Madagascar - Adjustment in the industrial sector and an agenda for further reforms

Report No. 7784-MAG Madagascar Adjustment in the Industrial Sector and an Agenda for Further Reforms October 29,1990 Industry and Energy Operations Division South-Central Indian Ocean Department Africa Region FOR OFFICIAL USE ONLY Document of the WoMd Bank 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.  CURRENCY AND EQUIVALENTS Currency Unit: Malagasy Franc (FMG) Exchange Rates (FMG/US$) 1975: 214 1978: 226 1981: 281 1984a 577 1988s 1,407 1989: 1,603 June JO, 1990: 1,529 FISCAL YEAR January I - December 31 WEIGHTS AND MEASURES Metric System ABBREVIATIONS AND ACRONYMS BTN Brussels Tariff Nomenclature CPI consumer price index GDP gross domestic product HS Harmonized System ICO International Coffee Organization ICOR incremental capital output ratio LIR Liberalized Import Regime OGL Open General License PPN products of primary necessity PPP purchasing power parity RER real exchange rate TC taxe de consommation (consumption tax) TUT taxe unique sur les transactions (tax on transactions)  FOR OFFICIAL USE ONLY MADAGASCARt ADJUSTMENT IN THE INDUSTRIAL SECTOR AND AN AGENDA FOR FURTHER REFORMS Table of Contents Pate EXECUTIVE SUMMARY ................................................. . i-v INTRODUCTION .....1*....**o ....*so**** ..... 1 Is THE ECONOMIC SETTING O 2 A. Background ..... ... ...2 B. The Changes in Economic Policy 2......................... 2 C. The Current Macroeconomic Policy Framework 4................... 4 Historical Overview 4........... ...... 4 Real Exchange Rate .. . .*. ... . .... Is D. Adjustment in the Agricultural Sector 8 ................ 8 E. The Performance of the Industrial Sector .....10 II. THE POLICY ENVIRONMENT AND THE STRUCTURE OF INCENTIVES .......... 12 A. Changes in the Instruments of Trade Policy ......-... -.... 13 Toward a Liberalized Foreign Exchange Allocation System ...... 13 Elimination of Non-Tariff Barriers .......15 Tariff Reform ....... 17 B. The Evolution of Policies Affecting Domestic Competition ...... 21 Barriers to Entry and Exit .................................. 21 Price Control Policies 23 Barriers to Commodity Trading ........23 Barriers to Manufactured Exports ............24 This report was prepared by Orsalia Kalantzopoulos, Ignacio Mas and Ulrich Thumm. Felipe Jaramillo analyzed the evolution of the agricultural sector. The report is based on the work of three missions. The first took place in June-July 1988, 0. Kalantzopoulos, I. Mas and Deborah Bateman participating. The second took place in January-February 1989 and was comprised of 0. Kalantzopoulos, U. Thumm and F. Jaramillo. The green cover version of the report was transmitted to the Government of Madagascar in October 1989. The report was discussed with the authorities and the analysis was updated in July 1990. Stefano Pagiola's insightful comments and assistance on the tariff analysis is gratefully acknowledged. 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.  TABLE OF CONTENTS (cont'd.) Paae III. IMPACT OF THE REFORMS ON PRIVATE INDUSTRIAL SECTOR BEHAVIOR .... 24 A. Sector-Wide Aspects ..**o.. . *.. o *...**- *... . ......... 26 Effects on Capacity Utilization ................. . 25 Export Orientation ............. ......................... 26 Rationalization of Production ............. . ........... 27 Constraints on Financial Intermediation ...... ............... 27 Management of Stocks .........*.. .*.*. ....* .. ............. 29 labor Costs and Employment ..... ....... ....... 29 Prices and Profit Margins ......*........ . 30 Firm Entry and Exit ....................... ...... ......... 30 B. Subsectoral Aspects .* ...... ..... ** .*........ .... ... .. 32 Textiles ............................... 31 Garment Manufacturing ......... ....... ......... 32 Footwear . ... ....................** 33 Food Processing and Beverages ............................ 34 Tobacco ....... ...** ...... so ....... ... 35 Pharmaceuticals ...*........**...... .**.* 35 Packing Materials ...... . .................... . 36 C. The Supply Response .. *.. ..... *.*.. ......**..... .........* 37 IV. INDUSTRIAL POLICY FOR ADJUSTMENT AND GROWTH IN THE MEDIUM TERM ... 38 A. Completing the Liberalization of the Foreign Exchange Regime ... 39 B. The Credit Constraint and the Efficiency of the Banking Sector ....eoo**... ***.*.**. ....*... 39 C. Tariff Reform and Industrial Incentives *...................... 41 D. Import Tax Administration .* ....... * .. * .... 42 E. The Liberalization of Domestic Activities * .................... 42 F. Export Promotion ......... ......................**. 44 G. Attracting Private Domestic and Foreign Investment * ........... 46 H. Regional Development Strategy ................................. 47 APPENDICES 1. Macroeconomic Tables ..............*.****** *** ** * ************* 49 2. Macroeconomic Figures .........** *....* ........*...*....*. *.* 54 3. Structure of Nominal Protection as of April 1989 .................. 60 4. Firms in Industrial Survey . *......*.* .* * . *........ 62  LIST OF TABLES AND FIGURES pare TABLES 1. Key Indicators, 1960-88 4* ............ .. .....* ...........** *. 4 2. Bank Credit, 1987-88 *............................................ 6 3. Cross-Country Comparison of Manufacturing Value-Added Ind.cators, 1985 ................................ 11 4. Index of Industrial Production, 1970-86 ............................ 12 5. Nominal Protection Rates (2), 1985-87 ............................. 18 6. Nominal Protection Rates (x), 1988-89 ............................. 20 7. Hourly Compensation Costs for Production Workers in Manufacturing for Selected Economies, 1986 ................... 29 FIGURES lo CPI, 1985-88 oo........... 5 2. Real Exchange Rate and Terms of Trade, 1984-88 .................... 7 3. Comparison of Real Exchange Rates, 1985-88 ........................ 7 4. Distribution of Quantitative Restrictions, 1987 ..... .............. 16 5. Nominal Protection in Madagascar: Frequency Distribution of Tariff Rates 1988 and 1989 Schedules ......................... 19  EXECUTIVE SUMMARY i. Madagascar's persistent difficulties since the late seventies can be traced to the economic policies pursued after 1972, which entailed unprecedented expansion of the public sector through nationalization and large-scale investment. This policy of widespread Government involvement in the economy signaled the end of the conservative fiscal policies of the post-independence period. To finance the higher rate of public investment, Madagascar resorted to borrowing abroad and inflationary financing. The results were rapidly growing fiscal sad external current account deficits that peaked in 1930 at about 18 percent of GDP. There was an inevitable and marked annual decline in GDP of -3.6 percent between 1980-83. ii. In 1985 the Government initiated a program of reforms to turn the economy around and resume economic growth. This report assesses the reaction of the economy at the macro, sectoral and subsectoral levels to the program of trade and industrial liberalization and outlines the major areas where further adjustment is needed. The approach adopted was to observe the responses of individual enterprises to the changes in the economic rules. A Program of Stabiliz&t ion and Adjustment iii. To address the country's economic and financial distress, the Government initiated L , :ogram of macroeconomic stabilization and structural reform in 1985, supported by foreign financing, including debt rescheduling. The program has involved restrictive fiscal and monetary policies to contain aggregate demand and structural reforms to improve resource allocation and encourage the resumption of growth. The main objectives of the reforms have been greater emphasis on free market forces and market-based price signals and reliance on private sector initiative. This strategy was seen as leading to: a more efficient structure of production; a greater degree of outward orientation that would solve the recurrent balance of payments difficulties, and greater employment opportunities; the rationalization of the public