Madagascar - New horizons : building a strategy for private-sector, export-led growth - a private sector assessment

Report No. 14385-MAG Madagascar New Horizons -Building a Strategy for Private-Sector, Export-Led Growth A Private Sector Assessment May 31, 1995 Industry and Energy Division Corporate Planning Departnment South-Central and Indian Ocean Department Sub-Saharan Africa Department Africa Region International Finance Corporation - - - - . . A -R~~~~~~~~~~~~~~_  CURRENCY EQUIVALENTS Currency Unit = Malagasy Franc (FMG) US$1 = FMG 1,914 (average 1993) = FMG 2,947 (May 9, 1994 - first day of free float) - FMG 4,245 (May 31, 1995) ABBREVIATIONS AND ACRONYMS AELGS Accelerated Export-Led Growth Strategy AGETIP Agence d'Execution de Travaux d'lnteret Public AGETIPA Agence d'Execution des Travaux d'Infrastructure Publique d'Antananarivo AGS Accelerated Growth Strategy BCRM Banque Centrale de La Republique de Madagascar BDE Banque de Donnees de l'Etat BFV Commercial Bank (Banky Fampandrosoana ny Varotra) BLRC Business Law Review Committee BMOI Banque Malgache de l'Ocean Indien BNI Industrial Development Bank (Bankin'ny Indostria) BOO Build-Own-Operate BOT Build-Operate-Transfer BTM National Rural Development Bank (Bankin'ny tantsana Mpamokatra) CAS Country Assistance Strategy CCBEF Commissioin de Contr6le des Banques et d'Etablissements Financiers CEM Caisse d'Epargne de Madagascar CIP Commission Independante de Privatisation CMN Compagnie Malgache de Navigation CNAPS Caisse Nationale de Prevoyance Sociale CNFTP Conseil National pour la Formation Technique et Professionnelle CoC Chamber of Commerce CRES Conseil de Redressement Economique et Social DGGP Direction Generale de la Gestion de la Privatisation EDP Electronic Data Processing EEC Export European Committee EPZ Export Processing Zone ESN Economic Strategy Note FDI Foreign Direct Investment FNI Fonds National d'Investissements GEM Groupement des Entreprises de Madagascar GSP General System of Preferences HVFEs High-Value Food Exports ICPR Investment Code Preferential Regime ICSE Investment Code Small Enterprises ILO International Labor Organization IPO Inter-Professional Organization JIRAMA Power and Water Malagasy (Jiry sy Rano Malagasy) KRAOMA Kraomita Malagasy LC Loi Commune  Madagascar: Private Sector Assessment PREFACE This Report is a joint World Bank/International Finance Corporation assessment of the prospects and constraints for Private Sector Development in Madagascar, and the potential contribution of the private sector (domestic and foreign) to that country's longer run economic growth. It is based upon the findings of a joint Bank/IFC mission that visited Madagascar in March/April 1993, and that undertook a sample survey of private enterprises there, as part of its work. The mission team included: Messrs. Paul Ballard (World Bank staff member - AF3IE), David Donaldson (IFC staff member - CPLD 1), and Mrs. Caroline Doggart and Mr. Richard Randriamandrato (Consultants). Mr. Stephen Gaull (World Bank Consultant - AF3IE) prepared the analysis of the sample survey results. Mr. Govindan Nair (World Bank staff member - AF3IE) undertook the analysis of the financial sector (with Mr. Donaldson), as well as an earlier private sector review (as a desk study in 1992). Preparation of the Report was coordinated jointly by Messrs. Ballard and Donaldson. Ms. Linda Desscan (World Bank staff member - AF3IE) provided logistic and word processing support, and prepared the Statistical Appendix. The peer reviewers were Mr. Chad Leechor (EA3CO) and Ms. Tomoko Tatara (CFAF1). The Managing Division Chief is lain T. Christie (AF3IE) and the Department Director is Andrew Rogerson (AF3DR). The main findings of this Report were first discussed with a Madagascar Government delegation that visited Washington D.C in early October 1993. Findings and recommendations were then discussed with Government officials from the main economic ministries and a cross-section of sector ministries in Antananarivo in November-December 1993. A later version of the report was transmitted to the Malagasy authorities in May 1994, and contributed to the discussion and negotiation of a draft Policy Framework Paper in June 1994. Comments from the government and private sector, received in May 1995 contributed to the final version. The report also helped define the scope of further policy design work since undertaken, in the areas of trade and export policy, taxation policy, investment code reform, privatization and business law. As such, it has been used over the past eighteen months as an interactive framework for discussion and policy dialogue with the Government and the private sector on these issues. The analysis has been updated to reflect the current status of government policies and recent economic performance, based upon latest available data. The issues and strategy it presents are very much at the heart of the policy debate today in Madagascar and in the policy dialogue with the Bank and the international financial community.   Madagascar: Private Sector Assessment LDC Less Developed Country NGOs Non-Governmental Organizations NIEs Newly Industrializing Economies ODA Official Development Assistance OECD Organization for Economic Cooperation and Development OGIL Open General License OTC Over-The-Counter PLBF Privatization Long-Term Bond Fund PTF Privatization Trust Fund PVO Private Voluntary Organization RNCFM Reseau National de Chemins de Fers Malgache QR Quantitative Restriction SECALINE Securite Alimentaire et Nutrition SEPT Societe d'Exploitation du Port Toamasina SILI Systeme Int6gre de Liberalisation des Importations SIRAMA Malagasy Sugar (Siramamy Malagasy) SONAPAR Societe Nationale des Participations SOTEMA Societe de Textiles de Majunga SMPL Societe Malgache de Produits Laitiers TM Telekom Malagasy   IBRD 24945 MADAGASCAR PRIVATE SECTOR AT A GLANCE SOCIO/ECONOMIC INDICATORS >Antsiromna POPULATION AND LAOUR (IN FIGURES) FORtCEIN'0Os - 199" FARITANY (PROVINCE) .y GDP per cap;ta, 1991: 210 ARNY O PbpuIrtion: 12,000 Grooth Rote 1980-1991: 0.5% pa. FARITANYBOUNDARIES Gwwfh Rate: 2.8% p.a. Wlant Mortolity 116 * NATIONAL CAPITAL Labour Force: 5,400 Adulh Literacy: 80Yr . 4300 Pr,nrury School Enrollment: 92% - Tertioay -oo LiHe Epr-cton,ry. 51 Mohajango -t Empnent: 380 IToamasina REGIONAL DISTRIBUTION GROSS DOMESTIC PUONCT - " OF PRIVATE SECTOR ACTIVITY ANTANANARIVO / Anulrtonorrrino / crs.w PUBUC 50% 7 ~~~~~~~~~~~~~~~~~~~~~~~~~25% i/ > hJ ,/ _~~~~~ I E r,g th- PRIVATE Lnrployrrel Othe,,S; Fron)oraotsoerP i A 50% Flaator 5 A46toOooOrro S Y 4econdary 33% 0180 58 IsO ~14% Toliory7 I Thi. mop h., bon pr.pored by The Wortd B.nl.P stof ezclsi,'el, fo, the cof-o,mc tornrber o ( . of r-oders ond u for th_ trltnrpr'$oO Otho r , nternol -s. of The WorldBook Trory 54% / ~~~~~~~~~~~~~~~~~~~Grou Th. d-.norotino, rod 1 549'o \ . ond the borndor,ies shown -sthisrso dorrtinsplyorthro port of r . World =ohGrou /,ony dl rent o- thl. legs te., rr itory o n -ndorsement or oc-eptoco 0f ,u.h b-udor-o FREE TRADE ZONE EXPORTS AS A IVSMN %o N)I" - 9 % OF TOTAL MERCHANDISE EXPORTS INVSTMENT ( of GNP) 1985-1991 16.00 r 16- 4- 14 __2__ _ 0886 PU0LIC Orober 1993   Madagascar: Private Sector Assessment CONTENTS Executive Summary i I - PROFILE AND CHANGING ROLE OF THE PRIVATE SECTOR ............ 1 A. Country Background and Recent Economic History ..................... 1 B. Profile of Malagasy Private Sector ................................ 4 C. Sectoral Characteristics and Performance ............................ 6 D. Changing Role of Public Sector .................................. 9 E. Structure and Role of Financial Sector .............................. 9 II - PROSPECTS AND CONSTRAINTS FOR ACCELERATED PRIVATE SECTOR DEVELOPMENT ......................11 I A. Potential and Prospects for Private Sector Development ................... 11 B. Private Sector Business Sentiment and Outlook ........................ 22 III - BUILDING POLICIES FOR PRIVATE-SECTOR EXPORT-LED GROWTH .... ...... 33 A. Overcoming Bottlenecks and Distortions in the Exchange, Trade and Export Regimes .............................................. 33 B. Reforming the Tax System and Fiscal Incentives ....................... 38 C. Re-Orienting and Upgrading the Role of Government in the Economy ... ....... 42 D. Achieving Transparency while Accelerating Privatization .................. 46 E. Improving Equality of Access and Participation: Reshaping Domestic Competition and Regulatory Policies .................................... 57 F. Creating a "User Friendly" Environment for Foreign Investment .... ......... 64 G. Mitigating Investment and Transactions Risk: Modernizing and Rebuilding Business Law ................................................ 65 H. Consolidating Financial Sector Reforms and Deepening Capital Markets .... ..... 69 IV - LAYING FOUNDATIONS FOR SUSTAINED LONGER RUN PRIVATE SECTOR COMPETITIVENESS: INFRASTRUCTURE, SKILLS, PRIVATE SECTOR INSTITUTIONS AND SUPPORT SERVICES .......... .. ............... 81 A. Modernizing and Expanding Madagascar's Infrastructure .................. 81 B. The Human Factor: Building Labor Skills for the Future .................. 87 C. Empowering Private Sector Business Leadership: Private Sector Organizations, Information and Support Services .............................. 91 V - SYNTHESIS: A POLICY AGENDA FOR ACCELERATED, PRIVATE SECTOR EXPORT-LED GROWTH ....................................... 99  Madagascar: Private Sector Assessment Text Tables 1.1 Madagascar: Key Macroeconomic and Fiscal Indicators 1980-1993 3 2.1 Coffee: World Prices and Supply Trends (1980-2005)-Mt 000's 14 2.2 Apparel Exports of Some Leading Asian LDC Countries and Mauritius 1970-1991 16 2.3 World High-Value Food Exports, 1980-90 18 2.4 World Shrimp Exports, 1977-91 19 2.5 PSA 1993 Enterprise Survey: Sample Profile 23 2.6 PSA Firm Survey: Characteristics of "New Generation" Versus Older Companies 25 2.7 PSA Survey: Comparison of Export-Oriented and Import-Substitution Firms 25 4.1 Education in Madagascar and Selected Countries 88 4.2 Madagascar: Private Sector Business Support Services 94 5.1 Madagascar: Macro-Economic Projections (1994-2000): Accelerated Export- Led Growth Scenario - Growth, Exports, Investment and Capital Inflows 100 5.2 Madagascar - A Policy Agenda for Accelerated Private Sector, Export-Led Growth 104 Text Boxes 1 Free Trade Zone Performance 1990-1993 8 3.1 Opportunities for Economic Growth and Jobs in Former "Natural" Public Monopolies such as Telecoms and Power 57 3.2 Madagascar: Selected Examples of Restricted Competition and Their Economic Consequences 61 3.3 Madagascar: Competition, Price and Market Controls in Agriculture 62 3.4 Investment Finance for Non-Traditional Exports to Achieve 6 percent Real Growth by 2002 70 3.5 Structure of Malagasy Financial Sector 71 3.6 Financing for Large, "Lumpy" Long-Term Investments for Privatized Infrastructure and Utilities - The Concept of a Privatization Long-Term Bond Fund 80 4.1 Senegal: Private Delivery of Municipal Works 85 Text Figures 2.1 Madagascar Traditional & Non-Traditional Exports, 1985 & 1991 (%) 12 2.2 Hourly Unit Labor Costs in Garments Manufacturing for Madagascar and Selected Exporting Countries in US cents (1991) 20 2.3 Madagascar: Private Sector Assessment 1993 Enterprise Survey 26 2.4 PSA Firm Survey: Variations in Constraints by Incentive Regimes 30 3.1 Madagascar - Trends in Exchange Rate, Terms of Trade, and Merchandise Trade Balance, 1980-93 34 3.2 Madagascar - Tax Revenues in 1984 and 1990 (%) 39 3.3 Madagascar - Government & Public Enterprise (PE) Sector Role in The Economy: Key Indicators (1991) 44 3.4 Madagascar: Government/PE Intervention in Key Sectors 47 3.5 Madagascar: Public Enterprise (PE) Reform - Status of Privatization Program (as of March 1993) 51 Annexes 1 - 7 are available upor request from the report file.  Madagascar: Private Sector Assessment i MADAGASCAR: A PRIVATE SECTOR ASSESSMENT Executive Summary 1. Country Background. Madagascar is a country with tremendous economic potential, yet one whose performance has been very poor. It has an abundant, trainable, low-cost labor force and a diversified natural resource base offering strong potential for agriculture, fisheries, mining and tourism. It can also benefit from proximity to Mauritius to develop low-cost, labor-intensive, non-traditional exports (notably garments). Yet economic performance has been disastrous: over 1971-91, per capita income fell by 40 percent to $230 making it one of the poorest countries in the world. 