Tunisia - Country economic memorandum : the road to an outward oriented economy (Vol. 1 of 5) : Main report

Report No. 8044-TUN Republic of Tunisia Country Economric Memorandum: The Road to an Outward-Oriented Economy (In Five Volumes) Volume IlI: Annex 2 The Tunisian Financial System in Support of Investment March 1990 Country Operations Division Country Department 11 Europe, Middle East and North Africa Region FOR OFFICIAL USE ONLY Document of the World Bank This document has a restricted distribution and may be used by fecipier.ts only in the performance of their official duties Its contents may not otherwise be disclosed without World BOk authorization.  CURRENCY EQUIVALENTS SDR 1.00 - dinars (TD) 1.2245 (as of April 1989) Official exchange rate: Dinar (TD) Per US Dollar Period End of Period Period Average 1973 0.4451 0.4200 1974 0.4065 0.4365 1975 0.4253 0.4023 1976 0.4309 0.4288 1977 0.4121 0.4290 1978 0.4034 0.4162 1979 0.3959 0.4065 1980 0.4187 0.4050 1981 0.5157 0.4938 1982 0.6158 0.5907 1983 0.7271 0.6788 1984 0.8666 0.7768 1985 0.7570 0.8345 1986 0.8402 0.7940 1987 0.7779 0.8287 1988 0.8985 0.8578 1989 0.9446 (Sept.) 0.9642 (Sept.) Source: IMF, International Financial Statistics, July 1989 FISCAL YEAR January 1 to December 31  FOR OMCIL USE ONLY GLOSSARY OF ABBREVATIONS APB Association Professionnelle des Banques (Professional Association of Banks) BCT Banque Centrale de Tunisie (Central Bank of Tunisia) Billets de tresorerie Commercial paper Bons d'Equipement Treasury Bonds (Government bonds) Bons du Tresor Treasury bills CD Certificate of deposit CENT Caisse d'Epargne Nationale Tunisienne (National Savings Bank) CMT Complexe Mecanique de Tunisie CNEL Caisse Nationale d'Epargne-Logement (Housing savings fund) CPG Compagnie des Phosphates de Gafsa Emprung national Savings bonds GC Groupe Chimique IRC Imp6t sur les revenus des creances (Tax on income from credit) IRVM Imp6t sur les revenus des valeurs mobilieres (Tax on income from marketable financial instruments) PPG Public and publicly guaranteed SNCFT Societd nationale des chemins de fer tunisiens (National Railways company) STEG Societe tunisienne de l'electricit6 et du gaz (Electricity & Gas Company of Tunisia) STIA Socidt6 tunisienne d'industrie automobile (Tunisian automobile industry) VAT Value added tax UNDP United Nations Development Program WPI World Price Index 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.  COUN1TRY DATA SIINZT FOR 1988 General Area (km2) (Thou.) 163.6 Population (millions) 7 8 Growth rate (latest decade) 2.6% p.a. Density (per kW2) 91 Social Indicators Population Characteristics Crude Birth Rate (per 1000) 32 Crude Death Rate (per 1000) 9 Health Infant Mortality (per 1000 live births) 8 Population per Physician (Thou.) 3.6 Population per Hospital Bed (Thou.) 0.5 Income Distribution (% of national income) Highest Quintile N.A. Lowest Quintile N.A. Distribution of Land Ownership X Owned by Top 10% of Owners N.A. % Owned by Smallest 10% N.A. Access to Safe Water X of Total Population 89 % of Urban Population 98 X of Rural Population 79 Access to Electricity I/ X of Total Population 34 X of Urban Population 68 X of Rural Population 6 Nutrition Calorie Intake as X of Requirements 111% Per Capita Protein Supply (g/day) 77 Education Adult Literacy Rate (%) 62% Primary School Enrollment (X of relevant age group) 118% 1/ Latest figures available are for 1975.  -OSS m Lrr - 1988 1988 Armnutl Growth Rate- 2 n.a. 1980 Price?) US$Z4 % of GNP 1976-81 1981-86 1987 1988 GNP at Mtarket Prices 9536 100.0 6.22 3.3Z 5.7Z 1.41 Gross Domestic Investmbnt 1914 20.1 6.6X -4.3t -9.5% -8.92 Gross National Savings 1937 20.3 11.98 -7.1X 37.4X -2.4% Current Account Balance 23 0.2 Exports of Goods & NFS 4732 44.4 8.52 1.4Z 14,0% 19.52 Imports of Goods & RIS 4227 44.3 10.8S -2.4X -4.22 16.2% GNP per capite (US$M) 1210 WTPUT, 8ELOIn, A PRD EaTVITY Value Added F.C. Labor Force in 1988 in 1988 UM$M 2 of Total Thousands 2 of Total Agriculture 1174 13.4 481 24.4 Industry 2e92 33.1 678 34.4 Services 4667 53.5 811 41.2 Total/Average 8734 100.0 1970 100.0 w_v ne Central Government Mill. Diners 2 of GDP 1988 1988 1983 Current Receiits 2482 28.8% 31.2X Current Expenditures 2011 23.32 25.3X Current Surplus 471 5.5% 5.9X Capital Expenditures 934 10.8% 13.92  MHNEY, CREDIT, AND F8ICES 1983 1984 1985 1986 1987 1988 (November) (millions of Dinars, outstanding, end of period) I i Money Supply 1/ 2431 2715 3091 3266 3713 4137 Credit to Government 354 451 554 627 721 616 * Credit to Economy 2558 2908 3381 3635 3878 4148 * 1983 1984 1985 1986 1987 1988 ! (percentage or index numbers) Money as I of GDP t/ 44.2 43.5 44.7 46.5 46.4 47.9 General Price Index (CPI) (1980-100) 136.6 148.0 159.5 169.3 183.3 196.4 Annual parcentege changes in: General Price Index (CPI) 9.5 8.4 7.8 6.2 8.2 7.1 Credit to Government 15.5 27.3 23.0 13.2 15.0 -14.6 Credit to Economy 19.9 13.7 16.3 7.5 6.7 7.0 BALANCE aF PAYMTS 1984 1985 1986 1987 1988 (millions of USS) Exports of Goods & NFS 2721.04 2699.94 2721.91 3374.08 4232.21 Imports of Goods & NFS 3659.24 3207.07 3363.98 3490.41 4226.74 Resource GOp (doficlt = -' -933.21 -50?.13 -e42.07 -11'43 5,47 Interest Payments -264.28 -269.29 -330.56 -357.73 -420.25 Otber Net Factor Payments 10.03 -82.42 -91.10 -111.44 -82.08 Net Private Transfers (incl. WR) 317.07 270.22 358.82 486.91 519.77 of which: Workers' Remittances 316.56 270.58 361.59 486.30 511.63 Current Account Balance excl. Net Official Transfers -875.39 -588.62 -704.91 -98.59 22.91 Net Official Transfers 28.58 36.55 40.55 34.51 52.33 Current Account Balace incl. Net Official Transfers -846.81 -552.07 -664.36 -64.08 75.24 Direct Private Foreign Investment 205.97 139.48 155.04 92.31 110.47 Net MLT Loans (DRS) (excl. IMF) 358.47 307.56 265.00 61.93 60.05 Disbursements MLT PPG 767.58 744.39 785.51 718.51 805.38 Repayments MLT PPG 409.11 436.82 520.51 656.58 745.33 Other LT inflows NG (net) 82.00 24.51 3.96 -24.30 9.30 Other Net Capital & Capital n L .i. 50.65 -32.13 48.04 50.58 93.79 Total Change in net reserves 149.72 112.64 192.32 -116.45 -348.84 Gross Reserves (incl. Gold) (IFS) 463.95 293.85 378.40 616.03 985.00 1/ Money and quasi-money of Monetary Survey only. 2/ Change in net reserves from Tunisian BOP; including use of IMF Credit.  r25 UDI8G P2YRS (AVAGF. 1984-88) Value (millions of USS) I of Total Agriculture 132.9 6.7 Fuel 567.6 28.9 Phosphates 32.7 1.7 Manufactured Goods 1231.9 62.7 Total Merchandisc 1965.1 100.0 kmTE w Annual Averages End Period 1986 1987 1988 Jan.