Zambia - Economic Recovery Program Project

Docunent of The World Bank FOR OFFICIAL USE ONLY 6CR Z/I (-I Z Report No. P-5483-ZA REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED DEVELOPMENT CREDIT OF SDR 149.6 MILLION AND AN IDA REFLOWS SWJPPLEMENTAL CREDIT OF SDR 19.4 MILLION TO THE REPUBLIC OF ZAMBIA FOR AN ECONOMIC RECOVERY PROGRAM FEBRUARY 8, 1991 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 authirization.  CURRENCY AND EQUIVALENT UNITS Currency Unit = Zambian Kwacha (ZK) ZK/US$ (annual average) 1985 2.71 1986 7.30 1987 8.89 1988 8.22 1989 12.90 1990 47.40 (end-December) FISCAL YEAR Government 5 January 1 - December 31 ABBREVIATIONS AND ACRONYMS ADB = African Development Bank ADF = African Development Fund BOZ = Bank of Zambia CSO = Central Statistics Office DBZ = Development Bank of Zambia EEC = European Economic Community HIID = Harvard Institute for International Development IMF = International Monetary Fund KfW = Kreditanstalt fur Wiederaufbau MOF = Ministry of Finance OGL = Open General License ODA Overseas Development Administration of the UK PER = Public Expenditure Review PFP = Policy Framework Paper PIP = Public Investment Program SGS = Societe Generale de Surveillance SOE = Statements of Expenditure USAID United States Agency for International Development  FOR OFmICIAL USE ONLY ECONOMC RECOVERY CREDIT lable of Contents CREDIT AND PROGRAM SUMMARY . . . . . . . . . . . . . . . . . . . . 1 PART I - COUNTRY POLICIES AND LANK GROUP ASSISTANCE STRATEGY . . . 5 A. Background . . . . . . . . . . . . . . . . . 5 B. Recent Economic Performance . . . . . . . . . . . . . . . . . . 7 C. Reform Actions Taken . . . . . . . . 10 D. Impact of Reforms and 1990 Financial Outcome . . . . . . . . . 13 E. Adjustment Issues . . . . . . . . . . . . . . . . . . . . . . . 14 P. The 1'licy Frameworkt 1991-93 . . . . . . . . . . . . . . . . 17 G. Prospects and Financial Requirements . . . . . . . . . . . . . 20 H. Bank Strategy and Operations . . . . . . . . . . . . . . . . . 23 PART 11 - THE PROPOSED CREDIT . . . . . . . . . . . . . . . . . . . 31 A. Credit Objectives . . . . . . . . . . . . . . 31 B. Monitored Actions . . . . . . . . . . . . . . . 32 C. Project Description . . . . . . . . . . . . . . . . . . . . . 33 PART III - JUSTIFICATIONS AND RISKS . . . . . . . . . . . . . . . . 35 PART IV - RECOMMENDATION . . . . . . . . . . . . . . . . . . . . . 36 ANNEXES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38 I. Economic Indicators . . . . . . . . . . . . . . . . . . . . . 38 II. Status of Bank Group Operations . . . . . . . . . . . . . . 43 III. Letter of Development Policy . . . . . . . . . . . . . . . . 45 IV. Policy Matrix . . . . . . . . . . . . . . . . . . . . . . . . 58 HAP This document has a restricted distribution and may be used by recipients only in the performance 2 of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  ZAMBIA ECONOMIC RECOVERY CREDIT CREDIT AND PROGRAM SUMMARY Borrower s Republic of Zambia Beneficiary s Republic of Zambia Amount X IDA SDR 149.6 million (US$210.0 million) IDA Reflows SDR 19.4 million (US$ 27.2 million) Cofinancing : Germany DM 34 million (US$18.8 million) The IDA amount includes SDR 48 million (US$67 million) from the Special Allocation provided for in the President's Memorandum to the Executive Directors entitled 'A Review of the Use of IDA Reflows", dated June 5, 1990. This Memorandum was considered by the Executive Directors on Thursday, June 28, 1990. Zambia's adjustment program is being supported by donors under the Special Program of Assistance to Low- Income Debt-Distressed Countries in Sub-Saharan Africa. In addition to the cofinancing identified above, the African Development Bank has expressed interest in participating in this IDA operation. In addition, the Zambian Government is seeking cofinancing from the Overseas Economic Cooperation Fund (OECF) of Japan and has made an official request to the Government of Japan. Terms a Standard IDA terms, 40-year maturity. with a 10-year grace perio Description s The objective of the proposed operation is to provide import financing in support of Zambia's economic adjustment program, and, in particular, to assist Zambia with its foreign exchange cash flow at the time that the arrears to the World Bank are being paid. Satisfactory clearance of arrears to the Bank 4nd the Fund will be required before signing and effectiveness of