Report No. 1 5477-ZA Zambia Prospects for Sustainable Growth 1995-2005 August 1, 1996 Macroeconomics I Economic Management and Social Policy Group Africa Region Document of the World Bank CURRENCY EQUIVALENTS Currency Unit: Zambia Kwacha (K) US$1=1240.93 FISCAL YEAR January I to December 31 ABBREVIATIONS AND ACRONYMS ASIP Agricultural Sector Investment Program BOP Balance of Payments BOZ Bank of Zambia CBI Cross Border Initiative CEM Country Economic Memorandum CG Consultative Group for Zambia COMESA Common Market for Eastern and Southern Africa CPPR Country Portfolio Performance Review CSO Central Statistics Office DBZ Development Bank of Zambia ERC Economic Recovery Credit ERIP Economic Recovery and Investment Credit ESAC Economic and Social Adjustment Credit ESAF Enhanced Structural Adjustment Facility GDP Gross Domestic Product IBRD International Bank for Reconstruction and Development ICOR Incremental Capital Output Ratio IDA International Development Association IMF International Monetary Fund LUSA Lusaka Stock Exchange MOAFF Ministry of Agriculture, Forestry and Fishing MMD Movement for Multiparty Democracy NEAP National Environmental Action Plan NGO Non-Governmental Organization PER Public Expenditure Review PFP Policy Framework Paper PIRC Privatization and Industrial Reform Credits PTA Preferential Trade Agreement RAP Rights Accumulation Program RPED Regional Project for Enterprise Development SCC Systematic Client Consultation VAT Value Added Tax ZACCI Zambia Association of Chambers of Commerce and Industry ZCCM Zambia Consolidated Copper Mines ZESCO Zambia Electricity Supply Company ZIMCO Zambia Industrial and Mining Corporation ZPA Zambia Privatization Agency ZRA Zambia Revenue Authority TABLE OF CONTENTS Page No. Preface Executive Summary ......................................................i 1. Introduction ......................................................1 PART I: A Review of Economic Developments 1965-1995 2. Copper and Its Consequences ..2 A. Introduction .2 B. Trends in Economic Activity .2 C. Trends in Economic Policy .9 D. Summary ............................................... 17 3. A Closer Look at Agriculture and Manufacturing . . 18 A. Changes in Manufacturing ..................................................... 19 B. Changes in Agriculture ..................................................... 29 4. KeyPerformance Issues 1990-1995 ..................................................... 44 A. Why has attaining growth through policy reform been so difficult? ..................................................... 44 B. What has been the impact on the poor? ........................................ 49 PART II: Prospects for Growth ................................... .................. 51 5. Emerging Opportunities in Agriculture and Manufacturing .. 51 A. Opportunities for Agro-related Activities .................................... 53 B. Opportunties for (Non-Agro-Based) Industry and Commerce ..... 64 C. Realizing the Opportunities ..................................................... 71 D. Balancing Growth and Equity ..................................................... 83 6. Aggregate Prospects for Sustainable Growth 1995-2005 .................... 85 A. Scenario Assumptions ...................................... 85 B. Baseline Scenario ......................................... 86 C. Feasibility Tests ......................... ............................ 90 (i) Investment ..................................................... 90 (ii) Stimulous and Response ..................................................... 91 (iii) Balance of Payments ................ 92 D. Alternative Scenarios .................... .. ......................... 102 E. Conclusion ............................................... 106 7. Summary of Policy Conclusions ..................................................... 108 Annexes A. Supplementary Tables B. Debt Sustainability PREFACE 1. This report is based on previous economic and sector work and the findings of several missions which visited Zambia in the Spring and Summer of 1995. The macro missions were led by John E. Todd (Task Manager, AF 1 MI) and included Lemma Menrid (AF 1 MI), Bilin Neyapti (Consultant), and Ellah Chembe (Resident Mission). The sector work was directed by Brian Levy (AF 1 MI). The industry portion drew heavily on the Industry Project work by Ahmet Soylemezoglu (AF 1 MI) and Dan Mozes (AFSD), and the agriculture work was directed by Steven Jaffee (AF 1 AE), who was assisted by Michael Macklin and Paul Siegel (AF1AE) and John Keyser, Guy Scott, and George Gray (Consultants). The sections on international trade were written by Lloyd McKay (AFIMI). Data analysis and projections were produced by Maria Teresa Benito (AF I MI). Production of the final report was co-directed by John E. Todd and Brian Levy. A Government Counterpart Team led by Benjamin Mweene (Ministry of Finance) assisted in the work of the missions, provided extensive comments on the first draft, and assisted in preparing the final paper. That team included Abraham Mwenda (Bank of Zambia), Gilbert Mudenda (Institute of Policy Studies), Gedion Lintini (NCDP), Mark Pearson (NCDP), A. Muanaumo (MAFF), M. Ndulo (MCTI) and Mr. Wotela (National Farmers Union). Peer reviewers for this report have been William Easterly (PRDMG), Andrew Ewing (PSD), and James Coates (AF2AE). The Lead Economist was Gene Tidrick (AF I DR), the Country Operations Manager was Ms. Phyllis Pomerantz (AF1C2), and the Division Chief was Ataman Aksoy (AFIMI). 2. This paper builds on previous World Bank studies of Zambia's economy, including the most recent Country Economic Memorandum (August 1993), sector studies in Agriculture (1992), Transport (1992), Public Sector Management (1993), Public Expenditure Review (1995), and the Poverty Assessment (1994). It has also benefited from a growing academic literature on Zambia's economy, several examples of which are cited in the report. 3. Two data efforts have greatly aided this analysis. The first is the data base compiled by the Regional Program of Enterprise Development (RPED), a regional research effort conducted by the World Bank. In the case of Zambia, two surveys of manufacturing firms (covering over 200 companies each time) have provided a rich source of data, especially on the most important constraints faced by the major sub- sectors. In agriculture, as part of this study, a detailed data base has been assembled on output and input prices and available technologies which permits a calculation of cost structures and profitabilities for different crops with different technologies in different regions. I EXECUTIVE SUMMARY HISTORY 1. Zambia's economic history since Independence has been dominated by the boom and bust in copper exports and accompanying missteps in policy. In the first decade after Independence, Zambia's copper exports were at an all time high. While these helped economic output grow at about 3 percent over this period, this rate was still below the rate of population growth and well below the rates of growth that would be expected from a country with such an increase in its export proceeds and with such high levels of investment. Not only was an exceptional opportunity lost, but public and private expectations were raised to levels that turned out not to be sustainable, and government was encouraged to take a dominant role in the economy in part by virtue of its access to these additional resources. 2. The defining event in Zambia's recent economic history was the collapse in copper export earnings (particularly the fall in the copper price in 1975) and government's response to that collapse. Expressed in 1990 US Dollars, copper export earnings fell from US$3.4 billion in 1974 to US$1.8 billion in 1975 and declined more or less steadily after that to a low of US$725 million in 1994. Two aspects of government's reactions have had far-reaching impact. First, expecting export proceeds to recover, the Government borrowed heavily abroad, and this began the rapid rise in Zambia's external debt burden. Second, the pressures for adjustment within the economy caused discomfort, and this in turn elicited an increase in government controls over the economy, especially in the market for foreign exchange and the setting of domestic prices. 3. Not only did Zambia's continued reliance on copper exports cause these distorting and disruptive variations in export earnings, it also created a constituency of urban consumers that created pressures to keep agricultural prices low, created a manufacturing sector a large portion of which had little prospects for market expansion, and encouraged an attitude of seeking access to centralized rents rather than searching for ways to increase output and productivity. 4. The dominance of the public sector in Zambia's economy was only partly attributable to the central role of copper, however. It was also a response to the experience of the colonial period, a reflection of the economic theories of the time suggesting limited growth prospects for primary products, and an affirmation of the belief that the copper boom would continue. Whatever the causes, the basic strategy was a disaster. It focused on the wrong sector (manufacturing), the wrong primary actors (parastatal companies), and the wrong methods (tariff protection and price controls). The result was one of the worst records of economic decline of any country not engaged in external or internal warfare. By 1990, per capita output had fallen at an annual average rate of 2.8 percent from its peak in 1974, and per capita income had fallen even further (4.8 percent annually) because of the falling price of copper. - ii - 5. During the 1980s, the Zambian Government increasingly recognized that copper proceeds were not going to return to their previous highs and that Zambia had to begin expanding other export sources instead of borrowing. There was also increasing support for a more positive environment for agriculture (and for the private sector in general) and for a greater reliance on markets. The arguments for macroeconomic stabilization and for a generally reduced role for parastatals were also heard more frequently. Government approached the IMF, World Bank, and bilateral donors to support a series of reform programs. These programs turned out to be partial and short-lived, but they were generally headed in the right direction. Unfortunately, the results of the financing turned out to be more long lasting than the reforms themselves. More debt was acquired through these reform programs. When donor support was reduced during the non-reform periods, arrears on debt service payments began to accumulate, and Zambia's external debt underwent a second growth surge to levels above twice the level of annual output. 6. As a result, the prospects at the close of the 1 980s were not bright. Fifteen years of economic decline had exhausted nearly all participants in the private sector. Controls were extensive, external debt unsustainable, donor confidence low, infrastructure deteriorated, and public sector capacity seriously eroded. 7. In that context, a more comprehensive program of economic reform was adopted over the period 1989-1991. Following elections in late 1991, a new Government came to power with a greater commitment to such a program, and the pace and breadth of reform increased. The resulting program has been in place since then, although the pace and quality of implementation have varied considerably. In some areas, particularly the ending of price and market controls, the performance has been extraordinary. Zambia now has one of the most liberalized economies in Africa. In other areas, progress has been slower. In the critical area of controlling inflation, things got worse before they got better, and inflation exceeded 100 percent per year through 1994. In areas of institutional reform such as privatization and public service reform, progress has been made, but there is much more to be done, and effects are just beginning to be felt. COPPER'S CONTINUING CHALLENGE 8. The challenges posed by copper dependence to Zambia's economic management will not diminish over the next decade. On the contrary, two major challenges in the mining sector will be paramount. First the operating efficiency of ZCCM will have to be improved in order to offset the projected decline in production from existing mines, and second, investment in new mines will be essential to-replace those mines as they are exhausted. Even with moderately optimistic assumptions on restructuring and new investment, copper output is expected to be about flat overall, falling to a low of 300,000 MT in 2002 and then increasing to 380,000 tons in 2005, still below production levels in the early 1990s. 9. Private sector capital and management offer the only way to increase investment substantially and to enhance production efficiency. However, even with large injections - ini - in investment -- and some associated gross increases in domestic procurement -- the process of restructuring will not be easy, nor will it be business as usual once accomplished. There are likely to be sharp reductions in employment, especially in the short term. Some purchases may be directed to external suppliers, and many social services currently performed by ZCCM will have to be transferred to government. In the light of these continuing challenges in the copper sector, it becomes especially urgent to evaluate the response to economic reforms of the other potential sources of exports within the Zambian economy. AGRICULTURE AND MANUFACTURING 10. Despite the far-reaching reforms of recent years, the real level of activity of the Zambia economy was, in aggregate, slightly lower in 1995 than in 1991. Beneath that aggregate stagnation, however, there have been dramatic changes within the economy, as illustrated by the particular experiences in agriculture and manufacturing. 