Mozambique - Impediments to industrial sector recovery

Report No. 13752-MOZ Mozambique Impediments to Industrial Sector Recovery August 22, 1995 Macro, Industry, and Finance Division Southern Africa Department Document of the World Bank  GLOSSARY OF ABBREVIATIONS ADENA State-owned Customs broker ASYCUDA Computer system for Customs BCM Commercial Bank of Mozambique BRE Export Registration Bulletin BRI Import Registration Bulletin CFM Mozambican Railways CNAA National Commission for Valuation and Privatization CPI Center for Promotion of Investment CRF Clean Report of Findings DD Duty Drawback DE Duty Exemption DFIA Duty Free Import Administration DPR Enterprise Restructuring Dossier EGA Customs Handling Fee ESRP Economic and Social Economic Recovery Program FD Fixed Drawback FRIGO Maputo Road Terminal GATT General Agreement on Tariffs and Trade GREI Office for Restructuring Industrial Enterprises within the Ministry of Industry & Energy HS Harmonized System ID Individual Drawback IDA International Development Agency IFZ Industrial Free Zone IPEX Institute for Export Promotion L/C Letter of Credit LAM Mozambican Airline NIEs Newly Industrialized Economies PSI Pre-Shipment Inspection SGS Societe Generale de Surveillance SMWs Special-bonded Manufacturing Warehouses TIRO Beira Road Terminal UREA Unit for Restructuring Agricultural Enterprises within the Ministry of Agriculture UTRE Technical Unit for Enterprise Restructuring within the Ministry of Finance VAT Value Added Tax  PREFACE This World Bank report is based on the findings of a mission which visited Mozambique during June - July 1994. The mission was comprised of Rocio Castro (AFlMI), Task Manager, Arnold Sowa (AFIMI), Peter Glenshaw (IEMIN), Yung Rhee (PSD), Araceli de Leon (IFC), Patrick Low (IECIT), Jehan Arulpragasam (AFIMI), Bert Cunningham, Katherine Katterbach, Hilmar Hilmarsson and Bret Masterson (Consultants). This report was discussed with the Government of Mozambique in October 1994. It was presented to the Consultative Group meeting for Mozambique in Paris in March of 1995 and at the First Private Sector Seminar in Maputo in July of 1995.   TABLE OF CONTENTS Executive Summary Overview i Industrial Sector Performance and Constraints iii Policy and Implementation Issues xviii Chapter 1 - Industrial Sector Performance and Constraints Background I Impediments to Industrial Recovery: A Firm-level Analysis 3 Policy and Implementation Issues 18 Chapter 2 - Customs Administration and Pre-Shipment Inspection Introduction 21 Weaknesses in Current Customs Procedures 22 Customs Modernization Program 28 Chapter 3 - Development of Mozambique's Manufactured Exports Introduction 33 Access to Imported Inputs at World Market Prices 34 Access to Trade Finance for Exports 45 Access to Foreign Collaboration 48 Chapter 4 - The Business and Investment Climate Introduction 55 Regulatory and Institutional Constraints 56 Summary of Recommendations 66 Chapter 5 - Privatization Policy and Implementation Introduction 68 Preparatory Procedures 69 Redundant Labor 72 Transparency in the Bidding and Sales Process 74 Summary of Recommendations 75 Chapter 6 - The Cashew Sub-Sector Introduction 77 Output Performance 78 Pricing and Marketing System 79 The Current Processing Situation 82 Growth Prospects for Cashew 84 Summary and Recommendations 89 Annexes Annex I - Companies Interviewed by Mission with Summary Assessments Annex 2 - Proposals Regarding Pre-Shipment Inspection Contract Renewal   EXECUTIVE SUMMARY OVERVIEW 1. While most sectors in the Mozambican economy have responded favorably to the Economic and Social Rehabilitation Program (ESRP) initiated in 1987, the level of gross industrial output is no higher today than in 1986. Industrial output has actually declined steadily since 1990 with negative implications on export revenue. The value of commodity exports fell from a post-reform peak of US$162 million in 1991 to US$131 million in 1993. Exogenous factors can partly explain this situation. The war has disrupted production and marketing systems in rural areas and the supply of raw materials for agro-processing, Mozambique's largest manufacturing sub-sector. In addition, the loss of markets in the former Soviet Union and the Eastern Bloc has severely hit textile exports. However, it is also evident that the policy environment currently in place has not facilitated a reversal of the on-going decline in output. 