sector and a greatly reduced role for Government in productive activities; and an economic system with sufficient flexibility to adapt to shifting economic conditions, particularly in foreign markets. iv. The adjustment program initially involved measures in the agricul- tural, trade and industrial sectors aimed at improving the efficiency of resource allocation. The centerpiece of this program was the introduction of a system of more flexible management of the exchange rate so as to maintain the competitiveness of exports and to compensate for the elimination of the major restrictions on external trade. Trade reforms included elimina- tion of all prohibitions and quantitative restrictions imposed for protective purposes and lowering of tariffs. .11 price controls were removed to improve the allocation of resources, realign factor prices in keeping with resource endowments, and encourage adoption of production technologies that reflect the country's comparative advantage in labor. The Government then undertook reforms in the financial and public enterprise sectors. v. Since 1987, the Government has made good progress toward liberalizing the external trade regime. A cumulative devaluation of 52 percent in 1987 in trade-weighted foreign currency terms was followed by the progressive introduction of a market-based Open General License (OGL) system for the allocation of foreigr. exchange. Furthermore, the quantitative restrictions  - ii - and prohibition of imports for protective purposes were abolished. At present, 99 percent of total imports require no licensing, compared with zero percent in 1985 and 20 percent in 1987. With respect to tarlffs, the Government has reduced the maximum import duty from more than 1,000 percent Li 1987 to 70 percent at present, and there has been a rationalization of rates. These measures lowered the unweighted mean rate of trade taxes to 32 percent, down from 45.5 percent. The dispersion of rates across the Harmonized Nomenclature was also reduced; the standard deviation decreased from 35 to 20. vi. To promote competition, the Government liberalized all industrial profit margins, a step completed in early 1989. In the agriculture sector, it legalized private commercial activity and removed all barriers to entry in the marketing of agricultural inputs. Similarly, to promote the expansion and diversification of export activities, the Government has taken a number of measures to eliminate the barriers to exports and simplify the administra- tive requirements. There are no longer any export licensing requirements, all export taxes on non-tiaditional exports have been repealed, and the temporary admission mechanism, while still administratively demanding, has been reinstated. The Results vii. The reforms of the macroeconomic, trade and industrial policy instru- ments have led to significant improvements in the structure of incentives. The overall macroeconomic situation is stable and conducive to adjustment, although debt service payments continue to absorb a substantial share of national savings. The real exchange rate, defined as the relative price of traded versus non-traded goods, has depreciated considerably. The supply effects of the adjustment program are manifested in the increased outward orientation of the manufacturing sector. The successful macroeconomic stabilization and, in particular, the devaluations and the liberalization of imports and exports have stimulated a significant shift in orientation toward external markets. New export activities are characterized by high labor- intensive production technologies. The increased export orientation allowed the garment subsector, for one, to increase production threefold and total employment by about 5,000 jobs between early 1987 and 1989. Between June 1989 and June 1990, an additional 5,000 jobs were created in the export- oriented garment subsector. There has also been significant entry by new firms in the subsectort of the 10 major garment manufacturers in the Antananarivo province, 8 were established after 1986. viii. The extensive reforms implemented since 1985 and in particular after 1987 have resulted in a significant transformation in the industrial sector, which was strongly oriented toward import substitution. Nearly all indus- trial subsectors have achieved higher capacity utilization since the onset of the adjustment program, and firm entry has increased significantly. The industrial survey conducted for this report revealed increasing rationaliza- tion of production and concern for efficiency as a result of the greater competition from abroad. Many firms have sought to economize on the cost of labor and have narrowed the number and diversity of outputs, while others have begun to procure intermediate inputs locally as a means of reducing  - iii - production costs. A direct effect of the increased and improved allocation of foreign exchange has been a reduction in the inventories of imported inputs and spare parts, a shift that has lowered operating costs. Pursuing Further Adjustment ix. In short, the country's competitiveness has improved significantly. Producers have responded favorably, and the scope for further adjustment at the firm level is considerable. Despite the progress, however, remaining constraints are impeding further adjustment. The OGL system of foreign exchange management still requires ex-ante administrative clearances and documentation that are causing delays in obtaining foreign exchange. The service and capital accrunts have yet to be liberalized. Restrictive policies with respect to dividends and the repatriation of foreign capital are discouraging vital foreign direct investment. Remaining distortions in the tariff structure counter the effectiveness of import taxation as an incentive and a fiscal policy instrument. Reform of the financial sector is incomplete; in particular, credit for investment, particularly medium- and long-term, remains inadequate and costly. Entry and exit of firms are still difficult, in part because of the rigidity of regulations governing layoffs and restrictions on closure and bankruptcy. The taxation of export crops is still inappropriate. Finally, some firms appear to be having some success in obtaining continued protection, particularly larger firms with less flexibility, that are having trouble adjusting to the liberalized economic environment. x. In order of importance, swven areas are priorities for further reform: completion of the liberalization of the foreign exchange regime; improved efficiency of the banking sector and greater availability of credit; further reform of the tariff structure and industrial incentives regime; strengthening of the administration of the import tax; further liberalization of domestic activities; promotion of exports; and attraction of private investment, foreign and domestic. xi. With respect to further reform of the current account, the next step is to consolidate the previous measures and to extend them to the service account. The fiche statistiaue d'importations, a type of product-specific license, could be eliminated. Importers need to be able automatically to get foreign exchange for the value of imports of goods and services. Opening up the service account would afford automatic repatriation of dividends, with the resultant benefit of increased foreign investment. In the lo;tger term, the Government might also want to adopt a more liberal capit-al account policy, a step that should be pursued with great caution and initially would require more aggressive management of the exchange rate and perhaps increased balance of payments support. xii. Firms surveyed during 1988-89 identified access to credit as the most important constraint. In 1990, the situation improved considerably; huwever, banks continued to see small and medium-size businesses as higher risks. After 1987, banks stopped extending large proportions of available credit to inefficient and often non-viable public enterprises that could not repay their loans. As a result, the crowding out of the private sector was substantially reduced, and the financial position of banks improved. However, the Government needs to mobilize more domestic resources by  - iv - fostering greater domestic savings. It also needs to strengthen the intermediation of the financial system. Because domestic savings will be insufficient to meet investment needs for some time to come, continuing access to direct foreign investment and credit will be necessary. with safeguards to avoid such possibilities as appreciation of the exchange rate and a decrease in the relative price of capital. Policy reforms in the financial sector should focus on improving the efficiency of the domestic banking sector and further expand the availability of credit to the private sector. The Government will also need to follow closely the implementation of ongoing reforms related to opening up the banking system to the private sector and improved supervision of commercial banks. xiii. Madagascar needs a rational, transparent and effic!