Document of The World Bank FOR OFFICIAL USE ONLY Report No. 10846 PROGRAM PERFORMANCE AUDIT REPORT ZAMBIA INDUSTRIAL REORIENTATION PROJECT (IDA CREDIT 1630-ZA AND AFRICAN FACILITY CREDIT A-004-ZA) JUNE 30, 1992 HICOF~ ICHEj Copy Et N)AR Authr-o. :10846-f Dept. Operations Evaluation Department 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 EQUIVALENTS (annual averages) Currency Unit = Zambian Kwacha (K)* 1983 US$1.00 = K 1.25 1984 US$1.00 = K 1.79 1985 US$1.00 = K 2.71 1986 US$1.00 = K 7.30 1987 US$1.00 = K 8.89 1988 US$1.00 K 8.22 1989 US$1.00 K 12.90 1990 US$1.00 = K 28.99 1991 US$1.00 = K 61.73 ABBREVIATIONS AND ACRONYMS BOZ - Bank of Zambia CPI - Consumer Price Index DCA - Development Credit Agreement EPB - Export Promotion Board EXIM - Export Import Bank FEAC - Foreign Exchange Auction Committee FEMAC - Foreign Exchange Management Committee FMO - Netherlands Finance Company for Developing Countries IDAT - Industrial Development Advisory Team INDECO - Industrial Development Corporation MMD - Movement for Multiparty Democracy NAMBOARD - National Agricultural Marketing Board NERP - National Economic Recovery Program ODA - Overseas Development Administration (UK) OED - Operations Evaluation Department OGL - Open General License System PAR - Performance Audit Report PCR - Program Completion Report PDL - Poverty Datum Line PFP - Policy Framework Paper PIC - Prices and Incomes Commission PPAR - Program Performance Audit Report PR - President's Report SIDA - Swedish International Development Authority TFP - Total Factor Productivity UNIP - United National Independence Party ZCCM - Zambia Consolidated Copper Mines, Ltd. ZIMCO - Zambia Industrial and Mining Corporation, Ltd. ZIMOIC - Zambia Oil Company FISCAL YEAR Government: January 1 to December 31 ZIMCO/INDECO: April 1 - March 31 *The Zambian Kwacha is officially valued in terms of a basket of currencies, for which the US dollar is the intervention currency. FOR OFFICIAL USE ONLY THE WORLD BANK Washington, D.C. 20433 U.S.A. Office of Director-General Operations Evaluation June 30, 1992 MEMORANDUM TO THE EXECUTIVE DIRECTORS AND THE PRESIDENT SUBJECT: Program Performance Audit Report on Zambia - Industrial Reorientation Project (IDA Credit 1630-ZA and African Facility Credit A-004-ZA) Attached, for information, is a copy of a report entitled "Program Performance Audit Report on Zambia - Industrial Reorientation Project (IDA Credit 1630-ZA and African Facility Credit A-004-ZA)" prepared by the Operations Evaluation Department. Yves Rovani by H. Eberhard K8pp Attachment This document has a restricted distribution and may be used by recipients only In the performance of their eMcIal doties. Its contents may not otherwise be disclosed without World Bank aulhorization. PROGRAM PERFORMANCE AUDIT REPORT FOROFFICIALUSEONLY ZAMBIA INDUSTRIAL REORIENTATION PROJECT (IDA CREDIT 1630-ZA AND AFRICAN FACILITY CREDIT A-004-ZA) TABLE OF CONTENTS Page No. PREFACE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . BASIC DATA SHEET . . . . . . . . . . . . . . . . . . . . . . . . iii EVALUATION SUMMARY . . . . . . . . . . . . . . . . . . . . . . . v PERFORMANCE AUDIT REPORT I. BACKGROUND............ ...... . . . . .. 1 Overview of Past Industrial Strategy and Policies . . . . I The Manufacturing Sector at the Mid-1980s - Structure and Performance .. . . . . . . . . . . . . . . . . . . . 3 Earlier Government Initiatives and Their Effectiveness . . 4 II. CONCEPT AND DESIGN OF ACTION PROGRAMS. ..... . . . 9 Industrial Reorientation Strategy - Objectives . . . . . . 9 Policy Instruments and Conditionality ... . . . . . 9 Expected Outcome. . ............. . . . . . 11 III. IMPLEMENTATION AND OUTCOME. . ........... . . . .13 Credit Administration and Utilization..... . . . . . .13 Rationalization of Parastatal Operations .. . . o . 13 Investment and Export Incentives. ........ . . . . o. 15 The Foreign Exchange Auction System at Work...... . . 16 Policy Reversal................... . . 18 Social Impact of the Reforms.......... . . . . .20 IV. THE AFTERMATH............... . . . .. . o. 21 The Post-Auction Foreign Exchange Allocation Regime . . . 21 The Policy Framework, 1987-92 . . . ..... . . . . . 23 V. FINDINGS & ISSUES . . . 2% Ownership . . . . . . . . . . . . . . . . . . . . . . . . 26 Commitment and Consensus . . . . . . . . . . . . . . . . . 27 Conditionality . . . . . . . . . . . . . . . . . . . . . 30 External Financial Assistance . . . . . . . . . . . . . . 31 The Controversy Over the Auction System. ...... . . . 32 Timid Efforts at Raising Tax Revenues.... .. . . .41 Underutilization of the Agricultural Potential . . . . . . 42 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its conents may not otherwise be disclosed without World Bank authorization. TABLE OF CONTENTS (cont'd.) Page No. VI. EVALUATION OF EXPERIENCE AND SUSTAINABILITY . . . . . 45 VII. LESSONS AND RECOMMENDATIONS.... . . . . . . . . . . . .49 ATTACHMENTS 1. Key Economic Indicators, 1980-1991 . . . . . . . . . . . . .57 2. Memorandum on Development Objectives and Policies . . . . . 59 3. Statement of Industrial and Trade Policy..... . . . . . .69 4. Summary of Weekly Auction Results. ........ . . . . .79 5. 1. Short-run Influences on the Parallel Market Premium during the Auction Period . . . . . . . . . . . . . . 81 II. Trend of Parallel Market Premia, 1977-1988..... . .81 6. Sectoral Distribution of Foreign Exchange . . .. . . . 82 7. Foreign Exchange Allocation (Oct. 10, 1985 - Oct. 4, 1986) 83 8. Allocation of Foreign Exchange for Key Industrial Inputs and Equipment. . .............. . . . . . .84 9. Trend in Net Transfers, 1980-1987. .......... . . .85 10. Exchange Rate Regimes, 1964-1991......... . . . . . .86 11. ZCCM - Sales Revenues, 1984-1991.......... . . . 87 12. Government Budget Accounts, 1983-1988........ . . . .88 13. Government Budget/GDP, 1981-1986...... . . . . . . . . . 89 14. Composition of Central Government Expenditures, 1983-1988 . 90 15. Sources of Government Revenue, 1983-1989 . . . . . . . . . . 91 PROGRAM COMPLETION REPORT PART I: PROGRAM REVIEW FROM THE BANK'S PERSPECTIVE..... . . .95 Identity . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95 I. INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . 95 II. ACCOMPLISHMENTS OF GOVERNMENT'S INDUSTRIAL REORIENTATION PROGRAM . . . . . . . . . . . . . . . . 96 III. IMPLEMENTATION OF THE REFORM PROGRAM . . . . . . . . . . 97 IV. THE INDUSTRIAL REORIENTATION CREDIT . . . . . . . . . . 100 V. EVALUATION . . . . . . . . . . . . . . . . . . . . . . . 101 VI. FINDINGS AND LESSONS LEARNED . . . . . . . . . . . . . . 102 PART III: STATISTICAL INFORMATION. . ......... . . . .103 1. Related Bank Loans/Credits . . . . . . . . . . . . . . 103 2. Project Timetable . ... .'. . . . . . . . . . . . . . . 103 3. Cumulative Estimated and Actual Disbursements . . . . . 104 4. Project Implementation . . . . . . . . . . . . . . . . 104 5. Project Cost and Financing . . . . . . . . . . . . . . 105 A. Project Costs . . . . . . . . . . . . . . . . . . 105 B. Project Financing . . . . . . . . . . . . . . . . 105 6. Studies . . . . . . . . . . . . . . . . . . . . . . . 106 7. Status of Covenants . . . . . . . . . . . . . . . . . . 107 8. Use of Bank Resources . . . . . . . . . . . . . . . . . 108 A. Staff Inputs . . . . . . . . . . . . . . . . . . 108 B. Missions . . . . . . . . . . . . . . . . . . . . 109 APPENDIX: Comments Received from INDECO on the Draft PPAR . . . 111 PROGRAM PERFORMANCE AUDIT REPORT ZAMBIA INDUSTRIAL REORIENTATION PROJECT (IDA CREDIT 1630-ZA AND AFRICAN FACILITY CREDIT A-004-ZA) PREFACE This is a Program Performance Audit Report (PPAR) on the Industrial Reorientation Project, involving IDA Credit 1630-ZA and African Facility Credit A-004-KE for a total of US$62 million. The Credits were approved on October 22, 1985, and were closed in December 1988, on schedule. Disbursement was effected in two tranches. The last disbursement was on April 1, 1989, and $0.6 million was cancelled. The project was co-financed by the Overseas Development Administration (ODA) of the United Kingdom and the Netherlands Finance Company for Developing Countries (FMO) in the amount of E10 million and Dfl 29 million, respectively, raising total funding to US$84 million. Of the Dutch grant, Dfl 10 million was not disbursed on this project, but was reallocated to other activities. The PPAR consists of the Performance Audit Report (PAR) prepared by the Operations Evaluation Department (OED) and the Program Completion Report (PCR) prepared by the Africa Regional Office of the Bank (Parts I and III). The PAR is based on the attached PCR, the President's Report, sector and economic reports, the credit documents, the summary of the Board discussion, study of the project files, and discussions with Bank staff. An OED mission vi&ited Zambia in January 1992 and discussed the effectiveness of the Bank's assistance with Government officials, management of parastatals, and represen- tatives of the business and financial community. Their kind cooperation and invaluable assistance in the preparation of this report is gratefully acknowledged. The PCR provides a satisfactory account and assessment of the adjustment effort with regard to the implementation of the various action programs, achievements of the reforms, credit use, and draws lessons from the project experience. To better appreciate the rationale for the action programs enacted and the results achieved, the PAR discusses briefly the status quo ante and the pressing issues that led to the genesis of the industrial reorientation effort; sketches government initiatives prior to the inception of the reorientation effort; assesses the quality of the design of the policy package and action programs, including theic consistency and appropriateness for the problems identified; considers the effectiveness of the IDA/Borrower dialogue, including IDA's role in assisting the Borrower to articulate policy options, evaluate proposals for action, or redirect priorities; dwells on the issues of ownership and consensus; evaluates the progress made in enacting and imple- menting agreed upon action programs; discusses at length the design and implementation of the auction system, a novel device for allocating foreign exchange, and the economic, political and social reasons that led to its demise; examines the extent of consultations and coordination with the IMF; determines the purposefulness and effectiveness of conditionality and tranching* and ascertains the key factors that determine the outcome, effective:...ss and sustainability of the policy reforms. The PAR then draws ftrther lessons from the project experience. Copies of the draft PPAR were sent to the relevant Government officials, INDECO, and the co-financiers for review and comments. INDECO's comments are reproduced in the Appendix. - iii - PROGRAM PERFORMANCE AUDIT REPORT ZAMBIA INDUSTRIAL REORIENTATION PROJECT (IDA CREDIT 1630-ZA AND AFRICAN FACILITY CREDIT A-004-ZA) BASIC DATA SHEET CREDIT POSITION (Amounts in US$ Million) As of May 31, 1992 Credit No. Original Disbursed La Cancelled Renaid Outsanding La 1630-ZA 20.0 22.5 0.6 - 27.1 A-004-ZA 42.0 47.4 - 58.3 CUMULATIVE ESTIMATED AND ACTUAL DISBURSEMENTS La FY86 FY87 FY88 FY89 Appraisal Estimate (US$M) 60.6 61.2 61.8 62.0 Actual (US$M) 60.4 60.9 61.2 61.4 Actual as % of Appraisal (2) 99.7 99.5 99.0 99.0 Date of Final Disbursement: April 1, 1989 PROGRAM DATES Original Actual Identification 07/83 07/83 Preparation 06/84 06/84 Appraisal 11/84 11/84 Post-Appraisal 02/85 02/85 Negotiations 07/85 07/10/85 Board Approval 07/85 10/22/85 Signing 07/85 10/23/85 Effectiveness 09/25/85 11/01/85 Credit Closing 12/31/88 12/31/88 Credit Completion 06/30/89 06/30/89 STAFF INPUTS (staffweeks) FY84 FY85 FY86 FY87 FY88 FY89 FY90 FY91 TOTAL Pre2ppraisal 25.2 10.4 - - - - * - 35.6 Appraisal - 84.4 - - - - - - 84.4 Negotiations - - 15.8 - - - - - 15.8 Supervision - - 41.9 15.7 6.9 1.5 2.0 3.6 71.6 Other 2.6 6.5 12.5 - - - - - 21.6 Total 27.8 101.3 70.2 15.7 6.9 1.5 2.0 3.6 229.0 /a Disbursed and outstanding totals differ from the original amount of the credit in terms of US$ because of changes in the US$/SDR exchange rate. - iv - MISSION DATA No. of No. of Staff Month/Year 'leeks Persona Weeks Preparation 06/84 1.0 5 5.0 Appraisal 10/84 3.0 4 12.0 Appraisal 02/85 3.2 4 12.8 Appraisal 04/85 1.0 1 1.0 Appraisal 07/85 2.0 2 4.0 Supervision I 11/85 3.8 3 11.4 Supervision II 02/86 4.6 3 13.8 Supervision III 03/86 1.0 1 1.0 Supervision IV 11/86 2.6 2 5.2 Supervision V 11/87 4.2 1 4.2 OTHER PROGRAM DATA Borrower/Executing Agency: Republic of Zambia Follo -on Operations: 0,oeration : Recovery Pro&ram I %;redit Number: 1720-ZA Amount : $50.0 million Approval Date: June 26, 1986 Operation Recovery Program II Credit Number: 2214-ZA/2214-1-ZA Amount : $237.2 million Approval Date: March 5, 1991 -v - PROGRAM PERFORMANCE AUDIT REPORT ZAMBIA INDUSTRIAL REORIENTATION PROJECT (IDA CREDIT 1630-ZA AND AFRICAN FACILITY CREDIT A-004-ZA) EVALUATION SUMMARY Introduction by establishing an auction system; reform the import regime, by elim- 1. This is an audit of the Indus- inating the discredited licensing trial Reorientation Project, ap- system and rationalizing the tariff proved in October 1985, for US$62 structure; remove disincentives to million. Donor co-financing raised exports; improve the efficiency of the total funding to US$84 million public manufacturing enterprises, by (Preface, p. i). The economic cir- phasing out uneconomic parastatals cumstances and pressing issues that and by rationalizing the operations led to the genesis of the industrial of those to remain; eliminate inter- restructuring effort and sanction of est rate controls; and enact a new the Project are detailed in paras. Investment Code that would be more 1.01-1.23. supportive of the private sector. Also, the Project would extend tech- Obiectives nical assistance to the Government and relevant agencies to help imple- 2. The immediate objective of the ment these reforms (paras. 2.03- Government's "new" industrial strat- 2.09). egy was to raise the level of capac- ity utilization in the sector. Implementation Experience Increased supply response would reduce the economic and social pres- 4. Progress in implementing the sures associated with the economic reform package, with a few excep- stabilization and adjustment tions, was satisfactory. Major process. For the longer term, the policy actions and technical assis- objective was to increase the ef- tance initiatives were taken on ficiency of the sector and foster time, effectiveness and second its export orientation. To this tranche release conditions were met, end, the Govern!:.nt was committed to and the Credits were disbursed on pursue less protective and more schedule. Bank supervision was export-oriented policies, rely in- intensive and effective. About 95% creasingly on marke- forces, improve of the funds were allocated for the the incentive structure, limit in- importation of industrial inputs and dustrial investments in the public 5% for technical assistance (paras. sector, and increase the efficiency 3,01, 3.04, 3,06). of public sector manufacturing (paras. 2.01, 2.02). Outcome 3. To advance these objectives, 5. After several halfhearted the Project would support policy and trials, this was the most ambitious institutional changes designed to attempt at reform, and the Bank improve the foreign exchange regime, entertained high expectations re- - vi - garding the prospective economic and tance exacerbated the situation social impact of the agreed package (paras. 3.13-3.16). of policy measures (paras. 2.10- 2.13). 8. The binding constraints in eliciting a prompt supply response 6. The reforms, however, were had been underestimated. The imme- reversed only 18 months after their diate benefits of the depreciation inception and, as a result, they had were not apparent, and were offset no measurable impact. After a short by the deterioration of living stan- period of implementation, the indus- dards. The unimaginative handling trial reorientation program became of consumer subsidies was not help- unsustainable and was abandoned by ful either. The pervasive senti- the Government, because it felt it ment, given several earlier aborted was losing economic and political efforts, that the determination and control of the situation. In par- courage of the political leadership ticular, the novel auction system to carry out the reforms was not for allocating foreign exchange, commensurate with the task at hand, which was the cornerstone of the undermined confidence in thr auction reform "ackage, quickly became a system and the reform program. The contentious issue, was ineptly in- program's sustainability called for terfered with and, ultimately, led its proponents and managers to re- to the collapse of the entire reform main in power to shepherd the effort effort on May 1, 1987. Erratic -- but they were ousted early on in access to foreign exchange led to a the process. Finally, a politically deterioration of industrial perfor- sensitive Government succumbed to mance (paras. 3.07-3.16, 5.15-5.29, pressure in the face of a pervasive 6.04). and entrenched opposition fostered by vested interests and ideological 7. An array of economic, politi- concerns (paras. 5.16-5.29, 6.04, ca1 Qnd social factors contributed 6.05). to the demise of the program, and the unsuccessful outcome of the 9. Initially, the auction system effort. Inept demand management and functioned relatively well. After the Government's inability to con- an initial sharp decline reflecting trol the fiscal deficit, which was a more realistic market value, the financed by an equally uncontrolled exchange rate stabilized, the short- growth in money supply. Inade- comings of the import licensing quacies in the monetary policy system were eliminated, inflation framework and controlling mechanisms moderated, and manufacturing produc- that could not stem the mounting tion, capacity utilization and ex- inflationary pressures. This chain ports picked up (paras. 3.07, 3.09, of events resulted in a much greater 3.10). A period of instability and faster depreciation of the cur- ensued only at a later stage, fol- rency than originally anticipated lowing an array of inapposite inter- under the auction system. The situ- ventions in an effort to stem the ation was aggravated. n part due to downward slide of the currency. haphazard administra,ive interven- They were prompted by the belief tions in the auction's operation that, by allowing a precipitous and in part due to foreign exchange depreciation of the exchange rate, shortage. The heavy external in- the auction system was leading to a debtedness and the absence of any worsening of the fiscal position and contingency plan to meet projected an increase in monetary growth and/or unexpected shortfalls in (paras. 3.07-3.11, 3.15, 5.19, export earnings and external assis- 5.21). - vii - 10. Although these interventions garding the privatization of para- were largely impelled by the tight statals, and the fact that important foreign exchange due to declining considerations relating to the im- export earnings and donor support, plementation of a divestiture plan the fact is that the economy re- had not been fully thought out. In mained highly liquid because the the wak- of the new Government's Government was not decisive enough decision to move ahead in earnest to curb the budget deficit and/or with parastatal privatization, raise tax revenue, and even less INDECO's role is being reassessed determined to make more effective (paras. 3.05, 5.10). use of monetary control instruments. In the absence of strong political Findings and Issues leadership and lack of fortitude, as reflected in the early replacement 13. The reform package was prac- of the economic team that had spear- ticable and it was "owned" by the headed the reform program, the sub- Government (para. 5.01). The Bank sequent misguided interventions in played an important role in the the operation of the auction system, design of the reforms. Earlier and the weak overall demand manage- economic and sector work helped ment, donor confidence was shaken focus attention on areas where sig- and external financial support came nificant change was needed, define to a standstill (para. 5.28). technical and policy options, and translate adjustment strategy into 11. Some progress was. made in mutually consistent and actionable improving the operating, mainly programs. There has been close financial, performance of a number consultation and coordination with of parastatals under the Industrial the IMF and the donors in the course Development Corporation (INDECO). of articulating particular action However, INDECO has made no infor- programs to en3ure congruity of mation available on the extent of purpose (para. 6.01). the rationalization of their opera- tions and their financial condition 14. The thrust of the strategy, in the last three years. In the the objectives, and the support absence of such vital data, it is policy instruments were appropriate, not possible to ascertain whether albeit the weak link with more far- initial improvements were due to reaching reforms in the agricultural fortuitous factors, whether the sector attenuated their potential momentum has been sustained, and impact. The action programs were what has been each parastatal's more well-conceived, were purposefully recent financial performance. Also, designed, and addressed priority in the absence of the requisite issues. Nonetheless, building some information, no assessment can be flexibility into the program to cope made on the economic viability of with unexpected shortfalls in for- these parastatals (paras. 3.02- ! exchange proceeds, provision of 3.04). short-term compensationto those who bore the brunt of the reforms, and a 12. An Economic Evaluation Unit more realistic assessment of insti- was established at INDECO's head- tutional delivery capacity and out- quarters, but its vetting capability come, could have enhanced the cred- and effectiveness remain limited. ibility of the reform effort (paras. INDECO prepared no action program to 3.13-3.19, 5.11-5.14, 5.16-5.29). phase out non-viable enterprises, Actions to be taken were spelled out reflecting self-serving purposes, in considerable detail, thereby the Government's ambivalence re- facilitating the monitoring of time- - viii - bound programs. Conditionality and takes time to build new capacity and tranching were germane to the objec- develop new export markets, even tives and actions agreed and perfor- assuming that market access is not mance-oriented. Although comprehen- restricted by non-tariff barriers. sive, conditionality was not exces- The actual performance of non-tradi- sive in the face of the task at tional exports during the late 1980s hand. With a few exceptions, the reflects the force of these abiding Government complied fully (paras. constraints, and suggests that the 6.02, 6.03). original optimism was not warranted (paras. 6.07, 6.08). 15. The effectiveness and sustain- ability of the package of policy 17. The workability of any form of reforms were predicated on the foreign exchange regime essentially Government's ability to develop and depends on developing an effective effectively use proper policy in- supportive policy framework, par- struments to maintain sustainable ticularly of operative fiscal and internal and external balances; a monetary control mechanisms, which rise in industrial production; the is cushioned by adequate foreign undertaking of new investment and exchange flows to enable it defend a expansion of exports; and access to rate that would sustain internal and external resources to bridge the external equilibria. Fragile mone- external resource gap in the face of tary and fiscal systems are likely the slow export growth and faster to foster speculative tendencies in rising imports in the initial stage, the face of foreign exchange short- make up for unforeseen shortfalls in ages, and drive the exchange rate to export earnings, and serve a size- inappropriate levels, causing a able debt -- prerequisites that were depreciation-induced inflationary not met (prra. 6.04). spiral and internal imbalance, whether a freely floating (such as 16. The response of the indus- the auction system) or a crawling trial sector to the new signals peg arrangement is in place. The could not reasonably be expected to workability of the crawling peg be immediate. The development of system is equally dependent on the non-traditional exports and a reduc- effectiveness of fiscal and monetary tion in import dependence require controls, in addition to adminis- more time than was allowed within trative dexterity to elicit timely the framework of the reform program. responses to internal and external The promotion and reorientation of shocks. In the face of poor demand non-traditional exports toward new management, a crawling peg can only products and markets is inherently a delay through "rationing" but not difficult and protracted process. avoid altogether subsequent substan- Lack of competitiveness emanating tial devaluations, as the pre- and from outdated technology, inef- post-auction period have amply ficient production and quality con- demonstrated (paras. 1,17, 4.01- siderati,ins, and absence of market 4.09). Furthermore, a floating contacts; narrow supply of in- exchange rate system can be skill- digenous entrepreneurship and, per- fully "managed" to introduce an force, reliance on foreign inves- element of stability, as in the case tore; shortage of skilled manpower, of Ghana (para. 5.16, footnote 29). poor condition of much plant and On the other hand, had the Govern- equipment, unavailability of term ment been assured at the critical financing, and poor infrastructure; breaking point that, as long as it and low labor productivity, are persisted with the auction system binding constraints. Finally, it and the reform package assistance - ix - would be forthcoming, the political high duties and taxes on luxuries, leadership might not have given up or even temporary prohibition, could (paras. 5.28, 5.29). have scored high psychological points. In short, purity and uni- 18. In retrospect, the poor out- formity may have to be compromised come of this adjustment operation in to a degree, and second best solu- light of Zambia's history of rever- tions may have to be considered, sals casts doubts on the seriousness provided that they do not defeat the of the Government's renewed commit- original purpose, if they are polit- ment, and on the soundness of the ically more palatable and have a Bank's decision to support the re- better chance to work (para. 6.06). form effort, at the time. To be sure, the risks of a reversal were 21. The question still remains, acknowledged at appraisal. But however: was it right to undertake arguably, any Bank decision is lia- the reform given the difficult con- ble to be challenged, and this ditions at the time? There can be presents a real dilemma. Realis- no doubt that reform of some sort tically, there is no easy answer to was long overdue. However, had this quandary. The resolution of certain measures been initiated this issue, intractable and inher- prior to, or even concurrently with, ently risky as it may be, will in- the launching of the program and evitably be a matter of judgment adhered to, a reversal might have based on a subjective assessment of been prevented, by adding cred- the surrounding circumstances -- and ibility to the Government's effort perforce a close decision (paras. and commitment and, thereby, pla- 5.01, 5.02, 7.08). cating concerns both domestically and abroad. For instance, measures 19. In the same vein, there are to raise the tax effort; adoption of serious difficulties in establishing more effective fiscal and monetary with a measure of confidence the controls to support a sustainable existence of a consensus among var- fiscal deficit; implementation of ious constituencies, as this desid- agricultural reforms (e.g., unravel- eratum cannot be readily quantified ling of uniform prices, institution and its incidence cannot always be of property rights on land); exter- ascertained ex ante (paras. 5.03- nal debt rescheduling to ensure 5.07). A practicable approach to serviceability; access to a regular address this issue would be to es- flow of external resources to sup- tablish whether or not the proposed port the auction system in case of program satisfies a set of funda- an unexpected. decline in export mental preconditions, i.e. a Pre- earnings; greater appreciation of sumptive consensus, as set out in the need for a safety net and better para. 5.08. In Zambia's case, con- targeting of subsidies to the lowest sensus was fractious at best, and income groups to induce them to this accounts in part for the demise continue to participate in the pro- of the program (paras. 5.03, 5.04). cess, might have helped sustain the reform program (para. 6.11). 20. Though the advantages of the auction system were overwhelming 22. The sustainability of the from the allocative standpoint, a auction system, and of the reform limited second-tier at a lower ex- package, was predicated on the reau- change rate exclusively for essen- lar flow of external resources. But tials which affect the well-being of the Government's ability to mobilize the low income groups could have external resources was conditioned been tolerated. Similarly, very on the progress made in carrying out its reform commitments while, in crucial threshold constraints vis-a- turn, performance was heavily de- via important requirements (e.g., pendent on the timely availability size of plant and market, technology of sufficient external assistance, and skills, attitudes and values, fostering a link which was intended organizational structures, institu- to be reinforcing but which turned tional arrangements). The process out to have a debilitating effect. cannot be unduly stretched and ac- It would seem that the absence of celerated with impunity. initiatives referred to in para. 21, among other factors, undermined the 26. With regard to the timing and Government's credibility within and conceptualization of policy reforms: without the country, as well as the Government's confidence in its own * Chronic neglect, procrastina- ability to carry out the reforms tion, inertia, tentativeness, and (paras. 5.24, 5.25, 6.11). continuction of the status quo by adopting palliatives or intermittent 23. By the end of 1991, Zambia was measures, only perpetuate an unten- in no better economic situation than able situation, postpone the hard in the mid-1980s. But despite the political choices, and render the reversal and the fact that no tan- eventual decisions tougher. Pro- gible structural adjustment took longed delay in launching an adjust- place during the relatively short ment program not only results in period during which the policy re- Paying a much higher price for re- forms were in effect, vestiges of storing conditions for growth, but the defunct program remain, as im- renders the adjustment process more portant elements (e.g., price de- vulnerable as economic agents tend controls, tariff reform) were pro- to doubt the sustainability of the gressively reinstituted. The new program which, in turn, enhances the Government, which came to power chances of a reversal. Finally, it after the October 1991 elections is far more difficult for reforms to that swept out of office the one- take root when there is a history of party system under UNIP, appears aborted attempts at reform. determined to capitalize on these elements, and forge ahead with addi- * A deep understanding and ap- tional measures (paras. 4.06-4.10, preciation of the cultural back- 5.30, 5.35). ground, political realities, insti- tutional arrangements, attitudes Lessons and Recommendations and, more generally, of the way decisions are taken and implemented 24. The lessons of experience and in a country can lead to less dog- suggestions for potential courses of matic approaches to institutional action are detailed in paras. 7.01- and policv reforms, and more prac- 7.08, and are briefly summarized ticable solutions and condition- below. ality. 25. Concerning the strategy and * Crucial elements for the suc- speed of industrial development and cessful implementation of action diversification: programs are a strong political will, broad consensus, unwavering * Industrial growth and reorien- commitment, fortitude, and staying tation should be pursued in parallel power of incumbent proponents of the with and be firmly anchored in agri- reforms to see to their implemen- cultural development. The deepening tation. Ensuring public support for of the industrial structure faces policy reform, particularly during - xi - implementation, is crucial. But, of interdependence and interaction political commitment and support of with reforms in other sectors; e public opinion are likely to be pro- body a reasonable element of flexi- gressively more difficult to sus- bility insofar as the means of pur- tain, the longer the adjustment suing agreed ends are concerned; and process continues without tangible provide some latitude for adiust- payoff in terms of growth, and the ments during implementation to ac- longer social conditions are allowed commodate unforeseen constraints. to deteriorate. 6Conditionality should aim at * The notion of "ownership" can striking and reinforcing a prac- be elusive. A program can be said ticable balance between industrial to be "owned" by the Government when and trade Policy reform3, regulatory there have been extensive exchanges, changes, and macroeconomic stabili- thc-re is concurrence on strategy and zation. measures and, more importantly, when the top political leadership made To alleviate the socio-eco- the final decisions. This reflec- nomic repercussions of measures tive process implies political will enforced under restructuring pro- and commitment, and betokens "owner- grams, it would be expedient to ship" in the sense that the Govern- identify early on in the design ment satisfied itself that the pol- process Rarticular population icy reforms and actions represented groups/industries in need for an appropriate, realistic, and special assistance, and to ensure feasible course of action; con- that such assistance would be forth- sidered the political trade-offs; coming for a transitional period. understood fully its requirements and implications; and accepted it in 28. With respect to the sustain- its totality, ability of the adiustment effort: w There are inherent difficul- i The prior satisfactory imple- ties in defining the contours of a mentation-of a stabilization Progr consensus. A practicable approach through iudicious demand management would be to establish whether the provides the requisite economic reform program proposed by t environment and confidence for a political and economic leadership more effective implementation and satisfies certain fundamental pre- sustainability of industrial and conditions. A positive assessment trade adiustment measures. of these desiderata, as detailed in para. 5.08, should provide a fairly tFirst-best olicies may not reliable basis to presume the exis- always be sustainable because of tence of a broad consensus, suf- strong opposition. Arguably, more ficient to justify the launching of differentiated and nuanced second- a reform program (presumptive con- best policies responding better to sensus). economic, political, and social realities may prove more successful 27. Concerning the design of ac- in the longer pull. tion programs: * Although a crisis situation The effectiveness of action may embolden a overnment to intro- programs is enhanced if they are duce radical reforms and make a commensurate with the implementation clean break with the past, sustain- capacity of ministries and agencies ability of the adjustment effort is concerned; have built in the effects far from assured. - xii - * Policy reversals are more adiustment program to facilitate likely to be avoided when the nega- debt serviceability and, by exten- tive effects of the reform effort on sion, enhance the sustainability of growth, employment and living stan- the reform program. dards are mitigated and short-lived; supply response is fairly quick and 29. The experience with the effec- visible; the reform program is un- tiveness of external financial as- derpinned with effective macro- sistance leads to the following economic policies; actions are cred- observations. ible and sustainable and, more im- portantly, are perceived to be sus- * External assistance can be tainable; there is access to a ragu- helpful in promoting reform when it lar flow of external resources; is conceived and presented as a external debt is serviceable; and reinforcing agent and as a means of there is faith in the determination, reducing the cost of reforms to courage and capacity of the politi- which the policy-makers in the re- cal leadership to carry out the cipient country are already com- reforms. mitted. Aid is likely to be self- defeating if it is proffered as a * Whether a freely floating or a quid pro quo for the reform commit- crawling peg foreign exchange regime ment itself. is adopted, what really matters for its workability and sustainability * Only those forms of aid that is the emplacement of an effective have the effect of changing eco- supportive policy framework, par- nomic, social and organizational ticularly of operative fiscal and structures can provide essential monetary control mechanisms, which benefits to the recipient. External is further cushioned by adequate assistance therefore should be cir- foreign exchange flows to enable it cumspect and discrete to avoid defend a rate that would sustain thwarting government efforts to internal and external equilibria. address pressing economic and sector Weak monetary and fiscal systems are issues by Providinz a convenient likely to cause a depreciation-in- cushion. Furthermore, since aid duced inflationary spiral and in- does have an opportunity cost, to ternal imbalance with destabilizing assure effective delivery, bilateral effecte. and multilateral agencies need to act in concert and take a firm * Efforts to reduce budget defi- stance '.o ensure congruity of pur- cits tend to place an inordinate pose, consistency in policy reforms, emphasis on cutting expenditures, coordination of the total effort and while lip service is paid to insti- synchronization of actions, prevent tuting credible tax reforms to raise the transmission of conflicting revenues. Stabilization and struc- signals, and avoid duplication and tural adjustment efforts are more dissipation of effort. likely to be sustainable, if expen- diture reductions and an increased 30. With regard to parastatal tax effort are pursued in tandem. privatization: * In instances of heavy indebt- * It is extremely difficult to edness, it would be advisable to reorganize, let alone dismantle, consider some form of debt reprieve unessential moribund entities and by Governments and/or private cred- enterprises in the public domain itors concerned prior to or concur- because of the resistance of en- rently with the implementation of an trenched bureaucracies and a con- - xiti - cerned labor force. The situation * There is a trade-off con- is exacerbated when the political cerning the speed with which import leadership is unable to reach a restrictions and licensing should be consensus on this issue; when there eliminated: the longer the com- is lingering suspicion of the non- petitive pressure is delayed, the indigenous private sector and the more time protected firms are af- implicit objective of divestiture is forded to adjust; but, at the same to ensure indigenous ownership; and time, undue prolongation of the when there is vacillating concern adjustment process is likely to meet about the transparency of asset with increasing resistance, poten- valuation, funding, concentration of tially rendering implementation more economic power, and social repercus- difficult and compromising the bene- sions. fits from import liberalization. A realistic timetable for the elimina- * Early initiatives to ease the tion of restrictions would instill social impact of privatization and steadfastness, credibility, and facilitate the redeployment of the certainty in the reform process, and affected work force would go a long would thwart pressures from affected way toward speeding up the process groups to vitiate the reform effort. and mitigating resistance. Such provisions may include retraining * Expansion of foreign exchange programs, assistance in finding new earnings from the adoption of an jobs and relocation, arrangements export-oriented strategy will take for and funding of severance pay- time because of binding constraints. ments, unemployment compensation, This suggests the need for regular transfer of accumulated pension and flows of external resources to sus- health benefits, access to land, tain the import liberalization ef- extension of credit to set up a fort. Understandably, access to business activity, incentives for external resources would depend on early retirement, etc. sound macroeconomic management. 