2. Focus of This Report. Since the mid-1980s, Madagascar has undergone major, but incomplete, structural changes in its economy. These have underscored its longer run potential, provided the necessary transformation (in policies, infrastructure and skills) can be effectively carried out. Expanded private investment and production made a key contribution to structural change. They were promoted by a major shift towards a liberalized market economy. However, state intervention remains pervasive in the modem sector and in important sectors of the economy (notably agriculture, mining and infrastructure). Yet Madagascar finds itself today in a similar position to that three decades ago of East Asian economies (such as Malaysia, Indonesia, Thailand), which have since achieved sustained rapid economic growth and improved well-being for their populations. This Report analyzes Madagascar's prospects in this context, and the major constraints it faces. It proposes specific measures to overcome these through accelerated private-sector, export-led growth. 3. The Challenge: Harnessing Unrealized Potential. Today, Madagascar is a largely undermobilized economy: 80 percent of the adult population is literate, but 80 percent of the labor force works in subsistence activities. The financial system is very shallow and under-developed in terms of savings and investment. Decades of isolation from world markets have retarded acquisition of modem technology, marketing and management skills. Achieving its considerable unrealized economic potential thus presents Madagascar with an immediate challenge but also a major opportunity. 4. Low and very competitive labor costs by world standards, a large pool of underemployed, easily "trainable" labor; and a strong natural resource base are powerful sources of comparative advantage. However, these need to be viewed as a starting point, enabling Madagascar - if it so chooses - to embark upon a path of sustained, dynamic, export-led growth. This shift will necessarily involve a gradual transition, given the major structural changes required. As in the East Asian high- performance economies (HPEs), in Madagascar pursuing a course of growth with equity - that is, from the outset, ensuring broad popular participation in the growth process - will be essential. In this, private sector development has a vital role to play, through expanded start-ups and productivity in local small enterprises, and promoting major inflows of foreign direct investment (FDI), with greater openness (removal of barriers to entry) and competition.  Madagascar: Private Sector Assessment ii Recent Economic Performance and Role of the Private Sector 5. Recent Economic Performance. After a decade of economic decline over 1975-85, due to inward-looking policies and state domination of the economy, the Government undertook major reforms leading to fundamental changes in the private sector business environment. These included liberalization of the exchange and trade regime, and of most domestic markets for manufactures and for some - but by no means all - key agricultural commodities, initial efforts at privatization of public enterprises (PEs), and at restructuring the state-run banking system, and liberalization of credit policies. The private sector response was very positive: Over 1986-91, GDP growth accelerated to 4 percent p.a., private investment expanded massively, and non-traditional exports grew rapidly. However, the 1991 political upheaval halted growth and economic reforms, but led by 1993 to a new Constitution and installation of a fledgling multi-party democracy. 6. Current Macroeconomics Framework: No Room for Maneuver. From mid-1993 into early 1995, Madagascar emerged facing massive and growing macro-economic imbalances critically impairing its ability to shift to an accelerated growth path, hamstringing the Government's ability to provide key public services, and impeding private investment and production. 7. This has been due to poor fiscal and monetary management, despite renewed efforts since mid- 1994 to restore export competitiveness through the floating of the FMG and renewed trade liberalization measures: (a) The tax/GDP ratio declined from an already low 10 percent in 1993 to about 7.5 percent in 1994, greatly reducing public sector resources and expanding the fiscal deficit to 11.5 percent of GDP; (b) Inflation accelerated to over 60 percent, fueling uncertainty for private investors, further undermining the banking system, and eroding competitiveness gains from the FMG float. Meanwhile, the trade deficit widened to almost 12 percent of GDP, financed by massive further accumulation of arrears in payments to external creditors, adding to Madagascar's already high extemal debt burden. 8. Increased Private Investment Vital for Growth. Stabilizing Madagascar's economy - by now a top priority - calls for re-establishing fiscal and monetary discipline. This will require addressing the unsustainable gap in public finances through increasing tax revenue collection, containing public expenditures and improving their efficiency, and reducing the fiscal deficit and govemment borrowing. Implementing fiscal reforms will take several years to raise the tax effort to comparable levels elsewhere in Africa. Meanwhile, Madagascar's investment rate has been very low in the past, particularly private investment which averaged only 4 percent of GDP, compared with 10 percent for African adjusting countries and 20 percent for East Asian HPEs. Implementing a critical mass of policy reforms to win domestic and foreign investors' confidence and considerably expand private investment will thus be key to Madagascar's growth prospects. 9. Profile of Madagascar's Private Sector. Since the mid- 1 980s, Madagascar's private sector has been undergoing a fundamental transition. A "new generation" of more dynamic, modern technology small and medium enterprises has evolved rapidly to take advantage of market liberalization reforms by expanding non-traditional exports (see below). Before then, despite state domination of the modern sector, the private sector had always predominated in terms of employment and number of firms, but overwhelmingly through small-scale and informal rural subsistence activities. Madagascar's formal private sector remained limited in scope, and highly concentrated regionally (in and around the capital Antananarivo), and in terms of size, with monopolies or oligopolies in many sectors.  Madagascar: Private Sector Assessment iii 10. The Malagasy private sector thus comprises four broad categories of enterprises and entrepreneurs: (a) a large-scale, formal indigenous private sector, including prominent families from the highlander elite, until recently involved in import-substitution and trade, and over-represented in business organizations; (b) a foreign affiliated private sector, comprising long-time resident non- indigenous groups of Indo-Pakistani, Comorian, French or Chinese origins, representing a dominant share of foreign investment; (c) a non-resident foreign private sector, which includes foreign investors (often Mauritian, French, South African, or Asian) who started businesses in Madagascar in the late 1980s in response to the market liberalization reforms, many on the export processing zone; and (d) a small-scale, indigenous private sector, which is largely family-based, and often subsistence-based, and comprises the vast bulk of the firms, as well as more modem ones representing over 80 percent of registered enterprises, but with few if any trading or financial links overseas. 11. A Dynamic "New Generation" of Private Entrepreneurs. In this context, a March 1993 survey of about 40 Malagasy private enterprises undertaken for this Report highlighted the emergence of a new generation of dynamic private enterprises, following the economic reforms of the mid- to late 1980s. These firms are: (a) predominantly (though not all) export-oriented; (b) smaller in size (in terms of sales and employees) than older firms; (c) rapidly expanding (experiencing 25-50 percent production growth since 1988); (d) operating at higher capacity utilization, and facing expanding demand; (e) more often located outside Antananarivo; (f) more often Malagasy owned; and (g) frequently engaged in non-traditional exports, including under the Export Processing Zone (EPZ) regime. In short, it is these firms which have spearheaded Madagascar's export diversification since the mid-1980s. 12. Sectoral Performance Trends. Recent sectoral performance has been dominated by the quality of the business environment and the impact of economic reforms: (a) those sectors experiencing market liberalization (notably in agriculture and manufactures, e.g., rice, garments, horticulture) have enjoyed rapid expansion in private investment, production and exports, while other sectors have stagnated, or declined (e.g., major traditional exports such as vanilla, cloves, as well as sugar, meat, cotton); (b) non-traditional exports, including some manufactures (e.g., garments) and high-value foods (e.g., shrimp, fish, fruit, etc.), have expanded rapidly - by over 20 percent p.a. over 1984-91 - to represent a much increased share of total exports; (c) creation in 1990 of a functional (not geographic) Export Processing Zone regime (EPZ), modeled after Mauritius - granting free trade and off-shore investor status to firms exporting all their production - contributed by 1993 to a spectacular growth in merchandise exports (1 5 percent of total), in modem sector employment (over 10,000 new jobs), and in foreign direct investment; and (d) while it remains pervasive, the share of public enterprises (PEs) in the economy has declined: Over 1988-92, about 68 PEs were privatized or liquidated, still leaving well over 100 PEs dominating major sectors of the economy. Prospects and (Constraints for Accelerated Private Sector Development 13. The lnIperatives of Export Diversification and Growth. With limited domestic demand, and a major import constraint, expanding and diversifying exports are key to accelerated growth. This is even more the case because of major shifts in world market demand for Madagascar's traditional exports since the mid-I980s: (a) coffee, vanilla and cloves exports have declined in terms of prices and volumes, and the long-term world market outlook is poor; (b) meanwhile, non-traditional exports have expanded rapidlv, undertaken by local and foreign private firms, notably fruit and vegetables, shrimp and fish, some minerals, tourism, and more recently EPZ exports of garments. In effect, a  Madagascar: Private Sector Assessment iv permanent structural shift is occurring in Madagascar's external trade, with non-traditional exports displacing traditional ones as the major source of growth. 14. Achieving a 6 percent annual economic growth rate by the year 2002 will require a major expansion in export earnings in real terms from $320 million in 1993 to over $800 million, most of which will need to come from non-traditional exports. 15. Madagascar has good potential to achieve this because its non-traditional exports are concentrated in areas where world market growth is high, Madagascar's cost advantages are potentially strong, and current output is well below feasible production levels. These are also areas in which East Asian HPEs - and other fast-growing developing countries - have achieved considerable export success since 1980, posting export growth rates over 15-20 percent p.a., or often more than double overall world market growth. Key factors in this performance have been: (a) high and expanding private investment and production; (b) foreign investor involvement - alone or in joint-venture with local entrepreneurs - which has provided technology and marketing expertise, as well as market access, and (c) Governments maintaining appropriate export-oriented policies and making investments in infrastructure and skills development. 16. Lessons from the East Asian Experience. Recent studies have highlighted that East Asian HPEs' successes have been due to consistent pursuit of appropriate macro-economic and sectoral policies that are key to dynamic export-led growth. These have included: (a) pro-export trade and exchange rate policies, giving broad-based market incentives to private exporters; (b) fiscal discipline and low inflation, facilitating high domestic savings and investment; (c) open and close government-business cooperation, facilitating consensus-building on economic growth objectives; (d) forging consensus among different groups on a principle of "shared growth" by which all benefited as the economy expanded; (e) giving high priority to building human capital (in primary and secondary schools), and to flexible labor market policies; (f) openness to foreign technology and foreign direct investment; (g) adoption of a conscious "export push" strategy aggressively promoting non-traditional export development; and (h) emphasizing efficient infrastructure development to enhance export competitiveness. 17. Malagasy Business Sentiment and Outlook. Entrepreneurs' perceptions of the constraints they face and their confidence and future outlook are key factors affecting private sector behavior. To assess private business sentiment in Madagascar, a survey of 38 private firms was undertaken for this report in March 1993, the results of which are still highly relevant today. 