11. Compared with many other Southern African countries, Zambia has abundant high-quality land for farming and plentiful water, although only about 10 percent of arable land presently is under cultivation Despite this comparative advantage in agriculture, the country's economic policy after Independence gave primacy to import- substituting industrialization. Industry grew rapidly at first, led by four subsectors (chemical, metal, paper and non-metallic-mineral related products) which in 1975 together accounted for 54 percent of manufacturing production. This industrial growth came to an abrupt end at the time of the copper collapse, however, with especially severe consequences for the four hitherto favored subsectors, whose production volumes fell by one-third between 1975 and 1981 (and a further third from 1981 to 1994). 12. While the leading role of agriculture began to be formally acknowledged in the wake of the problems experienced by the industrial sector, agricultural policies still were not "market-friendly". On the contrary, the policy and institutional framework applied during the 1970s and 1980s was tilted towards promotion of maize (and hence away from high potential cash crops and away from traditional, drought resistant food staples such as sorghum, millet, and cassava) and was implemented via price controls, centralized delivery of agricultural support services, and parastatal dominance of agricultural processing and distribution. 13. These policies and institutional arrangements did partially achieve their objectives (national maize production rose by 60 percent over the- 1980s), but the system was not sustainable. By the late 1980s, direct maize-related subsidies accounted for as much as 16 percent of the national budget. Delays in input deliveries and crop collection were frequent, as were breakdowns in agro-processing factories. Bottlenecks in the marketing system resulted in large crop losses, under-utilization of storage and processing capacity, and sometimes chaotic inter-provincial movements of goods. Moreover, the controlled system had perverse effects on farmer behavior, including excessive farmer dependence upon government, an exceedingly lax attitude toward credit repayment, a lack of - iv - understanding of the functioning of markets, and an almost complete absence of local commercial networks and rural enterprises. 14. The domestic and international market liberalizations which were initiated in 1989 and accelerated after 1991 have finally aligned Zambia's price incentives with its underlying comparative advantage. Throughout the 1980s, local prices of manufactured goods were rising more rapidly than the price of agricultural commodities. Liberalization has reversed this trend. Viewed from the perspective of farmers, by 1995 the ratio of agricultural to manufacturing prices was at least twice as favorable as it had been in 1989. Liberalization and the associated relative price shifts are having their desired effect on the composition of economic activity although the aggregate level of activity has decreased. 15. Turning first to the changes in composition, in value terms agriculture's share of GDP has risen from 16 percent of GDP in 1985-90 to 22 percent in 1991-5. There have also been very substantial shifts in fortune within agriculture and manufacturing. Within agriculture, the share of maize in total plantings has fallen from 68 percent over the 1985- 90 period to 56 percent in 1994/5. Producers of non-food cash crops are emerging as major beneficiaries of policy reforms, and there also seems to be an increasing preference by smallholder farmers for more drought-tolerant food crops. Within manufacturing, the past five years have seen an acceleration in the long-standing trend of an increase in the relative importance of the agro-related subsectors -- which build on the twin foundations of sustained domestic demand for food and the country's agricultural endowment. By 1994, the share of food, beverages and tobacco in manufacturing production had reached 55 percent (up from 27 percent in 1975). Cotton spinning is another agro-related growth area within the manufacturing sector. Between 1992 and 1995, production of spun yarn (80 percent of which is exported) has risen by almost 50 percent, and a further 50 percent increase is projected for the next two years. 16. In aggregate, however, performance in both agriculture and manufacturing has been poor. By 1995, the total land area cultivated had declined by more than 15 percent from the 1985-90 average, and the volume of manufacturing production in 1994 was 6 percent below the 1991 volume. The reasons for this poor aggregate performance include the following: * Economic stabilization proved elusive, with inflation only falling below 50 percent in 1995. The resulting uncertainty inhibited a positive investment response to new opportunities in two ways -- by raising questions as to the sustainability over time of the program of economic reform, and by creating confusion as to what were the underlying trends in relative prices (and hence as to what were the potentially most profitable areas for-new investment). * The credit crunch that resulted from the combination of financial sector liberalization and macroeconomic stabilization sent real interest rates to unprecedented levels (above 100 percent for a time in late 1993) -- with - v - disastrous consequences for the financial health of commercial farmers, private manufacturers, and other private firms. * The prevalence of drought in three of the last four years severely hurt agriculture, more than offsetting the potential income benefits that otherwise would have resulted from the pro-agriculture changes in relative prices. * The institutional transition from an agricultural system organized around monopoly public institutions to one organized around markets and decentralized, predominantly private networks and institutions proved to be difficult -- with the result that the new pro-agricultural price incentives did not translate instantaneously into real opportunities for profit on the part of farmers. (The slow pace of privatization of agro-processing firms prior to 1995 contributed to this institutional logjam.) * Far-reaching and broadly appropriate, but imperfectly designed and implemented trade liberalization also hindered the domestic supply response - - both because unintended anomalies ended up exposing some local manufacturers to negative effective rates of protection from imports, and because the reformed trade regime still contained a residual bias against production for export markets. (In quantitative terms, however, the impact of these international trade related effects on overall economic performance was small.) As of early 1996, Zambia appears to have emerged from the most difficult stages of its economic transition. Not only does the macro-economy appear to have stabilized, the institutions and players crucial for the success of market-led agricultural growth are beginning to take root. 17. Looking to the future, weather permitting, Zambia's prospects for agricultural growth, and development of related agro-processing industries, are good. Projections prepared for this study (and based on micro-analysis of demand, profitability, and the potential impact of drought) suggest that over the 1995-2005 period agricultural GDP can expand at about 5 percent per annum. This growth rate can be achieved so long as private sector agricultural trading and processing continues to expand, the core set of agricultural support services are strengthened, and Zambians are not confronted with major barriers to entering regional markets. In contrast with the pattern during the prior two decades, this growth is expected to come from the full spectrum of small and commercial farmers, and to be based on contributions from a broad range of commodities, including: * a continuing annual growth rate of 2.5 percent in maize production which, at 45 percent of agricultural value added, remains the mainstay of Zambian agriculture. While some of this expanded production is likely to go to - vi - neighboring markets (including South Africa), most of the increase will go to feed Zambia's continually expanding population; * a doubling over the next five years of seed cotton production by small farmers, supported by outgrower schemes managed by the new multinational owners of the recently privatized ginneries, and by local textile spinners eager to expand the local supply of cotton lint to meet their growing demand; * a continuing rapid expansion of areas that already showed success in the early 1 990s, including horticultural production and trade, and sugar; and * average annual growth of 7 percent in the production of a variety of legumes and oilseeds (groundnuts, sunflowers, soybeans etc.), for which there are both opportunities for import substitution and significant export opportunities to the South African market. 18. While the short-term prospects do not appear as promising for non-agro-related manufactured exports, the manufacturing and service sectors are quite well positioned to take advantage of new "induced" opportunities for growth -- expansion that occurs by virtue of the sectors' ability to service expansions of local demand that result from "inducing" activities, such as the expansion of agriculture outlined above. The quality of the demand that results from agricultural expansion appears especially attractive from the perspective of inducing a domestic supply response, since smallholders and emergent farmers will play a leading role in agricultural expansion, and they are more likely than their large farmer counterparts to use the income which they earn to buy locally produced goods and services. Consequently, to the extent Zambia capitalizes on its agricultural potential, it can expect substantially larger multiplier effects than it has realized in the past. REALIZING THE OPPORTUNITIES FOR GROWTH 19. Based in part on the above assessment of specific opportunities for increased production in agriculture and manufacturing, the conclusion of this study is that Zambia has the potential to achieve GDP growth over the next decade of between 4 and 5 percent, provided that the economic reform program continues and provided that there is continuing support from the international community. 20. Achieving 4-5 percent growth is predicated on the assumption of macro-economic stability and continued economic reform. In addition, three assumptions are critical. First, investment will need to increase to over 20 percent in order to provide the increased capacity and enhanced productivity. Some short-term growth will be possible without a major increase in investment given the scope for increased efficiency and the substantial excess capacity, but in the longer-term, significant new investments will be needed if the economy is to be redirected in more profitable directions. Second, non-traditional exports - vii - will need to grow very fast (at least twice as fast as total output) both because that is the only potential source of major new demand to get the economy moving and because such growth will be essential to offset the poor short-term prospects for mining exports. Third, the international community will need to agree on an external financing strategy that will both meet the short and medium term needs for balance of payments assistance (while Zambia adjusts to the limited short-term prospects for copper exports) and deal with the external debt burden in a way that allows for a predictable transition to a sustainable balance of payments position for Zambia. 21. Seven broad messages emerge from this analysis: * First, controlling inflation and hence containing fiscal deficits is still the essential base for a successful transition to growth. * Second, the basic policy agenda is sound; sudden shifts in economic policy should be avoided, and attention focused on consolidation and implementation of this agenda. * Third, there is a pressing need to expand non-mining exports, and policies that support that growth should receive high priority. An approach to exchange rate management which permits a real depreciation of the kwacha is especially relevant here. Additionally, given Zambia's geographic isolation and long-standing inward-orientation, a case can be made for a series of activist initiatives which can facilitate an acceleration of the private sector response -- so long as these initiatives are designed in ways that are "light" in their institutional requirements and that minimize the risks of politically- motivated decision-making. * Fourth, it is vital that Zambia's pattern of growth be increasingly inclusive, breaking unequivocally from the country's long-standing economic dualism. An increasingly inclusive pattern of growth would be rural-oriented, with a strong emphasis on participation by emergent and smallholder farmers. Outgrowing "partnerships" between these farmers and commercial agribusiness appear to have particular promise. * Fifth, the international community will need both to continue to provide high levels of balance of payments assistance (assuming Zambia makes credible efforts to close the current account deficit) and to address the issue of Zambia's considerable external debt burden in ways that show a clear and credible path to a sustainable balance of payments position. * Sixth, rejuvenation of mining output will depend ultimately on the infusion of private sector capital and management. - viii - Seventh, sustained increases in national output will only be possible if major improvements are made in the operation of key public institutions, and in the provision of infrastructure in key areas. Improvements in roads and in the performance of public institutions which support agriculture are of particular relevance for the growth strategy outlined in this document. 