- hensive trade liberalization will not be possible until the exchange rate approaches equilibrium, a centralized administration of foreign exchange will be required for some time for those categories of goods still subject to QRs and foreign exchange licensing. If demand will exceed supply for the non-liberalized import categories for some time to come, the excess demand for imports will have to be screened according to a more effective set of criteria than in the past. The recommended approach involves four relatively simple screening tests which are to be applied once the relevant requests are consolidated, the availabilicy of foreign exchange assessed, and sectoral allocations determined. The major objective of the screening is to weed out negative value added activities (at world prices), and to give priority to high value added operations. If the implementation of the system is successful, some improvements in resource allocation may be expected when compared with the gross inadequacies of the past. However, even under the best of circumstances regarding the design and implementation of a screening device, this centralized allocative mechanism cannot be expected to lead to a very efficient allocation of resources in the economy. The screening mechanism for foreign exchange allocation outlined here should therefore be implemented on a temporary basis only. Administrative allocation of foreign exchange for imports will not be required once the exchange rate approaches equilibrium and the trade reform program is implemented. lxx. Promoting Exports: A realistic exchange rate is the most important incentive for promoting exports. While the exchange rate remains over- valued, however, an export retention scheme could prove to be an effective substitute for export promotion for all sectors, includin? industry. However, the current export retention scheme already in place should be  - xxii - modified to eliminate its potential for creating distortions. The reformed retention scheme, therefore, should incorporate the following features: (i) It should be uniform for all firms and all sectors (or, if there is any variation, it has to be very small, not exceeding 5-10 percent between the highest and lowest rates); and (ii) the retained export proceeds should be transferable (at the parallel rate) to allow equal access to foreign exchange to efficient import-substituters. lxxi. Permanent Comnlementary Measures: The following main comple- mentary measures would need to be implemented on a permanent basist (i) further liberalization of own-funds imports; (ii) further price decontrol and deconfinement; (iii) stable fiscal and monetary policies; (iv) financial sector reforms; (v) tariff changes; and (vi) institutional and pricing reforms in agriculture and in other sectors. lxxii. Own-Funds ImDorts: This window has been broadening significantly over the past two years. The continuing liberalization of own-funds imports is expected to continue to (i) result in a larger supply of imported goods; (ii) exert downward pressures on domestic prices and encourage quality improvements in local production; and (iii) in combination with the other complementary policies, result in a more moderate and uniform structure of effective protection to domestic industry. lxxiii. Price Decontrol and Deconfinement: With the increasing importance of the own-funds imports window, the policy of price control and confinement has already become less relevant than in the past. As the exchange rate moves towards equilibrium and trade liberalization proceeds, the importance of setting price controls and confinement will be diminished further, since external competition would provide an effective price Ocap.w However, official removal of the remaining controlled items would still be an important objective, since distortions in production and in consumption are still created by some price controls and the confinement of many inputs. lxxiv. Stable Fiscal and Monetary Policies and Interest Rate Refo mt As part of the ERP, the Government intends to reduce substantially the fiscal deficits in 1986/87 to 11.1 percent of GDP compared with 16.3 percent of GDP in 1985186, the expected result of increased revenue collections from customs duties and sales taxes, a reduction in real wages, a virtual freeze on public employment and the elimination of budgetary subsidies to the para- statal sector. In addition, in order to mitigate the effects of devaluation on inflation and to strengthen the balance of payments, the Government will restrict the rate of credit expansion to 12 percent in 1986/87, compared with a 29 percent increase in 1985/86. This would be achieved through reductions in the Government borrowing from the banking system and in bank credit extended to crop marketing boards. The timely implementation and continuation of these prudent fiscal and monetary policies are important for ensuring economic stability throughout the adjustment program. Macro- economic stability is a crucial pre-condition for the implementation of a successful trade liberalization program.  - xxiii - lxxv. Interest Rate and Other Financial Sector Reforms. The attainment of positive real interest rate levels is a crucial component for the success of the adjustment program. Negative real interest rates would continue to result in substantial excess demand for credit and create a strong incentive for capital flight, thus causing additional pressures on the balance of payments and on the exchange rate. Positive real interest rates are also needed for adequate savings mobilization and for improved allocation of credit and capital throughout the economy and in industry. The existing allocation of credit throughout the economy, which is mainly determined by NBC, is extremely inefficient also for reasons other than the structure of interest rates. The economic restructuring process associated with the reforms in the exchange rate, trade and fiscal policy areas would be hampered if the existing rigidities and inefficiencies in the financial sector are not tackled concurrently to the macroeconomic and trade reform process. An effective reorientation in the channeling of financial resources can only take place once the Central Bank's and NBC's institutional weaknesses are addressed and the financial health of the term lending intermediaries is restored. It is therefore