18. The PSA Firm Survey generated very significant findings in four areas: (a) in terms of performance, newer, smaller, mainly export-oriented private firms substantially out-performed larger, older import-substitution enterprises over 1987-92, posting major expansion in investment, employment, output and exports; (b) the same group of more successful firms were more optimistic about the outlook for future growth, provided their major constraints could be overcome, but felt more exposed to risks of macro-economic and political uncertainties; (c) most firms identified the same half dozen major and immediate common binding constraints: poor infrastructure (especially telecoms and roads), high cost of and poor access to finance; high political uncertainty; difficult access to foreign exchange; and high cost factors of production; and (d) importantly, the Survey highlighted major variations in the nature and magnitude of constraints faced by different categories of firms, pointing to discrimination among firms across different types of activities but also among ones in the same line of  Madagascar: P'rivate Sector Assessment v business. This is due to the highly segmented and distortionary system of fiscal incentives regimes: the Investment Code (divided into two regimes, one for small enterprises), the EPZ regime, and the far less advantageous "common law" ("droit commun") regime that applies to all other firms. Building Policies for Private-Sector, Export-led Growth 19. A range of govemment economic policies and regulations crucially affect the efficiency of the private sector and its contribution to Madagascar's economic development. The key policy factors, and proposals for specific reforms, are presented in the following paragraphs. Since first preparation of this report (in 1993), these recommendations have been discussed with the Malagasy authorities and a number of actions taken, though as yet these are far from complete enough to support the accelerated growth objective. 20. Overcoming Distortions in the Exchange, Trade and Export Regime. Madagascar has undertaken far-reaching changes in its exchange, trade and export regime since the mid-1980s. These extemal trade liberalization measures led to a major improvement in Madagascar's export competitiveness into the early 1990s, and to a rapid expansion of non-traditional exports. This was cut short by the political upheavals of 1991-92. The policies undertaken comprised: (a) adoption of a flexible exchange rate policy, with gradual depreciation of the FMG over 1984-86, followed by major devaluations over 1987-89, halving the real exchange rate; (b) removal of quantitative import restrictions (QRs); (c) customs tariff reform over 1988-92 simplifying the rate structure and reducing peak rates to 50 percent in 1992; (d) export trade liberalization through removal of export licensing and abolition of state export monopolies; and (e) creation in 1990 of the Export Processing Zone (EPZ). 21. Exchange and trade liberalization were partially but significantly reversed in 1991-93: the real exchange rate appreciated substantially, meanwhile exchange controls for merchandise imports were re-introduced, increasingly eroding export competitiveness, especially for non-EPZ but also for EPZ exports. To offset this, in mid- 1994, the Govemment allowed the FMG to float (resulting in a nominal devaluation of over 100 percent), once again liberalized import controls, and reduced peak customs duty rates to 30 percent. 22. Despite recent actions, Madagascar's incentives regime still has major short-comings as a means of promoting accelerated export growth: (a) while it restored competitiveness initially, gains from the FMG float are being eroded by increased inflation, which is creating increased uncertainty for exporters; (b) the EPZ is enabling EPZ exporters to operate on an offshore, free-trade basis to hedge against exchange risks and maintain competitiveness. However, non-EPZ exporters are discriminated against compared to their EPZ counterparts, facing taxes and controls on their activities; (c) even after recent reforms, the customs tariff structure remains cascaded and distortionary: high protection is given to finished goods relative to intermediates and other inputs, and pervasive duty exemptions discriminate randomly among producers and reduce tax revenues greatly. 23. Strategic Options for Export-led Growth. Experiences of successful exporting developing countries point to two alternative strategic options for Madagascar to promote accelerated export-led growth: (A) maintain and extend the EPZ, but keep it separate from domestic market activities, which would remain (as now) protected and regulated; or  Madagascar: Private Sector Assessment vi (B) maintain the EPZ, but take steps progressively to harmonize the domestic market and non-EPZ export regime with the EPZ regime in the medium term (say 2-4 years). 24. Of these two, Strategy (B) is recommended as more appropriate for Madagascar, as it will enable Madagascar to achieve faster and more balanced export growth and employment creation, by building upon the success of the EPZ to exploit its large natural resource base for raw materials, as well as using imported inputs. Strategy (A), on the other hand, is more appropriate for a small island economy such as Mauritius, where the export boom has been largely imported-input based. 25. Implementing Strategy (B) would involve: (a) fully liberalizing imports of goods and services, and reducing customs duties to low levels (e.g., a flat 15 percent rate); (b) permitting non-EPZ exporters to retain up to 50 percent of their foreign exchange receipts, until current account transactions can be liberalized; (c) streamlining and improving temporary admission, duty-drawback, and VAT exemptions to place all exporters effectively on a free-trade regime; (d) reforming the tax system to shift revenue collection away from extemal trade and towards protection-neutral sales and value added taxes, while drastically reducing ad hoc customs duty exemptions. 26. Reforming the Tax System and Fiscal Incentives. Because of its effect upon costs and prices, upon investment returns, and its widespread use to provide incentives, the taxation system is a comerstone of the business environment for modem private enterprise. Madagascar's taxation system has a major impact on the incentives for and behavior of private firms. Its performance has deteriorated substantially in recent years, and it suffers from a number of major shortcomings in policy and administration. 27. Weaknesses of the Taxation System. The main deficiencies are: (a) low and declining revenue generation: after averaging almost 13 percent of GDP over 1987-91, tax revenues fell sharply since to only 7.7 percent in 1994 (compared with a range of 18-37 percent of GDP for other African countries), thus falling far short of Govemment's needs to provide key social services and infrastructure. A major cause is a complex and pervasive system of ad hoc tax exemptions to firms and individuals, compounded by weak administration and evasion; (b) weak tax administration; (c) excessive dependence upon taxes on international trade, notably customs duties and VAT on imports, which are distortionary and support inefficient industries; (d) antiquated taxes and collection systems, most notably an outdated, low-yield, complex property tax, outmoded features of the corporate income tax, including inadequate treatment of depreciation and of asset revaluation, and a highly discretionary ad hoc system of exemptions with no clear rationale; (e) inadequate tax treatment of foreign investment: Madagascar has no double-taxation avoidance treaties other than with France - a major handicap for attracting foreign investors from other countries, (f a low-yielding distortionary system of petroleum product taxes, due to subsidized petroleum prices (until the very recent increase in February 1995); (g) special fiscal incentives regimes (two in the Investment Code, a third under the EPZ, others under the General Tax Code) that are complex, cumbersome and administered in an ad hoc fashion. These have created a very uneven playing field, discriminating strongly against local small firms and foreign investors. 28. Need for a Major Overhaul. Madagascar's taxation system is in urgent need of a major overhaul in order to improve tax administration and revenue collection, while avoiding price distortions that bias private investment and production decisions towards economically less viable activities, and  Madagascar: Private Sector Assessment viz ensuring equitable treatment of different categories of private investors. Key elements of this should be: (a) major reorganization and strengthening of tax administration, first at the central then the local levels; (b) a time-bound program for increasing tax revenue yield, to raise this quickly to previous levels (around 12 percent of GDP) in the short-term, and then to levels on a par with other developing countries (around 18 percent) in the medium term; (c) shifting tax revenues away from external trade taxes and replacing these with protection-neutral consumption and sales taxes, notably through phasing out of fiscal exemptions and improvements in the VAT and its administration, in order to encourage export growth; (d) modernizing and revamping the corporate income tax and property tax systems; and (e) overhauling the Investment Code and other ad hoc fiscal incentives regimes, to establish a level playing field among all investors and to ensure automaticity and equity, and that incentives are based upon a clear economic rationale, that justifies the revenue foregone by the exchequer (see below). 29. A comprehensive reform and modernization of Madagascar's taxation system needs to be undertaken in stages. The immediate priority need is to strengthen tax administration and its basic systems, so as to ensure significant near term improvements in revenue collections. Involvement of private sector firms and taxpayers should be achieved through joint public-private sector focus groups, as well as much improved taxpayer information and education. Subsequent stages of the tax reform should focus on revamping major categories of taxes, as well as reorganization and modernization of major tax administration functions. It is also proposed that a major reform of the Investment Code be prepared separately. Since first preparation of this report, a govermment inter- ministerial working group has prepared the design of the Investment Code reform, which has been approved by Cabinet and submitted to the National Assembly. A work program has been prepared for implementing the first stage of the tax system strengthening, to be supported by IMF and Bank staff and Bank-funded technical assistance. 30. Re-Orienting and Upgrading the Role of Government in the Economy. Despite major changes since the mid-1980s, Govemment still plays a predominant, controlling and intrusive role in Madagascar's economy. Government has a vital function in providing efficient public services in support of economic growth and private sector development. For it to do so in Madagascar wvill require a major re-orientation. In aggregate, in 1991, Govemment and the public sector accounted for almost 30 percent of output, 50 percent of modem sector employment, a predominant share of total investment and almost 40 percent of domestic credit. They also dominate major economic activities, including five of the seven major sectors of the economy (agriculture, mining, utilities, infrastructure, and banking). Inefficiencies in Govemment and the public sector are key factors constraining Madagascar's economic performance: They are inefficient consumers and investors, using resources and implementing projects slowly and inefficiently, due to complex and cumbersome procurement procedures, shortages of counterpart funds, and overextended managerial capacity and skills. As a result, public services are often of poor quality or even non-existent. 31. Upgrading Govemment and the Public Sector will require: (a) focusing scarce public resources on priority public services, and disengaging from activities better undertaken by the private sector or by local communities; (b) shifting from a "control-oriented" bureaucracy to a modem technocratic govemment administration focused on policy-making, and planning and efficient delivery of key public services; c) a major overhaul of implementation capacity, including streamlining and simplifying public sector procurement procedures and practices, and greatly increasing contracting out  Madagascar: Private Sector Assessment viii to private operators; (d) modemizing policy-making and regulatory capacity, aimed at promoting competition and efficiency, and removal of "barriers to entry", while adequately protecting consumers' interests; and (e) building a partnership with the private sector, through active dialog on policy reforms, and through expanded private sector service delivery. 