22. If these messages are heeded and Zambia stays the course more generally regarding the process of economic liberalization and reform, the prospects for steady and sustainable economic growth are good. Provided that efforts are also made to increase the access of all Zambian's to these opportunities and to use a good portion of the growth dividend in the expansion of basic human services, this economic growth will also arrest the increase in poverty Zambia has suffered over the past 20 years and begin the process of genuine and sustainable poverty reduction. 1. INTRODUCTION 1.1 The main purpose of this paper is to assess the prospects for sustainable and broad-based economic growth in Zambia over the next decade. In doing so, it also provides a brief analysis of some key economic developments during the past five years; most particularly, it addresses the question of why economic growth has been so disappointing despite an impressive record of economic liberalization. 1.2 A distinctive characteristic of this report is the emphasis on a micro level analysis of the problems and prospects within two key sectors, agriculture and manufacturing. This emphasis reflects a belief that economic growth does not flow automatically from the adoption of sensible economic policies, however essential those policies may be. If this growth is to come primarily from the private sector, we also need to assess directly the availability of markets and the capability and financial health of the individual producers. Given the limited possibilities for short-term growth in the mining sector, these new sources of economic growth are most likely to be found in these two sectors. 1.3 This paper does not address all sectors or all issues concerning economic policy and growth in Zambia. In particular, the future of the vital copper mining sector is mentioned but not analyzed in any detail, and many issues vital to longer term growth such as population growth, education, and health care are not included. Rather the focus is on recent and near-term economic growth, with a special emphasis on the specific problems faced in agriculture and manufacturing. 1.4 Chapter 2 presents a brief review of economic developments since Zambia's Independence in 1964, focusing on economic policy and results during the past five years of economic reform. It emphasizes the lost opportunities and distortions that resulted from Zambia's heavy dependence on copper mining and extensive use of economic controls. Chapter 3 looks specifically at manufacturing and agriculture over this period, both to record and explain the transformations that have occurred in those two sectors and to assess their basic health. Chapter 4 analyzes some of the key economic issues over the past five years, including the central issue of why the pace of economic growth has been so disappointing and the related issues of limited growth and limited progress in the alleviation of poverty. Chapter 5 returns to the micro perspective to identify the specific potentials for economic growth within agriculture and manufacturing, since if Zambia is to reduce its reliance on mining, these sectors will have to be the primary sources of new growth. Chapter 6 then presents the aggregate projections of potential economic growth, including analysis of some potential requirements for that growth in the areas of investment, export expansion, and external debt. Chapter 7 summarizes the conclusions and policy recommendations of the report. -2 - PART I. ECONOMIC DEVELOPMENTS: 1965-1995 2. COPPER AND ITS CONSEQUENCES A. INTRODUCTION 2.1 Economic performance and policy in Zambia have been intimately tied to the copper industry. During the first decade after Independence, copper mining accounted for about a third of GDP, over 80 percent of foreign exchange earnings, and about a third of fiscal revenue. Mining, mainly copper, pervaded all aspects of life as about 50 percent of the population depended on it directly or indirectly for their livelihood. Although employment in the mining sector proper averaged only about 10 percent of formal sector employment, much of the other labor force served the mining industry directly or indirectly. In spite of the over 50 percent reduction in output in recent years, the copper industry still plays an important role, particularly in foreign exchange earnings. 2.2 Economic policy-making centered around using the copper surplus during the boom years and responding to the fall-out from the collapse of the sector during the bust. Thus, this Chapter takes the copper industry as its point of departure, first tracing its impact on overall economic activity and then outlining the policies Zambia took to absorb the surplus and to respond to the crunch. This provides the backdrop for Zambia's future prospects. B. TRENDS IN ECONOMIC ACTIVITY (i) Copper: Production and Price 2.3 Production of copper and other mineral products declined steadily after the early 1970s, as the development in new sites failed to offset the loss in output from old mines. As shown in Figure 2.1, Zambia produced about 680,000 metric tons of copper in 1965 and this rose to over 700, 000 tons in 1969 and 1972. However, by 1990, production had fallen to 441,200 tons -- only 65 percent of the level achieved 20 years earlier. The decline in output continued through the first half of the 1990s as the yield of the mines subsided and technical and managerial problems emerged. In 1995, only 327,000 tons of copper were produced -- less than 50 percent of the level at Independence and only 77 percent of the level in 1990. - 3 - Figure 2.1: Copper Production and Real Price Boo 7 700 T 6 00 4 v t 10 - - 1 0 O- . |f i-e - - . E r . i - I-Production (thousands of metric tons) Price (19W USS per metric ton)i 2.4 The fall in the volume of production was compounded by a similarly sharp decline in the international price of copper. (See Figure 2.1). The real price of copper was at its historic high from the mid-1960s to the mid-1970s. A sharp decrease was experienced in 1975 when the price dropped to US$1237 per ton -- less than the price in 1965 or to 60 percent of the price in 1974. The real price of copper in 1975 was about 46 percent of the level in 1965. Despite the subsequent recovery in nominal prices, the real price continued to trend downwards until 1986. Even with recent increases, the real price in 1995 was only about 40 percent of the level of 1965. (ii) Debt and Balance of Payments 2.5 When the price of copper declined in the mid 1970s, it was initially thought to be temporary. Hence, instead of initiating policies to stimulate other export sectors and to restructure the economy away from its dependence on copper, the authorities borrowed abroad to finance a large balance of payments deficit and to maintain imports. In the 1980s, the pace of new borrowing declined, but Zambia found itself increasingly unable to service this debt, and, particularly when donor funds were reduced due to policy differences, Zambia experienced a second surge in external debt due to increasing debt service arrears. As the copper revenue failed to revive and the debt contracted in the mid- 1970s started to mature, servicing the debt became increasingly difficult. As a result Zambia's foreign debt increased from US$1.7 billion in 1975 to over US$7 billion in 1990, making Zambia one of the most indebted countries in Sub-Saharan Africa. (See Table 2.1). 2.6 The debt service ratio (before rescheduling), climbed from a yearly average of 21 percent of the value of exports in the decade between 1975-84 to 64 percent in 1985-90 and to 57 percent during the first half of the 1990s. As a result, the management of Zanbia's debt assumed center stage in policy dialogue and exposed Zambia to its perennial balance of payments crisis. Table 2.1: Selected Macroeconomic Indicators, 1965-1995 65-74 75844 85 90 91-95 65-95 Real GDP growth rate 2.4 0.3 1.6 -0.6 1.2 Real per cap.cons.growth rate -1.3 -1.8 -2.4 -3.0 -1.3 Gross Domestic Investment/GDP |I 31.1 22.3 15.1 12.0 22.1 Gross Domestic Savings/GDP 42.5 18.9 15.4 7.0 24.5 Extemal Debt Stock (US$ mil.) 1191 3805 7242 6595 4079 Exteual Debt Stock (% of GDP) 46.1 94.1 231.0 190 120 External Debt Service/ Exports of GS | 21.31 64.4 57.1 42 CurrentAccountBalance/GDP 1.4 -11.9 -12.5 -15.5 -9.0 ...after official grants 1.4 -8.3 -8.0 -3.2 -4.1 Total Gov't Revenue/GDP 30.1 24.4 20.1 17.3 24.1 Total Gov't Expenditures/GDP na 38.1 35.0 31.6 35.7 Overall Fiscal Deficit/GDP na 13.8 14.9 14.3 11.6 Sgu=u: 1965-1989, Monthly Di1eet of Statistics, Central Statistics Office (CSO); 1989-94, CSO (and IMF) revised accounts, January 1995. 1995 Staff Estinutes Notes (1) The ratio of investtnent to GDP is in current prices. Rex ZJ utch Disease" f cV fCpe it is a that the abundance of copper Zambiad reliance on it as a source of export eaarnings r s effectivel impeded the development of non-copper related sources of growth. T7his phenomenon whereby the success:or:presence of a largeresourcrela ted sector impedes the development of other activities is commonly called the "Dutch Disease-"in reference to the effects that developing; energyrelated resourceshad on. the Dutch economy.: i: Though copper mining has greatly benefited related activities and provddhe entire economy with a largerpurchasg power, it has inevitably disadvntaged oteeorting activities and those that compete closely for.lbor and capital. In the absence of copper,Zambia's exchange rate would have gbeen lower, and this would hav benefited other exporters and import competing activities. This does not mean that growth as a whole woudd have been higher without copper, but the growth of other exporting activities presumably would have been.:. The medium to longer- term effects depend very heavily on how the: incomee neratedrm copper has been used and the comparative dynamic effects offocusing heavily on copper as developing a more diversified economy. In Zambia's case, the "Dutch disease " effect of copper mining has been exacerbated by the relatively inefficient investments made with resulting savings. 2.7 Zambia's balance of payments had recorded current account surpluses for most of the period before the copper crises. During the ten years between 1965-74, these surpluses averaged 1.4 percent of GDP. Since 1974, however, the current account has continually deteriorated. While the share of exports in GDP declined from about 50 - 5 - percent in 1965-74 to about 31 percent in 1990-95, the share of imports only declined from 39 percent to 34 percent. (iii) Government Revenue and Expenditures 2.8 The decline in rents from the copper sector also led to a sharp fall in fiscal revenue. Total fiscal revenue fell from 30 percent of GDP for the period 1970-74 to 19 percent for the years 1990-94. Over the same period, revenue from mining declined from 10.8 percent of GDP (4 percent of mining company tax and 6.8 percent mineral export tax) or 36 percent of fiscal revenue to 1.6 percent of GDP, or 8.4 percent of revenueI Figure 2.2: Government Expenditures as shares of GDP 16.00 14.00 --i Personal Emoluments 12.00 10.00- ~~~~~~~~~~RDCs a 8.00 - Domestic Capital i; 6.00 j 2 \ t \& < A Expenditure IL. 6l00 - Transfers+subsidies 4.0 2.00 0.00 I l l l l r- e o 00 00 0o 00 0O : 0 a., o~ o~ 0" 0' , "I 0 ' :' 2.9 While revenue was falling, expenditure restraint was delayed. In particular, consumer and producer subsidies continued unabated until the early 1990s. Consumer subsidies were dropped in 1992, although some implicit producer subsidies persisted. At the peak, subsidies accounted for 6.7 percent of GDP in 1980. Public sector employment and the wage bill continued to increase, resulting in tight constraints on non-wage spending, and low and declining public sector productivity. Increased recurrent expenditures, including the growing cost of domestic interest reduced capital expenditures adversely and contributed negatively to the overall investment picture. (iv) Aggregate Growth and Structure of Output 2.10 In the first decade after Independence, the economy grew at an average annual rate in excess of 3 percent per annum (see Table 2.2). After the copper price collapsed in 1975, however, economic performance was disastrous; real GDP in 1995 was only 13 The World Bank, Public Expenditure Review, Report No. 13854-ZA, April 20, 1995. - 6 - percent higher than in 1975. With a population growth over the period in excess of 3 percent per year, per capita income declined by 53 percent between 1975 and 1994. 2.11 As can be seen in Table 2.2, aggregate GDP has remained relatively constant since 1990, with a rise in 1993 offset by a similar fall in 1994. Industrial sector GDP increased at an average rate of close to 1 percent due to exceptionally high growth in power and utilities operations, modest manufacturing growth, despite a contraction of mining at an average annual rate of almost 4.5 percent. The service sector maintained a growth rate of slightly over 2 percent. Agricultural sector GDP experienced wide swings which averaged to a decline of over 3 percent per annum due, in large part, to one major and two minor droughts during this period. Table 2.2: Sectoral Shares and Real Growth Rates, 1965-1995 (In percentages, LCU) Average 1 1966-741 1975-844 1985-901 1991-951 19901 19911 19921 19931 19941 19951 1966-95 Real Growth Rates (1977 prices): GDP 3.1 0.3 1.3 -0.6 -0.5 0 -2.5 6.5 -3.1 -3.9 1.3 Agriculture 1.8 1.0 2.0 -3.2 -8.9 5.2 -33.1 79.6 -19.9 13.2 1.3 Industry 3.6 -0.5 2.5 -0.3 4.6 -1.2 9.6 -8.5 -5.5 3.3 1 .4 o/w Mfg 9.0 0.6 6.8 0.1 7.8 0 12.0 -10.5 -6.5 5.5 3.9 o/w: Mining -1.2 -0.6 -2.2 -4.5 -7.3 -9.0 12.8 -8.8 -12.7 -9.2 -1.8 Services 3.0 -0.4 -0.9 -0.2 -6.2 5.7 -3.8 1.8 5.1 -3.9 0.5 o/w: Gov't a/ na 0.9 0.7 1.3 1.6 1.6 -0.6 1.5 2.1 2.1 1.6 Shares of GDP (current prices) GDP _/ 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Agriculture 11.8 15.0 16.0 22.4 18.2 15.8 21.3 28 24.7 22.3 15.5 Industry 53.9 40.1 46.9 42.1 45.3 46.3 43.7 42.5 37.5 40.4 45.9 o/w: Mining 34.5 14.7 14.1 7.7 7.4 8.3 5.6 8.0 7.7 9.0 19.3 o/w Mfg 11.0 18.4 30.2 31.0 31.9 33.3 33.2 29.6 27.7 30.4 20.0 Services 34.4 44.9 37. 