Morocco - Second Structural Adjustment Loan Project

Documt of The World Bank FOR OFFICAL USE ONLY MICROFICHE COPY Report No. P- 5637-MOR Type: (PR) ReporttNo. P-5637-MOR GUERRERO, / X37407 / H4065/ EM2CO REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED SECOND STRUCTURAL ADJUSTMENT LOAN IN AN AMOUNT EQUIVALENT TO US$275 MILLION TO THE KINGDOM OF MOROCCO APRIL 8, 1992 This document bas a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY AND EXCHANGE RATE Currency Unit - Dirham (DH) 1.00 $US - 8.2423 DH (1990) 1.00 DH 0.12133 $US FISCAL YEAR January 1st - December 31  FOR OMCIAL USE ONLY ABBIMVIATIONS AND ACONYNS AfDB African Development Bank (Banque Africaine de D6veloppement) ASAL Agricultural Structural Adjustment Loan (Pr6t d'Ajustement au Secteur Agricole) ASIL Agricultural Sector Investment Loan (Pr6t a l'Investissement du Secteur Agricole) DOD Debt Outstanding and Disbursed (Encours de la Dette) EEC European Economic Community (Communautd Economique Europeenne) GATT General Agreement on Tariffs and Trade (Accord gen6ral sur les tarifs (ouaniers et le commerce) GDP Gross Domestic Product (Produit Intdrieur Brut) GNP Gross National Product (Produit National Brut) ICB International Competitive Bidding (Appel d'Offres International) IMF International Monetary Fund (Fonds Monetaire International) ITPA Industrial & Trade Policy Adjustment Loan (Pr6t a l'Ajusttment Industriel et Commercial) LSMS Living Standards Measurement Survey (Enqu6te Nationale sur le Niveau de Vie des Menages) MFA Multi-Fiber Agreement (Accord Multi-Fibre) MLT Medium- and Long-Term (Moyen et Long Terme) NGO Non-governmental Organizations (Organisations non-gouvernementales) OCP Office Cherifien des Phosphates (National Phosphate Company) ORMVA Agricultural Regional Office (Office Regional de Mise en Valeur Agricole) PAL Public Administration Loan (Pr6t d'Ajustement a l'Administration Publique) PERL Public Enterprise Rationalization Loan (Pr6t a la rationalisation des Entreprises Publiques) PGI Programme G6n6ral des Importations (General Import Program) PIC Programme Investissement-Cible (Target Investment Program, TIP) REER Real Effective Exchange Rate (Taux de Change Reel Effectif) SEGMA Services geres de maniere autonome (Autonomously-Managed Entities) SIT Special Import Tax (Prelevement Fiscal sur les Importations, PFI) SOE Statement of Expenditures (Releve de Depenses) STEP Social Target Expenditure Program (Programme de D6penses Sociales-Cibles, PDSC) TIR International Transport Convention (Transports Internationaux Routiers) VAT Value Added Tax (Taxe sur la Valeur Ajout6e) XGS Exports of Goods and Services (Exportations de Biens et Services) This document has a restricted distribution and may be used by recipients only in the perfonnance of their oMcial duties. Its contents may not otherwise be disclosed without World Bank authorization.  KINGDOM OF MOROCCO SECGN STRUCTURALn AI2USTMUENT LOAN (SA,L-11) Laan -arid Proga Su.Mgmu The Kingdom of Morocco. Amnounk US$275 million equivalent. 20 years, including 5 years of grace, at the standard variable interest rate. fliminilAn: Norocco's economic reform program aims at achieving a sustainable increase in the rate of economic growth in order to ensure employment opportunities and acceptable living standards for its growing population, while enhancing external creditworthiness. The proposed SAL would support the last phase of the Government's stabilization and adjustment program of action within a macroeconomic framework which permits the achievement of the Government's objectives. The loan would focus on the following areas: (i) a public expenditure rationalization component which would support private investment through providing the necessary infrastructure, encouraging the private sector to supply some of the services hitherto supplied by the public sector, and promoting a dynamic role for private investment; (ii) a poverty alleviation component which would support a shift in budget expenditure priorities toward the social sectors and the implementation of a poverty alleviation strategy for the nineties; and (iii) the continuation of the trade reform program and the simplification of foreign trade procedures. EmHnnlf The principal benefits of the adjustment program resulting andl9: from the acceleration of economic growth through increased factor productivity would be: a rise in employment opportunities and living standards for the growing population; the development of an outward-oriented private sector; and continued improvement in external creditworthiness with a view to restoring voluntary access to commercial borrowing. Two main risks can affect the success of the project. The first relates to the consolidation of the macroeconomic progress already achieved. While the fiscal deficit has been reduced substantially over the last decade, further progress is  - ii- required at a time when foreign financing of the deficit through rescheduling is going to disappear. The Government is committed to further fiscal efforts which will be finalized as part of the 1992 Finance Bill. The second area of potential risk is the economy's vulnerability to external shocks from droughts, oil and phosphate price changes as well as increases in international interest rates. Given the country's excellent macroeconomic and export performance in the past years, there is some cushion to face these shocks. In addition, oil import and phosphate export prices have historically moved in an almost parallel cycle. Esiatteu The proceeds of the proposed loan would be disbursed in two tranches: Dki2U3OHMMM: US$138 million upon loan effectiveness, which is expected to take place by May 1992, and the remaining US$137 million after the completion of a number of key actions upon which success of the program depends. Release of the second tranche is planned for early 1993. AMMorabReoRg: None. m:Ado\mor\sa12\sum=zy April 7, 1992  KINGDOM OF MOROCCO SCND SRUCTURAL ABUWBMEl QLAN Table IntCnt INTRODUCTION . . . . ..... .................. ... . 