Zambia - Second Economic Recovery Credit (ERC II)

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 13238 PERFORMANCE AUDIT REPORT ZAMBIA SECOND ECONOMIC RECOVERY CREDIT (ERC II) (CREDIT 2214-ZA) (SUPPLEMENTAL CREDITS 2214-1-ZA AND 2214-2-ZA) JUNE 29, 1994 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 EOUIVALENT (period average) Currency Unit = Kwacha (K) Initial Year (March 1991) Completion Year (June 1992) US$1.00 = K 53.3 US$1 = K 148.9 ABBREVIATIONS AND ACRONYMS ERC - Economic Recovery Credit ESW - Economic and Sector Work OED - Operations Evaluation Department OGL - Open General License PAR - Performance Audit Report PCR - Project Completion Report SAL - Structural Adjustment Loan (Credit) SAP - Social Action Plan ZCCM - Zambia Consolidated Copper Mines FISCAL YEAR January I - December 31 FOR OFFICIAL USE ONLY THE WORLD BANK Washington, D.C. 20433 U.S.A. Office of Director-General Operations Evaluation June 29, 1994 MEMORANDUM TO THE EXECUTIVE DIRECTORS AND THE PRESIDENT SUBJECT: Performance Audit Report on Zambia - Second Economic Recovery Credit (Credit 2214-Z4. Supplemental Credits 2214-1-Z4 and 2214-2-Z4) Attached is the Performance Audit Report on Zambia - Second Economic Recovery Credit (Credit 2214-ZA, Supplemental Credits 2214-1-ZA and 2214-2-ZA) prepared by the Operations Evaluation Department. The objectives covered six areas: macroeconomic stabilization, liberalization of the agricultural sector, expansion and improvement of the Government's Social Action Program, trade liberalization, expansion of the private sector, and restructuring and reforming the civil service and the parastatal sector. Bank-country dialogue improved significantly during the ERC II implementation. Zambia's economic situation, however, deteriorated significantly, partly as a result of a severe drought. This PAR rates the ERC II outcome as satisfactory, as did the PCR. Sustainability however is rated as uncertain and institutional development as negligible. The satisfactory outcome rating reflects ERC II's pivotal role in helping the Government change its approach away from reluctant and toward active and credible attempts to carry out adjustment measures. Thus, although there was modest compliance with the specifics of conditions in five of the six areas, and complete compliance with those relating to trade liberalization, the most significant development was Government's adoption of a pro-active attitude toward adjustment. Sustainability is rated as uncertain primarily because of the stagnation and decline in the private, formal economy coupled with rapid growth in the informal economy. Lessons from this evaluation of ERC II include the important role which the decontrol and rapid rise of interest rates had in increasing the effectiveness and credibility of the Government's stabilization program. In addition, they point to the need for Government policies to reduce costs of operation in the formal economy, to reduce the Government expenditure/GDP ratio and to alter the composition of such expenditures so as to more efficiently provide the formal sector with access to infrastructure. Robert Picciotto by H. Eberhard K6pp Attachment 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.  FOR OFFICIAL USE ONLY PERFORMANCE AUDIT REPORT ZAMBIA SECOND ECONOMIC RECOVERY CREDIT (ERC II) (Credit 2214-ZA) (Supplemental Credits 2214-1-ZA and 2214-2-ZA) TABLE OF CONTENTS Page No. PREFA CE ......................................... ...... .. i BASIC DATA SHEET........................................... i EVALUATION SUMMARY ....................................... v I. INTRODUCTION. .......................................1 II. BACKGROUND ....1............................. . III. THE POLICY PROPOSALS AND IMPACT OF ERC II ............... 3 The Policy Proposals in ERC II .............................. 4 The Impact of ERC II. ....................................5 Macro and Stabilization Measures ........................... 6 Liberalization of the Agricultural Sector ....................... 6 The Social Action Program ............................... 7 Trade Liberalization .................................... 7 Privatization .................... 7 Restructuring the Public Sector with Civil Service and Parastatal Reform . .. 8 IV. THE INSTITUTIONAL ROLE OF IDA ......................... 8 V. OVERALL ASSESSMENT. .................................9 The Success of ERC II.....9 The Sustainability of ERC II .............................. 9 VI. LESSONS LEARNED .................................... 10 Appendix I: Policy Matrix and Implementation ... ............................ 13 Attachment: Comments Received from the National Commission for Development Planning ........................................... 19 This report was prepared by Robert Myers (Task Manager) and Gilbert Uwujaren (Consultant) who audited the project in February 1994; Geri Wise provided word processing assistance. 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.  PERFORMANCE AUDIT REPORT ZAMBIA SECOND ECONOMIC RECOVERY CREDIT (ERC II) (Credit 2214-ZA) (Supplemental Credits 2214-1-ZA and 2214-2-ZA) PREFACE This is a Performance Audit Report (PAR) on the Second Economic Recovery operation (ERC II) for Zambia. The Credit, in the amount of SDR 149.6 million ($210.0 million equivalent) was approved on March 5, 1991. In addition, through the reflows program two supplemental credits, Cr. 2214-1 in the amount of SDR 19.4 million (US$27.2 million equivalent) and Cr. 2214-2 in the amount of SDR 7.6 million ($10.0 million equivalent), were approved in support of the program. The credits were fully disbursed and closed on June 30, 1992, as scheduled. The PAR is based on the Project Completion Report (PCR) prepared by the Africa Regional Office and issued in 1993,1' the President's Report, sector and economic reports, the credit documents, summaries of the Board discussions, study of the program files, and discussions with Bank staff. An OED mission visited Zambia in January/February 1994 and discussed the effectiveness of the Bank's assistance with Government officials, the donors, and the business community. Their kind cooperation and invaluable assistance in the preparation of this report is gratefully acknowledged. The PCR included a limited account of the program experience and implementation, and a discussion of the performance of the Bank and the Government. The PCR suggests that the implementation of ERC II was satisfactory. This PAR rates the ERC II as satisfactory, but with uncertain sustainability and with negligible institutional development. The successful rating is not based on specific compliance and the impact of ERC II conditions. Rather, it reflects ERC II's pivotal role in helping the Government change its approach away from reluctant and toward active and credible attempts to carry out adjustment measures. Thus, although there was modest compliance with the specifics of conditions in five of the six areas, and complete compliance with those relating to trade liberalization, the most significant development was Government's adoption of a pro-active attitude toward adjustment. Sustainability is rated as uncertain primarily because of the stagnation and decline in the private, formal economy coupled with rapid growth in the informal economy. These developments suggest that new policy initiatives are needed to lower costs of operation in the formal sector, reduce the Government expenditure/GDP ratio and change the composition of Government expenditures. The draft PAR was sent to the Borrower for comments; the comments received from the National Commission for Development Planning are reproduced as an Attachment to the PAR. 1' PCR, Zambia - Second Economic Recovery Credit (Credit 2214-ZA and Supplemental Credits 2214-1-ZA. 2214-2-ZA), Report No. 12437, November 2, 1993.  - III - PERFORMANCE AUDIT REPORT ZAMBIA SECOND ECONOMIC RECOVERY PROJECT (ERC II) (CREDIT 2214-ZA) BASIC DATA SHEET CREDIT POSITION (Amounts in US$ Million) As of May 31, 1994 Credit Original Disbursed /a Cancelled Repaid Outstanding /a 2214 210.0 208.9 - - 211.7 2214-1 27.2 27.0 - - 27.5 2214-2 10.0 10.9 - - 10.8 247.2 246.8 CUMULATIVE ESTIMATED AND ACTUAL DISBURSEMENTS la FY91 FY92 FY93 Actual (US$M) 2214/2214-1/2214-2 155.9 245.7 246.8 Date of Final Disbursement: March 18, 1993 PROGRAM DATES Original Actual Initiating Memo 08/16/90 08/16/90 Negotiations 02/01/91 02/01/91 Letter of Development Policy 02/01/91 02/01/91 Board Approval 03/05/91 03/05/91 Signing 03/13/91 03/13/91 Effectiveness 03/13/91 03/13/91 Second Tranche Release 08/30/91 01/31/92 Credit Closing 06/30/92 06/30/92 /a Disbursed and outstanding amounts differ from the original amount of the credits in terms of US$ because of changes in the USS/SDR exchange rates. -iv - STAFF INPUTS (staffweeks) FY88 FY89 FY90 FY91 FY92 FY93 EY9 I Preappraisal - - 94.3 16.9 - - - 111.2 Appraisal - - - 47.6 - - - 47.6 Negotiations - - - 11.0 - - - 11.0 Supervision - - - 11.2 22.2 9.3 0.1 42.8 Other 0.3 - 34.6 1.8 - _ 3 Total 0.3 - 94.3 121.3 24.0 9.3 0.1 249.3 MISSION DATA No. of No. of Staff Report Month/Year Weeks Persons Weeks N Appraisal 08/90 2 8 16 09/19/90 Supervision I 04/91 1 2 2 n.a. Supervision II 06/91 1 2 2 n.a. Supervision n11 08/91 1 2 2 n.a. Supervision IV 11/91 1 2 2 n.a. Supervision V/Completion 01/93 1 2 2 06/18/93 YEAR-END ANNUAL REPORT ON PORTFOLIO PERFORMANCE RATINGS Evaluation Development Legal Management Year Overall Objectives Covenants Performance 1991 2 2 2 2 1992 2 2 2 2 OTHER PROGRAM DATA Borrower/Executing Agency: The Republic of Zambia Follow-on Operations: Project: Privatization and Industrial Reform Credit No.: 2405/2405-1-ZA Amount: US$220.9 Board Date: June 30, 1992 Project: Privatization and Industrial Reform II Credit No.: 2523/2523-1-ZA Amount: US$110.0 Board Date: June 24, 1993 -v - PERFORMANCE AUDIT REPORT ZAMBIA SECOND ECONOMIC RECOVERY CREDIT (ERC II) (Credit 2214-ZA) (Supplemental Credits 2214-1-ZA and 2214-2-ZA) EVALUATION