25.3| 24. 28.6 24.3 20.9 26.1 26.7 34.7 1ow: Gov't na 17.0 8.9 7.2 6.7 6.4 7.5 6.3 7.9 7.7 123 Sources: 1965-1989, Monthly Digest of Statistics, Central Statistics Office (CSO); 1989-94, CSO (and IMF) revised accounts, January 1995. 1995 Staff Estimates Notes: a/ Overall average growth rate covers the period between 1985 and 1994. _/ Sector shares refer to factor cost after 1984. (1) The figures in real termns for 1965 to 1974 were originally expressed in 1966 Kwacha; for 1974 to 1977 in 1979 Kwacha; and for 1975 to 1994 in 1977 Kwacha. The above growth rates are based on rebased series in 1977 Kwacha. (2) The ratios of investment to GDP and imports to GDP are in current prices. (3) Imports (goods and non-factor services) are from the National Accounts. (4) ICOR stands for Incremental Capital Output Ratio. 2.12 Together with the decline in the overall economic performance, major structural shifts have taken place in the economy. With the gradual decline in the production and price of copper and other mineral products, the share of copper has fallen precipitously, -7 - from a third of GDP in the mid-1960s to about 6.5 percent in 19942. Although this decline in the share of copper was offset, to some extent, by the increase in the share of manufacturing, the share of industrial output (including construction, manufacturing, power, and mining) declined from over half of GDP in the mid-1960s to about 37 percent in 1994. During this period, the share of the services sector also declined from 34.4 percent in 1966-74 to about 26 percent in 1994, following the decline in public services which shrank as a result of the dwindling rents from the copper sector. The agricultural sector share increased substantially; from about 12 percent in 1966-74, to 25 percent in 1994 due in part to a relative increase in the sectoral deflator. (v) Investment Performance 2.13 During the era of copper-induced abundance, a significant portion of the mining surplus was invested locally, but the choice of investment projects did not reflect the long-term comparative advantage of Zambia. When the copper surplus started to dry-up, the source of demand for many of these operations also weakened and investment plummeted. At the same time, public investment, including that for public services, also declined as public revenue fell and recurrent expenditure took a larger share. In recent years, enterprises slated for privatization have been forbidden to make investments other than the type and magnitude required to maintain the value of physical assets intact. Since the enterprises were financially constrained as well, and cross-subsidies from one ZIMCO member to another were declining, they did not have had financial resources to make tangible investments. 2.14 National Accounts data suggest that Gross Domestic Investment (Gross Fixed Capital Formation (GFCF) plus changes in stocks) fell from close to 30 percent of GDP during the first decade after Independence to 11 percent in 1991, and has remained about that level since (see Table 2.1 and table 2.3). However, a revised series based on data on capital good imports, combined with information on building materials and related employment, suggests that investment was over 20 percent of GDP from 1989 to 1992 and has fallen sharply since. (See Table 2.3). 2 Sectoral shares fluctuate considerably in the official national accounts because of large differences in sectoral deflators as well as differences in real output growth rates. - 8 - Table 2.3: Investment 1989 1990 1991 1992 1993 1994 (As a percentage of GDP) National Accounts 6.6 13.5 11.4 10.6 12.0 8.2 Revised 21.0 27.4 27.6 20.6 15.2 - 12.5 (Constant million Kwacha) National Accounts 123 173 149 165 209 222 Revised 392 351 362 321 269 264 Source: The World Bank, Investnent in Zambia: A Historical Overview and Prospects Preliminary Draft, July 1995 (vi) State of Poverty 2.15 Before Independence, Zambia's social indicators were among the lowest in the world, and the distribution of income and wealth were highly uneven. After Independence, addressing the social well-being of the population received high priority, and this was facilitated by the high copper income which made it possible to increase social expenditures and support high levels of consumption through various forms of subsidies. Improvements in social indicators and consumption were achieved until the mid 1970s. However, as copper income started to shrink and the debt service began to bite, consumption and social indicators started to deteriorate. 2.16 Poverty in Zambia is still very high. In 1991, about 68 percent of all Zambians were living in households with expenditures per adult equivalent below a level sufficient to provide basic needs. If the poverty line is reduced to cater only for basic nutritional needs, 55 percent of the population fall below the "core poverty line". Moreover, it is widely agreed that poverty has not decreased, and may well have increased, since 1991. 2.17 Rural poverty is more prevalent and more severe than urban poverty. Furthermore, rural poverty is more prevalent in remote provinces and is especially severe in remote districts within a province. The development of poor people living in remote areas has been held back by the concentration of efforts in Lusaka and the Copperbelt and by the lack of local linkages. Urban poverty is concentrated in peri-urban areas and in the compounds. The prevalence of urban poverty was negligible in the seventies (4 percent in 1975), but it increased to just under 50 percent of the urban population in the nineties. As a result, the disparity between urban and rural income decreased from over 17 times in 1965 to 6 times in 1994. 2.18 The poor remain very vulnerable to price and income changes as they spend a very high proportion of their income on food. More than 30 percent of Zambians spend - 9 - 85 percent or more of their income on food, making them extremely vulnerable to price and income shocks. An ever-smaller share of the urban population is engaged in formal sector wage employment with its attendant security and access to services, such as housing. Crowding and inappropriate sanitation make the poor vulnerable to weather conditions and associated diseases. In rural areas, vulnerability is exacerbated by dependence on a single main crop (maize) that is not highly drought-resistant. 2.19 The poor's welfare and their productivity are negatively affected by malnutrition, poor health, and low levels of education. Chronic malnutrition (stunting) is pervasive in both rural and urban areas and affects even non-poor households in rural areas. Acute malnutrition (wasting) is less pronounced. More than half a million children of school age (one-third of all, mainly girls) do not attend school in the appropriate grade. Non- attendance varies from 45 percent among the core poor in rural areas to 20 percent among the non-poor in urban areas. Furthermore, Zambia is one of the few countries to experience an increase in infant mortality over the 1980s (from 97 per thousand in 1980 to 107 in 1990). 2.20 The prevalence of AIDS exacerbates current poverty and threatens to undermine the prospects for economic growth. Recent data suggest that infection rates of HIV are above 30 percent among urban residents and more than 15 percent in several rural areas. Funeral costs are already among the top concerns of private business-owners. The costs of manpower training have been substantially increased as many companies find they must train three candidates for each two potential openings because of the likelihood of illness and early death. C. TRENDS IN ECONOMIC POLICY (i) Policies Pre-1990s 2.21 The economic policies of thefirst 15 years after Independence (1965 to 1980) were characterized by (a) import-substitution industrialization, (b) pervasive controls and expansion of the parastatal sector, and (c) neglect of the agricultural sector. First, the country's copper wealth was used to promote an aggressive program of import- substituting industrialization. Unfortunately, subsequent experience from around the world has revealed that industrialization built to serve a small domestic market does not offer a sustainable path of development. As already mentioned, this error was compounded when the copper price collapsed in 1975 and Zambia's choice to borrow in the hope of maintaining living standards. 2.22 Second, starting in 1968, the Government took control of strategic parts of the economy and started to use state enterprises as the leading sector in the economy. Both INDECO (the state holding company for manufacturing) and ZIMCO (the state master holding company) were established to expand the share of the state sector in productive activities. Some potential entrants were formally excluded, while others were discouraged by the excess capacity and the uncertainties of obtaining access to foreign - 10- exchange. The environment became more restrictive in 1972 as competition was limited, the role of the market was suppressed. and the scope of the public sector was extended. 2.23 Third, the agricultural sector, neglected before Independence, continued to be neglected until the 1980s, in spite of the country having abundant land and relatively good rainfall. Heavy import duties on imports of manufactured goods, and the controls on agricultural prices, turned the terms of trade against agricultural activities. As a result, dualism in the economic structure became more stark, and the gulf between the country- side and the urban centers, in terms of social and economic infrastructure and amenities, was reinforced. A large proportion of the rural population left the villages and flocked to the towns and cities in the Copper Belt. By the mid- 1970s, Zambia had a heavily protected, state-led industrial sector with a copper enclave, and a very backward agriculture. 2.24 Some policy improvement was made over the course of the 1980s. In particular, Zambia's controlled agricultural system achieved significant gains in maize production. However, these gains were unsustainable, and their effect was to inhibit agricultural production and investment in non-maize crops -- areas in which Zambia enjoyed an especially large potential for growth. Industry meanwhile remained subject to continuing controls, and many sectors were still dominated by parastatals. controls to provided an artificial stimulus for uncompetitive areas of manufacturing (or at least slowed the pace of an inevitable decline) and undercut the incentive for efficient production and investment in potentially more competitive areas. This left many manufacturing activities vulnerable to foreign competition once controls were lifted. The fact that most of the modem sector of the economy was under parastatals deprived it of the potential for flexibility and rapid adjustment. (ii) Recent Policy Thrust: 1990-95 2.25 The economic reforms of 1991-1995 have finally put in place policies which support activity in relatively efficient segments of the Zambian economy. As chapter 3 of this study will show, the short-term consequence has been an aggregate decline, due to the scaling back of inefficient activities. But there are also signs of emerging growth in areas where Zambia has comparative advantage. 2.26 The current reform effort can be divided into the pre and post 1991 era. The first phase started in 1989, with the decontrol and market determination of all consumer prices (except maize meal which was decontrolled in 1991) and ended in September 1991, when donor support to Zambia was delayed and the Government defaulted on its payments to the World Bank. Donors became reluctant to release their resources as Government adherence to the policy reforms began to slacken during the run up to the multi-party elections. - 11 - 2.27 Economic reform resumed in earnest in 1992 as: * Product and factor markets (excluding land) were liberalized, and price controls dismantled. * The exchange rate and the allocation of foreign exchange (including capital transactions) were allowed to be market determined, following the unification of the previously dual exchange rate in 1993. * The borrowing and lending interest rates were decontrolled in October 1992, when the Treasury Bill auction was introduced as a less inflationary form of public borrowing. Since then, the nominal interest rate has risen substantially, and the real rate has been positive for most of the time. 2.28 In addition to removing foreign exchange controls as mentioned above, Zambia had, by the end of 1995, moved to a more competitive and more outward-oriented trade regime by: * reducing the maximum tariff from 100 percent to 40 percent in 1993 (although a temporary across-the-board 5 percent import levy was introduced in October 1995 to meet revenue needs); * progressively increased the COMESA (previously PTA) tariff preference, so tariffs on imports from COMESA partners are now a minimum of 40 percent of the corresponding rate for general imports; * abolished the 20 percent uplift factor applied to import values when computing duties in July 1995; and lifted most export controls in 1991, with the ban on export of maize being lifted in 1993 (although temporarily re-instated in mid-1995). 2.29 However, even with these reforms, the current trade policy environment was still not export friendly because of the continued existence of substantial border taxes and the general increase in low tariffs to a minimum of 20 percent (with a few exceptions, such as education and health goods and selected materials). Zambia addressed this in the 1996 budget by reducing most tariffs by 15 percentage points, so tariffs now range from 0 to 25, and concurrently removing most exemptions, including for government purchases. 