32. Achieving Transparency while Accelerating Privatization. Up until its suspension by the newly elected Govemment in July 1993, Madagascar's privatization had made some significant progress since its inception in 1988 in terms of the number of enterprises privatized or liquidated. However, achievements had been much less than planned, and the program had aroused much public controversy due to widespread perceptions of lack of transparency. Of about 175 commercial and financial PEs existing in 1985, at least 100 remained under state ownership in 1993, accounting for about 14 percent of GDP and with about 100,000 employees, or 25 percent of modem sector employment. 33. Over 1988-93, Madagascar's privatization program had encountered major problems: (a) it was limited in scope, and avoided divestiture of larger and loss-making PEs, and thus had little impact upon reducing the fiscal burden of PEs (net govemment transfers were still 8 percent of GDP in 1991); (b) a clear structure of authority was lacking for managing the privatization process, and thus too many actors with conflicting goals were involved (including a range of govemment agencies and sector ministries) and were able to obstruct and delay transactions; (c) the legal framework for privatization was unclear and complex, notably as regards procedures for judicial review, right of foreign investors to own land, cross-ownership of assets among PEs, bid evaluation systems, reservation of shares for employees, responsibility for past PE debts, etc.; (d) consequently, too many transactions were left for a long time unconsummated, leaving many PEs in a limbo of unclear corporate govemance. 34. Resuming and accelerating privatization of PEs will be key to Madagascar's export-led growth strategy: to reduce the fiscal burden of PEs on government finances, to improve the efficiency of potentially viable PEs by divesting them to private investors to provide experienced commercial management, and to send a clear signal of state disengagement to encourage local and foreign private investment. To do so effectively will call for: (a) greatly improved transparency, through an open and competitive divestiture process with equal access to local and foreign investors; (b) an efficient, time-bound divestiture process, to inspire confidence in private investors and the public; (c) making improvement in efficiency and jobs the main goal, rather than maximizing sales revenues; and (d) adopting more effective approaches to encourage local share ownership, and to ensure public awareness. 35. In this context, it is recommended that: (a) political decisions concerming which PEs to divest, when and how, should be authoritatively vested in a single high-level Govemment committee, subject to broad authorization of the National Assembly through a privatization law; (b) preparation and implementation of divestiture transactions for PEs could be contracted out experienced private investment bankers on a competitive, payment-by-results basis; (c) competitive bidding procedures should be used in all cases, including publicized tender offerings and public opening of bids, to ensure transparency; and (d) a review of past experience with privatization in Madagascar should be undertaken by a "blue ribbon" independent privatization commission (CIP) to design more effective, transparent arrangements for a new privatization program, including a more effective enabling legal framework.  Madagascar. Private Sector Assessment ix 36. Enhancing Local Ownership and Attracting Foreign Investment. Encouraging local private investment in PEs to be privatized is important as it supports indigenous private sector development, as well as local capital markets. However, granting equal access to foreign investors is also key, as a means of attracting much needed management skills, technology, and capital, and of gaining access to foreign markets. A careful balance therefore needs to be struck promoting local and foreign investment in privatizations, while putting in place specific means to facilitate effective local investor participation. 37. A pragmatic and feasible approach could be to: (a) encourage foreign ownership by placing foreign investors on a equal footing with local private investors in bidding for PEs, and freeing up regulatory restrictions (e.g., on land ownership by foreigners); and (b) promote local ownership through: reserving a portion of company shares for management and employee purchase, "warehousing" a portion of company shares (up to 30 percent) in Privatization Trust Funds (PTF) independently run on a competitive market basis to manage their portfolios and to sell off shares in blocks over time to Malagasy investors; (c) float limited initial public offerings (IPOs) in major PEs, (d) as a proxy for the "voucher" schemes adopted in Eastern Europe (but probably less feasible in Madagascar), establish a Privatization Social Fund, financed from part of PE sales proceeds, to invest in small scale, grassroots employment generation and social services through NGOs and PVOs (such as SECALINE and AGETIPA), to benefit the mass of the population. 38. It would be most important to undertake a major public awareness campaign to explain the new privatization program to the broader public in different groups and regions of the country before it is launched and during implementation. Remaining commercial and industrial PEs could then be privatized in batches over two years, and PEs in monopcly/oligopoly sectors requiring prior regulatory frameworks to be set up could be divested over 3-4 years. 39. Improving Equality of Access and Participation - Reshaping Domestic Competition and Regulatory Policies. While important liberalization measures have been undertaken since the mid- 1980s to free up government controls on domestic markets and external trade, the process is still far from complete and private business in many sectors is constrained by inadequate competition policies and restrictive regulations. The main problems are: (a) cumbersome and non-transparent systems of regulations and licensing of operators in a wide range of sectors; (b) a very uneven system of domestic competition policies, that discriminates against Malagasy small firms and foreign investors - most notably the Investment Code, which acts in fact as a "barrier to entry" because of long delays in approvals and highly discretionary decision-making; (c) monopolies and oligopolies dominate a wide range of economic activities, either through PEs or through collusive private behavior; (d) Madagascar lacks legislation to uphold domestic market competition; (e) important "good" regulations - designed to protect health, safety and the environment - are poorly designed and administered. 40. The effects of these shortcomings are to create "barriers to entry" that depress private investment and output by inhibiting new entrants from competing with established producers, and thus a lack of competition that permits monopoly rents to accrue to existing firms and reduces incentives to innovation and efficiency. 41. The key reforms that are needed to promote accelerated growth are: (a) streamlining the investment approval process and sector regulation by simplifying company registration and remaining licensing requirements (e.g., in forestry, fishing...), and consolidation of the different special  Madagascar: Private Sector Assessment x incentives regimes and simplification of their administration; (b) this should involve a two-stage reform of the Investment Code: first, to abolish ex ante approval by switching to ex post granting of fiscal incentives based upon performance documented in tax retums, and simplifying eligibility criteria, and second, to replace the Code within two years with a system of performance based investment allowances, built into the general tax code, linked to "public good" investments by firms. Since first preparation of this report, concrete measures have been prepared by the Government to implement the first stage of the Investment Code reform, and are awaiting National Assembly approval. However, several major issues have been raised in the private sector and in government that will need resolution before the reform can be passed. This includes, notably, the feasibility of switching from ex ante to ex post approval of tax incentives to firms. Some private firms have claimed that expost approval will adversely affect cashflow, especially for start-up enterprises. In fact, since the 10 percent minimum import duty is to be retained, and the VAT on equipment and working capital is deductible, the impact should be mitigated. It is proposed, however, to revamp the tax credit system and to introduce a transferable tax credit to reassure private investors; (c) undertaking market liberalization in key sectors still subject to price controls and market entry restrictions (notably in agriculture: vanilla, sugar, cotton and wheat; in transport: air transport, ports and shipping; in mining; in petroleum: importation, refining, storage and distribution; in utilities: telecoms, power, and water); (d) adoption of competition policy legislation, to provide legal recourse against restrictive trade practices. 42. Creating a "User Friendly" Environment for Foreign Investment. While the success of the EPZ and the reforms of the late 1 980s have shown Madagascar's strong potential to attract foreign direct investment (FDI), the basis for sustained FDI flows remains extremely fragile. Mauritian and European foreign private investors (interviewed for this report) indicated concerns about political and macro-economic instability, and a capricious and arbitrary regulatory and incentives framework, massive infrastructure bottlenecks, and an unwelcoming stance vis-a-vis the foreign investor. The challenge for Madagascar will thus be to establish and maintain a stable and open business environment for attracting greatly increased FDI flows on a longer term basis into activities where they can contribute to accelerated growth, exports and employment. In addition to the measures presented elsewhere in this report, some more specific measures needed are: (a) removal of the effective ban on foreign investor access to and ownership of land; (b) abrogation of redundant regulations limiting foreign investment; (c) relaxation (or removal) of restrictions on employment of foreign professionals and skilled labor; (d) considerably widening the number of trading partner countries with which Madagascar has double-taxation avoidance treaties; (e) relaxing foreign exchange controls on remittances of dilidends and royalties. 43. Mitigating Investment and Transactions Risks: Modernizing and Rebuilding Business Law. Foreign and domestic private investors (interviewed in the PSA Survey) almost unanimously pointed to the absence of the "rule of law" as a major impediment to doing business in Madagascar today. The main shortcomings are: (a) lack of a single coherent system of law (due to the overlay of the pre-Independence French law, with customary law, and socialist-era administrative regulations in the present system); (b) lack of clearly established property rights, due to weaknesses in the land tenure system and in the mining code, and an archaic and weakly established system of land and company registries; (c) weak administration of the judicial system (which lost independence and authority during the socialist era) resulting in poor services conditions and training of judges, dilatory court procedures, and thus general ineffectiveness of legal remedies for settling commercial disputes;  Madagascar: Private Sector Assessment xi (d) out-of-date business laws, notably for bankruptcy and liquidation; (e) lack of a well-established system of law for settling disputes through arbitration, to reduce need for lengthy and costly court proceedings; and (f) lack of public access to legal texts and information, including recent legal judgments. 44. Establishing an efficient, impartial system of business law, well administered by a competent judiciary, knowledgeable about business practices is key to creating a positive business environment for private investment, by reducing transactions costs and the risks inherent in doing business. Under the 1992 Constitution, which instituted the separation of the judiciary from the legislative and executive branches of government, Madagascar's legal system is in a phase of fundamental transition. 