1 PARTI - THE1980s: A DECADE OFADJUSTMENTAND REFORMS ............ 1 PART II - THE STRUCTURAL ADJUSTMENT PROGRAM AND THE CHALLENGES OF THE 10..s .............. . 6 A. The Macroeconomic Framework: Achevng A MoreEfficlentSelf-flnanced Growth . ................ 7 B. PublcExpendtures ..... .. 12 C. Poverty Reduction Stategy .................. 15 D. Trade Reforn ..... ...................................... 19 PART III - THE PROPOSED LOAN . . ......................... 23 A. Components and Conditonality .................. ............ 23 B. Loan Amount, Coflnancng, and TrancNng . ....... ............... 24 C. Impact of theS BenL efsand Riks ........................ 24 D. Procurenent and Dlsbursement .............. 27 PART IV - OTHER BANK OPERATIONS ... . .................... .......... . 29 A. Expedence with Past Adjusment Lending .. ................ O... 29 S. Stategy for the 199s ... .................................. 30 PART V - LEGAL INSTRUMENTS AND AUTKORITY ............... ........... 32 PART VI - RECOMMENDATION ............................. ........ 32 ANNEXES 1. Ltr of Development Poilcy and Policy Matices 2. Status of Bank Opeatons In Morocco 3. Key Macaoconomic Indicators m:\do\mor\sal2\toc  REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED SECOND STRUCTURAL ADJUSTMENT LOAN IN AN AMOUNT EQUIVALENT TO US$275 MILWON TO THE KINGOM Qf MQRQCGO IBTRODUQMON 1. I submit the following report and recommendation for a proposed Second Structural Adjustment Loan (SAL II) to the Kingdom of Morocco in an amount equivalent to US$275 million to provide financial support for the Government's economic reform program. The loan would support the last phase of a structural adjustment program aimed at achieving more rapid growth and a more equitable distribution of welfare. The loan would have a term of 20 years including five years of grace, at the standard variable interest rate. The African Development Bank will provide cofinancing. PARTE THFO 19808: A DECADE OF ADJUST-MENT AND) REFORMS 2. During the 1980s, Morocco achieved commendable macroseonomic results and moved closer to being a private sector-led, outward-oriented economy. Effective demand management, exchange rate realignments, and sweeping reforms of incentives allowed the economy to take advantage of a fairly favorable international environment, particularly in the second half of the decade, and to attract the support of the international financial community. But infrastructure and social services have lagged behind. A redirection of investment priorities towards these sectors has become critically important. 3. Morocco has abundant natural resources including the world's most easily accessible phosphate reserves, vast areas of arable land, extensive coastlines well suited for tourism, and considerable maritime resources. However, much of these resources have not been adequately developed. Per capita income is still below US$1,000 in spite of the rapid growth of the second half of the eighties. The Nacroeconomic Results Speak for Themselves 4.. Mo-.rocco has one of the lowest inflation rates among developing countries. Blespite the recovery in economic activity that took place in the second half of the 1980s, inflation remained below 51 until 1990, when it increased to 6.71 following a nominal devaluation and higher oil prices. The current account turned around in the second half of the 1980s, moving from a deficit of almost 81 of GDP in 1984 to small surpluses in 1987 and 1988. However, it slipped back to deficits of 3.61 of GDP in 1989 and 0.81 in 1990. The transitory deterioration of the current account in 1989 reflected mainly a  - 2 - fall in phvsphate exports because of a contractual dispute with Morocco's main buyer of phosphoric acid. The low current account deficits have allowed debt indicators to improve systematically: the ratio of debt outstanding and disbursed (DOD) to GDP dropped from 1071 in 1986 to 931 in 1990, and the ratio of debt service to exports from 36X to 231 (after reLciheduling). 5. The second half of the 1980s was also an exceptior-' period of growth for the Meroccan economy, with real GDP growth averaging about 4.81 a year from 1985 to 1989. Partly because Morocco complemented stabilization measures with structural reforms, growth suffered less than it did in countries that relied on stabilization alone. Agriculture performed remarkably well despite the droughts in 1985 and 1987, in part because of changes in producer incentives supported by two Bank adjustment loans. Even though the sector represents less than 201 of GDP, it has contributed almost one-third of growth in the latter part of the eighties. Protress Towar4 a Private Sector-led. Outward-oriented Econom' o. Between 1980 and 1989, manufacturing exports increased from 12X to 221 of total exports, including nonfactor services. Despite this shift in structure, exports remain narrowly based on a few products: fish, processed foods, phosphate derivatives, and clothing, which is fast becoming Morocco's primary export. But there has been diversification within these categories. Phosphate-derived products, only 91 of phosphate exports in 1972, soared to 641 in 1988. Processed foods (canned fruits and vegetables, fish, juices) increased from 161 of agricultural exports in 1972 to 47X in 1988. The higher share of finished products in total exports means that exports are less vulnerable to exogenous developments and more responsive to economic incentives. 