31. Regarding the imports control * Import demand is not likely to regime and arrangements to promote be very responsive to a change in manufacturing exports: the exchange rate, as devaluation does not necessarily enable a coun- * The pace of import liberali- try to derive quick benefits from zation and sectoral adiustments is the "switch effect" (i.e. the sub- conditioned basically on export stitution of domestically produced performance, as affected by domestic for imported goods) due to short- and external economic developments. term supply rigidities, heavy import dependence on high technology in- * The strong link between an puts, equipment, and consumer dur- efficient production substructure ables, and binding constraints to and export potential, in view of the efficient import substitution. constraining effects of short-term supply inelasticities, should be 32. Finally, a retrospective re- duly appreciated in efforts to stim- flection on the Bank's relationship ulate a speedy export growth. with countries that over the years have had a poor record in imple- * The promotion and reorienta- menting economic reforms raises tion for non-traditional exports sensitive issues concerning the toward new products and markets is a Bank's way of reasoning* postures difficult and drawn-out process. and approach vis-a-vis its Borrowers. - xiv - * The long-standing notion en- less flows of external resources tertained within the Bank of working viewed as an entitlement inadver- closely with the Borrower and within tently creates a disincentive effect the existing economic. social and on the recipient's behavior since, political structures, to the end of by providing a cushion, it allevi- inducing piecemeal changes, has not ates the pressure on the political met with success in the case of authorities to be more resolute in Zambia (and in other countries as addressing pressing economic prob- well). The results achieved hereto- lems. The resolution of this issue, fore suggest that this approach has intractable and inherently risky as hardly helped promote the long-term it may be, will inevitably be a interests of the Borrower -- or of matter of judgement based on a sub- the Bank for that matter. jective assessment of the sur- rounding circumstances -- and per- * A country's poor performance force a close decision. record and history of aborted ad- justment efforts inevitably calls * To be sure, the Bank faces a into question the seriousness of a perennial dilemma. Nonetheless, a new Government's genuine commitment de,!ision will have to be made: to reform, and raises a difficult should the Bank continue to support issue for the Bank and the donor policies which are not working, community as well: how should re- cannot reasonably be expected to versal-prone, remiss Governments be work in the circumstances, and which treated? Should they be ostracized it is not in a position to influ- -- and at which point? Can the ence? Or, in the face of uncom- causes of earlier failures unequiv- promising Borrower attitude, should ocally be established and culpabil- the Bank retrench, question the ity meted out, including the Govern- wisdom of its further involvement, ment's share? Can a meaningful and even suspend lending? In view "probation" period be established? of the serious implications of this Is fumbling and stumbling part of decision for all concerned, the the learning process and, by exten- difficulty in making a determination sion, of the development process? should not deter the Bank (and the At what juncture multilaterals and donors) from pondering over the donors should let bygones be bygones issue, weighing carefully the pros and start afresh? Can there ever be and cons, and justifying its deci- assurances that economic realities sion whether to continue supporting will have sway over political ex- the new Government's development pediency, that the ever new Govern- efforts or back away. ment and economic team are more enlightened than their predecessors, * In deciding to end the recent and that they have learned the les- stand-off with Zambia, evidently the sons of past experience and will Bank satisfied itself that the newly stick to their commitment? What elected Government was given a does it really take to bridge '.he strong mandate, and appeared deter- credibility gap, given that a fine mined and fully committed to pro- distinction should be drawn between ceeding steadfastly with the imple- bona fide shortfalls in performance mentation of a convincing program of due to imponderables or factors economic reforms. demonstrably beyond the Government's control, and an accommodating pos- ture by multilateral and bilateral institutions eager to discern exten- uating circumstances and provide assistance? Easy access to bound- PROGRAM PERFORMANCE AUDIT REPORT ZAMBIA TNDUSTRIAL REORIENTATION PROJECT (IDA CREDIT 1630-ZA AND AFRICAN FACILITY CREDIT A-004-ZA) I. BACKGROUND Overview of Past Industrial Strategy and Policies!/ 1.01 Zambia's industrialization strategy from the mid-1960s through the early 1980s was characterized by a diminished role of the market mechanism in guiding resource allocation in industry; state ownership of important industrial enterprises; major public investments in intermediate sectors (chem- icals, fertilizers, cement) and consumer durables (e.g., automobile assembly); restriction of foreign competition through import licensing and tariffs; promotion of import-substitution industries through high levels of protection, investment controls, restrictive licensing, and other regulatory devices; and a strong bias against exports. The strategy was underpinned with foreign exchange and tax revenue generated by the copper mining sector, which secured the needed foreign exchange for the importation of the capital goods and input requirements of the new industries, provided the requisite fiscal resources for capital investments, and sustained effective demand for industrial goods. A serious flaw in the design of this strategy was that, inter alia, it did not envisage the growth of agricultural and industrial production in an integrated fashion to ensure a mutually supportive pattern of development. 1.02 This inward-looking strategy succeeded in expanding and diversifying the industrial sector. However, the overvalued exchange rate (para. 1.03), duty-free imports of capital goods, and negative real interest rates encouraged the use of capital-intensive processes and the establishment of over-dimen- sioned plants; led to highly import dependent and management/skill intensive investments, excess capacity, and low levels of efficiency; and resulted in the virtually total dependence of the sector on the domestic market, in an attempt to accelerate the pace of industrialization. However, the domestic market remained depressed as real incomes declined, in part due to misguided policies and tepid efforts to develop the agricultural setor (paras. 1.07, 1.17). i For details on industrial sector and macroeconomic developments in Zambia see the following World Bank reports: No. 5000, Zambia - CEM: Issues and Options for Economic Diversification, April 16, 1984; No. 4436, Zambia - Industrial Policy and Performance, August 6, 1984; No. 5658, SAR, Zambia - Fertilizer Industry Restructuring Project, February 4, 1986; No. 5727, Zambia - Wage Policy and the Structure of Wages and Employment, Ma5 7, 1986; No. 6355, Zambia - CEM: Economic Reforms and Development Prospects, November 19, 1986; No. 6438, Zambia- Public Expenditure Review, 2 vols., October 6, 19P7; R. Gulhati, Impasse in Zambia - The Economics and Politics of Reform, EDI Development Policy Case Studies No. 2, 1989; No. 9827, Zambia - Public Sector Management Review (draft), 3 vols., August 14, 1991. -2 1.03 The set of policies adopted to implement this industrial strategy undermined further any chances of promoting competitiveness and generating sustainable growth. The exchange rate remained significantly overvalued for almost three decades (until the end of 1982), sustained by extensive external borrowing and assistance. This reduced the competitiveness of Zambia's tradable goods both domestically and abroad, and put additional pressure on an already difficult balance of payments situation. A cumbersome system of import licensing and foreign exchange control developed over the years to protect domestic industries and maintain external equilibrium at highly distorted exchange rates. As the foreign exchange shortage worsened, the system of import licensing/foreign exchange allocation became the main instrument of industrial policy, with the government bureaucracy, the Central Bank and the commercial banks exercising an undue and arbitrary influence on the final allocation. This situation resulted in rent-seeking activities, created inequities in the treatment of individual firms, gave rise to windfall profits for particular firms and individuals, and led to inefficient allocation of resources. 1.04 The tariff structure provided cascading protection as consumer and luxury goods were subject to high tariff rates (up to 150%), and intermediate and capital goods to very low or zero rates. In fact, many intermediate and capital goods industries received negative effective protection. This structure, intended to encourage rapid industrialization and protect infant industries, produced high and extremely variable levels of effective protection to local industries which largely engaged in assembly or processing-type activities with low value added. The biase& of the protective structure were reinforced through widespread duty exemptions on imported inputs granted as incentives to local industry. However, for all practical purposes, the tariff structure eventually became irrelevant as the system of import licens- ing/foreign exchange allocation effectively eliminated foreign competition, and provided open-ended protection with no incentive for cost discipline. Thus, the incentive effects of the trade regime turned out to be unpredictable, varying with the pattern of import license allocation and the decisions of the exchange control authorities. Also, zero duties on many intermediate goods and an overvalued exchange rate provided a strong incentive for substituting imported materials for local inputs, thereby forestalling their development. 1.05 The system of price controls, which was increasingly broadened in an attempt to influence the pricing behavior of the shielded local industry and protect consumers in the face of increasing shortages, introduced further distortions. Three major categories of prices came under some form of control: farm gate prices of agricultural goods, wholesale and retail prices of "essential commodities," and prices of goods produced by parastatals. The bias against exports and agriculture fostered the growth of an industrial sector which was not fully consistent with Zambia's resource endowment and comparative advantage. Because of the high level and variance of effective protection, industrial production has hardly achieved acceptable levels of international competitiveness, while it has encouraged excessive allocation of resources in industry and away from mining and agriculture, which carried negative effective protection. In particular, past investments in such large-scale projects as fertilizers, paper, packaging materials, and automobile assembly have imposed high resource costs on the economy. Ironically, there appear to be sectors in which Zambia could achieve international competitiveness: food products, wood and wood products, some textiles, and fabricated metal products (see also para. 1.11). -3- 1.06 The Government's decision to get directly involved in manufacturing, including majority participation in firms previously in the private sector, undermined investor confidence and adversely affected private sector invest- ment. The declining economic activity reinforced this trend. In an effort to attract private investment, in 1977, the Government enacted the Industrial Development Act. The Act was highly regulatory, did not provide any new incentives, access to the incentives continued to be arbitrary, and did not fully abandon the overall industrial strategy that assigned a dominant role to parastatals. The Act singled out manufactured exports for some additional benefits, but these were more than compensated by the negative impact of exchange rate overvaluation and cumbersome export regulations. Predictably, the Act was not successful in achieving its stated objectives. The Manufacturing Sector at the Mid-1980s - Structure and Performance 1.07 By the mid-1980s, manufacturing comprised some 540 firms and employed some 48,000 persons. Production was concentrated primarily in consumer goods; but two sectors producing intermediate and capital goods stood out -- chemicals (oil, refinery and fertilizer) and engineering goods and metal fabrications linked to the mining sector. Manufacturing production declined by 15% in real terms between 1975 and 1980, and showed only nominal annual growth through 1985; its share in GDP remained virtually constant -- at about 20% (Attach- ment 1). Capacity utilization had been fal.ing since the mid-1970s, inter alia, as a result of the worsening economic situation and the increasingly critical foreig exchange shortage; by the mid-1980s, it was estimated to have been about 42%. Total factor productivity (TFP) for the manufacturing sector as a whole declined at an annual average rate of 3.8% between 1965 and 1980, a pattern which conforms closely to the macroeconomic trends in aggregate demand and foreign exchange availability. There is every reason to believe that the trend persisted through the mid-1980s. Since TFP declines are tantamount to increases in unit costs, this progression clearly suggests a substantial increase in the average costs of industrial production. None- theless, high levels of protection permitted domestic prices to rise to levels well above those of traded equivalents. Industrial exports accounted for less than 0.7% of total exports, and represented 0.6% of gross manufacturing output in 1980; they had not grown either in volume or in number of commodities over the preceding decade or during the first half of the 1980s. 1.08 The parastatal sector played a leading role in industrial development, accounting in the mid-1980s for 69% of assets in manufacturing, 66% of value added, and 54% ot employment. During the 1970s, the public sector grew at rates exceeding those of the economy as a whole and those of private manufac- turing.!' This growth, however, was accompanied by deterioration in capacity utilization and efficiency, and sizeable financial losses due to government policies (e.g., price controls), intrusive intervention by political authori- ties, the general downturn of the economy, over-dimensioned plants, weak management, shortage of technical skills, excessive employment, labor inefficiencies, and unavailability of imported inputs. The policy of setting prices on a cost-plus basis did not encourage cost reduction and efficiency, while enforcement of price restraints to protect consumers weakened further the financial position of parastatals. A preliminary review of the econcmic ' Represented basically by the Industrial Development Corporation (INDECO), a holding company controlling 37 subsidiaries (43 in 1992). -4- efficiency of INDECO's subsidiaries coneacted in 1985 indicated that a good number appeared to be uneconomic under any conditions, while the economic viability of many others was questionable. These findings suggested the urgent need to assess the economic viability of the industrial parastatals, institute substantial changes in the way INDECO's enterprises were run, and restructure and/or close down uneconomic enterprises (see also para. 2.08). 1.09 Private manufacturing comprises some large scale firms, many of which serve the mining sector; medium and small scale firms using reasonably modern machinery and methods and employing wage labor; and very small, artisanal industries. With few exceptions, private manufacturing firms are smaller than public sector firms. Private irdustry has been subject to widespread administrative controls and regulations, interspersed with incentives to selected firms and sectors. Private investment has been low during the decade 1975-1985 (para. 1.06), and employment has been declining. Capacity utiliza- tion has been lower than in parastatal companies (38%), partly because the administrative allocation of foreign exchange has favored the parastatals. 1.10 The industrial (and mining) activities continue to be dependent on expatriate technical, managerial, and administrative skills. Real wages have dec?lted over the years for workers of different skill levels and different employer groups (parastatal, private), as the Government has been trading off wage and salary increases for employment growth. The policy of "narrowing the gap" has left unskilled workers relatively better off than higher skill categories, as unskilled wage rates in the formal sector have been relatively more insulated against inflation. As a result, the wage structure has become increasingly compressed over time, a trend that may also have contributed to a decline in the workers' incentive to acquire skills. Earlier Government Initiatives and Their Effectiveness 1.11 By 1982, Zambia's economic difficulties had come to a head as corrective measures introduced as early as 1980 met with limited success. Although the vulnerability of the economy to developments in the world copper market had been amply demonstrated since the mid-1970s, and despite declining resource availability, macroeconomic policies were geared to maintaining living standards and consumption levels in the expectation of an imminent upturn of the copper pricas. Subsidies were increased which, combined with declining budgetary revenues, repulted in growing fiscal deficits. External borrowing inc:eased, and when new loans abroad became difficult to obtain, reliance was placed on domestic banks to finance the deficits. No systematic effort was made to reduce the excessive reliance on the dwindling copper mining sector which accounted for 90% of foreign exchange earnings, 30% of GDP, 30% of government revenue, and 16% of employment. And no progress was made in exploiting development opportunities in other sectors, agriculture in particular, where apparently there is the greatest potential for efficient import substitution (cotton, oilseeds, livestock, grains, forestry products, fish) and for exports (beef, cotton, coffee, tobacco). To the contrary, price controls and subsidy policies favored urban consumers at the expense of agricultural producers, depressing the latters' income and incentive to produce for the market. Ideological biases and disdain for orthodox prescriptions, high levels of industrial protection, adoption of an industrial strategy incompatible with the country's resource endowment, disregard for binding constraints, lack of adaptability to changing circumstances, tentative political will, and inept and myopic economic management had led to an impasse. -5- 1.12 Negative in real terms deposit and lending interest rates limited resource mobilization and generated excess demand for credit. In the absence of a sustained recovery in copper export earni,.-s, the pattern of financial policies resulted in large budgetary and external deficits, a rapid build-up of external debt, and distortions in savings/investment patterns. Foreign reserves dwindled and external payment arrears built up. As the foreign exchange crisis tightened, the authorities resorted increasingly to administra- tive mechanisms to control the allocation of resources, particularly foreign exchange. Fiscal deficits led to high rates of domestic inflation. The ensued scarcity of external and domestic financial resources led to a decline in imports and investment, and neglect of capital stock maintenance. As a result, the economy's productive capacity remained underutilized, and production and employment stagnated. 1.13 Institutional inadequacies exacerbated the economic difficulties. There was limited capacity to carry out economic policy analyses, to devise coherent policy packages, and to take quick and appropriate action. Outdated budgetary procedures, reinforced by the interplay of political forces, led to a tenuous link between recurrent and capital expenditures, inadequate allocations for maintenance, and deterioration of the eccnomic infrastructure. Lack of vigorous debt management contributed to high levels of borrowing on hard terms, partly to shore up recurrent deficits. Economic criteria were not given the requisite weight in the choice of public industrial projects, while the cost of pursuing non-economic objectives was not recognized sufficiently. Shortage of managerial, administrative, and supervisory capacity in parastatals led to increasing inefficiencies. Thus, many parastatals became persistent loss-makers and a drain on the budget. 1.14 The deepening financial crisis forced the Government to recognize the need for action to arrest the deteriorating situation and achieve financial stability. But it also felt that it was equally important and urgent to initiate a program of structural adjustment to diversify production and exports, lessen the country's dependence on copper, exploit the potential in agriculture, and thereby bring the economy back on a path of sustainable growth. The Government, in an unprecedented move, officially acknowledged the dire economic difficulties it faced and, in a sense, it became its own most severe critic. The appreciation of the role and invocation of market forces, on the face of it, represented a complete break with past policies.' Also, a country-wide campaign was launched in 1983 to explain the crisis to the public at large so that the economic problems were more widely understood. The economic issues facing the country were also aired in the Third National Convention of the Party (UNIP) in July 1984. 1.15 During 1983 and 1984, the Government, with Bank and IMF assistance, developed a wide-ranging package of policies and specific measures to strengthen economic management and create a policy environment conducive to economic growth and diversification. The Government's economic restructuring policies basically aimed at devising a system of incentives to producers and exporters of agricultural and industrial products in which prices were responsive to market forces; ensuring the competitiveness of exports through an active exchange rate policy; reversing past trends of import dependence and See Attachment 2 -- Government of the Republic of Zambia, Memorandum on Development Obiectives and Policies, January 13, 1983. -6- capital intensity through an appropriate tariff structure and interest rate policy; liberalizing restrictions on foreign trade and the licensing of production to improve resource allocation and encourage investment in productive activities; reducing the fiscal deficit and recourse to domestic bank borrowing, by curbing expenditure on personnel, subsidies, and non- development activities; improving planning and budgetary procedures to shift resources to productive uses and economic investments; ensuring, inter alia, consistency between recurrent and capital expenditures, and preventing underfunding of existing and new development projects; reorganizing and strengthening agricultural planning, and allowing greater competition in the procurament and marketing of food crops, with the National Agricultural Marketing Board (NAMBOARD) acting as buyer and seller of last resort; strengthening the technical and managerial capacity of INDECO to enable it improve the efficiency of parastatals; and improving the management of foreign debt, by establishing the National Debt Office in the Central Bank.!' 1.16 The Government made some progress in translating these intentions into tangible actions. Among important institutional reforma in 1983 was the creation of a Special Economic Unit, chaired by the Minister of Finance, to prepare, coordinate and implement the Government's policies and efforts to stabilize and restructure the economy. It was composed of senior officials of the economic ministries, the Central Bank, major parastatal units, the Cabinet Office, and the Office of the President, and wielded considerable decision- making powers. Also, a Planning and Budgeting Committee was established, with representatives from the Ministry of Finance, the National Commission for Development Planning, and the Central Bank. In the parastatal sector, to increase the autonomy and commercial orientation of the enterprises, a Board of Directors and an executive management group was set up in the Zambia Industrial and Mining Corporation (ZIMCO) to sever the direct links between company management and parent ministries previously responsible for policy, financial and corporate planning, and investment decisions, but without much success. 1.17 A program to restore financial stability was initiated in 1983, and stand-by arrangements were agreed with the IMF in 1983 and 1984. The Kwacha was devalued by 20% in January 1983 and, in July 1983, it was linked to a basket of currencies. At the same time, a crawling peg exchange rate system was adopted. The currency underwent further gradual devaluations, so that between January 1983 and December 1984, a cumulative nominal depreciation of 60% had been achieved. Interest rates were raised significantly: between 1982 and mid-1985 deposit rates went up from 6% to 15%, while lending rates from 12% to 20% -- albeit they were still negative in real terms. Budgetary measures (e.g., substantial reductions in subsidies and a cap on new government employment) were taken to reduce the Government's domestic borrowing, and wage increases were held to less than rises in the cost of living. But these measures were short-lived, and consumer prices increased from 13.6% in 1982 to 20% in both 1983 and 1984 in the wake of price decontrols, currency devalua- tions, and lax monetary and fiscal policies. Real GDP growth, which stagnated during 1973-1980 (averaging 0.3% annually), experienced negative growth rates from 1982 through 1984, and only marginal improvement in 1985. GNP per capita declined from US$460 in 1975 to US$320 in 1985, or by 30%, and almost all 1' Ibid. -7- economic sectors had suffered from the poor performance of the economy. Unemployment increased by an estimated 18% between 1980 and 1985. 1.18 In terms of improving conditions for longer-term growth, and aside from the exchange rate adjustments, measures included considerable increases in real terms of producer prices for agricultural crops, concessionary tax rates for agricultural income, freer marketing arrangements for the livestock sector, and decontrol of all industrial prices (except for wheat flour, maize flour, and bread) and utility service charges. This led to a significant increase in the area under cultivation, albeit output did not increase commensurately because of successive severe droughts (1982-84). Allowing private traders to compete with official marketing organizations in the livestock sector changed Zambia within a few years from a substantially net importer of meat products to a small net exporter. The decontrol of industrial prices led to price increases, helped restrain aggregate demand, and increased the profitability of firms. In 1984, the price of wheat flour and bread was also decontrolled. 1.19 The Government improved export incentives by introducing in 1984 a foreign exchange retention scheme (50% of gross export earnings) and by extending subsequently the retention period from 21 days to 60 days; by granting concessional tax rates for non-traditional exports; and by imposing a minimum tariff of 10% on many non-dutiable imports to reduce the high rates of effective protection afforded to import-intensive industries. In January 1985, the Government implemented additional changes in customs duties and in sales taxes on imports: removed certain manufacturer's rebates and duty exemptions on imports of industrial inputs; introduced a duty on all items which were previously exempted by ministerial decree; increased the rate of sales tax on imports from 12.5% to 15%; and raised the sales tax on virtually all taxable local products and services from 10% to 15% where the rate was below this level.!' 1.20 As the main source of foreign exchange, a rehabilitated copper industry had a major role to play in the Government's diversification effort. In 1984, the Bank approved the Export Rehabilitation and Diversification Project, which aimed to increase the efficiency and international competitive- ness of the mining industry.' In the context of that project,.the Government reaffirmed its commitment to pursue vigorously needed changes in macroeconomic and sector policies in order to restructure and diversify the rest of the economy, and create the conditions for developing new sources of revenue, employment and exports.zi 1.21 Zambia's terms of trade had been deteriorating steadily and, by 1984, they were 70% below the average for the early 1970s. The decline in copper production from some 650,000 tons to 480,000 tons between the mid-1970s and ' See Attachment 3 -- Government of the Republic of Zambia, Statement of Industrial and Trade Policy, June 13, 1985; PR, para. 57. i For details see OED, PPAR No. 10847, Zambia - Export Rehabilitation and Diversification Proiect (Loan 2391-ZA), June 30, 1992. i PR No. 3664, Export Rehabilitation and Diversification Project, February 29, 1984, Annex VI. For the outcome of this project and the issues confronting the mining sector see OED, PPAR, Ibid. -8- mid-1980s exacerbated the effects of the worsening terms of trade, as did severe droughts which necessitated substantial food imports. The balance of payments had been in chronic disequilibrium since 1975, and the current account deficit had re"ched 22% of GDP in 1981; it declined to 11% by 1984, largely due to severe restrictions on imports. The large current account deficits led to a high level of indebtedness, with total external liabilities amounting to US$3.9 billion at the end of 1984 and US$4.6 billion at the end of 1985 (excluding arrears). Debt service obligations accounted for 70% of export earnings in 1984, despite debt reachedulings amounting to nearly US$400 million in 1983 and 1984 (Attachment 1). The Government was unable to negotiate and sign individual rescheduling agreements with some creditors, and external trade moved to a cash basis as banks refused to open new letters of credit without reducing the outstanding volume. Disbursements of foreign loans had fallen sharply due to reductions in capital expenditure by both the Government and public enterprises. The steady decline of imports resulted in a severe underutilization of industrial capacity, and to a large backlog of maintenance and rehabilitation work in the mining sector, which contributed to further declines in copper production and exports. 1.22 The exchange rate realignments in 1983 and 1984 were insufficient to restore external equilibrium, partly because of the continued decline in copper prices and low capital inflows, and partly because of the increased fiscal deficits, external debt and arrears. Under these conditions, excess demand for foreign exchange persisted. The large backlog of commercial bank arrears, the accumulation of import licenses for which no foreign exchange was available, the existence of a parallel market rate which was a multiple of the existing official rate, and evidence of unrecorded exports and capital flight, were a reflection of the fact that the Kwacha continued to be significantly over- valued, and that Zambia's external liquidity position had become extremely precarious. 1.23 By mid-1985, Zambia continued to be in an acute stage if economic and financial crisis, 'and still in search for solutions to its intractable problems. Reforms initiated during the first half of the 1980s to achieve stability and diversification were not sufficiently comprehensive or not consistently implemented, and the efforts at reform were tentative and intermittent. Gradual approaches to correcting Zambia's malaise had failed to overcome the underlying rigidities of what de facto had become an inflexible centrally directed economy under the one-party political system. Many times, decisions to pursue reforms taken unanimously by the entire Cabinet were stopped or reversed by the President when the political stakes were high. As a result, the goal of moving the economy off dead center remained elusive. At this juncture, it became clear to all concerned that there was need for more fundamental structural changes in the economy. The Industrial Reorientation Project (approved in October 1985), the Agricultural Rehabilitation Project (approved in March 1985), and the Recovery Program I (approved in May 1986) collectively were to address these concerns. -9- II. CONCEPT AND DESIGN OF ACTION PROGRAMS Industrial Reorientation Strategy - Objectives 2.01 The immediate objective of the Government's "new" industrial strategy was to raise the level of capacity utilization in the sector by providing additional foreign exchange t,o efficient import-substitution industries and exporters. Increased supply response would reduce the economic and social pressures associated with the economic stabilization and adjustment process, while the growth in industrial exports would help restore external equilibrium. For the longer term, the Government's objective was to increase the efficiency of the industrial sector and foster its export orientation by instituting an incentive structure and a set of policies that would encourage the flow of investments to the more productive industrial subsectors and away from inefficient industries. To attain these objectives, the Government was committed to pursue a less protective and more outward-oriented industrial policies, by replacing quantitative restrictions with tariffs, by selective changes in the tariff structure, and by providing incentives designed to offset the anti-export bias in the protective structure; rely increasingly on market forces as opposed to administrative mechanisms to allocate resources; limit investment in new projects in the public industrial sector and apply strict economic criteria in their selection; increase the efficiency of public sector manufacturing, by phasing out those firms that cannot operate economically, improving the operating efficiency of those to remain in the public domain, and enhancing managerial skills and productivity; and eliminate interest rate controls (PR, para. 51; Attachment 3). Policy Instruments and Conditionality 2.02 To advance the objectives of the Government's industrial reorientation strategy, the project under review would support policy and institutional changes designed to improve the foreign exchange regime, reform the import regime, remove disincentives to exports, streamline and improve investment incentives, increase the efficiency of public enterprises, and improve the public sector's investment program in manufacturing. These measures would be undertaken in the latter part of 1985 and in 1986, building on certain earlier actions initiated by the Government (paras. 1.15-1.19). On the whole, the initial conditions were far from propitious, as discussed in paras. 1.11-1.23. 2.03 The keystone of the reform package would be the institution of a foreign exchange regime that would allocate foreign exchange more efficiently, encourage exports and efficient import substitution, and restore external equilibrium. This would be achieved through a dramatic shift from an administrative to a market determined mechanism of foreign exchange alloca- tion -- establishment of an auction system cum parallel elimination of the import licensing system (condition of effectiveness). The capacity of the Bank of Zambia (BOZ) to forecast and budget foreign exchange would be enhanced by implementing a program of technical assistance (condition for release of the second tranche). US$59.8 million (96%) of the proceeds of the Credit would be added to the foreign exchange pool available for the auction and would be used only for the importation of raw materials, spare parts and other inputs for manufacturing enterprises (PR, paras. 53-55, 73, 76; Development Credit Agreement (DCA), Section 6.01, Schedules 4, 5). - 10 - 2.04 The auction system would be organized and operate in the following manner. A Foreign Exchange Auction Committee (FEAC) would be established in BOZ to administer the auction system, inter alia, matching the successful bids with available foreign exchange from various sources; requests for foreign exchange for all purposes would be made to the FEAC through a commercial bank; a Secretariat, staffed with qualified persons, would be set up in BOZ to allocate foreign exchange available from different sources to successful bidders; BOZ would hold weekly or bi-weekly auctions of foreign exchange, the amount of which would be announced in advance; the exchange rate at each auction would be determined by the marginal bid which exhausts the foreign exchange available in that particular auction, and the rate would apply to all foreign exchange transactions; importers would be required to receive the imports within a reasonable time of the purchase of foreign exchange and report to BOZ; administrative allocation, at the auction rate, would continue only for the foreign exchange requirements of the Government, ZCCM, public debt service, and for imports of crude oil, drugs, books and, when necessary, maize and fertilizer (DCA, Section 5). To improve rate determination, the subsequently approved (Jure 1986) Recovery Program I broadened the scope of the foreign exchange auction by including government goods and services requirements beginning March 31, 1987 (PR No. P-4310, p. 25). Also, in February 1986, the Bank agreed to a Government request to channel the funds of the Agricultural Rehabilitation Project through the auction system, and to allow the funds to be used for all imports, in support of the foreign exchange rate reforms (Draft PCR, Agricultural Rehabilitation Project, Credit 1545, para. 7). 2.05 To ensure that protection would be granted mainly through tariffs, the imports regime would be drastically modified. The import licensing system and all import prohibitions for protective purposes (about 50 items) would be eliminated (condition of effectiveness); maximum tariff rates would be reduced from 150% to 100% (condition of effectiveness); items (some 300) with zero import tariff rate would be subject to a 10% minimum tariff, plus the 15% sales tax (condition of release of the second tranche); the 15% sales tax levied on imports would be extended to all final goods produced domestically; and the tariff base would be shifted from f.o,b. to c.i.f. Furthermore, the Tariff Commission, to be established shortly, would prepare and carry out a comprehen- sive reform of the tariff structure and indirect taxes by June 30, 1987, with the aim to introduce further reductions. Finally, additional excise taxes may be levied to prevent potential revenue losses and curb the consumption of non- essentials, to be applied equally to domestically produced and imported luxury consumer goods (PR, paras. 56, 58, 59; DCA, Sections 4.05, 6.01, Schedule 4; Attachments 2 and 3). 2.06 Further to steps already taken to reform the export regime (para. 1.19), the Government undertook to introduce measures to remove procedural impediments to non-tzaditional exports. The cumbersome system of drawbacks would be replaced by a simpler process based on average drawbacks for major groups of exports, with the averages to be revised periodically (condition for release of the second tranche); the export licensing system would be simplified; an autonomous Export Promotion Board would be established with private participation to replace the ineffective Zambian Export Promotion Council; feasibility studies would be initiated, and an action program would be formulated and adopted, for the establishment of an export credit insurance and export credit guarantee scheme (PR, para. 60; DCA, Section 4.02, Schedule 4). - 11 - 2.07 To promote private investment, domestic resource mobilization, and efficiency in resource use, and further to measures already taken (paras. 1.15- 1.19), the Government agreed to remove all controls on interest rates shortly after the introduction of the foreign exchange auction system; and enact a new Investment Act that would be more supportive of the private initiative. The new Act would provide moderate but automatic incentives in the form of income tax deductions and grants for training and R&D to firms that export, produce with high local content, are located in rural areas, or are classified as small scale. Both measures were conditions for release of the second tranche (PR, paras. 61, 62; DCA, Schedule 4). 2.08 To increase the efficiency of public industrial investment and rationalize the operations of public industrial enterprises, INDECO's management agreed to establish an Economic Evaluation Unit, to build up its capability for project appraisal and assessment of the operational performance of the enterprises under its control, based on sound technical, economic and financial analyses; initiate a review of the economic viability and operational efficiency of the enterprises under INDECO's control, concentrating initially on enterprises identified as probably uneconomic; submit to IDA and commence implementing by April 1, 1986, an action program to phase out those found clearly non-viable and restructure those likely to be viable; discontinue projects in its Investment Program costing more than US$1 million equivalent which, although started, were found after reappraisal not to be economically viable; agree with IDA (condition for release of the second tranche) on the amount and composition of its Investment Program for 1986/87; and undertake a study and implement an action program on the appropriate compensation levels and other measures necessary to enable INDECO recruit and retain qualified staff (PR, paras. 63-66; DCA, Sections 4.03-4.05, Schedule 4). 2.09 Finally, the Credit would extend technical support and training to BOZ to strengthen its capacity to forecast and budget foreign exchange transactions and to operate the new auction system; to the Ministry of Finance to establish a Tariff Commission and simplify the duty drawback system; to the Ministry of Commerce and Industry to set up an Export Promotion Board; and to INDECO to develop its capacity to appraise new investment projects and improve the performance of existing public industrial enterprises (PR, paras. 77, 79; DCA, Schedule 2). Expected Outcome 2.10 After several halfhearted trials, this was the most ambitious attempt at reform since the early 1980s, and the Bank (and the Government) entertained high expectations regarding the prospective impact of this project. The proposed credit would help increase the efficiency of the manufacturing sector, and would lead to improved allocation of resources in the economy. The increase in the availability of foreign exchange would arrest the decline in output and employment in manufacturing, and would raise the average level of industrial capacity utilization from 45% in 1985 to 55% in 1986. After 1987, the beneficial impact of the new policies, particularly of the pervasive change in the foreign exchange regime, was expected to result in further increases in output and capacity utilization, and most importantly, in manufactured exports (PR, para. 87). - 12 - 2.11 The dismantling of the import licensing system and greater automa- ticity of the auction system, the resulting depreciation of the Kwacha,!' and the elimination of the excess demand for foreign exchange were expected to improve the transparency of the exchange allocation mechanism; remove the potential for windfall profits accruing from the administrative allocation of foreign exchange; allow industrial enterprises to have access to imported inputs and spare parts on the basis of their needs and cost competitiveness rather than their ability to deal with the committees that allocated foreign exchange; avoid the frequent delays of the earlier system, result in the placement of smaller, more regular orders, and improve inventory management; lead to a more efficient allocation of the scarce foreign exchange available; and increase the supply of foreign exchange through the diversion of unrecorded exports and the rechannelling of transactions from the parallel to the auction market. On the other hand, the Government's commitment to adopt prudent fiscal and monetary policies would help curb the demand for imports. In a similar vein, the proposed reforms of the tariff system would narrow the dispersion of effective protection rates among products; reduce protection on domestic manufacturers by increasing the cost of imported inputs; encourage the use of local raw materials; and raise tariff revenue (PR, paras. 54, 59). 