SUMMARY 1. This is the Performance Audit Report of income fluctuations, while taxing the copper the Zambian Second Economic Recovery Credit sector and engaging in modest, long-term ex- (ERC II -- Credits 2214-ZA, 2214-1-ZA and ternal borrowing to finance diversification, or 2214-2-ZA) for US$247.20 million presented to non-copper, productive investments. The alter- the Board on March 5, 1991. Most of the native was to use copper windfalls and too much disbursements from the operation freed up foreign borrowing to finance excessive consump- foreign exchange which was used to clear ar- tion. This latter is essentially what occurred in rears or pending debt service obligations to the Zambia. The Government employed heavy Bank. The credit was a follow-up to the first intervention into the productive and distributive Economic Recovery Credit (ERC I) which was elements of the economy, thereby suppressing audited by OED (see Report No. 12100 dated profits and profit earning by private households. June 29, 1993) and was rated unsatisfactory. This engendered a situation in which a signifi- ERC I was undermined by a lack of political cant share of what might have been reinvested commitment and implementation capacity, and, profits was instead transferred, frequently "in prior to release of the second tranche, by a kind", to households for consumption. Thus, break in relations between Zambia and the Bank Zambia began to experience a serious case of the and IMF. ERC II was different; it successfully "Dutch disease". The economy stagnated, the supported Zambia's return to the international tax base and tax collections relative to GDP mainstream and initiated an intensity of reform declined, and inflation and other indicators of which is remarkable by past standards in macro instability appeared. Zambia. Several developments subsequent to ERC II suggest that Zambia is beginning to 3. Adjustment attempts prior to ERC II were transform an economy formerly dominated by characterized by the Government's lackluster Government and an ethos of socialism. How- adjustment performance, including, at times a ever, the rapid growth of the informal and the near avoidance of compliance with adjustment stagnation of the formal economy suggest that conditions. As a result, the lack of diversifica- the sustainability of the policy impact of ERC II tion, increased inefficiencies, particularly in the is uncertain and rests on appropriate solutions to copper sector, increasing external debt servicing some remaining, quite difficult transition prob- requirements and Government attempts at self- lems. preservation caused GDP to stagnate and the real value of the income transfers to households to 2. Because Zambia has been so extremely decline. This, in turn has stimulated households dependent on copper, it has been susceptible to to save and invest in order to attempt to replace copper price and export "shocks". The ap- the real income foregone. However, because it propriate overall adjustment policy, given this is easier and less costly, they have been dependency, was to engage in offsetting short- investing in the informal rather than formal term external lending and borrowing, to smooth economy. The informal economy has, there- - Vi - fore, grown rapidly while the formal economy ERC II period. Much agricultural liberalization and the country's tax base first stagnated and occurred, but it was inconsistent and, in com- then declined, thus calling into question any bination with the drought, resulted in some macro stabilization which did not involve a decapitalization of the sector. Although some significant cut in Government expenditures. specific conditions regarding the SAP were not Since there has been a significant amount of fulfilled, the program was innovative. Further- foreign borrowing and successful trade liberal- more, it was essentially the case that trade ization in recent years, the prospects for obtain- liberalization, long an adjustment aim, was ing protection from imports, and, therefore, completed under ERC II. Tentative initiatives easily garnered scarcity rents, are poor. Instead, regarding privatization, and restructuring of the ease and lower costs of operation in the public enterprises and the civil service were also informal sector attracted most of the private made. investment in the country. 6. IDA's institutional role under ERC II was 4. The immediate financial objective of at extremely supportive of the Government's new least the first tranche of ERC II was the clear- approach to implementation of adjustment poli- ance of Zambia's arrears to the World Bank and cies. IDA maintained an active relationship with the IMF in order to regularize its international Zambia even after the country "broke relations" debt relations and bring the country back into with the Association mid-way through ERC I. the international financial community. The Both for the first and the second tranches IDA policy proposals in the ERC II consisted of staff helped arrange bridge loans, one with the particular policies grouped under six policy Bank of England and, for the second tranche categories. Two very significant ones involved release, one with Citicorp. Principally because macroeconomic stabilization and liberalization of of a sustained and professional effort by the the agricultural sector. Two more involved country team and the Resident Mission, Zambia continuing and improving support for the Gov- now has one of the most active country dia- ernment's Social Action Plan (SAP) and the logues with IDA in Sub-Saharan Africa. increasingly successful trade and foreign ex- change liberalization program. The final two Lessons Learned related to newer initiatives concerning privatiza- tion and public enterprise and civil service (i) One lesson from ERC II is that in Zambia, restructuring. Compliance with these adjustment where virtually all prices had previously conditions was much better than in the past even been controlled, it was the belated liberaliza- though there were inconsistencies, as the "Imple- tion of, and subsequent dramatic rise in, mentation/Performance" and "Remarks" columns nominal interest rates, including those paid of the attached policy matrix (Appendix 1) show. by the Government, which presaged ERC II's successful influence on macro- 5. The impact of ERC II cannot be seen in economic stability. The dramatic rise in the movement of official statistical data, which interest rates signalled the end of the Gov- worsened during the ERC II period, but in the ernment's attempt to finance its deficit with shift in the intensity of the Government's efforts excessive money creation and seignorage to carry out its adjustment program. Expecta- taxes. This increased the Government's tions, including those set out in the macro stabilization credibility. Rising real interest framework, were too optimistic and did not rates can also be viewed as sending a signal allow time for adjustments to work out. None- that savers and investors can expect to be theless, progress, particularly in trade liberaliza- better compensated providing adjustments in tion, was achieved even during the ERC II the real economy are consistent with these period. Nominal interest rates were finally freed higher rates. This is a reversal of the up and rose rapidly, finally becoming signifi- previous precedent when, under a more cantly positive about a year after the end of the socialist regime, real interest rates were - vii - negative thus depressing saving and investing (iii) A final lesson relates to the impact which behavior. asymmetrically rapid growth in the informal economy can have on the Government bud- (ii) A second lesson concerns the message which get. In order to capture more taxes and a rapidly growing informal economy sends draw some informal activities into the formal about a stagnating private, formal economy sector, adjustment programs should include in a setting in which liberalization of the tax reforms which increase the use of VAT trade and foreign exchange regimes has been or expenditure taxes. However, since the successfully completed. In such settings, informal economy won't pay normal scarcity rents are likely to be very low so amounts of taxes, even if indirect that the differentials in rates of return in the expenditure taxation is significant, it is likely two sectors signal differentials in cost of that the tax/GDP ratio cannot rise very much operation. In Zambia, formal sector pro- over the medium term and thus cannot be ducers are not complaining about a loss of counted on to reduce deficits. Instead, the protection, but rather about a legacy of labor Government expenditure/GDP ratio will laws and conventions, Government regula- have to be lowered somewhat if deficits are tions and excessive user charges, and poorly to be reduced. However, these expenditure maintained infrastructure which make their cuts could have an additional, negative taxes and costs of operation too high, so that impact on private, formal sector incentives. they cannot compete with imported goods This calls for a careful examination of the and informally provided services. This composition of government expenditures suggests that if future adjustment operations with a view toward shifting them so as to are to be more sustainable, they should focus improve the private, formal sector's access to a greater extent on removing impediments to efficiently provided infrastructural goods to cost reductions in the private, formal and services. sector.  