-ent tariff schedule that guarantees adequate effective protection for all industrial activities. The resulting tariff structure should be stable over time. It is also important that the Government publicize how it intends to implement the tariff reforms to be in place by 1992 so as to gain the confidence and full support of the business sector. Simplification and reduction of the tariff structure will also help improve the poor current record in tax collection. The Government needs to resist the pressure for continued protection, while -making some temporary provisions to give firms that need it the time to adjust. xiv. Effective administration of the import tax is being impeded by inefficiency and administrative irregularities. In addition, the documenta- tion and approvals required for clearance through customs are very burdensome and time-consuming. Evasion is widespread. The Government needs to streamline the procedures and improve enforcement by customs and taxation agencies. Indirect taxation should also be streamlined in line with the international tax reforms. xv. General principles that should guide further reform of industrial policy are to allow competitive market forces to shape the economy and to give the private sector responsibility for economic growth. The latter requires less regulation by Government and its withdrawal from productive activities. Because restrictions on entry and exit limit competition, they must be eliminated. Other measures include: extending the liberalization to all industrial subsectors and to the service industries; freeing up factor mobility, particularly labor and capital; and rationalizing the public enterprise subsector and restricting public involvement to those activities which the private sector will not undertake and to natural monopolies. xvi. To facilitate the expansion of exporting, the Government may need to implement special measures that give export manufacturers automatic access to imported inputs of world quality at world prices. Examples of such export promotion measures includes strengthening and publicizing to exporters the temporary admission scheme that exempts their imports of inputs from duties; implementing a drawback or similar rebate mechanism; establishing some type of export processing zone; establishing flexible in-bond manufacturing for exports; and providing prefinancing for exports through the financial sector. Mnother pressing need is for reform of the taxation of export comsodities. A clear long-term strategy that defines optimal mixes of crop production and levels of taxation of crops should be developed.  xvii. As noted, the recovery and expansion of the industrial sector will require foreign investment. Remaining constraints nced to be addressed to attract the required foreign capital. The foremost obstacle is uncertainty over the speed and scope of the economic reforms. Second, a liberal policy on repatriation of dividends is essential. Finally, foreign investors will want assurance that the Government will maintain the policy of free enter- prise. Establishment of an Investment Center would ease communication of the Government's intentions, provide easier access to information on potential investments in the country, and facilitate actual investments. The Investment Code might be modified to ?rovide more uniform incentives across subsectors. xviii. The Government objectives on employment preservation and creation can be addressed effectively only through the implementation of a strategy that takes explicitly into account the factor endowments and comparative advantage of the regions. The structural adjustment effort will be greatly served by a public investment program designed on the basis of regiot.al comparative advantage, concentrating on the provision of infrastructure and guided by the actions of the private sector. xix. Policy reforms are necessary but not sufficient conditions for long- term development and growth. Other constraints such as human capital and infrastructure need also to be addressed. Madagascar's unique flora and fauna need also to be protected from environmental damage and their preservation should be secured.  MADAGASCAR: ADJUSTMENT IN THE INDUSTRIAL SECTOR AND AN AGENDA FOR FURTHER REFORMS INTRODUCTION 1. This report analyzes the trade and industrial policies of the Democratic Republic of Madagascar since 1972 and describes the framework of the industrial policy reforms initiated since mid-1987. The aim is to evaluate the effects of the past policy regime and the current liberalization effort on the industrial sector. rhe report identifies the early supply response at the firm level and examines the prospects of the industrial sector in the changing policy environment. It then outlines major areas for further adjustment. The report does not cover in detail policy issues related to the institutional arrangements of the banking sector and the vast public enterprise sector. These topics are covered in the President's Report of the Public Sector Adjustment Credit (P-4780-MAG) and the Financial Sector Credit (P-5076-MAG). 2. Chapter I presents some backgxound on the country and its economy, followed by an overview of Madagascar's development strategy in the 1970s and the stabilization and adjustment process in the 1980s. It points out the implications of the macroeconomic policies for the agricultural and industrial sectors in terms of the constraints and incentives they face. 3. Chapter II takes a closer look at a subset of the policies that shaped the earlier industrialization strategy and how they have evolved in the course of the current economic restructuring. Special attention is given to the trade environment, in particular to foreign exchange allocation mechanisms and exchange rate management, non-tariff barrierb and the structure of nominal protection. 4. Chapter III first examines the effects of the liberalization measures on the behavior of the private sector at the enterprise level. By comparing the private sector's objectives and performance before and after the libera- lization, insights can be gained on the direction in which the economy is going. There is evidence of widespread supply response to the liberalization measures. Firm entry in labor intensive activities has intensified. Similarly, during 1990, there were observable increases in the number of takeovers and restructurings in industrial activities that pre-existed the liberalization. At the same time, new constraints facing the private sector have surfaced. This analysis is carried out on the basis of a survey of enterprises conducted in the field. The second part of the chapter evaluates the adjustment of the various industrial sub-sectors to the new policy environment. 5. The last chapter discusses the issues that need to be addressed to achieve a balanced restructuring of the industrial sector. These issues have been subdivided into foreign exchange liberalization, tariff protection, the financial sector, domestic trade liberalization including improved factor mcbility, export promotion, and attraction of private domestic and foreign capital.  -2- I. THE ECONOMIC SETTING A. Background 6. Madagascar is a large island with an area of 587,000 sq km (km2), sparsely populated by about 12 million inhabitants and endowed with a wide range of natural resources and a variety of soils. Large regional variations in climate and ecology and widely dispersed urban centers are manifest in the blend of traditional and modern activities and a unique ethnic and cultural composition. The population is receptive to innovation, while the administrative and legal frameworks are sophisticated and well- defined. 7. At the same time, Madagascar is one of the i5 poorest countries in the world: its per capita income stood at about US$230 in 1986. Close to 90 percent of the labor force is employed in the agricultural sector, which contributes about 40 percent of GDP and over 85 percent of exports (coffee, vanilla and cloves). The main staple is rice, which is grown in small- and medium-scale private holdings on the Central Highlands and in larger, capital-intensive state-run operations in the western plains. On the positive side, the adult literacy rate is much higher than in countries of a similar income level, and primary school enrollment is close to 00 percent. B. The Changes in Economic Policy 8. Since 1985, Madagascar's macroeconomic and industrial policies have been completely re-oriented in an attempt to reverse the previous system of planned economic management adopted in the late 1970s. Recognizing its limited ability to allocate resources efficiently, the Government has sought to increase its reliance on the market system to promote industry and economic well-being generally. This dramatic shift in policies has profoundly altered the economic environment and incentive structure in which the Malagasy industrial sector operates. Today, the sector is at a cross- roads, as it faces the challenge of restructuring to survive in the new free market system, while minimizing the short-term disruptions that are bound to occur as inefficient, previously protected firms can no longer compete. How quickly and effectively firms move to adapt to the new conditions will provide a good indication of the future of the Malagasy industrial sector. 9. The previous interventionist industrial policy in Madagascar was targeted toward encouraging the development of a self-sufficient national industrial sector. This process was reinforced by the nationalization of large foreign enterprises and a massive public investment program over 1978-80, and was maintained by prohibiting imports of domestically produced goods and imposing quantitative restrictions and tariffs on the remainder of imports. This general environment had deep repercussions on the industrial sector. Heavy protection implied little or no competition from abroad, a condition that was compounded by the minimal domestic competition, due to the system's bias against the entry of new enterprises. The source of this bias was the regime for foreign exchange allocation and other bureaucratic  licensing procedures. Exports were discouraged by restrictions on trade goods deemed to be vital nationally. This inward-looking overall trade regime led to small monopolistic domestic markets. 10. Becduse of the limited number of domestic producers, the Government imposed controls on prices and profit margins that severely distorted the price signals and led to a misallocation of resources. The latter is clear from the inappropriate choices and decisions taken by entrepreneurs and managers of public enterprises, who failed to take economic costs into account in many instances. The evidence is the unjustifiably large size of factories built during the period, which were doomed since inception to operate well under capacity; the range of goods produced, which was not based on any notion of comparative advantage but rather on what was deemed essential for national development; and the technology adopted, which was capital-intensive and required imported inputs and spare parts whose purchase aggravated the foreign exchange situation. 11. In 1982 the Government initiated a successful set of reforms, which the IW supported with standby agreements, aimed at stabilizing the main macroeconomic aggregates. Although stabilization was a precondition to any kind of economic restructuring, it did little to address the underlying problems the economy faced. As a result, in 1984 the Government began a general liberalization of most economic activities, although it pursued the program in earnest only after 1987. The main objectives of the economy-wide and industrial sector specific reforms have been to: put greater emphasis on the marketplace, price signals and private initiative to ensure an efficient structure of production; achieve a greater degree of outward orientation so as to solve Madagascar's recurrent balance of payments difficulties permanently and to provide employment; rationalize the public sector, in particular the large number of public enterprises, the aim being a reduced role for Government in productive activities; and infuse the system with sufficient flexibility to adapt to shifting economic conditions. 12. With respect to the industrial sector, this process, which is still underway, has focused on: (i) adoption of a market-determined foreign exchange allocation regime; (ii) pursuit of an active and more realistic exchange rate management policy; (iii) elimination of all import prohibitions andi quantitative restrictions for protective purposes; (iv) abolition of controls on prices as well as on industrial and commercial profit margins; and (v) simplification of the administrative procedures for exporting. 13. This report analyzes how the Halagasy industrial sector has responded to this dramatic change in environment. The approach is to look at the micro responses of individual enterprises to the changes in the macro rules of the  - 4 - game. A thorough understanding of the macroeconomic environment currently affecting the industrial sector should help establish the content and phasing of future reforms. C. The Current Macroeconomic Policy Framework Historical Overview 14. Madagascar's current macroeconomic policy framework has to be seen against a historical background marked by stagnation and decline as a result of poor macroeconomic management and inefficient resource use. For a little more than a decade after Independence (1960-72), Madagascar enjoyed modest economic growth of about 2.7 percent per year, which resulted in a marginal increase in per capita GDP of 0.3 percent per year. The reorientation in economic policy after 1972, best characterized by a sharp expansion of the public sector through nationalization and new large-scale investment, translated into economic stagnation and eventually decline. GDP expanded by an annual average of only 0.9 percent during 1972-80 and then declined markedly by -3.6 percent per year during 1980-83 (with a drop of nearly 10 percent in 1981). With high and accelerating population growth, this trend resulted in a continuous fall in per capita GDP of -1.5 percent per year during 1972-80 and -6.3 percent per year during 1980-83. With the onset of economic reforms and improved macroeconomic balances since 1983, a modest recovery of growth has been underway. As a result, annual GDP growth averaged 2.4 percent during 1983-89. However, per capita GDP continued to drop by an annual average of 0.4 percent. In 1989 it was about 31 percent lower than in 1960 and 34 percent lower than in 1972. Private consumption per capita fared even worse: in 1987 it was 36 percent below its 1960 level and 38 percent below the 1972 level (Table 1). Table 1: MADAGASCAR -- KEY INDICATORS, 1980-89 (av-erage annual growth rates, percentage) 1980-72 1972-80 1980-89 1983-89 GDP 2.7 0.9 -3.6 2.4 Agriculture 1.4 0.7 0.7 2.9 Industry 8.8 1.6 -12.4 4.1 Services 2.2 0.8 -8.9 1.7 Private Consumption 2.5 -0.6 -4.7 0.6 GDP per capita 0.3 -1.6 -6.8 -0.4 Private Consumption per capita 0.1 -1.9 -7.4 -2.2 1980 1972 1980 1988 1987 Industry as X of Current GDP 9.8 17.0 WiT. 13.6 14.4 Source: World Bank estimates, based on data provided by the Malagasy authorities. 