2.30 The role of the public sector in the economic sphere has been re-assessed with a view to narrowing its scope and strengthening its capacity to perform its legitimate functions more effectively. To this end, the Government has embarked on privatization and public sector reform programs. Considerable progress was made in passing the Privatization Act, founding the Zambia Privatization Agency in 1992, and carrying out the valuation and negotiation for each parastatal. Despite this effort, by mid-1995, nearly - 12 - 3 years into the program, only 15 parastatals had been sold. But in an effort to accelerate the pace of privatization, the holding company, Zambia Industrial and Mining Corporation (ZIMCO), was dissolved in March 1995 and progress in the second half of 1995 was considerable. By March 1996, 40 companies had been sold, with total receipts at US$43 million. 2.31 Zambia has initiated a Public Sector Reform Program to recast the role of the Government's administrative machinery to deliver public goods more efficiently and create a conducive atmosphere for the private sector. This program involves a three pronged strategy: * restructuring Ministries and Provinces to streamline the structure and make them more consistent with current policy priorities; * improving human resource management by developing and instituting performance management systems and individual performance appraisals, training, encouraging optimum human resource utilization, and building a culture of accountability and instituting measures which motivate workers; and - decentralizing and strengthening local government - addressing the performance management system, and financing functions of provincial and local government, and facilitating the decentralization of functions to provinces and local authorities in support of participatory governance. 2.32 While the preparatory work has proceeded well in most of the components of the program, implementation has lagged far behind the original schedule. In addition, a key component is still missing. There is not yet a comprehensive and affordable plan for accomplishing the considerable reduction in public employment that will be needed in order to be able to offer competitive salaries to the remaining workers. This plan should be ready in 1996. 2.33 Zambia also improvedfiscal and monetary management, albeit with limited success in the early years. Measures were taken to increase revenue and restrain expenditures. A tax reform was introduced in 1993 and has been periodically refined, including the introduction of a Value Added Tax (VAT) in 1995. Tax administration was improved with the overhauling of the previous organizations and the setting-up of the Zambia Revenue Authority in 1994. This should be further imposed as a result of the tariff simplification of reduction in exemptions introduced in 1996. To maintain expenditures within the resource envelope, a cash budgeting procedure was introduced in 1993. Efforts have also been exerted to improve the allocation of public expenditures in a manner that would improve the provision of vital infrastructure and social services. - 13 - (iii) Trends in Key Indicators 2.34 Sound macroeconomic management is crucial for Zambia to achieve self- sustaining growth. Unless price stability is fully regained and the interest rate declines, it is unlikely that badly needed investment will occur, growth increase, and employment expand. Similarly, Zambia needs an exchange rate regime that provides the incentive for the production of traded goods, particularly non-traditional exports, to expand. To shed light on the extent to which Zambia's recent policies have brought changes in the key prices, four key macroeconomic indicators will be reviewed here -- inflation, the real exchange rate, the real interest rate, and the agricultural non-agriculture terms of trade. Figure 2.3: Annual Inflation Rate 200.00 o 150.00 c 100.00 I. 50.00 0.00- CD CD 0 N C4D 0 0 N N N CD ~~CD CD i CD (NY)D s s 0 ~~~0- 0) 0) 0 c c Inflation 2.35 As shown in Figure 2.3, during the late 1980s and the first half of the 1990s, inflation was unacceptably high. Inflation averaged 44 percent between 1985 and 1987. Following the abandonment of the economic reform program in 1987, it increased to 55 percent in 1988 and escalated to 128 percent in 1989. Although it subsided a bit in 1990 and 1991, inflation still averaged over 90 percent. In 1992, there was a resurgence and an escalation of the inflationary pressure. Inflation reached close to 200 percent per year in 1992 and 1993, and Zambia was on the verge of hyper-inflation3. In 1994, monetary control was more firmly established, and inflation fell sharply to 53 percent and was 3 C. Adam and D. Bevan, Stabilization and the Risk of Hyper-inflation: Issues in Zambian Macroeconomic Performance. 1992-93, Unpublished Draft, Center for the Study of African Economies, University of Oxford, March 1993. - 14 - about 35 percent in 1995. By and large. the Government seems to have turned the corner in the search for price stability, but the delay has been very costly in terms of delayed investment and foregone economic growth. Real Exchange Rate 2.36 When Zambia's policy turned inwards again after the mid 1980s experience with a foreign exchange auction, there was a substantial appreciation of the real exchange rate from the low that had been reached in 1986. This was followed by a smaller depreciation at the turn of the decade (see Figure 2.4). With the introduction of the Open General License in February 1990, and inter-bank foreign exchange system in December 1993, the exchange rate has been fully market determined. Since the start of the 1990s, the tight containment of domestic demand, coupled with continued large aid inflows and a modest recovery in the price of copper has resulted in the real exchange rate remaining relatively constant in spite of trade liberalization. In fact, the rate appreciated sharply for a few months in late 1993. Figure 2.4 Real Exchange Rate 140 120 100 x 80 -60 40 20 Note: Decrease=Depreciation Interest Rates 2.37 Before March 1993, lending and borrowing interest rates were administratively determined. Rates were periodically adjusted to reflect changes in the rate of inflation, but as the adjustments did not match inflation fully, the real interest rate was negative for most of that period. In March 1993, the Government introduced the sale of Treasury Bills as part of the liberalization of the financial market. Since then, the nominal interest rate has been determined in the Treasury Bills market, as both the borrowing and lending rates have been tied to it. When it was introduced in March 1993, the compound annual - 15 - yield of 28 days TBs stood at about 182 percent. The rate continued to increase until it reached 591 percent in July 1993. But it started to decline thereafter and fell to less than 25 percent during the last quarter of 1994. At the moment, the rate stands at around 50 percent (Figure 2.5). Long maturing Treasury Bills of 182 days were introduced a bit later, and their yields were equally high and followed the same trend. In spite of the high inflation during this period, the real yield on these bills has been positive and high. In fact, between the third quarter of 1993 and 1994, the real yield averaged over 100 percent. Figure 2.5: Annualized Monthly Nominal and Real Interest Rates. 600 - 500 - 400 - 300 ~~~~~~~~~~~~~~omi-nal- 200 ~~~~~~Real Years Agricultural/Manufacturing Terms of Trade 2.38 The terms of trade (TOT) between agricultural and non-agricultural goods (or rural and urban goods) have changed substantially. This is illustrated in Figure 2.6, using two different ratios. One line (associated with the right hand axis) represents a ratio between a weighted average of the producer prices for major agricultural crops (i.e. maize, sunflower, cotton, wheat, soybean, and Virginia tobacco) and the wholesale price of manufactured goods. The second line (associated with the left hand axis) is a ratio of the official GDP deflator for agriculture and the GDP deflator for non-agricultural goods. Both lines indicate a steady decline in the agricultural TOT during the early-to-mid- 1980s. The top line suggests a continued (and significant) deterioration of the agricultural TOT through the late 1980s, reaching a low point in 1991. The bottom line suggests some recovery of the agricultural TOT in the late 1980s before a decline again in 1991. As both lines show, since 1991 there has been a sharp improvement in the barter terms of trade for agriculture. While the large shift in 1992 was certainly a result of the 1991/92 drought, the more recent pattern in the TOT is associated with the market liberalization process. The impact of these relative price shifts on the profitability of agriculture has been blunted by the removal of (fertilizer and transport) subsidies and the - 16 - adverse impact of drought on crop yields in parts of the country in three of the past sour seasons. Figure 2.6: Agricultural - Non-agricultural Terms of Tradell (1980-100) 2.5 1.25 21 1. ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~0.75 1 ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~0.5 0.5 0.25 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 Yean i GDP Deflator (agoricuture)1GDP Deflator (non-agriculture) Weighted Nominal Pnces of Major Cropsl Weighted Norninal Prices of Manufactured Goode I/ Note that these measures of the terms of trade do not capture changes in subsidies either to transport or agricultural inputs and hence, may overstate the real change in 1992 as these subsidies were reduced at that time. Employment 2.39 One of the most formidable economic and social problems Zambia faces is creating gainful employment for the large and increasing labor force. In 1993, the size of the labor force was estimated to reach 3.5 million, of which about 80 percent reported as having been employed (including in smallholder agriculture and the informal sectors)4. Due to the existence of large scale seasonal and structural underemployment, however, most of the employed were engaged in occupations where the marginal product was very low. In addition, even among those in the formal sector, estimated at slightly over half a million people, many were only partially employed. The effective unemployment is therefore much larger than the statistics suggest. 2.40 About 40 percent of the unemployed live in rural areas, while 60 percent live in urban areas. The geographic distribution of the labor force in Zambia between urban and rural areas poses a major challenge for Zambia's growth and poverty reduction. While Republic of Zambia, Central Statistical Office, Priority Survey 11. 1993: Tabulation Report, December 1994. Labor force defined as the economically active population seven years and above. - 17 - most of the urban labor force is either unemployed or engaged in petty trade and informal sector activities, the rural sector suffers from seasonal constraints on labor availability. D. SUMMARY 2.41 In summary, this Chapter has made two important issues clear. First, Zambia's economic performance and policies have been inter-twined with the performance of the copper industry. As copper revenue declined due to production and price changes, demand in the economy declined, and the economy as a whole declined. Overall economic growth, the balance of payments, fiscal performance and social indicators deteriorated as the copper sector contracted. Second, policies that have been initiated since the early 1 990s have radically changed the economic policy scene and have created a more conducive environment for private sector investment and growth. Provided these policies are sustained and macroeconomic stability is fully regained, the real sector will be in a position to respond positively. - 18 - 3. A CLOSER LOOK AT MANUFACTURING AND AGRICULTURE 3.1 As the previous chapter has shown, since Independence the Zambian economy has been a captive of copper. Initially this captivity took the form of an illusion of abundance that was fed by the enormous financial resources brought into the country. But since 1975, it has been manifested in the radical economic imbalances that came in the wake of the copper collapse. It is a tautology that, if the country is to escape the thrall of copper, the non-mining segments of the Zambian economy will need to grow. Yet, as the aggregate data in Table 2.1 shows, the recent performance of both manufacturing and agriculture has been weak. 3.2 This chapter will probe behind these aggregate statistics. Focusing predominantly on manufacturing and agriculture, the analysis aims to shed light on why, after so much hope at the outset of the recent reforms, subsequent economic performance in manufacturing and agriculture has seemed so mediocre. In exploring this question, it is helpful to view recent events against the backdrop of a longer sweep of Zambia's economic history. 