PERFORMANCE AUDIT REPORT ZAMBIA SECOND ECONOMIC RECOVERY CREDIT (ERC II) (Credit 2214-ZA) (Supplemental Credits 2214-1-ZA and 2214-2-ZA) I. INTRODUCTION 1. This is the Performance Audit Report of the Zambian Second Economic Recovery Credit (ERC II - Credits 2214-ZA, 2214-1-ZA and 2214-2-ZA) for US$247.20 million presented to the Board on March 5, 1991. ERC I received contingent approval by the Board pending Zambia's settlement of arrears to the Bank. With the help of a forty-two minute bridge loan from the Bank of England, Zambia was able to settle the arrears to the Bank about a week later, on the 13th of March, 1991. The bridge loan of US$200 million was repaid in part by the US$130 million first tranche of ERC II. The release of the second tranche was delayed from August 1991 to January 1992, at which time a significant portion was used to repay a second bridge loan which had been arranged to cover yet more debt service payment arrears. 2. The previous Economic Recovery Credit (ERC I) was audited by OED (see Report No. 12100 dated June 29, 1993) and was rated unsatisfactory. It was undermined by a lack of political commitment and implementation capacity, and, prior to release of the second tranche, by a break in relations between Zambia and the Bank and IMF. ERC II was different; although primarily providing financing to enable the Government to settle arrears due to the Bank and IMF, it successfully brought Zambia back into the international mainstream and initiated an intensity of reform which is remarkable by past standards in Zambia. Although the operation was successful, its policy horizon was necessarily a short-term one. Partial compliance with the Credit's conditions, the destabilizing impact of a serious drought in the agricultural sector, and the slower and less than complete reactions to ERC II, make the sustainability of the operation uncertain. Several developments subsequent to ERC II suggest that Zambia is beginning to transform an economy formerly dominated by Government and an ethos of socialism. However, the rapid growth of the informal and the stagnation of the formal economy suggest that the sustainability of the policy impact of ERC II is uncertain and rests on appropriate solution to some remaining, quite difficult transition problems. II. BACKGROUND 3. Zambia is a large, landlocked, scantily populated country, bigger than Belgium, the Netherlands, Germany, Austria, Czechoslovakia, and Hungary combined. About 50% of its population of 8.6 million (mid-1992) is, unusually for Africa, concentrated in urban areas. At independence in 1964, GNP per capita was about US$520 (Atlas methodology). After 28 years of attempted development, characterized by enormous growth in the Government sector, the comparable (Atlas) GNP figure in 1992 was US$300 per capita. 4. The principal characteristic of the Zambian economy since the 1950s has been its heavy dependence on a single commodity, copper. This dependence has meant that Zambia is highly sensitive to copper price "shocks" or fluctuations in the world price of copper. The dependence also raises the -2- specter of the "Dutch disease" in Zambia -- a situation in which investment and work incentives are depressed by excessive availability of foreign exchange due to copper "windfalls" and easy access to foreign borrowing. Such mineral dependencies call for particular and unusual sorts of Government interventions in the domestic economy and in the country's foreign borrowing process, if major income fluctuations and the onset of the "Dutch disease" are to be avoided. In particular, Government policy should stimulate economic diversification, or investments in efficient, non-copper income alternatives. This involves achieving an appropriate private, formal sector savings and investment atmosphere through short-term Government foreign lending and borrowing policies to stabilize the country's copper income, coupled with appropriate use of copper income in order to stimulate private, formal sector investments in copper alternatives. 5. Neither the Government nor the international donor community pursued such a diversification investment strategy in Zambia. Instead, international lending/borrowing supported excessive domestic consumption. Rather than reducing the debt when copper prices were high, Government expenditures and domestic consumption were ratcheted upwards. Then, when copper prices or exports declined, foreign borrowing was increased in order to support artificially high levels of Government expenditures and national consumption. The result was the onset of the "Dutch disease" and a prolonged decline, albeit in relatively stable fashion, in Zambia's income and productive capacity. 6. The Government of Zambia played an increasingly large role in the country's economic difficulties, significantly by crowding out private, formal sector investment. The state dominated the economy. It became massively and directly involved in the productive sector. In addition, it maintained a very strict regime of control over the economy in terms of policy and regulatory or administrative controls. At various times, even up to the recent past, the Government implemented price controls over foreign exchange and over most domestically produced and imported goods. Privately earned foreign exchange was confiscated by the Government, imports were licensed and copper was excessively taxed to provide subsidies for formal sector wages and urban consumer goods. The result was the suppression of profits and investment incentives and stimulation of migration to urban areas by workers in search of a very few, overpaid, formal sector jobs. 7. The impact of this on the formal economy in Zambia has been to slowly strangle it. Growth in measured (i.e., formal sector), real GDP has been dismal since the mid-1970s, at or below 1% per year or well below the about 3% per year population growth rate. The agricultural sector, which has some of the greatest economic potential, per capita, in the world, has failed to feed the nation or provide any savings for industrialization. The Government expenditure/GDP ratio has remained high, at about 30%, but the tax/GDP Ratio has declined from about 30% to a present 15% each year. This has led to an enormous amount of Government borrowing so that the Government's external debt/GDP ratio has risen from 0.80 in 1976 to a completely unsustainable 2.85 in 1992. 8. The exception to this generally dismal picture in Zambia is a vibrant informal economy. This sector avoids the costs of Government and labor union regulation and taxes while benefitting from Government borrowing from abroad. The informal economy's activities are generally not captured in Zambia's national accounts, even though they have become very significant in providing final consumer goods and services and in providing inputs to certain private, parastatal and even direct Government activities. The importance of the informal economy can be appreciated by observing Zambian employment statistics. Between 1980 and 1990 formal sector employment stagnated at about 380,000 persons, while the labor force more than doubled, from 1.6 to 3.7 million persons. As a result, formal sector employment declined from 24% to 10% of the labor force. Lately formal sector employment has declined by nearly 100,000 workers. Clearly, at least a significant portion of the remaining 90% of the labor force must find employment in informal activities. -3- 9. More telling from the standpoint of private sector investment incentives, were answers to three questions posed to a broad spectrum of Zambians during the evaluation mission for this operation. One question was whether formal sector economic activities were experiencing increased competition from the informal economy. A second question concerned whether "moonlighting", or holding a second job in the informal economy, by formal sector middle and upper level employees had increased. To both of these questions, the answer was "yes". However, whether the increase was considered to be a good thing or not depended on the job of the respondent. Public servants tended to view this growth as good (or very good); they felt it represents the correct working of structural adjustment because formally excessively protected enterprises are now having the profits squeezed out of them. That is, they view the development of the informal sector as a chance for the "little man". Private, formal sector producers/investors view this development differently; they didn't make profits in the past, so there are none to be squeezed out of them now. Essentially, they view growth of the informal sector as competition which could force them out of business. 10. A third question concerned whether there was interest amongst mid and upper level formal sector employees in taking a large severance package, and if so, what would recipients do with the money. Yes, there is tremendous interest in both the public and private, formal sector in receiving a severance package. Furthermore, as long as recipients are convinced that they will not easily get another formal sector job, they would invest a significant portion of the package in the informal economy, i.e., not abroad and not in the formal sector. 