7. The industrial sector response to the reforms has also been positive. Manufactured goods increased from 151 of total production in 1982 to 251 in 1988. The rate of investment has increased in export-oriented sectors, with their share in total fixed investment growing from less than a quarter in 1984 to over a half in 1988. Investment in textiles doubled as a proportion of total investment in 1984-88, with a parallel increase in the ratio of exports to total production. The new, stronger class of entrepreneurs that emerged in the 1980s has expanded its activities beyond manufacturing to investments in modern agriculture-based exports and services. Fiscal and Mone Restraint and Exchanae Rate Realignment 8. After years of budget deficits above 101 of GDP, the Government is bringing under control one of the most difficult remaining macroeconomic imbalances. The share of the budget deficit in GDP fell from historical double- digit levels to 4.41 on a cash basis in 1989 and 3.41 in 1990.1 Government expenditures were reduced from an average of 331 of GDP in the first half of the 1980s to 281 of GDP in 1989, mostly through cuts in public investment. Although the cuts initially were needed, they were so drastic that basic social and material infrastructure was hardly maintained (paras. 15-16), endangering both private sector activity and social stab-lity. Since 1988, public investment has expanded, with the support of SAL I, to ensure a core minimum of spending (para. 33). Revenues, which had temporarily dropped to 191 of GDP in 1986 when 3/ After grants, the deficit was only 0.41 of GDP in 1990.  - 3 - the value added tax (VAT) was introduced, have recovered to about 23X of GDP, a level higher than that reacned before reform. 9. Monetary and credit policies also contributed to the restoration of internal and external equilibria. Tight control of the monetary aggregates throughout the decade supported the fall in the inflation rate, from over 12X in 1981, to around 31 in 1989, and provided financial stability. Credit ceilings, interest rate controls, and selective credit policies were among the monetary instruments used. Because of the need to finance a lzrge budget deficit, credit was squeezed and banks were forced to invest a large share of their liabilities in low-interest government bonds. By and large, selective credit policies and interest rate controls were successful in avoiding excessive crowding out of ?rivate investment. As inflation dropped and real interest rates2 increased from -5X in 1981 to 81 in 1988, savings responded promptly. 10. Fiscal and monetary restraint was supported by exchange rate realignment to better reflect the relative opportunity costs of tradable and non- tradable production, supporting the economy's export drive. The real effective exchange rate (REER) depreciated by a total of 33X in 1980-89, depreciating from 1979 through the end of 1985 and then remaining stable until 1989. After the May 1990 nominal devaluation of 9.25X, real exchange rate indexes were at one of the most depreciated levels since the 1970s (see Figure 1). SweeRin Reforms of Incentives 11. Accompanying the macroeconomic stabilization program has been an impressive reform of the incentives structure aimed at bringing about a shift from administered to market-determined incentives. The domestic economy has been gradually exposed to external competition through a reduction of both tariffs and the scope of quantitative import restrictions. At the same time, most domestic price controls have been removed and trade monopolies are being gradually eliminated. Consumer subsidies have been reduced in scope and magnitude. A major tax reform was implemented to increase tax buoyancy and decrease distortions in relative prices. A public enterprise rationalization program was also implemented in the second half of the 1980s (see Part II for a description of the structural reforms). A Fairly Favorable External Environment 12. Although in the first half of the 1980s international prices for both phosphate and oil fell, the net effect was a deterioration in terms of trade until 1986. Phosphate prices recovered significantly after that, while oil prices continued to fall. As a consequence, Morocco's terms of trade (merchandise only) regained their 1980 level and were about 8X higher by 1989. Adequate rainfall after 1987 gave an additional exogenous boost to overall growth. The fall in world oil prices and the strong agricultural production during most of the second half of the 1980s, led to a drop in import values in the period following trade liberalization. Crude oil imports decreased from 81 of GDP in 1985 to 31 in 1989. Food imports decreased from 4X to 3X of GDP. V/ These refer to the 6-month deposit rates.  - 4 - Figvre 1: SELECTED MACROECONOMIC INDICATORS Real Exchange Rate and MOROCCO Terms of Trade Debt Indicators so 1~~~~~~~~~~~~~~~~~40%1 100 looik-~~~~~~~~~~~~10 so ~~~~~~~~~~~~~~~~~80% 1 20 9~~~~~~~~~~~~~~0% 10 '8 1 os 1 o0 it8l IOSa 1986 ;i:S ts17 t24 IM 19890 0 1981 1982 tt t198U 1984 16 19 I"? 18 1099 Real 111 90h Rafte Terms ol Trade - 00'oP lD aot omevie Ratio bow"S . 08uI 4 IMe _F .t . MOROCCO Current Account and Budget Deficit In Percent of GDP 4% - 2%- 0%- -2%- -4%- -6% -8%- - 10% -12% -14% 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 Current Account M Budget Deficit Source: Ministry ot Finance  Support from th6 Inteunational Financial Community 13. Following several traditional reschedulings with the Paris and London Clubs, Morocco concluded new agreements that brought the country closer to balance of payments viability. The agreement witlh the London Club has two parts. The first consists of a block rescheduling of the entire US$3.2 billion owed to commercial banks. The bulk of the debt was rescheduled with a 20-year maturity, including a 10-year grace period, saving Morocco about US$700 million a year in 1990, 1991, and 1992. 