2. In addition to restoring macroeconomic stability, reducing domestic inflation through tight fiscal and monetary policies, economic reform under the ESRP has focused on four key areas. First, trade has been substantially liberalized and the exchange rate realigned with the objectives of removing foreign exchange constraints and improving the competitiveness of tradable goods. Most exchange controls and quantitative restrictions on imports have been removed, and since 1992 the exchange rate has been determined by a unified market for foreign exchange. Second, the tax and tariff regime has been rationalized to reduce dispersion and to eliminate anomalies. In 1991, ad-valorem taxes replaced specific duties, and the number of duty categories were reduced. More recently, import duties on raw materials were lowered, industrial inputs exempted from the turnover tax, and the export tax suspended for five years. Third, enterprise and financial sector reform has aimed at increasing the efficiency of real and financial resources. By end 1994, 370 small and medium state-owned enterprises and twenty large ones had been privatized. Banking reform introduced new legislation and separated the commercial and central banking functions of the Bank of Mozambique in order to improve banking services and to stop the transfer of financial resources to loss-making parastatals. State- owned commercial banks are also being restructured and stricter lending rules are being enforced. Fourth, in order to boost private investment, a revised investment code enacted in 1993 simplified authorization procedures, revised the incentive package, and established an investment promotion center. 3. Despite these reforms, industrial performance in Mozambique has remained disappointing. The industrial sector is no larger today than it was in 1986; manufacturing output has declined since 1990. The purpose of this study is to identify impediments to industrial recovery that can be addressed in the short term, to assess growth potential, and to propose a strategy for achieving this potential. Taking the general macroeconomic and policy framework as given, a firm-level analysis has been carried out to determine how much of the industrial decline could be attributed to ownership, management and technological factors (microeconomic constraints) and how much to shortcomings in  ii policy design and/or implementation. Other constraints less amenable to short-term policy remedies such as poor infrastructure and lack of skilled labor, are not directly addressed in this study. The methodology relies largely on firm-level interviews and, to the extent possible, on available official data. 4. The conclusion of the study is that a multiplicity of factors account for poor industrial performance. First, a sharp distinction needs to be drawn between state and privately-owned firms. For the most part, private firms are potentially well placed to compete in the world markets given installed technologies, capital stock, and production costs.' However, firm-level analysis of the business environment points to several impediments to enterprise and industrial development. These include: (i) uneven collection of statutory duties and taxes, where local producers (generally) pay duties and taxes on their inputs and outputs while most importers escape them, resulting in 'negative' effective protection for import-substituting firms; (ii) inadequate provisions to ensure quick access to inputs at world prices undermining the capacity of manufacturing exporters to compete in international markets (for example, lack of a functioning duty drawback or temporary admission regime, retention schemes, or pre-financing facilities); and (iii) the imposing and often non-transparent regulatory framework, as evidenced by current labor and investment regulations, has further exacerbated the unfavorable conditions under which firms are forced to operate, and discouraged private investment, both domestic and foreign. 5. The picture with respect to state-owned firms is quite different. Apart from the constraints described, the operating difficulties of most state firms stem primarily from problems of poor management, low productivity, and high levels of indebtedness. The slow privatization of "large" firms has delayed enterprise restructuring, leaving approximately half of industrial output, notably agro-industrial exporting firms, under poor management and in a state of near paralysis. While the government has been successful in privatizing small and medium enterprises only eight large industrial firms had been privatized as of the end of 1994. Such slow progress reflects implementation problems resulting, in particular, from lengthy preparatory procedures and uncertainty about the accrual of labor liabilities (such as excess labor and wage arrears). 6. Finally, the cashew industry, historically one of Mozambique's main export earners, faces several distinct problems that go beyond those that affect public and private industrial firms which are a function of sub-sector specific policies. Most factories are either being privatized or rehabilitated. However, privatization/rehabilitation alone will not suffice to ensure the viability of the industry. High levels of protection have been given to the local industry, through low producer prices and exports restrictions on raw I This conclusion is supported by the findings of "Mozambique: Industrial Sector Study - The Development of Industrial Policy and Reform of the Business Environment", May 22, 1990, World Bank.  iii nuts, at the expense of the farmer, and of overall export revenues for the country as a whole. 