11. These developments in the informal economy are important. They indicate that the entrepreneurial spirit is alive and well in Zambia and that, given appropriate policy corrections, the private, formal sector can respond with increased investment and output. At present, the growth of the informal economy indicates that the most attractive private investment incentives lie there. In addition, this sector's growth suggests what sorts of policy changes are needed to remove the distortion between social and private rates of return in the formal economy and stimulate growth in investment in the private, formal sector. Since liberalization of the balance of payments has essentially succeeded in Zambia, it is unreasonable to assume that the private investment money which is going into the informal economy is seeking monopoly prices or scarcity rents. Instead, it is the cost savings, or lower costs due to avoidance of taxes and Government and Labor Union regulations, which attract private capital to this sector. In other circumstances, in other economies, this tendency toward investment in the informal economy can be offset by improved access to formal sector bank credit, to Government infrastructural benefits and to Government contracts. Not so in Zambia. At present, and for the foreseeable future, given the ineffectiveness of Government and the enormous size of its foreign debt service obligations, the cost reductions available to investors in the informal economy significantly outweigh the benefits which they can receive by participating in the formal economy. III. THE POLICY PROPOSALS AND IMPACT OF ERC II 12. ERC II, the second of two such operations, was one of several adjustment operations undertaken by the IMF, the World Bank and other donors in Zambia. All consisted of a package of suggested policy adjustments combined with relatively large amounts of lending of untargeted foreign exchange for support of the BOP. The first two such World Bank operations were Program Loans in the mid- and late 1970s. They were accompanied by a series of IMF programs, and were followed by three adjustment loans/credits -- Export Rehabilitation and Diversification Loan (Loan 2391-ZA), Agricultural Rehabilitation Project (Credits 1545-ZA, A-005-ZA), and the Industrial Reorientation Credit (Credit 1630-ZA, A-004-ZA). These previous operations had limited impact, primarily because they were -4- undertaken in an adjustment atmosphere much less favorable to success than that which emerged under ERC II. The Policy Proposals in ERC II 13. The immediate financial objective of at least the first tranche of ERC II was the clearance of Zambia's arrears to the World Bank in order to regularize its international debt relations and bring the country back into the international financial community. The policy proposals in the ERC II consisted of particular policies grouped under six policy categories. A) macroeconomic stabilization implemented under IMF monitoring; 1) a unified market-clearing exchange rate by end-1991; 2) positive real interest rates in 1991; 3) a budget deficit, excluding interest and grants, of less than 1% of GDP in 1991 and surpluses in subsequent years of the PFP period; 4) monetary growth of no more than 25% in 1991 falling to 10% or less in 1993 with limits to Government recourse to domestic banking sector for credit; 5) inflation of no more than 40% in 1991, dropping to 10% or less in 1993. B) liberalization of the agricultural sector; 1) full decontrol of maize and fertilizer pricing and marketing; 2) strict limits on maize handling subsidies; C) implementation of measures to support the Government's Social Action Program (SAP); 1) evaluation of the maize meal coupon system in assisting the vulnerable D) trade liberalization; 1) expansion of OGL system to almost all import categories (except for petroleum and petroleum products and a short negative list agreed with IDA); 2) reduced constraints on exports and promotion of non-traditional exports; 3) a more uniform level of tariff protection; E) expansion of the role of the private sector in the economy; and F) restructuring the public sector, with particular emphasis on civil service and parastatal reform. 1) privatization, divestiture, and closing down loss-making operations 2) civil service reform (staff audit, staff reduction, efficiency and rationalization of salaries) 3) parastatal reform 4) reorientation of public spending to improve efficiency of public expenditures. Compliance with these adjustment conditions was much better than in the past even though there were inconsistencies, as the "Implementation/Performance" and "Remarks" columns of the attached policy matrix (Appendix I) show. 14. A look at key variables in the macro framework (see Table 1, forward) suggests that the primary stabilization effort under ERC II (the first main policy area list above) was focussed on financing nearly constant and quite high levels (as a percentage of GDP) of Government expenditures in "non- inflationary" ways rather than significantly cutting Government expenditures. The projected overall -5- budget deficit was to be financed by foreign borrowing and/or "crowding out" of private expenditures via high interest rates paid by the Government. Although many of these policy proposals were not new, particularly those in the first four areas, they were much more clearly and tightly specified under ERC II. In addition, the Government was becoming committed to moving away from a socialist course. This caused the Government to increase the intensity of its attempts to comply with policy conditions. The Bank and other donors also stiffened, raising their expectations of what constituted thorough and complete compliance with the conditions. Thus, regarding the stabilization package, it was effectively signalled that past laxness regarding the need for positive real interest rates and money supply expansion targets would not be easily overlooked under ERC II. The result was that the Government became serious about trying to implement important stabilization conditions, which it had previously shied away from. 15. Policy conditions on the agricultural sector and on supporting the Government's Social Action Program (SAP) were more tightly and completely specified under ERC II than previously, and more thoroughly understood and appreciated by the Government. A major reason for this was the focus and intensity of IDA's Economic and Sector Work Program (see forward). The policy focus of the two areas was in a sense opposite. The overall aim concerning agriculture was to get the Government out of the sector, it being felt that private enterprise would flourish there. The aim with respect to the SAP was to improve and intensify Government involvement by using information generated by household surveys to improve targeting by the income redistributions. 16. The policy proposals for privatization and restructuring the public sector and reducing the civil service (E & F) were essentially initiated under ERC II with an expectation that they would become significant and integral elements of future adjustment operations. As a result, the Bank and the Government were feeling their way to a greater extent concerning compliance with these conditions than with the previous four areas. Since successful completion of conditions in these areas would result in the private sector or local government providing goods and services which were formally the responsibility of the Central Government, timing issues are crucial if the adjustment process is to avoid causing the cessation of provision of these goods and services during the switch-over from public to private provision. The Impact of ERC II 17. The impact of ERC II cannot be seen in the movement of official statistical data, which worsened during the ERC II period, but in the shift in the intensity of the Government's attempts to carry out adjustment policies. Expectations, including those set out in the macro framework, were too optimistic and did not allow time for adjustments to work out. Nonetheless, progress, particularly in trade liberalization, was achieved even during the ERC II period. -6- Table 1: ZAMBIA: MACROECONOMIC INDICATORS (all in %) ACTUALS ERC II PROJECTIONS 1980-90 Prel. Est. Annual Avg. 1991 1992 1993 1991 1992 1993 1. GDP Growth 1.1 -1.8 -10.0 n.a. 3.1 3.7 4.3 2. Government Revenues/GDP 23 23 32 n.a. 26 25 24 Taxes/GDP 20 19 16 15 * * * 3. Government Expenditures/GDP 31 31 28 n.a. 30 28 26 4. Investment/GDP 16 13 15 n.a. 19 21 22 5. Current Balance/GDP 12 13 17 n.a. 14 15 15 6. Inflation under 20% 193 190 270 40 20 10 7. Nominal Treasury Bill Rate 13% 37% 47% 124% n.a. n.a. n.a. *The projected tax/GDP ratio under ERC II does not explicitly appear but by subtracting grants, etc., from revenue projections; it can be estimated to have been about 15% in 1991 rising to about 17.5% in 1993. Sources: BESD, ERC II President's Report, Country Strategy Papers. 18. Macro and Stabilization Measures. The macro and stabilization measures taken under the ERC II did not achieve macroeconomic stabilization or private, formal sector growth during the ERC II. GDP declined by -1.8% and -10.0% respectively in the 1991 and 1992 years (Table 1). The huge decline in 1992 is attributable to the drought of that year. GDP was projected to grow at 12% in 1993 based on the assumption that the agricultural sector would grow by 100% in 1993 over 1992. Achievement of the overall growth projection is unlikely, however, since the non-agricultural sector has been depressed by the country's stabilization efforts. The main macro problem has been the continued dominance of public expenditures or, the gap between a declining tax/GDP ratio and a nearly stagnant expenditure/GDP ratio. The ERC II program probably called for too small reductions in public expenditures (Table 1), given the decline in tax base. Because of this, the program projected the non-debt service, fiscal deficit to decline from 4.3% of GDP in 1990 to 0.7% in 1991 and then to generate surpluses in 1992 and 1993. In reality, the fiscal deficit rose to 7.1% in 1991 and remained negative in 1992. Inflation, instead of declining from 40% to 10% (1991-1993) rose from 93% to 270% during the period (Table 1). Government compensated for its lack of fiscal discipline by engaging in tight monetary policy, and reducing credit to the private sector. This caused interest rates to rise to well over 100% in 1993. Because of the high rate of inflation, interest rates continued to be negative in real terms. However, more recently, they have become significantly positive in real terms as inflation has fallen. This is a significant indication of the potential stabilization success of ERC II's program. 