the credit. Without the cash flow assistance provided by this operation, Zambia would find it very difficult to clear its arrears to the Bank, and access to Bank financial and other support would not be restored. As outlined in the Policy Framework Paper 1991-93 (PFP), the overall aims of the adjustment program are to stabilize the economy through fiscal and monetary restraint and to restore sustainable growth in the medium term through policies of structural realignment and improved incentives. The main structural objectives are to reduce the dependence on copper by encouraging non-traditional  - 2 - export growth, to lower the capital and import intensity of production and consumption, to increase savings and investment levels, and to help reduce poverty by expanding employment and income opportunities. Since achieving these objectives will mean substantial restructuring of the economy, a complementary goal is to protect vulnerable groups from the worst impact of the adjustment. Good progress has been made in implementing the Government's economic reform program. Many of the reforms supported by this Credit are already being implemented. This Credit will further those gains by supporting a number of important structural measures, includings decontrol of maize and fertilizer marketing and pricing; privatization of all parastatals except public utilities and natural monopolies; trade liberalization, involving tariff reform, the removal of export restraints, and rapid expansion of the open general licensing system in the second foreign exchange window; and civil service reform. It will also support the program's macroeconomic policies and objectives, including a market-clearing exchange rate, positive real interest rates, lower fiscal deficit and monetary growth, general decontrol of prices, higher savings and investment, lower inflation, and improved productive efficiency. Benefits X This is Zambia's last reasonable opportunity to set a policy environment for restructuring without profound economic and social disruption. The present program provides the basis for sustainable development and more efficient use of resources. The macroeconomic policies are expected to reduce the rate of inflation and provide the stability required for a resumption of economic growth. They should also bring about the realignment of prices and the incentives needed to restructure the economy along the lines of Zambia's comparative advantage, which lies primarily in agriculture. The dependence on copper should be reduced, as should the capital and import intensity of production and consumption. Savings and investment rates are expected to rise, and, concomitantly, the high consumption ratio to decline. This in turn should give rise to increased employment and income opportunities, and to improved standards of living generally. Substantial efficiency gains are expected from the decontrol of maize and fertilizer marketing and pricing, particularly through increased private trading in these items, leading to a more efficient structure of production, reduced subsidies, and greater food security. Efficiency gains are also  - 3 - expected from privatization of the parastatal sector and from the increased competition flowing from the tariff reform. Diversification is expected to render the economy less susceptible to external shocks. Lastly, Zambia's relations with the international financial community would be regularized, with all that implies for future financial and technical support. Risks 2 There are substantial risks associated with this program. The political changes underway in Zambia give rise to considerable uncertainty and could slow implementation of the adjustment program. For example, political pressures could make fiscal restraint more difficult. It seems unliLely, however, that there would be a major turnaround in policy since the need for adjustment now seems broadly accepted in the ccuntry and the commitment is strong. There are serious social risks to the program also, as demonstrated by the maize price riots of June 1990. The sharp decline in living standards over the past 15 years has left large segments of the population on the edge of subsistence, and any further erosion of their real incomes could result in social upheaval. This risk is made even more real by the high degree of urbanization in Zambia. Implementation of the social action