2.12 The proposed package of policy measures would eliminate long-standing distortions in the economy, and provide powerful incentives for the reorienta- tion of manufacturing and other productive activities (e.g., agriculture) away from their historical inward-looking stance. The maintenance of a realistic exchange rate, the liberalization of the interest rates, and the withdrawal of duty exemptions on many imported capital goods and raw materials would provide incentives to increase the use of labor and domestic raw materials, and reduce the sector's dependence on imported capital goods and inputs. Within the contours of the Government's new industrial development strategy, the improved macroeconomic policy environment and the new Investment Act were expected to lead to increased private sector investment in efficient import-substitution and export-oriented industrial activities. Finally, the gradual improvement in the performance of public industrial enterprises (the INDECO Group) following their restructuring, and the rationalization of INDECO's investment program, would increase the productivity and ensure the financial viability of the parastatal sector (PR, para. 88). 2.13 The aggregate impact of the project on income and welfare levels was expected also to be positive. Aggregate employment was projected to be higher under the proposed credit than in the absence of the program, since the reforms would eliminate biases (in the exchange rate, interest rates and tariffs) which had encouraged the use of capital and discouraged the use of labor; a more productive use of resources in the economy would result in higher investment and GDP levels than otherwise; and the additional availability of foreign exchange would result in higher capacity utilization. Overall income distribution was also expected to improve under the proposed program, as a result of the higher employment levels and the change in the internal terms of trade in favor of the agricultural sector. Welfare levels were expected to be higher for the average citizen, and for the lower income strata of the ' Since the amount that could reasonably be made available for the auction would be insufficient to meet Zambia's import needs at the prevailing exchange rate, a sharp depreciation in the auction-determined rate was expected. - 13 - population in particular. The main social costs would include price increases as a result of the expected depreciation of the Kwacha, and an increase in unemployment in the short run in inefficient or overprotected industries. Also, real wages might continue to fall in the non-tradeable goods sector, which could generate social and political pressures from segments of the urban middle-class. However, price adjustments, which had already taken place following earlier price decontrols, and the overall income and employment gains in the tradeable goods sector and in the efficient industries in general, were expected to more than compensate for the economic losses in some subsectors (PR, para. 89). III. IMPLEMENTATION AND OUTCOME Credit Administration and Utilization 3.01 Progress in implementing the reform program, with a few exceptions, was satisfactory. Major policy actions and technical assistance initiatives, as detailed in paras 2.02-2.09, were taken on time; effectiveness and second tranche release conditions were met (PCR, Part III, paras. 4, 7); and the Credits were disbursed on schedule (PCR, paras. 2.3-2.9, 3.1-3.11). The only covenants not complied with were the establishment of a credit insurance and export guarantee scheme; implementation by INDECO of an action program to phase out non-viable parastatals; extension of the 15% sales tax levied on imports to final goods produced domestically; and inability of the Tariff Commission to prepare and carry out the envisaged comprehensive reform of the tariff structure and indirect taxes (see also PCR, para. 4.4 and Part III, para. 7). About 95% of the funds were allocated for the importation of industrial inputs and 5% for technical assistance. Procurement and disbursement procedures were in line with Bank guidelines (PCR, paras. 4.2, 4.3, 4.5). The counterpart funds were made available to the Government without restriction, and were used to supplement its budget. Bank supervision was intensive and effective, particularly until the Government formally abandoned the reform program (Basic Data Sheet, p. iv). However, because the reforms were reversed only 18 months after their introduction, they have not had any measurable impact, while the adoption of the novel auction system for allocating foreign exchange became a controversial issue and ultimately brought down the entire program (paras. 3.07-3.16, 5.16-5.29). Rationalization of Parastatal Operations 3.02 In spite of the suspension of Bank operations in Zambia in May 1987, the work on restructuring INDECO subsidiaries proceeded. Consultants were engaged, and some progress was made in improving the operating, mainly financial, performance of some of INDECO's subsidiaries. During FY87-FY89, and following the implementation of the recommendations of the Industrial Development Advisory Team (IDAT) and the training programs that were carried out, the performance of the 13 companies reviewed improved measurably except for three.- A fourth parastatal, a cannery, was closed down in 1991 because of low capacity utilization due to inability to procure produce. However, the results reported in IDAT's report (and shown in the PCR, paras. 3.9, 3.10) 2' IDAT, Industrial Reorganization Program, Final Review Report, March 1989. - 14 - cover the achievements of the initial two years, and in some instances the financial results are estimates. Also, it is difficult to ascertain to what extent the increase in sales and profitability achieved during this period should be ascribed to fortuitous factors -- improvement in the regulatory environment (e.g., lifting of price controls), ability to raise prices in a protected environment due to market dominance, preferential access to foreign exchange for importation of inputs, increased market share due to production constraints by competitors, trading on imported goods, tariff exemptions, subsidies, etc. (paras. 4.03, 4.04). Therefore, inefficiencies may still persist even if profitability has improved. 3.03 There is no denying that new managers were appointed, some upgrading of skills occurred, the work force was reduced by 15%, wages were adjusted, and management information systems were somewhat improved -- which helped improve financial performance. However, INDECO has provided no information for these companies on the extent of rationalization of their operations, specific cost- cutting measures taken and their impact, extent of persistent overmanning, pattern of capacity utilization, changes in capital structure (e.g., conversion of debt to equity), and financial performance for the last three years. In the absence of such vital data, a meaningful assessment of each parastatal's most recent financial performance and progress in implementing IDAT's recommenda- tions is not feasible; nor is it possible to pass judgment on whether or not the momentum has been sustained. The more so, since these firms had been ranked as the least efficient among INDECO's subsidiaries, many could not replace outdated and worn out equipment due to lack of funds or shortage of foreign exchange, maintenance was a pervasive problem, most had inadequately trained and undisciplined work force, important IDAT recommendations had yet to be implemented, almost all had serious management problems, and remuneration was inadequate to attract and retain good managers.- Improved profitability does not necessarily mean improved efficiency in a fairly closed economy. Furthermore, in the absence of information on the physical condition of the equipment, optimality of plant scale, market analysis and forecasts, and binding constraints, no assessment can be made on the economic viability of these firms in a truly competitive environment, which was the ultimate objective of the exercise. 3.04 IDAT helped INDECO vet investment projects on the basis of economic criteria and, as a result, several unviable projects were dropped from INDECO's investment program. The Economic Evaluation Unit was established at INDECO headquarters in November 1986 (para. 2.08), but its vetting capability and effectiveness remain limited. The Unit has had serious difficulties in attracting qualified staff for the task at hand, because professionals of the caliber and experience required to discharge this function are not readily available locally, or they command high salaries that INDECO cannot afford. As a result, the Unit has built up basic economic and financial capability, but has not developed the requisite engineering capacity and expertise in important aspects of industrial management (see also PCR, para. 3.11 and IDAT's Final Report, op. cit.). -i "Absence of an identified pool of potential managers and the problems in finding alternatives for poor performers has made difficult the replacement of incompetent managers." Ibid, para. 1.14. - 15 - 3.05 INDECO prepared no action program to phase out non-viable enterprises, largely because it continued to see a role in parastatals, a view which it still entertains; the Government's ambivalence regarding the privatization of parastatals;.Li and the fact that important considerations relating to the implementation of a divestiture plan had not been fully thought out (para. 5.10). Only in 1991, four of the thirteen parastatals were put up for sale which is expected to be completed sometime in 1992 (para. 4.08). In the wake of the new Government's decision to move ahead in earnest with the privatization of industrial parastatals, INDECO's role is being reassessed. Indeed, most functions discharged by INDECO, such as promotion of new or rehabilitation of existing parastatals; guidance in corporate and budget policies; advice and technical assistance in civil and mechanical engineering, marketing and personnel; putting together financing packages for new projects, extension of credit guarantees, and the like; export promotion and public relations; and monitoring the operating performance of parastatals, either are no longer required, or have changed significantly, or involve activities that parastatals could (and should) develop in-house and not rely on INDECO. Investment and Export Incentives 3.06 The Investment Act (para. 2.07), enacted in 1986, was more supportive of the private sector and provided incentives that were better targeted and more streamlined, compared to the Industrial Development Act of 1977 it replaced (para. 1.06). However, while the export retention incentive had been actively utilized by non-traditional exporters, only a limited number of eligible investors made use of the "common" and "additional" incentives. Moreover, to prevent abuses, the Government introduced tight controls on manufacturing registration which, by frustrating the automaticity of the process, ran counter to the spirit of the Act. The Act was revised in 1991, in an attempt, inter alia, to minimize government discretion and regulation, render it more promotional in nature, lay down strict ground rules regarding expropriations and other forms of government intervention in investment decisions, and attract foreign investors. The new Investment Code provides guarantees against nationalization of foreign firms, incentives such as duty and tax exemption on imports for initial investments, tax exemption on income and dividends, preferential access to foreign exchange, and freer remittance of profits. Also, the Code reduces regulations and controls over businesses, and creates a better environment for competition and free enterprise. Furthermore, the Act established an Investment Center for the promotion, coordination and monitoring of investments, and is expected to serve as a one- stop facility to investors. An Investment Board is being organized to discharge the functions of the Center. The Export Promotion Board (EPB) was established in mid-1986 (para. 2.06). Its main functions include assistance to exporters in identifying potential importers, addressing major issues affecting exporters, advising the Government on the effectiveness of export promotion instruments (e.g., the duty drawback system), and making policy 1 For instance, INDECO and the Government decided not to close down the Livingstone Motor Assemblers parastatal, which the Bank considered an economically unviable venture. Instead, the company was restructured financially, and 50% of the shares were acquired by the Party's (UNIP) holding company (Zambia National Holding Company). This is an example of a parastatal which, though not econumically viable, it can still be financially profitable by operating in a protected environment. - 16 - recommendations (e.g., simplification of export procedures and documentation, access to credit). It also sponsors trade fairs, seminars and training activities. The EPB has increased the awareness among producing firms on export possibilities. But it is understaffed and underbudgeted, and its role to date has been limited. Finally, the Export Import Bank (EXIM) was established in May 1987, and started operations on a very limited basis in September 1988. EXIM has no funds, vegetates, and its contribution so far has been negligible. The Foreign Exchange Auction System at Work 3.07 As already mentioned (paras. 2.03, 2.04), the cornerstone of the reform package was the establishment of an auction system to improve the allocation of foreign exchange. In the first of the weekly auctions on October 11, 1985, the Kwacha rate to the US dollar reached K 5.0, up from K 2.0, the prevailing rate just prior to the inception of the auction. The rate rose to K 7.0 in the third auction, but remained relatively stable (fluctuating between K 6.0 and K 7.0) during the next six months. By the 53rd auction on October 11, 1986, the rate had depreciated to K 8.3. Thereafter, the rate declined sharply reaching K 15.2 in the 60th auction on November 29, 1986 -- a 300% depreciation since the first auction and 750% since the inception of the system (Attachment 4). Changes in key top officials, procedures, and administrative requirements introduced in mid-1986, adoption of the "Dutch Auction" systemI in August 1986, and persistent shortfalls in the amounts of foreign exchange pledged in auctions, undermined confidence in the system, accelerated the Kwacha rate of depreciation, and doomed the sustainability of the auction as an allocative mechanism (for details see paras. 5.15-5.29). 3.08 Following the riots in the Copperbelt and in Lusaka in December 1986, and with the rate having depreciated to K 14.9 in the 68th auction on January 24, 1987, the auction was temporarily suspended on January 28, 1987, and the rate was set administratively at K 9.0. Subsequently, six auctions were held, beginning on March 28, 1987, under a two-tier auction system: an official window at K 9.0 was restricted to debt service, essential imports, and receipts of loans and grants, while the auction rate was allowed to fluctuate between this rate and an upper ceiling of K 15.0. This restriction was abandoned after four weeks. In the fifth of these auctions on April 24, 1987, the Kwacha rate fell to its lowest value, K 21.0. The system was abolished on May 1, 1987, after a final auction which served only to allocate foreign exchange at the rate of K 15.0, and the rate was fixed at K 8.0 (Attachment 4). 3.09 The auction system functioned relatively well during the first six months: after an initial sharp decline, the exchange rate remained relatively stable (para. 3.07); the real effective exchange rate fell by 52% (Attach- ment 1); the parallel market premium declined to about 15% early in 1986 and to 31% for the year 1986 as a whole compared to 68% in 1985 (Attachment 5); and on average 70% of the bids were accommodated -- albeit erratically, ranging from 31% to 99% (Attachments 4, 6). Inflation, after an initial surge, moderated, and the system helped eliminate the shortcomings of the licensing ,' Under the "Dutch Auction" system, successful bidders paid the full amount of their bid, and the difference over the marginal bid was surrendered to the Treasury. - 17 - process and reduced delays in obtaining foreign exchange.-' Initially, namely during the last quarter of 1985 and the first quarter of 1986, manufacturing production, value added, exports and capacity utilization improved due to greater availability of imported inputs. During the first year of operation, it is estimated that 63% of the foreign exchange auctioned was allocated for imports of intermediate goods and equipment, with 87% allotted to private manufacturing and the parastatals (Attachments 6, 7). However, essential industrial inputs and equipment accounted for less than one-third of total allocations for the auction year, allocations in the last two quarters (auction weeks 27-52) actually declined by 5% (Attachment 8), while the irregularity of allocations and the attendant unpredictability made business planning and procurement very difficult.-' Also, while allocations during weeks 1-26 to private manufacturing and parastatals amounted to 67% and 71% of requests for foreign exchange, respectively, the percentages dropped to 46% and 54% during weeks 27-52 (Attachment 6). In general, although total allocations increased by 36% in absolute terms, particularly for spares, they were not sufficient to satisfy the pent-up demand for industrial inputs and equipment replacement. 3.10 During the first 26 weeks of operation of the auction system, allocations progressively tended to approximate the amounts requested; but in the following weeks, and until its suspension, disparities became increasingly wider. Particularly during October-December 1986, the amount of foreign exchange offered at the auctions was reduced substantially (Attachment 4). Thus, for the calendar year 1986, merchandise imports declined by over 9%, and manufacturing production and exports fell by 3% and 5%, respectively (Attach- ment 1). There are no data available on capacity utilization; but industrial performance in 1986 seems to suggest the absence of improvement -- if not further decline.151 3.11 The auction system resulted in a much greater and faster depreciation of the Kwacha than originally anticipated. Just before the suspension of the auction system, exchange rate movements had become extremely volatile. The simultaneous attempt at agricultural price adjustments to improve its terms of trade, coupled with the attempt to restore the profitability of the copper sector, heightened the negative effects of the exchange rate adjustment. Inadequacies in the monetary policy framework and controlling mechanisms failed to minimize the destabilizing effects of the exchange rate depreciation. Poorly implemented price decontrols resulted in staple food price increases and shortages causing social unrest. The events of December 1986-January 1987 aggravated the fiscal situation, as the budget deficit doubled to 29% of GDP within a year (Attachment 1). With the benefit of hindsight, it is clear that - See also SIDA, Zambia, Exchange Rate Policy, 1989, pp. 63, 154. L There are no time series on manufacturing investment. -t The manufacturing sector's unsatisfactory performance in 1986 has been officially attributed to the inadequate and erratic access to foreign exchange due to inability of many companies to bid successfully, the introduction of the "Dutch" system, the requirement of a 30% interest-free advance deposit per bid, and the increased interest rates on overdrafts, which led to insufficient procurement of spares and intermittent supply of raw materials. As a result, "the sector continued to experience depressed capacity utilization." Bank of Zambia, Report and Statement of Accounts for the Year Ended 31st December 1986, p. 31. - 18 - by early 1987, the expected one-time inflationary consequences of devaluation had not been contained. They had, instead, been exacerbated by the Govern- ment's inability to control the fiscal deficit which, in turn, was being financed by an equally uncontrolled growth in money supply. 3.12 There was a dramatic increase in the budget deficit in 1986. The fiscal deficit rose from K 232 million in 1984 to K 2,067 million in 1986 (almost ten times), or from 9% to 37% of GDP (Attachments 12, 13); at the same time span, the annual growth of money supply accelerated from 22% to 93% (Attachment 1). The deficit largely stemmed from the rise in subsidies; greater losses of parastatals; increased interest payments, reflecting the higher cost of debt service on foreign loans as well as the rise in domestic interest charges following the liberalization of interest rates; extraordinary expenditures; and the much slower growth in revenues. In 1986, to reduce liquidity and curb the speculative demand for foreign exchange, BOZ adjusted upward interest rates; raised the minimum reserve requirement by 5% to 25% for demand deposits and 17% for time deposits; instituted an interest free advance deposit equivalent to 30% (raised to 40% in 1987) of the value of the bid; and directed that no more than 20% of the foreign exchange requested could be financed by bank overdrafts. In March 1987, supplementary reserve requirements of 10% on demand deposits and 7% on savings and time deposits were introduced. However, these measures have had very limited success in easing the pressure on the auction system. In a highly liquid and stagnant economy constrained by shortages of foreign exchange, these effects were driving the Kwacha down precipitously. The economy did not seem to be benefitting from the reforms. Policy Reversal 3.13 Political considerations more than economic rationale led to the demise of the auction system -- and of the economic program as well. The design of the policy package involved difficult trade-offs and a painful transition, especially in the short term, and the Government succumbed to political pressure in the face of pervasive and entrenched opposition. Undoubtedly, opposition was aided by the fact that the immediate benefits of the depreciation were not apparent, and were far outweighed by the more visible costs that were reflected in the domestic price level and living standards. Zambia's difficult external debt situation and limited external resource flows exacerbated the problem. Lack of confidence in the Government's willingness and ability to implement the reforms by the providers of external assistance also contributed to the collapse of the reform effort. Donor confidence was shaken by the absence of strong political leadership and lack of fortitude, as reflected in the April 1986 replacement of the economic team and the aftermath, the Government's persistent mismanagement of the increased agricultural harvests (para. 5.34), weak budgetary restraint efforts, awkward handling of the maize price increase, and the very limited movement toward systematic parastatal reform and privatization. As a result of this tentativeness, external financial support came to a standstill (Attachment 9). 3.14 In the circumstances, the country's economic managers felt that they were losing economic and political control, and decided to abandon prescrip- tions they no longer believed in and adopt a domestically designed program with which they felt more familiar and comfortable. An Interim National Development Plan for the period 1987-88 was adopted in May 1987 as the first step toward a National Economic Recovery Program (NERP). The five-year plan for 1989-93 was released in January 1989. The NERP represented a major shift in the - 19 - orientation of economic policy in Zambia. In some ways, the objectives of the NERP coincided with those of previous reform programs -- growth through diversification, reduced dependence on imports, and stabilization through control of inflation. Some of the earlier sectoral reform programs were continued and strengthened. Where the NERP did differ, however, was in the rationing of foreign exchange through the newly created Foreign Exchange Management Committee (FEMAC); in seeking to combat inflation by stabilizing the exchange and interest rates, and the reintroduction of price controls; and in giving emphasis to recovery through "the use of own resources." 3.15 Although some marginal gains were achieved, no tangible structural adjustment took place in the relatively short period during which the policy reforms were in effect." Despite some promising signs during the early stage of the auction system, the supply response was insufficient (para. 3.09). Although most controls over the exchange rate, the interest rate, and major producer and consumer prices were lifted, the pri-e liberalization measures were not fully institutionalized, as certain prices remained subject to effective administrative control. High inflation rates in 1985 and 1986 nullified the economic impact of price changes. Reform of the agricultural sector was the most neglected, as uniform prices were never removed, and marketing arrangements were not clarified. Producer and consumer prices of maize were out of step and controlled by different ministries (paras. 3.07- 3.12, 5.31-5.34). By the end of 1986, fuel prices did not reflect import costs and remained under government control, the price of fertilizer was below domestic costs, and interest rates remained substantially negative in real terms. The Government had failed to control the money supply, and the budget deficit was much larger than expected because of revenue shortfalls -- in part because of the unexpectedly low external aid and the rising losses of parastatals due to the exchange rate depreciation and persistent inefficien- cies. The foreign exchange system was subject to haphazard administrative interventions, and the auction market lacked stability (paras. 5.15-5.29). Export diversification had failed to materialize. To all intents and purposes, the Government was not able to manage effectively the demanding reform program, the adjustment process quickly became unsustainable, and the policies were ultimately reversed. 3.16 A number of reinforcing factors seem to account further for the failure of the program, and relate to design, adequacy of external resources, staying power of the reformers, and social impact. The program placed heavy emphasis on short-term adjustment of the balance of payments and fiscal deficits through the reduction of aggregate demand, which had already been declining since the mid-1970s and left limited margins for further compression (para. 1.17). While the program was designed to expand domestic supply, the time frame for the supply response to manifest itself was overly optimistic. A long history of procection from market forces and the conviction that profits were evidence of profiteering rather than of market response tended to weaken the Government's capacity to steer and manage the economy steadfastly through such a transition, particularly after the genuine reformers had been removed -t The problem of course had been exacerbated by past myopic and lax policies, a high rate of population growth (3.5%), persistent economic stagnation, a large urban population, underutilization of the agricultural potential, and an economic structure biased towards heavy import dependence and unafford- able social expenditure levels. - 20 - from power. The likely macroeconomic response to the package of the adjustment policies in light of the existing institutional capacity and rigidities had not been fully thought out. In particular, the proposed foreign exchange reform overestimated the Government's ability to control the fiscal deficit and money supply, the more so since a rather substantial depreciation of the exchange rate was anticipated, and the program was launched in the midst of an economic and financial crisis. Also, there was no fall-back position in case of shortfalls in foreign exchange earnings due to exogenous factors on which the auction system was so crucially dependent (paras. 5.11-5.14). Social Impact of the Reforms 3.17 The negative social impact of the reform measures, and the sudden and large depreciation of the exchange rate was felt by both the low and middle income segments of the population, particularly in the urban centers. The consumer price index (CPI) rose 52% for low income groups and 58% for higher income groups in 1986, while real per capital private consumption declined by 9% (Attachment 1). Between October 1985 and February 1987, the CPI for low income groups rose by 72%. Moreover, employment in the formal sector -- though not in manufacturing and mining -- declined by about 1.3% between 1984 and 1986. A study by the Prices and Incomes Commission (PIC) in 1985 based on estimates of basic needs indicated that 35%-40% of all households were living below the Poverty Datum Line (PDL). In the urban areas, 35% of households were estimated to fall below PDL. The situation was worse in high density urban areas (50% below PDL) and in urban centers in the rural areas (63% below PDL). In rural communities, consumption was below the PDL in 40% of households, with considerable variation between districts. In the urban areas, as costs rose faster than incomes, the number of households in poverty increased. A recent study by the PIC estimates that the proportion of all urban households living below the PDL rose from 35% in 1985 to 55% in 1987. In terms of Kwacha per month, the urban PDL more than doubled, increasing from K 207 in 1985 to K 421 in April 1987.-'i 3.18 The rise of imported prices impacted directly on real living standards, particularly during the unstable phase of the auction. The impact was somewhat greater on the better-off urban segm6ats whose consumption pattern included a higher proportion of imported goods than on the poorer income groups whose consumption was based primarily on domestic staples. Apparently, during the period that the auction system was operative the impact of the exchange rate depreciation on importers' rents (redistribution away from licensees) was weak or of very short duration. As a result, it did not prevent a substantial rise in import prices, and failed to mitigate the effects of depreciation on consumers and import users. Furthermore, the high direct and indirect import dependence suggests that the more vulnerable segments of the population were also directly affected as costs of production (and prices) of domestically produced manufactures also rose. As salary and wage adjustments lagged and a safety net of targeted subsidies for the poor was not in place, this resulted in a substantial decline in real purchasing power. The inept handling of the maize meal subsidy (para. 5.22) exacerbated the situation. Between 1985 and 1986, the producer price of maize rose by 94%, reflecting in part the continued Government objective of improving the agricultural terms of trade; but they were also in response to increased costs of imported agricultural inputs. L' See SIDA, op. cit., pp. 138, 139. - 21 - However, as long as the consumer price of maize was controlled, the rising costs were borne in part by the Government in the form of budgetary subsidies rather than by the consumers. But, in December 1986, the consumer price of maize was raised by 120%, with no provision to protect the more vulnerable groups. 3.19 Conspicuously missing from the design of the reform program was even an elementary safety net. The more so, since the government repeatedly had attempted in the past to phase out the maize meal subsidy, but had retrenched due to political pressure and urban unrest.- Apparently, this was because the aggregate impact on the project on income and welfare was expected to be positive, and the attendant hardships non-enduring. Employment would rise, income distribution would improve, welfare levels would be higher for the average citizen, and particularly for the lower income groups, and the social costs in the form of a decline in real wages due to higher prices and short- term rise in unemployment in inefficient industries would be offset by the overall income and employment gains in the tradeable sector and in the efficient industries (para. 2.13). Furthermore, the sentiment was that the country had no alternative to adjustment, and that without adjustment the standard of living would continue to fall. But while the projected gains from adjustment were substantial, the hardr' ps faced by a significant segment of the population, particularly in the uCDan areas, during the transition were real, immediate and difficult to bear. IV. THE AFTERMATH The Post-Auction Foreign Exchange Allocation Regime 4.01 On May 5, 1987, a regime of fixed rate policy was introduced at K 8.0 to the US dollar, along with tight import controls and an administrative mechanism for foreign exchange allocation. Requests for foreign exchange continued to be filed through the commercial banks, but allocations and issue of import licenses were decided by FEMAC. Government imports and debt service payments, and the claims of ZCCM, ZIMOIC, Zambia Airways and NAMBOARD were satisfied outside the FEMAC system. Import duty rates were raised for many items and exemptions became widespread. Non-traditional exporters were allowed to retain 50% of their export earnings, but imports were subject to control. Trade of title to the retained foreign exchange occurred at a premium on the official rate, but required FEMAC's prior approval. In a climate of persistent high rates of inflation, the reversal to a fixed and highly overvalued rate for over two years after the auction system was abolished eroded the gains from the depreciation of the real effective exchange rate achieved during the auction period, and the premium in the parallel market soared to 418% by 1988 (Attachments 1, 5). -t Belatedly, the Recovery Program Credit provided for a study of the impact of subsidies on the poor, including a mechanism for targeting the lowest income groups. It was to be completed by December 31, 1986, and the subsidy to higher income groups was to be removed by September 30, 1987 (PR No. 4310, May 27, 1986, p. 25). - 22 - 4.02 In October 1988, the Kwacha was devalued by 25% to K 10.8, and again in June 1989 by 49% to K 16.1. Subsequently, the exchange rate was adjusted regularly, reaching K 21.6 by end-1989 and K 43.0 by the end of 1990. In February 1990, a two-tier foreign exchange market was introduced as a transitional arrangement: an "official rate of exchange" at K 27.8 to the US dollar and a "market exchange rate" at a substantially depreciated rate of K 40.0. BOZ sold foreign exchange through the first window (the official rate) under existing FEMAC procedures for imports, and purchased all foreign exchange earned by ZCCM. The second window, financed with non-traditional export earnings and donor funds, operated at the market rate and was used for goods eligible under the Open General License System (OGL). During the course of the year, and while subject to exchange control, nearly all service and capital payments were transferred to the second window exchange rate. By December 1990, foreign exchange at the first window rate was provided only for oil, fer- tilizer, and ZCCM's requirements. At the inception of the system, only 10% of imports by volume were eligible for OGL allocation; but, by the end of December 1991, most imports had been transferred from the first to the second window, and OGL covered over 92% of imports. The rate at the second window was adjusted in steps, and reached K 47.4 by the end of 1990. Donor funding accounted for 54% of the funding of the second window in 1990 and for all of its resources in 1991. The second window OGL has helped alleviate distortions created during the FEMAC regime (paras. 4.03-4.05). On the whole, the OGL system has worked reasonably well, albeit there have been periodic accumula- tions of unsatisfied applications due to foreign exchange shortages. L' Other non-prohibited imports not covered under OGL could be purchased under the "export-retention" and "no-funds" schemes. By 1990, these actions had narrowed considerably the gap between the official and various parallel market exchange rates. In April 1991, the rates were unified at K 58.0 and a crawling peg was introduced.21 4.03 FEMAC allocations gave priority to firms producing essential consumer goods and non-traditional exports. Among sectors, agriculture had first priority followed by mining, manufacturing and tourism. At the enterprise level, priority was given to those that used relatively labor-intensive methods of production and lccal raw materials. There was a blanket requirement that imports be permitted only when similar goods were not domestically available. Also, preference had to be given to small and indigenous entrepreneurs. Between mid-1987 and mid-1988, foreign exchange availability was increased because of the improvement in the world price of copper and the decision to restrict debt servicing. This fortuitous increase in foreign exchange availability enabled FEMAC to increase allocations, and apparently capacity utilization in industry improved. ' 4.04 The FEMAC system was more streamlined compared to the pre-auction licensing system since import licenses and foreign exchange were allocated -' The auction system is indifferent as to the k-..nd of imports to be financed, while the OGL scheme allows the authorities discretion to set priorities as the exchange rate is not the key determining factor. -' While the crawling peg is preferred by the business community because it allegedly provides greater "stability", the system does involve discretion- ary decision-making and intervention by the monetary authorities. 1t SIDA, op. cit., pp. 67-69. - 23 - concurrently, as opposed to the pre-auction aystem when the two functions were split. This avoided the approval of more licenses than could be accommodated by the available exchange, a practice which had led to delays and corruption in the past. Also, prima facie, FEMAC was subject less to external influences because of the openness of the system, because the details of applications and licenses granted were made public. Yet, the system left much to be desired. There were constant complaints that parastatals were favored, while private firms and multinationals were discriminated against, and this is substantiated by the level of rejections of private sector applications (82%). Allocations for industrial capital goods were marginal, suggesting that the system did little to encourage new investment or diversification activity in the private sector. "Retention" and "no funds" import facilities were used to a large extent for passenger vehicles and spares, and only to a limited extent for consumer goods. Some of the FEMAC allocation principles conflicted directly with efficiency considerations. For example, the fact that an item is "locally produced" does not provide a rational ground for prohibiting its import, as domestic production may be inefficient and far more expensive than the import. Also, the fact that an item is "essential" affords no economic justification to import it, if the item is an input to an inefficient domestic activity. Support of small enterprises can be more efficiently extended by interventions at the source of the distortion (e.g., ensuring availability of finance) rather than by creating another distortion. Increasing labor intensity, reducing import dependence, etc., may be laudable desiderata, but it is doubtful that a committee will have the capacity, information, and time to make economically sound decisions. 4.05 Progressively the pressure on the system became excessive. Reported- ly, especially as the parallel market premium was increasing, the demand for licenses grew to between five and ten times the number of licenses issued. Under such pressure, FEMAC tended to adopt rules of thumb, e.g., allocation of exchange based on "stated" capacity or past allotments. But such decisions did not necessarily meet criteria of fairness, efficiency or actual need, and often led to abuses. As under any licensing system, the FEMAC system tended to divert real resources into activities on which rents could be earned. Furthermore, the FEMAC system not only supported an overvalued exchange rate, but tended to perpetuate it because it suppressed its symptoms. A severe disequilibrium in the foreign exchange market developed as evidenced by the persistence of shortages in goods, the sharp increase in the parallel market premium, the increase in unrecorded border trade, and the dramatic divergence between applications for foreign exchange and licenses granted. Under such circumstances, the FEMAC system eventually became inefficient and corrupt.L2' FEMAC was dissolved at the end of 1990, following the progress made in the meantime in liberalizing the trade regime. The Policy Framework, 1987-92 4.06 From May 1987 to June 1989, price controls were reintroduced either through administrative measures (for 23 commodities), or the requirement of prior approval of price increases by the Prices and Incomes Commission. Sales of agricultural goods at prices above the established producer prices had to be approved, and controls were also extended to services such as transport. Interest rates, already negative in real terms, were reduced substantially. -t SIDA, op. cit., pp. 69-70. - 24 - The imposition of price controls created incentives for smuggling, black-mar- keteering and hoarding. By late 1988, Zambia was facing a rapidly deterior- ating fiscal position, accelerating inflation, and shortages of foreign exchange and essential imported inputs (Attachment 1). Severe difficulties were also encountered in servicing external debt obligations, much of which had been contracted on commercial terms. The May 1987 "own" adjustment program had failed to bring about the hoped for stability and recovery. 4.07 Faced with a serio4sly deteriorating economic situation, Zambia resumed its policy dialogue with the Bank and the IMF. Following the resumption of the dialogue in late 1988, some initial actions were taken in an effort to arrest the accelerating inflation. Interest rates, reserve requirements, and the liquid assets ratio were raised, and the consumer price of maize meal was tripled to lower subsidies and the budget deficit. A coupon scheme was introduced to target the maize meal subsidy to more vulnerable groups.L' The Kwacha was devalued in November 1988, and again in June 1989. By mid-1989, an agreement was reached with the Bank and the Fund on a Policy Framework Paper (PFP), outlining the Government's medium-term objectives and development strategy for the period 1989-93. In the context of the PFP, a number of actions were taken. Prices, except for maize, maize meal, and fertilizer were decontrolled; although still fixed, interest rates were raised; there was a significant real depreciation in the exchange rate, partly in conjunction with the introduction of dual exchange rate in February 1990 (para. 4.02). In September 1990, export licensing was streamlined and shifted to the banking system. There was some improvement in fiscal performance, as the budget deficit, although still high, fell from 12.1% of GDP in 1988, to 10.3% in 1989, and to 7.7% in 1990. However, the effort to bring down the rate of inflation and reduce macroeconomic imbalances during 1990 was disappointing. Poor weather affected agriculture, while copper production and export earnings declined. Although monetary growth fell from 62% in 1988 to 46% in 1990, the CPI rose from 56% to 105%, reflecting in part the effect of price decontrol, exchange rate depreciation, and reduction in subsidies. Gross investment as a ratio to GDP fell from 20% in 1986 to 10% in 1989 and 13% in 1991. Since 1988, real GDP experienced a negative growth (-1.8% by 1991). The current account deficit rose from about 4% in 1988-89 to 4.5% in 1990, despite the continued improvement in world copper prices and the growth of merchandise exports (Attachment 1). Also, Zambia met only part of its payments obligations to multilateral institutions. 