45. As part of this process, actions are needed to overhaul and modernize the system of business law, recognizing that these are likely only to be completed in the longer term. The main areas for action are: (a) clarification of property rights, through the review of land tenure and mining laws, and overhaul of the land and company registries; (b) revision of legal texts and regulations relating to business law; (c) reform of the administration of the judicial system, including streamlining of court procedures, and retooling and training of judges and the legal profession, and re-equipping of the courts and judicial offices; (d) establishing private arbitration mechanisms; (e) streamlining and modernizin'g bankruptcy law; and (f) improving public access to legal texts and information. It is proposed that a Business Law Review Committee be established to undertake a Judicial System Review to spearhead the above efforts. 46. Consolidating Financial Sector Reforms and Deepening Capital Markets. Since the mid- 1980s important steps were taken to start restructuring Madagascar's banking system and financial sector, hitherto totally dominated by the public sector. Two state-banks were privatized, and two new private banks licensed, deposit and final lending rates were liberalized, new banking legislation adopted, and limited prudential supervision of banks initiated. In many respects, these reforms were limited and incomplete, and were partially reversed by the deterioration in macro-economic policies since 1991. 47. Structurally, Madagascar's financial system remains very shallow and under-developed (the M2/GDP ratio of 21 percent in 1993 is one of the lowest in Africa). After decades of state dominance of the economy, the banking system is significantly undersized relative to the credit and investment needs for accelerated private sector, export-led growth. As one indication, to achieve 6 percent annual growth by the year 2002, private investment for non-traditional export expansion over 1995-2002 could require annual increments in term debt financing of $140 million - equivalent to the total term debt outstanding in Madagascar's financial system in 1992. A small, informal equities market exists but is still embryonic. Meanwhile, despite being a largely rural subsistence economy, informal and semi-formal financial institutions, such as credit unions and savings and loan associations, are largely undeveloped. 48. Add to this the large share in bank lending taken up by government and the public enterprise sector, and it is not surprising that access to and the cost of finance are perceived by private investors to be a major constraint to business expansion. In the PSA Firm Survey, this was particularly the case for EPZ firms, which faced relatively few other problems.  Madagascar: Private Sector Assessment xii 49. Broadly, three phases could be envisaged for restructuring of Madagascar's financial system, that could be carried out over 5-7 years, but with significant overlaps between them: * Completion of Credit Policy and Institutional Reforms. This should include: (a) macro- economic stabilization to reduce the fiscal deficit and lower inflation, to encourage holding of financial assets; (b) completing the transfer of the state-dominated financial system to private ownership and management, to ensure independent assessment of commercial risks in lending decisions, starting immediately with the divestiture of the two state-owned commercial banks (BTM and BFV), that still represent two-thirds of the assets of the banking system; (c) encourage competition in banking, through licensing of new banks, to avoid oligopoly problems that led to high real interest rates in 1993/94; (d) complete the liberalization of interest rates; . Consolidation of a Sound and Efficient Banking System. This would involve: (a) improving management of monetary and credit policies by strengthening the capacity and independence of the Central Bank (BCRM); (b) introduction of indirect instruments of monetary control and creation of an inter-bank money market, once the two state-owned banks are privatized; (c) strengthening of prudential supervision of banks by the CCBEF; (d) streamlining the Banking Act to remove rigidities in risk exposure rules that limit competition; (e) improving the efficiency of the payments (and check clearance) system; (f) strengthening accounting, audit and financial disclosure rules and practices; and (g) establishing an effective framework of modem business law (notably conceming bankruptcy, contract law, property rights) to reduce risks and costs of intermediation. . Deepening and Broadening Capital Markets to Meet the Needs of an Expanding Economy. Key elements would be: (a) creating the legal and tax framework for development of leasing - to improve access to equipment finance (in transport, agriculture, and other sectors); (b) fostering increased savings mobilization and term transformation, by increasing the attractiveness of longer maturity savings instruments; (c) expanding access to extemal term investment finance and its allocation through efficient market-based instruments; (d) promoting growth of an expanded and strengthened equities market, initially through enabling regulation for creation of an over-the-counter market; (e) restructuring and expanding contractual savings, by privatizing and overhauling the social security fund CNAPS; (f) strengthening availability in the medium-term of export finance, including through off-shore banking facilities to service the needs of EPZ firms; (g) support for broadening financial services markets in rural areas, based upon grass-roots, semi-formal financial mechanisms such as savings and loans associations. Laying Foundations for Longer Run Competitiveness: Infrastructure, Skills and Private Sector Institutions 50. Modernizing and Expanding Madagascar's Infrastructure. In the PSA Firm Survey, all firms interviewed considered Madagascar's weak infrastructure the number one problem affecting current operations and future growth prospects. The main problems (in order of importance) are: (a) a grossly under-developed and run-down telecommunications system; (b) a weak and dislocated transport network, most notably the "core" road network, but also shipping, railways and coastal ports; (c) a state monopoly air transport system unable to meet freight and tourist needs; (d) poor trade facilitation (due to cumbersome port procedures and weak intermodal links) resulting in delays, increased shipping costs and losses of perishable goods.  Madagascar: Private Sector Assessment xiii 51. The combined impact upon the Malagasy economy has been crippling: infrastructure deficiencies have isolated internal regional markets from each other, and also Malagasy exporters from foreign markets, increasing the costs and risks of doing business, and greatly reducing the scope for increased production. Major generic causes underlying these problems are: persistent underfunding and shortfalls in infrastructure investment and maintenance by Government; inefficient public monopolies; restrictive regulations preventing entry of private operators in competition with public services; and a lack of contracting capacity in govemment agencies, combined with an ingrained bureaucratic resistance to contracting out to the private sector. 52. A Vital Link for Competitiveness. In rapidly changing globalized international markets for manufactures and high-value food products, speed, reliability and low costs of infrastructure (esp. transport and communications) are key to a country's competitiveness; the more so since lead-times between placement of orders and delivery of goods are short and being reduced almost by the year. Timely and efficient investments and operations in infrastructure have enabled the East Asian HPEs to handle rapid expansion in export volumes at very competitive costs despite long distances to their major export markets. 53. To meet the needs of massive increases in export volumes implicit in the Accelerated Growth Scenario (to achieve 6 percent growth by 2002), a major revamping of Madagascar's infrastructure systems will be needed over the next five years. Key elements would be: a major increase in overall investment and operating efficiency, as well as a substantial expansion in public service implementation capacity. This could be achieved through: (a) simplification and greater transparency in public sector procurement and contracting procedures; (b) maximizing privatization, corporatization and contracting out to private sector operators; (c) attracting foreign direct investment, while also promoting development of local private operators (e.g., through expansion of programs such as AGETIPA); (d) adoption of pro-competitive, market-based regulatory frameworks (e.g., in telecoms, power, air transport) to reduce "barriers to entry" and encourage competition between private and public operators; (e) implementation of cost-effective intermodal transport and modernized trade facilitation systems. Specific sector priorities are in: telecoms, road transport and roads, air transport, shipping and trade facilitation. (These are discussed more fully in the main report). This strategy would involve a major upgrading of the role and capabilities of the public sector in long term planning and regulation, as well as building a partnership with the private sector. 54. The Human Factor: Building Labor Skills for the Future. Recent'studies have confirmed the strong correlation between the quality and depth of a country's education system and sustained productivity growth. In the East Asian HPEs, strengthening and broadening basic education by expanding enrollment and quality in both primary and secondary education, and a strong focus upon vocational and technical training, and on-the-job and in-plant skills development have been key factors contributing to rapid longer term productivity growth averaging almost 6 percent annually over 1965- 90. 55. In Madagascar, low labor costs by intemational standards, combined with high adult literacy, an undermobilized labor force, and (until recently) high enrollment and improving quality in primary education have given it a pool of "trainable" labor and a strong labor cost advantage, that has been key to rapid start-up of the EPZ.  Madagascar: Private Sector Assessment xiv 56. However, education and training in Madagascar will need to be strengthened in key respects to ensure sustained longer run productivity growth: (a) the recent decline in enrollment levels and quality of primary education need rectifying as a matter of priority; (b) secondary education coverage is very limited, and well below Madagascar's current and future needs: at 19 percent enrollment is only slightly above the African average, and well below East Asia and Mauritius (generally above 50 percent); (c) most secondary education and vocational and technical training are of poor quality, with high failure and repeat rates, as reflected in the PSA Firm Survey finding that private firms do not feel their needs are being met; (d) in-plant, on-the-job and enterprise-sponsored training are of very limited scope and coverage; (e) these factors help explain major emerging skills gaps in managerial, technician and supervisory levels across many sectors; (f) meanwhile, there is a structural imbalance in Madagascar's education system, with excessive enrollments in university education, and in non- technical subjects, at the expense of secondary, vocational and industrial training. 57. For the medium to longer run, Madagascar must start now to improve its education and training system. This will call for a significant increase in public expenditure, since Madagascar's spending on education (2.8 percent of GDP) is well below the averages for Africa (4.1 percent) and East Asia (3.7 percent). However, at least equally importantly, major improvements in management and quality of education will be needed. A key objective should be to sustain a major long-term effort to upgrade, broaden and deepen labor force skills. Important elements of this would need to be: (a) reversal of recent declines in primary education quality and enrollments; (b) overhaul and expansion of secondary education, and strengthening of technical and vocational training in both public and private schools; (c) increased private sector involvement especially in secondary, technical and industrial training to improve quality and relevance to employers' needs; and (d) promotion of a major expansion in private firm's in-plant and on-the-job training for their employees, as well as in specialized industry schools and in revitalized apprenticeship schemes. 58. Finally, beyond formal education per se, actual participation in successful and productive, especially export activities, will provide a most important training ground for future managers, technicians, and skilled workers, as well as future entrepreneurs. For this reason, policies supporting accelerated export growth and foreign direct investment will contribute much to skills development. 