15. The pattern of development during the 1960-83 period was characterized by the stagnation of agriculture, an attempt to shift to accelerated, mainly domestic market-based, industrialization, and expansionary macroeconomic policies. This pattern resulted in mounting fiscal deficits and unsustainable current account deficits in the balance of  - 5 - payments after 1977/78. Resource use was very inefficient, as reflected by an extremely high ICOR (incremental capital output ratio) that approached 30 during the 1972-80 period. 16. The policy reforms undertaken since the early 19808 to correct the major imbalances have brought about improvements. The fiscal deficit was reduced from its peak of over 18 percent of GDP in 1980 to about 3.3 percent in 1986. During 1987-88. the fiscal accounts have been relativo.ly stable. The fiscal deficit has been stabilized, albeit at a slightly higher level of about 4.1 percent of GDP (mostly because of minor slippages on the revenue side). In parallel, the current account deficit on the balance of payments, which had stood at about 18 percent in 1980, was brought down to 9 percent in 1986 and has remained at that level. The fiscal adjustment was mainly achieved through reductions in current and capital Government expenditures. At the same time, the Government devalued the exchange rate and managed it in a more flexible manner, and began progressively to liberalize domestic prices. The sharp fiscal adjustment during the early 1980s was accompanied by a significant drop in GDP. The continued efforts at reform led to some economic recovery that accelerated in the late 1980s. In 1987. GDP growth was estimated at 1.2 percent, and in 1988 at 3.8 percent, or faster than population. In 1989, GDP grew by 4.9 percent. 17. By 1986 the macroeconomic balances had improved substantially. The fiscal and monetary policies were conducive to an improved external balance, and the restrictive monetary policy allowed the build-up of international reserves. Inflation experienced a marked acceleration during 1987 because of the exchange rate devaluation, but has since been brought under control: after averaging 9.4 percent per year during 1983-86, it increased to 36.8 percent during 1987 (December 198? over December 1986) and slowed to the predevaluation level of 9.4 percent during 1988 (as measured by the consumer price index [CPI]) (Figure 1). Figure 1: MADAGASCAR CPI, 198I-$ JUNE V67T-0O 1601 110 .. . .....- 90 . ............... . 5 8 70 *I. *IjIIBjSII ItIi,I8.IIIItItin j3*I.u.ijuui I 6 % 9 I %8 1 j I %. MONT WYEAR - opi Sourc: Malagasy authoritles  - 6 - 18. The Government has also pursued prudent domestic credit expansion for a number of years. Indeed, credit was very restrictive during 1987-88. Net cred.t to the Government was reduced in absolute terms as a result of the prudent fiscal policy and plentiful eAternal financing. Credit to the most critical state enterprises was frozen or even reduced, while it was expanded somewhat for private sector enterprises (see Table 2 and Appendix Tables lb-ld). The credit restrictions on the public sector enabled the banking system to increase credit to the private sector by almost 12 percent in real terms during the second half of 1988, thus preparing the ground for a possible acceleration in economic recovery. Credit to the private sector has gone mostly to meet short-term financing needs. However, medium- and long- term credit has stagnated in real terms, probably because of both a lack of demand (given the overall stagnatior of the economy and the existence of spare capacity) and a lack of supply. It is evident from the monetary statistics that the banking system has not been able to mobilize longer term resources (quasi money has actually declined relative to GDP since 1986), and the expansion of credit to the private sector has been largely financed through the withdrawal of excess reserves at the Central Bank. The problem of resource mobilization obviously is related to the country's overall savings capacity, which has been constrained by the deterioration in the terms of trade in recent years, and to rigidities in the level and structure of interest rates as a result of the lack of competition in the banking system. Table 2: MADAGASCAR -- BANK CREDIT, 1987-88 (billions of June 1987 FMG) March 1987 June 12aSepeme Dcob-r 1987 Public Private Total Public Privaet Total Public Priv`t. Total Public Private Total Short 150 1S6 338 145 185 aso 147 1SO 327 ? 119 1 232 Med;ua 25 12 37 28 11 40 23 11 aS 21 S1 31 Laig 20 10 S0 20 1I 82 25 18 38 21 1i 32 Tote I 19 206 403 194 208 402 1o6 205 401 160 1I5 846 MARCH12A 1988 SEPEMER lCS1s DECEBER 198S Public Privet ToteT Pubiic Privet. Total Public Privats Tota l Public Privet. Total Short 128 167 289 S5 179 264 97 198 295 101 195 296 Nedius 20 1: 31 14 11 25 1, 13 27 14 1e 30 I.oflg 22 1l 34 23 13 36 25 14 38 25 13 S 7 TOTAL 165 189 3S4 122 203 825 i 186 224 860 15 22 We Source: Date provided by Malagasy authoriti"; 1forld Bonk etimates. Real Exchange Rate 19. To improve the current account of the balance of payments, a change in the real exchange rate had to take place. That improvement has been achieved by maintaining greater flexibility in the nominal exchange rate for a number of years and, in particular, the significant devaluation in June 1987. The real effective exchange rate--the trade-weighted nominal exchange rate adjusted for the inflation differential between Madagascar and its trading partners--has depreciated substantially since 1983, most markedly since the middle of 1987 (Appendix 2, Chart 2b).  - 7 - 20. The real effective exchange rate is based on the purchasing power parity (PPP) approach. While it gives some rough indication of the development of the country's competitiveness vis-a-vis its trading partners, a more relevant concept of the real exchange rate--from a general equilibrium and resource allocation point of view--is the price relation between traded and non-traded goods in the domestic economy. Analysis of this key variable is, however, hampered by lack of data.1 However, an attempt was made to construct time series of price indices for traded and non-traded goods based on a detailed breakdown of the CPI. (The results of this analysis are shown in Figures 2 and 3 and Appendix 2, Figure 2c). The real exchange rate so defined changed significantly over time. Movements in the terms of trade played some role. However, price rigidities, mainly resulting from the price controls, prevented the real exchange rate from fully adjusting until the progressive price liberalization began. There has been significant depreciation since mid-1987: between June 1987 and December 1988, the real exchange rate fell by about 15 percent, a rate of decline, however, that is not as marked as that based on the PPP-based real effective exchange rate (Figure 3). FIgure 2: REAL EXCHANGE RATE AND TERMS OF TRADE, 1984-88 Jgwe?-=O 120 -_ _ _ _ tic ------- ttOt ______ __________________1 00l 70 4r May 6r ma7 e May Jr 51 Mos m 4sY r ell I Month/Yea Twie- oft Tred - RER Tenms of TSde - Price of Imports/Price of Exports RER * P1e of enldwutro . Pets of trwoom seam tb0 Md 'fWm wAt ws nmu FlaTsur : COMPARISON OF REAL EXCHANGE RATE, 1985-88 3t Semesltr VS?-10 120 _ 00c.--1-------1 --- -----1- 4Jr May 8o Jr 7may apr May so0 p4 may as Month/Year -RPAl En E PR -RER wi doe -RIRW a rla lacteros - Appr.ciLtion ~td Soft nOnion 11 The only price index available in Madagascar is the CPI, which, since it is based on Antgxianarivo only has serious limitations. Ideally, estimates of the real exchange rate as defined above should be based on producer prices.  - 8 - 21. Since rice is a major item in the CPI, the domestic price of rice, which continues to be distorted by Government intervention in the market, significantly influences the real exchange rate. For illustrative purposes, the real exchange rate was also calculated without rice (Figure 3). Comparing the two real exchange rates, it is evident that the prices for traded goods other than rice have increased faster than rice prices relative to the prices of non-traded goods. 