program and the targeted maize coupon program should help protect the vulnerable groups, thereby lowering this risk. Government's limited Implementation capacity is another serious risk, especially given the comprehensive nature of the program. Technical assistance in economic management, to be provided by the Harvard Institute for International Development (HIID), has been arranged for the Ministry of Finance and the Bank of Zambia to help reduce this risk. This assistance includes advice on economic management, planning and budgeting, debt management, external aid coordination, and various Central Banking functions. There is also considerable risk that the necessary amount of donor financing will not be forthcoming, particularly if there is any significant policy backsliding. Frequent donor coordination meetings and the new donor coordination consultant in Lusaka shoiuld help provide an early warning of such difficulties. Lastly, there is the risk that because of past over-regulation and expropriations, the economic agents in Zambia will not respond promptly to the incentives being offered by the program. The program includes efforts to convince the local and foreign business communities that the authorities are serious about an expanded role for private initiative.  Disbursements s The IDA Credit would be disbursed in two tranches, the first for SDR 92.6 million immediately upon effectiveness and the second for SDR 57 million on or about August 30, 1991, upon satisfactory fulfillment of specified conditions. The IDA Reflows Credit would be disbursed immediately upon effectiveness. Disbursement of the large first tra;.che of the IDA Credit and the IDA Reflows Credit covering prior expenditures (retroactive financing) is essential in order to assist Zambia with its foreign exchange cash flow at the time the arrears to the Bank are paid. The second tranche would be disbursed following normal Bank procedures for imports through the Open General License (OGL) facility of the dual exchange rate system in Zambia. ATvraisal Report s This is a combined President's Report and Staff Appraisal Report.  - 5 - INTERNATIONAL DEVELOPMENT ASSOCIATION MEMORANDUM AND RECOMMENDATION OF THE PRESIDENT TO TIE EXECUTIVE DIRECTORS ON A PROPOSED DEVELOPMENT CREDIT AND AN IDA REPLOWS SUPPLEMENTAL CREDIT TO THE REPUBLIC OF ZAMBIA FOR AN ECONOMIC RECOVERY PROGRAM 1. I submit the following report and recommendation on a proposed IDA Credit of SDR 149.6 million (US$210 million), and an IDA Reflows Credit of SDR 19.4 million (Us$27 million), on standard International Development Association (IDA) terms with 40 years maturity, to the Republic of Zambia in support of the country's Economic Recovery Program. The Federal Republic of Germany will participate in the financing of this program with DM 34 million in direct cofinancing. 2. An Economic Memorandum on Zambia (Report No. 5000-ZA) was distributed to the Executive Directors in April 1986. A second-year Policy Framework Paper (PFP), updating the PFP distributed in September 1989 (Report No. SecM89-1115), was distributed to the Executive Directors along with this President's Report to be discussed the same day. I, COUNTRY POLICIES AND BANR GROUP ASSISTANCE STRATEGY A. Background 3. The Zambian economy suffers from severe and longstanding distortions that will require a major structural adjustment effort over an extended period if they are to be overcome. Its major characteristic is the heavy dependence on a single commodity - copper - and the dualistic economic structure that has evolved around this dependence. This industry alone accounts for nearly 85 percent of the country's total exports, contributes about 15 percent of GDP, and is an important source of budgetary revenue. As a result of favorable copper prices and output prior to the mid-1970s, a highly capital and import intensive economic structure was created. The emphasis was placed on import substitution and high protection of domestic industry. A highly overvalued exchange rate was maintained, which provided no incentive for the development of non- traditional exports. In addition, the copper mines set high wage standards, which became the guideline for the rest of industry. The attraction of good wages, together with widespread urban consumer subsidies (including free education and health care, and food subsidies), led to rapid migration from rural areas, making Zambia one of the mo-t urbanized countries in Africa. This, in turn, elicited an urban bias ax, economic and  - 6 - social policy to the detriment of the rural and agricultural sectors, both in terms of incentives and available manpower. At the same time, Zambia used the high copper earnings to acquire large segments of industry, and state ownership became widespread. 