59. Empowering Business Leadership: Private Sector Organizations, Information and Support Services. Since the mid-1980s, market liberalization has brought about significant changes and a number of improvements in private sector support services and in private sector organizations. However, weak and under-developed statistical information systems on the economy, as well as the still narrow range of business services available constitute important constraints to private sector development: (a) government and public sector statistical services (notably the State Data Bank, BDE) suffer from major shortcomings, notably out-of-date data bases and methodologies, and long delays in processing and dissemination of data; (b) other data are weak or in short supply, notably information on govemment laws and regulations, financial and accounting information on public and private enterprises as a basis for credit ratings and decisions, and domestic and extemal market information. Due to weak public statistical services, more specialized private information services have been slow to develop. 60. Since the liberalization of consulting and business support services in the early mid-1980s (formerly they were reserved for public enterprises), there has been a rapid growth of private firms in these fields. However, many of these are still quite small (less than 10 employees) and they are  Madagascar. Private Sector Assessment xv concentrated in a narrow range of expertise (mainly market and feasibility studies, or accounting and auditing, with very few in technical or engineenrng services). 61. Meanwhile, the quality and effectiveness of private sector representative and trade organizations varies widely. Some newer associations set up on a voluntary basis by the groupings of private entrepreneurs are reportedly proving quite successful in responding to their members information and support needs. However, the older, established organizations (such as the chambers of commerce) are perceived as too closely allied with the government and controlled by it, as much less responsive, and thus generally lack credibility with private entrepreneurs. There is thus a lack of effective broad organizations to engage in a dialogue on competitiveness issues with Govemment on behalf of the private sector. 62. Key areas for action thus are: . strengthening macro-economic and sectoral data systems, and other "public" information sources, as well as promotion of private sector information services, which these would help develop; . encouraging expansion of private business support services, through expanded market liberalization (e.g., in agriculture, mining), simplification of government procurement procedures, increasing contracting out to the private sector, and using "matching grant"-based consultancy funds as a temporary means of stimulating emergence of private consultancy services; * strengthening the framework for private sector representative organizations, by completing the liberalization and privatization of the chambers of commerce and of inter-professional organizations, and creating a temporary "private sector foundation" (as a non-profit private company) to provide support for service upgrading in private sector associations; and * creation of established institutional means for regular government-private sector dialogue on competitiveness policy reforms, to help find practical solutions to binding constraints, as well as bodies to permit high-level government contacts on a continuing basis with leading private entrepreneurs. Synthesis: PolicyAgenda forAccelerated Private-Sector Export-led Growth 63. The preceding sections have presented an agenda of policy and institutional reforms aimed at supporting accelerated private-sector export-led growth in Madagascar. The main areas for action and specific recommendations and timeframe are summarized in matrix form in Table 5.2 in the main report. 64. Priority Areas for Action. Importantly, many of the components of the policy reform agenda are intrinsically inter-related. Thus, achieving the Accelerated Growth Strategy proposed in this report (see below) will require coordinated reforms in a "core" of key policy systems, as well as sustained actions to address the most binding capacity constraints. This report maps out a policy and institutional reform agenda for the medium-to-longer term. Initially, the priority areas for action are: (a) creating and maintaining an "outward-oriented" exchange, trade and export regime, harmonizing the non-EPZ  Madagascar: Private Sector Assessment xvi with the EPZ to deepen "export-push"; (b) upgrading the efficiency of Govemment through a concerted State Disengagement Strategy, including relaunching the privatization program, deepening market Liberalization and demonopolization (notably through early progress on the Investment Code reform), and modernizing government implementation capacity; (c) modernizing and improving the efficiency of the tax system (initially through strengthening tax administration); (d) establishing a sound, competitive and expanding market-based financial system (initially through divestiture of the two state banks, and issuing licenses to sound new private banks); and (e) major efforts to address key infrastructure bottlenecks, most importantly in telecommunications and roads. 65. The aim of the Accelerated Growth Strategy proposed in this report (and in the Bank's Economic Strategy Note) is to achieve 6 percent annual economic growth by the year 2002. To do so, major structural changes will be required: (a) rapid non-traditional export growth, averaging about 20 percent p.a. (from $235 million in 1993 to $1,313 million in 2002); (b) a major expansion in investment, especially by the private sector: gross domestic investment would have to grow by 12.5 percent p.a., with private investment increasing by over 20 percent p.a.; (c) substantial improvements in investment efficiency; (d) greatly increased long-term capital inflows and foreign direct investment by 25 percent p. a.; (e) increased external debt, but with a lighter debt service burden, and an enhanced ability to repay, to finance the crucially necessary modernization in Madagascar's aging and weak plant and equipment and infrastructure. (The main macro-economic parameters are summarized in Table 5.1 in the main report.) Achieving these growth targets will be ambitious but is still feasible. It will require discipline, perseverance and a very strong political commitment to the necessary policy and institutional reforms. Since 1993, valuable time has been lost. The ball is now in Madagascar's court to decide whether or not to chart the course.  Madagascar: Private Sector Assessment INTRODUCTION 1. This Report assesses the potential and constraints for a major expansion in private sector activity - from both domestic and foreign investors - in support of an accelerated, export-led growth strategy for Madagascar. As such, it is also one of a series of reports being prepared by the World Bank to assess the potential contribution of the private sector to economic development, and how this can be enhanced. 2. This Report follows on from the June 1994 Economic Strategy Note (ESN) prepared by the Bank and already discussed with the Malagasy authorities. The ESN presented a feasible high economic growth scenario for Madagascar over the next decade - (Accelerated Growth Scenario) - under which a real rate of economic growth of 6 percent per annum could be achieved starting in the year 2000. On this basis, per capita income could double within a generation. The ESN presented in broad, macro-economic terms the major policy reforms needed to achieve this rate of growth. 3. Under the AGS, however, far-reaching structural changes would be needed in Madagascar's economy, involving a very major expansion of the role of private investment and activity - by both domestic and foreign investors. Specifically: (a) non-traditional exports would need to grow by over 20 percent p.a. from $235 million in 1993 to $1.3 billion in 2002; (b) gross domestic investment would have to grow by over 12 percent p.a. in real terms over the same period, with private investment expanding by over 20 percent p.a. to FMG740 billion; (c) meanwhile, foreign direct investment would need to grow at over 25 percent p.a. to over $200 million; and (d) a very major increase in efficiency of investment would be required. 4. Taking the AGS as its starting point, therefore, this Report provides an assessment of the potential and prospects of the Malagasy private sector today, and assesses the major binding constraints to private sector development that will need to be overcome to achieve this rate of accelerated growth. 5. Chapter I of the Report gives an overview of the recent performance, and structure of the Malagasy private sector and the overall economy. Chapter II then provides an analysis of the global market context for the major non-traditional exports in which Madagascar appears to have a competitive edge (notably textiles and garments, high-value food products, shrimp, etc.) to identify key factors contributing to export success in other fast-growing developing economies. It also gives the results of a sample survey of Malagasy private firms. Chapter III analyses the major policy constraints to increased private sector competitiveness and productivity. Chapter IV then focusses on key longer run constraints in the areas of infrastructure, labor skills, private sector institutions and support services. Finally, Chapter V brings together the main elements of a phased longer run strategy for Accelerated Private Sector Export-led Growth.   Madagascar: Private Sector Assessment 1 I - PROFILE AND CHANGING ROLE OF THE PRIVATE SECTOR A. Country Background and Recent Economiic History 1.1 Madagascar is a country with tremendous potential, yet one whose social and economic performance has been very poor. It has an abundant, easy to train and inexpensive labor force, and preferential access to EEC markets for a variety of products; a wide range of soils, climates and natural resources, including tremendous tourism potential, underdeveloped fisheries, and flora and fauna unique to the island; and, more recently, it has started to benefit from the proximity of Mauritius where labor scarcity is prompting many entrepreneurs in labor-intensive manufacturing to look elsewhere in the region to invest. Yet its social indicators are poor; annual population growth is currently high at 2.8 percent, infant mortality is 116 per 1000 births. Economic performance has been disastrous; between 1971 and 1991 per capita income dropped by 40 percent and at 1992 it stood at $230, making the country one of the poorest in the world. This is combined with mounting external indebtedness, environmental degradation and a widening gap between rich and poor. 1.2 Economic Policy and Business Environment: 1970s and early 1980s. Since independence, up until the mid-1980s, Madagascar's economic policy and regulatory environment was characterized by: (a) highly restrictive and inward-looking trade and exchange rate policies, with a strong bias against export production; (b) state domination of the productive sectors, with extensive government regulation, including domestic market and price controls, leaving little room for private initiative and investment (which remained very low as a share of GDP); (c) a large but inefficient public enterprise sector, dominating virtually all sectors of the economy, including trade and services; (d) an inefficient, poorly administered taxation system; (e) a weak and outmoded system of business law; and (f) a repressed financial system, dominated by a few state-owned financial institutions. 1.3 Structural Adjustment Reforms of the late 1980s. Over 1986-91, however, the Government undertook a major program of structural adjustment reforms, resulting in fundamental changes in the policy and business environment for the private sector: (a) the exchange, trade and export regime was substantially liberalized, including creation of the EPZ in 1990, giving a major boost to non-traditional exports; (b) domestic markets and prices were liberalized for a range of - although by no means all - goods (including most manufactures and some agricultural commodities); (c) a major privatization program was launched, involving divestitures as well as liquidations of public enterprises, although implementation proved slow, incomplete and lacking in transparency; (d) a financial sector restructuring program was undertaken, including liberalization of interest rates (to market-determined levels), strengthening of prudential supervision of banks, restructuring (and privatization) of two state-owned banks, and licensing of two new private banks; (e) an initial reform was made of the investment code; and (f) a law review committee was created to identify reforms needed in business law and regulation. 