of high priority to develop a more in-depth understanding of the financial sector, with the objective to recommend policy and institutional reforms which would improve the functioning of this important segment of the economy. lxxvi. Tariff Reform: Under an increasingly liberalized trade regime protection to industry in the medium term would be provided by the tariff regime. A moderate degree of protection to Tanzanian industry would be justified to foster the strengthening of the existing efficient activities, the rehabilitation and restructuring of potentially productive domestic producers, and the emergence of new firms. Such protection, aside from being moderate, should be as uniform as possible. Since Tanzania's tariff schedule is relatively simple, and, with the exception of some extrene duty rates (zero, and 100-120 percent), reasonably uniform at present, no major tariff reform seems to be required (see Chapter Two). However, a compression of the tariff structure to make it more uniform would be desirable. At a first stage, the lowering of maximum tariff rate from 120 to about 50 percent, and the imposition of a minimum duty of 10-15 percent, with no exceptions, would result in a substantially lower dispersion in effective protection among firms, while still providing industry with an adequate average level of overall protection. Unproductive firms with potential to become efficient would then be given the opportunity to restructure their activities in order to become more competitive over time. At a later stage, once industry had time to adjust to the new environment, lower tariffs should be considered. lxxvii. Policy Reform in Agriculture and Other Sectors: The strengthening of industry in particular, and of the economy in general, depends in large measure on future agricultural performance in Tanzania. Agriculture perfor- mance will depend, in turn, on the overall package of incentives and on the resources allocated to that sector. Adequate farmgate prices provide the key component of an improved policy package for agriculture, which requires reforms in agricultural pricing policy and in the institutional structure, specially in agricultural marketing. In addition, improvement in the infra- structural sectors is very important for industry. Since the economic infrastructure is greatly rundown, resources channeled to key rehabilitation targets in the transport and power sectors would have a significant economic impact, while improved resource allocation within these sectors should be an important objective as well.  - xxiv - S. conomic Recovery Prospects of a Gradual Adiustment Program lxxviii. Effective implementation of the policies outlined under the gradua 1 adjustment scenario, combined with the inflow of additional external finance, is highly likely to lead to a reversal in the deterioration of the economy and to sustained recovery of output. According to Bank staff projections, Gross Domestic Product over the next five years is expected to grow at around 4 percent p.a. the result of substantial improvement in allocation of resources--imported inputs in particular--among the various sectors and within each sector in the economy, supported by additional ext*ebal finance. The largest sector, agriculture, is expected to grow at an aWVrage rate of 4.2 percent, while the fastest growing sector in terms of vaiue added is expected to be industry. Consumption is expected to rise at 3 percent per annum and investment at around 1 percent per annum. The efficiency of investment improves throughout the recovery period, with the aggregate incremental capital output ratio falling significantly. Domestic savings should strengthen as a result of the reduction in the budget deficit and the recovery of exports and, over the medium term, through the attainment of a positive interest rate structure. Progress towards restoring a viable balance of payments will be slow, however, due to the large volume of external debt and the current low level of exports. P. Social Aspects of Adlustment lxxix. The short-term impact of the measures introduced under the ERP, the additional complementary policy measures presented here, and the additional external resources that will eA forthcoming, should in most respects be beneficial in social terms. The continued devaluation of the shilling will have an impact on the price level, but this will be mitigated by the fact that for many goods, particularly imported consumer items, the parallel exchange rate rather than the official rate prevails in the market place. Furthermore, the following factors should offset upward pressures on prices: (i) reduced costs and additional supply availability in efficient industrial activities as capacity utilization increases; (ii) increased imports availability, initially from higher aid flows and subsequently from stronger export performance; and (iii) reduction in effective protection and increase in competitive pressures brought about by the broadening of the own-funds window and by a gradual trade liberalization process, which will exert downward pressures on prices of domestically produced goods. Finally, the expected fiscal and monetary restraint, coupled with more realistic interest rates, should provide a check on inflationary pressures. lxxx. Higher producer prices for the main export crops should substan- tially raise farm incomes, and thus improve rural purchasing power. Improved price incentives for export crops will encourage farmers to increase production of these crops. In the urban areas, in the aftermath of good rains and the partial liberalization of domestic marketing two years ago, food grain prices have either been steady or falling, and they have subsequently remained stable while the shilling has been devalued. Regbrding urban wages, a very significant downward real wage adjustment for utfbii workers took place over many years preceding the devaluation. During  - xxv - the adjustment process, some reallocation of labor resources will be required in the short to medium term. As output and productivity growth materialize, urban employment and real wages will increase in the medium and long term. Safeguarding essential social expenditures is a very important objective that the Government will have to face in light of important changes in relative prices, fiscal restraint, and the requirement of channeling