-Mar.1989 March 1989 USS1.00 - Tunisian Dinars 1.2594 1.2067 1.1658 1.0711 1.0502 Tunisian Dinar 1.00 - US$ 0.7940 0.8287 0.8578 0.9336 0.9522 ESTE=&L MT, D UXmEI 31, 1988 US$M Public Debt, incl. Guaranteed 5776.6 Ron-Guaranteed Private Debt 235.0 Use of IMF Credit 276.8 Short-term 274.7 Total Outstanding & Disbursed 6563.1 DEBT SERVI R3O FM 1s8 Percentage Public Debt Dncl. Guaranteed (incl. IMF) 23.7 Pon-Guaranteed Private Debt 1.2 Total OutstandLng & Disbursed t/ 25.3 1/ Including Interest payments on abort-term debt.  iDiIDA LMDB (12/31/8S) (IIS) ZDRD IDA Outstanding & Disbursed 1019.0 62.1 Undisburs*d 689.2 0.0 Tot,sj Outstanding inl. Undisbursed 1708.2 62.1  REPUBLIC OF TUNISIA COUNTRY ECONOMIC MEMORANDUM: THE ROAD TO AN OUTWARD-ORIENTED ECONOMY TABLE OF CONTENTS Page no. COUNTRY DATA MAP IBRD 18707 SUMMARY & CONCLUSIONS .i... . . . . . . . . . . . . . . . . . . . I. ECONOMIC DEVELOPMENT: 1980-1986. . . . . . . . . 1 A. The 1970s: Oil Exports and a Growing Public Sector . . . . . . 1 B. 1980-84: Nearing Crisis . . . . . . . . . . . . . . . . . . . 3 C. 1985-86: Avertir,g Crisis . . . . . . . . . . . . . . . . . . . 7 D. Growth Performance .10 II. STABILIZATION AND ADJUSTMENT ..11 A. The Need for Change . . . . . . . . . . . . . . . . . . . . . 11 D. Thc R-sou-ce Pcsition . . . . . . . . . . . 12 C. 1987-89: Growing Exports and Declining Domestic Absorption . 14 III. POLICY REFORMS FOR IMPROVED ECONOMIC EFFICIENCY . . . . . . . . . . 22 A. Outline of the Reforms ......... ... .. ... .. . 22 B. The Reform Program ............ .... ..... . 22 C. Creating Competition .......... .... ... ... . 31 IV. INVESTMENT WITH ECONOMIC ADJUSTMENT . . . . . . . . . . . . . . . . 39 A. The Issues of Lower Investment & Higher Efficiency . . . . . . 39 B. Public Sector and Household Investment . . . . . . . . . . . . 41 C. Private Enterprise Investment ... . . . . . . . . . . . . . . 44 D. The ICOR and Efficiency Gains ... . . . . . . . . . . . . . . 53 This report is based on the findings of an economic mission, whose members were: Mr. S. Rahim (mission leader and author of the main report); Mrs. M. de Melo (author of Annex 1); Mrs. A. Akin-Karasapan (co- author of Annex 3 and the Appendix to the main report); Ms. S. Razamara (responsible for Annex 4, co-author of Annex 3 and the Appendix to the main report); Mr. G. Caprio (author of Annex 2); Mr. J. Parks (co-author of Annex 3); and Mr. B. Hubert, who covered private sector investment. The main mission took place in February/March 1989, with subsequent missions occurring in October 1989 and January 1990.  REPUBLIC OF TUNISIA COUNTRY ECONOMIC MEMORANDUM: THE ROAD TO AN OUTWARD-ORIENTED ECONOMY TABLE OF CONTENTS Page no. V. MACROECONOMIC POLICIES FOR THE MEDIUM TERM: 1989-1997 . . . . . .55 A. The Policy Framework . . . . . . . . . . . . . . . . . . . . . 55 B. Macroeconomic Balances .... . . . . . . . . . . . . . . . . 61 C. Summing Up .6.6.. . . . . . . . . . . . . . . . . . . . . . . 66 APPENDIX I: A DECOMPOSITION OF TUNISIA'S CURRENT ACCOUNT BALANCE: 1980-1988 ......................... . 69 TILES Thble 1 Economic Performance: 19701.979 . . . . . . . . . . . . . . . I Table 2 Budget and Current Account as percent of GDP . . . . . . . . . 2 Table 3 Resource Balances and Current Account as percent of GDP: 1980-1984 . . . . . . . . . . . . . . . . . 4 Table 4 Financing of the Current Account in US$ Million: 1980-1984.. 5 Table 5 Central Government Budgets as percent of GDP: 1980-1984 . . . 6 Table 6 Wages and Prices: 1985-1984 . . . . . . . . . . . . . . . . . 7 Table 7 Resource Balance and Current Account as percent GDP: 1984-1986 . . . . . . . . . . . . . . . . . . 7 Table 8 Financing of the Current Account in US$ Million: 1984-1986 8 Table 9 GDP Growth in percent: 1980-1986 . . . . . . . . . . . . . 10 Table 10 GDP Growth in percent: 1986-1989 . . . . . . . . . . . . . . 14 Table 11 Resource Balance and Current Account Deficit as percent of GDP: 1986-1989 ..15 Table 12 Financing of the Current Account in US$ Million: 1986-1989 16 Table 13 Budget and Current Account as percent of GDP: 1986-1989 . . . . . . . . . . . . . . . . 18 Table 14 Fixed Investment by Agent as percent of GDP: 1980-1988 . . . . 42 Table 15 Budget and Current Account as percent GDP: 1988-1997 . . . . 59 Table 16 Fixed Investment by Agent as Percent of GDP: 1988-97 . 62 Table 17 Resource Balance and Current Account Deficit as percent of GDP: 1988-1997 ..63 Table 18 Fi:.ancing of the Current Account in US$ Millions: 1988-1997 . 64 Table 19 GDP Growth in Percent: 1988-1997 . . . . . . . . . . . . . . 66 .  l SUMMARY AND CONCLUSIONS The Maior Issues 1. Tunisia has surmounted the difficulties brought on by large macroeconomic imbalances in the early 1930s and is now addressing the issues of the efficiency and level of investment, on which macroeconomic stability and economic growth will in the long run depend. The imbalances were not characteristic of economic management in Tunisia; rather they were the outcome of domestic political circumstances leading to high l,els of investment and rapid consumption growth at a time when earnings from oil exports were falling. Normally macroeconomic management has been prudent and this prudence has reasserted itself since 1986, when the balance of payments came close to a crisis. The issue now is to achieve adequate sustained rates of growth of consumption and employment while maintaining macroeconomic stability. 2. The main condition for such long term growth is an improvement in the efficiency of investment. If the 5-year non-oil ICOR is taken as an indicator, there was a substantial decline in the efficiency of investment in the late 1970s and early 1980s, when this ICOR rose over 6 from levels of around 4 in the early and mid-1970s. This was manifested in levels of fixed non-oil investment of around 30 percent of GDP from the mid-1970s to 1984, without a noticeable acceleration in the rates of economic growth or job creation. Such high levels of investment, and even big increases in real wages and consumption, could be financed as long as Tunisia's earnings from oil exports continued to increase, as they did through the late 1970s. But, when these earnings began to fall after 1980 and Tunisia failed to cut back its expenditures, large current account deficits developed that could not be sustained. With an efficiency of investment that results in an ICOR over 6, adequate growth rates require rates of saving and external capital inflow that would be hard to sustain. 