22. By any measure, the real exchange rate has depreciated significantly during the past two years. However, whether the resulting rate is at a sustainable level is open to question. Given that Madagascar's non- traditional exports have expanded by almost 17 percent per year in current SDR terms during 1987-88, it could be concluded that the country's competitiveness has improved substantially.2 The development of non- traditional exports has not, however, been sufficient to compensate for the shortfalls in traditional exports (see Appendix 2, Figure 2d). Nor has it been sufficient to produce a current account balance that does not require continued resort to debt rescheduling. 23. Other factors to be taken into account when judging the adequacy of the real exchange rate level with regard to a sustainable current account balance are: (i) the fact that dividend payments and capital transactions continue to be restricted; and (ii) the level and structure of protection. Payment restrictions are probably the main reason for the parallel market in which foreign currencies (mainly the French franc) are traded at a 20-30 percent premium above the official market rate. Progressive liberalization of foreign investment-related payments and reductions of effective protection, which form part of the Government's medium-term policy intentions, might well require further adjustment of the real exchange rate. 24. The real exchange rate (conceptualized as the relative price of traded versus non-traded goods) is the key real variable to bringing about macroeconomic balance. It is obviously dependent on the trade regime (i.e., on quantitative restrictions, tariffs, export taxes and the flexibility of domestic prices) and the magnitude of the current account balance that is considered sustainable. In managing the nominal exchange rate in the future, the above measure of the real exchange rate should also be taken into account, along with other variables now being considered by the Central Bank. It is also important to collect better and more relevant price data for a more meaningful measurement of the real exchange rate. D. Adjustment in the Agricultural Sector 25. Agriculture is Madagascar's most economically significant sector, accounting foc 35 to 40 percent of aggregate production and. the majority of employment and export revenues. During the 1980s, the proportion of the 2/ There is a close connection between changes in the real exchange rate and export performance. For example, empirical studies indicate that, on average, in Sub-Saharan Africa a percentage point appreciation in the real exchange rate reduces agricultural exports by 1 percentage point.  labor force directly employed in this sector has remained high, at around 87 percent. Agriculture has been required to absorb most of the increase in the labor force, given the lack of alternative employment options. Malagasy agriculture remains concentrated on a small number of products. Rice is the major consumption staple, while coffee, vanilla and cloves usually account for 60-70 percent of the annual export revenues. 26. As in the case of industry, agriculture was characterized by a large and increasing government role during the 1970s. Marketing of major food crops such as rice was nationalized during that period, and prices were see administratively by the government. An attempt to decentralize the provision of agricultural services through local government reform had severely damaging effects on the provision of such services. Agriculture also suffered from the higher priority accorded to industry by the Government, which channelled public resources and foreign exchange into the latter sector. To further favor the industrial sector and extract resources from agriculture, the price of rice--the staple crop in Madagascar--was kept below import parity, while high implicit taxes were levied on export crops. As a result, average annual agricultural sector growth during the 1970s was only 0.6 percent, well below the estimated population growth rate of about 3 percent. 27. The Government began liberalizing internal trade in rice in 1983 (except in the major surplus regions of Lac Aloatra and Marovosy, where deregulation only occured in 1986). In 1985, official maximum producer prices for paddy were replaced with floor prices, effectively letting market forces determine the producer prices. Floor prices for paddy, wheat, soybeans, and coffee and fixed prices for sugarcane and cloves were replaced by indicative prices in 1986-87. On the consumer side, retail prices for rice were decontrolled in 1987. Official distribution of rice was abolished in 1987; public sector rice imports were channelled exclusively through the buffer stock, whose purpose was to limit price fluctuations during the dry season or under exceptional weather conditions, and to supply certain segments of the population. Internal and external trade liberalization for export crops began in 1988. The state monopoly on agricultural exports was eliminated on all crops except vanilla. 28. Liberalization has resulted in a slight revival of agricultural growth.3 Since 1984, average annual growth in agricultural sector has increased to 2.8 percent per year, a marked improvement over the level of the 19709 but still not enough to compensate for the high population growth rate. However, this figure masks a wide disparity in the performance among sub-sectors. Most of the growth has been concentrated in the fisheries sub- sector, which has been growing at an average annual rate of 4.9 percent, and to a lesser extent in livestock. By contrast, crop production has grown at a more modest annual rate of 1.5 percent. 31 In addition to the policy changes described above, agriculture has been hit by substantial exogenous shocks, including large swings in the price of coffee and a decline in clove prices due to increasing production in Indonesia, the most important importer.  - 10 - 29. The performance of the fisheries sub-sector is due primarily to its export orientation, its openness to foreign investors and know-how, a low level of taxation, and the presence of a significant comparative advantage (large, hitherto under-exploited, natural resources and low labor costs). Increases in crop production have been ham?ered by the very poor state of supporting infrastructure. This is particularly true in the high-potential regions which are oriented towards export crops (East Coast and Northern Provinces), which have historically been neglected in terms of investments in infrastructure relative to the rice-producing regions of the Hauts Plateaux. Indeed, among crops rice has had the most marked supply response. 30. Recent years have also seen a slight revival of private investment in the agricultural sector. For example, a- agroprocessing industry is taking over the green pepper fields, abandoned since 1969, belonging to a bankrupt French company. Foreign and some domestic investors have also begun producing lychees, pickles, and ducks (for foie gras) for export. Such investment has occurred only in areas better served by infrastructure. Japanese and French investors have also been active in the fisheries sector, particularly in shrimp and lobster fishing. 31. Agriculture provides important inputs into several industrial sub- sectors, and particularly into textiles and food processing. Liberalization in the industrial and agricultural sectors should have allowed the develop- ment of profitable linkages between the two sectors. However, deficiencies in infrastructure and the continuing role of the Government in some sub- sectors have proved a major obstacle to such linkages. Cotton, for example, continues to be controlled by a Government monopoly, HASYMA, which has had a very poor record in terms of output quality and supply reliability. Poor infrastructure has aggravated the problems faced by the food processing industry in acquiring raw materials of acceptable quality on a timely basis. 