sufficient resources to the key productive sectors, which may necessitate particular interventions in the most sensitive social expenditure areas. lxxxi. Any assessment of the possible economic and social costs of an adjustment program ought to also consider the expected social costs in the absence of an adjustment program. The downward trend of the Tanzanian economy over the past six years, which has resulted in substantial social costs for the population, would continue if a comprehensive program of reform stalls. The significant drop in rural and urban incomes, employment stagnation in the face of a growing labor force, and the dramatic deteriora- tion in the provision of basic social services are likely to continue if adjustment is postponed or only partially implemented. Particularly when compared with these prospects, the social costs of a comprehensive adjusL- ment program, while possibly present in the short-run for some selected groups in the economy, do not appear to be large--and can be made even smaller by the appropriate set of complementary interventions. G. ProsDects for the Manufacturing Sector and the Costs of Industrial Adiustment lxxxii. A simulation based on the MIES data was performed assuming that the outlined policy reforms under the gradual adjustment scenario are implemented and that the macroeconomic growth prospects are realized. A gradual reallocation of recurrent resources from low and negative value added activities to high value added activities was simulated, taking demand considerations and other constraints into account. The results indicate that industrial value added would grow by an average of 12 percent p.a. over the next three years. By 1990 manufacturing value added at world prices could be over 50 percent higher than at present, resulting in a larger share contribution to GDP. By 1995, manufacturing value added could exceed 7.5 percent of GDP, at world prices, (vs. the current 3 percent of GDP), while utilizing a smaller share of resources. The substantial increase in manufacturing value added is the result of the substantial productivity gains to be realized by reallocating recurrent resources from inefficient activities (with negative value added in particular) to efficient product lines. lxxxiii. In spite of the expected benefits of a healthier industrial sector and of a stronger economy resulting from a reform program, the implementation of any policy reform package may result in short-term costs due to adjustments in some industrial firms and temporary dislocations for its workers. The restructuring required to make industry a productive contributor to Tanzania's economy will be associated with short-run dislocations in industry. It would be incorrect to infer, however, that massive closures of firms would take place. Our analysis suggests that although some firms will be expected to close down, including some very  - xxvi - unproductive large enterprises, much of the industrial restructuring will take place as the result of the streamlining of product lines within firms, the output expansion and rehabilitation of viable enterprises, and the eventual emergence of new firms. Regarding labor dislocations, the potential increase in short run unemployment resulting from closure of Inefficient product lines would be partly alleviated by: (i) labor reallocations across activities within enterprises towards expanding product lines; (ii) labor reallocation across firms within each subsector; aad (iii) labor reallocation across subsectors within the industrial sector. For semi-skilled workers the mobility may be more limied in the very short run. At any rate, it is likely that some jobs will be lost in the industrial sector in the short-run. Presently there is surplus employment in the sector, and the expected shutdown of some operations would result in some employment losses. The economic and social costs of these job losses could be ameliorated by limiting new hirings in activities undergoing restructuring, regular job attritions, the provision of incentives for early retirement, for alternative job search, for engaging in agricultural activities, and the promotion of small-scale and self-employed operations. lxxxiv. In the medium run, as a restructured and healthier industrial sector emerges, industrial employment would be expected to rebound. As important, real wages would be expected to rise again from the extremely low levels existing today as a result of the substantial productivity gains envisaged under the industrial restructuring program. In sum, the costs of adjustment for industry, albeit non-negligible for some firms and workers in the short run, are not foreseen to be very large when compared with the substantial gains in capacity utilization, productivity, real wages and jobs in the productive activities of industry and in other sectors. The short- term adjustment costs for industry should also be compared with the cost of inaction--or the costs of postponing the adjustment process, which would result in a large waste of resources, affecting overall economic growth and employment generation. Capacity utilization and productivity in industry would continue to be extremely low, resulting in the need to either shed significant numbers of industrial workers, or in the further drop in industrial wages. Lisk. of a Gradual Adlustment ProSram lxxxv. The gradual adjustment path described above, if effectively imple- mented in conjunction with its complementary policies, has a reasonable chance of succeeding in generating renewed economic and industrial growth. This gradual adjustment path is, however, subject to potential risks and costs. First, a gradualist approach necessitates a more prolonged and stringent monetary and fiscal policy stance to ensure that mini-devaluations do lead over time to real depreciations in the currency. Socio-political pressures, when translated into budgetary expenditures and credit expansion, could lead to higher inflation and a failure to achieve real devaluations. Furthermore, the problem may be exacerbated by inflationary expectations if interest rates are negative in real terms for some time, and if monetary and fiscal expansion does take place. Inflation, in turn, will make further real exchange rate adjustments increasingly difficult, thus threatening the adjustmenti program. Second, a program of gradual