3. A considerable improvement in efficiency can be achieved through reforms aimed at making the economy more outward oriented and at increasing the role of the private sector. This is the major objective of the program of ecoromic reforms that the Government began to formulate in 1986. The program has been constantly broaderv-d since, despite an easing of economic pressures because of an unexpectedly good performance by the economy. Both the deficit on the balance of payments current account and that on the budget have been much smaller than they were before 1986. And lower investment does not yet appear to have noticeably affected economic growth, though transitory factors, especially droughts, have. 4. But investment has fallen lower than compatible with long run growth and employment creation, given the probable limits to efficiency improvement, and, unless it recovers, the economy will increasingly face capacity constraints. In particular, private investment declined continuously from 1983 until it increased modestly in 1988. Although fixed investment will not need to reach the same shares of GDP as in the early 1980s, it will still need to be around 23-24 percent of GDP to yield long run annual growth rates  - ii - of around 5 percent, whereas it has been around 18-20 percent. The increase would have to come from the private sector, since the Government's policy of increasing the private sector's economic role also implies limiting public sector investment. The chnllnga for the Tunisian authorities is to attain their policy objective in a manner that induces private enterprises to increase their investment to almost double its present share in GDP over the medium. term. Macroeconomic Management: The Ouest for Stability 5. The fall in investment and the tight restraint on wages and consumption, which started in 1985, were the effect of resource scarcities, which had been developing since 1980 and threatened to get worse. Oil export earnings had begun to decline in 1980, initially because of the depletion of Tunisia's reserves and later because of the fall in world oil prices. With this decline, cutbacks ': diomestic expendituye and a devaluation became more and more necessary, but E' : postponed. As a result, the current account deficit varied between 4. and 10.9 percent of GDP from 1980 to 1984 and, since the government drew revenue from oil that declined with the value of its exports, budget deficits were also high, ranging from 3.4 to 7.6 percent of GDP. Over the same period the ratio of external debt to GDP rose from 40 percent to 51 percent and the debt service ratio from 14 percent to 22 percent. 6. It was clear that if the trend continued the balance of payments would be in crisis. By 1985 the Government had begun encouraging and facilitating exports, cutting back on investment, limiting wage increases, reducing the budgetary cost of consumer subsidies, and devaluing the Tunisian dinar. But bad harvests due to poor rainfall and the drop in world oil prices brought the economy close to crisis in 1986, from which it escaped only through more drastic measures: imports were severely curbed, government investments were sharply reduced, and the Tunisian dinar was devalued again, this time by 10 percent. By the end of 1986 Lhe real effective exchange rate was 17.5 percent below its level at the end of 1984. 7. Since then the balance of payments has recovered unexpectedly well and the budget deficits have also improved. Exports played a large part, but so did a fall in domestic absorption. The measures taken in 1985 and 1986 led to a rapid growth of exports of manufactures, which is continuing, and allowed tourism to expand considerably as well. Exogenous circumstances helped; apart from strong world demand and the absence of the violence in the region that had deterred tourists before, there was a large unanticipated inflow of visitors from neighboring countries in 1988. The average rate of growth of exports of manufactures in 1987 to 1989 was 16 percent p.a. and that of tourism 24 percent p.a.. The deficit on the current account, which had risen to 10.9 percent of GDP in 1984 was stij1 8.3 percent in 1986. fell to 0.9 percent in 1987 and was slightly in surp.us in 1988, despite a disastrous drought that year necessitating increased food imports. The counterpart to the growth of exports was a gradual decline, between 1984 and 1988, in the volume of domestic absorption as a result of restraint on consumption, mainly  - iii - due to wage restraint, and a decline each year in the volume of fixed investment. Imports consequently also declined in volume, except for a spurt in 1988 to meet tourist demand. In 1989 the number of visitors from neighboring countries fell sharply and continued drought renewed the need for large food imports, but the current account deficit was kept to 3.8 percent of GDP, a level Tunisia has no difficulty to finance. Although the improvement of the deficit of the government budget over the period 1986-89 was not as marked, it still fell to around 4 percent of GDP. 8. The growth of exports was strong enough to prevent the restraint on consumption that began in 1985 from causing a serious drop in GDP growth, though weather remained a major determinant of output. Over 1980-84 domestic consumption had grown fast, on average at 6.9 percent p.a., whereas GDP annual growth rates ranged around 5-7 percent if the drought year 1982, when GDP fell slightly, is left aside. An excellent harvest in 1985 kept GDP growth at 5.6 percent, despite a drop in consumption growth to 2.9 percent. The difficult year was 1986, when world oil prices fell, drought caused a bad harvest, and rapid growth of exports had not yet begun. Once this difficult passage had been navigated the situation eased, though consumption continued to be restrained. Exports of manufactures and tourism became major determinants of growth in industry and services, and the pattern of economic growth was, to a large extent, the combination of growth due to exports in these sectors and fluctuations, due to weather, in growth in agriculture. When there was good rainfall, as in 1987, growth was high overall, and when the drought occurred in 1988, causing a 24 percent loss in agriculture output, growth still remained positive (1.5 percent). In 1989 there was a shrinkage of tourism, because the number of visitors from neighboring countries fell while traditional tourism grew slowly, and consequently the services sector stagnated. With another drought preventing a rebound in agriculture, GDP growth of 3.0 percent was largely due to growth of exports of manufactures, though consumption grew faster than population (at 2.8 percent) for the first time since 1985. Policy Reform: The Ouest for Efficiency 9. At the same time that it grappled with the immediate pru'lems of the balance of payments