7. The study has been organized in six chapters. Chapter 1 presents an overview of industrial sector performance and competitiveness on the basis of firm-level information and the existing policy environment by sub-sectors (import substitution industries, manufactured exports, and agro-industrial exports). The subsequent chapters are concerned with policy and implementation constraints. Chapter 2 deals with the administration of Customs and pre-shipment inspection. Chapter 3 presents priority tasks to develop manufactured exports. Chapter 4 examines the business and investment climate. Chapter 5 discusses privatization policy and implementation. Chapter 6 presents a detailed discussion of the problems facing the cashew sub-sector. A. INDUSTRIAL SECTOR PERFORMANCE AND CONSTRAINTS 8. In order to identify constraints to output recovery and determine the potential of Mozambique's industry, an assessment has been made of the efficiency and competitiveness of the sector given: (i) management and technical capabilities; and (ii) the impact of the incentive structure resulting from the existing trade and price regime (e.g., tax structure, exchange rate). Because of the lack of official disaggregated sub- sectoral data (on production, imports, prices, taxes and duties paid, etc.), relevant information was obtained through interviews conducted with sixty medium to large industrial firms (employing on average 580 workers). Taken together the firms represent over half of gross industrial output. Of the sample of firms interviewed, thirty-eight were privately-owned, six majority state-owned but privately managed, and sixteen state- owned. About a half of the firms interviewed are exporting or have the potential to export. 9. Based on these interviews, a distinction needs to be drawn between state and privately-owned firms when analyzing the efficiency and growth potential of the industrial sector. For the most part, existing capital stock, installed technologies, management capabilities and production costs within privately-owned firms indicate that most firms would be well placed to compete in the world market given a more conducive business environment. High protection levels are not a precondition for private firms to survive and prosper. However, several factors are preventing this competitive potential from being realized: (i) a discriminatory tax collection pattern whereby a large flow of imports enter the country tax-free while local producers generally have to pay taxes, severely undermining the capacity of domestic industry to compete against imports; (ii) lack of access to duty refunds or a temporary admission regime, impairing the ability of exporters to compete in international markets; and (iii) cumbersome and often non- transparent regulations and procedures significantly increasing the cost of doing business for the private sector.  iv 10. The picture with respect to the majority of state-owned firms is different. The slow privatization has left large industrial firms, which account for about half of industrial output, in need of restructuring and in a state of near paralysis. Because of inappropriate incentives and lack of managerial skills, these firms face problems of poor management, low technical performance (such as poor maintenance of machinery and equipment), and high levels of non-performing debts. Already starved of working capital, many enterprises have incurred wage arrears and are not in a position to make badly needed investments to replace obsolete plant and machinery. Moreover, once the announcement has been made that a company is to be privatized, it becomes difficult for the company to operate. Banks are reluctant to extend credit because of uncertainty about the future of the loans and customers are wary of engaging in any contractual arrangements. 