19. Liberalization of the Agricultural Sector. An assessment of the impact of ERC II's agricultural liberalization policies has been completely overshadowed by the drought and the subsequent return to adequate rainfall. Important policy changes were implemented, but when rainfall returned to its normal levels, the agricultural sector was left in some disarray. During the drought, donated maize was sold by the Government at relatively low consumer prices, with the net result that consumers and the Government benefitted while the (mainly uninsured) agricultural producers were left to carry over bank debt rather -7 - than repay it with insurance or maize sales revenues. Following return of the rains, the tight credit squeeze and high interest rates, coupled with asymmetric increases in input prices vis-a-vis the rise in maize prices, meant that producer profits were low or nil. In addition, the Government was forced to step in and purchase some of the post-drought crop, which private buyers couldn't handle. However, the Government paid for these purchases with promissory notes rather than money. The net result is that farmers have experienced liquidity problems and some decapitalization of assets. 20. The Social Action Program. The available information does not permit a rigorous assessment of the impact of the social provisions of ERC II. The program calls for an increased allocation of budgetary expenditures to social services, but it is not clear that this occurred. Several producers of agricultural or industrial output complained that the Social Action Program protects consumers at the expense of producers. However, it is likely that they are complaining about the poor targeting rather than the excessiveness of SAP programs. In spite of the fact that the SAP may be experiencing some efficiency and targeting problems, it contains some very interesting micro initiatives. Some of the funds derived from the sale of donor maize were utilized in aiding village improvement schemes for water supply and improved food storage. The labor-intensive, food for work program also appears to have significant potential for feeding the poor, providing employment and helping in rebuilding roads, schools and clinics. In addition, the Bank-assisted, social recovery fund has aided local communities in the building and rehabilitation of social infrastructure. 21. Trade Liberalization. Viewed from the perspective of the series of adjustment operations in Zambia, of which ERC II was an important part, trade liberalization appears to have been the most effectively carried out adjustment policy in Zambia. Coupled as it has been with larger amounts of foreign lending, it has resulted in the availability of significant amounts of cheap consumer good imports. Many Zambians recognize the Bank's role in this success and appreciate that it has given the country some relief from the harshness of stabilization policies. 22. The success of trade liberalization is a primary reason for the growth of the informal and the decline of the formal economies. It has led to a situation where the sector which manufactures consumer goods does not seem to be able to compete with imported, final goods and used products. With a formal sector industrial base which developed under high protective walls, the new trade policy threatens to severely damage Zambian formal sector industry. Between January 1992 and January 1993, 72% of the textile establishments in the manufacturing sector folded up because of an inability to compete with imported textiles or second-hand clothing ("salaula"). More have since closed and are still closing. The same difficulty is being experienced by other industries in other sectors who are being outcompeted by subsidized imports from South Africa and duty-free imports from Zimbabwe (PTA). Manufacturers are objecting to the current trade liberalization regime not because they are against the measures, per se but because they perceive that the playing field is uneven in a way which makes them have much higher costs of operation. Ordinarily, one would dismiss this as the expected response of those who have thrived on controls and special concessions in the past and are unable to deal with the new competitive atmosphere. However, their concern is not about trade liberalization per se, but that it be carried to its logical conclusion; that is that the collection of customs duties and taxes be improved and that tariffs be made uniform both across all imports be they capital items, imported inputs or final goods, and that they be uniform across all export destinations and import origins. This latter applies to some anomalies in the PTA (duty free) Agreement, which allows certain imports to come in duty-free but does not allow Zambia's exports reciprocal, duty-free access. 23. Privatization. ERC II essentially marks the initiation of the privatization effort in Zambia. Very little progress was made under ERC II. When the new Government took over in 1991, it decided to give parliamentary approval for the privatization program and it set up a quasi-autonomous Zambian -8- Privatization Agency. Scant progress was made largely for two reasons. First, privatization is a very slow process in any event, one which, conceptually at least, requires more time than money. Second, the private, formal sector investment climate is not now conducive to the sale of formal economy enterprises, either restructured, or already efficient ones. 24. Restructuring the Public Sector with Civil Service and Parastatal Reform. Civil service reform has been slow in coming. A lot of effort has been spent on defining rather than actually identifying and purging "ghost" workers from the public sector. In 1992, about 12,000 central Government employees were retrenched. However, because a full package of retrenchment benefits has not yet been agreed upon and financed, it is said that most of these workers were simply reabsorbed by local government authorities who then began to run larger budget deficits. In addition, it appears that the small number of workers actually laid off has not had a favorable impact, from producers' point of view, on conditions in the formal sector labor market. A greater number of layoffs, will, however, improve the vibrancy of the informal economy. Regarding parastatal reform, to date it appears that indecisiveness over whether to reform and then privatize or privatize in order to achieve reforms, has severely curtailed any successes in this area. IV. THE INSTITUTIONAL ROLE OF IDA 25. Under ERC II, IDA played a pivotal role in keeping country dialogue active. The approach was innovative and somewhat risky, because IDA maintained an active relationship with Zambia even after the country "broke relations" with the Association mid-way through ERC I. In addition, IDA took a considerable risk in asking the Board to approve the credit before the arrears owed to it were actually cleared. Both for the first and the second tranches IDA staff helped arrange bridge loans, one with the Bank of England and, for the second tranche release, one with Citicorp. This enabled the approval of ERC II which essentially re-initiated the adjustment process in Zambia. In addition, IDA used the consultative group meetings, which it chairs, to garner support for the program and to reach a consensus among the country donors and the Bank on the broad outlines of the financing and policy packages and the direction of the program. IDA also worked closely with the IMF. Principally because of a sustained and professional effort by the country team and the Resident Mission, Zambia now has one of the most active country dialogues with IDA in Sub-Saharan Africa. 26. ESW has traditionally been active and of high quality. This continued even after the abandonment of ERC I by Zambia and the suspension of IDA operations. During the late 1980s ESW relating to macroeconomics, was focussed on the development of a market foreign exchange system and completion of the public expenditure review. On the sector side, ESW stressed development of a master plan for agricultural research and extension, and for agricultural producer prices as well as a review of the structure and functioning of the Ministry of Agriculture. In addition, sector studies for reforming the energy, industrial and parastatal sectors and of the civil service were undertaken. An innovative aspect of ESW in Zambia was that the Government established a negotiating team under the Ministry of Finance, consisting of the Governor of the Central Bank, the Senior Adviser to the Minister of Finance, and the Permanent Secretary of the National Commission for Development Planning. This group coordinated the Government's interaction with the Bank on the ESW program. 27. IDA supervision was intense. In addition to regular monitoring by the Resident Mission, four supervision missions, in April, June, August and November 1991, one supervision in March 1992 and two informal donor consultations in June 1991 and June 1992 were undertaken. Once Board approval was obtained to release the tranches, the credit disbursed extremely quickly and generally in accordance -9- with Bank procurement guidelines. However, some exceptions to the rules were granted, along with waivers from using international competitive bidding procedures for certain large contracts. The speed of disbursement also meant that proper documentation was usually not available at the Bank of Zambia, but instead, at least for ZCCM imports, had to be obtained by the Bank directly from the offices of a procurement agent in London. V. OVERALL ASSESSMENT 28. The Success of ERC 1. ERC II was a successful operation. It convinced the Government to seriously embrace a mainstream, internationally recognized adjustment and development philosophy. Under it, the Government began to seriously implement policy changes which had been the focus of several previous adjustment operations, but which had not been taken seriously before. Expectations regarding the impact of ERC II, including those set out in the macro framework, were probably too optimistic. However, the Government moved away from a public sector-dominated, socialist philosophy and complied with several long sought after adjustment conditions. Although things did not improve as fast as expected, the Government has so far staid the course and there is evidence, including a decline in annual inflation rates, the achievement of positive real interest rates and very recently, an apparent decline in the Government expenditure/GDP ratio that indicate that a more stable economic environment is emerging. 