3.3 As the previous chapter has outlined, by the early 1980s, Zambia was saddled with persistent dualism, with an increasingly urban population built on an exceedingly narrow and fragile economic base, and with a foreign debt burden which effectively eliminated any prospect that the country's copper wealth might continue to fund an ambitious poverty-reducing program of social investment. A three-fold transformation was called for. * First, Zambian policymakers and investors needed to acknowledge that a significant fraction of industrial investment decisions were misconceived (e.g., an auto assembly plant that never assembled more than 400 vehicles per year and a nitrogen fertilizer plant that not only was very small relative to efficient global scale but, as a result of repeated technical problems, proved unable to serve even a highly protected domestic market) and that it was counterproductive to throw good money after bad. * Second, those segments of manufacturing that were potentially viable needed the opportunity and discipline of greater integration into the international marketplace -- with ready access to foreign exchange ensuring reliable access to imported inputs, with the discipline of some import competition acting as a spur to - 19- efficiency, and (to the extent possible) with export opportunities acting as a spur to new investment. * Third, and most important, Zambia needed finally to commit itself to a pro- agriculture development strategy -- one that could take advantage of the country's abundant non-copper resource base in a way that held the promise of sustained increases in the levels of living of many the country's poor. 3.4 As the next sections will show, some progress was made over the course of the 1980s in each of these three areas. However, only subsequent to the policy reforms of 1991-95 have those segments of the economy which have the potential to achieve sustained and broad-based growth been operating in a policy environment which supports rather than hinders them. The short-term consequence has been a scaling back of inefficient activities, but there are clear signs of emerging growth in areas where Zambia's comparative advantage is substantial. A. CHANGES IN MANUFACTURING 3.5 Figure 3.1 delineates the trends since 1969 in Zambia's manufacturing production. After an initial spurt of growth, Zambia's manufacturing sector has seemed virtually stagnant -- at least in aggregate. Yet this seeming stagnation since the mid- 1 970s is illusory. As Table 3.1 shows, over the past two decades there have been radical shifts in the mix of activities within manufacturing -- with substantial increases in the share of food processing, a stable share for textiles (at least until 1990), and declines in the remaining subsectors. As the next subsections will reveal, three central factors account for these shifts. These are: (1) changes in the level and composition of domestic demand; (2) structural and policy-induced barriers which prevented firms in most subsectors from redirecting production toward export markets; and (3) the rising competition from imports. Figure 3.1: Manufacturing productlon, 1969-1994 140.00 12000 1 00.00 80.00 X60.00" > 40.00 _- un ear 1 I t-19 A YOatr: 1969-1994 - 20 - Table 3.1: Subsectoral Distribution of Zambia's Manufacturing - 1975-1994 Percentage of Gross Output 1975 1990 1994 Food, beverages and tobacco 27.4 39.3 54.9 Textiles, garments and leather 12.5 12.2 7.7 Wood and Furniture 5.2 2.3 2.3 Paper and printing 5.5 5.4 4.3 Chemical and rubber 20.2 19.0 13.5 Non-metallic minerals 5.0 6.4 4.3 Basic metals and metal products 23.6 15.1 12.7 Other 0.5 0.3 0.2 TOTAL (%) 100 100 100 Source: Central Statistics Office 3.6 The substantial structural shifts that took place between 1975 and 1990 can straightforwardly be attributed to the combination of stagnant aggregate demand and substantial shifts in the composition of that demand, since import controls (and parastatal dominance which inhibited domestic competition) continued unchanged through the period. Only after the trade and domestic market liberalizations of the early 1990s did the competition-driven process of "creative destruction" that drives the development of private market economies begin to work its influence on Zambian manufacturing-- with, as will be seen, quite mixed results in the short-term. A Disaggregated View 3.7 As a way of clarifying what were the determinants of changes in Zambian manufacturing at different points in time -- and what these changes portend for the evolution of Zambian manufacturing over the next decade -- it is helpful to examine in turn each of four groups: "boom-and-bust" subsectors, the food, beverage, and tobacco subsectors, the textile and clothing subsectors, and the subsectors linked to the mining base of the economy. 3.8 The "boom-and-bust" subsectors. Zambia's surge in national income and wealth in the decade after 1964 came to a screeching halt in the mid- 1 970s after the price of copper collapsed. The consequences of this collapse were immediate and devastating for investment, which by 1979 was at less than one-third the level which it had been in 1974. 3.9 Figure 3.2 depicts a similar pattern of boom and bust for four subsectors -- metal products; cement and other non-metallic mineral products; chemicals, rubber and plastic products; and paper products. The boom era for each subsector can straightforwardly be associated with a combination of surging investment (and other domestic) demand, and industrial policies of aggressive import substitution initiated in the mid-60s. However, by the latter part of the 1970s, easy opportunities for import substitution had become - 21 - quite limited; imports of chemicals, for example, fell from US$140 million in 1974 to US$53 million by 1979. So when investment demand (plus other non-wage government expenditures') collapsed, production in these subsectors collapsed as well. Figure 3.2: The "boom and bust"subsectors 2.00 - 1.20 1.00 0.60+ 0.40 I 1 I l l l l !l I _ e a i- os w _ e n - cn .- X~ e r- - _ _ _ _ N N N N Year: 1969-1994 rChemicals, rubber & plastic -U-Non-mietallic mineral products! -*- Metal products and other -~*-Paper & paper products 3.10O In principle, when domestic demand declines, firms can redirect their activities towards export markets. However, aside from exports of fabricated copper items (on which more below) none of the firms in these subsectors have been able to significantly diversify their markets. As of 1994, there were no recorded exports for either the chemicals or the paper subsectors; total exports of cement amounted to below UJS$3 million; and non-copper-related exports of engineering products were minimal. Zambia's disadvantageous location in central Africa (combined with the high weight/value ratio -- and hence high transportation costs -- typical of these products) offers part of the explanation. Another part of the explanation is to be found in-the fact that domestic facilities were very much smaller than plants of efficient global scale. 3.11 As is evident in Figure 3.2, the decline of the "boom and bust" subsectors occurred in three distinct phases: an initial collapse in the late 1 970s; stagnation (then, for some subsectors, a modest recovery) in the 1 980s; then a further round of sustained decline since 1990. The explanation for this final phase of decline must lie in some combination of declining local demand and increased competition from imports -- although it is difficult to detect either in official statistics. Overall, combining the indices The relation between investment levels and trends in production of metal products and non-metallic minerals is straightforward. The relation is less obvious for chemical (including fertilizers) and paper (including publishing) products. The relevant proximate source of demand here may have been from government. Between 1975 and 1979, non-wage government expenditures fell by 37 percent. - 22 - of production for the four subsectors,2 the value of the joint index falls from a peak of 159 in 1974 to 104 in 1981, and -- after a modest rebound to 119 in 1987 -- falls further to 71 in 1994. 3.12 These four subsectors declined relatively as well as absolutely. In 1975 they together accounted for 54.3 percent of total manufactures production, up from 35.5 percent a decade earlier. By 1994 that share had declined to 34.8 percent.3 The brevity of the period in which production was relatively high, the long period that has elapsed since that time (with associated obsolescence of the capital stock), plus the absence of realistic export potential, suggests that much of what was promoted in these subsectors in the 1970s should not now be considered as part of Zambia's industrial base. In large part, these artificially-stimulated "boom-era" investments can usefully be characterized as exemplars of "stillborn" industrialization. 3.13 The food-related subsectors. Domestic demand factors have been kinder to food-related firms than to their "boom-and-bust" counterparts. Even in the face of declining per capita incomes, people must eat to live. Consequently, in a relatively urbanized society such as Zambia's, population increases translate directly into increases in demand for marketed food (with producers of more income-elastic non-food products taking the brunt of the decline in incomes per person). Indeed, as Figure 3.3 shows, the production index for food, beverages and tobacco has increased more-or-less consistently over the quarter-century since 1969 -- a trend consistent with real GDP which rose only modestly, plus a 2-3 percent annual average increase in population over the period. The contrast between the rising trend in the food-related index, and the declining trends for the "boom-and-bust" subsectors accounts in large part for the radical shifts in composition of manufacturing evident in Table 3.1. 3.14 As the above relationship between production and domestic demand suggests, international trade in the food subsector has been modest. Once import substitution had worked its course, imports have been low (other than in drought years). Imports of processed foods fell from US$67 million in 1974 to under US$10 million in 1987. Even subsequent to the 1992 trade liberalization, local food producers have by and large held their own against imports -- although, as discussed below, there is some indication that Zambia's producers of processed foods are beginning to feel the pressure of foreign competition. (See Table 3.2) Aside from sugar, exports have also been modest. 2 Using 1975 weights for their relative shares, with each subsectoral index set at 100 in 1980. For purposes of comparability, these data include basic metals which in 1994 accounted for 2.5 percent of manufacturing output. - 23 - Figure 3.3: Trends In the food and textile subsectors 180.00 - . ~ ~ . _ . 140.00 T 120.00 60.00W#8,|||I 40.00 Year: 1969-1994 - Food, beverages & tobacco -U-Textiles & cothing 3.15 The role of state-owned enterprises, which in general was disproportionately large in Zambia's efforts at industrialization, was especially significant in the food, beverage and tobacco subsector: in 1980 they accounted for 72 percent of the subsector's production and 76 percent of employment. As of 1988, agro-related activities accounted for 55 percent of total turnover of Zambia's largest holding company, INDECO. Initially, INDECO perhaps contributed to the acceleration of this relatively successful subsector. However, (perhaps after its initial pioneering role) the virtual monopoly position of INDECO has been a brake on the subsector's dynamism. Subsequent to the liberalization of domestic markets, there has been a rapid proliferation of small-scale grain millers (see below), dairies and bakeries. Thus, the RPED survey of 39 food firms found that employment in food parastatals declined by 19 percent between 1991 and 1993; over the same period, employment in private firms rose by 6 percent. More broadly, as discussed further below, there are grounds for optimism that some of the international firms interested in acquiring former INDECO subsidiaries, might provide the skills and orientation for the subsector to make a breakthrough into export markets. 3.16 Textiles and garments. Until 1990, textiles and clothing firms had weathered the shifting fortunes of the Zambian economy at least as well as their counterparts in the food subsector. Like food, clothing is a non-durable consumer good -- and consequently relatively sheltered from the vagaries of investment and government expenditure. Further, until the early 1980s there were still opportunities to substitute for imports (behind protective barriers). Imports of textiles and clothing were US$86 million in 1974, and US$62 million in 1980 but fell below US$30 million for the remainder of the 1980s. The combination of stable demand and continuing opportunities for import substitution led to the four-fold increase in production between 1969 and 1985 that is evident in Figure 3.2. - 24 - 3.17 However, import liberalization in the early 1990s precipitated a major shakeout in the industry -- evident from both a 40 percent decline in subsectoral production between 1990 and 1994 (see Figure 3.2) and the results reported below of firm interviews. Imports of used and "seconds" clothing have decimated the domestic garment industry: the RPED survey documents a 40 percent decline in employment between 1991 and 1993 for its sample of 25 garment firms; between 1990 and 1995, employment in four medium- to-large garment firms interviewed informally as background for this study fell from almost 1,800 to under 600. More broadly, industry informants report that total formal sector employment in garment-making has fallen from 8,000 to 800 workers. The domestic weaving industry (which supplied both fabric to garment firms and African prints for domestic use4) has been correspondingly decimated -- with the production of woven cloth falling from 21 million meters in 1992 to 11 million meters by 1994, and employment declining from 7,900 to 5,800. 3.18 Despite these dramatic declines, the recent record of the subsector is not uniformly bleak. As discussed below, one of the central objectives of trade liberalization was to encourage exports in efficient subsectors. And the upstream segment of the "cotton-to-garments" pipeline has responded. Between 1992 and 1995, production of spun yarn (80 percent of which is exported directly) has risen by almost 50 percent -- and a further 50 percent increase is projected for the next two years. Additionally, the public- private joint venture Kafue Textiles, which had been oriented overwhelmingly towards the domestic market, currently sells about 80 percent of its (substantially reduced5) output on export markets in the form of woven gray cloth. In 1994, total exports of yam and textiles amounted to US$28.5 million -- up from US$5 million in 1988. We explore in more detail below whether this export surge might be a harbinger of increased dynamism throughout the cotton-to-garments pipeline. 