'Zhis part of the agreement also provided a waiver for buy backs of Moroccan debt on the secondary market. The seconQ part of the deal, conditional on an Extended Fund Facility (EFF) with the IMF, provided for further possible negotiated debt reduction. This possibility is no longer being pursued by the Government since recent economic performance allows it to achieve viability without recourse to debt reduction. In addition, in September 1990, Morocco obtained from the Paris Club a rescheduling of 100l of principal and interest of eligible debt falling due between January 1990 and March 1991 amounting to US$1.3 billion. Furthermore, in February 1992, the Paris Club rescheduled US$1.25 billion representing ar&uzrs as of January 31, 1992, and maturities falling due from February 1, 1992, to December 31, 1992. Repayment terms have been the same for both reschedulings: 20 years, including 10 years of grace, for official development assistance loans; and 15 years, including 8 years of grace, for commercial credits of more than 1 year. in total, the Paris Club deals saved Morocco approximately US$1 billion in 1990, US$900 million in 1991, and US$600 million in 1992. 14. In 1991, Saudi Arabia forgave Morocco's entire debt obligation amounting to around US$2.7 billion. This is equivalent to almost 25X of the Paris Club debt. The cancellation of this debt results in a dramatic improvement in the country's creditworthiness indicators, especially after 1992. It has prompted the Government to target ambitious macroeconomic objectives: convertibility and a balanced budget by 1993. 1mlogment Generation and the Development of Infrastructure have Lagged Behinb 15. Despite Morocco's macroeconomic achievements, it is facing major challenges. While GDP growth was exceptional in the second half of the eighties, unemployment remains very high, at around 15X i.t urban areas, and anecdotal evidence suggests large wealth imbalances. The labor force grew at 3.21 per year owing to the demographic momentum inherited from earlier periods. Since the rate of increase of the labor force will not drop much below 31 until the late 1990s, the economy must sustain a high growth path just to avoid severe social stress triggered by critical levels of youth unemployment. 16. Essential to the country's development is the rehabilitation and development of infrastructure, critical to support private sector activity. While the civil service is large and represents 75X of non-interest current expenditures, basic public investment is inadequate. Up to 60% of tertiary roads, more than 45% of the total road network, were deemed in bad condition in 1988, compared with 401 five years earlier. As a result of accumulated delays in maintenance, most of these roads now need extensive rehabilitation before they can receive regular maintenance. Telecommunications and utilities have become increasingly deficient in critical areas. By the end of 1986, Morocco had less than one line per 100 inhabitants, compared with two per 100 inhabitants in Algeria and Tunisia, and five in Turkey. The existing network meets less than 601 of expressed demand (with waiting time for new connections averaging  - 6 A six years), and it is of poor quality. Modern communicat..on sr 'Ices necessary to compete in interrational markets are virtually unavailable. The Need to Provide Social Services is Immense 17. Morocco's welfare indlicators are much lower than those of countries with similar per capita incomes. Child and maternal mortality, nutritional status, access to safe water, illiteracy, urban employment, and child labor are critical poverty issues.3 In particular, 55X of males and 78X of females are illiterate. Quite apart from equity considerations, illiteracy, through its effect on labor qualifications, is a big handicap for Morocco's expanding export sector. As for infant mortality, this is higher than countries at comparable income levels: 73 per 1000 live births. Moreover, there is wide disparity between urban and rural areas, with a range of 50 to 198 deaths per 1000 live births. Both the volume and the "quality" of some social expenditures are inadequate (para. 45). PART If - THE STRUCTURAL ADJUSTMENT PROGRAM AND THE CHALLENGES OF THE 199 18. During the last decade of the twentieth century, Morocco faces three related challenges: (1) to develop an efficient private sector; (2) to resume normal external financial relations; and, most critical, (3) to achieve a more equitable distribution of welfare. To contribute to these objectives, SAL-II proposes to support the Government's objective to ensure the reallocation of public expenditures to respond to critical social needs and to further strengthen private sector development. .he proposed loan would also support the elaboration of a poverty reduction strategy for the 1990s. Together with the increased public provision of social services, private sector growth, through employment and income generation, would contribute to a more equitable distribution of welfare. SAL-II would also support further liberalization of the trade regime. Increased competition from abroad under stable macroeconomic conditions and the recent liberalization of the financial sector are the best guarantees for dynamic and efficient private entrepreneurial activity. 