29. The Sustainability of ERC II. ERC II's successes are of uncertain sustainability. The primary reason concerns the poor investment climate in the private, formal sector and the concomitant tendency for relatively rapid growth in the informal economy. This problem of an inadequate supply response or poor GDP growth performance, characteristic of many adjustment programs, will require some fine- tuning of future adjustment policy packages if stagnation and policy reversals are to be avoided. 30. At the heart of the sustainability issue is the extent to which private investment and productive incentives can be improved and domestic consumption suppressed so that there is growth in the private, formal economy in Zambia without any further increases in external indebtedness. The rapid growth of the informal economy, the decline in formal sector employment, the relatively high (but now declining) Government expenditure/GDP ratio and the extent to which the deficit is financed from abroad, suggest that this is not yet ready to happen. Instead, Zambia is caught in a situation in which private, formal sector investment and productive incentives are depressed by high costs of operation, while foreign grant and borrowing inflows indirectly finance increases in informal sector activity by maintaining a relatively high demand for (unofficially) imported consumption goods and services. 31. Given the past predominance of the Government in Zambia, but the steady decline in the tax/GDP ratio (from about 28% to 14% over the past 15 years) a priority is to redress the fiscal/monetary policy but in ways which lower real interest rates. This can be done by making greater use of fiscal solutions to lower the budget deficit. Since the informal economy can only be lightly taxed, it is unlikely that large amounts of deficit- financed Government expenditures are sustainable. Instead, sustainability involves narrowing the gap between the tax and expenditure to GDP ratios primarily by lowering the public expenditure/GDP ratio, while improving private, formal sector investment opportunities. Were present production processes in the private, formal sector efficient, this problem might be solved by expanding domestic demand. However, the sector is not currently efficient. Instead, the combination of successful trade liberalization and growth in the informal economy suggests the need for reductions in Government expenditures and a change in composition so that they aid in lowering costs of operation - 10 - in the private, formal sector. This can most directly be accomplished by improving the private, formal sector's access to efficiently provided infrastructural goods and services. VI. LESSONS LEARNED 32. The apparent stabilization results under ERC II were more successful than previous operations, even though the policy packages were similar. It is of interest to question what it was that signalled this different, better outcome. One lesson which emerges from this evaluation is that it was probably the Government's new-found tolerance of liberalized and, therefore, much higher interest rates which presaged this success and increased the Government's credibility with the Bank and Zambian citizens. Beyond this, two lessons emerge regarding possible policy adjustments which would increase the sustainability of adjustment policy packages in Zambia. Both arise as a result of the implications of rapid growth in the informal vis-a-vis the formal economy. One is that this relatively rapid informal sector growth, coupled as it is with a successfully liberalized trade regime, suggests that private, formal sector costs of operation are higher than and rates of return to investment lower than those in the informal economy. The other concerns the need, in the longer term, to narrow the Government deficit/GDP ratio in ways which will stimulate private, formal sector growth.' In Zambia, the rapid growth in the informal economy has been accompanied by a decline in the tax/GDP ratio. Even with the anticipated increased use of expenditure or VAT taxes, this ratio cannot easily be raised again by extending taxation to the informal economy; the informal sector simply cannot continue to exist while paying normal taxes. The result is that sustainable policy regarding the Government budget should intensify its focus on continuing to lower the expenditure/GDP ratio and changing the composition of expenditures so as to efficiently provide increased availability of infrastructural goods and services to prospective, private, formal sector investors. (i) One lesson from ERC II is that in Zambia, where virtually all prices had previously been controlled, it was the belated liberalization of, and subsequent dramatic rise in, nominal interest rates, including those paid by the Government, which presaged ERC II's successful influence on macroeconomic stability. The dramatic rise in interest rates signalled the end of the Gov- ernment's attempt to finance its deficit with excessive money creation and seignorage taxes. This increased the Government's stabilization credibility. Rising real interest rates can also be viewed as sending a signal that savers and investors can expect to be better compensated providing adjustments in the real economy are consistent with these higher rates. This is a reversal of the previous precedent when, under a more socialist regime, real interest rates were negative thus depressing saving and investing behavior. (ii) A second lesson concerns the message which a rapidly growing informal economy sends about a stagnating private, formal economy in a setting in which liberalization of the trade and foreign exchange regimes has been successfully completed. In such settings, scarcity rents are likely to be very low so that the differentials in rates of return in the two sectors signal differentials in cost of operation. In Zambia, formal sector producers are not complaining about a loss of protection, but rather about a legacy of labor laws and conventions, Government regulations and excessive user charges, and poorly maintained infrastructure which make their taxes and costs of operation too high, so that they cannot compete with imported goods and informally provided services. This suggests that if future adjustment operations are to be more sustainable, they should focus to a greater extent on removing impediments to cost reductions in the private, formal sector. - 11 - (iii) A final lesson relates to the impact which asymmetrically rapid growth in the informal economy can have on the Government budget. In order to capture more taxes and draw some informal activities into the formal sector, adjustment programs should include tax reforms which increase the use of VAT or expenditure taxes. However, since the informal economy won't pay normal amounts of taxes, even if indirect expenditure taxation is significant, it is likely that the tax/GDP ratio cannot rise very much over the medium term and thus cannot be counted on to reduce deficits. Instead, the Government expenditure/GDP ratio will have to be lowered somewhat if deficits are to be reduced. However, these expenditure cuts could have an additional, negative impact on private, formal sector incentives. This calls for a careful examination of the composition of government expenditures with a view toward shifting them so as to improve the private, formal sector's access to efficiently provided infrastructural goods and services.  ZAMBIA: ECONOMIC RECOVERY CREDIT II MATRIX OF POLICY ACTIONS I. MACROECONOMIC STABILITY Objective: To restore a stable macroeconomic environment in the economy needed to permit the orderly restructuring of the economy that will pave the way for self-sustained growth. ISSUES ERC ACTION CREDIT SUPPORT MEASURES IMPLEMENTATION/PERFORMANCE REMARKS PROGRAM/STRATEGY I Despite actions to stabilize the 1 Achieve stable macroeconomic A. Board Presentation: Implementation was not very good Government tax effort is very low. economy, the rate of inflation conditions through pursuit of tight Agreement on an acceptable fiscal and initially. Effort to reduce the fiscal deficit Collection as a percent of GDP is remains too high, at an estimated fiscal and monetary policies monetary program as contained in the was unsuccessful. Inflation soared to down to 12-15% from about 25% 80% for 1990. consistent with reducing rate of Letter of Development Policy. close to 300% p.a. in 1993 before previously. inflation to 40% in 1991, 20% in stringent action was taken to control it. 2 The second window introduced in 1992 and 10%, in 1993. B. Effectiveness: This consisted of tight monetary policy The credit squeeze has resulted in Feb. 1990 has been expanding None. which squeezed credit to the economy. By scarcity of the Kwacha. The result slowly, progress needs to be made 2 Expand the operation of the OGL beginning of 1994 inflation was down to is that even the govt. and the ZCCM to move all imports to an OGL 2nd window so that all imports C. Further Actions: about 20%. This was achieved by offering are caught in the squeeze, with the system. (except for a small negative list) are Satisfactory performance on the 1991 treasury bills at rates in excess of 120% to latter unable to pay taxes to the govt. under the system. program. The measure of adequate fiscal mop up excess liquidity in the economy. or settle its domestic debt. This in 3 Fiscal performance remains weak and monetary control to be monitored will Prior to this interest rates had been raised turn has affected govt. revenues, largely because of ineffective 3 Enhance fiscal performance through be that net banking credit to the from the prevailing highly negative rates. which were already very low to start mechanisms for control of tighter budgetary controls and government in the first quarter of 1991 By 1993, commercial bank rates that had with. budgetary expenditures. further reductions in subsidies. shall not exceed K 4,725 billion.