and budget, the Government began to address the longer term issue of the economy's overall efficiency. Over time, but especially when oil gave the State large amounts of revenue, the Tunisian economy had become highly protected and regulated, with a large and growing public sector. This was an environment that made private investment attractive, since it assured good financial returns, but it was not conducive to efficiency, since it gave small scope to competition or price signals. Through elaborate administrative controls over prices, imports, entry into economic activity, and the allocation of resources, the authorities attempted to reconcile numerous competing interest, in particular protecting producers arnd distributors from competition while protecting the consumer from exploitation by monopolies. Since the authorities also aimed to keep inflation moderate and to prevent a big external debt burden, at least during the 1970s, serious macroeconomic imbalances did not occur. In fact the system was more  -iv - successful than might have been expected during the 1970s in permitting high i economic growth, a considerable expansion of non-oil exports, remarkably high levels of education and health services, and a distribution of income conspicuously more even than in most developing countries. 10. A return to the status guo ante was ruled out by deterioration in Tunisia's resource position since 1980 and by the difficulty of applying the old dirigiste policies in the more complex economic environment of today. Comparing Tunisia's external resource position in 1986 with that in 1980, the loss of earnings from oil exports amounted to 10.4 percent of GDP and the debt service ratio had risen from 13.9 percent to 27.9 percent. The external debt also included a substantial amount of bank loans and suppliers' credits, whic' were unlikely to be repeated until the country's longer term prospects improved, especially given the cautiousness of banks in a time of world-wide debt problems. The budget was also affected: government revenues from oil fell from 6.0 percent of GDP in 1980 to 5.6 percent in 1986, and the fall would have been greater but for the depreciation of the Tunisian dinar. The budgetary cost of servicing government debt rose at the same time from 3.7 percent of GDP to 9.0 percent. 11. Tunisia also faced more complex problems than it had faced in the early 1970s, when the panoply of administrative controls had appeared to work well. Apart from the fact that the economy became more complex as it evolved, there were now a number of enterprises of low efficiency in both the private and the public sectors. Thus public enterprises, as a rule, were unable to generate sufficient resources to carry out investment, and the gross budgetary transfers to them for investment and to cover operating losses in 1986 reached 11.8 percent of GDP, far above the revenues the Government received from the enterprises. Numerous private firms were protected from import competition through import restrictions, raising doubts about their real contribution to the nation's income. The system for protecting the poor had also become costly and inefficient, price subsidies on several basic items of consumption and fertilizers had reached the equivalent of 3.3 percent of GDP in 1986, but benefited the not-so-poor more than the poor. Furthermore, Tunisia would in due course need to regain access to international financial markets and to attract foreign investment since the inflow of official assistance that it could reasonably expect would not suffice for its longer term development. Given the smallness of its own markets, its success would be determined by how much the economy opened up. 12. To achieve the greater efficiency it aims for, the Government has directed its reforms primarily to making the economy more outward oriented and expanding the role of the private sector. This implies allowing more competition, both within the economy and from abroad, and consequently the removal of many administrative controls that have restricted competition. The reforms allow greater scope to price signals, notably through the decontrol of domestic prices and the replacement of import restrictions by tariffs. As a necessary accompaniment, the direct and indirect tax systems have been undergoing reform as well. Administrative controls had been especially tight in the financial sector; but the pace of reform has been such that only a few  v controls remain that need to be removed, and competition is now coming from the development and diversification of financial and capital markets. 13. The main ways that administrative controls restricted competition were by creating barriers to entry into economic activities and by interfering with the operation of the price system. One barrier to entry that has been removed is the need for prior authorization of investment, which not only constituted a major bureaucratic obstacle to investors, but failed to allocate investment efficiently. Another barrier to entry, the requirement for prior Central Bank authorization for most loans, has been dropped as part of the reforms of the financial sector. On the other hand, entry into wholesale distribution is still tightly controlled and, apart from unnecessarily prolonging the need for control over distribution prices to protect consumers, this discourages investors who may fear becoming captive to one group of suppliers or distributors. Anti-trust legislation is under preparation as a necessary complement to measures to allow free entry into economic activities. 14. Since controls over domestic prices protected consumers from monopolistic practices by suppliers while restrictions on imports protected enterprises, and therefore jobs, from external competition, the decontrol of domestic prices and the removal of import restrictions need to be combined in such a manner as both to allow imports to create competition and to give enterprises the opportunity to adjust to the new competition. Decontrol of producer prices began in 1988 as the first of several stages in the Government's program to remove controls on all but a handful of these prices by 1991. Decontrol of wholesale margins is similarly scheduled to occur in stages to cover at least 50 percent of prices by 1992. Import tariffs have been reduced to a maximum of 41 percent and their range has been narrowed. The Government's program is to reduce the maximum tariff further to 35 percent over the medium term. However, most domestic production is protected from external competition by import restrictions, so that the Government's program, to remove these restrictions on all but a handful of subsidized consumer goods and luxuries before the end of 1992, faces considerable resistance. To give enterprises that can do so viably the opportunity to restructure to face competition from imports, and thus reduce opposition to trade liberalization, the import restrictions can be replaced by temporary, supplementary tariffs, exactly as the Government envisages for infant industries. The Government is also establishing anti-dumping and safeguard procedures to protect domestic producers against unfair foreign competition, though it is important that these procedures not be used as a disguised form of protection. 