3.19 Mining-related subsectors. The impact of mining deserves explicit mention in this disaggregated review of manufacturing performance. Apart from GRZ, the parastatal ZCCM is the single largest domestic customer of Zambian manufacturing firms. Total local procurement of ZCCM for the year ended March 1995 was about K98 billion (approximately US$125 million) from 1,833 local suppliers. Firms from virtually all subsectors of manufacturing supply ZCCM -- although dependence on the giant copper company appears to be largest in the metal and wood industries. For three engineering fabrication firms interviewed in advance of this study, dependence on ZCCM exceeded 95 percent of sales. 3.20 As was outlined in Chapter 2, ZCCM's level of activity has declined since the early 1970s, with annual copper output falling steadily from over 700,000 tons in the The market for African prints is not directly affected by garment imports. However, industry informants report that "smuggled" low cost imported prints have nonetheless radically undercut the local market. [According to these informants, if duties and indirect taxes were collected on imports, then local production could be competitive.] Total employment in Kafue Textiles has fallen from a peak of 2,400 to below 900 as of early 1995. - 25 - early 1970s to under 400,000 tons by the mid- 1990s. Although the data do not permit as clear a linkage as for the other subsectoral groupings, this steady decline in production -- and hence demand for inputs -- seems to account in part for the evolving production pattems in the basic metals and wood subsectors (and is a contributor to the declines in metal products and other subsectors as well). Also relevant here is the extent to which the copper mining operations procure their requirements locally or from outside Zambia. An especially crucial question is how the sourcing patterns might change if and when ZCCM (or some part of it) is privatized. More broadly, as discussed further below, sustaining the copper base will be crucial for the continuing survival of significant portions of Zambian manufacturing. Enterprise Constraints: A Firm's-eye View 3.21 Evidence from June 1994 surveys of 215 firms conducted as part of the World Bank-sponsored Regional Program for Enterprise Development (RPED) highlights the central importance of domestic demand and import competition in accounting for the performance of Zambian manufacturing and uncovers some important additional constraints. Firms were asked to identify their most important problems in two ways -- they were asked to volunteer their "three most important problems", and they were asked to evaluate on a 1 (no problem) to 5 (severe problem) the relative importance of twelve distinct constraints on enterprise operation and expansion. Table 3.2: Three Largest Business Constraints, as Volunteered by Firms (June, 1994) 1% of firms volunteering constraint] Leading 3 Constraints All Firms Food Metals Textiles Wood (all) Lack of access to credit 19 12 8 28 31 42 Insufficient Demand 18 16 26 13 17 35 Competition from imports 13 10 21 17 3 35 High Interest Rates 12 12 18 6 11 32 Competition from local Firms 4 10 0 2 3 12 Source: Regional Prograrn for Enterprise Development 3.22 Constraints by subsector. Tables 3.2 and 3.3 underscore the impact of the two constraints highlighted in the previous section. In Table 3.2, 35 percent of all sample firms identified lack of demand and competition from imports as their "most severe problem". And in Table 3.3, 46 percent of firms gave scores of 4 or 5 to "lack of demand", while 36 percent gave similar scores to "competition from imports". 3.23 Disaggregation yields some revealing differences across subsectors in the relative importance of import and demand constraints. Garment and textile firms were most - 26 - likely to highlight the impact of imports; by contrast, wood products firms have been relatively unscathed by import liberalization. These contrasting results appear to be in part a consequence of natural protection given the relatively high costs of transporting wood products relative to value, and in part a reflection of Zambia's strong endowment of forestry resources. 3.24 The remaining constraints examined in Tables 3.2 and 3.3 can be grouped into three categories: constraints that appear to have been eased by recent pro-market policies; constraints that have been exacerbated by these policies; and supply-side constraints. To begin with the first group, the uniformly low scores reported in Table 3.3 to constraints associated with lack of access to foreign exchange, to raw materials, and to equipment signal a major benefit of pro-market reforms. 3.25 During the pre-reform era, access to all of these crucial inputs was rationed -- and, as numerous reports attested, the resulting restrictions on access imposed a severe constraint on manufacturing. Similarly striking is the fact that only one (!) of 171 firms surveyed volunteered "government restrictions on activities" as one of its three major problems (it rated it third). Only two firms volunteered "difficulty gaining investment benefits" as a problem, and none volunteered "difficulty in obtaining licenses". Deregulation of what had been a tightly-controlled economy represents a major gain for reform. 3.26 Yet the tables also reveal that firms are not uniformly enthusiastic about the (economically efficient) consequences of market-based pricing. In particular -- as the high scores given by a significant minority of firms to "cost of foreign exchange", "cost of imported raw materials", "high interest rates" and "competition from local firms" suggest -- some beneficiaries of rationing and other controls in the pre-reform era appear to have found market disciplines difficult to live with. And the increases in prices associated with new commitments to cost recovery by public utilities are broadly unpopular. Of course, the lack of enthusiasm on the part of firms for losing their special privileges in no way implies that these important, economically efficient reforms should be reversed. 3.27 Turning to the supply-side, as Table 3.2 shows, lack of access to credit was reported as the most important problem by 33 of the 142 respondent firms -- a higher proportion than for any other constraint.6 Equally striking is the subsectoral distribution of the results for access to credit. The proportion of textile and wood firms reporting credit as their leading problem was more than twice as high as for food firms, and more than three times higher than firms engaged in metal fabrication. The analysis earlier suggested that textile firms were under especially severe pressure from imports -- and the results on access to credit suggests that these firms have been disproportionately constrained from restructuring by lack of access to finance. Wood firms were at the other 6 Unfortunately, the 1994 RPED survey did not include lack of access to finance among the list of constraints scored on a I to 5 scale. - 27 - end of the spectrum -- least threatened by imports, and not all that severely affected by insufficient demand. For these firns, the results suggest that lack of access to credit may be inhibiting them from aggressively exploiting any potential competitive advantage. Credit aside, none of the other supply-side constraints (problems with infrastructure, business services, or lack of access to export information and opportunities) emerge as first-order problems -- although the relatively high score food firms (dependent on supply sources in rural areas) give to the infrastructure constraint is noteworthy. 3.28 Constraints by enterprise size and ownership. Along with variations by subsector, variations in the performance and perceived constraints of Zambian manufacturing also are evident by type of firm. Parastatals have been disproportionately hurt by recent changes in the Zambian business environment: total employment in 15 state-owned firms included in the RPED sample declined by 35 percent-- from 7,051 to 4,588 employees -- between 1991 and 1993;7 among 142 private firms, total employment declined by only 15 percent. By size, employment losses have been disproportionately greater among the largest firms, with smaller firms showing fewer losses -- and the smallest firms as of 1991 actually showing some gain in employment. However, larger firms dominate total employment, so in aggregate terms the employment gains of the smallest firms are virtually irrelevant. 3.29 Paralleling these patterns, Table 3.3 documents some striking differences by enterprise type as to which constraints are perceived to be most binding. Larger firms were more likely to volunteer scores of "4" or "5" across a wide variety of constraints than did their smaller counterparts -- added evidence that changes in the economic environment have been more difficult for these larger players. Further, there are some striking differences among private and state-owned larger firms (those with 100 or more employees). A high proportion of parastatals, but not private firms, reported that they were severely constrained by domestic competition and the high cost of foreign exchange; demand constraints also are more likely to be perceived as severe by parastatals. Taken together, these results suggest that the loss of their monopoly dominance of domestic markets, and of their privileged access to (formerly rationed) foreign exchange, has been especially unsettling to parastatals. This result is dominated by the loss of 1500 jobs in Kafue Textiles alone. With Kafue excluded, parastatal employment declined by 21 percent -- still a higher percentage than the decline for private firns. 8 It is important not to read too much good news into the results for the smallest firms. Worldwide, smaller firms tend to be relatively young, and tend to grow most rapidly on average. However, the international evidence suggests that within five years up to 80 percent of these small firms will be out of business. - 28 - Table 3.3: BUSINESS CONSTRAINTS BY ENTERPRISE SIZE AND OWNERSHIP (% Scoring 4 or 5) Size (Number of Employees) 100+ 100+ (State- All 3-9 10-49 50-99 (Private) Owned) Firms Lack of demand 34.0 43.1 55.2 47.4 73.3 45.6 Utility prices 18.4 45.8 48.3 52.6 66.7 41.0 Import competition 24.0 36.7 37.9 63.2 33.3 35.9 Cost of imported raw 18.0 23.3 29.6 68.4 50.0 30.0 materials Cost of foreign exchange 08.0 21.4 27.9 26.3 53.3 23.7 Local competition 16.3 23.3 24.1 05.3 46.7 21.1 Infrastructure 14.0 19.0 20.7 36.8 26.9 20.5 Lack of business services 18.0 08.8 13.8 10.5 13.3 13.0 Lack of export opportunities 12.0 01.8 13.8 31.6 26.7 11.8 Lack of access to raw 10.0 05.5 07.1 15.8 06.7 8.4 materials Lack of access to equipment 02.0 03.6 03.5 00.0 06.7 3.0 Lack of access to foreign 02.0 00.0 03.5 00.0 06.7 1.2 exchange Number of firms 50.0 56.0 29.0 19.0 15.0 168 Source: RPED 3.30 Accounting for recent manufacturing performance. The analysis thus far clarifies why manufacturing performance has been so disappointing, even after the recent round of policy reforms. Part of the explanation is a continuation of the long-term trends in the level and composition of demand which since the late 1 960s have been the dominant determinants of the evolution of Zambia's inward-oriented manufacturing. Since 1991, in addition to the continuing impact of demand effects, two further sets of reasons have contributed to the disappointing performance. The first set concerns aspects of the international competitiveness of Zambian firms: * 1990-1994 has witnessed the culminating phase of the process of shake-out and consolidation of endemically non-competitive activities that has been underway since the latter 1970s. * Even firms with the potential to be competitive have experienced difficulty in fending off import competition ( which, as will be seen, was a result of intended policy changes, unintended policy anomalies, and increases in smuggling) -- in large part because they had become accustomed to operating in a controlled, and hence cocooned, environment. * The set of manufacturing activities in which Zambian manufacturing firms have proven able to penetrate export markets successfully has been exceedingly small - - thus far confined virtually entirely to spun yarn, fabricated copper and processed sugar (all resource-based activities). - 29 - 3.31 The second set of reasons for disappointing performance concerns the impact on private firms of shocks to the financial system. Two complementary effects are relevant: * rapid rises in real (and nominal) interest rates created very severe liquidity crises for many firms; and * even those firms that wished to borrow at very high interest rates found themselves unable to do so as a result of tight monetary policies and "crowding out" of private firms by government borrowing. 3.32 As will be examined in chapter 5, the experience so far does not offer much basis for optimism that manufacturing can be an important driving force of Zambian development in the short-to-medium term; non-resource-based manufacturing seems especially poorly positioned. It does, though, offer some hope that Zambia's accumulated experience could enable manufacturing to play a significant "induced" role in sustaining any dynamism that might be "kick-started" in agriculture and other resource-based activities -- so long as measures are enacted to alleviate some key constraints identified by Zambia's manufacturers. B. CHANGES IN AGRICULTURE 3.33 It has long been recognized that the key to sustained poverty reduction in Zambia lies in agriculture. As Robert Baldwin put it back in 1966, "if one sets as his prime objective the raising of income levels for the great mass of people living in the subsistence sector, then it is clear that this must be done mainly by raising agricultural incomes".9 Yet in the boom decade after Independence, Zambia's new government devoted a disproportionate share of its resources to industrial development, despite the country's relatively abundant land, water and other endowments for agriculture (see Box 3. 