11. These unfavorable conditions have led to low levels of output and capacity utilization, excess labor, and severe financial distress. Though more pervasive among state firms, a situation of excess labor is evident throughout industrial firms, as costly mandatory severance payments have prevented necessary reductions in the work-force, fuirther limiting competitiveness. While significant rehabilitation would be required for most state firms to work at full capacity, most private firms could increase production with little or no additional investment. Since over half of the firms interviewed are either exporting or possess the potential to compete in world markets, creating conditions for firms to better utilize installed capacity should have a significant impact on Mozambique's foreign exchange earnings.2 Import-substitution industries 12. With the liberalization of the trade regime through the removal of quantitative restrictions and the basic realignment of the exchange rate, the competitiveness of domestic industry is determined by the tax structure. The tax and tariff structure in Mozambique has been greatly rationalized and simplified with a reduction in the level and number of import duties, elimination of 'specific' duties, and homogenization of domestic and import taxation.3 Measures to lessen the cascading effect and tax burden for local manufacturers have been adopted over the past year. These have involved a reduction of import duties on raw materials and industrial inputs to 5 percent, lowering the customs handling fee, the Emolumentos Gerais Aduaneiros (EGA), from 7.5 to 2.5 2 Financial difficulties constitute a symptom rather than a cause of the problems currently being faced by industrial firms. 3 A tariff reform was implemented in 1991. There are five import duties (5, 10, 15, 25 and 35 percent) applied according to degree of processing plus a customs handling fee (EGA) which operates as a minimum duty. Both imported and domestically-produced goods are subject to a turnover tax (5 percent) and a consumption (excise) tax ranging from 20 to 150 percent for a selected number of products.  v percent, and exempting industrial inputs (both imported and locally produced) from the 5 percent turnover tax. 13. Firm level data on prices and production costs indicate that if the statutory tax and tariff structure were applied in practice, enterprises would enjoy positive levels of effective protection in the domestic market,5 ranging from minus 40 percent to 114 percent for the sample of goods examined in this study. Such protection levels are not excessive for developing countries, but the variance suggests some need for further rationalization of the tax structure, once the current problem of poor tax collection is solved. 14. Despite the apparent rationality of the tax structure from the point of view of domestic industry, in practice many producers face 'negative' protection in the local market. This derives from the fact that domestic manufacturers are more easily targeted by tax authorities to pay consumption and turnover tax on their final output, while Customs is often unable to enforce payments of duties and taxes on competing imports. The resulting negative effective rates of protection for domestic industry could be very high. In the extreme case, where local producers pay all taxes and importers evade them, negative rates of protection are estimated at minus 35 to minus 440 percent for the sample of products shown in Table 1. Although some importers of competing goods probably pay some taxes and some domestic producers have found ways to evade theirs, the lack of comprehensive data on tax and duty collection makes it impossible to assess actual levels of protection by product or sub-sector category. 15. Nevertheless, the evidence obtained in this study demonstrates a tax collection pattern that severely discriminates against the domestic industrial sector. First, a rough comparison between the revenue collected by Customs in 1993 and what should have been collected if statutory duties had been charged on recorded imports, reveals a shortfall of at least 55 percent. Part of this shortfall is explained by exemptions granted under various regulations (donor financed projects, the investment code), which account for some 18 percentage points; the remaining gap of 36 percent reflects tax evasion. It should be noted that this gap is under-estimated as it excludes the effect of under- declaration of goods by importers, thought to be a major vehicle of tax evasion, and 4 These measures were taken in December 1993 and August 1994. 5 Effective protection is the protection (duties and taxes) relating to the value-added whereas nominal protection relates to the final product. The level of effective protection depends on the level of duties and taxes on output and on the imported inputs. It measures the proportionate difference between value-added at domestic prices (including duties and taxes) and the value-added at world prices. Nominal protection affects the consumer. Effective protection is the relevant concept for a producer. 6 The effective rate of duty collection (including EGA), which is, total duties collected over total imports recorded by customs, was 12.4 percent in 1993. If exemptions were included, the rate would increase to 17.2 percent. This compares with a theoretical rate of 26.9 percent estimated using the import structure of 1992.  