32. Trade and marketing reform has been an important first step on the path to vigorous supply response and the development of effective linkages between industry and agriculture. However, further growth will require additional reforms to remove remaining Government monopolies, such as that in cotton, and measures to address the structural problems faced by the agricultural sector. particularly in terms of infrastructure. E. The Performance of the Industrial Sector 33. The initial reaction of aggregate Jndustrial production to the correction of macroeconomic imbalances and the system of incentives has been anemic. Industrial output stagnated during 1985-87; growth accelerated only slightly in 1988. Overall employment (in the modern sector) stagnated, with minor increases taking place in the service sector (see Appendix 2, Figure 2a). 34. The Halagasy manufacturing sector is smaller in size than those of other low-income countries in Sub-Saharan Africa, accounting in 1984 for about 11 percent of GDP (Table 3). The contribution of manufacturing to domestic output has been almost constant since 1972, the year the Government brought the industrial sector under direct state control. The industrial sector, which accounted for 2 percent of total employment in 1960, increased  - 11 - its share to 4 percent by 1980. Manufacturing is concentrated in light industry: production of consumer goods contributed about 83 percent of manufacturing output in 1985. This concentration ratio is much higher than that in other low-income African countries. Intermediate and capital goods have been a negligible and decreasing part of manufacturing production, while the heavier industries (metals and machinery, electric and transport equipment) accounted in 1985 for less than 11 percent of manufacturing output. Table 8: CROSS-COUNTRY COMPARISON OF MANUFACTURING VALUE-ADDED INDICATORS, 1985 Uadagascar Senegal Zambia Manufacturing Value Added (1984 US$ billion) 0.8 0.4 0.6 Share of Mfg. Value Added In Total CDP 11.0 16.5 20.9 X Shere of Mtg. Output: Light Industry 82.6 67.2 64.3 Non-Metal Minerals 1.4 6.0 6.7 Heavy Industry 10.8 24.0 24.6 Other Mfg. 5.2 3.8 4.4 Growth of Mfg. Value Added 1972-85 (X p.a.) 0.7 11.7 -2.6 Growth of CDP per Capita 1965-85 (X p.a.) -1.6 -0.6 -1.8 Source: IENIN data base. 35. In 1984, of a total of about 360 manufacturing establishments in Madagascar (excluding artisans), the Government controlled approximately 50, which accounted for 75 percent of the manufacturing productive capacity and about 60 percent of manufacturing value added. A large number of enterprises over which the state had majority control were classified as strategically important to development and fell under the special status of 'socialist enterprises." Investment and resource allocation decisions involving public enterprises were based upon perceived social needs and regional and political considerations. Public enterprises enjoyed privileged access to credit, foreign exchange and imports. 36. Table 4 shows the structure and performance of the industrial sector. Industrial production was weak in the early 1970s, with little or no growth. Implementation of the inward-looking strategy led to an increase in production in 1974. The next burst in industrial activity peaked in 1979 with the introduction of the ambitious public investment program. This all- out investment program primarily fueled import demand, with a lesser effect on domastic demand.  - 12 - Table 4: MADAGASCAR, INDEX OF INUSfRIAL PRCDUCTION, 1970-86 (1981 = 100) 1982 1970 1974 1979 1982 19W weights Beverges, Tobacco 83.8 126.6 116.7 121.9 79.6 145.4 Textiles, Clothing, Leather 63.a 70.7 106.2 107.4 90.6 68.2 Wood, Rubber A Products 1.7 144.1 107.5 126.0 86.9 163.0 Paper A Printing 6.6 91.1 111.0 117.4 96.3 91.2 Chemicals A Petroleum 4.1 90.6 127.1 161.8 78.6 84.9 Other (excluding mining) 0.6 817.6 208.1 142.6 108.8 283.9 General Index 94.8 111.0 116.7 86.7 99.3 Source: Date provided by the authorities. Nots: The a mple of enterprIs s is constant over time and thas Ignores the entry of new fir ms. 37. Although production remained high for a few years after the beginning of the inward-looking period, a downturn became obvious by 1980 and lasted until 1982, by which time industrial production had dropped by 25 percent from its 1979 peak. Even though some subsectors benefited initially from the import-substituting policies, the overall effect of these policies was negative. The restrictive stabilization measures further exacerbated the effect of the inwrard-looking policies. Among the subsectors hardest hit were food and beverages, chemicals and construction materials. 38. The import-substitution strategy was designed specifically to promote the industrial sector. It was a failure and necessitated the reorientation in economic policies. As Table 4 shows, industrial activity has already demonstrated signs of responding to the liberalization policies: since 1982 the index of production has risen modestly but steadily. 39. These statistics on the performance of the industrial sector serve as a bottom-line summary of the impact of the pre- and post-1982 policy environments. Subsequent sections analyze in greater depth the relationship between the policies and the resulting pattern of industrialization at the enterprise and subsectoral levels. II. THE POLICY ENVIRONMENT AND THE STRUCTURE OF INCENTIVES 40. Acknowledging the importance of a more neutral incentives regime, Madagascar embarked on an extensive program of structural reform to restore and sustain growth in the medium term. The objectives of the program were defined and internalized by the Government in the context of discussions and research on the structure of industrial incentives. The determining factor conditioning the success of the liberalization program haa been the sustained commitment of the Government to the policy reform. It also used the four years between starting the discussions and implementing the major liberalization steps to try to develop the requisite commitment within the public service and throughout the economy. At first, most of the private sector, having been affected negatively by the previous administered regime,  - 13 - supported the program. But as the liberalization effort widened, the traditional import substituting industries felt the increasing pressures of international competition and began to oppose the program. As industrialists witness the potential benefits of increased exports, however, they have returned to a more positive attitude. A. Changes in the Instruments of Trade Policy 41. The liberalization of the external trade regime has involved reforms of both import and export policies. This section documents the major changes since 1987. Toward a Liberalized Foreign Exchange Allocation System 42. Since the mid-1970s, when the Government shifted toward a planned system of resource allocation, it has used administrative controls to allocate foreign exchange. Policy-makers shared the belief that national objectives could better be met by direct allocation of foreign exchange than by the decentralized decisions of producers and consumers responding to market signals. 43. The system of administered foreign exchange allocation required thousands of decisions that affected hundreds of firms in each period. The system was inefficient and inflexible and placed excessive burdens on scarce administrative resources. It also provided significant rents to successful foreign exchange applicants, creating substaDtial incentives for enterprises to lobby for increased allocations. The dual effect was to encourage firms to intervene in the decision-making of the exchange control authorities, a situation that imposed further administrative burdens, and to foster the stockpiling of undue quantities of imported inputs when foreign exchange could be obtained. 