15. Taxation has undergone major reform to reduce distortions and to simplify taxes, though some distortions remain and will need to be removed over the medium term. A valued added tax was introduced for production other than agriculture in July 1988 and was extended to all wholesale, except in basic foodstuffs, in October 1989. Its extension to large-scale retail is under study. But there are, in addition, consumption taxes that were kept to avoid an immediate shortfall in revenue and which are to be gradually narrowed to a few luxuries. A new direct tax law took effect from January 1, 1990. Its maximum rates are lower than in the previous system, but its incidence would be broader. The highest marginal rate of 35 percent on personal incomes  - vi - is much below the highest rate of the old tax, but fringe benefits that were exempt before are now being taxed. The corporate tax has been reduced to two rates, a normal rate of 35 percent, and a low rate of 10 percent for agriculture, small scale enterprises, and certain special ventures, such as retail cooperatives. This new law simplifies direct taxation, which will make it easier to tax professional incomes and profits that escape taxation. But the gain is limited by the existence of several schemes of special investment incentives in various sectors, which provide a diversity of tax coneessions. Not only do these schemes perpetuate the distortions the new tax is designed to remove, but they compete among themselves in attempting to attract investment, without a clear overall gain. 16. Reform in the financial sector has gone far to transform what was a limited and closely regulated sector to one in which competition and diversification are becoming increasingly important. The Government now faces the delicate task of fostering competition between banks while enabling the banks to provision adequately for the numerous low quality loans they accumulated before the reforms. The main reforms have been to drop the requirements for Central Bank authorization, which applied to the great bulk of lending; to free interest rates, with the major exception of a cap on bank lending spreads; and the development of a money market. A new environment has resulted in the financial sector with much greater scope for competition than in the past, but, so far the banks have tended to be cautious and even to enter into cartel arrangements to keep deposit rates down. 17. Competition in banking must above all consist of innovation and a search for a wider range of customers. The money market, itself, implies competition through innovation, since the certificate of deposit and commercial paper that it offers did not exist before 1988 in Tunisia and compete directly with bank deposits. As it is extended and secondary markets for longer term securities are revived and expanded, the bariks as a whole will face more competition. They will need to diversify their services, including becoming active in the new financial markets. They will also need to be bolder in their search for borrowers. Here they are inhibited by the cap on their lending spreads over the money market rate, which confines them just to safe, low cost borrowers and needs to be removed, or at least relaxed. Banks also appear to be cautious in their lending, because they already have substantial low quality loans and are risk averse. They are now provisioning for these loans much faster than before, but the tax treatment of provisions is ungenerous, despite recent improvements, and should be revised to encourage provisioning more. Private Investment: Decline and The Need for Recovery 18. In addition to the increase in efficiency and labor intensity of investment, and the changes in the incentive structure these reforms will bring about, there will be an increase in efficiency brought about by a rise in the share of private enterprises in total investment. At present private investment is low as a result of a persistent decline since 1983, although there was a modest recovery in 1988. The issue is to stimulate a strong  - vii - recovery within the context of the reform program. If private investment does not recover sufficiently, apprehension over the consequences for economic growth and employment will strengthen pressures to halt or reverse the reforms. But an increase in investment, whether private or public sector, without an improvement in efficiency would mean that Tunisia had failed to adjust to the loss of its oil export earnings and its greater debt burden. 19. Although the initial decline in private enterprise investment in 1984 was due to resource scarcities, the persistence of the decline since has been due largely to uncertainties associated in the minds of entrepreneurs with the changes in the economic policy environment, as well as to weak domestic demand and difficulties in obtaining financing. The uncertainty over the Government's policy objectives on the medium term level of import protection to be expected could be removed by a clearly enunciated liberalization program. A schedule for the removal of individual import restrictions could be prepared and announced, and the procedures governing temporary supplementary tariffs and infant industry protection could be specified clearly. 20. With its liberalization policies made fully explicit and better understood by the public, the Government could stimulate investment on a broader basis. Although investment in export activities, where policies are better established and where demand has been strong, has been growing rapidly, it is still too small a part of total investment to generate adequate growth and employment by itself. Domestic demand has been weak, as seen from the fact that total consumption had been growing more slowly than population since 1985, until in 1989 it grew slightly faster. As the medium-term analysis in Chapter V indicates, per capita consumption could be allowed to grow at around 2 percent p.a. in real terms, which could be achieved by allowing modest increases in the real wage. But this presupposes that import competing investment occurs in a framework that ensures its economic efficiency. 