19. Consistent with the foregoing, and with the Bank's strategy and lending program, SAL-II would focus on four components: (1) macroeconomic framework; (2) public expenditure rationalization; (3) the articulation of a poverty reduction strategy; and (4) trade liberalization. The macroeconomic framework is consistent with the IMF program (para. 93). The following sections, and the matrices as well as the Letter of Development Policy in the annex, describe the Government's adjustment program. A selected set of the measures presented constitute specific conditions for second trancbe release (see Part III). They have been selected on the basis of two considerations: (a) they are critical to get the program completed; and (b) tney are easily monitorable. ]/ World Bank, "Morocco - Reaching the Disadvantaged: Social Expenditure Priorities in the 1990s," Report No. 7903-MOR; Table 10.  - 7 - A. THE NACROECONOMIC FRAMEWORK: ACHIEVIZG A MORI OFICIENT SEEL-FIN&NCED ORQOTH The SAL-I Framework: -o rras- to Date 20. An important objective of the first SAL, presented to the Board in 1988, was to reinvigorate the economy by bringing average growth above the 3.31 of the preceding years. During 1988-90, growth improved to almost 5X a year. A second objective was for SAL-I to serve as the starting point for a series of operations that would help restore Morocco's access to international financial markets by the mid-1990s. Morocco is now close to balance of payments viability, and creditworthiness indicators have improved significantly. The ratio of debt outstanding to GDP and that of debt survice to exports have both met the improvements anticipated under the first SAL. Most of the macroeconomic indicators targeted under SAL I have been met (Table 1), and some have been surpassed. The few transitory deviations, such as the low level of foreign assets in 1989, were discussed with the Government, which took corrective measures to bring the economy back to its projected path. !able 1: MACROECONOMIC IEDICATORS NONITORED UNDER SAL-I 1988 1989 1990 Total Gross Fixed Capital Formation/GDP - SAL-I 19.01 19.5X 20.0X - Actual 20.5X 23.1X 24.6X Gross Public and Publicly-Guaranteed External Debt/Total Foreign Exchange Earnings - SAL-I 2.8 2.6 2.4 - Actual 2.9 3.2 2.6 Real Growth Rate of Manufactured Exports - SAL-I 12.01 10.01 10.01 - Actual 14.0X 13.12 22.1X Net Foreign Assets of Bank Al-Maghrib (US$ million) - SAL-I 450 850 1,050 - Actual 500 463 2,040 Nacrosconomic Priorities 21. Morocco's macroeconomic priorities for the first half of the 1990s are to inctease growth, improve the fiscal stance, and attain balance of payments viability. Higher growth would increase opportunities to bring larger groups of the population into the development process so that they could share. its benefits. Fiscal discipline contributes to domestic and external macroeconomic stability and to private sector development by avoiding private sector crowding  -8- out and providing a credible macroeconomic framework, particularly important during a period of structural reforms. Balance of payments viability, strongly supported by fiscal adjustment, would help Moroaco return to voluntary lending and increase foreign investment during the 1990s. 22. High_er growth. The growth rate of GDP should accelerate from about 4X in the second half of the 1980s to over 51 a year by the end of the 1990s (Table 2). The two main sources of the increase in growth would be the productivity gains resulting from the reforms, and the expansion in the share of private sector investment in GDP by four percentage points over 1990-98. A public investment program of about 4.41 of GDP would provide the physical and social infrastructure needed to sustain this growth. 'The resulting expansion of national income would in turn allow both an increase in per capita consumption growth to 2.2% a year by the late l990s, and an improvement in Morocco's savings mobilization. The systematic growth in private consumption, in both rural and urban areas, would help alleviate social pressures. Table 2: MACROECONOMIC FRAMEWORK FOR THE 1990s * (in X) 1990 1991 1992-93 1994-98 Real GDP Growth 2.6 4.2 4.3 5.0 Current Account/GDP / -2.6 -2.9 -1.7 -0.3 Budget Deficit/GDP /1' -2.2 -3.0 -0.4 -0.1 Gross Domestic Investment/GDP 25.7 24.5 25.1 25.7 Debt Outstanding/GDP 19 93.3 82.9 75.5 55.3 Debt Service/XGS /A 45.0 35.6 32.5 23.3 Real Import Growth 12.6 4.0 5.3 5.8 Real Export Growth /A 19.6 2.6 8.1 6.9 /a Before debt relief. /d Commitment basis. /o After debt relief. /_ Export growth drops in 1991 because of the large drop in tourism. * This framework is based on World Bank price projections for a base scenario and assumes SAL-II reforms will be carried out as scheduled. 23. Sustainable budget deficit. Expansion of private investment, both domestic and foreign, requires a stable macroeconomic environment. A necessary condition for macroeconomic stability is a low and predictable budget deficit with financing that is compatible with a viable balance of payments, low inflation, and greater private sector access to bank credit. For 1992-95, this would mean a budget deficit of about 0.41 of GDP (Table 2). Although difficult, it is attainable: in 1990 the budget deficit on a cash basis was already down to 3.41 of GDP. This fiscal effort should be consolidated and strengthened in the second half of the 1990s, when the commercial banks' rescheduled public debt comes due. The Government's enhanced contribution to the increase in national savings is, therefore, critical for both domestic private sector development and an improved current account (Table 4).  - 9 - 24. Balance of -ayments viability. Achieving a viable balance of payments by 1993, which would be sustained thereafter, is another cornerstone of Morocco's macroeconomic stability. It hinges on completing the trade reforms and increasing creditworthiness. As exports grow and diversify following the completion of the trade reforms, the resource gap would be reduced from 6.11 of GDP in 1990 to 3.61 by 1995. And as foreign investment expands and voluntary projezt-related financing resumes with improved creditworthiness, the composition of capital inflows would improve. The resulting balance of payments viability will greatly facilitate the transition to full convertibility of the dirham, now envisaged for 1993, further strengthening confidence in the economy. 25. The significant external adjustment should take place early on, before convertibility is implemented and when principal repayments are relatively low due to recent reschedulings. The reduction in the resource gap, supported by appropriate fiscal and exchange rate policies, will obviate the need for exceptional financing after 1992 and allow Morocco to face the more stringent debt service requirements in the second half of the decade. Under the most likely scenario, net exports would grow vigorously in response to the trade reform. Exports--benefiting from both fiscal and monetary policies consistent with the necessary real effective exchange rate to maintain a constant non- interest current account, and the trade reform- -would grow at high rates, reaching 8.51 in 1993.4 In the mid-1990s, export and import growth rates, while still exceeding GDP growth, would be compatible with a manageable resource gap maintained at about 3.61 of GDP and a non-interest current account surplus at 3.61 of GDP. The reduction in the resource gap, together with a fall in interest payments on foreign debt from about 61 of GDP (before debt relief) in 1988-89 to about 3.6X in 1994-98 (Table 3), would bring the current account deficit to less tharn 11 of GDP in the mid-1990s. 26. As noted earlier, our current assessment shows that further commitments for exceptional financing, such as reschedulings or debt reduction, would not be required beyond those already obtained. The financing of the capital account reflects the latest rescheduliig agreement reached (see para. 13), which cover arrears as of January 31, 1992 and maturities falling due between February 1 and December 31, 1992, for the Paris Club, and in 1990-97 for the London Club. Debt obligations to Saudi Arabia for around US$2.7 billion have been eliminated. 27. Beyond 1993, external financing requirements should be within the limits that Morocco can expect through normal access to official and private sources. First, as the reforms are completed, direct foreign investment would increase from US$217 million in 1990 to almost US$800 million a year in the second half of the 1990s, about 1.51 of GDP. Given foreign investors' growing interest in Morocco, this is a reasonable estimate. In fact, it could reach even higher levels in coming years, especially if the privatization program is successful. Second, gross medium- and long-term disbursements of public and publicly-guaranteed debt, which averaged US$1.4 billion annually in the 1980s, would increase to about US$1.75 billion a year in 1991-98 (US$430 million from private creditors, US$540 million from bilateral creditors, and about US$780 million from multilaterals). Because repayment obligations are expected to be _/ Although this is lower than recent export growth, it starts from a significantly higher initial export base. International experience shows that such a drop in export growth rates should be expected.  - 10 - Table -3: XTERNAL PINANCING REQUIREMENTS (as a percentage of GDP) 1988-89 1990-91 1992-93 1992-98 Non-interest Current Account 4.2 2.8 3.6 3.3 Interest Before Debt Relief -6.1 -5.6 -5.3 -3.6 MLT Payments Before DR -7.7 -6.8 -5.0 -4.2 Change in Reserves /a (incl. IMF) -0.9 -5.1 -1.5 -1.7 Total Requirements -10.5 -14.7 -8.2 -6.2 Total Debt Relief 6.2 4.8 1.1 0.0 - Interest 1.1 1.2 0.2 0.0 - Amortization 5.0 3.6 0.9 0.0 Voluntary Foreign Financing 4.3 9.9 7.1 6.2 - MLT Disbursements 5.6 5.7 5.7 4.5 - Other Capital /k -2.0 3.4 0.2 0.1 - Direct Foreign Investment 0.8 0.8 1.1 1.6 /a Minus represents an increase in reserves. ,1k Includes official capital grants. about US$1.5 billion a year, net disbursements would be low and declining, but enough to cover both the declining current account financing requirements and a systematic buildup of foreign reserves. 28. A smaller resource gap would reflect the country's increased savings mobilization effort and hence the narrower investment-savings balance. The largest contribution toward narrowing the resource gap would come from fiscal discipline, which would add around 4X of GDP to the national savings rate over 1991-98 (see Table 4). 1g~Isa.: 13YTW MD SAVIM UTAES. (As a percentage of GDP) im 1989 1m I IM 1993 225 IM Investment 21.1 24.0A AliS 24 24.9 25.2 2lS ILu - Noncv.rnuent 16.5 18.6 20.1 10.5 10.8 20.0 20.2 20.5 - Government 4.1 4.4 4.5 4.0 4.1 4.2 4.4 4.4 - Changes in Stock 0.6 1.0 1.1 1.0 1.0 1.0 1.0 1.0 not Foreisn Savinasf -2.2 LI 0._ LI LI L4 ga LI National savinags IL 20.6 25.0 22.2 2 U 23.9 2.6 - Nonsovernient 20.3 18.6 19.9 18.1 17.6 17.7 18.6 17.7 - Government 3.0 2.0 5.1 4.1 5.7 6.2 6.9 7.9 Ig The somewat large increase in 1990 represents lUrge machLnery purchases of two public enterprises whicb are included under non-Goverment.  - 11 - Indicators to Assess the Outcome 29. The set of macroeconomic indicators monitored under SAL-I (para. 20) would continue to be monitored under SAL-II, to help ensure that the economy remains within the desired growth path. The list of monitored indicators would be expanded to include direct foreign investment, a key government target for the 1990s. The five indicators, whose targeted paths are presented in Table 5, are as follows: (a) the ratio of gross fixed capital formation to GDP; (b) the ratio of gross public and publicly guaranteed debt outstanding to total foreign exchange earnings; (c) the real rate of growth of manufactured exports; (d) the net foreign assets of Bank Al-Maghrib; and (e) direct foreign investment. 