44. A foreign exchange system that operated across the board and did not discriminate between activities or end users was needed. In January 1987, the Government took a first step in this direction by introducing the Liberalized Import Regime (LIR) to allocate foreign exchange in a manner more responsive to market demand. The regime covered imports of consumer goods, raw materials, small equipment and spare parts. Foreign exchange was made available by end-use product category. Importers made monthly bids for foreign exchange for a nominal, non-refundable fee levied on the total amount of foreign exchange requested. The fee, calculated as the ratio of foreign exchange requested to foreign exchange granted, stood at about 30 percent in the first four months of 1987. It gradually decreased after September 1987, when tie monthly foreign exchange allocation was increased from SDR 7 million to SDR 12 million and the product categories were unified into a single basket that also included imports of equipment. In parallel with the introduction of the LIR, the Government devalued the Malagasy Franc by 36 percent in trade-weighted foreign currency terms in June 1987 and by a cumulative 52 percent for 1987 as a whole. 45. In July 1988, the Government extended the foreign exchange policy reforms by implementing an Open General License (OGL) system. 'Inder this system, the exchange rate follows a crawling peg, managed according to  - 14 - certain indicators, including the availability of adequate levels of free reserves. All economic agents can participate in this market to obtain unlimited amounts for trade purposes. The Government phased in the OGL system between February and June 1988, to allow for a smooth transition. During the first few months of the OGL, the Government requested 100 percent cash provisioning for all foreign exchange requests in an effort to discourage demand. It eliminated this rule in May 1988 to stimulate use of the OGL. 46. The reform of the foreign exchange allocation regime has been a major step toward a more efficient allocation ot scarce resources. The introduction of the OGL has been instrumental in removing the discriminatory element in foreign exchange allocation. Nevertheless, however non- discriminatory, the system is still characterized by inflexibility and is limited in scope. Companies have to specify their foreign exchange requests at the 10-digit nomenclature level in a fiche de statistiques. Substitution across products is not possible. The processing time for an application is about two weeks on average, and a minor inconsistency or mistake in the application can easily double this time. Enterprises have to go through the fiche statistique d'importations process every time, regardless of the amount requested. 47. Further, the OGL covers only imports of goods. The service account remains completely closed. As a result, most foreign exchange demand for services such as trips, expenditures for international courier services as DHL continues to be financed through the parallel market. The unavailability of foreign exchange for business travel or for participation in international product fairs is a major barrier to entry into the export markets. 48. The natural barriers to competition are higher in the export than in the domestic market, mainly because marketing and know-how are more complex and expensive for exporters to acquire than for domestic firms. While the Government seems to recognize these difficulties, in practice the foreign exchange regulation system increases the risks of doing business in the export market. For example, exporters must repatriate the foreign currency from the proceeds of exports within 90 days from the day of the export. If they fail to do so, even for reasons beyond their control, e.g., theft or damage of the mercheodise or lack of payment by the client, they are prosecuted and may be imprisoned. 49. In the past, overall demand management has been restrictive. This was achieved partly by limiting the amount of credit available for financing foreign exchange purchases. The reduction in the Central Bank discount rate in July 1988 and the increase in the credit available to the private sector suggest that the credit situation is now more relaxed. 50. Government policies with respect to dividends and repatriation of foreign capital still have an adverse effect on private sector behavior. According to the investment code, foreign investors can repatriate dividends or capital in line with regulations an's the availability of foreign exchange. However, the Central Bank and Treasur3 are only now authorizing repatriation of 1983-85 dividends and only at today's exchange rate. While the Government does appear willing to negotiate preferential regimes for repatriation of  - 15 - dividends for important foreign investments, thiu discriminatory practice discourages the small investor who, by nature, would be more suitable to the Malagasy environment. 51. A final point is that the present exchange regulations, although designed to reduce foreign exchange outlays, achieve the opposite. As a rule, entrepreneurs over-_nvoice imports and under-invoice exports in order to create a buffer amount in foreign savings abroad. This practice is a sine aua non for covering future risks in the export market or for capital/ dividend flight. Elimination of Non-Tariff Barriers 52. In the past, the prices of imported goods in Madagascar were substantially higher than tariff protection alone could explain. The reason was that they embodied the rents generated from the quantitative restrictions and foreign exchange shortages. Prior to the liberalization, quantitative restrictions applied to all imports, with goods classified under three major categories (the distribution of the three product categories by sector is presented in Figure 4): (i) Prohibited imports included all products and their derivatives produced within Madagascar. The prohibitions amounted to 23.1 percent of the merchandise import nomenclature (496 items) and 100 percent of local output. (ii) Authorized imports were planned import allocations based on enter- prises' historical uses of foreign exchange. The Central Bank and the Council of Ministers issued detailed annual guidelines, and the sectoral ministries made specific allocation decisions covering the areas under their jurisdictions. The Ministry of Commerce then cleared all licensing decisions, revised them according to global foreign exchange availability criteria, and communicated all the allocation decisions to firms and overseas importers. (iii) Liberalized imports (a total of 964 items, or 44.9 percent of the nomenclature) were, despite their title, under similar restrictions as authorized imports except that they did not require approval by the sectoral ministry. 53. In January 1988, the Government eliminated all non-tariff barriers on imports, although it did institute a temporary 30 percent surcharge on some previously prohibited imports to ease adjustment in these sectors. Even so, import-substituting firms ar^ finding the liberalization abrupt and have requested time and additional protection in order to adapt to a trade environment with no protective quantitative restrictions or prohibitions on imports. 54. The request of the textile industry for a system of reference prices for imports is unsettling. Since the elimination of the import prohibitions, this subsector has faced competition from imports of fin de serie products whose prices are deeply discounted. Because of seasonality and fashion trends, foreign producers are willing to sell the remainder of a pa .ticular  - 16 - production run at prices well below normal prices, and maybe even below marginal costs the opportunity cost of these sales for the producer is very low, so that he is willing to sell to the highest bidder at any price. Under these circumstances, even full ad valorem protection at the scheduled rate offers Malagasy producers very limited protection. Malagasy producers are arguing that these below-cost sales are *anomalous' and merit special protection because they undermine production; they draw a parallel with dumping, a practice that is punished internationally. Unfortunately, neither the industry nor the Government has estimated the magnitude of these imports or their impact on domestic production. Flour. 4: DISRI ON OF QUANTITATIVE RESTRICTIONS, 1987 OSipBun OF LnUS fROUC BY S9=OR too so 602 4W~~~4 40. A 20 . tS 32* ,~~~~~ . 60 '60~~~~ CEnMDJN OF ROHED 5R= SY SMCOR C5gBr