* reached over 200% in some instances, were on their way down, reaching 80%. The credit crunch resulted in an Real rates were however, on their way appreciation of the Kwacha initially down. With inflation now brought down before action was taken to case it. the real rates have become excessively positive from highly negative levels. If revenes do ant improve or if there is a shortfall in aid flows, the Until 1993, money supply had grown by inflationary pressure will be back. more than 60% p.a. This makes the present sat poteaialy sustaiable. OI II. AGRICULTURE Objective: Development of an internationally competitive agricultural sector that provides for food security and generates future export growth in accordance with the country's comparative advantage. ISSUES ERC ACTION CREDIT SUPPORT MEASURES IMPLEMENTATION/PERFORMANCE REMARKS PROGRAM/STRATEGY I Low farm productivity in I Increase agricultural productivity A. Board Presentation: After several attempts at decontrolling the Movement of the price of the maize smallholder agriculture resulting through: Initiate measures toward the reform of price of maize and an initial reluctance, crop announced by government in from the use of poor technology and i) improving management and maize pricing and marketing, i.e. the government has finally succeeded in dollars kept shifting along with inadequate or inappropriate inputs. delivery of support services, stock-taking of the quantity and quality of abolishing maize subsidy. As late as 1993, movement of the exchange rate. especially research and extension maize; clarification of ownership of grain however, the govt. was still finding ways This creates uncertainty for 2 Poor quality of and inadequate and credit; storage facilities; and establishment of of intervening to control the price of producers and hence affects linkages among agricultural support ii) raising efficiency of marketing appropriate institutions for managing the maize, production decisions adversely. services (research, extension, and distribution of inputs; maize strategic reserve. marketing, input supply, credit, iii) improving incentive structure Fertilizer prices and marketing have also Development of adequate storage rural transportation and through appropriate pricing and B. Effectiveness: been decontrolled. facilities is still a major problem, but agro-processing). distribution systems; and None. hopefully, with decontrol of maize iv) increasing budgetary allocations market, private initiative may finally 3 Inappropriate pricing policies which to priority programs. C. Further Actions: lead to a solution of this problem. have distorted incentive structures Satisfactory progress on implementation of and production patterns e.g. 2 Development of new sources of maize and fertilizer price decontrol and Several large agricultural producers subsidies on maize and fertilizers -- growth and diversification of liberalization of marketing arrangements, have stopped production. This may national uniform prices for maize production through: including: postpone the prospect of attaining and fertilizers. i) removing maize related a) As an essential step towards taking food self-sufficiency for many years. subsidies; other actions (given below), adequate 4 Ineffective marketing and ii) intensifying ongoing research increases in the into-mill price of maize Some of the restructuring is as distribution systems due to controls and extension programs; and and the consumer price of maize meal expected from previously on private forestry, wildlife, and iii) encouraging special programs products so as to limit cost of maize overprotected producers. lack of environmental policy, for supports to export crops such as handling subsidies to the level specified in cotton, tobacco, oilseeds, etc. the 1991 budget. If supplies (including available imports) are adequate, full 3 Policy reforms for smallholder decontrol of maize price.* agriculture aimed at: b) adoption of a system of floor producer i) aligning input/output prices to prices (FPS) for maize, which are related market value by eliminating to export paty prices and differentiated subsidies and pan-territorial pricing seasonally and geographically; through a regionally differentiated... c) decontrol of fertilizer prices; ii) liberalizing producer prices for d) appointing an agent to manage on maize and fertilizer; and behalf of the Government, a Maize iii) encouraging greater participation Strategic Reserve (MSR); and by the private aector in product e) allowing private sector to establish marketing including export and freely, w maize mills of any capacity. import aupply (fertilizer import marketing) and agricultural Processing, e.g., ilating. s d Z3 ON ii) ntenifyig ogoin resarc and xtesionprorams an iii) ncouagingspecal prgram III. TRADE POLICY Objective: Diversifying the export base of production, reducing the import intensity in consumption and production, and improving the efficiency of import substitution activities. ISSUES ERC ACTION CREDIT SUPPORT MEASURES IMPLEMENTATION/PERFORMANCE REMARKS PROGRAM/STRATEGY I Continued overvaluation of the I Attainment of a market clearing A. Board Presentation: Exchange rate unification has proceeded The result of the program is to foster exchange rate. exchange rate; Continued adjustment of second window along, the importation of used and second exchange rate towards goal of market hand goads particularly textiles, 2 Inefficient administrative allocation 2 Establish an OGL system for all clearing rate by March 1991. The introduction of bureaux de change and tires, etc. The result has been that of foreign exchange. import categories except for a more generous retention provisions have several of the local textile limited negative list; B. Effectiveness helped to attain a market clearing manufacturers have folded up as a 3 Distorted incentive for export and None. exchange rate. result of inability to compete. import substitution activities 3 Remove export bans and aimplify especially regulations and bans on export procedures; C. Further Actions The OGL has been expanded to as Given the depressed incomes and exports, and excessive protection of 1 Expand the use of 0GL system to include indicated, high cost of domestic production, industries and variations in tariffs. 4 Reduce tariff dispersion and all import categories (i.e. all but a small second hand items may be all that excessive protection to domestic agreed negative list) other than petroleum The tariff structure is being rationalized, domestic incomes can support at the industry; and petroleum products. with the dispersion reduced from moment. But this cannot become 0%-100% to 15%-50%. Further long-run trend. 5 Eliminate tariff exemptions except 2 Furnish evidence satisfactory to IDA that compression is anticipated. for those required by international it has removed: (a) all restrictions on There are some legitimate reasons to agreements. exports with the exception of maize, maize Underinvoicing is still rampant however, take a closer look at the tariff products, fertilizer and ivory; and (b) all and further rationalization to remove the structure to ensure that it provides a exemptions from import duties and sales most glaring aspects of the tariff level playing field for competition taxes except those in effect as of distortions are called for, among all participants. January 1, 1991. 1 The major problem with the current Greater enforcement of customs 3 Introduction of a minimum levy of 15% on system is that it does nothing to stem the collection is called for; and all but a few zero-rated import items, tide of subsidized imports from South protection neutral tax structure. reduction of the up-lift factor (used to Africa and Zimbabwe, and the PTA calculate the sales tax) to 1.20; lower the agreement seems to confer further maximum import levy from 100% to 50% advantages an imports from Zimbabwe. with the exception of a few luxtry items, and eliminate most discretionary exemptions from customs duties and sales taxes. 4 Agreement on a work program for the next phase of the tariff reform program to be introduced with the 1992 Budget. as exemtios frm cstom duies nd ale IV. PUBLIC SECTOR Objective: Improve the efficiency and effectiveness of public expenditures through improved allocation and management of public investment and the capacity for delivery of services ISSUES ERC ACTION CREDIT SUPPORT MEASURES IMPLEMENTATION/PERFORMANCE REMARKS PROGRAM/STRATEGY I Structure of public expenditures I Focus public expenditures on A. Board Presentation: The government's ability to highly inappropriate in the light of priority public investment program, Increased 1991 budgetary allocations in circumscribed by the dismal revenue development priorities. and restructure recurrent real terms by 6% for education and by picture. Widespread corruption customs expenditures to enhance delivery 100% for road maintenance, administration is alleged. 2 Capacity of public service to and provision of essential services, manage conditions of service. esp. health, education. B. Effectiveness: Expenditures have to be cut further or None, revenue effort raised. The latter will pose 3 The size of public service remains 2 Improve the implementation a huge challenge and the former is too large in relation to capacity of capacity of the public service C. Further Actions: infeasible in view of the state of government to provide appropriate through strengthening the planning I Complete and furnish to IDA a satisfactory deterioration of the social and recurrent departmental expenditures. and budgeting functions of the Public Investment Program for 1991-1993 infrastructural services in Zambia. government; and through technical consistent with the program and ensure assistance and training, that no new investment projects are Improved management capacity needs to undertaken outside the framewor2 of the be implemented. 