21. Financing has also been a problem for many investors, especially the small ones. Banks tend to be averse to risk and are encouraged in this by the cap on lending spreads, which limits the range of their clients, and by the large amount of borrowing by the Government, which provides an alternative source of income that is both safe and remunerative. On the other hand equity financing is discouraged by lax accounting requirements for enterprises and the consequent lack of reliable information on enterprise finances for the shareholders not controlling the enterprise. The supply of equity is also small because of a strong tendency for investments to be made by families or groups of investors. Removing the cap on lending spreads, or at least relaxing it, would encourage banks to be more active in seeking small and less well established clients. The adoption of better accounting practices could be encouraged by downgrading loans to enterprises that do not meet specific standards, thereby discouraging bank lending to these enterprises. Privatization of public enterprises could be used to provide a supply of new equity and stimulate the stock market. The development of this market is already being helped by an IFC/UNPD training program.  - viii - Medium-Term Prospects 22. Analysis of Tunisia's medium-term prospects indicates that the country would attain its objective of adjusting to the loss of oil export earnings and its higher external debt service by an increase in efficiency in terms of a gradual decline of the 5-year ICOR from its level of over 6 in the early 1980s to around 4 in the mid-1990s. A gradual increase in the CDP growth rate from 4.5 percent in 1991 to a steady 5.0 percent in the mid-1990s would be achieved with a level of total investment moderately higher than the rate of 19 percent of GDP in 1988. Part of the decline in the ICOR would be due to an increase in the share in GDP of private sector investment, while that of public sector investment would fall. And part would also be due to changes in relative prices, notably the rise in real interest rates that has occurred as part of the banking sector reforms and the increase in the cost of capital relative to wages due to the devaluation of the Tunisian dinar in 1986. 23. The lower level of investment needed to achieve the above growth rates, as compared to the levels in the late 1970s and early 1980s, would result in current account deficits small enough for Tunisia's debt indicators to improve steadily. Tunisia's non-interest current account would be close to balancing after 1991 and the current account itself, after reaching 3.4 percent of GDP in 1990, would decline slightly to 2.6 percent in 1995. External debt would decline to 48 percent of GDP in 1995 and the debt service ratio to 16.6 percent, from 66.5 percent and 26.F percent respectively in 1990. Since a balance on the non-interest current account is equivalent to a zero net resource transfer, Tunisia's external debt will grow in nominal terms over the medium term, though declining relative to GDP and exports. Much of the growth will be from borrowing in financial markets as the country regains access in the coming years on the basis of its good credit standing. 24. Because of the decline in oil revenues, there will be greater pressure to restrain budget deficits by limiting transfer for public enterprises and price subsidies. Creating money to finance the deficits is ruled out by the smallness of the money base and the consequent risk of high inflation. The alternative of reducing the deficits by increasing taxation or reducing recurrent expenditures are inherently difficult in Tunisia. Another alternative, devaluation of the dinar, had a favorable net budgetary effect in the past, but is unlikely to have one in the future. This is due to fact that, on the one hand, the positive effects of devaluation on revenues will be less as dollar denominated budgetary oil revenues will continue to decline and import taxes have been reduced since 1986, and, on the other hand, the adverse effects of devaluation on foreign debt service will offset the positive effects. Consequently, the size of the deficit must be determined taking into account the economic costs of financing through borrowing and of lower transfers for public enterprises. The costs of borrowing are primarily the potential crowding out of private investment and the risk, if government debt is allowed to grow large, of economic instability. The cost of lower transfers to public enterprises is postponement of the economic benefits of restructuring. Price subsidy reductions are politically sensitive, but more  - ix - efficient targeting could reduce the financial cost and the political sensitivity. 25. It may seem trite to say that Tunisia must increase the efficiency of its investment to grow faster, but this reflects the fact that the country has, through good management and a modicum of luck, avoided falling into many of the difficulties that other developing countries face. Now Tunisia is better protected from exogenous uncertainties, other than the weather, than most developing countries, and its future economic development will therefore be determined directly by the policies pursued. It is not expected to require debt relief, so it is free of the associated uncertainties over resource flows; most of its debt is at fixed interest rates, so it is not sensitive to interest rate changes; and oil is no longer a major export, so there is less risk of terms of trade effects. One major uncertainty is rainfall, which determines a large part of agricultural production. Analysis of the effects of a single drought comparable to that of 1986 indicates that GDP growth would be reduced for a year and that the deficits in the current account of the balance of payments and on the budget would increase briefly. However, the effects of the resulting increased debt would be insignificant. The impending economic unification of Europe in 1993 and the recent changes in Eastern Europe are new sources of uncertainty, whose effects on investment, especially in export activities, cannot yet be predicted. The uncertainty is, however, at the moment the same for all countries that rely on the European market and may result in gains as much as in losses to these countries. It will be the economies that can most quickly seize opportunities and adapt to circumstances that will make the most of the gains. This apart, however, and if droughts are not frequent or as severe as in 1988, with appropriate economic policies Tunisia can look forward to acceptable increases in per capita consumption and employment over the long term.  