adjustment of the exchange  - xxvii - rate may be difficult to implement. The need for political consensus and repeated announcements preceding and following each devaluation has proven to be in several cases politically more costly than the one-time consensus and announcement of a once-and-for-all reform in the exchange rate regime. Temporary complementary measures, which would not be required if the exchange rate were to adjust very rapidly, are not simple to implement and would stretch Tanzania's institutional capability even further. Third, a more gradual adjustment scenario may necessitate more restrictive fiscal and monetary policies than an immediate exchange rate adjustment so that internal and external balance can be maintained while trade liberalizatioa is initiated. This would run the risk of imposing contractionary pressures during the adjustment period. If the Government still chooses to continue adjusting gradually, emphasis will have to be placed on optimizing foreign exchange inflows into the country and the adequate provision of credit for efficient and potentially viable activities during the restructuring period, thereby limiting the potentially contractionary impact of monetary and fiscal policy on the productive activities in the economy. lxxxvi. In light of the above, considering a faster or immediate adjustment path may also be relevant. The announced Government intentions, following the partial exchange rate adjustment of June 1986, are generally consistent with a gradual adjustment path, although many of the required complementary measures which would be required under such an adjustment scenario remain to be worked out and implemented. However, at any point in time during a gradual adjustment path the Government may consider a much faster--or immediate--adjustment, which would make scenario II below relevant. Since a gradual adjustment path, however well designed, has a risk of running off- track during implementation, it is also relevant to consider the implica- tions of a partial adjustment scenario (III). The two alternative adjustment scenarios are considered in turn. lxxxvii. Scenario Il: [mediate Adiustment/liph Growth Scenarios From an economic standpoint, the most desirable policy framework would be one where all relative prices, and particularly the exchange rate would reflect the true scarcity of goods and of foreign exchange. This would eliminate the rents to importers, would result in efficient allocation of resources among producers and would generate sufficient incentives to exporters. As discussed in the report, a large additional exchange rate adjustment would be required for the currency to be close to equilibrium. lxxxviii. A significant and immediate exchange rate adjustment to equili- brium, may, however, be regarded as politically costly if there is a widespread perception of possible large and sudden adjustment costs for important sectors and social groups resulting from the reforms. Political consensus-building may take time under such circumstances, suggesting that a more gradual adjustment program may be preferable--in order to solidify the political commitment to the reform process in the medium run. Furthermore, a gradualist approach to exchange rate adjustment may not be inferior to an immediate adjustment when institutional rigidities in the agricultural and financial sectors can only be removed gradually. However, even when these political economy and institutional factors are present, it is important to implement the gradual adjustment process relatively fast--and in all the important fronts--in order to maintain the momentum and commitment to the  - xxviii - reforms and, relatedly, to speedily generate a significant supply response during the early stages of the program. Two distinct alternatives can be considered for rapidly--or immediately--attaining equilibrium: (i) large step devaluations; and (ii) a marke .-based exchange rate regime, such as an auction of foreign exchange or other similar market mechanisms. lxxxix. A. LarRe Step Devaluation: A large nominal step devaluation (or a few significant devaluations in a short period of time) could result in an equilibrium exchange rate. The two potential problems that have to be faced, however, are: (i) the precise criteria to determine the equilibrium rate, since there is a multiplicity of factors that determines an equilibrium exchange rate, making any criteria open to error; and (ii) the need for further recurrent nominal devaluations, since the rate of domestic inflation may continue to be above international inflation. These problems could be alleviated by: (i) leaving the option open to re-adjust the value of the currency following the first large devaluation if large discrepancies be.ween demand and supply for foreign exchange remain, and (ii) instituting a mechanism for maintaining a realistic value of the real exchange rate, where every quarter the nominal rate would be adjusted by the differential inflation and any changes in any other fundamental variable. xc. B. Market Determination of Foreign Exchange Rate: A market-based mechanism determined by demand and supply would obviate the problem of trying to second-guess an equilibrium exchange rate and would also introduce automaticity in the process of achieving and maintaining an equilibrium exchange rate. One such market-based mechanism could be a foreign exchange auction. In a foreign exchange auction, the Central Bank would auction off a weekly amount of foreign exchange to importers, who would submit bids stating the desired foreign exchange amounts and the bid price. The lowest (marginal) bid price that exhausts the weekly supply of foreign exchange becomes the official exchange rate for that week. All foreign exchange transactions, whether included in the auction or not, would then take place at the same weekly equilibrium rate. xci. Similar types of foreign exchange auctions have recently been instituted in various countries (Guinea, Ghana, Bolivia, Jamaica, Zambia, Nigeria, Somalia, etc.), while other countries--particularly in Africa--are in the process of designing similar market-determined systems. Various other developing countries use other market-based mechanisms such as inter- bank exchange rate determination. Under these systems, a periodic determi- nation of the exchange rate is made on the basis of demand