4. The vulnerability of the Zambian economy due to its heavy dependence on copper was vividly demonstrated beginning in the mid-1970s, when the commodities boom of the previous decade came to an end. World copper prices fell sharply at that time and continued to decline in real terms, with occasional, brief exceptions, until 1987. The resulting deterioration in Zambia's terms of trade, which by 1986 had fallen by about 80 percent, threw the economy into a deep recession from which it has yet to recover. A decline in copper production (from about 700,000 tonnes to less than 450,000 tonnes) during this same period exacerbated the effects on the economy of the worsening terms of trade, further highlighting the risks of single commodity dependence. S. During most of the 1970s and early 1980s, economic policy was aimed at maintaining consumption levels and living standards, despite declining real resource availability. Subsidies were increased sharply, which when combined with declining budgetary revenues, resulted in growing fiscal deficits. External borrowing increased, and when new loans abroad became difficult to obtain, reliance was placed on domestic banks to finance the deficits. Price controls were tightened, and the exchange rate was kept fixed in an effort to contain inflation. However, the artificially low price encouraged the smuggling of goods to neighboring countries and, together with the scarcity of foreign exchange, reduced the supply of goods on local markets thereby further contributing to inflationary pressures. The resulting price distortions (including an overvalued currency and negative real interest rates), together with the anti-agriculture bias described above, contributed to a further misallocation of resources, increased capital and Import intensity of production and consumption, and discouraged export diversification. Due to the growing shortage of foreign exchange, blackmarketeering became endemic. Agriculture, the sector believed to have the greatest growth and export potential. stagnated due to a lack of incentives. Low domestic savings and investment translated into declining output and productivity, and into rising unemployment. 6. Zambia's per capita real GNP fell by an average of 2.3 percent per annum during the 1970s. In the following decade, real growth exceeded the rate of population growth in only two years (1981 and 1988); as a result, GNP per capita declined by a further 50 percent during the 1980s. A number of factors account for the low growth in this past decade. A persistent drought during most of the decade adversely affected agriculture, while declining ore grades and increasingly inaccessible ore reserves, together with manageriai and technical problems in the mines, led to a somewhat erratic, but steady drop in mineral output. The foreign exchange shortage associated with the drop in mineral exports and the depressed copper prices adversely affected all sectors of the economy. Capacity utilization declined and economic and social infrastructure deteriorated due to lack of maintenance and rehabilitation. Also, the shortage of foreign exchange, together with a poor business climate due in  large part to excessive government control and regulation, reduced the investment level significantly. 7. The Zambian Government made several half-hearted attempts at reforming the economy during the 1970s and 1980s, with support from the Bank, Fund and bilateral donors. None of these were sufficiently comprehensive to bring about the structural changes required in the sconomy, however. In most cases they involved slight devaluations of the Kwacha and adjustments to interest rates, plus intentions to make a number of other policy changes subsequently. These further changes were, at best, only partially implemented. Probably the most ambltious attempt at reform was the Bank/lund-supported program in 1985-87, the main pillar of which was adoption of a foreign exchange auction to establish a market rate and a substantial liberalization of