CHAPTER I ECONOMIC DEVELOPMENT: 1980-1986 A. THE 1970s: OIL EXPORTS AND A GROWING PUBLIC SECTOR 1. The 1970s were a period of marked progress in which growing State activity was assisted by substantial earnings from oil. The annual growth of the economy averaged 7.4 percent and was well distributed over the sectors. Manufacturing grew at 11.0 percent and agriculture at 5.4 percent. By 1979 the share of manufacturing in GDP had reached 11.6 percent and of agriculture 13.5 percent. Consumption grew at an average of 8.0 percent p.a.. Great emphasis was placed on social development and the results were equally striking. Between the late 1960s and 1980, the number of absolute poor declined from 33 percent of the population to 12.9 percent, infant mortality fell from 131 to 83 per thousand, life expectancy at birth rose from 54 to 62 years, and the average calorie intake rose from 96 percent to 111 percent of minimum standard requirements. Adult literacy rose from about 24 percent to 62 percent and the gross reproduction rate declined from 3.2 percent to 2.4 percent. Table I Economic Performance: 1970-79 Average AnnuaL Average AnnuaL Share of Manuf. Share of Exports Oil exports as growth rate of GDP growth of consumption in GDP in X in GDP in X X of GDP in X p.a. in X 1970 1979 1970 1979 1970 1979 7.4 8.0 8.4 11.6 22.0 39.0 3.5 12.1 2. That these results were achieved vithout serious macroeconomic imbalances was due to prudence in macroeconomic policy and the windfalls from rising oil prices. Investment, which was the main source of economic growth, rose from about 20 percent of GDP to about 30 percent over the decade, while consumption also grew rapidly. Yet there was sufficient restraint to avoid high inflation and balance of payments problems. Deficits on the balance of payments current account averaged 3.5 percent of GDP, which Tunisia could finance sustainably, except for a brief episode in 1976-78, when, following declines in the world prices of phosphates and oil, they ran at 9-11 percent of GDP. This performance was helped by an almost uninterrupted decline in the real effective exchange rate. The bulk of the financing came from official sources, mostly on concessional terms. Otherwise a significant portion consisted of direct foreign investment by oil companies corresponding to gross fixed capital formation in oil extraction. Tunisia increased its recourse to financial markets in 1976-78, but was saved, by the resurgence of oil prices in 1979, from making the difficult choice between increasing its external debt  - 2 - on market terms and sharply cutting expenditures, which restored the current account to its normal levels. In that year oil exports were equivalent to 12.1 percent of CDP. 3. Emerging from the 1970s it seemed that the economic policies pursued had been remarkably successful. Nonetheless, there were already indications that presaged difficulties. The most striking feature of these policies was the pervasive influence exercised by the State, both as an economic agent itself and in controlling economic activity. The State's role as an economic agent grew through the decade. Budget expenditures increased from about 26 percent of GDP at the beginning to over 34 percent towards the end. Nor was this increase entirely due to increases in oil revenues, since roughly half the increase of government revenues from about 22 percent of GDP around 1970 to 29 percent in 1979, arose from increased non-oil revenues. Both recurrent and capital expenditures from the budget increased, the former rising from 17 percent of GDP to 20-21 percent and the latter from 9 percent in 1970 to a peak of 14 percent in 1977 before declining to 13 percent in 1979. Thus Tunisia became a high tax economy with the State playing a large, direct role. The State also played a major indirect role through the rapidly growing public enterprise sector. Precise data are not available, but it is certain that well over half of gross fixed capital formation of the economy in the late 1970s was accounted for by the budget or by public enterprises. Budgetary restraint was, however, by and large maintained: deficits were kept to 3-4 percent of GDP, except for the period 1975 to 1978, when they ranged as high as 8 percent, the greater part being financed in most years from external borrowing, while borrowing from the Central Bank remained negligible. Tabte 2 Budaet and Current Account as percent of GDP el 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 Governvment Revenues 22.8 21.7 21.0 22.4 23.0 24.9 24.2 25.6 27.4 29.1 Govermnent Net Expenditures a/ 26.5 26.0 23.4 26.0 26.2 29.5 30.5 33.4 34.5 33.2 Overall Net Deficit -3.7 -4.3 -2.5 -3.6 -3.2 -4.7 -6.3 -7.9 -7.1 -4.2 Current Accowit Deficit -6.5 -2.4 -1.9 -3.5 -0.2 -4.9 -9.3 -11.1 -9.8 -4.8 Real Effective Exchange Rate (WPI) (1980=100) b/ 121.1 124.9 122.9 121.6 110.5 120.0 117.6 115.8 108.2 101.1 a/ Expenditures net of amortizations b/ Decrease implies depreciation  4. The State's regulatory role matched this trend. Investment was directed into favored activities by a combination of widespread import controls, high tariffs, requirements for approval by the Investment Promotion Agency, and the need for Central Bank credit authorization. In numerous activities entry was restricted to avoid duplication. Elaborate price controls were used to prevent monopoly rents. An extensive system of subsidies was used to provide the most commonly used foods and :ertilizers at low and stable prices. Wages were determined through a bargaining process between the State and the trades unions, with the public sector leading the way. And enterprises were obliged to set up committees with workers' representation in a complex system that depended on the enterprises' size. A social security system evolved, to which employers and workers contributed, and, though, on the whole, it functioned well, it had distortionary effects because enmployers' contributions were determined by locality so as to give incentives to investments in less developed areas. The fact that such a system did not run into difficulties earlier was largely due to the high quality of the civil servants and their success in spreading the benefits across the population so as to avoid extreme concentrations of wealth and corresponding poverty. B. 1980-84: NEARING CRISIS 5. Despite the