1.4 Important but Incomplete Reform Process. By 1990/91, much progress had been made in implementing the adjustment reforms outlined above. Their impact had been positive in terms of private sector performance: Madagascar achieved real GDP growth rates of about 4 percent p.a. over 1986-90. Non-traditional exports - undertaken almost entirely by the private sector - expanded rapidly (as noted in Chapter II, paras. 2.14-2.15). Private investment expanded fourfold as a share of GDP accounting for 9 per cent in 1990, equal to that of public investment (para. 1.14). Nevertheless, the process of reform remained incomplete in many respects and the period of faster growth was relatively short thus having a limited impact upon the welfare of the mass of the population.  Madagascar: Private Sector Assessment 2 1.5 Political Upheaval and the Stalling of Refonns. However, with the nationwide strikes in 1991 and the political upheaval which led to the new Constitution in 1992 and multi-party elections in 1993, the economic policy reform process stalled. While many aspects of the reforms were retained, some key policy reversals occurred: (a) the open general licence system for imports (SILI) was abandoned in 1992, meanwhile the FMG became significantly overvalued; (b) fiscal and monetary policies became more lax, resulting in an increased budget deficit, and increased inflation, meanwhile, the tax collection effort declined. Despite the expansion of the EPZ, this resulted in a steady and continuing erosion of export competitiveness (as indicated in the PSA Firm Survey results - See para. 2.41). Although 1994 saw the re-establishment of a liberal exchange regime, including the free-floating of the FMG, fiscal and, especially, monetary policy continued to deteriorate. 1.6 The Current Macroeconomic Framework: No Room for Maneuver. Madagascar has emerged from this period facing macroeconomic imbalances as wide as in the past; the aborted reform programme was neither extended enough, nor complete enough to achieve any lasting improvement. In order to understand why there is now so little room for manoeuvre, and why implementation of the wide-ranging programme of policy reforms described in this report is the only possible route to re-establishing sustained positive per capita growth of GDP, it is necessary to consider Madagascar's economic status in some detail (see Table 1.1). A comparison with other adjusting countries in sub-Saharan Africa is particularly illuminating. l/ 1.7 An unsustainable Gap in Public Finances. In recent years, Government spending has been modest relative to Madagascar's development needs. Despite this, an extremely poor revenue effort has resulted in unsustainable fiscal deficits. Revenue is estimated to have averaged around 9.5 percent of GDP in the period 1991-1993, significantly lower than the previous two years, and much lower than the level in 1980. For FY94 it is estimated to have been 7.8 percent of GDP, reflecting the impact of worsening collection and accelerating inflation. These figures are very low: for 29 adjusting countries in sub-Saharan Africa, the median revenue was 18.5 percent of GDP in 1991. Government total expenditure (on a commitment basis) averaged around 21.5 percent during the period 1991-1993, and is estimated to have fallen to 16.9 percent in 1994; again, much lower than the comparator average of 25.1 percent of GDP during 1991-93, compared to a median of 7.4 percent for the group of adjusting countries. (Grant receipts in both cases reduce these figures by 2.4 percent). The improvement estimated for 1994 is largely attributable to the impact of inflation on current expenditures, particularly wages, and probably unsustainable in the medium-term. 1.8 Madagascar's fiscal difficulties are compounded by its indebtedness. Its total stock of external debt was equivalent to 140 percent of GDP in 1994, slightly higher than the average for all sub-Saharan Africa, of 110 percent. Debt service interest payments due accounted for around 40 percent of government revenues in 1993; a figure projected to rise over 50 percent in 1994. By contrast, the average for the African adjusting countries was 16 percent. 1.9 What are the implications of these figures? Even when judged by rather weak adjustment efforts of other countries in Africa, Madagascar's public finance problems are severe. Fiscal reform will be a major immediate challenge in the years ahead; the priorities being to: (a) increase Government revenues, particularly tax revenues; (b) contain expenditure, thus; (c) reducing the deficit and restricting government 1/ A recent study by the World Bank - "Adjustment in Africa: Reform, Results and the Road Ahead" (1994) permits a comparison of Madagascar with a group of 29 adjusting nations.  Madagascar: Private Sector Assessment 3 borrowing. An even greater priority is monetary discipline; inflation jumped to 60 percent at the end of 1994 from an average of 10 to 15 percent the previous 5 years, largely as a result of monetary expansion. Table 1.1 Madagascar: Key Macroeconomic and Fiscal Indicators 1980-1993 1980 1989 1990 1991 1992 1993 1994 (est.) (est.) Real GDP Growth 4.1l 3.1 -6.3 1. I 2.1 1.3 Inflation (CPI) 9.0 11.8 8.5 13.3 9.2 61.6 % of GDP Government Revenues 14.1 11.5 12.0 8.7 10.0 9.9 7.8 Government Expenditure 27.9 25.5 21.2 20.1 23.5 21.4 16.9 - Current (16.6) (15.8) (13.3) (13.5) (15.2) 12.6 (10.9) - Capital (11.3) (9.7) (7.9) (6.6) (8.3) (8.5) (6.0) Fiscal Deficit 13.8 14.0 9.2 11.4 13.5 11.5 9.1 Gross Domestic Savings 0.0 9.8 6.3 0.7 3.4 2.5 4.2 Total Fixed Investment 14.4 13.4 14.8 8.2 11.3 11.4 13.3 - Public n/a (9.7) (7.9) (5.2) (6.6) (7.3) (5.3) - Private n/a (3.7) (9.0) (3.0) (4.7) (4.1) (8.0) Trade Balance (GNFS) -16.4 -3.4 -11.0 -8.9 -8.5 -7.9 -11.7 Total Debt Outstanding 32.3 131.0 116.3 138.8 130.7 119.6 140 (i) Excluding both current and capital grants (ii) Includes all interest due, both internal and external. In practice, during 1989-1992 only a small proportion of this was paid. Source: World Bank, CAS June 1994; updated by IMF Staff Estimates, Feb. 1995 1.10 Public Investment Will Therefore Be Constrained. Balancing this against the major demands on government spending in the future and the need to generate growth in the economy will be a delicate task. Even if debt is rescheduled, with a substantial amount of forgiveness, resolving the current tax- gathering problems will be a major task that will take time; and it will not be possible to achieve a massive increase without stifling economic growth (see paras. 3.17-3.25). The ability of the Government to invest in the next few years will therefore be limited, probably to a level at or around the current 6 to 7 percent of GDP. 1.11 Closing the Trade Gap. Simultaneously, Madagascar faces the need to close the trade gap: in the last three years imports of goods and non-factor services have exceeded imports by the equivalent of over 9 percent of GDP annually. The depreciation of the FMG following the mid-1994 float is currently being offset by inflation; and the trade gap is being financed in large part by the accumulation of arrears.  Madagascar: Private Sector Assessment 4 1.12 Mobilizing Private Sector Savings. Finally Madagascar's Gross Domestic Savings Rate in 1993 was 4.2 percent, compared to a median for the adjusters of 7.7 percent; the need to mobilise domestic savings is therefore acute. (See para. 3.84). 1.13 Increasing Private Sector Investment - the Only Path to Sustained Growth. Increasing growth on a sustained basis depends on increased investment. The total investment ratio in Madagascar has been 10 to 12 percent of GDP during the 1990s; private sector investment has averaged around 4.0 percent of GDP, and has historically always been low, apart from the brief period of response to the reforms in 1990 (para. 1.5 above), and an apparent surge prompted by the inflationary policies adapted in 1994. By comparison, the median level of private investment for the 29 sub-Saharan adjusters was 10 percent of GDP; and, of course, the dynamic, high-growth industrialising countries of East Asia have private investment rates exceeding 20 percent of GDP. 1.14 Transforming the response of the private sector will require more than macroeconomic adjustment; it will require rapid implementation of a critical mass of policy reforms to win the confidence of domestic and foreign investors alike. The key dimensions of this program of reforms are the subject of this report. B. Profile of Malagasy Private Sector 1.15 The private sector in Madagascar is thus in a phase of fundamental transition. The descriptive information in this section focuses on two aspects of the private sector: its structural, socio-economic and sectoral characteristics and its contribution to various macroeconomic aggregates such as output, employment, investment and credit as well as its role in social services. Information on the private sector in Madagascar suffers from two major inadequacies which are also common in other low-income countries. First, there is a lack of comprehensive, systematic and consistent data on the private sector and most descriptive information is therefore fragmentary and anecdotal in nature. Second, available data almost exclusively refer to registered economic activity, thereby excluding the very significant area of informal sector (unrecorded) activity. In addition to official data, most other data on the private sector are drawn from surveys and reports undertaken by bilateral and multilateral donor and aid agencies. 1.16 Notwithstanding the socialist ideology which emphasized state roles in production and ownership and widespread government controls on economic activity, the private sector, particularly in agriculture, remained the most important agent of economic production in Madagascar, during most of the last decade and a half. (The frontispiece provides a picture of the private sector in Madagascar at a glance). Although its growth was either stagnant or declining during most of this period, the private sector has accounted historically on average for between two-thirds and three-quarters of total measurable output (see SA Table 2). This reflects the pre-dominance in the economy of the subsistence rural sector. As a result, as SA Table 4 indicates, the proportion of GDP accounted for by the public sector, although high, is still lower than Indonesia, for example, and about the same as Cote D'lvoire. 1.17 The private sector's dominance of employment is even greater. Subsistence rural agriculture, together with other unmonetized activities, employs about 92 percent of Madagascar's labor force of approximately 5,400,000 persons. Of the 8 percent of the labor force in the modern sector, the private sector employs about 4 percent and the remaining 3 percent are employed by government and public enterprises (see SA Table 8). Growth of the modern private sector has not been sufficient to absorb the growing labor force which increased by an average of 147,000 per year during 1985-90. The 30,000 formal sector jots created during 1983-89 came largely from public sector employment which grew 120 percent during this period against 58 percent for modern private employment.  Madagascar: Private Sector Assessmentt 5 1.18 Another notable feature of the private sector in Madagascar is its degree of concentration, both regionally and in terms of size. As SA Tables 10 and 14 show, 50 percent of formal wage employment is in Antananarivo; and 46 percent of all registered firms are based in Antananarivo. Regarding size, SA Table 11 shows that 95 percent of the 222,000 registered firms are individually-owned. The total is dominated by individual traders (who comprise 75 percent of all enterprises). As SA Table 15, which is based on the industrial census of 1985-87, shows however, even excluding small-scale traders, 94 percent of the total number of industrial enterprises employed fewer than 10 people, whilst there were only 415 firms employing more than 50 people. The pyramid of firm size is thus sharply tapered in Madagascar - and a corresponding feature of economic life is that many subsectors are dominated by monopolies or oligopolies. 1.19 The Malagasy private sector can be characterized, albeit in a stylized fashion, by a four-tier structure based on size, national origin, and integration into the formal economy, as follows: (a) an indigenous small-scale and traditional private sector; (b) an indigenous large-scale and formally established private sector; (c) locally established and resident entrepreneurs with foreign national origins or affiliations; and (d) the non-resident foreign private sector. In addition to these profit-oriented activities, it also includes an important number of non-governmental organizations (NGOs), churches and voluntary associations which are also active in the delivery of services and represent potential private alternatives for delivery of public services. 