30. These indicators would be reviewed semiannually. Deviations from the projections in Table 5 would t-igger discussions with the Government to identify underlying problems and explore corrective policy measures. In the past two years, this monitoring of macroeconomic indicators has facilitated discussion among the Government, the IMF, and the Bank (para. 20). As a result of the lower foreign exchange earnings, particularly of tourism, due to the Gulf crisis, the ratio of external public debt to foreign earnings increased to 2.5 in 1991. Similarly, direct foreign investment dropped below the 1990 level and is expected to recover in 1992. The indicators included extend beyond the duration of SAL-II in order to provide continuity to the economic dialogue in the context of the Bank's overall lending program. Table S: MACROECONOMIC INDICATORS TO BE MONITORED UNDER THE SAL 1291 1992 1993 1224 Total Gross Fixed Capital Formation / GDP (X) 23.5 23.9 24.2 24.4 Gross Public and Publicly Guaranteed External Debt / Total Foreign Exchange Earnings 2.5 2.3 2.1 1.9 Real Growth Rate of Manufactured Exports (%) 9.0 9.5 9.0 9.0 Net Foreign Assets of Bank Al-Maghrib (USg million) 2,900 3,200 3,400 3,600 Direct Foreign Investment (US$ million) 180 300 400 500  - 12 - B. PIBLIC RXPVDIT 31. The Bank's support to Morocco in ensuring adequate public expenditures to promote private sector and social development follows a two- pronged approach: (a) devising a framework for the level and allocation of expenditures; and (b) ensuring the quality of projects at the microeconomic level. The public expenditure component of the proposed SAL-II, in line with SAL-I, focuses on the first of these two issues by defining a level of public investment and a minimum allocation for critical social expenditures to complement the development of a poverty reduction strategy. 32. The second aspect of this strategy, dealing with the quality of public investment, is addressed through other parts of the lending and sector work program at three levels. First, infrastructure needs, such as ports and roads, are supported through specific operations, including the two recently approved Ports Sector and Fifth Highway projects. The quality of infrastructure investment in agriculture is being addressed in the Agricultural Sector Investment Loan (ASIL). Second, the quality and adequacy of social expenditures are being addressed through operations in health (Health Development and Health Sector Investment Projects), basic education (Rural Primary Education and Rural Basic Education Project), vocational training and skill development (Vocational Training I and II Projects), nutrition (sector work on Food Security and Nutrition), and employment services. In addition, the proposed SAL will lead to two comprehensive Social Priority Sector Loans, providing support for a broad range of critical human capital investments against a background of retargetting of expenditures and resource mobilization policies. Progress to Date 33. SAL-I supported the Government's objectives: (a) to maintain a minimum level of central government investment (Target Investment Program--TIP) consistent with an increase in government gross fixed capital formation from 3.51 of GDP to 4.2Z by 1991, and (b) to strengthen investment planning and budgeting to improve the management and efficiency of public investment expenditures. 34. These two objectives have been met. First, quarterly reviews of the TIP have shown that the targets set under SAL-I have been attained despite a large budget reduction in 1990. Payment orders approved by the Treasury General increased from 2.61 of GDP in 1988 to an estimated 3.31 in 1990 for the six main ministries5 (see para. 37). Second, new budget preparation and control procedures have considerably improved the efficiency of the public investment process. Payment delays were reduced from four months in 1984 to one and half months in 1989. The budget staff can now monitor the evolution of commitments, payment orders, cash disbursements, and performance ratios over the course of the year. Assessments of the use of investment appropriations are obtained within two to three months from the end of the quarter, and unused but committed credits are automatically carried over to the following year. As a result, the ratio of payment orders to investment authorizations continued to improve, from 301 in 1986 and 501 in 1987, to 651 in 1989 and 1990. These efforts have been complemented by a new budget nomenclature. The budget office and the offices of / Including DH 600 million in projects carried out by the local governments in 1990 on behalf of the central government. The TIP is a subset of the government investment program.  - 13 - the comptroller of commitments and expenditures (CED) and the Treasury General have been gradually computerized. The Bank's Public Administration Loan (PAL) has provided institutional support, technical assistance, and training programs to support the public expenditure program of SAL-I. 35. SAL-I also supported a major fiscal reform that increased fiscal revenues by about two percentage points of GDP between 1987 and 1989. The reform eliminated the cascading effect of indirect taxes by introducing the VAT system; simplified direct taxation; reduced maximum corporate rates from 52.8X to 44X; and made direct taxation more. equitable. The elimination of a number of exemptions to the VAT broadened the indirect tax base. The General Income Tax was introduced in 1989, replacing the existing schedular system by a uniform income tax schedule and reducing the highest marginal tax rate. Fiscal exemptions from profit taxes were shortened from 10 to 5 years and the exemption rate reduced from 100l to 501 for all sectors (except for some regions) other than export-oriented activities. Finally, as part of the stand-by agreement with the IMF (para. 93), revenue options have been agreed upon. These include a tax on the National Phosphate Company (Office CharlfIen des Phosphates, OCP), an increase in the minimum corporate tax, and an extension of the VAT to retailers. Projram to Be SuMported by the SAL 36. The public expenditure component of SAL-II would include three elements to support the desired acceleration in private sector development. Firs,1 the public investment program would be extended to include those expenditures transferred from the central budget to local communitits. Second, private investment would be promoted through SAL-II's support of the reform of investment incentives, which will rationalize fiscal incentives to invest and eliminate the exemptions that encourage tax evasion and distort resource ailkCAtion. Third, the possibility of private sector provision of basic infrastructure will be explored. The Public Investment Plan 37. The authorities and the Bank have developed a common view of central government investment priorities over the medium term. The plan covers investment expenditures of six core ministries6 and is consistent with the overall macroeconomic prospects of the country over 1992-95.7 38. SAL-II would support the authorities' decision to protect the core investment necessary to support private sector activity. Investment appropriations for the core ministries (including transfers to local communities) would be kept at least constant relative to GDP in the period covered by the proposed operation, with 1990 as a base year. The macroeconomic framework envisages further reductions in the budget deficit in the coming years. In this context, the proposed loan would support a shift in budget spending priorities, by ensuring that a minimum investment in infrastructure is maintained throughout the budget reduction process envisaged for 1992-93 and social spending even hI The six ministries covered under SAL-I and SAL-II are Agriculture and Agrarian Reform; Public Works, Vocational Training and Staff Training; Transport; National Education; Health; and Housing. i/ The budgetary impact of the proposed measure is summarized in para. 81.  - 14 - increases (see paras. 50-53). The public investment plan would require payment orders to increase in nominal terms by an average of DH 750 million a year, stabilizing at about 3.252 of GDP. The public investment plan would be reviewed for second tranche release, when the 1993 Finance Bill is prepared, keeping in mind the perrormance of important macroeconomic indicators. Investment Incentives 39. Investment incentives were revised under SAL-I to reduce their fiscal costs. In 1988 tax holidays were significantly shortened. There is still considerable room for improvement, however. Seven differeni: codes, covering industry, tourism, exports, real estate, maritime, mining, and handcrafts, address investment incentives. The ad hoc incentives provided in these codes, with tax exemptions, no ex-post controls, and different criteria for approval, have resulted in si-nificant distortions in resource allocation. They have also unintentionally favored real estate speculation since corporate tax and tax exemptions for capital gains make investment in other sectors relatively unattractive. Furthermore, the cost of these codes to the Government in revenue foregone is substantial.8 40. SAL-II would support the administration's efforts to reform the system of investment incentives. The results of a study carried out by the Government have prompted the authorities to call for either the unification of the existing codes in one single text or the elimination of the sectoral investment codes altogether. If the latter approach is adopted, any investment incentive would become part of the fiscal legislation, granted independently of the sector and location in which the investment is made. Either system would eliminate the distortions inherent in the sectoral approach to investment incentives, ensure greater transparency and reduce budgetary costs by eliminating cash outlays in the form of interest rebates and other subsidies. The draft texts spelling out the new system will be submitted to the Council of Government before second tranche release. An Expanded Role for the Private Sector 41. Some of the services now offered by the Government could be offered by the private sector, thus increasing efficiency and reducing the burden on the budget. The proposed SAL would support the Government's efforts to encourage private sector provision of services as part of its long-term reform program. This strategy is consistent with the objectives of (a) reducing fiscal imbalance without exerting excessive fiscal pressure on the economy, and (b) promoting the role of the private sector as the engine of economic growth. The SAL program would include a study to identify areas in which the private sector could promote services, including higher education and road and port infrastructure. The study would draw on current work undertaken for the preparation of the Transport Sector Master Plan, higher education financing reforms, and the authorities' privatization program. LI See the recent IMF Technical Assistance Report on taxation "WARC : Vers le renforcement et la consolidation des r6formes fIscales", May 1991.  - 15 - C. POVT REDUCTION SaAMT