4.08 In November 1990, a minimum duty of 15% was imposed on imports that had previously carried a zero duty rate (with a few exceptions), and the maximum duty rate was reduced from 100% to 50% for all but a small number of luxury goods. The uplift factor was reduced from 25% to 20%, and discretionary import duty exemptions were removed. The net effect of these changes was to compress the tariff structure to a narrower range, make the regime more uniform across and within import categories; and reduce the excessive protection granted to some goods; but the average level of tariffs was not changed. Also, licenses for exports were granted automatically and the items in the prohibited list were reduced from 48 to 4; administration of the export retention scheme moved from BOZ to the commercial banks and, since May 1991, the retention Lt The coupon program was discontinued in early 1992 by the new Government due to inefficient targeting, and the resources were shifted to the social welfare program for aid to the indigent. - 25 - entitlements of exporters are held in special BOZ accounts, thereby avoiding delays in access; and licensing requirements for "no-funds" imports were removed. These actions marked the first timid steps at reorienting economic policy from administrative controls to greater reliance on price signals. Other changes announced in 1990 included: initiation of a privatization program that would transfer essentially all parastatals except public utilities and natural monopolies to the private sector; adoption of a parastatal reform program that would lead to the organizational, managerial and financial restructuring of those parastatals remaining in the public domain; introduction of policies to enhance the role of the private sector, mainly through deregulation and decoutrol of private business activities and the provision of incentives; and initiation of a civil service reform program designed to pare down the size of the Government. However, only token progress has been made in advancing these objectives to date. 4.09 In early 1991, efforts at adjustment were renewed. Frontloading of aid disbursements enabled Zambia to clear its arrears to the Bank, reduce its unpaid dues to the IMF, and become eligible for disbursements from the Bank. The IMF endorsed a rights accumulation program (the first of its kind) and, in April 1991, approved the accumulation of rights over a period of three years based on the updated PFP for the period 1991-93. However, performance under the rights program was poor, and Zambia failed to accumulate any rights in 1991. Problems in meeting the fiscal and monetary targets emerged, as a decision to tax fringe benefits was withdrawn; the copper company (ZCCM) fell behind in meeting its income tax and mineral resource levy obligations; and fiscal subsidies for maize meal rose sharply as a result of a decision not to adjust consumer prices after a tripling of producer prices, substantial funds were lent to agricultural cooperatives to purchase the maize crop, and large pay awards were granted to the civil service and military personnel. A number of tax and spending measures were taken that helped reduce the fiscal deficit to 7.1% of GDP in 1991. To contain the monetary impact of the enlarged budget deficit and encourage savings, BOZ introduced a new liquid assets requirement and increased interest rates. The liquid assets requirement prompted a squeeze on credit to the non-government sector; but broad money still grew by 98% and consumer prices rose by 95%. By the end of 1991, Zambia was in no better situation than in the mid-1980s. Between 1984 and 1991, real per capita GDP grew erratically at 1% annually, on average, inflation remained unabated, fiscal and current account deficits persisted, outstanding external debt (excluding arrears) rose sharply to US$7.4 billion (up 90%), and manufacturing growth has been unimpressive (Attachment 1). External debt service obligations could not be met, arrears mounted, and Bank lending was suspended once again in September 1991. 4.10 The new Government under the multi-party regime that emerged following the elections of October 1991, dubbed the Third Republic, has stressed its unwavering commitment to policy reforms to stabilize and continue the liberalization of the economy, and has set out a wide-ranging and ambitious agenda to arrest and turn around the protracted decline of the economy. It envisages, inter alia, stern measures to instill monetary discipline; reduce the fiscal deficit by increasing revenue (see para. 5.30) and reducing - 26 - expenditure, e.g., through complete elimination of subsidies' maintain a realistic foreign exchange rate (the Kwacha was devalued to K 125 to the dollar in January, 1992); seek external debt relief; restrain wage increases in the government and parastatal sectors; promote the development of the private sector; and expedite the privatization of parastatals." A PFP agreed in February 1992 between the Government, the Bank and IMF, establishes the broad objectives, targets, and corresponding macroeconomic and structural adjustment policies for 1992-94. The PFP and the Budget document paved the way for settling Zambia's arrears to the Bank and IMF, put an end to Zambia's status of "suspension," and provided the basis for resumption of financial assistance by the Bank. V. FINDINGS AND ISSUES Ownership 5.01 In the context of the preparation of the project, the Government and the Bank reached agreement on the diagnosis of the main impediments to restoring internal and external equilibria, the needed macroeconomic and microeconomic policies and institutional changes to restore economic growth, the development objectives for the manufacturing sector, and the most appropriate strategy to achieve them. These understandings were reflected in the Government's Statement of Industrial and Trade Policy (Attachment 3). The specific policy changes supported by the project had been the subject of extensive discussions between the Bank, the Government and, where appropriate, the IMF (PR, paras. 71, 72). The dialogue was based on the findings of earlier, high quality economic and sector work, which had pinpointed weaknesses in economic management, dwelt on strategic issues for the longer-term development of the industrial sector, and proposed concrete policy actions and institutional reforms that could be undertaken in the short-to-medium term (see also para. 5.14). These extensive exchanges, the concurrence on strategy and measures and, more importantly, the fact that the top political leadership made the final decisions reflected a "renewed" political will and commitment, and betoken that, in effect, the Government "owned' the program, in the sense that it satisfied itself that the policy reforms and actions represented an appropriate, realistic, and feasible course of action, considered the political trade-offs, understood fully its requirements and implications, and accepted it in its totality. 5.02 Between 1973 and 1985, Zambia entered into six stabilization and adjustment programs, all of which turned out to be short-term palliatives (paras. 1,14, 1.23). By 1991, two additional efforts at adjustment had been aborted (paras. 4.07, 4.09). Such a poor record of performance and history of reversals certainly call into question the seriousness of the Government's commitment to reform. Indeed, the dilemma lending institutions are faced with is how reversal-prone, remiss governments should be treated: should they be ostracized -- and at which point? Can the causes of earlier failures unequivocally be established and culpability meted out, including the Lt The price of breakfast meal was increased by 165% and that of roller meal by 100%, while the price of mize and breakfast meal would be liberalized and the subsidy on roller meal will be reduced to 20% by the end of 1992. L' Budget Address by the Minister of Finance, January 1992. - 27 - Government's share? Can a meaningful "probation" period be established? Is fumbling and stumbling part of the learning process and, by extension, of the development process? At what juncture multilaterals and donors should let bygones be bygones and start afresh? Can there ever be assurances that economic realities will have sway over political expediency, that the ever new Government and economic team are more enlightened than their predecessors, and that they have learned the lessons of past experience and will stick to their commitment? What does it really take to bridge the credibility gap, given that a fine distinction should be drawn between bona fide shortfalls in performance due to imponderables or factors demonstrably beyond the Government's control, and an accommodating posture by multilateral and bilateral institutions eager to discern extenuating circumstances? Easy access to flows of external resources inadvertently creates a disincentive effect on the recipient's behavior since, by providing a cushion, it alleviates the pressure on the political authorities to be more resolute in addressing pressing economic problems. The resolution of this issue, intractable and inherently risky as it may be, will ineluctably be a matter of judgement based on a subjective assessment of the surrounding circumstances -- and perforce a close decision. Commitment and Consensus 5.03 Judging from measures taken during 1983-1985 -- price liberalization, successive devaluations, reductions in the budget deficit, increases in interest rates, improvements in tariff structure -- the Bank felt that the Government had proven its commitment to reform and its ability to implement the necessary measures, including some politically sensitive ones. More impor- tantly, the Bank maintained that the prolonged nature and severity of the crisis had helped create at the time of appraisal of the project "a national consensus" on "the need for change" (PR, para. 90). However, as already indicated (paras. 1.14, 1.23), the reforms initiated during the first half of 1985 were not dramatic, were not vigorously or consistently implemented, and failed to produce the desired outcome -- despite an appreciation for the need for change. This is because consensus on the need for chanpe does not necessarily mean'consensus on the thrust of an adiustment path, a particular reform program, or the manner in which it will be implemented. Also, there may be a formal, albeit at times different intensity of, commitment at the political level but covert opposition at various levels of the implementing technocratic hierarchies, or from adversely affected individuals, groups and agencies. Therefore, the Bank's assertion cannot be construed as a coalescence of interests and an endorsement of the proposed reforms by concerned, even informed (para. 1.14) constituent groups, as it would be unrealistic to expect that there can be a consistent and widespread unanimity and commitment. Or, if that is what it meant to convey, i.e. that consensus had actually been built, the assertion is hardly substantiated in the absence of critical presumptive elements, and in light of the actions taken that led to the poor outcome of the program (paras. 3.07-3.15). As it will become evident from the analysis to follow, basically, the absence of unanimity stemmed from divergent ideological predilections; the perception that the payoff was doubtful or, at least, a long way down the road, while the immediate sacrifices inordinate; concern about who the actual beneficiaries would be, and who will bear the social costs of change; and the sentiment, given several earlier aborted efforts, that the determination and courage of the political leadership in - 28 - power to carry out substantive reforms was not commensurate to the task at hand.L' 5.04 It is arguable how effective was the Bank in ascertaining the extent of consensus, let a-one in helping build a broad consensus, among the diverse constituencies. The reform package in general, and the auction system along with the parallel abolition of the rent-riddled import licensing system in particular, were spearheaded by a small group of perceptive and hardheaded top economic officials. It was expected that adversely affected vested interests, including entrenched bureaucracies, would resist their implementation. And there was a degree of uncertainty regarding the ability of the political leadership to withstand likely social pressures. More importantly, the Bank had no real sense of the Party's sub rosa, yet dominant, role in economic decision-making and, as a result, did not attempt to ascertain where the Party (UNIP) stood on the proposed reforms. The more so, since there was ample evidence of internal divisions and factionalism within the Party at the time, which suggested that the Party's position was far from monolithic. For some Party members, the reform's heavy reliance on the market system meant an abandonment of socialist principles, and a dilution if not loss of control over the economy. Also, the attendant social costs of the reform (e.g., impact of substantial price hikes of staples on the urban poor, increased unemployment) were also a matter of grave concern in the absence of a safety net. Thus, perceptions of ideology, humanism, venality and fear of the unknown were hardly conducive to consensus building. These perceptions were reinforced by the distrust of the business community in the Government's ability to carry out che proposed reforms effectively and equitably given earlier unsuccessful attempts. As it turned out, the power and ability of opponent groups to reverse the process was apparently underestimated; or, alternatively, the leadership's strength and ability to press forward with the reforms in the face of strong opposition and make midway adjustments to stay the course was overestimated. 5.05 There is no doubt that intellectual conviction did not have deep roots, and that it was limited primarily to key policy-makers who faced intense opposition. The need for change, an issue about which there was virtually no disagreement although there was no agreement as to how to bring it about, is 2i "The significant reforms of 1985 were extremely unpopular among nearly all strata of the population, from senior cabinet and party figures right down to the unemployed urban worker. Senior officials feared a social and political backlash; bureaucrats and parastatal managers worried about job security and their power, prestige, and standard of living; labor leaders were seriously disturbed about the grave social consequences of the price increases, stagnant wages, 'capitalist exploitation,' and layoffs resulting from these reforms, as well as their own power and standard of living; the very small domestic business community feared for its ability to compete in a liberalized economic environment; and urban workers and the unemployed feared for their very survival. All of these groups believed that the benefits of the reforms would go to external actors and resident for- eigners...virtually no one beyond the small economic team viewed the crisis as systemic or caused by domestic factors." Thomas M. Callaghy, "Lost Between State and Market: The Politics of Economic Adjustment in Ghana, Zambia, and Nigeria," in Joan M. Nelson (Ed.), Economic Crisis and Policy Choice - The Politics of Adjustment in the Third World, Princeton University Press, 1989, p. 293. - 29 - hardly suggestive of consent to the proposed reforms by the various constituen- cies, in the sense that they fully appreciated the benefits to accrue and were prepared to pay the price that such a change entailed. Moreover, the perceptions of the groups that wielded power, their capacity to stultify and derail the reform program, and the leadership's ability to withstand the force of the strong undercurvents and the initial reaction to the shock of the measures were colored by an aura of optimism by both the Government and the Bank. Finally, no safety net was envisioned for the more vulnerable groups that would be affected by the reforms to cushion their plight. Ultimateiy, the Government retrenched in panic because it realized that the political transaction costs of pursuing steadfastly the reform program would be prohibitively high. Yet, in reaching this decision, the political leadership apparently failed to fathom and factor in the implications for the economy and for its own future. This does not mean, however, that an inconclusive consensus was the prime or only cause for the demise of the program. 5.06 In the drive to build up grassroots consensus, the more numerous and diverse the interests, the greater the need for coalition formation; but such efforts are usually thwarted in one-party states. The political leadership in Zambia had never encouraged the formation of constituent groups that would be prepared to support long overdue radical economic changes. Rather, the approach was to play off one interest group against the other, -.n order to prevent any particular group from assuming greater importance over the other, or form an assertive and threatening majority. Under such circumstances, the task of placating and accommodating the particular interests of the various factions and devising generally acceptable policy prescriptions becomes more onerous. The presence of ethnic groups with considerably different economic power exacerbates the difficulties. Furthermore, in one-party political systems the perceptions and interests of the various constituent groups and the ideologies of the actors are seldom allowed to be articulated and filtered through intellectual movements. This hampers the formulation of platforms and policy prescriptions for economic reforms and changes in the institutional matrix, and fristrates attempts to muster constituent support. 5.07 Barring a referendum or a parliamentary vote in a democratic regime on a particular reform program, consensus cannot be readily quantified and its incidence cannot always be ascertained conclusively. Yet, the large majority of the population expects the Government to provide leadership and look after their interests. Usually, it is a small group of pragmatic and determined technocrats who initiate chnges and who are prepared to take the attendant risk, but whose staying pu4er to carry out the reforms remains uncertain. In reality, there is seldom commonality of interest and perception regarding the incidence of costs and benefits even among well-identified economic groups (e.g., "industrialists", "farmers", "labor unions") but, rather, a wide divergence of concerns (e.g., between protected producers for the domestic market and exporting enterprises, big and small firms, parastatals and private firms, urban poor and farmers, among sectors, etc.). Entrenched vested interests (the bureaucracy included) and pressure groups that stand to lose will most certainly oppose the reform, while an attempt to co-opt them may severely compromise the reform program. A debilitating factor in consensus building can also be the credibility gap and cynicism created following past abortive attempts at reform, which may suggest that only a radical political change could restore confidence -- as it turned out in Zambia. Also, the response to Government's initiatives to propose and justify the reform program to the general public in any form (rallies, TV appearances, press releases, - 30 - etc.) cannot always be unequivocally interpreted as reflecting genuine consent and support. The vast majority of the population affected by the reforms practically has no effective way to express consent or dissent ex ante. Finally, public support may be more important in sustaining rather than initiating the adjustment effort. 5.08 In light of the inherent difficulties in defining the contours of a consensus, a practicable approach to take would be to establish whether the reform program proposed by the political and economic leadership, as custodians of the public interest, satisfies certain fundamental preconditions. Specifically, whether (a) the design and implementation of the proposed reform program in its major facets (timing, capacity, scope, content, sequence, pace) appears sustainable, in the sense that it provides a careful balance between demand-side measures to achieve macroeconomic stability, supply-side measures to induce economic growth, and sufficient financial resources to ensure the viability of the program; (b) the longer-term effects of the reform can be reasonably expected to benefit the general public and the economic agents at large; (c) the risk in launching the reform program is minimized because the program is realistic, in the sense that it is restrictive, reflecting the financial and foreign exchange constraints, yet it is socially and politically tolerable as the costs will be shared equitably; (d) the policy package has been approved by the parliament (in democratic regimes) or the Party (in one- party systems); (e) provision is made to alleviate the social costs of the reform for a transitional period; (f) the action programs embody some flexibility to pe-mit fine-tuning of policy measures and adjustments during implementation that could accommodate imponderables or difficult to predeter- mine constraints, and thereby prevent a stall or reversal; and (g) a credible effort has been made to debate the issues, raise awareness, arouse interest, and rally to the cause key groups who share common interests and have the power to influence the outcome, by explaining to the public at large and the economic agents concerned in no uncertain terms the origin of the crisis, the rationale for a reform program, what is involved, the benefits to be derived, the price to be paid, and what the consequences will be if action is not taken. Given that unanimity is a virtual impossibility, a positive assessment of these desiderata should provide a fairly reliable basis to presume the existence of a broad !:onsensus, sufficient to justify the launching of the proposed reform program (presumptive consensus). Conditionality 5.09 The proceeds of the industrial imports component (US$60 million) were added to the foreign exchange pool available for auction, but disbursements from the proposed credit were to be made only to reimburse against imports of goods for the manufacturing sector (para. 2.03). This provision inadvertently introduced an administrative allocation of foreign exchange and in a sense violated the neutrality of the auction system, in contradiction of the very principles on the basis of which the system was expected to operate. Under a properly functioning auction system, it cannot be predetermined whether the manufacturers would necessarily be among the highest bidders -- nor, as a matter of principle, an attempt should be made to pre-empt funds for particular economic activities (para. 2.04). The pre-emption of foreign exchange for manufacturing inputs apparently was stipulated to guarantee access to much- needed imported inputs in the face of pent-up demand for consumer goods that might eliminate altogether the importation of inputs in the short run, since a major objective of the project was to raise capacity utilization of - 31 - industrial enterprises -- which is understandable. But even though the objective was laudable, earmarking funds for an otherwise presumed neutral and automatic auction system and reintroducing bureaucratic micro decisions in the allocation process created an inconsistency and a precedent, which could be easily extended to other activities as well and potentially undermine the system. 5.10 INDECO undertook to produce and implement within less than six months of Credit approval an action program to phase out non-viable parastatale (para. 2.08). However, important aspects relating to the implementation of a divestiture plan had not been fully thought out. In the first place, INDECO was not disposed to act and, in fact, had a self-serving interest in maintaining the status quo. There was genuine concern among government circles about foreign or ethnic minority ownership of larger enterprises; procedures and capacity to effect the privatization (e.g., for asset valuation) were not in place; no decision had been reached as to the shape in which these firms would have to be before making a public offer (e.g., physical condition of equipment, size of work force, capital structure), including the time and financial implications of such a decision; and financial arrangements had not been worked out. Also, there were no initiatives to ease the social impact of privatiza- tion, such as retraining of the work force to be laid off, assistance in finding new jobs, arrangements for and funding of severance payments, unemployment compensation, transfer of accumulated pension and health benefits, assistance to relocate, extension of credit to set up a business activity, access to a plot of land, etc. This state of affairs suggests that the Government and INDECO probably were led to make a hasty commitment. Predict- ably, the chances of compliance were slim. External Financial Assistance 5.11 The effectiveness and outcome of the reforms, in particular the unperturbed functioning of the auction system, were heavily conditioned on the Government's access to external funding to bridge the external resource gap in the face of declining copper prices and capital inflows. At appraisal, the Bank estimated that the industrial sector's requirements for foreign exchange to achieve a modest increase in capacity utilization rates would be about US$240 million in 1985 and US$260 million in 1986. Given that allocations from the country's foreign exchange receipts were estimated at US$140 million, the unfinanced gap would likely amount to some US$150 million per annum over the next two years. The IDA credits, along with the Special Joint Financing from the UK, would cover about 50% of the gap during the first year. No firm commitments had been obtained by other external sources to cover the balance (PR, para. 75). 5.12 The Bank and the Government considered the introduction of the auction system as the cornerstone of the development strategy and the proposed reforms in industrial policy, and fully appreciated the need to ensure that a fairly stable amount of foreign exchange be channelled through the auction systems (PR, paras. 53, 55). Yet, no steps were taken to assure that the auction system would be adequately funded, at least for an initial period, to instill confidence and ensure that it is firmly entrenched. Extension of technical assistance to BOZ to improve its capacity in forecasting and budgeting foreign exchange receipts was the only provision -- but this was a necessary and not a eufficient condition to ensure the smooth operation of the system. - 32 - 5.13 Since expansion of foreign exchange proceeds from increased exports was bound to take time; .mports of industrial and other inputs would be growing as a result of the trade liberalization and the need to improve capacity utilization; and copper earnings were difficult to forecast due to the volatility in production and prices, inflows of quick-disbursing external funds would continue to be required for some time to sustain the reform effort and the unimpeded functioning of the auction system. Implicitly, albeit under- standably, Zambia's access to external resources would depend on sound macroeconomic management and on sustaining the reform effort. But, given the prevailing economic climate and the novelty of the arrangement, the absence of credible safeguards for replenishment during the early phase of the operation of the auction system inadvertently introduced an element of uncertainty concerning the continual availability of foreign exchange resources and, by extension, the sustainability of the system -- particularly among a concerned business community. In addition, a climate of uncertainty concerning prospective foreign exchange availability would tend to fuel speculative demand, exert severe pressure on the local currency, and thereby increase the vulnerability of the auction system. 5.14 It would appear that the project focussed rather narrowly on securing funding for the importation of industrial inputs through the auction system, and did not address sufficiently the broader and more crucial issue of the totality of foreign exchange resources to be made available for allocation to ward off unanticipated pressures on t1'e system and ensure its unimpeded functioning. The more so, since it was understood that "the Government's decision to adopt an auction system is being taken with the clear expectation that higher prices will inevitably follow further depreciation of the Kwacha. It is therefore essential that additional foreign exchange resources be made available for the auction to work in order to increase production, expand the supply of basic consumer goods and minimize upward pressure on prices" (PR, para. 17, emphasis added). Nonetheless, the issue was left open-ended and, effectively, the task of matching whatever resources would be available to the effective demand was thrust primarily on the exchange rate. The Co,-troversy Over The Auction System 5.15 Reform of the foreign exchange regime was the mainstay of the policy reforms supported by the Project. In deciding on the approach to take, the Government considered two alternatives: an initially limited but progressively more comprehensive auction system of foreign exchange for imports (see para. 2.04); or, a step devaluation, to be followed by an accelerated crawling peg thereafter, combined with measures to improve the efficiency of the administvative allocation of foreign exchange, including steps to reduce the excess demand for foreign exchange (e.g., through import surcharges) -- basically a continuation of the status quo. A completely free foreign exchange market was not a viable option at that juncture, as it went too far, too fast in the direction of free markets, and raised important practical consider- - 33 - ations." The auction system was the Bank's preferred solution -- at least for a limited period, as it would pave the way for a gradual transition to a totally market-determined exchange rate, and do away with the discredited import licensing scheme." The Government !qas apprehensive as to how different sectors and various interest groups would be affected and how they would react. In particular, there was concern thp some influential elements would be adversely affected in the process of . smantling foreign exchange rationing, and that particular groups could benefit from increased access to scarce foreign exchange. Furthermore, the Government understood that Bank and donor support for the auction system would be forthcoming (para. 5.14). After weighing the pros and cons, the Government opted for the auction system, whose modus operandi is detailed in para. 2.04. This was a bold move and suggests that the Government wanted to make a clean break with the past and "depolit!- cize" the issue of foreign exchange allocation. 5.16 The auction system was short-lived -- it lasted about 18 months. A confluence of economic, political and social factors account for its demise. In the first place, there was very little experience with auction systems, L1 E.g, need for severe restrictions on capital movements to avoid destabiliza- tion due to wide fluctuations of the exchange rate; need to curb windfall gains and the use of foreign exchange for non-productive purposes, luxury imports, or capital flight by those holding excess financial assets -- which could be prevented only through complex arrangements and administrative decisions; inability of competitive firms to obtain foreign exchange because of temporarily weak financial position or lack of access to credit; price increases to socially unacceptable levels by producers of essential consumer goods; need for complementary policies at the macroeconomic (e.g., trade, monetary, fiscal) and microeconomic (e.g., improvement of efficiency in the parastatal sector) levels to insure appropriate corrections in other economic variables. L8 Issues Paper, December 19, 1984, paras. 19-23, 33-36, and Annex 1. The view has also been expressed that, although the Bank favored the auction system, it had an npen mind, interested more in a substantial devaluation and less in what form it will be achieved. The evidence does not seem to support this view, as there were serious doubts whether the efficiency of an administrative allocation of foreign exchange could be improved in light of past experience. - 34- particularly in Africa." The actual amount of foreign exchange allocated to the weekly auctions progressively became more erratic, and in most weeks fell below intended levels, reflecting the exigencies of the overall balance of payments situation.L1 This led to a significant depreciation of the currency, which was reinforced by speculative demand for foreign exchange to stock up on imports, emanating from concern among importers that the auction system will not survive, tariff duties on consumer goods would be raised, and geo-political developments in South Africa would impede the smooth flow of imports. The speculative fever was intensified by accommodating fiscal and expansive monetary policies and the build-up of liquidity in the economy (paras. 3.07, 3.11, 3.12, 5.17-5.20; Attachments 1, 12-15). The backlog of undisbursed commitments on successful bids from past auctions, which had built up due to the continued severe foreign exchange difficulties, coupled with the fact that subsequent auctions had been conducted on a commitment rather than on a cash basis contributed to a further depreciation of the Kwacha. Furthermore, the backlog of undisbursed commitments implied that earlier successful bids were being funded at lower than the ruling exchange rate. This practice which effectively raised the availability of liquid funds and, by extension, the demand for foreign exchange, and exercised pressure on the rate.Ly 5.17 There was concern that large bidders were more successful in securing auction resources; but, apparently, the claim was not substantiated as successful bids were not much larger in amount than unsuccessful bids, bids at the higher price end were few and for small amounts of foreign exchange, and successful bids were concentrated in a rather narrow range. The range of bids widened much later when the auction system was interfered with (Attachment 4). A variant of this issue was the perception that there was collusion among commercial banks leading to excessive depreciation of the Kwacha. However, the presence of a large number of bidders made collusion difficult, while it would be to their interest to lower the rate below a competitive market clearing 1i Auction systems were introduced in Ghana and Nigeria in late 1986 .Ind have functioned quite well. Both Governments "managed" the auction, but on the whole intelligently so, as is evidenced by the fact that the established rate in Ghana varies very little for three or four months at a time and then drops suddenly, resulting in a series of step-wise devaluations, followed by plateaus of relative stability. Apparently, the motivation to manage stemmed from concern that an unbroken descent might accelerate due to speculation and thereby undermine confidence in the auction system. It is notable that the parallel market did not disappear, which led to an attempt to legalize it by allowing the establishment of licensed foreign exchange bureaus. In Nigeria, there were occasional opposition, political flaps, and modifications of the rules, but not of decisive importance. In both instances, increased resource inflows from the Bank, the IMF, and the donor community helped sustain the system. P. Mosley, J. Harrigan, J. Toye, &id and Power, Vol. 2, pp. 177; 191-2; Callaghy, op. cit., pp. 276, 280-286, 300, 309. 1t For instance, earnings from copper exports declined from US$1,045 million in 1984 to US$785 million in 1987, or by 25% (Attachment 11). at P.D. Nkube, M. Sakala, M. Ndulo, "The International Monetary Fund and the Zambian Economy - A Case," in Kjell J. Havnevik, (Ed.), The IMF and the World Bank in Africa, Scandinavian Institute of African Affairs, Uppsala, 1987, pp. 144, 148. - 35 - level rather than raise it. There was also concern that the auction fueled inflation. In reality, the underlying causes of inflation (and depreciation) were lack of monetary and fiscal discipline, and more importantly, expectations regarding the future course of Government action on these policy instruments -- not the performance of the auction system per se. Moreover, under conditions of uncertainty and expectations of imminent shortage, there is an inherent tendency among bidders to bid at a price closer to their reservation price, e.g., to secure foreign exchange in order to avoid underutilization of capacity, which tends to drive the rate up. Furthermore, there was the perception that the auction allocated significant foreign exchange resources to non-essential goods, although in fact they were flowing in not so much through the auction system," but through the "own funds" scheme.A Legiti- mate concerns regarding the social and psychological implications of luxury consumption would point to the need to levy steep excise taxes rather than alter the functioning of the auction system -- but no action was taken. Finally, the auction was openly opposed by those who reaped rents from the old import licensing system. 5.18 In the mid-1980s, the regime had very little socio-political insula- tion, which made it vulnerable to pressures by vested interests and an influential urban middle class. Affected groups took advantage of this fact, and used every means at their disposal to discredit the reform effort and undermine the program. Senior officials viewed the reforms as unnecessary and as externally imposed. The minuscule technocratic core of convinced officials was always politically weak, uninfluential, and became increasing isolated as there were perceived as the instrument of the Bank and the IMF, in view of the extensive involvement of these institutions in conducting the necessary, studies and analyses, in putting together a coherent reform package, and in guiding the negotiations -- a case of misconstrued ownership (para. 5.01). Moreover, the team received uneven support from the President, as is evidenced by the fact that, in a surprise move, six months after the introduction of the reform package and the auction system, they were replaced by vocal critics of the reforms who were charged to continue their implementation. According to one viewpoint, the move was made to co-opt the opponents. But, probably, subtler political considerations accounted for the decision, while the move suggests the lack of fortitude of the political leadership to resolve the tensions that unavoidably are associated with the process of change -- an attribute nonetheless on which the sustainability of the adjustment effort was heavily predicated. 5.19 To stem the precipitous downward slide of the Kwacha, the new team introduced unsuccessfully several procedural changes and more stringent administrative requirements with significant negative consequences. For instance, bids were advertised in the thought that publicity would discourage bidders from bidding too high; bidders were required to submit tax clearance certificates, and -vidence that previously obtained foreign exchange had L221 "Contrary to popular belief, the share of luxury consumer goods did not rise much." SIDA, op. cit., p. 63. i Remittance of foreign exchange held abroad, or payment for imports of goods and services out of funds held abroad, was allowed without restriction or declaration as to the source of the funds -- a quasi-legalization of the parallel market. - 36 - actually been used for the stated purposes; bidders were disqualified for technicalities, or bids which claimed more than 5% of the auctionable funds were ineligible to participate in that auction. In August 1986, the Government introduced the "Dutch auction" system, whereby successful bidders paid the rates they had quoted in their bids instead of the marginal rate as determined in each auction, in the belief that the marginal bid had a built-in deprecia- tion bias. The amount that would be bid for in weekly auctions was raised without making available adequate foreign exchange to pay the successful bidders. This resulted in what was referred to as the "auction pipeline", which reached some US$40 million within a few months, and successful bidders had to wait 10 weeks to access their foreign exchange. Not surprisingly, the -ate quickly fell from K 7 to the dollar in April 1986 to more than K 15 before the end of the year. And since the auction was the centerpiece of the recovery program, these actions weakened the larger reform effort as well. The fact that key players were aware that high-ranking officials opposed the auction, coupled with the whimsical interventions and handling of the system, shattered their confidence in the sustainability of the auction and the liberalization measures. These spasmodic actions and resolutions of the monetary authorities were also refitcted in the rising parallel market premium on foreign exchange (Attachment 5). This fueled speculation, an attitude that was reinforced by the past experience of aborted reforms, and led ultimately to the demise of the system -- and of the reforms in general. 5.20 Opposition to the reforms was powerful, pervasive, and deeply rooted within the Government, the UNIP Party, the labor movement and, ultimately, the general public. Reforms that removed or reduced political discretion over major policy instruments and spending decisions implied loss of political control, and significant changes in long-standing decision-making patterns, power relations within the bureaucracy, and linkages with constituents. Not only were dominant interests directly threatened, but also the tenets of President Kaunda's political philosophy of humanism, which the elite and labor had long used to defend their interests. Their entrenched statist, anti- capitalist, anti-market, and anti-foreign sentiments, coupled with their welfare, "common man" thrust helped activate and organize popular opposition. They were reinforced by the fact that the Government had neither the capability nor the will to use moral suasion -- let alone coercion. On the other hand, there were no visible beneficiaries of the reforms as agricultural policy changes were not fully implemented (see paras. 5.31-5.35), an African private business sector barely existed, and improvements in real per capita GDP and poverty alleviation were far from evident. Asian and other foreign businessmen eventually became scapegoats of the reform effort. 