vi because it is based on the value of imports recorded by Customs (US$598.9 million) which is well below the value estimated for the balance of payments (US$955 million). Second, the effective domestic tax burden on industry is proportionally much higher than that on imports.7 Third, actual price comparisons between imported and domestically produced goods sold in local markets indicate that many imported products, mostly consumer goods, enter the country effectively duty-free. Table 1: Mozambique - Effective Protection of a Sample of Products Theoretical effective Estimated effective rate Product rate of protection of protection Capulana (Texlom) 51 3o -69% Capulana (TA) 58% -100% Gray Fabric (TL) 88% -84% Gray Fabric (TA) 92% -87% Shirts 107% -113% Trousers 1 14% -126% Sacks 31% -60% Cigarettes 32% -331% Fluorescent lamp 32% -113% Rail tanker -40% -134 Plastic razor 32% -127% Ball point pen 31% -239% Plastic pencil sharpener 41% -127% Metal truck trailer 10% -63% Tire 16% -44% PVC paint (I liter) 49% -35% Margarine 16% -82% Condensed milk 92% -439% Source: Survev data, WForld Bank analysis Manufacturing exports 16. Although the potential exists for manufacturing exports to expand, the inability to access imported raw materials and intermediate inputs at world market prices is viewed by exporting firms as the main reason for their lack of competitiveness in international markets. The impact of duties and customs charges (including the 5 percent EGA and the one percent ADENA charge) on manufacturing costs is considerable, raising these costs by 10 to 22 percent of total manufacturing costs for the sample of exports shown in Table 2. This reflects the high import content of Mozambican manufacturing exports, averaging 65 percent for the sampled exports. 17. Although duty drawback/exemption schemes for exporters are defined under the law, in practice, such schemes have proved virtually inoperable mainly because of lack of 7 For example. the turnover tax collected from industry amounted to US$17 million in 1993 and the turnover tax collected from imports amounted to US$20 million even though the value of industrial sales is at least half the level of imports.  vii implementation procedures and the inability of Customs to evaluate technical coefficients. Seven out of the exporting firms interviewed claimed to have applied in the past for duty drawbacks but with no success; only five exporters were found to hold licenses to operate bonded manufactured warehouses. 18. A second major difficulty confronting manufacturing exporters is the lack of quick access to short-term trade finance in hard currency. This difficulty stems primarily from the underdeveloped local banking system and uncertainty about the availability of foreign exchange (including allowed export retention schemes) which depends largely on external donor funds. Table 2: Impact on Manufacturing Costs of Duties Paid on Inputs * Excess costs of lack of access to imports at Excess costs of imported world price as % of inputs over world market Import total manufacturing Export Item prices (%) content costs Ball point pen 33% 60% 20% Plastic pencil sharpener 26% 66% 17% Disposable razor 32% 69% 22% Fluorescent light fitting 32% 65% 21% Steel roofing materials 22% 78% 17% Rolling stock 16% 60% 10% Car tire 23% 48% 11% Steel pipe (general use) 29% 770/o 22% Drainage pipe 28% 77% 21% Bicycles 23% 60% 14% Asbestos/cement construction materials 16% 60% 10% * Assumes EGA of 5% effective until August 1994. Source: Survey data, World Bank analysis Agro-industrial exports 19. Agro-industrial exports (cashew, tea and sugar), historically Mozambique's main foreign exchange earners, have been severely hit by the war which disrupted production and marketing systems.8 In addition, most agro-industrial firms are still controlled by the state and face serious problems of excess labor and wage arrears, obsolete/destroyed capital equipment, and high levels of overdue debts.9 Operations have nearly stopped in many factories because of lack of working capital and because significant investments, including the restoration of farm-level production systems, would be required to expand output. 8 The state "intervened" these firms after independence and grouped them into large conglomerates. For example, Caju de Mocambique (for cashew) and Emocha (for tea). The sugar estates have been kept separate. 9 These firms are among the largest delinquent debtors of the banking system.  viii 20. The economic viability of investments in tea and sugar will depend upon international technological and market changes and the establishment of efficient farm level production and marketing systems. Clearly, the risk of such investments should be borne by the private sector through privatization. The government should therefore re- assess its decision to embark on expensive rehabilitation projects prior to privatization which could generate marginal or negative returns.