1.20 Large Scale and Formal Indigenous Private Sector. Although firms owned by Malagasy entrepreneurs are usually small-scale, a number of well-established families are prominent in larger businesses. They include, for example, the families which own and operate Savonnerie Tropicale (soap) and Hazo (furniture), the prominent local businessman who recently took over the Bata shoe factory, and other ventures such as Virio, Prochimad and Debra. While it is difficult to estimate the size of this indigenous element of the large-scale formal private sector, it is clear that it represents an active entrepreneurial tradition particularly on the plateau (less so in coastal areas). The recent increase in new private enterprises has tended to be concentrated in the capital area in particular in the highland or central plateau area of the country. However, the traditional distinction between the highlander elite (essentially the dominant Merina ethnic group in business and liberal professions) and the more recent state-based "c6tier" elite (originating from the coastal area) has become increasingly blurred. This large scale and formal indigenous private sector group is proportionately over-represented in existing business organizations and professional associations. This group also has more extensive trading and financial links overseas than the small-scale traditional group, including ownership of assets abroad. 1.21 Foreign-affiliated Private Sector. A major part of industrial and commercial activity has historically been dominated by a small number of large foreign-affiliated firms. This is even true of several large domestically-oriented activities such as construction and public works, and tends to include the oldest and best-established enterprises. Most foreign-affiliated firms are owned or managed by non- indigenous persons, mainly of Indo-Pakistani, Comorian, French or Chinese origin, who account for less than 1 percent of the Malagasy population, and whose degree of integration into Malagasy society varies. Among the Indo-Pakistani community which is especially prominent in trading are notable extended families such as Ismail and Bardav which have been well establislhed and very successful over the past 30 years. The Indo-Pakistani group also tends to dominate among well-established foreign-affiliated industries, and this dominance, and their perceived lack of integration, has given rise to widespread adverse sentiment in the past. The Comorian group is concentrated at the lower end of the economic scale and tends to be more in direct competition with indigenous Malagasy entrepreneurs. The French group tends to dominate foreign ownership in agri-business and includes Bollore (tobacco), Fraise (originally import-export, but now diversified into breweries and hotels by taking advantage of the  Madagascar: Private Sector Assessment 6 privatization program), and sisal operators in the South. The Chinese group, which is relatively smaller in scale and includes businesses in services such as restaurants and hotels, has integrated much better into Malagasy society than the Indo-Pakistani community. SA Table 14 provides a broad overview of this picture for the industrial sector. 1.22 Non-Resident Foreign Private Sector. In addition to these entrepreneurs who have been established in Madagascar for two or more decades, there is a purely non-resident foreign private sector including investors who have started businesses in the new environment of the late 1980s, many with free zone enterprise status. A prominent example is Floreal, a large Mauritian-based textiles firm, which now employs around 3,000 people. There is considerable potential interest among the foreign private sector within the region, particularly from Mauritian and South African investors, in areas such as agribusiness, seafood processing, textiles, mining, and tourism. A number of firms based in Hong-Kong and Taiwan as well as others in Europe and North America have also been exploring opportunities in Madagascar recently. 1.23 Small Scale and Traditional Private Sector. In terms of numbers of economic agents, this segment of the private sector is by far the largest in Madagascar. It is also very diverse. A majority within this group are Malagasy entrepreneurs engaged in economic activities which are largely small scale, family-based subsistence or non-monetized in nature. In addition to this traditional economic sector, this segment of the private sector includes a major part of the modern sector including approximately 95 percent of all registered enterprises which employ fewer than ten persons. The potential for this segment of the private sector to generate a rapid supply response with economic liberalization is dramatically illustrated in the fisheries sector which boomed during the 1980s largely due to a six-fold growth in the output of small-scale private fisheries, accounting for most of the growth in agricultural value-added. While this small-scale and traditional private sector is predominant in agriculture, many small firms have also recently emerged as the main source of growth in many secondary and tertiary sector activities. 1.24 The largest number of private activities within this segment are undertaken as owner or family- operated ventures (including the preponderant majority who are smallholder farmers) or micro-enterprises with five or less employees, but it also includes a number of small (6-20 employees) and medium enterprises (up to 50 employees). The maximum assets of these enterprises is below $500,000 and they are generally labor-intensive. The majority of women-owned enterprises in Madagascar are found in this segment both proportionally and in absolute numbers. For most economic agents in this group, trading and financial links to the domestic economy are largely limited to barter and small regional markets and to informal finance provided by traders and moneylenders. Trading and financial links overseas are practically non-existent within this group except for a number of small and medium enterprises that have succeeded in focussing on export-oriented activities. A notable example of the latter is one female-owned firm currently exporting pate, vinegars and condiments to Europe (winning an international award in 1991) which started as a sole proprietorship in 1980 and transformed into a limited company in 1988. C. Sectoral Characteristics and Performance 1.25 The recent sectoral performance of the Malagasy economy has been dominated by the environment for private sector development in each sector, and the impact of government reforms. The distribution of GDP by sector and subsector is shown in SA Table 1. Agricultural production accounts for a third of GDP, and has always been predominantly undertaken by the private sector. Principal domestic and subsistence crops include rice (40 percent of value added in the agricultural sector), cassava, and maize. Agricultural exports currently account for around 45 percent of total exports and four crops  Madagascar: Private Sector Assessment 7 (vanilla, coffee, cloves and pepper) account for 60-65 percent of agricultural exports. In the early 1980s, however, these figures were 80 percent and 85 percent, respectively. 1.26 The key to the performance of the agricultural sector has been the role of government control of prices and marketing. During the 1970s and early 1980s, agricultural growth was significantly below population growth, reflecting tight controls. Coffee and vanilla producers, for example, received only 40 percent and 25 percent of the world prices for their products respectively. Not until the reform program of 1988 did production per capita increase. The extent of the response by commodity was primarily a function of the extent of reform in the subsector. Rice paddy prices were progressively decontrolled from 1983, and production responded to the 55 percent devaluation of the FMG in 1987 together with the introduction of a system of open import licenses from 1988. Production of the traditional exports (coffee, vanilla, pepper and cloves) did not respond significantly to the reform program, because to a large extent falling world prices (coffee, cloves) neutralized the effects of devaluation, marketing decontrol and a measure of decline in the rates of taxation. In fact, the maintenance of levels of production in the face of sharp world price declines could be seen as a positive response to adjustment. Non-traditional exports such as garments, food products, shrimp and fish have seen rapid growth. (See Chapter II). 1.27 Civil disorder and increased insecurity, an appreciating Malagasy franc (in real terms), drought and incomplete decontrol of prices saw continued stagnation of the sector over the 1990-92 period. 1.28 The secondary sector accounted for 14 percent of GDP in 1991, a much smaller share than in many comparator countries, as SA Table 7 indicates. Food and textiles, dependent on agricultural inputs, account for 75 percent of sectoral output. The historical under-development of this sector is a product of the degree to which it has been dominated by the state. Since 1988, the relative dominance of public sector over private enterprises has also begun to recede in several areas, however. Examples of such shifts include the fruit processing and canning sector where increased opportunities for private firms have arisen from liquidation of parastatals and the beverage sector, especially after the dominant state-owned beer and bottling company was bought by private investors in 1990. Coupled with privatization, lower barriers to entry are now evident. This has spurred entry by small firms into areas such as tobacco production, mining of nontraditional minerals and precious stones, and food processing. Additionally, the increased access to imports over the 1988-90 period assisted sectoral development. 1.29 Evidence for the impact of the 1988-90 reforms can be seen in a number of areas. Private sector investment as a share of GDP reached an unprecedented level of nine percent in 1990 (SA Table 5). The creation of enterprises in the formal sector increased from around 135 a year over 1984-86 to nearly 300 in 1988 and nearly 500 in 1990 (SA Table 15). 1.30 Although the turmoil of 1991, and the subsequent restriction of foreign exchange availability saw both of these figures fall again, there has been continued investment activity, particularly in the transport, tourism, and industry/artisan subsectors, as SA Table 16, documenting investment approvals for the 1990- 92 period, shows. 1.31 Most spectacular, however, has been the growth of activity in the Free Trade Zone (see Box 1), reserved for firms who export 100 percent of their products, and offering unlimited foreign exchange retention and much reduced bureaucracy. After a relatively slow start in 1990 and 1991, it accelerated and around 90 operations have been approved to date, of which around half are currently in operation. The total number of jobs created by the end of 1993 was estimated to be around 20,000 or five percent of total formal sector employment; and output and exports were estimated to be around FMG100 billion,  Madagascar: Private Sector Assessmtent 8 equivalent to $50 million and around IS percent of total estimated exports for 1993. Total investment has been around $25 m-illion per annum, a mixture of foreign direct investment, typically from Mauritius or Honig-Kong, and domestic investment, often in the forms of joint ventures. Not oiily has the sector created eniployment and growth, therefore; it has also familiarized Malgache entrepreneurs with new technology and managerial skills. A large proportion of the firms created have been in the garments sector; other sectors have included food preparation and artisanal products. 1.32 The tertiary sector accounted for 54 percent of GDP in 1991. The conmiercial sector remains the single largest area of registered private activity, accounting for 75 percent of all private firms. The implementation of a liberalized import regime since 1988 has played a key role in stimulating increased private activity in this sector. Growth between 1988 and 1991 was IS percent in real terms. Other subsectors to have seen growth between 1988 and 1990 were transport and tourism; in the latter case arrivals inicreased fromi 23,500 in 1985 to 53,000 in 1990. Both sub-sectors suffered from the uncertainty and collapse in domestic activitv in 1991 however. 1.33 The broad pattern of recent development described above is starkly illustrated by the results of a survey of 38 private sector enterprises carried out in March 1993 (see Chapter 1I paras. 2.39-41)). ~~~~~~~~~~~~~~~~~. . . . . . . . . . . . . . . . . . -. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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