5.21 The sectoral impact was uneven, albeit through no fault of the auction system per se. Interestingly, the devaluation of the foreign exchange failed to stimulate exports -- both merchandise and manufacturing exports declined in 1986 by 13% and 5%, respectively. The auction favored basically the more liquid firms, and those with quick turnover or capacity to borrow: traders (quicker turnover) over industrialists,Li manufacturing (price decontrol made possible the shift of the rising costs of foreign exchange to customers) over at Reportedly, some large firms shifted from manufacturing a product to importing and trading. But this is likely to have happened because of the uncertainty during the later, unstable phase of the auction system. - 37 - agriculture (scarcity of Kwacha funds),15 and larger private firms over smaller enterprises. Concerning the parastatals, for those that could raise prices and were liquid, the auction eased their foreign exchange problems, and allowed them to improve their capacity utilization. But for those whose demand fell, or lost their monopoly position, or could not afford or secure credit from the commercial banks, the auction had inimical effects on their operating efficiency.' The new import and tariff rules also meant that parastatals had to compete with cheaper and often higher quality foreign goods. Fear of closures were widespread throughout the parastatal sector and tended to sap worker morale. Finally, for urban consumers, the effect of the rapid devaluation on prices was very real (see also paras. 3.17-3.19, 5.22). Politically, this was a cause for concern in a country with a 48% urbanization rate. 5.22 The handling of the maize meal subsidy and the ensuing riots delivered the coup de grace to the auction system and, by extension, to the entire reform program. The subsidy on premium quality maize meal mostly consumed by high- inccme groups had become a significant drain on the budget (Attachments 13, 14), and the Bank had urged cuts in the subsidy, but had counseled gradualism. In December 1986 the Government raised the consumer price on the higher quality maize meal by 120%, and sought to buffer the lower income groups by continuing the subsidy on a lower grade of maize meal. However, under the scheme it would have been unprofitable for the private millers to process the lower grade -- unless they received government compensation. Unfortunately, the Government announced these policy changes before firm arrangements were in place as to how, when and by whom millers would be reimbursed. Faced with these uncertain- ties, most private millers increased production of the decontrolled meal and discontinued the production of lower quality maize, causing wide-spread shortages of the lower priced meal. Riots broke out in the Copperbelt with 15 fatalities. The flare-ups in Lusaka were less serious, but still disquieting. The President immediately reversed the maize price increase and ordered the take-over of all large private maize mills. In January 1987, following the maize meal riots, the Minister of Finance was replaced, the auction was suspended, the foreign exchange rate was fixed at the highly overvalued rate of K 8.0 to the dollar, administrative allocation of foreign exchange was 2i During the first 52 weeks of the auction system, agriculture received only 6% of the foreign dxchange allocations (Attachment 6). Since maize prices continued tC oe controlled at levels determined lon before the cropping season, the bulk of agricultural producers could not freely pass on to consumers the higher costs of inputs resulting from weekly changes in exchange rates. As a result, bids for imported agricultural inputs diminished at the foreign exchange auctions. 2' Because of the high depreciation of the Kwacha, a much greater amount of local currency had to be put up to obtain a given amount of foreign exchange, and this created a liquidity problem for many parastatals, as well as the small scale industry. For some evidence see V. Seshamani, "Indus- trial Development in Zambia: Retrospect and Prospect," in P. Coughlin and G.K. Ikiara (Eds.) Industrialization in Kenya: In Search of a Strategy, 1988, pp. 59-61. - 38 - reintroduced, and the Government backed away from several other reform measures.L7 5.23 In the next several months, strikes by disgruntled public servants continued, and unrest among the organized mine workers increased. The President wavered over whether to resume the reform effort or to end it. External actors and isolated technocratic elements argued for continuation of the adjustment program, while most other constituencies exercised pressure to terminate it. An important background factor was the growing concern about the public's respcnse to elections scheduled for 1988. In late March 1987, the Government decided to restore the auction. The exchange rate fell immediately to K 21 to the dollar, and efforts to get the program back on track failed. Major critics convinced the President that pursuing the reforms would be politically and socially unacceptable. On May Day 1987, the President announced that the reforms were not succeeding; that, instead, they were leading to the disintegration of the nation's social fabric; and that Zambia was suspending the reform effort, abolishing the auction system, freezing prices, reinstituting price controls, reintroducing the import licensing system of allocating foreign exchange, and limiting debt service to 10% of foreign exchange earnings. 5.24 Low and declining foreign exchange reserves, a drop in copper export proceeds below expectations due to lower prices and decline in production, and the overhang of external payment arrears made it extremely difficult to support the auction system with a stable source of foreign exchange. The functioning of the auction was made motie difficult by the limited amount of foreign exchange provided by external actors. Net transfers fell from US$171 million in 1984, to US$164 in 1985, US$68 in 1986, and US$1 million in 1987 (Attach- ment 9). Skeptical about the Government's commitment to reform, multilateral and bilateral institutions were ambivalent and hedged their support. External actors had been disappointed by earlier efforts at reform, which thez had supported generously. Committed resources were slow to be disbursed,L" all in the context of an extreme foreign exchange scarcity. For its part, the Government appeared reluctant to reassess the situation and fine-tune policies. In the face of poor statecraft, reinforced by concern about the upcoming presidential and parliamentary elections, pervasive opposition culminated in riots following dramatic price increases of higher quality maize with parallel shortages of lower quality that led to the collapse of the reform program in 1987 and the return to the status quo ante. 5.25 Given the extent and locus of domestic opposition to the auction, it has been argued that it is not at all clear that substantially increased support would have saved the auction or the reform effort in general.L. Yet, in light of the experience in Ghana and Nigeria, the auction system and the economic reform program might have endured, if the political leadership had shown tenacity and greater confidence in the workability of the measures taken; AU E.g., an attempt to raise fuel prices by 70% in April 1987, collapsed in response to riots and protests. Li Conflicting and restrictive donor conditionalities and cumbersome adminis- trative procedures may live to some extent slowed down disbursements -- but not significantly so. Rt Callaghy, op. cit., pp. 268, 269, 292-299, 317. - 39 - the auction system was not tampered with and was allowed time to work; the maize price changes had been handled with more finesse (see para. 5.22); the Government had made a creditable effort to reduce discretionary expenditures (para. 5.28), and had taken positive steps to introduce reforms to broaden the tax base and improve collection to increase revenues (see para. 5.30); and, finally, the auction had been endowed with larger and timely resource flows. By imparting greater certitude in the system and credibility in the economic reforms, such flows could have kept the parallel market premia at low levels and thereby thwarted speculation, discouraging over-importing (and probably over-invoicing) of officially traded goods.-' In the face of declining copper proceeds, increased foreign aid could have mitigated the destabilizing effects of the terms of trade, and stabilized the parallel rate in the early stages of the reform.1 5.26 The auction system was a radical departure from past more familiar arrangements, and was conditioned (as was the entire reform program) on the exercise of fiscal and monetary discipline to contain the immediate negative effects of the substantial devaluation which was anticipated, while allowing sufficient time for the longer term positive effects to work their way through the system."' In the Zambian circumstances, as in other countries, it would be unrealistic to expect an immediate supply response from an active exchange rate policy -- e.g., non-traditional exports and substitutes for imports take i'i Because of the propensity to interact, unwarrantably rapid depreciation of the parallel rate tends to accelerate the domestic rate of inflation and encourages unrecorded trade. - For an econometric exercise suggesting that exogenous factors operating through the trade accounts, such as terms of trade, foreign aid, and expectations of future devaluation, are important potential determinants of the premium, see J. Aron and I.A. Elbadawi, Parallel Markets, the Foreign Exchange Auction, and Exchange Rate Unification in Zambia, World Bank Working Paper No. 909, May 1992, especially pp. 74-78. See also N. Ghei and M.A. Riguel, Dual and Multiple Exchange Rate Systems in Developing Countries - Some Empirical Evidence, World Bank Working Paper No. 881, April 1992. The behavioral pattern of the parallel foreign exchange rate tends to reflect the direction of key macroeconomic variables, the way the foreign exchange is being managed, the prevailing political conditions, as well as the expectations regarding prospective government actions and policy shifts. Yet, its use as a gauge of the market clearing rate, particularly at times of persistent foreign exchange shortages, should be circumspect, because the parallel market may be thin at the margin, the rate may reflect demand for a very limited quantity of inessentials affordable by few, or the rate may suggest the premium particular individuals are prepared to pay to transfer funds out of the country. Moreover, under a regime of capital controls, a free market premium on unofficial transactions will always persist. Indicatively, in January 1992, the official exchange rate was about K 90 to the US dollar, the parallel market rate for exchange available through the export retention scheme K 120, while the rate for exchange outside institutional channels K 150. It is arguable whether the latter was the market clearing rate. i' It should be borne in mind that lack of fiscal and monetary discipline had led to the failure of earlier foreign exchange regimes and adjustment efforts, and had led to a dramatic increase in external indebtedness. - 40 - time to develop (paras. 6.07, 6.08).gi Also, exchange rate policy becomes a blunt instrument in the face of an unexpected substantial loss of export earnings and/or external assistance. Furthermore, heavy import dependence (35%-40% of GDP) and external indebtedness exacerbate the adjustment process. Inevitably, such circumstances result in severe restrictions on spending and/or imports, and tend to tempt authorities to intervene administratively to set priorities in foreign exchange allocations. 5.27 The question has been raised whether the Government indeed had the requisite latitude to curb discretionary expenditures to offset the impact of the significant depreciation of the foreign exchange rate and the rise in interest payments. Given the protracted decline in national income and real public expenditures, and the large budget share of non-discretionary expendi- tures, allegedly there was little the Government could do in the short term to reduce the fiscal deficit. Since the transfer of external resources was insufficient, the fiscal deficit was accommodated by expanding the money supply and by accumulating large external and domestic arrears.- A related question is whether, and to what extent, the auction or the weak supportive institu- tional mechanisms is the ultimate culprit. In this regard, the view has been expressed that, given the Government's inability to counter its negative effects, the auction system was a risky way to effect the desired depreciation of the real exchange rate, and it may have not been the wisest course of action to take.!5 5.28 The fact remains nonetheless that the auction system initially experienced a period of relative stability, and only at a later stage entered into a phase of instability because of an array of inept interventions, which undermined confidence in the system and fostered a large speculative demand for foreign exchange. These developments cast doubts on the validity of the assertion that the auction system in itself, by allowing a precipitous depreciation of the exchange rate, was leading to an inordinate worsening of the Government's fiscal position and an increase in the rate of monetary growth. Although these interventions were prompted largely by the tight foreign exchange situation due to declining export earnings and donor support, the fact is that the economy remained highly liquid because the Government was not decisive enough to take steps to raise tax revenues and curb the budget deficit, and even less determined to make more effective use of monetary control instruments. In this context, an effort by the Government to compress ui Copper production is likely to be insensitive to the exchange rate. But availability of foreign exchange hampering the importation of key spare parts and consumables can affect production levels and exports. 'i M.A. Fardi, "Zambia: Reform and Reversal", in Vinod Thomas, Ajay Chhibber, Mansoor Dailani, Jaime de Melo, (Eds.), Restructuring Economies in Distress - Policy Reform and the World Bank, 1991, pp. 341, 342. -5i SIDA, op. cit., pp. 65, 66. - 41 - public expendituresii and increase the tax effort through tax and non-tax measures and improvement in tax administration (para. 5.30) might have allayed donor concerns and maintained aid flows, thereby removing an important hurdle in the smooth functioning of the auction system. Moreover, under such circumstances, there are no assurances that a more "controlled" rate of depreciation, e.g., through a discretionary crawling peg, would have fared better in the face of a shortage of foreign exchange resources: the currency depreciated from K 2.0 in October 1985 to K 21.0 in April 1987; between May 1987 and January 1992 it fell from K 8.0 to K 125.0. The workability of the crawling peg system is equally dependent on the effectiveness of fiscal and monetary controls, in addition to administrative dexterity to elicit timely responses to internal and external shocks. Furthermore, a floating exchange rate system can be skillfully "managed" to introduce an element of stability, as in the case of Ghana (para. 5.16, footnote 29). 5.29 It would seem therefore that, whether a free floating or a crawling peg foreign exchange regime is adopted, what really matters is the emplacement of an effective supportive policy framework, particularly of workable fiscal and monetary control mechanisms, which is further cushioned by adequate foreign exchange flows to enable it defend a rate that would sustain internal and external equilibria. Fragile monetary and fiscal systems are likely to foster speculative tendencies in the face of foreign exchange shortages, and drive the exchange rate to inappropriate levels, causing a depreciation-induced inflationary spiral and internal imbalance, regardless of what type of exchange rate arrangement is in place. In the face of poor demand management, a crawling peg can only delay through "rationing" but not avoid altogether subsequent substantial devaluations, as the pre- and post-auction period have amply demonstrated (para. 1.17, 4.01-4.09). On the other hand, had the Government been assured by the Bank and the donors at the critical breaking point that, as long as it persisted with the auction system and the reform package assistance would be forthcoming,L' the political leadership might not have given up.8 Timid Efforts at Raising Tax Revenues 5.30 In the past, the Government has not been able to institute and implement a credible tax reform program to improve the tax structure and i E.g., by an effort to rid the payroll from "ghost" and "casual" workers, refrain from absorbing the deficits of parastatals, or reduce subsidies to more acceptable levels by targeting more imaginatively the most vulnerable groups. Lay-offs of redundant regular government employees is a far more intractable issue and involves an increase in the budget deficit in the short run due to the need for compensation. 4i As a matter of principle, the Bank should provide limited financing for adjustment operations; yet, such funding should be enough to catalyze external support and ensure that the adjustment effort is not jeopardized. at For the views of the Bank's staff on this issue, see PCR, para. 5.2. - 42 - increase revenue.11 This inertia has put the burden to reduce budget deficits primarily on cutting down on expenditures. The new Government proposes to take significant measures to broaden the tax base, to promote a more fair and stable tax structure, and to improve tax administration. With regard to income tax, measures include compression of the tax bands from seven to three (15%, 25%, and 35%); reduction of the marginal rate on personal income from 50% to 35%; taxing of all allowances and fringe benefits that heretofore have been exempt; computerization of taxpayer records; raising penalties and fines for tax evasion; and tightening of enforcement. Concerning company tax, effective April 1, 1992, the rate for manufacturing and other companies will be reduced from 45% to 40%; cost deductions for providing non-cash fringe benefits (e.g., subsidized housing, company cars) will be disallowed; tax exempt parastatals will no longer enjoy this privilege; strict enforcement of the dividend policy regarding parastatals, requiring them to pay 10% on equity; abolition of exemption certificates for contractors and suppliers, and reduction of tLe withholding tax from 25% to 15%; taxing interest income over K 20,000 per annum at a flat rate of 10%, with the tax withheld at the source. On customs and excise, the steps envisaged include computerization of the Customs and Excise Department; pre-shipment inspection of imports over $5,000 in the source country; unification of domestic and import sales taxes at 20%; excise duties on domestically produced goods and competing imports will be harmonized; the duty drawback system on non-traditional exports will be streamlined, and manufacture in bond will be encouraged; export retention earnings will be increased from 50% to 100%; and the import license levy will be abolished. Finally, fees and charges for government services will be adjusted to recoup a greater proportion of the cost of pioviding such services.L1 It is regrettable that discretionary waivers of and exemptions from customs duties and sales taxes afforded under the Duty and Excise Act (Section 89), a much abused provision in the past, was not ended, given that the Act does not provide guidelines for granting such discretionary exemptions. Underutilization of the Agricultural Potential 5.31 The potential of agriculture, inter alia, as an earner and saver of foreign exchange, as providing the underpinning for industrial development (paras. 1,01, 6.02, 7.02), and as a positive contributor to the tax effort has not been duly appreciated over the years. The sector remains to date a heavy burden on the budget and a net drain on the external balance. Though industrial development and change will be necessary for sustainable long-term growth, the prospects are circumscribed. The domestic market is not likely to at Instead, the Government found it expedient to tax away ZCCM's copper export proceeds -- in addition to profits. Excessive taxation, along with myopic and disingenuous management practices, largely due to Government interven- tions, have deprived ZCCM over the years of the requisite resources to rehabilitate its aging plant and equipment, maintain its facilities, and devise a long-term program of ore resource development. A reform of the tax regime applied to ZCCM is long overdue. ZCCM's present condition, misguided diversification efforts, and prospects are discussed in OED, PPAR, (forthcoming). Lt Budget Address by the Minister of Finance, January 1992, pp. 17-29. Most of these revenue reforms were intended to be introduced by the former Government in the context of the PFP 1989-93, but were never implemented. - 43 - grow fast, especially if the pace of agricultural growth does not pick up; services to the mining industry are not likely to expand; and exports are limited by an array of constraining factors (paras. 6.07, 6.08). Also, industry's prospects appear brightest as processor of agricultural products for both domestic and foreign markets. This suggests that agriculture is the prime mover of future growth. To play that role, the necessary resources should be allocated to agriculture, the agricultural policy framework should be revamped, and rural-urban migration should be reversed. 5.32 The Government's failure to invest in agriculture over a long period (inadequate provision of irrigation and agricultural machinery and implements), and the persistent shortage of imported inputs have led to an underutilization of Zambia's abundant rural resources. Only 20% of the arable land is presently cultivated. In the meantime, villagers have been forced to seek better employment opportunities in the urban centers. Further constraints in agricultural development include inappropriate pricing policies (price controls, particularly for maize); overvalued currency; inefficiencies in output marketing and input distribution system; heavy maize and fertilizer subsidies; inimical land tenure arrangements;L' inadequate basic agricultural services; and labor shortages, resulting in sub-optimal crop husbandry practices which depress yields. Maize producer prices were kept low while consumer prices were heavily subsidized to provide cheap food for the urban population. The level of subsidies, combined with pan-territorial prices, distorted the cropping patterns, reduced efficiency of resource use, and strained the fiscal position leading to under-financing of essential agricul- tural services. The marketing of the major crops and distribution of inputs were monopolized by NAMBOARD and the cooperatives, thus stifling competition and efficiency. The severe strain on budgetary resources hampered further the operations of the NAMBOARD and the cooperatives. As a result, there were delays in the release of subsidies, and when they were eventually released, they were inadequate to cover output marketing and input distribution costs. Foreign exchange constraints inhibited importation of critical agricultural inputs, notably farm machinery, implements, crop-protection chemicals, and packaging materials.L/ 5.33 The Agricultural Rehabilitation Project (approved in March 1985) was to address some of these constraints, basically by introducing regional differentiation of producer prices to reflect varying comparative advantages, decontrolling wheat prices, phasing out maize and fertilizer subsidies, and improving the efficiency of the NAMBOARD and the cooperatives. However, one key element, i.e. the land tenure system, was never addressed, while the Government's actions, whether deliberate or not, seem to have been directed toward strengthening the large-scale commercial farming sector (under the 99- year leasehold arrangement), while neglecting the smallholders (under the Lt On the traditional land tenure system see Doris Jansen, Trade, Exchange Rate, and Agricultural Pricing Policies in Zambia, World Bank Comparative Studie3, 1988, pp. 31-33. L' PCR No. 10341, Zambia - Agricultural Rehabilitation Project, February 19, 1992; World Bank, Zambia - Agricultural Sector Strategy: Issues and Options, 2 vols., January 20, 1992; K. Good, "The Reproduction of Weakness in the State and Agriculture: The Zambian Experience," African Affairs, April 1986, pp. 239-265. - 44 - traditional land tenure system which ensures only usufruct rights). As the traditional land tenure system does not meet the smallholders' needs for land security and access to credit, it discourages on-farm improvements and optimal land use. The urgency to devise a system of property rights on land to rectify these shortcomings has yet to be felt, in part because this is a sensitive issue. Due to the limited attention paid to agricultural development, its export potential remains unexploited while the country continues to be dependent on imported food. While some progress was being made in implementing the policy changes envisaged by the Agricultural Rehabilitation Project (maize subsidies were reduced in 1985 and 1986, official producer prices for other crops became floor prices, private traders were allowed to deal in the marketing of crops), the reform program was abandoned in May 1987, along with the reforms of the Industrial Reorientation Project, and Zambia's subsequent suspension of withdrawal rights because it stopped servicing the Bank's loans and credits. 5.34 Agricultural marketing inefficiencies, price policies, and neglect of the small peasantry which represents almost 90% of all rural households have had significant negative consequences on production, the supply of food, and rural incomes. The increase in the producer price of maize led to signifi- cantly larger harvests. Yet, more than 20% of the bumper 1985 and 1986 harvests of maize went uncollected. Between 1982 and January 1986, NAMBOARD and the Provincial Cooperative Unions divided up the responsibility for purchasing the maize crop. But after several years of intense governmental effort, they were still unable to settle their differences, establish clear procedures, and provide the equipment and transportation needed to collect all the harvest. Allowing some private competition for collection of the 1986 crop improved performance only marginally, because the Government was unable to work out the administrative details and provide the necessary inputs. As a result, there has been a critical shortage of grain bags, lack of institutional credit, failure to meet payments for the produce, and lack of transport facilities. Smuggling of commodities out of the country, notably maize, groundnuts, and cooking oil; widespread practice of "retained production," through which the farmers effectively boycotted state marketing agencies and diverted their production; and costly imports of maize, while locally produced maize was retained as cattle feed, have been common. The state's mismanagement of agriculture has been felt particularly by the small peasant farms, which were scattered in remote areas and whose maize was most in danger of remaining uncollected by the agencies. Accounting for some 60% of all marketed maize, they were heavily dependent on receiving early payment for their produce if they were to replant the next season. Their inability to dispose of their crops created a disincentive to maintain, let alone increase, production. Finally, unnecessary wheat imports and critical shortages of flour and bread were the result of insufficient domestic production due to faulty price policies.- 5.35 More recently, the Government has been moving toward the goal of attaining market-based prices for maize and fertilizer in two ways. The producer price for maize and ceilings on maize products and on fertilizer have been raised substantially both to decrease the cost of subsidies and to give Lt K. Good, "Systemic Agricultural Mismanagement: The 1985 'Bumper' Harvest in Zambia," The Journal of Modern African Studies, Vol. 24, 1, 1986, pp. 257-284. - 45 - more appropriate incentives to faiiiers and private traders; all other agricultural prices were decontrolled. The marketing arrangements for these products were liberalized to provide more scope for private sector activity and thus enhance competition. In September 1990, the Government announced that private traders would be permitted to participate in all phases of maize and fertilizer marketing, thus allowing millers to buy directly from farmers and for consumers to buy directly from all parties. In December 1991, the Government announced a subsidy per bag for mealie meal, and allowed the mills to set their own prices. The Government has also been promoting the importa- tion of hammer mills to increase competition in the milling industry and to cut down on the need for long distance transport. These steps are expected t- increase competition, decrease the large margins between farm-gate and consumer prices, and improve the distribution of maize production by encouraging production in areas closer to consumers. The intention of the new Government is to introduce market-based prices for maize and fertilizer by the end of 1992. Nonetheless, the overriding importance of agriculture as the leading sector dictates that much more be done in terms of institutional reforms and agricultural investment -- areas on which the Bank has not placed the emphasis they deserve. VI. EVALUATION OF EXPERIENCE AND SUSTAINABILITY 6.01 The Bank played an important role in the design of the reforms undertaken by the Government. Earlier economic and sector work helped focus attention on areas where significant change was needed, define technical and policy options, and translate adjustment strategy into mutually consistent and actionable programs. The Bank's involvement and support helped articulate the arguments for structural adjustment, deepen the dialogue on technical issues, and facilitate access to concessionary financing -- as long as the momentum of the reform was maintained. There has been close consultation and coordination with the IMF in the course of articulating particular action programs to ensure congruity of purpose. On the whole, the reform package was practicable and was "owned" by the Government (para. 5.01). 6.02 The thrust of the strategy, the objectives, and the supportive policy instruments were appropriate, albeit the weak link with more far-reaching reforms in the agricultural sector attenuated their potential impact. The action programs were well-conceived, purposefully designed, and addressed priority issues, and their sequencing, pace, and timing were correct. Nonetheless, building some flexibility into the program to cope with unexpected shortfalls in foreign exchange earnings, provision of short-term compensation to those who bore the brunt of the reforms, and a more realistic assessment of the institutional delivery capacity and expected outcome, could have enhanced the confidence in and credibility of the reform effort. Actions to be taken were spelled out in considerable detail, thereby facilitating the monitoring of time-bound programs. 6.03 The conditions were formulated through a process of constructive dialogue and close collaboration with the Government, to the end of ensuring commonality of purpose, cooperation, and institutional commitment and support. Conditionality and trauching aimed at facilitating the implementation of prerequisite steps (such as preparation of special studies), or were supportive of forthcoming initiatives (e.g., establishment of an auction system, trade - 46- liberalization, public enterprise reform). The conditions were germane to the objectives and actions agreed upon, and performance-oriented, i.e. tranching and disbursement were conditioned on completion of specific tasks within agreed timetables. The timetables reflected the scope and priority of the issues at hand and were realistic. Conditionality was not excessive in the face of the task at hand, and was effective in eliciting compliance. Tranche release conditions referred to distinct and complementary areas, involved several ministries and agencies, and were purposeful and implementable. With few exceptions, the Government complied fully. 6.04 After a short period of implementation, the industrial reorientation program became unsustainable and was abandoned by the Government because it felt that it was losing economic and political control of the situation. The outcome of the reforms was predicated on the Government's ability to develop and effectively use proper policy instruments to maintain internal and external balances; a rise in industrial production; the undertaking of new investment and expansion of exports; and the Government's access to external funding to bridge the external resource gap in the face of the slow export growth and faster rising imports at the initial stage; make up for unforeseen shortfalls in export earnings; and service a sizeable external debt -- which in turn depended on maintaining sound macroeconomic management and on sustaining the adjustment effort. These prerequisites were not met. 6.05 An array of factors contributed to the demise of the program, and the unsuccessful outcome of the effort. Inept demand management and the Govern- ment's inability to control the fiscal deficit, which was financed by an equally uncontrolled growth in money supply. Inadequacies in the monetary policy framework and controlling mechanisms that could not stem the mounting inflationary pressures. This chain of events resulted in a much greater and faster depreciation of the currency than originally anticipated under the auction system, in part due to haphazard administrative interventions in its operation, and in part due to foreign exchange shortage (paras. 5.16-5.19, 5.24-5.29). The difficult external debt situation, and the absence of any contingency plan to meet projected and/or unexpected shortfalls in export earnings and external assistance exacerbated the situation. The binding constraints in eliciti-g an immediate supply response had been underestimated. The immediate benefits of the depreciation were not apparent, and were offset by the rapid deterioration of living standards. The unimaginative handling of consumer subsidies was not helpful either. The pervasive sentiment, given several earlier aborted efforts, that the determination and courage of the political leadership to carry out the reforms was not commensurate with the task at hand, undermined confidence in the auction system and the reform program. The program's sustainability called for the proponents and managers remain in power to shepherd the effort, but they were ousted soon after its initiation. Finally, a politically sensitive Government succumbed to pressure in the face of a pervasive and entrenched opposition fostered by vested interests and ideological concerns (paras. 3.13-3.16, 5.20-5.23; see also PCR, para. 6.01). 6.06 Building some flexibility into the program to respond to imponder- ables, a more diligent effort to reduce discretionary recurrent expenditures, and greater sensitivity to consumer well-being could have instilled greater confidence in the adjustment effort. Though the advantages of the auction system were overwhelming from the allocative standpoint, a limited second-tier at a lower exchange rate exclusively for essentials (e.g., medical supplies, - 47 - basic staples) which affect the welfare of the low income groups could have been tolerated. Similarly, very high duties and taxes on luxuries, or even temporary prohibition, could have scored high psychological points. In short, purity and uniformity may have to be compromised to a degree, and second best solutions may have to be considered, provided that they do not defeat the original purpose, if they are politically more palatable and have a better chance to work. 6.07 The effectiveness and sustainability of the package of policy reforms depended critically on a positive response from the private sector, reflected in new industrial investments and a rapid growth of non-traditional exports. However, the response of the industrial sector to the new signals and incentives could not reasonably be expected to be immediate. The development of non-traditional exports and a reduction in import dependenceL4 required more time than was allowed by the reform program. An export culture require. considerable time to take root. Inflationary pressures, leading to devalua- tions and increases in interest rates, raise the cost of funds and equipment and tend to discourage new investment, thereby negating the intended benefits of the reform program. The investment and export effort is further constrained by the narrow supply of indigenous entrepreneurship and, perforce, the reliance on foreign investors.L5 6.08 The promotion and reorientation of non-traditional exports toward new products and markets is inherently a difficult and protracted process. The existence of excess capacity in particular subsectors does not necessarily ensure that it could be used to produce for foreign markets because of lack of competitiveness emanating from outdated technology, inefficient production and quality considerations, and lack of market contacts. Restrictive land use regulations hamper new investment for expansion of processed agricultural exports. Traditionally, many firms are inclined to start exporting only after they have established a foothold in the domestic market, viewing exports as a residual in their production plans. Supply constraints stemming from the inadequate production and irregular flow of agricultural inputs, shortages of skilled manpower, poor condition of much plant and equipment, unavailability of term financing, and poor infrastructure exacerbate the situation. Labor costs are not necessarily low by the standards of other developing countries, particularly in the face of low labor productivity. Finally, it takes time to build new capacity and develop new export markets, particularly in the difficult to penetrate industrially advanced countries. The actual performance of non-traditional exports during the late 1980s reflects the force of these abiding constraints, and suggests that the original optimism was not warranted. L41 Devaluation does not enable Zambia to derive quick benefits from the "switch effect" (i.e. the substitution of domestically produced for imported goods) due to short-run supply rigidities, heavy import .dependence on high technology inputs, equipment, and consumer durables, and binding constraints to efficient import substitution. Li It is noteworthy that, during the 1970s, the share of the multinationals in the exports of the newly industrialized countries ranged from 31% (Korea) to 84% (Singapore). S. Lall, "Exports of Manufactures by Newly Industrial- izing Countries - A Survey of Recent Trends," Economic and Political Weekly, Vol. XV, No. 49, December 13, 1980, pp. 2103-2112. - 48 - 6.09 Structural adjustment entails changes in the returns to factors of production and reductions in real incomes; and though the gains from adjustment may ultimately be widespread, some form of short-term compensation would have to be considered to induce those who bear the cost to continue to oarticipate in the process -- notwithstanding the difficulties in devising a workable scheme.Li The removal of subsidies after a long period of decline in real incomes and widespread unemployment caused far stronger protests than expected. It appears that the short-term cost of adjustment for a significant portion of society was greater than its discounted present value of future benefits. 6.10 In retrospect, the poor outcome of this operation in light of Zambia's history of reversals casts doubts on the seriousness of the Government's renewed commitment, and on the soundness of the Bank's decision to support the reform effort. To be sure, chronic neglect and inertia in addressing the country's economic problems due to past inappropriate policies and the attendant longstanding imbalances could not be redressed effectively in a very short period of time. Also, the risks of a reversal were acknowledged at appraisal and were basically related to uncertainties about the length and severity of the prevailing at the time economic crisis, and the Government's ability to withstand the social pressures that might be generated against the continuation of the reforms. But the Bank, perhaps optimistically, felt that, in the circumstances, they were acceptable because the Government appeared committed, there was a sense of national consensus on the need for change to stem the economic decline, steps were being taken to implement earlier initiatives at policy reforms, while "the relaxation of the foreign exchange constraint would allow the structural transformation of the industrial sector -- and, indeed, of the overall economy -- to take place at a lower short-term cost in terms of lost output and employment" (PCR, para. 90). Arguably, any Bank decision is liable to be challenged, and this presents a real dilemma. Realistically, there is no easy answer to this quandary. Unavoidably, the resolution of this issue is a matter of judgment and inherently risky (paras. 5.01, 5.02, 7.08). In the same vein, there are inherent difficulties in establishing with a measure of confidence the existence of a consensus among various constituencies, as this desideratum cannot be readily quantified and its incidence cannot always be ascertained ex ante (paras. 5.03-5.07). A practicable approach to address this issue would be to establish whether or not the proposed program satisfies a set of fundamental preconditions, i.e. a presumptive consensus, as set out in para. 5.08. In Zambia's case, consensus was fractious at best, and this accounts in part for the demise of the program (paras. 5.03-5.08). 6.11 The question still remains, however: was it right to undertake the reform given the difficult conditions at the time? There can be no doubt that reform of some sort was long overdue. Nonetheless, had certain measures been initiated prior to, or even concurrently with, the launching of the program and adhered to, a reversal might have been prevented, by adding credibility to the Government's effort and commitment and, thereby, placating concerns both -' Targeted interventions to ensure that the social welfare of needy groups is maintained at an acceptable standard is not easy to engineer. One difficulty is how the burden of adjustment should be divided among various segments. Another major issue is how to ensure the efficacy of the measures targeted to reach the affected groups, as there are trade-offs between the quest for equity and the quest for efficiency. - 49 - domestically and abroad. For instance, measures to raise the tax effort; adoption of more effective fiscal and monetary controls to support a sustain- able fiscal deficit; implementation of more far-reaching agricultural reforms (e.g., unravelling of uniform prices, institution of property rights on land); external debt rescheduling to ensure serviceability; access to a regular flow of external resources to support the auction system in case oi an unexpected decline in export earnings; greater appreciation of the need for a safety net and better targeting of subsidies to the lowest income groups, might have helped sustain the reform program. The sustainability of the auction system, and of the reform package, was predicated on the regular flow of external resources. But the Government's ability to mobilize external resources was conditioned sn the progress made in carrying out its reform commitments while, in turn, performance was heavily dependent on the timely availability of sufficient external assistance, fostering a link which was intended to be reinforcing but turned out to have a debilitating effect. It would seem that the absence of such initiatives, among other factors, undermined the Govern- ment's credibility within and without the country, as well as the Government's confidence in its own ability to carry out the reforms. 