satisfaction over what had been achieved, some economists in the Government were aware that major problems had developed. First, it had been foreseen that oil extraction would begin to diminish because the depletion of reserves and the growth of domestic consumption would make Tunisia a net importer around 1991. Second, it was apparent that a number of industries were economically inefficient or in financial difficulties. Some were highly protected assembly operations, such as the motor car assembly plant, STIA, and the tractor assembly plant, CMT. But there were also the phosphate mining and related chemical enterprises 'CPG and GC), major industries based on low grade ores that made losses when world prices were depressed. Third, there was the stubborn problem of unemployment, which was estimated at about 13 percent, and which especially affected young entrants into the labor force. In part, at least, it could be blamed on the capital intensity of the public sector investments. But the growth of the labor force of around 3.0 percent p.a. raised disquieting questions for the future. 6. Around 1980, at the time of the preparation of the 6th Plan (1982-1986), the economic planners proposed to respond to the situation by cutting back on investment, restraining the growth of budgetary expenditures, increasing the emphasis on exports, and promoting more labor intensive investment. These were adopted as objectives of the Plan (1982-1986) but in practice they were not pursued until balance of payments difficulties became imminent. From 1980 to 1984 investment continued at around 30 percent of GDP and budgetary expenditures reached 41 percent of GDP. The exchange rate  - 4 - appreciated 4 percent in real effective terms and major public sector investments were initiated with little economic justification or permanent employment effect.y Table 3 Resource Batances and Current Account as percent of GDP: 1980 - 1984 1980 1981 1982 1983 1984 Gross Domestic Saving 24.0 23.8 21.2 20.9 20.3 Investment 29.4 32.3 31.7 29.5 32.0 Resource Balatce -5.4 -8.5 -10.5 -8.6 -11.7 Exports GNFS 40.2 41.3 36.9 35.4 33." Import GNFS 45.6 49.8 47.4 44.0 45.6 Net Factor Income P -3.3 -3.6 -3.6 -3.3 -3.2 Net Private Current Transfers ' 4.0 4.4 4.7 4.4 4.0 Current Account Deficit -4.7 -7.7 -9.4 -7.5 -10.9 Memo item: Total Debt/GDP kJ 40.5 42.9 46.5 50.3 51.1 Total Debt/Debt Service Ratio 13.9 15.2 16.1 19.2 22.3 TotaL Debt service (X of GDP) 6.2 7.1 6.9 7.8 8.7 Real Effective Exchange Rate Index (CPI) 1980=100* 100.0 99.1 98.5 97.4 97.3 a/ Workers remittances are included under Current Transfers. b/ Including PPG, IMF, MLT non-guaranteed and short-term debt. * Decrease implies depreciation. 7. The period was one of growing macroeconomic imbalances, much as in 1976-1978, except that the economy was not saved from the need for austerity measures by an increase in oil prices. On the contrary, the fall in oil prices when the balance of payments was tight in 1985 and 1986 made recovery considerably harder. Although GDP growth in 1980-84 declined to an average of 4.5 percent per annum, both private and government consumption continued to grow rapidly to give an annual average growth of total consumption of 6.9 percerLt. Gross domestic saving fell from 24 percent to 20 percent of GDP. With investment hovering around 30-32 percent of GDP, the resource gap widened to 11.7 percent of GDP, which was reflected in a steady increase In imports V Using the wholesale price index to deflate. Using the consumer price index, there was real effective depreciation over this period. This is the only period when the two measures of the real exchange rate moved in opposite directions and reflects the growing importance of price controls and subsidies in keeping the prices of the main articles of household consumption down.  while exports stagnated in volume and there was virtually no change in the terms of trade. The resource gap was partly compensated by an increase in workers' remittances to around 4 percent of GDP, a little more than interest oa external debt, so that net factor incomes generated a small surplus throughout the period. As a consequence, the deficit on the current account reached a maximum of 10.9 percent of GDP in 1984. Table 4 Financing of the Current Account in USS Mittion: 1980 - 1984 1980 1981 1982 1983 1984 Current Account Deficit -414.1 -649.1 -767.4 -603.3 -875.4 Net Direct Foreign Investment 236.1 367.2 402.2 223.8 206.0 Official Grants 41.5 20.3 19.0 25.3 28.6 Amortization Payments PPG El -247.0 -315.6 -288.7 -375.6 -407.7 Multilateral Gross Disbursement s 81.6 108.0 119.7 130.1 113.8 Bitateral Gross Disbursement 241.5 273.9 253.2 236.0 371.1 Private PPC Grass Disbursement 250.5 274.2 251.2 538.4 283.5 Others ti -156.3 13.3 37.9 -189.6 130.4 Change in Gross Reserves -33.7 -92.1 -27.1 14.7 149.7 (- implies increase) a/ Including IMF. b/ Others are net disbursement of short term debt, MLT non-guaranteed and capital NEI. 8. The financing of the deficits entailed greater recourse to international financial markets, with two major consequences: Tunisia became vulnerable to the impending world debt crisis and its debt indicators deteriorated. Borrowing from private sources, namely financial markets and export credits, had in fact increased in 1978, when the current account deficit was large, and 1980-84 merely continued the trend. The cumulative total of the current account deficits in 1980-84 came to US$3,309 million and gross disbursements from private sources were 39.4 percent of this, i.e., US$1,304 million. But by 1984 Tunisia began to experience, as had other countries already, effects of the world debt crisis on the financial markets. In 1983 disbursements from private sources had reached a peak of US$465 million as compared to US$20 million in 1975, but in 1984 they dropped to US$251 million. The borrowing from private sources was reflected in the debt service ratio, which rose from 12 percent in 1979 to 22 percent in 1984.Y Already, nearly 6 percentage points of this increase were due to 1 If exports had continued to grow in volume at the rate of the previous five years, the same debt service would only' have been 13 percent of their value.  - 6 - private lending, though it accounted for only about 24 percent of debt outstanding and disbursed in 1984. The increase of over 4 percentage points for servicing of debt owed to official sources reflected the gradual accumulation of such debt, high world interest rates, and the lapses of grace periods, more than an increase in borrowing. Table 5 Centrat Government Sudgets as Percent of GDP: 1980 - 1984 1980