and supply, by pooling the needs and availability of foreign exchange in the competing commercial banks. Although the experiences are still relatively recent, the evidence suggests that when complemented with adequate macroeconomic and trade policies, auctions and other market-based mechanisms are effective. Among their main advantages, market-determined mechanisms can result in: (i) significant improvement in resource allocation and efficiency in the productive sectors; (ii) major reduction in the administrative burden of foreign exchange allocation; (iii) simplicity and automaticity in deter- mining and maintaining an equilibrium rate; (iv) obviating the need for repeated difficult political pronouncements and justification every time a step devaluation is needed; instead, only one major announcement is required at the outset of the exchange rate reform (and once the auction is underway,  - xxix - the market sets the rate, which diminish the political difficulties associated with Government-decreed changes in a managed exchange rate regime); (v) auctions provide a powerful signal likely to result in a boost to domestic and external confidence in the country's economic management and its prospects for recovery; and (vi) the ability of producers in the economy to plan ahead improves significantly. One of the main potential disadvantage of auction mechanisms, which can be addressed, is one of negative perceptions regarding alleged abuses and problems which are sometimes mistakenly associated with the auction. Fiscal discipline, prior and during any exchange rate reform and trade liberalization process is a crucial determinant of the eventual effectiveness of these refonms. xcii. C. Comlementary Reforms to an limediate Richanie Rate Adiustment: A major advantage of an immediate--or fast--exchange rate adjustment is that it forces a quick reallocation of recurrent resources to the most efficient activities in the economy and does not require a complex package of temporary complementary measures as would be required in a gradual adjustment. Several permanent complementary measures to the exchange rate adjustment, however, would be required under such a scenario, preferably simultaneously with the exchange rate reform. Complete liberalization of own funds imports, price decontrol and deconfinement, prudent fiscal and monetary policies, interest rate and financial sector reforms, and institu- tional and pricing reforms in agriculture would be needed to complement the exchange rate adjustment. Furthermore, the proposed reform of the exchange rate regime would permit the introduction of a more comprehensive import liberalization program, which would include the elimination of import restrictions, to be complemented by reforms in the tariff structure to provide uniform and moderate protection to domestic production. xcii. Prospects: The simulation performed on the basis of the MIES estimates indicates that under an immediate adjustment scenario manufac- turing value added could grow at a significantly higher rate than under a gradual adjustment, assuming that the complementary policy and institutional measures can be speedily implemented. Manufacturing value added could double in constant terms by 1990 while utilizing only three-quarters the amount of resources that the sector used in 1984. Furthermore, one-fourth of the released resources could generate significant value added in other sectors. The rapid value added growth would result from the fast realloca- tion of resources from negative value added to high and positive value added activities. xciii. Scenario IIti Partial AdJustmentlLow Growth Scenario: A partial adjustment in the exchange rate has already taken place. The Government intends to continue adjusting the real exchange rate. However, since the risk of a gradual adjustment program running off-track cannot be ignored, the implications of only attaining a partial adjustment deserve brief consideration. If the level of the existing exchange rate were only to be maintained in real terms, or the currency is allowed to depreciate in real terms but at a slow pace, this would result in the existence of a significantly overvalued exchange rate for several years to come.  - xxx - xciv. A rather limited improvement in resource allocation to industry would be expected under a partial exchange rate adjustment scenario. While the exchange rate is significantly less overvalued at the end of 1986 than in 1985, it appears to be almost as overvalued as during 1982-84, when resource allocation to industry was extremely poor and resulted in considerable losses for the economy. Under a partial exchange rate adjustment, the financial profitability of extremely wasteful activities will not be significantly affected. The simulation of the resource allocation impact of an exchange of US$1 = T Sh 45 indicates that only 11.4 percent of activities with negative value added at world prices which were profitable before the devaluation would become unprofitable after devaluation. The great majority of the sector may be able to continue production as in the past. As a result, value added in the sector, in the best scenario, would increase by only US$15 m., which is only one-twelfth the total value added losses for the economy resulting from the inefficient allocation of resources to industry. xcv. In sum, a fast or immediate exchange rate adjustment promises the best economic recovery prospects, while a more gradual adjustment, if complemented with the appropriate measures to ensure tha: the core program is completed by mid-1988, could be associated with substantial growth prospects as well. A partial exchange rate adjustment is not likely to be associated with recovery and growth and thus should not be considered as a viable option. Whether an immediate or gradual adjustment path is chosen, important sectoral-specific measures will have to be implemented, since the macroeconomic and trade policy reforms discussed so far, however important, will not have a full impact on industrial restructuring and recovery unless complemented by measures tot (i) promote SSEs; (ii) rationalize public investments; (iii) promote technological capability development; (iv) restructure large enterprises and reform parastatals; (v) improve the situation of the development banks; and (vi) improve aid coordination. These measures are