6.12 Despite the reversal and the fact that no tangible structural adjustment took place during the relatively short period during which the policy reforms were in effect, vestiges of the defunct program survived, as important elements (e.g., price decontrols, tariff reform) were progressively reinstituted. The new Goverr mt, which came to power after the October 1991 elections that swept out c7 -,ffice the one-party system under UNIP, appears determined to capitalize on lese elements, and forge ahead with additional measures (paras. 4.06-4.10, 5.30). VII. LESSONS AND RECOMMENDATIONS 7.01 The experience with the industrial reorientation program, in particular the circumstances that led to its sanction and demise, offer instructive lessons and suggestions for defining a better analytical framework in shaping the Bank's posture and approach to country macroeconomic and sectoral issues.57/ 7.02 Fundamental preconditions pertaining to the strategy and speed of industrial development and diversification include the following. (i) Industrial growth and reorientation should be pursued in parallel with and be firmly anchored in agricultural development, and adequately supported by the requisite institutional, human and physical infra- structure. The path chosen should reflect the prevailing socio- economic realities, resource endowment, and binding constraints, while the opportunity cost of ideological biases iiijected into the strategy should be acknowledged and quantified. Impatience with and unwar- ranted acceleration of a country's industrialization effort are likely to entail heavy economic and social costs down the road. Government intervention should be circumspect and consistent, in appreciation of the fact that the evolutionary pace of development of human capital, gi See also PCR, para. 6.01. - 50 - institutional capacity and cultural parameters determine the pace of the industrialization process and set constrictive conditions for the sustained success of the industrialication effort. Infusion of external financial and technical assistance can be complementary -- at best. (ii) There are inherent difficulties in pursuing an industrial strategy stressing the rapid development of an indigenous producer goods industry at an early stage of industrialization, since the deepening of the industrial structure in the direction of intermediate inputs and capital goods faces crucial threshold constraints vis-a-vis important requirements (e.g., size of plant and market, technology and skills, attitudes and values, organizational structures, institutional arrangements). The process cannot be unduly stretched and accelerated with impunity. 7.03 The experience with the timing and conceptualization of policy reforms affirms the following conclusions. (i) Chronic neglect, procrastination, inertia and tentativeness on the part of the Government, and continuation of the status quo by adopting palliatives or fitful measures only perpetuate an untenable situation, postpone the hard political choices that inevitably will have to be made, and render the eventual decisions tougher. Prolonged delay in launching an adjustment program not only results in paying a much higher price for restoring conditions for sustainable growth, but renders the adjustment process more vulnerable as economic agents tend to doubt the sustainability of the program which, in turn, enhances the chances of a reversal. Finally, it is far more difficult for reforms to take root when there is a history of aborted attempts at reform. (ii) Policy-oriented economic and sector work is of critical importance in appreciating the modus operandi of key economic and institutional parameters, in identifying deficiencies in performance, institutional structures and policies, and in enhancing the Bank's (and the Borrower's) capability to craft workable policy reforms and purposeful and action-specific programs. Moreover, a deep understanding and appreciation of the cultural background, political realities, institutional arrangements, attitudes and, more generally, of the way decisions are taken and implemented in a country can lead to less dogmatic approaches to institutional -ad policy reforms, and more practicable solutions and conditionality. (iii) Crucial elements for the successful implementation of action programs are a strong political will, broad consensus, unwavering commitment, fortitude, and staying power of incumbent proponents of the reforms to see to their implementation. Well thought out proposals and con- vincing arguments grounded on correct diagnosis of the initial conditions, consistency in approach, and a firm Bank (and donor) stance on policy reforms are likely to reassure irresolute decision- makers, and ensure more effective implementation and sustainability of the adjustment effort. - 51 - (iv) There is greater likelihood that Policy reforms will be successful and sustained if the process of policV formulation is internalized, in the sense that sector reforms are basically initiated, formulated and implemented through institutional processes and mecha,.isms originating within the country and integrated in its industrial development program, than if reforms emerge from the exercise of external leverage. The Bank can facilitate the process by helping to f-cus attention on areas where significant change is needed, drawing on its economic and sector work; to define technical and policy options; and to translate the adjustment strategy into mutually consistent actionable programs. (v) A program can be said to be "owned" by the Government when there have been extensive exchanges, there is concurrence on strategy and measures and, more importantly, when the top political leadership made the final decisions. This reflective process implies political will and commitment, and betokens "ownership" in the sense that the Government satisfied itself that the policy reforms and actions represented an appropriate, realistic, and feasible course of action; considered the political trade-offs; understood fully its requirements and implications; and accepted it in its totality. (vi) There are inherent difficulties in defining the contours of a consensus. A practicable approach would be to establish whether the reform program proposed by the political and economic leadership satisfies certain fundamental preconditions. A positive assessment of these desiderata, as detailed in para. 5.08, should provide a fairly reliable basis to presume the existence of a broad consensus, sufficient to justify tie launching of a reform program (presumptive consensus). (vii) Ensuring public support for policy reform, particularly during implementation, is crucial. But political commitment and support of public opinion are likely to be progressively more difficult to sustain, the longer the adjustment process continues without tangible payoff in terms of growth, and the longer social conditions are allowed to deteriorate. (viii) A discriminating approach concerning areas of intervention in a structural adjustment operation is likely to be more successful. Although there might be advantages in endorsing an omnibus program, reforms should be limited to a more select subset of sector-specific measures for which Bank policy support would be most important and needed, where the Bank's technical inputs are most likely to make a critical difference, and where the country's institutional capacity is commensurate with the task at hand. Also, a more narrowly focussed sectoral adjustment program is likely to be more effectively imple- mented and more easily supervised and monitored. 7.04 The experience with the design of action programs yields some interesting insights. (i) The credibility of an industrial reform program can be greatly enhanced if the design and pace of implementation take fully into account the country's legacy of deep-rooted structural and institu- - 52 - tional weaknesses, prevailing economic conditions; the interdependence and interaction with reforms in other sectors (e.g., agriculture, infrastructure); social and political constraints; and actual economic opportunities. (ii) Conditionality should aim at striking and reinforcing a practicable balance between industrial and trade Policy reforms, regulatory changes, and macroeconomic stabilization. (iii) To alleviate the socio-economic repercussions of certain measures enforced under restructuring programs, it would be expedient to identify early on in the design process particular population groups/industries in need for special assistance, and to ensure that such assistance would be forthcoming for a transitional period. 7.05 Attention to particular concerns when designing reform programs can contribute significantly to the sustainability of the adjustment effort (see also para. 7.03 (iv), (vii)). (i) Given the complementarity and mutually reinforcing nature between stabilization and adjustment policies, the prior satisfactory implementation of a stabilization program through Judicious demand management provides the requisite economic environment and confidence for a more effective implementation and sustainability of industrial and trade adjustment measures. Yet, the magnitude and pace of the required stabilization effort depends, inter alia, on access to external funding to support the reform. In this regard, close collaboration between the Bank, the IMF and the donor community can ensure consistency of advice, enhance the chances of purposeful design and effective implementation of policy reforms, and provide the requisite resources to sustain the adjustment effort. (ii) Persistent fiscal imbalances and a heavy external debt service burden increase the chances of recourse to inflationary means of financing, and add to the pressure to devalue the currency. Also, high indebted- ness may thwart the entire reform effort if there is a widespread perception that the benefits of higher growth are to be transferred to foreign creditors. Since the adjustment effort takes a high toll politically and socially, this notion tends to strengthen the hand of the opponents to the reform, and can lead to the ousting of would-be reformers and contribute to a policy reversal. This suggests that, in instances of excessive indebtedness, it would be advisable to consider some form of debt reprieve by Governments and/or private creditors concerned Prior to or concurrently with the implementation of an adiustment program to facilitate debt serviceability and, by extension, enhance the sustainability of the reform program. (iii) First-best policies may not always be sustainable because of strong opposition. Arguably, more differentiated and nuanced second-best policies responding better to unforeseen shocks and economic, political, and social realities may prove more successful in the longer pull. - 53 - (iv) Although a crisis situation may embolden a government to introduce radical reforms and make a clean break with the past, sustainability of the adiustment effort is far from assured. (v) Policy reversals are more likely to be avoided when the negative effects of the reform effort on growth, employment and living standards are mitigated and short-lived; supply response is fairly quick and visible; the reform program is underpinned with effective macroeconomic policies; actions are credible and sustainable and, more importantly, that they are perceived to be sustainable; there is access to a regular flow of external resources; and there is faith in the determination, courage and capacity of the political leadership to carry out the reforms. In this regard, policy reforms, and in particular fiscal and monetary discipline, is harder to instill in a weak authoritarian milieu where political authority is maintained through discretionary public funds, and the Government is not insulated from societal pressures and entrenched vested interests. (vi) The workability and sustainability of any form of foreign exchange regime crucially depends on developing an effective supportive Policy framework, particularly of operative fiscal and monetary control mechanisms, which is further cushioned by adequate foreign exchange flows to enable it achieve and defend a rate that would sustain internal and external equilibria. Fragile monetary and fiscal systems and lack of discipline are likely to foster speculative tendencies in the face of foreign exchange shortages, and drive the exchange rate to inappropriate levels, causing a depreciation-induced inflationary spiral and internal imbalance, regardless whether a freely floating (such as the auction system) or a crawling peg arrangement is in place. In the face of poor demand management, a crawling peg can only delay through "rationing" but not avoid subsequent substantial devaluations. (vii) Efforts to reduce budget deficits tend to place undue emphasis on cutting expenditures, while lip service is paid to instituting and implementing a credible tax reform program to raise revenues, by broadening the tax base, promoting a more fair and rational tax structure, and improving tax administration. As part of a structural adjustment, a carefully crafted tax reform program would reduce severe distortions in economic incentives, and the resulting inefficiencies and inequities in resource allocation. As part of efforts to stabilize the economy, a tax reform would generate public revenue in a reasonably non-distorting, equitable, and sustainable matter. Stabilization and adjustment programs are more likely to be sustain- able if expenditure cuts and an increase in tax effort are pursued in tandem. 7.06 The experience with the effectiveness of external financial assistance leads to the following observations. (i) External assistance can be helpful in promoting reform when it is conceived and presented as a reinforcing agent and as a means of reducin, the cost of reforms to which the policy-makers in the recipient country are already committed. Aid is likely to be self- - 54 - defeating if it is proffered as a quid pro quo for the reform commitment itself. (ii) Only those forms of aid that have the effect of changing economic, social and organizational structures can provide essential benefits to the recipient. External assistance therefore should be circumspect and discrete to avoid thwarting government efforts to address Pressing economic and sector issues by providing a convenient cushion. Furthermore, since aid does have an opportunity cost, to assure effective delivery, bilateral and multilateral agencies need to act in concert and take a firm stance to ensure congruity of purpose, consistency in policy reforms, coordination of the total effort and synchronization of actions, prevent the transmission of conflicting signals, and avoid duplication and dissipation of effort. 7.07 The experience with actions that address specific issues on Parastatal reform and privatization provides some useful insights. (i) It is extremely difficult to reorganize, let alone dismantle, unessential moribund entities and enterprises in the public domain because of the resistance of entrenched bureaucracies and a concerned labor force. The situation is exacerbated when the political leadership is unable to reach a consensus on this issue; when there is lingering suspicion of the non-indigenous private sector and the implicit objective of divestiture is to ensure indigenous ownership; and when there is vacillating concern about the transparency of asset valuation, funding, concentration of economic power, and social repercussions. (ii) Early initiatives to ease the social impact of privatization and facilitate the redeployment of the affected work force would go a long way toward speeding up the process and mitigating resistance. Such provisions may include retraining programs, assistance in finding new jobs and relocation, arrangements for and funding of severance payments, unemployment compensation, transfer of accumulated pension and health benefits, access to land, extension of credit to set up a business activity, incentives for early retirement, etc. 7.08 Attempts to streamline the imports control regime and to devise arrangements to promote manufacturing exports yield some interesting insights. (i) Restrictive import policies, and the attendant reliance on administra- tive regulations and controls to ensure their effectiveness, tend to affect adversely production and resource allocation, are open to abuse, take a heavy toll on the country's scarce administrative resources, and foster rent-seeking entrepreneurship, Such policies should be used sparingly and only as an interim expediency until a rational tariff structure and a well-designed incentive system can be put in place. (ii) There is a trade-off concerning the speed with which import restg!c- tions and licensing should be eliminated: the longer the competitive pressure is delayed, the more time highly protected firms are afforded to adjust; but, at the same time, undue prolongation of the adjustment process is likely to meet with increasing resistance and implemen- - 55 - tation may become more difficult, potentially compromising the benefits from liberalization. A thoughtfully spaced out timetable for the elimination of the restrictions would instill steadfastness, credibility, and certainty in the reform process, and would thwart pressures from affected groups to vitiate the reform effort. (iii) The pace of import liberalization and sectoral adjustments is conditioned basically on export performance, as affected both by domestic and external economic developments, and the prospects for a stable inflow of foreign receipts. (iv) The strong link between an efficient production substructure and export potential, in view of the constraining effects of supply inelasticities in the short, and even the medium term, should be duly appreciated in efforts to stimulate export growth. This in turn suggests the importance of macroeconomic stability to maintain investor confidence; the institution of an appropriate policy of foreign exchange rate management; and the creation of an institutional and incentive framework conducive to industrial investment that would broaden the country's export base, including a system of export incentives that encourages backward integration. (v) Import demand is not likely to be very responsive to a change in the exchange rate, as devaluation does not necessarily enable a country to derive quick benefits from the "switch effect" (i.e. the substitu- tion of domestically produced for imported goods) due to short-term supply rigidities, heavy import dependence on technologically sophisticated inputs, equipment, and consumer durables, and binding constraints to efficient import substitution. On the other hand, the potential impact of the income effect may not be robust in the aggregate or even lasting. (vi) The rationale for instituting an export incentives scheme should be transparent. Incentives should basically be compensatory in nature, counterbalancing discriminatory domestic levies and/or equalizing advantages of competitors due to subsidies, and should not aim at making up for production inefficiencies. The focus should remain on maintaining a realistic foreign exchange rate. On the other hand, the effectiveness and serviceability of well-conceived incentives can be easily stultified by poor implementation practices. (vii) Promotion of non-traditional exports and reorientation of existing industrial capacities toward new products and markets is a difficult and protracted process. (viii) Expansion of foreign exchange earnings from the adoption of an export- oriented strategy will take considerable time to materialize because of binding constraints. This suggests the need for regular flows of external funds to sustain the import liberalization effort. Under- standably, access to external resources would depend on sound macroeconomic management and progress in carrying out Policy reform commitments. 7.09 Finally, a retrospective reflection on the Bank's relationship with countries that over the years have had a poor record in implementing economic - 56 - reforms raises sensitive issues concerning the Bank's way of reasoning, posture, and approach vis-a-vis its Borrowers. * The long-standing notion entertained within the Bank of working closely with the Borrower and within the existing economic, social and political structures, to the end of inducing Piecemeal changes, has not met with success in the case of Zambia (and in other countries as well). The results achieved heretofore suggest that this approach has hardly helped promote the long-term interests of the Borrower -- or of the Bank for that matter. * A country's poor performance record and history of aborted adjustment efforts inevitably calls into question the seriousness of a new Government's genuine commitment to reform, and raises a difficult issue for the Bank and the donor community as well: how should reversal-prone, remiss Governments be treated? Should they be ostracized -- and at which point? Can the ca'"ses of earlier failures unequivocally be established and culpability meted out, including the Government's share? Can a meaningful "probation" period be established? Is fumbling and stumbling part of the learning process and, by extension, of the development process? At what juncture multilaterals and donors should let bygones be bygones and start afreph? Can there ever be assurances that economic realities will have sway over political expediency, that the ever new Government and economic team are more enlightened than their predecessors, and that they have learned the lessons of past experience and will stick to their commitment? What does it really take to bridge the credibility gap, given that a fine distinction should be drawn betweea bona fide shortfalls in performance due to imponderables or factors demonstrably beyond the Government's control, and an accommodating posture by multilateral and bilateral institutions eager to discern extenuating circumstances and provide assistance? Easy access to boundless flows of external resources viewed as an entitlement inadvertently creates a disincentive effect on the recipient's behavior since, by providing a cushion, it alleviates the pressure on the political authorities to be more resolute in addressing pressing economic problems. The resolution of this issue, intractable and inherently risky as it may be, will inevitably be a matter of judgement based on a subjective assessment of the surrounding circumstances -- and perforce a close decision. * To be sure, the Bank faces a perennial dilemma. Nonetheless, a decision will have to be made: should the Bank continue to support policies which are not working, cannot reasonably be expected to work in the circum- stances, and which it is not in a position to influence? Or, in the face of uncompromising Borrower attitude, should the Bank retrench, question the wisdom of its further involvement, and even suspend lending? In view of the serious implications of this decision for all concerned, the difficulty in making a determination should not deter the Bank (and the donors) from pondering over the issue, weighing carefully the pros and cons, and justifying its decision whether to continue supporting the new Government's development efforts or back away. * In deciding to end the recent stand-off with Zambia, evidently the Bank has satisfied itself that the newly elected Government was given a strong mandate and appeared determined and fully committed to proceeding steadfastly with the implementation of a convincing program of economic reforms. - 57 - Attachment I ZAMBM INDUSTRIAL REORIENTATION PROJECT KEY ECONOMIC INDICATORS, 1980-1991 1980 1981 1982 1983 1984 1965 1986 1988 1989 1990 lg 12 Roal GDP Growth (Z) 3.0 6.2 -2.8 .2.1 -0.5 1.9 0.7 2.7 6.3 .1.0 .0.5 -1.8 Real Per Capita UP Growth (2) -0.3 2.6 *6.2 *.5. .4.1 -1.8 *2.9 *1.1 2.4 -4.4 *3.9 *5.1 Real Per Capita Private Consumption Growth (1) -4.2 3.0 -10.6 -2.2 *2.8 7.1 .4.6 17.9 6.8 *12.4 .3.0 -9.3 Real Growth-Mining (2) 5.2 4.7 0.2 3.0 *9.8 .5.3 *5.0 4.4 *12.9 9.5 *7.3 *14.0 Real Growth.HanufacturIng (2) .2.4 12.1 -3.5 -7.4 1.2 6.9 0.9 6.8 18.2 *.05 -3.5 -2.0 Manufacturing Production Index (1980*100) 100.0 106.3 101.5 108.1 107.6 114.9 111.$ 111.3 119.2 118.0 113.9 111.6 Mining Production (1980-100) !00.0 91.2 94.2 92.7 89.5 86.8 85.6 83.6 80.6 82.6 78.9 67.9 Copper Production (*000 HT) 607.2 560.0 585.5 $76.1 S23.3 479.9 459.7 483.1 423.2 450.8 436.1 363.1 Manufacturti!/GDP * in constant prices 19.2 20.3 17.7 19.2 19.4 20.6 20.7 21.9 24.3 24.5 24.0 42.6 - in current prices 18.5 19.6 20.6 19.8 Z015 22.9 22.7 28.1 31.6 36.5 42.7 n.e. Mining/GDP - in constant prices 10.3 10.1 10.5 11.0 9.9 9.1 8.6 8.7 7.1 7.9 8.2 7.2 - in current prices 16.4 14.0 11.0 15.3 13.7 13.6 18.2 13.6 10.5 9.9 8.2 n.e. Gross Domestic lavesteentlGODP (1980 prices)() 23.3 19.5 15.4 11.9 12.8 13.5 19.8 11.7 11.5 9.9 17.3 13.5 Gross Domestic SavingelGDP (1980 prices)(2) 19.3 8.5 8.4 13.0 14.2 14.0 19.2 15.3 20.3 13.7 16.6 12.0 Merchandise Exports, f.o.b. (US$M) 1.456.9 996.2 942.0 923.0 892.5 797.1 692.5 868.0 1.156.0 1,407.0 1,263.0 1,082.0 Merchandise Exoort Growth (2) 7 -31.6 *.54 .2.0 *3.3 ;10.7 -13.1 25.3 33.3 21.7 -10.2 -14.3 Exports of Copper, f.o.b. (USSH) 1.125.8 865.5 799.3 861.8 732.6 677.7 573.1 735.7 81.9 1,230.2 1.055.0 695.0 Copper Export Growth (2) - -23.1 .7.6 8.1 .16.3 -6.2 -15.3 28.2 33.5 25.3 -14.2 -15.2 Exports of Hanufactures. f.o.b. (USSM) 12.8 9.8 9.4 8.7 10.5 20.0 19.0 23.0 35.0 Manufactures Export Growth (Z) - .23.4 .4.1 .7.4 20.7 90.5 .5.0 21.1 8.7 Merchandise Imports. c.i.f. (US$M) 1.111.0 1.065.0 1.003.0 710.9 612.1 571.3 $17.7 772.0 888.0 1.020.0 1.084.0 949.0 Merchandise Import Growth 12) * .4.3 -5.8 .29.9 *13.9 .6.7 -9.4 49.1 13.0 14.9 6.5 -12.5 Trade Balance (US$M) 343.9 .68.8 -61.0 212.1 280.4 225.8 174.9 96.0 267.0 387.0 179.0 133.0 Current Account Deficit (US$0) -620.8 .852.9 -630.8 .267.4 .211.4 .270.7 .236.8 -241.7 .163.6 -149.0 .139.0 Current Account DefieitlGDP (Z) -16.0 .22.1 -18.1 -1.7 *11.1 *10.4 .13.4 .10.9 *4.3 .4.0 .4.5 Exporta/GDP (2) (constant 1987 $) 55.3 43.8 35.1 30.2 29.8 35.6 40.2 40.1 37.9 38.2 39.3 33.4 tmports/GDP (2) (constant 1967 S) 54.3 44.6 53.1 48.9 46.1 44.5 45.3 41.3 36.8 31.1 36.4 34.5 Terme of Trade (1980*100) 100.0 89.9 83.6 91.6 91.4 84.3 78.0 84.5 82.7 90.4 89.4 82.9 Change in Terms of Trade (2) .19.0 -11.1 -7.0 9.6 .0.2 -7.8 -7.5 8.3 .2.1 9.3 .1.1 -7.3 Government Deficit (accrual)/GDP 16.1 15.4 16.8 8.9 9.3 14.6 28.6 10.9 12.1 10.3 7.7 7.1 External Debt Outstanding (US$) La 3.266.0 3.632.7 3.708.4 3.799.0 3,881.3 4,637.5 5.707.3 6,598.8 6,831.6 6,739.0 7.326.0 7.377.2 Total External Debt/GDP (1) 84.1 90.6 95.8 114.4 140.1 20'..9 343.0 317.6 138.1 155.1 231.3 177.0 Total External Debt/Exporte-HS (Z) 201.0 310.6 355.1 345.0 395.6 5C.1 779.7 719.6 562.7 51.7 538.2 633.8 Total Debt ServicelGDP (M) 10.6 10.5 8.7 9.1 9.1 4.1 18.4 0.2 0.0 12.5 23.8 External Debt Service (US$) g 411.5 421.5 337.2 303.3 246.2 85.3 306.5 4.4 0.6 $62.7 742.7 Debt Service (accrual)/Exports oi Goods and Services (Z) L a.&. n.& n.. n.a. n.a. 74.b 109.9 99.7 79.2 53.0 60.2 65.2 External Interest (accruel)IExports of Goode and Services (Z) n.a. n.a. a.e. n.a. n.S. 28.7 41 - 37.7 34.5 28.9 28.3 30.8 Net DIrect nvestmant (US$H) 61.7 -38.4 39.0 25.7 17.2 0 . 0 0 0 0 0 Changes in Net Reserves (US$H) L 3.6 409.0 -62.6 68.6 135.2 *145.4 101.1 463.0 370.0 275.0 356.0 228.0 Exchange Rate (US$/Ki period average) 1.2682 1.1516 1.0773 0.7996 0.5573 0.3685 0.1369 0.1125 0.1216 0.0773 0.0330 0.0155 Nominal Effective Exchange Rate (1983-100) 149.8 156.6 174.0 154.0 125.1 100.0 34.1 27.4 32.8 26.3 14.3 Change in Nominal Effective Exchange Race (2) Ld 2.9 4.5 11.1 .1.5 .18.8 .20.1 .65.9 .19.6 19.7 -19.8 *45.6 Real Effective Exchange Rate (1980*100) 100.0 103.4 113.8 106.6 102.5 93.3 44.6 45.9 69.2 91.6 76.5 68.9 Change in Real Effective Exchange Rate (2) d * 3.4 11.0 .6.2 -3.8 .9.0 .52.2 2.9 50.8 32.3 -16.4 .9.9 Money Supply (K2) Change (2) -0.8 10.2 21.5 14.7 21.8 23.5 93.1 54.3 61.6 65.3 45.8 98.1 Credit to Govt. as t of GDP (period svg.) 40.1 40.8 48.4 49.3 45.3 36.8 26.1 21.2 18.0 25.0 - - Change (2) in Wholese Pricen (1985*100) 13.4 1.4 6.7 24.1 27.9 47.2 115.9 84.4 11.6 84.2 115.6 - Change (2) in Codser Prices (1985.100) 11.6 13.0 13.6 19.6 20.0 37.2 51.9 43.0 53.6 96.4 (05.0 95.0 Deposit Rates - Savings (2) 7.0 7.0 7.0 8.0 15.5 IS.0 19.8 8.3 13.0 23.0 27.0 - Leanding Ratee - Comercial Banks (M) 9.5 8.0 9.5 13.0 17.5 20.0 25.0 22.0 22.0 34.0 39.0 46.0 Employees In Mining 6 Quarrying (1000) 63.1 60.6 59.5 57.7 $8.5 57.4 56.8 55.8 %6.8 $6.8 56.8 - Ron-Zaabi6a 6.0 5.6 5.0 4.0 4.1 2.5 2.7 1.6 2.8 2.9 3.0 Employee in Manufacturing ('000) 47.8 47.9 48.2 48.8 48.2 48.5 48.8 50.0 49.9 50.3 30.9 - Non-ambtan 1.9 1.7 1.4 1.6 1.5 1.3 1.3 1.4 1.9 1.8 1.7 L& Excludes arrears. Lb Excludes payments of arrears. L - * incresee. Id - * depreciation. Ll Estieate. Sources Various World Sank economic reports IPSI Central Statist.cal Office. Lusaka. - 60 - Attachment 2 Page 2 of 9 (ii) to enhance the international competitiveness of the economy; and (III) to allocate resources in such a manner that they support the preceding objectives. GOVERNMENT MEASURES 6. The Government has already taken a number of steps to correct the fiuancial imbalances in the economy. In May 1981, an agreement was reached with the International Monetary Fund (IMF) on the use of a three-year Extended Fund Facility (EF). The policies pursued under the EFF aimed at the resumption of a sustainable rate of growth while achieving progressive improvements in the Balance of Payments. Under the programme, measures re- lated to ceilings on domestic bank financing and external borrowing, limits to credit expansion and external payment arrears were pursued. Some progress has been made in the attainment of several of the objectives spelled out in the EF programme, while some difficulties have been encountered with others. The Government is currently engaged in disucasions with the IMF on targets and policies to be pursued in the near future in respect of its latest application for a standby facility. It is the Government's firm intention to retain access to the facilities of the IMF. 7. Meanwhile, a number of other measures to affect both demand and supply conditions in the economy were initiated, including the following: - A commitment to eliminate subsidies over a period, as well as to reduce fertilizer and maize subsidies. In the 19b1 budget K125 million was allocated to these subsidies but only K107 million was spent. The provision for 1982 was reduced to K89 million. However, the actual expenditure rose to K153 million mainly due to maize imports necessitated by the drought. The provision for 1983 is set at K62 million. - In the 1981 budget, the mkximum tax rate on farming income was reduced from 80 to 25 percent, while in the 1982 budget this rate was reduced further to 15 percent. - Annual review and adjustment of agricultural producer prices to provide adequate incentives to farmers so as to efficiently substitute imports and promote exports. - Adoption of the principle of economic pricing for parastatal enterprises. 8. In drawing up the annual capital expenditure budget, consideration has been given to changes in resource availabilities and it is the Govern- ment's commitment to increase in real terms the "recurrent departmental charges" available to the productive sectors, particularly agriculture. - 59 - Attachment 2 Page 1 of 9 GOVERNMENT OF THE REPUBLIC OF ZAMBIA MEMORANDUM ON DEVELOPMENT OBJECTIVES AND POLICIES PURPOSE I. This memorandum sets out the Government' current development objectives and describes a number of actions and measures which the Govern- ment intends to take to help achieve structural change in the economy and better economic management. BACXGROUND 2. For a number of years, the Zambian economy has experienced severe external and internal financial difficulties. Foreign reserves have dwindled and external payment arrears have built up. Fiscal deficits has*e led to a high rate of domestic inflation. The scarcity of external and domestic fi- nancial resources has caused imports, investments and maintenance of capital stock to decline. As a result, the economy's productive capacity has become increasingly under-utilized, production and employment have stagnated. 3. To a large extent, external factors beyond the Government's control account for these developments. Weak copper prices and increasing costs of production in the mining sector have adversely affected foreign exchange earnings and government revenue. Droughts in recent years made substantial food imports unavoidable. Zambia's economy has also suffered from the unsettled political situation in the region, from increases in oil prices. and from disruptions of transport routes outside its borders. 4. The Government recognises that in the changed circumstances a number of economic policies need to be made more conducive to achieve financial equilibrium and economic growth. Pricing, exchange race and tariff policies need to provide the incentives necessary to realize the country's potenatial of agricultural and industrial production and to stimulate divera- fication and export growth. Large budget deficits have led to a pattern of over-consumption and falling investment as a result of these deficits being used to finance recurrent expendicure. As a consequence, the composition of Government expenditure has become less and less supportive of the development effort. Also, although many parastatal enterprises have become less unprofitable and lees dependent on subvention from the budget a greater degree of efficiency is still required. 5. Achieving the Goverment's prime goal of healthy economic growth requires first of all the restoration of financial stability. But equally important and urgent is the Initiation of a programme of structural adjust- menc which will bring the economy back on a path of sustainable growth and which will lead to economic diversificatione In drawing up a programs of growth and diversification, the Government will be guided by three key considerations: (1) to provide adequate economic incentives for production of both agriculture and locally manufactured exports; - 64 - Attachment 2 Page 6 of 9 are necessary to redress the low efficiency of manufacturing operations of enterprises; the heavy import dependence of the sector; its small contribu- clon to exports and its high capital intensity. 20. The Government also intends to review its tariff and other indus- trial policies, and to consider such changes in policies and incentives as may be necessary to bring about increased efficiency, high labour intensity and better export performance. To this end, the Government looks forward to receiving the findings and recommendations of the tndustrial Sector Policies Mission of the World Bank which could form a basis for further measures aimed at intensifying Import substitution, encouraging exports, improving capacity utilisation and increasing the efficiency of the sector. The measures aimed at improving capacity utilisation and increasing efficiencies may require financial assistance in the form of foreign exchange support for the purchase of essential raw materials, spare parts and equipment from the Bank and other donors. 21. Because of the foreign exchange constraints and the critical need to develop alternative lines of exports, the Government Intends to take necessary measures to promote manufacturing exports. To this end the Govern- meat has already introduced a foreign exchange credit system by which any exporter who earns foreign exchange is given credit of up to 50 per centum of the foreign exchange earned. Additionally, it has been decided to establish an Export Guarantee Agency to protect the interests of Zambian exporters. World Bank assistance in the form of an Export Revolving Fund will be welcome. IMPROVING BUDGETING AND PLANNING 22. In the past, lack of co-ordination among the Ministry of Finance, the National Commission for Development Planning, and executing ministries led to the preparation of Government investment programmes which were too large in relation to available resources. Also, the coordination between the annual recurrent and capital budgets has been less than satisfactory. The recurrent cost implications of past and new investments were not adequately considered. As a result, there has been an increasing disinvestment and under-utiLization of existing capital stock. Also resources have been spread too thinly over too many projects and this has ted to delays in execution. 23. At the request of the Government, the World Bank has recently carried out a Forward Budgeting Study which is intended to help develop an overall financial framework for projecting the main budget aggregates, establishing linkages between recurrent and capital budgets, and defining procedures for monitoring and setting priorities. These should enable the Government to increase the share of spending for development purposes. The Government looks forward to receiving the results and recommendations of this study, on the basis of which it intends to adopt the practice of mvitumterm financial planning and introduction of annual three-year rolling budgets for both recurrent and capital expenditure. The Government will ensure that capital budgett- will be consistent in she with estimated available re- sources, and in conformity with the Government's goals of diversifying pro- duction and exports, and increasing the utilisation of existing capital - 63 - Attachment 2 Page 5 of 9 15. The general principles on which the Government's pricing policies are based have been set forth above. However, operacionally useful guide- lines will need to be defined with greater precision. Objective method- ologies and criteria need to be developed to be used in setting comparative agricultural producer prices and in determining economic prices for indus- trial products in such a manner that the policy of economic pricing is not abused by the inefticient producer. The Government also intends to draw up work programmes for the generation and maintenance of data bases in the Ministry of Agriculture and Water Development and PIC, which would provide support for informed pricing decisions and rational allocation of resources based on the principle of comparative advantage. The Government welcomes assistance from the World Bank in these matters. AGRICULTURE 16. The Government intends to strengthen the Agricultural Planning capability of the Ministry of Agriculture and Water Development to enable policies to be formulated on the basis of a well defined agricultural de- velopment strategy and welcomes World Bank assistance in this area. Since Zambia possesses adequate land and water resources to enable a dual approach to agricultural development which emphasises both small scale and large scale farming including irrigation, the Government will examine the potential and requirements of both in the production of food and export crops within the total resources likely to be available. 17. The Government gives high priority to the promotion of agricultural small-holder production as an effective means of increasing output and re- distributing income. Equal in importance to proper price incentives is the provision of adequate services. The Government intends to review the whole range of services available to the small-holder, including extension, re- search, input supply and marketing, to identify inadequacies in the system and to effect improvements where necessary. The Government welcomes World Bank assistance in the form of a study on agricultural services and financial support. The Government will then draw up an action programme for the Ia provement of agricultural services. 18. Improving marketing services is particularly important in this respect. The Government intends to increase the efficiency of the market- ing system by allowlag a degree of competition among the official marketing organisations, co-operative unions, and private traders. This should eventually lead to a system in which official producer prices become floor prices. Such a system already operates for a number of crops such as Sorghum, Millet and Cassava. However, the volume of marketed output is con- strained by, among others, poor transportation facilities, lack of facilities for processing and inadequate credit for farmers. The Government has already made a start in relieving these constraints. INDUSTRY 19. The Government is concerned about the performance of the industrial sector. Although implementing the policy of economic pricing will increase the profitability of the sector, the Government feels that further measures - 61 - Attachment 2 Page 3 of 9 9. The proposed mining rehabilitation programme is intended to arrest the decline in copper production and enhance the efficiency and profitability of the mining sector. It is expected to increase not export earnings and Government revenues in the medium term. It is therefore an important element in the programme of redressing financial imbalances, and it will allow, through larger foreign exchange allocations, an increase in the capacity utilization of the productive sectors. It is not, however, a solution to the longer-term structural problems of the Zambian economy. Because of the projected long-term decline in production and exports of copper resulting from the depletion of ore reserves, there is an urgent need to develop viable alternative sources of production and exports. Zambia is endowed with alternative sources of wealth. It has excellent potential for increasing agricultural production and exports, and prospects for export-led industrial development based on agricultural products and other domestic resources are also good. FURTHER ACTION 10. The Government is resolved to take such further action as is necessary to bring about a resumption of economic growth and diversifica- tion of production and exports, and to continue with the policies which would promote structural change in the economy. 11. Developing a comprehensive and coherent set of adjustment policies, and devising concrete measures to effect the desired changes in the economy is a difficult task that may take a number of years to implement. In several instances, studies will be necessary to provide the proper analytical under- pinning of policy objectives. The Government recognizes that its own analytical capabilities need to be strengthened, and it therefore welcomes the World Bank's technical assistance in training Zambians to plan and imple- ment its program of economic adjustment and in carrying out supporting studies. 