trade. Failure to control the budget deficit and monetary growth undermined the auction, however, and led to great instability in the exchange rate. Inflation accelerated and the program was abandoned by the Government in May 1987 amidst rising popular discontent. This program was replaced by the Government's own adjustment program which represented a complete turnabout in policies. Price .ontrols were reintroduced, the exchange rate was fixed at a highly appreciated level (although not to the pte-auction level) and administrative allocation of foreign exchange reinstituted, interest rates were f'xed at highly negative real levels, and many of the tariff and other measures taken were either reversed or weakened. It was thought that inflation could be controlled by these policies and that the stable exchange and interest would stimulate economic growth. B. Recent Economic Performance 8. Although there was positive GDP growth (6.3Z) in 1988, Zambia's economic performance continued to deteriorate following the adoption of the 1987 policy package. Many of the key economic indicators for the recent years are summarized in Table 1 below. The 1988 growth was concentrated in agriculture and industry. Favorable weather and higher producer prices caused a 20 percent jump in agricultural production that year, while increased foreign exchange availability due to favorable copper prices resulted in a 15 percent gain in manufacturing output. Mineral output, on the other hand, declined by about 9 percent and output in the rest of the economy was stagnant. The 1988 trends in agriculture and manufacturing did not carry over into 1989. All sectors of the economy were stagnant that year and there was no growth in real GDP. Foreign exchange earnings continued to improve as a result of further increases in world copper prices, but these were largely offset by a decline in donor support, due primarily to the lack of an adjustment program. 9. Concerns about econonic policy and a lack of incentives led to a sharp decline in investment in the 1987-89 period. Gross investment as a ratio to GDP fell from nearly 24 percent in 1986 to less than 9 percent in 1989. The nationalization of the larger privately owned maize mills following the food riots in December 1986, and the expropriation of some other private companies subsequently, undoubtedly contributed to a pessimistic outlook on the part of businessmen. In addition, the surprise police searches of business premises and personal residences for  - 8 - blackmarket contraband, including both foreign and local currency (any large amount of Kwacha found was considered evidence of illegal activity and had to be explained), must also have been a factor. Many businessmen, particularly those of Asian descent, emigrated during this period. in any event, with most firms operating substantially bolow capacity, there was little incentive to invest. 10. The economy became increasingly unstable during this period (1987-89). Inflation (end of period) rose from about 35 percent in 1986 to 64 percent in 1988, and then surged to 154 percent in 1989. Part of the 1989 surge in inflation reflected the ending of price control in June, as well as the currency depreciation and the reduction in subsidies. For the most part though, this acceleration in inflation took place during a period TABLE 1s ZAMBIA -- KEY ECONOMIC INDICATORS ---------------------------------------------------------__---------------- 1985 1986 1987 1988 1989 1990 Actual Actual Actual Actual Actual Est. -----------------------------------------------------------------__-------- GDP GROWTH RATE 1.9 0.7 2.7 6.3 0.1 0.9 CONSUMP./CAPITA GR .. .. .. -8.5 -0.2 -2.4 DEBT SERVICE (IN US$M) (ACCRUAL BASIS)/1 716.9 831.7 923.7 971.2 851.7 912.0 DEBT SERVICE/XGS (ACCRUAL BASIS)/1 74.9 109.9 99.7 79.0 56.1 66.2 GROSS INVESTMENTIGDP 14.9 23.8 13.9 12.3 8.7 14.8 NATIONAL SAVINGS/GDP 4.5 10.5 3.0 8.0 5.5 3.6 GOVT. REVENUE/GDP /2 22.3 24.7 22.1 18.3 17.7 21.7 GOVT. EXPEND./GDP /3 36.7 53.3 33.0 30.4 27.0 29.7 GOVT. DEFICIT/GDP (ACCRUAL) -14.4 -28.6 -10.9 -12.1 -9.3 -8.0 (EXCL. GRANTS & INT.) -5.2 -11.8 -2.7 -7.1 -6.1 -4.5 CPI END PERIOD ZCHANGE 58.3 34.6 50.4 64.1 154.3 75.0 REAL EXPORT (GR) /4 .. -30.7 10.4 25.0 22.7 -14.5 REAL IMPORT (GR) /5 .. -29.4 3.0 9.4 24.1 0.9 CURR. ACCT.(IN USSM)/6 -271.0 -237.0 -242.0 -164.0 -149.0 -340.3 CURRENT ACCOUNT/GDP /6 -10.4 -13.4 -10.9 -4.3 -3.1 -8.1