discussed next. Industrial Policies xcvi. Promoting Small-Scale EnterDrise Developments The major exchange rate, trade and pricing reforms outlined in the previous section would provide a significant incentive for SSE development. By dismantling a skewed structure of protection which has allowed a disproportionate share of resources to be channeled to medium and large industries at the expense of SSEs, a major reorientation in the allocation of resources--towards smaller enterprises--would take place. Furthermore, the expected growth in industrial value added following the reforms, and the increases in agricul- tural production and GDP would give impetus to SSE growth due to the increase in demand for SSE products and the greater availability of domestic inputs. xcvii. In addition to the mucroeconomic, trade and pricing reforms, SSE development should continue to be supported by specific measures aimed at the sector. These measures should include the 4ollowing: (i) financial support for investment and working capital by providing access to credit,  - xxxi - low dounpayment requirements and Government guarantees; (ii) possible temporary income tax reductions, particularly linked to employment genera- tion; (iii) improved technical assistance for project planning, choice of technology, production and marketing; and (iv) equal treatment for SSE industries in foreign exchange allocation. At the same time, the existing programs should be reviewed to provide more focus to their support of SSE. Furthermore, SIDO is currently over-extended, which is taxing the administrative and technical abilities. xcviii. Public Investment Programing: Exceedingly high levels of public investment in industry and extremely low productivity of such investments have been two of the major problems facing Tanzania's industry. Some of these issues begun to be addressed in the context of SAP and have been emphasized under the ERP. Generally consistent with the economic objectives set out under the ERP, the following public investment programming recommen- dations are discussed belows (i) preparation of a consolidated public investment program; (ii) minimization of new industrial investments and of low priority investments which are underway; (iii) rationalization of rehabilitation investments; and (iv) improved investment decision-making. xcix. A. Preparation of a Consolidated Public Investment Pror At this time, there is no unified, consistent set of data on planned public sector industrial investments (PIP) in Tanzania. Existing documents provide substantial amounts of information but gaps and inconsistencies remain. Furthermore, a strategic approach that considers today's economic realities and the industrial sector reorientation objectives is still needed. High priority should therefore be given to the preparation of a strategy-oriented and fully consolidated PIP for industry. c. B. Minimization of New Industrial Investments: The current economic crisis and low productivity levels and capacity utilization in industry indicate that investments in new industrial capacity should be kept to an absolute minimum for the next few years. Priority ought to be given to the provision of inputs and rehabilitation in existing efficient industries, while channeling sufficient resources to other sectors comple- mentary to industry. The Government has repeatedly recognized the need to reorient resources towards agriculture and infrastructure and to reduce iavestments in new industrial capacity. Accordingly, since the early 1980s, budget appropriations in industry have declined in absolute terms and relative to other sectors. When financial institutions' lending and the industrial parastatals' own funds are included, however, the share of industry turns out to be much larger than any othe- sector and increasing. Furthermore, various documents suggest that the plans for industrial investments in new capacity are still substantial. The Government should centralize and screen all possible investments more effectively (see E below) in order to attain its stated objective of reducing investments in new capacity to a minimum. ci. The detailed preliminary review of planned industrial investments in Chapter Five indicates the existence of many projects that do not appear to be economically viable. In textiles, the following investment plans appear to be undesirable, and, therefore, subject to final review, consideration should be given to postponing the ventures indefinitely or  - xxxii - abandoning thems (i) Kiltex spinning mill and weaving shed; (ii) Kibo fabrics; (iii) Morogoro Sisal Bag; and (iv) Sewing Thread. In brewing, a relatively efficient sector which is high priority for the Government, Mwanza Brewery could prove, following a full economic evaluation, to be one of the few new investments worth implementing in the near future. Neither leather nor tobacco have plans for substantial new investments. In paper there are plans for new investments (e.g., tissue paper), whose economic viability appears doubtful at best, and thus implementation should not proceed until a full evaluation is performed. KILAMCO, a proposed offshore fertilizer project, is potentially risky for Tanzania, and should be subject to further scrutiny, particularly considering the country's macroeconomic constraints. In glass and construction materials, Saruji Corporation has some planned expansions and new proiects (e.g., a kiln coal conversion project) which do not appear viable. In iron and steel, NDC has two major projects in the pipeline: (i) a captive foundry, which seems to be uneconomic, and (ii) a farm implements projects, with better economic justification, but it could be postponed for some time until the overall economic and balance of payments situation improves. In transport, a full- fledged Land Rover assembly operation is envisaged, although it is unlikely to become a viable investment and thus should be shelved. Plans for a tractor assembly plant, which have been temporarily frozen, should be abandoned, as should the ambitious long-term plans for passenger car and motorcycle assembly. cii. C. Stonnina of Low Priority and Potentially Uneconomic Ontoina Investments: There are also ongoing industrial investments that appear to be economically unviable even when considering incurred expenditures as sunk costs, while other ongoing investments may prove