12, It is possible and necessary, however, to initiate a number of new adjuatment measures before the results of those studies are available. BuildLag on institutional arrangements already made, the Government intends to take in the immediate future a number of steps which are supportive of its objective of diversifying production and exports and achieving better manage- ment of resources. These measures will be aimed at: - Providing a system of incentives to producers and exporters of agricultural and industrial products in which prices are responsive to market forces. - Evolving a system that encourages co-operatives and other agents in the procurement and selling of food crops in which, except for maize, NAMBOARD will as the buyer and seller of last resort to ensure the effectiveness of incen- tive pricing. - 62 - Attachment 2 Page 4 of 9 - Mobilisation and allocation of resources for development through improved planning, budgetary and other procedures to shift resources to productive investment. - Using wages and interest rate policies to reverse past trends of increasing consumption and declining investment. - Improving management of foreign debt. - Continuing the programme of reform already started in respect of parastatal enterprises by strengthening the technical and r-.iagement capacity of ZIHCO. - Restructuring the energy sector with a view to bringing about lesser dependence on imported oil. - Ensuring the competitiveness of exports through an active exchange rate policy. The programmes to implement the above measures are spelt out in more detail in the following paragraphs: PRODUCER INCENTIVES 13. Past policies, which held prices for agricultural and industrial products too low, are, to an appreciable extent, responsible for the dis- appointing performance of the economy. As stated before, the Government has already instituted annual review of agricultural producer prices with a view to providing adequate incentives to farmers so as to efficiently substitute imports and promote exports. For industrial prices the Government has adopted the policy that they should be based on a clear definition of eco- nomic prices in terms both of reasonable rates of return based on current replacement costs and the international competitiveness of production. Producer prices for agricultural products and prices of several industrial products have recently been increased. 14. In May 1981, the Government established the Prices and Incomes Com- mission (PIC). PIC is set up as a semi-autonomous body, under guidance of a Consultative Council of Prices and Incomes. With the assistance of a full- time Secretariat, it has assumed full executive powers in executing the Government's pricing policies. The members of the Commission and of the Consultative Council have been appointed and the Secretariat is being pro- vided with adequate and experienced staff. The Government's role will be to lay down, through the Consultative Council, general principles and policy guidelines to be followed. The application of the guidelinrs are left to PIC, who will now exerc a "post facto" price control. In this respect, ex- cept for a few esfential commodities, the primary responsibility for setting economic prices now rests with the enterprises, and PIC will review those prices in the light of the Government's guidelines on a "no objection" basis. - 66 - Attachment 2 Page 8 of 9 26. There has been a substantial effort towards coordinarion of Group activities, reduction In costs and improvement in managerial efficiency. The merger of the tim mining companies will result in significant cost savings ad greater rettonalleation of operations. Many individual companies in the 1PLasseg eergy, Comercial and particularly in the Manufacturing sectors have shew improved profitability. Positive steps have been taken to reduce oss in the Transport sector and Improve overall operations. The management grep, gulded by the objectives oi cost reductions and iaproved efficiency is also responsible for the review and evaluation of ZINCO's pricing policies. 27. The Governmat Intends to continue to Improve the operations of the ZINC Group by strengthening the technical capacity of the management Group in the field of Investment &aelysis and managerial support to Group compeaes. A set of Investment criteria oriented towards efficient Import embstitution and export promoti*n will be drawn up. The Government also looks forward to the early conclusion of the Mining Rehabilitation loan and to seeking World Bank assistance on other mining projects Including small scale mining to exploit other Mineral resources. 28. The Government will continue to welcome private participation in joint cquity ventures with ZINC, recognistag the technical contribution whibch private participation can offer to the success of eusting or new eaterprises. 29. Altbough Zaabia's own energy resources are subs.artial, a coan- siderable proportoa of commercial energy is provided by imports of ol. he man" and commrcial transport sectors are the major users of oil and redumstio in ol fuel consumption bas occurred due to the general decline in ecooi activity. However, the Governmen to concerned about the Increasing burden of oit Imports on the Balance of Payments and realtses that a restruc- turing of energy Inputs is necessary. The Government ba already Initiated a number of projects in trte direction ad chse IcLude a * Indet Reftinery Modification Study - (financed by the World Sank) * Aview of energy use In the Mines with a view to substite- ste of oil fuel by hydropower and coal where ieaatble * Study on the electrification of the railway system (liaaced by the World ank). * Study on he rehabLittation of the CaIl&ery - (Itaased by the World Sak). - Kaptoreti #o pasglem depotsi * (tsawed by the World - 65 - Attachment 2 Page 7 of 9 stock. For this purpose, a co-ordinating Comittee composed of inter alia, representatives of the Ninistry of Finance and the National Commissiaon for Development Planning vill be set up. Executing ministries and agencies will be instructed to include in their submissions for the capital and recurrent budgets, estimates of the recurrent cost requirements of the various proj- ects, including estimates of costs associated with improving utilization of existing capital stock. In addition, objective economic criteria will be developed for investment projects to be included in the capital Budget. The World Bank assistance in training Zambians would be welcome. DEBT MANAGEMENT 24. As a result of large borrowing, Zambia's outstanding debt on medium ad long term more than doubled between 1975 and 1980. The servicing of t%ese loans, and of the drawings from the INF and the short-term arrears, will increase substantially the country's debt service obligations in the near future. This means that the Government needs to exercise great caution in -ontracting external debt. The Government, therefore, will euforce strictly tho existing legislation, which places the sole authority to con- tract external debt with the Minister of Finance. It will also strengthen the present debt management unit in the Bank of Zambia in order to avoid omissions in deDt reporting and advise the Government on the Implications of its external borrowing programse. The Government intends to evolve a system by uhich Integrated annual borrowing programes will guide its decisions on external financing. Zambia will seek World Bank's technical assistance in training local personnel to man the unit. PARASTATAL ENTERPRISES 25. In the past three years, the Government already has moved to improve the efficiency of parastatal enterprises In the ZINOD Group. Representing a major restructuring of ZIMCO's management, the changes include: (i) the severing of direct links between company management and government ministries previously responsible for operating decisions; and (it) the establishment of a new Board of Directors and an execu- tive management group in ZINCO Headquarters responsible for Group policies, financial and corporate planning, conditions of servce for Group employees and Investment dectstons. These maasures aim at increasing the commercial orientation of the eater- prises and have resulted in the institution of a Corporate Salary Structure and new Conditions of Servi.e, an annual Corporate Budget to establish per- torsace criteria and to review policies including Investment dectsions, monthly and quarterly reviews of performance and production constraints, the carrying out of Management Audits aimed at identiftyg areas for Improvement ti coMpanes, project sOVauion, and a seekly fact sheet to tntors the BIND Boatd, Managers and Government Agencies of the current status of major fLuan- ctal indleators. - 67 - Attachment 2 Page 9 of 9 - Review of energy pricing. - Planned studies on Energy Conservation measures in the mines, refinery and awjor consuming industries. * Restructuring of institutional arrangements in the energy sector for Improved planning. The Government iutends to develop a comprehensive energy policy. It looks forward to receivirg the results of the World bank's recent Energy Assessment Mission, and intends to consider Implementation of its recommendations. CONCLUSIONS 30. The Goverr at considers the actions spelled out above as sig* aiflcant sceps towards the formulation of a comprehesive structural adjust- enat programm. The Government recogaLies that the degree of progress with the economic recovery programe is an Important factor in determining the extent to which external assistance can be used in a meaningful way. To ensure satisfactory progress, the Government intends to continue to discuss with the World Bank the Implementation and further planning of its programe of structural adjustment. - 69 - %0410s. war senz n1hialt14 MIMTRY OF FINA1 P.O6 BOX UM LUSAKA Attachment 3 June 13, 1985 Page 1 of 10 Mr. Bdward V. K. Jaycos Vica-President Eastern and Southern Africa Region World Bank Washinton D.C. U.S.A. STATEMENT OF INDUSTRIAL AND TRADE POLICY Dear Mr. Jaycoz: Introduction 1. It has now been two years since my Government sent to the Bank the Memorandum of Development Objectives and Policies, dated January 13, 1983, which contained a statement of my Government's objectives and our intentions as regards policy refors. The progress made in implementing the new policies and programs during the.first year following this statement, was summarized in a more recent letter dated February 1, 1984, sent by me to the Bank. In that letter we also indicated the specific actions we planned to take to P-vacce further the policy reforms enumerated in the Memorandum. The purposa of this letter is to inform you of additional progress that has been made on the policy front over the past year particularly in the industrial and trade policy ateas, and to indicate to you the specific actions we plan to take in the coming months to support the proposed Industrial Be-orientation Project. 2. Considerable progress has been made (since early 1983) in carrying out the macro economic and sector reform specified in the Mememorandum and the letter, and we continue to believe that we are moving towards a policy framework essential to bring about the desired structural changes in the Zambian economy. 3. Clearly, mach remains to be done in various policy areas. Since we recognize that the long-term prospects for copper are limited, we epect that future economic growth will have to depend more heavily upon agricAlture and a more efficient industrial sector. 4. In the industrial sector we have adopted, and are planning to adopt in 1985 a large number of policy actions. We see the proposed Industrial Re-orientation Project as an essential element in our strategy for decreasing Zambia's reliance upon the copper sector and launching a program to re-orient manufacturing activity to Improve the efficiency of existing operations and the economic contribution of new Investments. 5. During most of the two decades since Independence, the policy to promote the development of manufacturing industry in Zambia was based on industrial and trade policy masures which emphasized import substitution and administrative controls, and relied on public sector investments to promote industrial development. Initially this policy led to rapid industrial growth and to the development of a relatively large and well diversified manufacturing sector. At present, however, the sector is experiencing low capacity utilization, declining labour productivity, - 70 - Attachment 3 Page 2 of 10 increasing capital intensity and high dependence upon imports in a period of foreign exchange scarcity. Recent Policy Changes 6. To set the stage for resuming efficient growth, a number of problems and policy issues needed to be addressed. The correctfve policies which started as early as 1980 met with limited success. In late 1982, however, we agreed with the Bank Group and the IMF on a new program to bring about better economic management and a more appropriate policy environment. Agreement was reached with the IMF on a one-year standby arrangement starting in April, 1983, and with the Paris Club to reschedule the 1983 debt. As a part of the IMF program, the Kwacha was devalued by 20% in January, 1983 and a flexible exchange rate policy was established in July 1983. 7. The Memorandum of Development Objectives and Policies mentioned above was sent to the Bank in conjunction with the Export Diversificaton Project and it formed a part of the policy dialogue between the Government and the Bank which focussed on the structural elements of our diversification program. The progress made in implementing the new policies and programs, which was summarized in the letter dated February 1, 1984, included a cumulative devaluation of the Kwacha of 62% in 1983 against the SDR, compared with inflation rates of roughly 20%, the decontrol of prices in December, 1982, which led to the realignment of producer and consumer prices and to a reduction of subsidies of about 80% in 1983; cutbacks in Government expenditure, tax increases, and a 10% limit on wage increases in the private sector, with no increases in the public sector; and higher customs duties on some capital goods introduced in the 1984 budget. The letter indicated that further progress in policy reforms would be made once the exchange rate and tariff policies were modified to provide additional and more appropriate incentives to non-traditional exports, and once generalized duties on intermediate goods were introduced. Also, we mentioned that the tariff base would be shifted from f.o.b. to c.i.f. in 1985 and that the Industrial Development Act of 1977 would be revised by December, 1985. 8. During 1984 my Government continued to take actions consistent with the development objectives specified in the Memorandum of Development Objectives and Policies. These objectives included production and export diversification, the reversal of past trends towards excessive consumption, lessened dependence on imports in consumption and production, lower capital intensity of production and greater economic efficiency all around. The main policy actions taken during this past year are as follows: (a) As noted earlier, we have made substantial progress in the realignment of the exchange rate. From January 1983 to December 1964 the cumulative devaluation of the Kwacha has been 118%, which amounts to about 50% in real terms. We are now following a policy of depreciating the Kwacha at about 2.5% per month, a rate which exceeds the domestic rate of inflation. - 71 - Attachment 3 Page 3 of 10 (b) During 1984 we continued the decontrol of retail and wholesale prices which is now virtually complete. Maize meal and candles remain the only exceptions. (c) We have managed to maintain in 1984 the levels of fiscal deficit and of borrowing from the domestic banking system at the significantly reduced levels which we achieved during 1983. The fiscal deficit dropped from 21% of GDP in 1982 to 7% in 1983, and borrowing from the domestic banking system from 14% of GDP-to 2%. (d) We were also successful in our policy of limiting wage increases in the public and parastatal sectors to 10% annually or less since the beginning of 1983. (e) Interest rates have been raised significantly during 1984. In May the maximum lending rate went up from 12 to 15%, and in December interest rates were increased again by 2.5 percentage points. The maximum lending and deposit rates are now 17.5 percent and 15.5 percent, respectively. (f) In addition to the above macroeconomic reforms, many important reforms have been instituted at the sectoral level. The mining industryhas been streamlined and made more efficient through a merger of the two copper mining companies (which took place prior to 1984). This has led to a consolidation of inventories and the establishment of a strategic planning unit in the new company's headquarters. Also, improved incentives for attracting high quality expatriate personnel have been introduced; the company has gained automatic access to foreign exchange to finance the imports needed for mining operations; and a set of studies has been initiated to raise labour productivity, to assess the economic viability of new tnvestments and to plan for the close of uneconomic mines. These initiativer, which were supported by the Mining Rehabilitation project, will help ensure the future financial viability of the industry. (g) In agriculture, producer prices have been increased by over 30% in real terms during the past four years, and the marginal tax rate on agricultural income has been reduced to a flat rate of 15%. Responsibility for the marketing of maize and fertilizer has been given back to NAMBOARD, with the provincial cooperative unions acting as agents of NAMBOARD. Also a major study is underway to reorient agricultural research and extension services towards the emallholder sector. Further reforms in the agricuitural sector have recently been egreed with the Bank in the context of ?he Agricultural Rehabilitation project; these include the decontrol of wheat prices and tractor hire charges, the establishmant of a pricing methodology based on border prices which should lead eventually to the termination of panteritorial pricing, the opening up of maize marketing and fertilizer distribution to private traders, and the initiation of studies on fertilizer usage and the efficiency of agricultural marketing agencies. - 72 - Attachment 3 Page 4 of 10 (h) We have begun to implement policy reforms in the industrial sector. In October 1984 we introduced a 10% minimum duty on intermediate and raw material imports which should significantly reduce the effective rate of protection on assembly-type industries and provide a minimum rate of protection for domestic resource-based industries. Also, the basis for levying import duties has been changed from f.o.b. to c.i.f. This, together with the new minimum tariff, should contribute to increased Government revenues while reducing somewhat the excess demand for forfign exchange in the economy. Furthermore, we have introduced a foreign exchange retention system for non-traditional exports and lowered the tax rate on profits derived from such exports to the same concessional rate of 15% that applies to agriculture. Industrial Strategy 9. For the new development strategy to succeed, it is necessary that the policy reforms be continued and, in some cases, accelerated. The Government is committed to this process and has requested further financial assistance from the Bank and the Fund -- as well as from other external donors - to be able to take the necessary measures, while minimizing the short-term costs of the adjustment. This is particularly important given the continuing low copper price and high debt service payments that will be posing serious constraints on Zambia's balance of payments for some years ahead. - 10. In the manufacturing sector, a major reason for the recent decline in industrial production is the shortage of imported inputs due to the reduced availability of foreign exchange. This is particularly important for manufacturing because of the sector's high import intensity. The foreign exchange allocated to the manufaturing sector for iports of raw macerials and spare parts was about US$240 million in 1983. Since then the scarcity of foreign exchange has become more acute, resulting in significantly lower levels of imported inputs and raw materials for industry. The foreign exchange available to manufacturing for their import needs during 1985 is not expected to exceed US$100 million. Therefore it is evident that we need support from the Bank and other donors to improve this situation. 11. Notwithstanding the importance we attach to alleviating shortages of imported inputs and to the need for additional foreign exchange, we recognize that unless protective controls and restrictions are removed and the policy framework changed, providing additional foreign exchange would not encourage efficient industrial growth. The policy measures to be supported by the proposed project are designed to reform the import regime, which provides high and variable protection to import substituting activities, to remove disincentives to exports, to improve the system of allocation of foreign exchange, increase the efficiency of public enterprises and improve the public investment program, and to eliminate interest rate controls. - 73 Attachment 3 Page 5 of 10 Further Policy Changes in 1985 12. We recognize also the need for further policy changes to complement the gains already achieved towards attaining the objective of industrial reorientation and diversification. As regards specific actions that are being implemented now and that we propose to take in coming months, which have particular relevance for the industrial sector, I would like to mention the following: 1. Foreign Exchange Regime (a) Exchange Rate Realignment. We regard a more competitive exchange rate as the cornerstone of the proposed industrial and trade policy reforms. In the context of our discussions with the IMF regarding the exchange rate regime, we have decided to introduce an auction system for the determination of the exchange rate and the allocation of foreign exchange. The auction may be preceded by a step devaluation. We regard a satisfactory solution to the current foreign exchange problems as the most important element of the policy changes needed to reorient the industrial sector. A reform of the foreign exchange regime will necessitate the improvement of the foreign exchange forecasting and budgeting process. As announced in the Budget Address of January 25th, 1985, we will improve the system of foreign exchange budgeting in the Bank of Zambia. Accordingly, we intend to Implement the following additional measures: (6) I stitutional Strengthening. The Budget Section of the External Finance Department at the Bank of Zambia which is responsible for preparing the foreign exchange forecasts and budgets will be strengthened by recruiting additional qualified staff and specialized consultants. (c) Foreign Exchange Budget Reform. The foreign exchange budget should become an operational document and a basis for making. decisions on how to allocate foreign exchange. To accomplish this change the foreign exchange budget will become a tool of economic policy decision making and will be subject to review and approval at the ministerial level in Government prior to the start of the period that the budget covers. The budget will provide operational targets that are realistic, with particular attention being paid to the expenditure side; when a deficit is projected, the budget will include specific recommendations on how to finance the deficit. The measures at 1(b) and (c) above are already in the advanced stage of implementation. Attachment 3 Paga 6 of 10 (d) Allocation of foreign exchange. The shortage of foreign exchange makes it particularry imperative that its allocation be done efficiently. In industry, as in other sectors such allocation has not always been done in an efficient manner, since the administrative mechanism and the sytems of protection and controls have sometimes resulted in resources being channelled to less productive uses. The auction system to be introduced will enable us to allocate foreign exchange to the efficient producers. As a crucial complementary meeasure to the auction mechanism, we will reform the import licensing system through the following measures: (I) eliminating the current system of import licensing and replacing it by a simple registration system as described below; (ii) shortening the period of validity of licences and making them non-renewable; (iii) recalling all outstanding uncovered licences and cancelling them; (iv) reducing the licence fee from 5% to 2% of the value of the licence, and making it - non-refundable; 2. Import Duties and Sales Tax Regime As announced In the Budget Address of January 25, 1985, we have adopted the following changes in the import duties and sales tax regime in connection with the new budget: (a) Removal of certain manufacturer's rebates under Section 89 of the Customs and Excise Act. This section exempts payment of duties on imports of industrial inputs by specific subsectors. (b) Introduction of duty on some items where duty has hithertofore not applied. Duty now applies to some goods that were still free of duty after the Customs and Excise Amendment Acts were approved in November 1984 and March 1985, and to goods that were previously exempted under Tariff Code 100.10.00. The only exceptions will be some agricultural inputs, which will continue to be free of duty temporarily. - 75 - Attachmant 3 Page 7 of 10 (r) The existing rate of sales tax on imports of 12.5% will be raised to 15%. (d) As for local products and services which presently attract sales tax (namely all final goods manufactured in Zambia in significant amounts, except for some basic foods), we are increasing the tax from 10% to 15% on most of those goods and services where the rate has not yet reached this level. A sales tax rate of 15% will be charged on an expanded range of products and services by December, 1987. (e) Sales Tax on Imports: The new sales tax on imports at 15% has been in effect as of April, 1985 on all dutiable goods. In addition to the measures announced in the Budget address which have been adopted, we intend to implement the following measures relating to import duties and the sales tax regime: (f) Removal of the remaining manufacturer's rebates under Section 89 of the Customs and Excise Act by December 1985. (g) Introduction of duty on those remaining items where duty still does not apply by April 1986, with the exception of agricultural inputs, which will continue to be free of duty temporarily. (h) When the-measures in (f) and (g) above have been instituted the 15% sales tax on imports will apply to all goods with the temporary exception of agricultural inputs. (i) Tariff Commission: In order to prepare a comprehensive review of the protection system and prepare changes in the structure of tariffs and indirect taxes, a commission for tariff and protection reform will be created by December 31, 1985 at the latest. The terms of reference of this commission will be ready and agreed with the Bank during negotiations. One of the main measures to be worked on and implemented will be the lowering of high tariff rates. All of the above changes aim to reduce the wide dispersion and the high level of effective protection to the manufacturing sector and encourage the efficient allocation of scarce resources to industry. These measures will also reduce the fiscal deficit. 3. Other Barriers to Imports. We intend to implement the following reforms: (a) Import licensing: The existing system of import licensing will be simplified at the time of introducing the auction mechanism, and will be replaced with a registration system (see policy measures 1(d)); and - 76 - Attachment 3 Page 8 of 10 (b) Import Prohibitions: Protection to new industries will be granted through the tariff system and through other incentives to be provided by the proposed new Investment Code for a limited period of time. Import prohibitions for protective purposes (the Control of Goods (Import and Export) (Commerce) (Import Prohibition) order, 1980) which now cover about 50 items will be replaced in two stages by appropriate tariff rates. One half of the prohibitions will be eliminated by December 1985 and the remaining half by December 1986. * 4. Export Promotion. In order to help increase non-traditional exports, the tolling measures, which were announced in the Budget Address, are being implemented: (a) The export licensing system will bh -7-plified. The exact features of the new system are under elaboration by the Ministry of Commerce and Industry. (b) The export earnings retention scheme has already been improved by lengthening the retention period from 21 days to 60 days. (c) A new revolving fund for export development will be established. The institutional arrangement, operational guidelines and financial requirements have been studied by a consultant. His report is expected soon. We hope to discuss this report with the Bank, as soon as possible in order to agree on a program of action to start the operation of such a fund. (d) An autonomous export promotion body to help exporters identify new export products and markets and to promote exports will be established. This promotional body is expected to become operational by December 31, 1985. In addition to the measures announced in the Budget Address, we intend to implement the following: (e) The existing duty drawback system will be simplified by December 31, 1985. The drawback will be based on average percentages of imported inputs for major types or groups of exports, and these averages would be revised periodically. (f) Exporters will be allowed to open interest earning foreign currency accounts at domestic banks. 5. Investment Code. The existing Industrial Development Act has had an inhibitive effect on business development, particularly by the private sector. As noted above, a draft of a new investment code has been prepared and is currently being discussed. As announced in the Budget Address we intend to adopt legislation to amend the Act. The proposed reforms of this Act currently under preparation will be adopted by December 31, 1985. - 77 - Attachment 3 Page 9 of 10 6. Small-Scale Enterprises. In order to promote Small-Scale Enterprises We have announced in the Budget Address that we will present legislation to amend the Bank of Zambia Act so as to introduce a credit guarantee scheme for small-scale industries. 7. Interest Rate Liberalization. As discussed before, over the past year we have raised interest rates significantly. Our objectives are to allow initially for a gradual % adjustment in interest rates in order to attain positive real rates and subsequently to free interest rates from all controls. In order to accomplish these goals we will continue to raise interest rates from time to time. We expect to lift all controls and thus achieve a completely deregulated interest rate regime by December 31, 1985. 8. Public Enterprises. In order to deal with two main problems faced by INDECO, namely: (i) the insufficient review and evaluation of existing operations and proposed new investments; and (ii) the inability of INDECO, and particularly its subsidiaries, to recruit and retain the necessary qualified staff, we will implement the following actions: (a) INDECO will adopt sound economic criteria to be applied in evaluating new investments and the performance of existing enterprises by June 30, 1985. (b) An Evaluation Unit to apply the above criteria will be set up and will engage consultants, to be financed under a Bank PPF with terms of reference and qualifications satisfactory to the Bank to undertake the following: (1) Review projects costing more than K2 million which started after July 1, 1984 or are expected to start prior to June 30, 1985 on the basis of the economic criteria referred to under (a) above; (ii) Review the economic viability of all other investment projects whose costs exceed K2 milion that are under study as part of INDECO's investment program for the three-yeaz period ending in 1987/88; (iii) Investment projects that do not satisfy the agreed criteria of economic viability will either be reviewed and restructured to satisfy such criteria or be discontinued; (iv) Review, with the help of consultants to be financed under the project, the economic viability and operational efficiency of operating INDECO subsidiaries, starting by October 1, 1985. Attachment 3 -78- Page 10 of 10 (c) INDECO will implement a program of action beginning October 1, 1986, based on the consultants' review to: (i) improve the performance of enterprises with potential economic viability; and (ii) restructure, reorganise or phase out enterprises that are not economically viable. (d) INDECO will undertake a study to determine: (i) The appropriate level of compensation as well as those other measures necessary to recruit and retain qualified staff; the terms of reference and qualifications of the study team will be discussed with the Bank by June 30, 1985; and (ii) an action program to implement the recommendations of the study will be agreed with the Bank by December 31, 1985. 13. This is an ambitious and far-reaching program that we have set for ourselves over the next year or so. However, we feel it is imperative to continue moving ahead with these reforms so that the structural changes required in industry can get underway. The Industrial Re-orientation Project is crucial to complement this program, given the acute scarcity of foreign exchange for industrial inputs. 14. We look forward to the World Bank's support in this endeavour. Yours sincerely, I L. J.MUK,M MINISTER OF FINANCE AND NATIONAL COMMISSION FOR DEVELOPMENT PLANNING - 79 - Attachment 4 Page 1 of 2 INDUSTIAL REORIENT,TION PROJECT SUMMARY OF WEEKLY AUCTION RESULTS Auction Number of Bids Kwacha Dollars Bid Exchan8e week Date Tota Accepted .J. OeMd Reuimd Allocatd Ranne at. 1 10/11/85 299 94 31.4 79.7 16.9 4.8 28.4 2.75-15.00 5.01 2 10/18/85 397 137 34.5 82.8 12.5 5.0 40.0 3.11-12.00 6.10 3 10/25/85 345 186 $3.9 69.1 10.3 5.2 50.5 2.44-9.15 7.00 4 10/31/85 270 241 89.3 74.1 10.2 7.5 73.5 4.66-9.00 6.44 s 11/08/85 232 181 78.0 52.6 8.1 6.2 76.5 4.22-7.50 6.25 6 11/15/85 229 195 85.2 30.8 4.8 4.1 85.4 3.50-7.50 6.03 7 11/23/85 234 213 91.0 31.2 5.0 3.9 78.0 4.22-7.50 5.80 8 Ill1/85 205 166 81.0 29.9 4.9 4.2 85.7 5.00-7.05 5.75 9 12/07/85 187 169 90.4 27.3 4.6 4.2 91.3 4.22-7.00 5.74 10 12/14/85 201 180 89.6 30.7 5.2 4.5 86.5 5.50-6.65 5.75 11 12/21/85 172 160 93.0 27.3 4.6 4.3 93.5 5.60-7.05 5.77 12 12/28/85 101 100 99.0 21.0 3.5 3.5 100.0 5.60-6.65 5.70 13 01/04/86 117 106 90.6 29.5 5.0 4.6 92.0 4.95-6.50 S.76 14 01/11/86 164 105 64.0 31.9 5.4 4.1 75.9 4.52-6.50 5.36 15 01/18/86 234 102 43.6 41.5 6.7 3.3 49.3 4.52-7.50 6.01 16 01/2586 309 151 48.9 67.7 10.2 4.7 46.1 4.52-7.50 6.40 17 02/01/86 287 260 90.6 40.6 6.5 6.1 93.8 4.00-7.50 6.36 18 02/08/86 254 143 56.3 44.2 7.2 3.9 54.2 4.00-7.11 6.51 19 02/15/86 281 205 73.0 45.2 6.7 5.2 77.6 5...,-7.50 6.68 20 62/22/86 304 191 62.8 75.7 11.9 7.7 64.7 5.05-7.50 6.78 21 03/01/86 301 136 45.2 71.5 10.2 5.4 52.9 5.54-7.50 7.01 22 03/08/86 287 141 49.1 55.9 7.7 5.9 76.6 6.00-8.00 6.90 23 03/15/86 246 143 58.1 53.2 7.4 5.6 75.7 6.50-9.50 6.75 24 03/22/86 357 253 70.9 76.2 10.8 8.8 81.5 6.00-7.65 6.91 25 03/29/86 193 173 89.6 57.7 8.3 7.4 89.2 6.00-7.60 6.85 26 04/05/86 258 216 83.7 58.1 8.3 7.2 86.7 6.50-7.60 6.87 27 04/12/86 246 171 69.5 64.9 9.3 3.7 39.8 4.50-7.50 6.98 28 04/19/86 273 176 64.5 81.5 1.4 8.6 75.4 6.50-7.50 7.06 29 04/26/86 281 196 69.8 64.3 8.8 6.8 77.3 4.50-7.50 6.98 30 05/03/86 236 200 84.7 50.9 7.2 6.3 87.5 4.50-7.50 7.00 31 05/10/86 274 234 85.4 63.3 8.9 7.6 85.4 S.50-7.50 7.03 32 05/17/86 297 148 49.8 75.3 10.6 3.7 34.9 3.50-7.50 7.11 33 05/24/86 279 153 54.8 50.9 7.8 4.0 51.3 5.50-7.50 7.23 34 05/31/86 332 244 73.5 75.0 10.1 7.3 72.3 6.25-8.00 7.31 35 06/07/86 SiS 170 53.5 53.2 7.3 4.0 54.8 6.50-8.00 7.26 36 06/14/86 397 244 61.5 82.2 11.1 7.0 63.1 6.51-7.75 7.32 37 0621/86 383 267 69.7 90.2 12.2 8.0 65.6 7.10-7.65 7.39 38 06/28/86 404 134 33.2 92.2 12.3 7.0 56.9 S.00-7.61 7.51 39 07/05/86 518 151 29.2 116.6 IS.2 7.6 50.0 5.50-7.70 7.71 40 07/11/86 451 168 37.3 103.1 13.9 7.3 52.5 5.50-9.00 8.07 41 07/19/86 396 82 20.7 128.0 15.2 4.4 28.9 5.00-9.51 5.03 42 07/26/86 600 155 25.8 166.7 23.5 7.5 31.9 4.01-9.53 6.08 43 08/02/86 760 634 83.4 169.0 24.0 20.8 86.7 5.01-9.10 5.01 44 08/09/86 502 329 65.7 99.3 17.5 10.3 58.9 4.01-7.53 5.35 45 08/16/86 542 220 40.6 89.4 15.4 6.0 39.0 4.50-6.85 S.76 46 08/23/86 621 173 27.9 111.3 18.2 3.8 20.9 5.00-6.85 6.26 47 08/30/86 690 264 38.3 136.7 20.4 9.9 48.5 5.00-7.75 6.87 48 09/06/86 674 501 74.3 165.0 22.8 13.6 59.6 S.00-7.99 7.00 49 09/13/86 418 326 78.0 94.7 12.9 11.7 90.7 5.00-8.01 S.64 50 09/20/86 484 99 20.5 101 5 14.8 3.1 20.9 4.50-7.83 6.37 51 09/27/86 606 167 27.6 136.9 20.1 6.0 29.9 5.10-8.00 7.09 52 10/04/86 712 172 24.2 165.1 22.3 5.6 25.1 5.04-8.11 7.64 S3 10/11/86 769 128 16.6 177.5 22.8 5.0 21.9 5.50-8.56 8.30 54 10/18/86 734 125 17.0 192.8 22.6 2.6 11.5 S.06-10.25 9.35 SS 10/25/86 493 84 17.0 150.0 17.3 4.1 23.7 5.50-11.51 10.32 56 11/01/86 517 119 23.0 146.9 13.8 4.0 29.0 6.00.12.50 11.51 57 11/08/86 439 111 25.3 133.1 12.2 4.2 34.4 6.00-13.15 12.30 58 11/15/86 407 116 28.5 138.5 I1.3 4.2 37.2 6.00-14.41 13.48 59 11/22/86 324 122 37.7 234.4 8.4 4.1 48.8 6.00-IS.17 14.68 60 11/29/86 273 :40 51.3 104.4 7.2 4.1 56.9 6.00-1t.52 15.25 - 80 -Attachmont 4 PaSe 2 of 2 Auction Number of Bids Kwacha Dollars Bid Exchange WA at [ Toa Accepted % Offered Required Allocated % Bang& Rate 61 12/06/86 221 130 58.8 ,.6 4.1 73.2 6.00-18.00 12.10 62 1V13/86 333 107 32.1 - 12.4 4.0 32.3 6.00-16.00 11.90 63 !2/20/86 310 116 37.4 8.4 4.0 47.6 6.00-13.77 12.50 64 !2/27/86 258 141 54.7 6.6 4.1 62.1 6.00-14.20 12.71 65 01/03/87 192 118 61.5 5.7 4.1 71.9 6.00-13.76 12.97 66 01/10/87 232 55 23.7 9.9 4.1 41.4 6.00-13.98 13.51 67 01/17/87 257 111 43.2 8.9 4.0 44.9 6.00-15.00 14.12 68 01/24/87 250 109 43.6 - 8.9 4.8 53.9 6.00-15.31 14.92 la 03/28/87 625 151 24.2 - - - 9.10-20.00 15.00 2& 04/04/87 457 62 13.6 9.25-20.00 16.99 36 04/11/87 370 71 19.2 13.00-20.75 18.75 4& 04/16/87 270 81 30.0 - 13.00-21.50 19.95 5 04/24/87 250 98 39.2 - - - 14.00-23.90 21.01 68 05/02!87 192 158 82.3 - - 15.00-25.00 15.00 Auction abandoned: new rate fixed at 8.00 (K/$) ourc: J. Aron end I.A. Elbadawi, Parallel Markets, the Foreign Exchange Auction, and Exchanie Rate Unification in Zambia, World Bank Working Paper No. 909. May 1992, Appendix Table 3a (p. 109). - 81 - Attachment 5 ZAMBIA INDUSTRIAL REORIENTATION PROJECT I. SHORT-RUN INFLUENCES ON THE PARALLEL MARKET PREMIUM DURING THE AUCTION PERIOD Parallel Parallel Auction Market Market Month Rate Rate Premium (%) Signals 10/85 0.190 0.100 47.4 - Auction instituted; import licenses abolished; no funds import liccases instituted 11/85 0.171 0.120 29.8 12/85 0.174 0.130 25.3 01/86 0.168 0.110 34.5 02/86 0.152 0.130 14.5 Increase in dollars offered announced; IMF standby concluded; Petroleum, IATA. TAZARA payments included in auction 03/86 0.145 0.120 17.3 04/86 0.144 0.120 16.6 05/86 0.141 0.100 29.2 - New Minister of Finance and Governor of BOZ appointed 06/86 0.136 0.110 19.3 - Bids published from this date on 07/86 0.150 0.130 13.5 - More stringent documentation requirements introduced 08/86 0.178 0.140 21.5 - Dutch Auction; "auction pipeline" begins; measures to control money supply 09/86 0.154 0.100 34.9 10/86 0.116 0.060 48.2 - Reduction in dollars offered announced 11/86 0.081 0.050 38.5 Bid deposit of 30%; bank rate raised to 30% 12/86 0.077 0.060 22.1 Maize price decontrol, food riots; recontrol 01/87 0.073 0.040 44.9 - Auction suspended from January 28 for nine weeks 02/87 0.111 0.070 36.8 03/87 0.113 0.090 20.2 Two-tier auction from March 28; bid deposit raised to 40% 04/87 0.054 0.100 85.6 05/87 0.125 0.100 20.0 - Auction abolished May 1: rate Kl5/S for allocation on May 2, thereafter K8/$. 06/87 0.125 0.070 44.0 II. TREND OF PARALLEL MARKET PREMIA. 1977-1988 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 Premium (%) 190 124 85 69 64 46 29 37 68 31 42 418 Source: J. Aron and I.A. Elbadawi, Parallel Markets, the Foreign Exchange Auction, and Exchange Rate Unification in Zambia, World Bank Working Paper No. 909, May 1992, Tables 3a and 3c (pp. 82, 84). IrDUSRtIAL MBIETATIM PROJCT SECfDML DISRIIUFIC OEEIGU orn&ae ocir 10. 1985 - Oct~BR 4. 196 (~nctloou 1-52) (1) (2) (3) (4) (5) 16) (7) (8) (9) (10) (11) (12> (3) Sectoral side Succeseful allotionat of quos allocationm Ieques AllocatouS ceoved side ~euesto ållocationa Lg rore~g (US$) (US$) (US$) (0S$) Soctor DeM (Moa.J - (USSN (S) Echang (t) k)a ek-26 Rac 1-26 V äeska 27-52 U5~he 27-52 1 (21) (S)(4) (9)0(4) (12)-(11) Agrrcultnre 1,667 853 51 43.0 19.3 42.9 6.0 15.0 7.3 50 30.0 11.8 39 Privato anufactaring 8.842 4.782 54 250.0 134.0 33.6 41.6 92.0 62.0 67 159.0 72.0 46 Paratatale 3,366 1.980 56 247.0 147.0 39.3 45.7 80.0 37.0 71 167.0 90.0 34 Other Mså 2.763 66 32.0 21.7 67.8 6-7 15.0 10.3 1170 11.2 66 Total 1. 0.= 37 374.0 322.0 56.0 100.0 202.0 13.0 de 372.0 183.0 30 La Exolude d9~brsm*nta to banks se norki~g capital and LICo. Smrcos CofpIöd fro 9. Mcube. M. Sakala, M. 8duo, lT utornational Vantary rund and the Zambian Econm7 - I Ca@*a a Kjell J. Eavnavik (Ed.). The F and the World sank in Africa, 1967. appendices IV 4 VII. rt rt (D 0% - 83 - Attachment 7 ZAMBIA INDUSTRIAL REORIENTATION PROJECT FOREIGN EXCHANGE ALLOCATION OCTOBER 10, 1985 - OCTOBER 4. 1986 (US$ million) Goode/Services Amount Consumer 20,584 6 Intermediate 159,212 47 Machinery and Equipment 53,583 16 Miscellaneous 14,950 4 Services LA 53,469 16 Allocation to Banks 40t260 _11 Total 342258 100 La Loan repayments, dividends, profits, insurance, etc. Source: Compiled from P.D. Ncube, M. Sakala, M. Ndulo, "The International Monetary Fund and the Zambian Economy - A Case" in Kjell J. Havnevik (Ed.), The IMF and the World Bank in Africa, 1987, Appendix VI. - 84 - Attachment 8 ZAMBIA INDUSTRIAL REORIENTATION PROJECT ALLOCATION OF FOREIGN EXCHANGE FOR KEY INDUSTRIAL INPUTS AND EOUIPMENT (US$9000) Percentage Auction Weeks Auction Weeks Auction Weeks of Total 1-26 27-52 1-52 Allocations Intermediate Goods Beverages and Tobacco 3,381.0 1,911.3 5,292.3 1.55 Petroleum Products 5,301.5 2,586.3 7,887.8 2.31 Iron Steel 233.0 5,829.3 6,062.3 1.77 Soap and Detergent Materials 3,172.5 43.4 3,215.9 0.94 Rubber Manufactures 3,659.7 775.6 4,435.3 1.30 Other Chemical Materials 7,778.2 10,419.3 18,197.5 5.32 Paper Products 702.3 1,269.0 1,971.3 0.58 Building Materials 5,695.4 2,422.3 8,137.7 2.38 Industrial Spares 697.6 11,833.8 12,531.4 3.66 Textiles 5,492.7 3,896.6 9.389.3 2.74 Subtotal 36,113.9 41,097.2 77,211.8 22.50 Eauipment Tools and Hardware 190.6 1,873.1 2,063.7 0.60 Industrial Machinery 13,219.1 3,700.2 16,919.3 4.95 Electrical Equipment 3,035.4 2,975.9 6,011.3 1.79 Other Machinery 2,984.1 2,952.2 5,936.3 1.74 Subtotal 19,429.2 11,501.4 30,930.6 9.10 TOTAL 55543.1 52.5986 1 41.7 31.60 Source: Compiled from P.D. Necube, M. Sakala, H. Ndulo, "The International Monetary Fund and the Zambian Economy - A Case" in Kjell J. Havnevik (Ed.), The IMP and the World Bank in Africa, 1987, Appendix VI. - 85 - Attachment ZAMBIA INDUSTRIAL REORIENTATION PROJECT TREND.INNET TRANSFERS,. 