3 Reform the public sector to restore PIP. efficiency and morale by increasing Our view from the mission is that a well salaries, esp. of higher-level staff; 2 Carry out a physical survey of public designed severance payment scheme for reduce the size of contract daily employees satisfactory to IDA to ensure retrenched workers will greatly benefit the- employees and retrenchment of civil salary payments to only botefide economy. servants, employees and to strengthen fiscal control.* 3 Undertake careful assessment of govt's. implementation capacity in priority sector identify optimal staffing needs and levels and areas for further redundancies. 4 Agreement on the work program and timetable to formulate cos-effective early retirement programs and discharge procedures for staff subject to retrenchment Boar Prsenttio: Th goernmnt' abiityto hghl Incrase 199 bugetay aloction in circmscibe by he isma reenu realters b 6%for ductio an by pictre.Widsprad crrutio cutom 100%forroadmaitenace.admnistatin isallged Effetivness Exendiure hae tobe ut frthr o None revnue ffor raied. he ltterwillpos V. PARASTATALIPRIVATE SECTOR Objective: The objective is to improve the economic and financial viability of parastatals, eliminate government budgetary support for the sector, and increase their contributions to government revenues, while strengthening their ability to compete domestically and internationally. Given the need to boost private investment, it will also be necessary to enhance the role of private sector through privatization of public enterprises, elimination of special advantages to parastatals, and creating an enabling environment for more private sector participation in the economy. ISSUES ERC ACTION CREDIT SUPPORT MEASURES IMPLEMENTATION/PERFORMANCE REMARKS PROGRAM/STRATEGY I Predominance of parastatals in the I Review the management and A. Board Presentation: By 1993 only 6 of the 19 firms offered for economy has been a drain on govt. financial performance of parastatals Announce government commitment to sale had been sold. The program is expenditures through subsidies and and the overall parent/subsidiary privatization program for most parastatals. progressing, but at a slow pace. other budgetary transfers to have relationships with a view to reduced consumer incomes and improving efficiency and overal B. Effectiveness: Restructuring of state enterprises is also impeded private sector performance. None, proceeding slowly. However, the situation development. is a welcome change from the previous 2 Reduce government subsidies and C. Further Actions: overdependence on parastatals. 2 Over extension of parastatals has introduce guidelines to make 1 Develop modalities and mechanisms for strained the government's parastatals mor autonomous and the Govt's. policy of transferring majority Utilities need to be reorganized and their managerial capacity. financially accountable on an of all parastatals except public utilities and rates made more commercially based. individual basis, other strategic industries to the private 3 Dominance of the industrial sector sector. by parastatals has constrained the 3 Remove barriers to private sector emergence of an internationally participation in the economy. 2 Employ consultants, under terms of competitive private sector, reference satisfactory to IDA, to carry out 4 Accelerate the process and expand the second phase of the parastatal reform the scope of privatization. program covering 14 enterprises the list of which has been agreed with IDA. 3 Complete review for restructuring or other disposition of Zambia Railways, ZPTC, and Zambia Airways. 4 Eliminate public sector monopoly in insurance. 5 As a first important step, provide evidence satisfactory to IDA, that government has offered for sale to the private sector at least six parastatals.pa B. ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ - Efetvns:Rsrcuigo>tt nepie sas None prceeing lowy. oweer, he itutio is awelcme hang fro th preiou C. ~~~ ~~ ~~~ ~ ~0 Fute"cin:oedpnec nprsaas VI. SOCIAL ACTION PROGRAM Objective: To ensure that the poor and the socially vulnerable groups participate in and benefit from the adjustment program while ameliorating the transitional cost of such adjustment on the poor. ISSUES ERC ACTION CREDIT SUPPORT MEASURES IMPLEMENTATION/PERFORMANCE REMARKS PROGRAM/STRATEGY 1 Continued economic decline has 1 Continue and improve targeted A. Board Presentation: Although much progress has been made in reduced real incomes and increased programs for maize meal coupon to None. this area, much remains to be done. The unemployment and vulnerability of cushion the impact of price social services are in highly deplorable the poor. decontrol of maize on the poor. B. Effectiveness: conditions and the infrastructure urgently None. needs rehabilitation. 2 Deterioration of essential services as 2 Implement special income a result of declines in budgetary generating activities for the C. Further Actions: Mere budgetary allocations to specific allocations for health, education, vulnerable -- the youth, I Complete, under terms of reference sectors without attention to the roads, and rural infrastructure. women-headed households, and the acceptable to IDA, an evaluation of the effectiveness and efficiency with which the urban poor, special nutrition efficiency of the maize meal coupon resources are being used is futile. programs, and public works, etc. system in assisting vulnerable groups. * 3 Restructure public expenditures to 2 Ensure adequate budgetary provision of reflect higher allocations education, resources for education, health, sanitation health and social services. and services aimed at the poor and vulnerable groups. 4 Remove barriers to informal sector entrepreneurial activities. 3 Agree with donors and the Bank on appropriate schedule for implementing the Government's Social Action Program. 00 4 Replace licensing requirements with registration requirements for small-scale enterprises. Note: indicate second tranche release conditions. 0~~ - 19 - Attachment Page 1 of 2 Comments Received from the National Commission for Development 3lannin Com-uwiti., sh".ld be addre,ed to the 1. -ply pkGi go"a Pt %a,, ec,.,Ot Tekz'wru. 211747, 2JC47 M I REPUBLIC OF ZAMBIA NCDP/6/7/10 OFFCE OF ThT DEPUTY MINISTER NATIONAL COMMISSION FOR DEVELOPMENT PLANNENG 21st June, 1994 NATIONALIST/M OITA ROAD P.O. BOX 50268 Mr. Manuel Penalver LUSAKA Division Chief Country Policy, Industry and Finance Operations Evaluation Department The World Bank 1818 H Street N.W. Washington DC 20433 USA. Dear Mr. Penalver, RE: ECONOMIC RECOVERY CREDIT II - DRAFT PERFORMANCE AUDIT REPORT. I thank you very much for your letter of 16th May, 1994 to which was attached the Draft Performance Audit Report of the Economic Recovery Credit II (Credit 2214- ZA). I have reviewed the draft Report and am happy to inform you that I am in substantive agreement with the Report's positive conclusions. However, I wish to make a few comments which may be helpful; first, I thought that it would useful if the Report brought out more clearly the pivotal role of the ERC II in assisting the Government of Zambia with mobilising bilateral co-financing in support of the Economic Recovery Programme. The ERC II, I feel, permitted bilateral BOP donors to focus their assistance on the crucial objective of strengthening the Government's commitment to structural adjustment and financial stabilisation; second, while I agree that the growth of the informal sector in Zambia must have been substantial, one of the weaknesses in economic management in that period has been the inadequacy of effort to investigate the issues affecting the informal sector; third, I believe that the draft Report may not fully bring out insufficiency of progress with the implementation of the Social Action Programme. As you know, the SAP was not implemented in accordance with expectations because of financial and administrative constraints, and while the current ESAC operation focusses explicitly on the attainment of social sector rehabilitation objectives, opportunities were missed in the 1991- 1993 period to solve problems in this critical area of adjustment in Zambia; Attachment -20- Page 2 of 2 finally, while I am in agreement with the statement in the Report that giving greater weight to adjustment in public expenditures would have been an appropriate approach towards reducing the fiscal deficit - rather than through revenue action - thereby reducing the burden of adjustment falling on the formal private sector, it would still have been useful to mention that an enhanced revenue collection effort - as currently undertaken by the Zambia Revenue Authority - undertaken at an earlier stage would surely have helped with the reduction of interest rates. As you know, it is the latter which has created serious problems in the formal sector in 1993 and which still impedes the transition towards economic growth. Please allow me, Mr. Penalver, to finish by supporting the statement of the Audit Team regarding the high quality of the policy dialogue between Zambia and the World Bank and pay tribute to the extraordinary quality of the Bank's economic work on Zambia which - as has been correctly pointed out - is carried out as a joint exercise. That key World Bank staff have been assigned to work on Zambia since 1990 at least has, of course, also greatly helped in ensuring the continuity of this high-quality policy dialogue. This also facilitated the timely correction of approaches where these appeared to be necessary. au S. bo, MP D rtar Planni g and Development Cooperation LUSA-A. Cc. The Honourable Ronald D.S. Penza, MP Minister of Finance LUSAKA. Cc. Mr. Dominic C. Mulaisho Governor Bank of Zambia LUSAKA. Cc. Mr. Gideon Nkojo Resident Representative The World Bank LUSAKA.