to be economic once the economic situation improves, but are of low priority at this stage. In both cases, investment outlays should be minimized over the next few years. In textiles, Mbeya Textile Mill, although near completion, is not needed under present demand levels. Additional outlays in the Tabora mill are totally unjustified given the lack of economic rationale and the infrastructural bottlenecks. A potential user for its installed machinery could be Friendship Textiles. Similarly, additional expenditures on the Ubungo mill should be minimized for some time. In tobacco and leather, the ongoing projects are relatively small, near completion and appear viable, as they emphasize rehabilitation needs. The only likely exception, Tanzania Industrial Boots, is near commissioning and should be evaluated as an oper4ting enterprise before recurrent resources are spent. In the paper sector, Mufindi has begun operations, yet in light of serious operational constraints, very high operating costs and doubtful economic viability, it should be subject to a rigorous evaluation with a view to minimize losses for the country. In chemicals, NCI has five projects at an early stage which have not been subject to a comprehensive economic evaluation and do not appear to warrant any priority in resource allocation. These include a sulphuric acid plant, a pesticides/insecticides formulation plant, a caustic soda plant, a vaccine plant and a veterinary drug plant. In construction and glass, Morogoro Ceramic Wares, which is near completion, appears to be viable, while Mbala Sheet Glass, Mwanza Container Glass and Arusha Bricks and Tiles are all ongoing investments at different implementation stages for vhith there appears to be no economic justification for additional outlays. In transport, the Land Rover reconditioning plant is to start operation and seems to be economically justified.  - xxxiii - ciii. The preliminary review of projects indicates the existence of possibilities for cutting back on currently unviable industrial investments, in addition to the planned investments that ought to be shelved. This project-by-project review is consistent with the macroeconomic and inter- sectoral approach discussed earlier, since both suggest that industrial investments ought to be held at absolutely minimal levels for the next few years. Instead, resources in industry should be channeled to recurrent needs and rehabilitation. civ. D. Rationalization of Rehabilitation Investmentas Rehabilitation is clearly of much higher priority for Tanzania than setting up new manufac- turing facilities. With a large amount of investments tied up in facilities which have been run down and forced to lie idle for lack of inputs, spares and maintenance, it now appears a highly rewarding use of foreign exchange resources to restore some activities to good working order. However, to rehabilitate plants properly and to ensure that they continue to operate efficiently rill require a much broader set of inputs than just material replacements or spares as presented in some rehabilitation proposals. As discussed in Chapter Five of the main report, there are also planned and ongoing rehabilitation investments which are not economically justified, while some rehabilitations which are warranted necessitate a more comprehensive approach. A rationalized rehabilitation program should be prepared, which should benefit potentially efficient enterprises that would survive under a reformed policy regime. These enterprises should be provided not only with physical rehabilitation requirements, but also with the technical, organization, managerial and training inputs needed for efficient operation. Otherwise, physical rehabilitation would be wasteful and counter-productive, extending the life of inefficient enterprises. In the short to medium term, overall rehabilitation needs should be carefully assessed against the competing needs for recurrent inputs within industry, and against the overall resource requirements in other sectors. cV. E. Imiroved Investment Decision-Makinas The Government's inten- tion to minimize investment expenditures now, and to have a better PIP in industry in the future, can only succeed if an improved investment decision- making process comes about. Better investment decision-making will require institutional and technical improvements, including a strengthened centralized investment approval process. Investments cannot be motivated any longer by specific objectives of a given parastatal, by considerations from the machinery supplier or the donor country, or merely by the availa- bility of financing. Every public investment ought to be subject to a rigorous economic, financial and technical review. The in-depth economic evaluation ought to integrate realistic shadow prices and consider the balance of payment and intersectoral implications of every proposed investment. Recurrent cost implications have to be considered in detail, and emphasis should be given to a realistic assessment of demand prospects, particularly in light of the significant idle capacity in all industrial subsectors. The potential technological, managerial and skill bottlenecks have to be integrated into the evaluation as well, highlighting the potential for technological capability development of the investment venture. No public investment should be a&proved unless these issues are assessed iu-depth, the expected economic returns are high, and the downside risks are relatively low.  - xxxiv - cvi. In addition, the concerned ministries should work jointly towards preparing a medium-term investment strategy for Tanzania's industry. Macro- economic objectives, as well as the elements of the desired industrial reorientation strategy should be integrated into the investment strategy. Last, but not least, the donor community and multi-lateral organizations ought to play an active supportive role in the improved investment decision- making in Tanzania by: (i) improving aid coordination; (ii) untying aid, away from specific equipment sources and capital intensive new investments, towards recurrent imports and rehabilitation needs in potentially efficient subsectors and enterprises; and (iii) supporting the main financial inter- mediaries, TIB and TDFL, with financial resources and institutional support to improve upon the existing project evaluation capability in these institutions, which is already considerable. cvii. Technological CaDability Development in IndustrX: The major policy factors affecting recent technological development in Tanzania have been the exchange rate and trade policy (resulting in inward-looking first stage industrialization), industrial policy (parastatal ownership and promotion of selected sectors) and education policy. Once the first two categories undergo the necessary policy reform process, the pace of technological learning will depend on: (i) the provision of indigenous skilled, techni- cally trained manpower; (ii) the elimination of some gaps in technical man- power, which in the short to medium term may require the use of expatriates, which together with its Tanzanian counterparts should be provided with incentives to improve the twinning process; (iii) parastatals could remedy particular shortages of skills (especially managerial and engineering) by collaborating with private enterprises, local or foreign; (iv) active promotion of elementary manufacturing skills in metal working; (v) the setting up and strengthening of consultancy enterprises, which is vital to the development and diffusion of technological expertise; and, (vi) setting up of centres for preventive maintenance. cviii. Restructuring of Larae Enterprises and Parastatal Reforms The environment for private sector development, which improved in the late 1970s, but which was subsequently hampered by the general economic decline, should be expected to improve again in the future as the economy recovers and a more neutral allocative framework evolves as a result of the overall reform program. The parastatal sector is expected, however, to continue playing an important role in Tanzania's industry. It is imperative, therefore, to transform the industrial parastatal sector into a productive contributor to the tanzania economy. The policy reform program outlined previously will be the key first step to to achieve such objective. In addition, firm-specific measures to rehabilitate, restructure and phase out parastatals will be needed once the new policy framework is in place. Identification of all currently inefficient medium- and large-scale parastatals is first required. This industrial sector report, through its efficiency survey and the subsectoral specific reviews (see Chapter Six of the main report and annexes), has identified a significant number of such parastatals, which should be complemented to the information already available from the SAP studies. In-depth studies of unproductive enterprises should be prepared with a view to implementing an action plan that woulds (i) rehabilitate, and, when necessary, restructure currently inefficient firms with clearly realistic prospects to become productive; and (ii) phase out, divest or otherwise end operations of very inefficient parastatal firms that lack potential to become viable.  - xxxv - cix. Institutional problems generally affecting parastatals ought to be tackled as well, namely: (i) lack of monetary incentives and of cost- consciousness; (ii) proliferation of control levels with inadequately defined responsibility and insufficient authority; (iii) serious inadequa- cies in managerial competence and skilled manpower; and (iv) labor regula- tions affecting labor mobility and resulting in surplus labor (see annex on parastatals for details). A well-defined program to address the institu- tional shortcomings will be needed, which ought to consider: (i) develop- ment of an organizational structure for holding companies which assimilates as much as possible features of the private sector; (ii) introduction of a salary and incentive systems which provide rewards in proper relation to achieved results; (iii) reorientation of the role and functions carried out by the Ministry of Commerce, Industry and Trade and the Treasury with regard to supervision of parastatals: while the sectoral ministry may focus on sectoral and subsectoral issues, Treasury could emphasize monitoring of financial performance of parastatals; and (iv) providing more autonomy to parastatals in running their day-to-day operations. In addition, specific proposals to improve the institutional relationship between Government, holding corporations and the parastatals are included in the annex in Volume II. cx. Develoument Banks: Both TDFL and TIB have important roles to play in the Tanzanian economy. Prospects for improving their effectiveness will not substantially improve until macroeconomic, financial, and industrial policies improve significantly. Once these issues are addressed, resumption of support to the development banks will be warranted. Both institutions have good management and qualified staff. However, staff training would need to be strengthenea in the areas of project appraisal and supervision and a restructuring of their portfolios may be required--which would be associated to *he restructuring of their client firms. The portfolios of the DFCs will need to be consolidated through the rehabilitation of the viable existing ventures and the financing of spare parts and imported raw materials to increase capacity utilization in efficient firms. cxi. Aid Coordination: Reorientationi of the nature and direction of aid flows should have a significant impact on the restructuring of industry and in improving resource allocation in the sector. lUe tying of donor funds for new investments should be minimized and the emphasis should increasingly lie on import support. Furthermore, the Government, the World Bank and donors should engage in an intensive dialogue on industrial projects currently under implementation, and on the support provided to many existing, yet economically unviable, operations in industry. In order to minimize the multi-million dollar yearly losses for Tanzania's economy resulting from unviable operations, a priority objective for the Government, with the support of the Bank and donors should bes (i) the discontinuation of low priority and economically unviable projects under execution and the release of the committed donor funds for allocation to recurrent inputs and rehabilitation of viable enterprises; and (ii) the identification of high priority rehabilitation and restructuring needs of industry, focusing on activities whose productive potential can be clearly demonstrated by a rigorous financial evaluation.