1980-1987 (US$ million) Source 1980 1981 1982 1983 1984 985 1986 1927 World Bank -19.3 -22.9 -15.9 -19.2 -12.8 66.6 62.1 22.0 IBRD -20.8 -25.0 -23.3 -28.4 -28.0 4.0 -15.7 -19.0 IDA 1.5 2.1 7.4 9.2 15.2 62.6 77.8 41.0 IMF -18.2 336.9 -111.4 10.7 21.9 -43.4 -98.0 n.a. Purchases 65.1 423.7 37.5 185.7 151.2 0.0 121.8 n.a. Repurchases 57.3 57.0 95.2 121.4 73.0 19.0 143.9 D.a. Net Purchases 7.8 366.7 -57.7 64.3 78.2 -19.0 -22.1 n.a. Interest 26.0 29.8 53.7 53.6 56.3 24.4 75.9 n.a. Other Sources 360.9 136.1 188.1 81.2 161.8 140.4 104.2 -21.0 Net Transfers 323.4 450.1 60.8 72.7 170.9 163.6 68.3 1.0 n.a. Not available. SoyISA: World Bank (1987a) and the World Bank World Debt Tables data base. - 86 - Attachment 10 ZAMBIA INDUSTRIAL REORIENTATION PROJECT EXCHANGE RATE REGIMES, 1964-1991 Period Poicy 1. 1964-1971 Rate fixed to the pound sterling 1971q4-1976q2 Rate fixed to the dollar 2. 1976q3-1983q3 From July, pegged to the SDR with occasional devaluations 3. 1983q3-1985q3 From July, the SDR link substituted by a crawling peg on a bastet of currencies of trade partners 4. 1985q4-1987q2 Foreign exchange auction; Dutch Auction; two-tier auction 5. 1987q3-1989q4 From May, a fixed rate initially to the dollar and since November 1988 to SDR, with occasional devaluations 6. 1990ql-1991q3 From February, a dual exchange rate system 7. 1991q4- From November, two windows unified; crawling peg Source: J. Aron and I.A. Elbadawi, Parallel Markets, the Foreign Exchange Auction, and Exchange Rate Unification in Zambia, World Bank Working Paper No. 909, May 1992. Table la, p. 79, updated. - 87 - Attachment 11 ZAMBIA INDUISTRIAL REORIENTATIN PROJEC ZCCM - SALES REVENUES. 1984-1991 (US$ million) Year ended March 31 198 IM M IM M IM Copper 936.8 796.8 844.6 701.0 1,203.0 1,835.8 1,641.0 1,577.5 Cobalt 43.2 75.9 74.0 43.6 59.2 74.7 80.5 90.4 Lead 5.9 4.4 3.0 3.3 4.7 5.7 2.7 0.4 Zinc 31.0 27.4 14.5 15.5 17.2 25.7 20.9 15.7 Othr 22. D-- 1, 5. 101, 1242 137. Total 1,044.7 927.0 964.3 785.5 1,341.8 2,042.9 1,869.8 1,821.1 Source: ZCCM Financial Statements and Annual Reports. - 88 -Attachment 12 ZAMBIA INDTUSTRIAL MR NIONPRIEQJT GOVERNMENT BUDGET ACCOUNTS, 1983-1988 (Kwacha million) 1983 1984 1985 1986 1987 1988* 1. Revenue 1,016.2 1,095.6 1,602.4 3,225.6 4,634.1 5,696.7 of which: Mineral 53.4 101.3 129.5 405.4 475.2 113.3 Other 968.0 994.4 1,472.9 2,820.2 4,160.9 5,583.4 2. Current Expenditure 1,217.0 1,216.2 1,906.4 4,301.4 5,846.0 6,681.7 3. Current Surplus (+) Deficit (-) (1-2) -200.8 -104.6 -372.8 1,075.8 -1,209.9 -985.0 4. Capital Expenditure 195.3 111.4 277.9 991.3 652.9 1,901.0 of which: Capital Outlays 151.2 98.4 224.5 - 560.5 664.8 Net Lending 44.1 13.0 53.4 11.1 92.4 736.2 5. Total Expenditure 1,412.3 1,328.0 2,184.3 5,292.6 6,498.9 8,082.7 6. Overall 3urplus (+) Deficit (-) (1-5) -396.0 -232.4 -518.9 -2,G-7.0 -1,862.8 -2,386.0 7. Financing 396.0 232.4 LI 8 1,862.8 2,386.0 8. Net Borrowing 428.6 42 177.1 615.2 J3.3 535.6 of which: Foreign 189.8 5.8 109.1 556.2 -54.2 463.0 Domestic (non-bank) 238.8 36.8 68.0 59.0 40.9 72.6 Banking System -32.5 1.8, 404.8 1.451.8 J49.5 1.,850.4 La This includes financing by banking system and non-bank financial institutions, government stocks, and treasury bills. *Preliminary. Source: Ministry of Finance. - 89 - 89 -Attactbnent 13 ZAMBIA INDUSTRIAL REORIENTATION PROJECT GOVERNMENT BUDGET/GDP. 1981-1986 (Percentage of GDP in Current Prices) Item 1181 9 183 1218 Revenue 24.45 24.14 25.57 23.54 22.41 26.50 Expenditure 39.84 40.90 34.49 32.87 36.86 63.83 Current 35.30 34.56 29.75 27.48 33.24 SS.79 Interest 3.38 4.16 4.64 4.38 9.69 19.34 Foreign 1.35 2.07 1.11 1.46 6.11 13.78 , Domestic 2.03 2.09 3.53 2.93 3.58 5.56 Wages and Salaries 8.02 8.13 7.25 6.96 7.61 5.46 Subsidies 3.17 3.49 1.97 1.80 2.67 4.71 Other 22.76 20.87 19.43 17.26 13.26 26.27 L Capital 4.54 6.34 4.74 5.39 3.62 8.05 Overall Deficit -15.39 -16.76 -8.92 -9.33 -14.44 -37.33 Source of Finance Foreign 7.98 3.12 2.42 1.20 6.03 21.81 Domestic 4.82 13.60 2.75 3.83 8.55 15.52 /a Interest on external debt in 1986 on accrual basis. /b "Other' expenditure in 1986 includes the following: Percentage of GDP Transfers for IMF Charges 6.8 Transfers for Foreign Exchange Losses 3.8 Transfers and Pensions 3.3 Recurrent Departmental Charges 4.7 Other Constitutional and Statutory Expenses 7.2 Source: World Bank data. - 90 - Attachment 14 ZAMBIA INMSIAL REORIENXA10QN PROJECT COMPOSITION OF CENTRAL GOVERNMENT EXPENDITURES. 1983-1988 (Kwacha million) 1983 1984 1985 1986 1987 1988 Current Expenditure L2?! 1.302 Z.343 5. 6.051 .9 Personal Emoluments 403 451 536 661 1,009 1,088 Recurrent Departmental Charges 203 219 416 568 900 1,061 Subsidies 82 91 188 570 824 1,157 Constitutional & Statutory 399 An5 1,024 3,204 2,788 3,327 Interest 225 204 683 2,339 1,863 2,184 Foreign 46 4 431 1,667 1,082 1,222 Domestic 179 120 253 673 781 962 Other 174 201 341 865 925 1,143 Transfers & Pensions 136 132 179 397 530 563 Capital Expenditure & Net Lending 194 177 573 129 L21 Contingencies - - - - 160 Total Current & Capital 1.416 1.479 2.598 6.374 260 2.4 Exceptional Expenditure - - - 1,348 547 /a - Toma! 1.416 1479 258 772 939 Arrears 9 40 45 1.033 1.163 J.100 Foreign 9 40 347 516 846 1,006 Domestic - - 105 518 317 - Total Excluding Arrears 1A.407 1j.439 2.146 669 .644 8.303 Total Excluding Exceptional Expenditure & Arrears 1.407 1.439 2.146 5.341 5.997 L# Includes unallocated supplementary expenditure. Sgurce: SIDA, Zambia - Exchange Rate Policy, p. 102. - 91 - Attachment 15 ZAMBIA INDUSTRIAL REORIENTATION PROJECT SOURCES OF GOVERNMENT REVENUE, 1983-1989 (K million) 1983 1984 1985 1986 1987 988* 1989 Total Revenue and Grants 1,016. 2 M J&2M L.256 4jL61. 5w696.7 91 Income Tax 36. 337.0 474.1 j 1,134.6 1,926.7 2,914.6 * Company Tax 222.6 176.1 201.8 363.0 611.1 909.0 1,387.7 PAYE 105.4 117.3 148.4 287.9 281.3 350.9 470.0 * Other Taxes 41.6 43.6 123.9 194.1 242.2 566.8 1,056.9 Taxes of Domestic Goods A Qrvices 439.0 445.7 5.5 a * Excise Duties 354.8 341.2 337.5 396.1 472.2 650.4 728.6 * Sales Tax 70.9 92.3 109.5 184.3 293.9 458.0 760.0 Othcr Taxes 13.3 12.2 33.5 35.1 65.8 39.2 23.7 Taxes on Foreign Trade (Import) 83.3 127.7 288.1 821.0 334.6 1,345.1 169.0 Mineral Export Revenues 53.4 101.3 129.5 405.4 475.2 113.3 10.0 Other Revenues 70.9 83.9 197.5 368.0 768.4 753.8 461.3 Grants - - 32.9 170.9 91.4 510.2 1,331.5 * Preliminary. Ll Budget. Source: Ministry of Finance. - 93 - PROGRAM COMPLETION REPORT ZAMBIA INDUSTRIAL REORIENTATION PROJECT (IDA CREDIT 1630-ZA AND AF CREDIT A4-ZA) June 26, 1991 Industry and Energy Operations Division Southern Africa Department Africa Regional Office - 95 - PROGRAM COMPLETION REPORT ZAMBIA INDUSTRIAL REORIENTATION PROJECT (IDA CREDIT 1630-ZA AND AF CREDIT A-004-ZA) PART I: PROGRAM REVIEW FROM THE BANK'S PERSPECTIVE Identity Name Industrial Reorientation Project Credit Nos.: 1630-ZA and A-004-ZA RVP Unit : Africa Region Country Zambia Sector Industry (Industrial SECAL) I. INTRODUCTION 1.1 Zambia's economy has traditionally been heavily dependent on external trade and on Government activity; the former accounts for 30-40% of GDP and Government expenditures for about 35% of GDP. Government owns a majority share of mining and most manufacturing enterprises. Copper mining has long been the mainstay of the economy, providing 90% of foreign exchange earnings, 15% of gross value added and 18% of the country's formal employment. 1.2 Zambia's development strategy during the late sixties and seventies was misdirected. Excessive reliance was placed on the copper mining sector,to the neglect of viable de-.elopment opportunities in other sectors. Economic policy, including progressive overvaluation of the exchange rate and rising levels of industrial protection, discouraged agricultural growth and export diversification and promoted the use of high import and capital intensive production methods. As a result of low copper prices and deteriorating terms of trade, the Government found itself in an acute stage of economic and financial crisis in the early eighties. 1.3 In order to cope with the crisis, the Government entered into standby arrangements with the IMF in 1983 and 1984 and started implementing a package of stabilization measures; it also agreed with the Bank to carry out certain policy reforms, both at the macro-economic and sectoral levels, to improve the performance and competitiveness of the mining and manufacturing sectors and the productivity of the agricultural sector. To support these reforms, the Bank approved a loan of US$75 million for the mining sector in 1984 (E:.port Rehabilitation and Diversification Project-Loan No. 2391-ZA) and IDA approved a credit equivalent of US$25 million (Credit No. 1545-ZA) and an African Facility Credit equivalent of US$10 million 'Credit No. A5-ZA) for the Agricultural Rehabilitation Project in 1985. The reforms in the exchange rate regime, trade policy and the industrial sector were supported under IDA Credit No. 1630-ZA and African Facility Credit A4-ZA, which are the subject of this review. IDA also approved a Recovery Program Credit (No. 1720-ZA) for SDR 42.6 million (US$50 million) in June 1986 to provide the minimum level of imports - 96 - needed for Zambia's recovery program, thus helping to maintain the momentum of the reform effort. II. ACCOMPLISHMENTS OF GOVERNMENT'S INDUSTRIAL REORIENTATION PROGRAM 2.1 In the context of the economic restructuring policies, the Government came up with a new industrial strategy (outlined in a letter of Industrial Policy dated June 13, 1985) whose immediate objective was to raise the level of capacity utilization in the sector by providing additional foreign exchange to efficient import substitution industries and exporters. The longer term objectives were to increase the efficiency and export orientation of the industrial sector by instituting an incentive structure and policies that would encourage the flow of investment resources to more productive sub-sectors. The Government proceeded to set in place a number of institutional and policy reform measures which were designed to improve the foreign exchange and the import regimes, remove disincentives to exports, streamline and improve investment incentives, increase the efficiency of public enterprises and improve the quality of public sector's investment program in manufacturing. 2.2 Policy Reforms. Specific policy reforms agreed to by the Government in the context of the Industrial Reorientation Project were: (a) introduction of foreign exchange auction, improvement of foreign exchange forecasting and budgeting and discontinuation of import licensing system; (b) removal of import and export restrictions; (c) tariff reforms; (d) dismantling of interest rate controls; (e) improvement of the incentive system provided by the Industrial Development Act; (f) restructuring of INDECO enterprises; and (g) rationalization of new public investments in manufacturing. These are described in the following paragraphs. 2.3 Foreign Exchange Regime. The cornerstone of the reform was the gradual but increasing reliance on the market for allocation of foreign exchange. The Government agreed, as a condition of credit effectiveness, to introduce an auction system for foreign exchange and to eliminate the import licensing system. The auction of foreign exchange was introduced on Octo- ber 11, 1985. The progress of the system and the problems it ran into are commented upon later in the report (paragraphs 3.2-3.5). 2.4 Foreign Exchange Forecasting and Budgeting. To assist the Government in laying the basis for an improved foreign exchange forecasting and budgeting process and in defining long-term technical assistance needs, IDA financed consultants' services. The completion of this work was made a condition for releace of the second tranche. The Bank of Zambia carried out this task on time in a satisfactory manner. 2.5 Import Tariffs. Recognizing the deficiencies in the tariff structure, the Government began to rationalize it in October 1984 by imposing a 10% minimum tariff on many items--mostly industrial inputs--which previously were not subject to duty. A series of actions were taken to complete the changes in the tariff structure, including introduction of a minimum level of duty, increasing sales taxes, and reducing the highest tariff rates. These measures represented the first phase of tariff reform; the second phase was to start with the establishment of a Tariff Commission by December 31, 1985. - 97 - 2.6 Export Promotion. The Government recognized the importance of the development and growth of non-traditional exports. It undertook a number of measures to remove the existing procedural impediments to non-traditional exports: (i) export licensing system was replaced by a simple registration system; (ii) duty drawback system was simplified in March 1986 (delayed by three months due to delay in the passage of the appropriate legislation); and (iii) the ineffective Government-run Zambian Export Promotion Council was replaced by an autonomous Export Development Board which had private sector participation. 2.7 Investment Incentives. A new Investment Act was enacted in March 1986 to replace the Industrial Development Act of 1977. The new Act was more supportive of the private sector but in practice did not remove the heavy bureaucracy and failed to stimulate investment. 2.8 De-Control of Interest Rate. Interest rates were de-controlled in September 1985; the de-control remained effective only until February 1987. The treasury bill rate jumped from a pre-auction rate of 13% to 23% within two months and the Bank rate moved from 14.5% to 21% over the same period. Since inflation was in the range of 50%-60%, real interest rates remained negative. Parastatal and private sector loan demand remained high and the credit ceilings, agreed with IMF, continued to be violated. In practice, the monetary control policy did not work. 2.9 Public Investment Program in Industry. INDECO, the Government holding company for all public sector investments in the manufacturing sector, had in the past financed many uneconomic, capital intensive and import- dependent enterprises some of which continued to operate even though they were uneconomic. With IDA's agreement, consultants carried out feasibility studies in respect of projects with costs exceeding $1 million. Based on these studies, agreement was reached on INDECO's investment program for 1985/86. Similar studies were undertaken for 1986/87. 2.10 Economic Efficiency of INDECO Enterprises. The program to improve the efficiency of manufacturing parastatals is referred to in paragraph 3.9 et seq. III. IMPLEMENTATION OF THE REFORM PROGRAM 3.1 The project got off to a good start with all major policy actions taken on time or even ahead of schedule so that effectiveness and second tranche release conditions were met and the credit was fully disbursed, except for the technical assistance component. Project implementation was generally adequate until late 1986. However, major deviations from the Bank/IMF supported reform program took place thereafter, and in May 1987 the Government formally abandoned the program. The progress of implementation and the problems encountered in respect of the major reforms leading to their abandonment are commented upon in the following paragraphs. 3.2 Foreign Exchange Regime. The auction of foreign exchange commenced on October 11, 1985, and continued until May 1, 1987; it remained suspended for about 8 weeks between January 24,1987 and March 20,1987. During the first period of six months, the auction seems to have worked reasonably well on the - 98 - supply side; against a bid of $ 201 million, an amount of $135 million was sold. By the end of April 1986, there were indications that demand for foreign exchange had stabilized and that the exchange rate was approaching the market clearing level. During this period, the exchange rate fell from 2.23 Kwacha/$ to about 7 Kwacha/$, close to the parallel market rate. 3.3 The manufacturing sector responded quickly to liberalization in 1985 by raising prices and increasing production, with real growth of 8%. There were significant increases in capacity utilization, particularly in textiles and clothing, paper products and non-metallic mineral production. Parastatals too are reported to have responded well to the new freedom and liberalization. For the financial year ended March 31, 1986, INDECO's profits before tax increased to K 103.6 million from K 11.7 million in the previous year. The number of INDECO companies losing money was reduced from 10 to 6 during the same period. There was a small increase in manufactured exports, following the substantial Kwacha depreciation in October 1985; it accounted for less than 2% of overall exports. It must be appreciated that a longer time frame than that under review is needed to evaluate the impact of new policies on export performance. Although the industrial sector's performance showed some improvement, it continued to be constrained by the inadequate supply of foreign exchange which led to lack of spares and intermittent supply of raw materials, most of which are imported. Foreign exchange earnings from export of copper dropped sharply in 1986 due to decline in copper prices and in the volume exported. The auction system used price to allocate foreign exchange, but did not remove the foreign exchange constraint in the economy. 3.4 The second, and more turbulent, phase of the auction covers the period April 1986 to May 1, 1987. In April 1986, the leaders of the economic reform team were replaced by persons who were not earlier involved in formulating the reform policies. At the beginning of the second phase, the Government carried out an internal review of allegations of abuse and problems with the auction which showed widespread dissatisfaction with how the mechanism was working. Bank staff reviewed the auction's workings and concluded that the allegations were not supported by evidence. 3.5 During the second phase, the exchange rate continued depreciating gradually and by July 12 had reached K 8.07/US$1. The authorities became concerned and in an effort to stem the downward drift introduced several proc-dural changes and administrative requirements; inter alia, bidders were asked to produce income tax clearances and evidence of payment of other taxes and use of previous allocations. At one point, bids higher than K 8.07 were rejected, and, subsequently and bidders' names and bids were published in newspapers, implying that the higher bids were unpatriotic. On August 2, 1986, the auction went "Dutch" i.e. the bidders were asked to pay at the rate they bid rather than at the marginal rate that would exhaust the supply of foreign exchange at the auction. At the same time, the supply of foreign exchange was drastically curtailed by a sharp decline in receipts from copper, caused by falling international prices, and by some modest shortfalls in promised donor aid. Faced with the prospect of continued depreciation of the Kwacha, the authorities started "overbooking" i.e. offering more foreign exchange than was available. These interventions destroyed confidence in the exchange rate and the auction. Business leaders surmised that the country was running out of foreign exchange and that the auction would eventually be suspended. They increased both the amount and price of their bids to assure themselves of - 99 - access to foreign exchange, while the auction lasted. Despite quick injections of foreign exchange by some donors in an effort to preserve the auction, the Kwacha continued to depreciate. From the end of October 1986 to January 24, 1987, the rate climbed from K 10.32 to K 14.92 to the dollar. On the latter date, the auction was suspended and the exchange rate was fixed at K 8=$1. It re-opened on Oarch 28, 1987, at K 15 to the dollar and finally closed on May 1, 1987, the final rate being K 21. Thus, contrary to official expectations, administrative actions taken to restrain the demand for foreign exchange generated additional speculative demand. With a continuing serious constraint on the supply of foreign exchange, this, together with other demand pressures, had the inevitable effect of the depreciation of the kwacha to levels unacceptable to the political system. 3.6 Abandonment of the Reform Program. On May 1, 1987, the Government formally abandoned the reform program. In particular: (i) the foreign exchange auctioning was discontinued and an administrative allocation mechanism was teinstituted; (ii) exchange rate was set at an oNervalued level of K 8 to a dollar; (iii) tight import controls were put into place with free access to export retention (paragraph 2.8) denied; (iv) duty rates for many items were raised and widespread duty exemptions were allowed; (v) prices of many products were controlled while underlying inflation was high; and (vi) interest rates which were already negative were reduced substantially. 3.7 The one incident which appears to have contributed most to the erosion of political commitment was the eruption of riots in the copperbelt in early December 1986; the riots were precipitated by the end of the subsidy on breakfast meal in November 1986 and the mismanagement of subsidy payments on roller meal which led to the disappearance of the lower-priced roller meal from the market. The reduction in subsidy was required to control an expanding budget deficit. Earlier in the year, the Bank and the IMF had recommended moderate subsidy reduction, among other measures, as a means of controlling the budget deficit. But political concerns about increasing maize meal prices delayed the action by several months. This had the unfortunate effect of requiring a much higher meal price increase later in the year to meet budgetary needs and still leaving too high a budget deficit during most of the year. The meal price increase and related problems led to riots and the large budget deficit to increased money supply. The latter, com7uined with an unchecked credit expansion to the non-government sector, created serious inflation and downward pressure on the exchange rate. When people saw the cost of living rise at the same time as the cost of foreign exchange they concluded that the deterioration of the exchange rate was responsible for the increase in the cost of living. In fact, the deterioration of the exchange rate and the increases in the cost of living were both caused by an increase in the budget deficit and the money supply. 3.8 The other reasons for failure in the implementation of reforms weret (i) absence of a broad-based political support for the program; (ii) signifi- cant changes required in long-established decision making patterns, power relations within the bureaucracy, and linkages with constituencies; and (iii) the reaction of the groups whose economic rents were substantially reduced. 3.9 Notwithstanding the collapse of the reform program, the one area in which considerable progress was made was the improvement of the overall - 100 - performance of a number of INDECO subsidiary companies. A team of consultants, designated as Industrial Development Advisory Team (IDAT), reviewed thirteen companies divided into two groups; the first group of six consisted of companies considered to be of high priority demanding immediate attention, which were making losses and included some which were only marginally profitable. Reviews of these firms were completed by July 1, 1986. 3.10 The. strategies for improvement recommended by IDAT were approved by the appropriate authorities and implementation taken in hand promptly. The firms in this group increased their turnover from K 54 million in FY87 to K 145 million in FY89 and improved their net profit before tax from a loss of K 1 million to a profit of K 28 million over the same period. The second group of seven firms was studied in greater detail. Reviews of this group were completed in July 1988 and IDAT's recommendations were accepted for implementa- tion. Performance improvement for the second group of companies was also remarkable; turnover increased from K 263 million in FY87 to K 545 million in FY89 and profits from K 4 million to K 40 million. IDAT also held productivity improvement workshops for yet another group of six firms and provided training to company managers in various areas of factory operation. In general, both INDECO and the subsidiaries were very responsive to the consultants' sugges- tions and benefitted greatly from exposure to them. 3.11 Another aspect of INDECO, of a longer term impact, which received assistance under the project related to establishment of an Economic Evaluation Unit in-house to carry out appraisal of investment projects using sound economic criteria, and to monitor and evaluate performance of existing enterprises. While this unit was established on time and its staff trained by an economist provided by UNIDO, because of staff inexperience it did not have the potential to develop into an effective appraisal or monitoring unit within a reasonable time frame. Such a team needed wide experience in fields of finance, production, personnel and marketing, which the EEU staff did not have. IV. THE INDUSTRIAL REORIENTATION CREDIT 4.1 Project Objectives. The objective of the project was to support policy and institutional reforms as set out in Section III. These reforms were expected to raise capacity utilization and production levels of efficient industrial enterprises in Zambia, help reorient manufacturing activity towards exports and greater reliance on labor and local raw materials, and provide technical assistance to INDECO for restructuring of its enterprises and for rationalization of the public sector investment program in industry. 4.2 Proiect Description. The project was appraised in October/November 1984 and a post-appraisal mission visited Zambia in February 1985. Negotia- tions took place in July 1985 and the credit was approved by the Board on October 22,1985; the credit was signed on October 23, 1985 and became effective on November 1, 1985. The total amount of the credit was SDR 62.2 million (US$62 million), consisting of an IDA Credit of SDR 20.1 million (US$20 million equivalent) and African Special Facility of SDR 42.1 million (US$42 million). About 95% of the funds were for imports of raw materials, spare parts, intermediate goods and other inputs for the industrial sector and 5% for technical assistance. - 101 - 4.3 Co-financing. Co-financing for the project was provided by way of Special Joint Financing by the United Kingdom in an amount of 10 million pounds sterling and by the Netherlands Government in an amount of Dfl 29 million; these funds were to be used for imports. Due to suspension of disbursements, a sum of Dfl 10 million remained unused from the Dutch grant and was allowed by the Netherlands Government to be available for repaying arrears of Bank loans and IDA credits. 4.4 Supervision. IDA's supervision of the credit was adequate and the monitoring of the progress of implementation of the various policy measures was quite effective. Conditions of effectiveness of the credit were fulfilled promptly and most conditions of release of the second tranche were also complied with on time. Slippages occurred in respect of commencement of feasibility studies on the establishment of a credit insurance scheme and an export guarantee scheme together with appropriate implementation, and submission of an Action Program for phasing out or otherwise disposing of enterprises considered to be economically unsound and improving the performance of on-going industrial enterprises considered to be potentially economically viable. In respect of the latter the action program was submitted to IDA in two installments; the program in respect of the first six companies was submitted on completion of their performance review in July 1986 and that in respect of the remaining seven companies in July 1988. Effective dialogue was maintained between IDA and INDECO in respect of implementation of the recommendations of IDAT. 4.5 Procurement and Disbursement. Since the major portion of the credit was made available to the Zambian authorities for the foreign exchange auction, IDA's normal procedures for procurement were not applicable. The 32% of the credit used for import of petroleum and petroleum products was, however, subject to competitive procedures acceptable to IDA. The proceeds of the US$59.8 million imports component were disbursed in two tranches of US$40 million and US$19.8 million. Special accounts were opened for the purpose with the Bank of Zambia and after an initial deposit of US$20 million, the accounts were replenished on a monthly basis on the basis of Statements of Expenditure and certificates from the Bank of Zambia that credit proceeds were used for eligible expenditure. External audit has confirmed the validity of the records. 4.6 Consultant&. Consultants under the technical assistance component of the credit were employed in accordance with the provisions of the credit agreement and on the basis of the Bank's Guidelines. V. EVALUATION 5.1 The industrial reorientation program and the economic reform program, of which the former was a part, although implemented for a while, ultimately proved unsuccessful with the exception of the program relating to the improvement in the performance of parastatal industrial enterprises. The main project risks, as perceived at appraisal and stated in the President's Report, were the uncertainties about the length and severity of the economic crisis then prevalent in Zambia and the Government's ability to withstand social and political pressures against the reforms which were likely to be generated from - 102 - the social costs of adjustment. While the polit.'cal risks were recognized at appraisal, the Bank decided to take these -risks because of the prospects of serious economic decline in the short term otherwise. 5.2 In retrospect, it appears that the Bank had over-estimated the political commitment to the reforms. It also did not react quickly or strongly enough to the lack of control on money supply and other violations of the covenants agreed with IMF. These led to suspension of the standby arrange- ments. In hindsight, the Bank Group should perhaps have recommended stopping the auction some time in November 1986, when the rate was $1=K 8, for a few months, putting it on a crawling peg, to allow the rate to stabilize, starting again a few months later. This might have avoided the precipitous decline in the value of the Kwacha and the loss of confidence in the reform program to pull Zambia out of the economic mess. Furthermore, given the limited administrative capabilities and lack of coordination mechanisms, IDA should have allowed the Zambians more time for implementation of the various reforms. VI. FINDINGS AND LESSONS LEARNED 6.1 The adjustment program supported by the Industrial Reorientation Credit failed because of the interventions in the management of the auction and the lack of control on money supply. Responsibilities for reforms required institutional changes that challenged entrenched interests. Administrative capabilities were limited and few mechanisms existed for co-ordination among central units responsible for defining economic policies. Notwithstanding these weaknesses, the program would probably still have worked if it had been managed properly. The lessons that can be drawn from this operation are that before the introduction of reforms the Bank Group should ideally have given higher priority to development of administrative and coordination mechanisms and recognized explicitly the lack of total consensus among the country's political leadership regarding the immediate costs of adjustment. - 103 - PART III, STATISTICAL INFORMATION 1. Related Bank Loans/Credits Loan/Credit Purpose Year of Statue Title Approval Credit 1S45-ZA Through specific policy 1985 completed Agricultural actions to encourage and 6/30/88 Rehabilitation support the Government's Project efforts in policy and institutional reform in the agricultural sector to reverse the declining trend in marketing agricultural output and reinforce Government's efforts to diversify the economy from the extreme dependence on mining. 2. Project Timetable Date Date Date Item Planned Revised Actual - Identification 7/83 7/83 7/83 - Preparation 6/84 6/84 6/84 - Appraisal Mission 11/84 11/94 11/84 - Post-Appraisal 2/85 2/35 2/85 - Loan/Negotiations 7/85 7/85 7/10-11/85 - Board Approval 7/85 7/85 10/22/85 - Loan Signature 7/85 10/22/85 10/23/85 - Loan Effectiveness 9/25/85 11/1/85 11/1/85 - Loan Closing 12/31/88 12/31/88 12/31188 - Loan Completion 6/30/89 6/30/89 6/30/89 - 104 - 3. Loan Disbursements Cumulative Estimated and Actual Disbursement (in US$ million) Credit 1630-ZA FY86 Ul8z EY88 FY89 Appraisal Estimate 60.6 61.2 61.8 62.0 Actual 60.4 60.9 61.2 61.4 Actual as 2 of Estimate 99.7 99.5 99.0 99.0 Appraisal Estimate - US$62.0 million Actual - US$61.4 million Actual as % of Estimate - 99.0% Cancelled - SDR 540,983.25 Date of Final Disbursement - April 1, 1989 4. Project Implementation Actual or Indicators Appraisal Estimate PLe Estimate I. Action to be Taken Before Credit Effectiveness (a) Initiate operations of the foreign exchange In 1985 and auction system; early 1986 (b) Conversion of the present system of import the Govt. licensing to one of import registration; took all (c) Elimination of import prohibition; and agreed (d) Reduce maximum tariff rates from 150% to 1002 actions and policy II. Actions to be Taken Before the Release of measures the Second Tranche so that effect- (a) Decontrol interest rates; iveness (b) Agree on the amount and composition of INDECO's and second investment program for 1986/87; tranche (c) Enact new Investment Act; conditions (d) Establish minimum 102 tariff on remaining vere met. duty free items; and (e) Implement program of action to improve foreign exchange forecasting and budgeting. - 105 - 5. Project Cost and Financinx A. Proiect Costs Appraisal Estimate Actual Africa Africa IDA Facility Total IDA Facility Toval ------------------------US$ millions------------------- (i) Financing of imported 1.8 42.0 59.8 17.2 42.0 59.2 spare parts, raw materials and other productive inputs for industry; (ii) Technical assistance 1.8 - 1.8 2.3 - 2.3 to INDECO, the Ministry of Comerce and Industry, the Ministry of Finance, and BOZ (iii) Equipment and vehicles 0.2 - 0.2 0.0 - 0.0 (iv) Training 0 0.2 20.0 42.0 62.0 19.5 42.0 61.5 B. Project Financing Source Planned (credit) Revised Final Comment -------------US$ million----------- IDA 20.00 20.00 19.46 Africa Facility 42.00 42.00 42.00 Comments: (a) SDR 540,983.25 of the credit was cancelled. - 106 - 6. Proiect Results A. Direct Benefits: Not applicable B. Economic Impact: Not applicable C. Financial Impact: Not applicable D. Studies Purpose as defined Status Impact of at Appraisal Study Industrial Perform an in-depth completed All of the Reorganization study of 13 INDECO in 1988 consultant's Program enterprises from the recommendations point of view of their were implemented economic efficiency, and to a major financial profitability, extent the operational efficiency, implementation and finance and accounting; outcome was develop strategies successful. for reorientation and restructuring. - 107 - 7. Status of Covenants Credit Deadline Agreement Subject for compliance Status 4.02(a,b,c) Hot later than December 31, 1985 Dec. 31, 1985 not complied with commence feasibility studies on the establishment of a credit insurance scheme and an export guarantee scheme under terms of reference acceptable to the association; not later than December 31, 1986 submit to the Association a plan of action for the implementation of the recommendation of the studies; and in consultation with the Association implement the recommendations of the studies. 4.03(a) Hot later than December 31, 1985 Dec. 31, 1985 complied with establish or cause to be established within INDECO an Economic Evaluation Unit to apply sound economic criteria for the appraisal oz new investment projects and the performance of existing enterprises; 4.03(b) Cause the Economic Evaluation Unit to carry out an appraisal, on terms and Dec. 31, 1985 complied with conditions satisfactory to the Association, of new investment projects and existing enterprisees 4.03(c) Cause INDECO to discontinue by Dec. 31, 1985 complied with December 31, 1985 new investment projects costing one million dollars equivalent or more which is considered by the Borrower and the Association to be economically unsound. 4.04(a,b) Not later than December 31, 1985 Dec. 31, 1985 not complied with submit to the Association an Action Program acceptable to the Association for: phasing out or otherwise disposing of on-going industrial activities and enterprises considered by the Borrower and the Association to be economically unsound; and restructuring and/or taking other appropriate measures to improve the performance of on-going industrial enterprises considered by the Borrower and the Association to be potentially economically viable; and commence implementing such Program not later than April 1, 1986. 4.06 The Borrower shall, in consultation with Dec. 30, 1986 not complied with the Association take not later than June 30, 1986 appropriate measures to ensure that its sales tax applies to such domestically produced goods, to be agreed upon between the Borrower and the Association. - 108 - 8. Use of Bank Reource. A. Staff Inuts (staff weeks) Stages of Project Cycle Planned Revised Final Coaments Through Appraisal 112.2 Apprateal through Effectivenss 328 Supervision 80.5 Total 225.5 ZAMBIA INDUSTRIAL REORIENTATION CREDIT (1630-ZA) PROJECT COMPLETION REPORT B. MISSIONS Stage of Number Days in Performance Project Cycle Month/Year of Persons Field Specialization a/ Rating Status b/ Preparation 6/84 5 5 Op, Op, Ec, Ec. Ln Appraisal 10/84 4 15 Op, Op, Ec, Op, 2/85 4 16 Op, Op, OA 4/85 1 5 OA 7/85 2 10 Ec, Ec Supervision 11/85 3 19 Op, Ind, Lg 1,1 2/86 3 23 Op, Ec, Con 1,l 3/86 1 5 Ln, 11/86 2 13 Ec, Ec 3,3 11/87 1 21 Ec 3,3 a/ Ln = Loan Officer; Lg = Lawyer Op = Operations Officer; FE = Financial Economist; F = Financial; OA = Operations Assistant; Ind = Industrial Restructuring; Con = Consultant; Ec = Economist. b/ Overall Assessment, Development impact. - 111 - APPENDIX INDECOPage of 4 .. INDECO LIMITED Yow ReM: INDECO HOUSE TELEPHONE:. 228483*70 BUTEKO PLACE TELEX:4A 41ga1 P.O. BOX 31M 1010f- LUSAKA OFFICE OF THE ZAMINA MANAGING DIRECTOR Comments Received from INDECO on the Draft PPAR June 11, 1992 Division Chief Country Policy, Industry and Finance Operations Evaluation Department The World Bank 1818 H Street N.W WASHINGTON DC 20 433 U.S.A. Dear Sir, ZAMBIA-INDUSTRIAL REORIENTATION PROJECT - PER7ORMANCE AUDIT REPORT --------------------- --------------- We wish to thank you for your letter of 22nd April 1992 soliciting our comments on the Draft Programme Performance Audit Report, of the captive subject matter. Find herewith our position on this matter as follows: 1. General We have found your report a well written one, whose conclusions seem to be valid, in general. However, as we have been concerned with only a component of this program, namely parastatal restructuring, we feel, this is the area we are more competent to comment on. 2. As you have correctly noted, despite the previous Government discontinuance of the structural adjustment program on 1st May 1987, the component on the restructuring of unviable INDECO subsidiaries, continued, and was successfully concluded on 1st April 1989. - 112 - APPENDIX Page 2 of 4 During the course of this exercise, there was a noted improvement in the financial performance of these enterprises, which saw thorn return to profitability; as you indeed acknowledge. We do agree with you that financial profitability may not be the only performance indicator, and note that, the other requisite data to complete the exercise was only obtained by the Bank after the Draft Report was circulated. We hope in future your evaluation teams will collect this relevant data in time so that realistic evaluation is carried out. Despite repeated All the same, we trust that with the data that you now equests,no have, you will be in a position to correct the incormationwas situation. inade available. 3. Concerning, your observation that INDECO did not phase out any unviable parastatals, thereby acting in a self- serving manner, we wish to refer you to the terms of Refertoparas. reference negotiated between the Bank Team and INDECO. 2.08.3.05. These terms of reference, contained in the final report of the Industrial Advisory Team (IDAT) stressed the need to turn around low performing parastatal companies rather than phase them out. In our view, this is a more positive approach, since it has the merit of preserving scarce investment resources and results in contributing to the growth of the country. In any case, by successfully restructuring poor performing enterprises, and returning them to economic viability the raison, d'etre for their closure is removed. 4. With reference to the establishment of the Economic Evaluation Unit (EEU) we confirm that this has been done. The Unit is now a fully fledged project appraisal team, whose reports are routinely accepted by both local and international financial institutions as a basis for financing industrial projects. As an example the European Investment Bank, our Development Bank, Commercial Banks and donor agencies have financed projects based on Appraisal Reports by the Unit. - 113 - APPENDIX Page 3 of 4 INDECO, has also now made it a requirement that any and all projects beyond $500,000, are proven viable by the Unit, prior to implementation. 5. Your report notes, that the EEU does not have the requisite "engineering capacity and expertise in important aspects of Industrial Management"; and this is attributed to INDECO's inability to attract experienced personnel due to poor condition of service. Whereas, the above may be.true, there are other more significant reasons for this. In the first instance, it was explicitly agreed with IDAT to reserve the EEU for project appraisal work. This program was successfully concluded with the Assistance of UNIDO. Consequently, one aspect of IDAT's terms of reference, that of transfer of expertise to local professionals to carry out enterprise evaluation was not achieved. IDAT operated in isolation of the Unit, in this respect and only interacted with the Unit in the design and implementation of the Performance Monitoring System, which the Unit has since expanded and continues to implement. Secondly, as a result of the decision taken above, it was then agreed that Ad hoc teams, that would include some members of the Unit, could in future undertake enterprise evaluation as the need arises. This has been the case since, and hence the absence of management consulting expertise in the Unit, although this expertise is available elsewhere in the group. Finally, you may note that despite the unattractive conditions of service referred to, the job content prescribed by IDAT was not dynamic enough to attract experienced and well qualified manpower. IDAT wished INDECO to employ "research assistants" which position no experienced personnel would accept. - 114 - APPENDIX Page 4 of 4 We would wish to advise that your team in future relies less on the consultants reports, but attempts to obtain the beneficiary institutions evaluation of such programmes. I trust you will find the foregoing useful in the finalisation of your report. Yours fait-fully S T/me y)e MANAGING DIRECTOR cc: Minister of Finance cc: Minister of Commerce, Trade and Industry /ly
Groupe de la Banque mondiale · Project Performance Assessment Report
Zambia - Industrial Reorientation Project
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