1). Only after the collapse of the copper bubble did the anti-agriculture tilt of policy begin to reverse -- haltingly, unevenly, but accelerating over time. 3.34 While the leading role of agriculture in the Zambian economy has been acknowledged since the late 1 970s, as this section will show the sector has been strongly influenced, both positively and negatively, by a series of wrenching structural changes. The primary focus is on the impact of the post-1991 period of accelerated agricultural reform on agricultural performance. However, it is only possible to understand the motivation for these reforms -- and to interpret their consequences -- in the context of the institutional and production environment which the government inherited in 1991. Baldwin (1966), p. 219. - 30- Box 3. 1: Plentiful Natural ResourcesforAgriculture Compared with many other Southern Africa countries, Zambia has relatively abundant land, water, and other natural resources for agriculture. Some 58 percent of Zambia's total land area of 39 million hectares is classif ed as medium to high potentialfor agricultural production, with rainfall varying between 800 and 1000mm annually. (On the plateaus in close proximity to Lusaka, Livingstone, Kabwe, and Chipata, soils are generallyfertile and rainfall is sufficient for the production of a broad range of crops. Population density is extremely low in most of the productive regions, rangingfrom I to 1I persons per square kilometer. Further north, the soils are less productive under natural conditions, however, many of the physical constraints could be overcome with small investments in fertilizer and lime. The northern provinces receive ample rainfall and are quite sparsely populated There is some evidence that the ctimatic regime over Zambia may be changing gradually, making conditions for rainfedfarming slightly less auspiciousfor the central, eastern and southern plateaus. While adjustments in cropping patterns and cultivation practices will be the primary response, there is some scopeforfurther development of irrigation in these; areas. Estimates of the technically irrigable area in Zambia rangefrom 80,000 to more then 300,000. Thusfar, about.50,000 hectares have been developed-- predominantly on large private or parastatals farms. Local experience withgovernment- developed and managed irrigation schemes; has been very poor. Even so, in some smalholder areas there is potential to promote low-cost water harvesting and irrigation technologies, rehabilitate and extend water retention structures, and strengthen the capacity of local communities to better manage water resources.:.. Zambia's Controlled Agricultural System and its Legacy 3.35 From independence and especially from the early 1970s onward, government support to agriculture rested on a commitment to food self-sufficiency. The primary objective was to provide inexpensive food to mine workers and other urban consumers. A secondary objective was to use support to food production as a means of distributing wealth to rural areas and improving regional equity. The primary focus of agricultural support was on maize, with a heavy bias toward maize in government research, extension, marketing services, and pricing policies. The policy and institutional framework applied during the 1970s and 1980s was characterized by: * Official price controls and determination. Consumer and into-factory prices for food staples and industrial crops were set by government, and official producer prices were set or negotiated each year for major crops and livestock products. From the early 1 970s onward, producer prices were set on a pan- territorial and pan-seasonal basis, ostensibly in the name of spatial equity. * Centralized delivery of support services: An effort was made to service large numbers of farmers spread over a relatively large geographical area using a centralized system of credit, input supply, extension, and marketing. One channel marketing systems were established (both for inputs and agricultural commodities), first under NAMBOARD and specialized crop development agencies (i.e., Lintco, Natco), and later involving provincial cooperative unions. - 31 - * Concentration and public sector dominance of agribusiness industries. Through nationalization of private companies, fixed allocations of raw materials to particular factories, and restrictions on imports and market entry, the processing of foods and other agricultural commodities and the distribution of important agricultural inputs became dominated by a limited number of large-scale, parastatal companies, based in one of a few urban areas. This crowded out the private sector and opportunities for rural -based industries, plus created enormous transport burdens (and costs). * Extensive subsidies. In order to apply officially determined prices, maintain relatively low consumer food prices, and provide incentives for maize production, a broad array of subsidies were applied. These included marketing/price subsidies for fertilizer and maize seeds, transport, storage and milling subsidies, and coupons to disadvantaged consumer groups. * Frequent policy and institutional changes. Especially during the 1980s there were frequent changes in the 'rules of the game' with the periodic redefinition of the roles for parastatal agencies, the cooperatives, and rural financial institutions. A mid-1980s policy reform program was short-lived and wide swings in crop and input pricing policies occurred. - A 'public sector peasantry'. During this period, large numbers of smallholders farmers essentially became 'maize outgrowers' for the government. The former provided the land and labor; the latter the inputs, guaranteed prices, and collection, storage, and marketing services. The farmer could retain enough maize for subsistence, but was obliged to sell his/her surplus to the state. This was the implicit contract. If the farmer's yield or return were inadequate, the farmer simply did not repay his/her inputs loan with little or no sanction. 3.36 The policies and institutional arrangements did partially achieve their objectives, although the system that generated these gains was unsustainable: its financial cost was enormous; it skewed agricultural effort (in terms of both product and region) away from areas in which Zambia has a strong comparative advantage; and it hindered the ability of farmers and enterprises to respond effectively as the economic environment began to change. Throughout most of the 1970s and 1980s urban maize meal prices remained below the level they would have reached had the full costs of production, transportation and milling been passed through to consumers. 3.37 Consistent with the objectives of policy, national maize production increased substantially, from an average of 1.05 million tons over the 1980/81 to 1982/83 period to 1.63 million tons over the 1988/89 to 1990/91 period. Marketed maize sales increased even more substantially from 705,000 tons to 1980/81 to 1.22 million tons in 1989/90. This growth was due to a large expansion in the maize planted area and the increased commercialization of the crop, since national maize yields registered no gain. Three - 32 - important structural and technical developments occurring in maize production during this period were: * the rising share of smallholder and so-called emergent farmers in total national maize production from 60 percent to 80 percent; * significant increases in the share of maize sales recorded in the Southern, Northern, Northwest, and Luapula Provinces, and a corresponding decrease from 38 percent to 26 percent in the share from Central Province (in large part as a consequence of the enormous subsides for outlying smallholders that resulted from the policy of panterritorial pricing); and * the adoption by many smallholders of hybrid maize varieties in response to the combination of subsidized inputs, supported product prices, and aggressive extension efforts. Use of hybrid varieties increased from about 30 percent in 1985 to nearly 57 percent in 1990 -- one of the highest adoption rates in East and Southern Africa. 3.38 At least among small holders, success in maize came at the expense of other crops -- some of which were more drought resistant (and hence more beneficial for food security), others of which could have generated more income in the export marketplace. In drier areas, maize partly displaced the production of traditional drought-tolerant staples such as millet, cassava, and sorghum'0 and (after the early 1980s) brought cut-backs in sunflower plantings. Elsewhere, maize competed with higher value food (groundnuts in Eastern Province) or industrial crops (cotton in Eastern and Southern Provinces). The very heavy subsidies on chemical fertilizers reduced the economic incentives for practicing crop rotations and contributed to the emergence of maize mono-cropping in some areas. 3.39 Unlike smallholders, medium to large-scale commercial farmers shifted increasingly towards non-maize crops, with the share of commercial fann land planted with maize declining from 83 percent in the mid-1970s to 61 percent by the mid-1980s. Production of wheat, soybean, poultry, and livestock all rose -- all for the domestic market. " Export-oriented production (of tobacco, coffee, cotton, and confectionery groundnuts), taxed heavily by the overvalued exchange rate, were all stagnant or declining among commercial farmers. Between the mid- 1 970s and mid-I 980s, the total area planted by commercial farmers was down by some 20-25 percent. 10 Although plantings of both sorghum and millet did apparently increase during the early to mid-l 980s. In 1988, maize accounted for only 13 percent of the value of commercial farm crop/livestock sales, although it was still the single biggest source of income. - 33 - 3.40 The strong past biases in agricultural Box 3.2: Dualism in Zambian Agriculture pricing policies and support services contributed to a situation where despite As is common in Southern Africa, Zambian - Zambia's varied agroclimatic conditions and agriculture exhibits a dualistic character, broad market opportunities, the country's comprising: agricultural production is ighy * some 550,000 small-scale farmers who cultivate concentrated on a single crop - maize. As 1-2 hectares of land using low input, hand hoe Table 3.4 shows, maize accounted for 45 technology relying predominantly on family percent of agricultural GDP in 1993. The labor, and retaining a large proportion of cluster of oilseeds, legumes, and potatoes is production of household subsistence; next in importance, accounting of 18 percent of agricultural GDP. Drought tolerant food . approximately 750 individually - or corporately- staples (millet, sorghum, cassava) rank next owned large-scale commercialfarms, each with a 12 percent share. Smaller shares are cultivating 40 ha. or more of landfor commercial accounted for by industrial and horticultural sale, having extensive mechanaion and relying crops, livestock products, and 'other upon permanent and casual hired staff; and cereals'(wheat and rice). * an intermediate group of some 50, 000 emergent 3.41 Table 3.5 details the approximate farmers, each cultivating 5-20 hectares, typically shares in the early 1 990s of small-scale, with draft power and with greater use of emergent and commercial farmers in the purchased inputs than smallholders. These farmers use both family and hired labor and production of Zambia's major agricultural produce mostlyfor market sake. Many have had commodities. Despite their small numbers, above average levels of education and have held large scale commercial farmers account for formal sector jobs. the bulk of the country's soybean, wheat, milk, coffee, tobacco (not listed) and beef (not listed) production. - 34 - Table 3.4: Commodity Share of Agricultural GDP* (Estimated; 1993) Commodity (Group) Share of Agricultural GDP (%) Maize 45 Oilseeds/Legumes/Potatoes 18 Drought-Tolerant Staples (1) 12 Other Cereals (2) 7 Industrial Crops (3) 9 Livestock Products 6 Horticultural Crops 3 Total 100 The agricultural GDP shares were derived from gross outputs (using CSO, MAFF, and industry specific data) multiplied by the value added percentages determined in the Comparative Advantage Study crop budgets. (I) Millet, sorghum, and cassava. (2) Wheat, rice. (3) Tobacco, coffee, cotton, sugar. 3.42 An unsustainable system. Despite its maize-related achievements, by the latter 1 980s it had become glaringly apparent that the controlled system of agricultural development was not sustainable. Direct maize-related subsidies alone accounted for about 9 percent of the national budget in the early 1980s, rising to over 16 percent by the late 1 980s. Maize mono-cropping, together with the application of chemical fertilizers in areas with leached and acidic soils, has also not been environmentally sustainable. 3.43 The centralized support service apparatus was also proving to be inefficient. Delays in input deliveries and crop collection were frequent, as were agro-processing factory breakdowns due to lack of spares. Bottlenecks in the marketing system resulted in large crop losses, underutilization of storage and processing capacity, and sometimes chaotic inter-provincial movements of goods. Similarly, major inefficiencies plagued the support services and marketing operations of Lintco (for cotton) and Natco (for tobacco). Official statistics point to little or no gain in agricultural productivity during the 1 980s. Even with a very large increase in maize plantings and livestock holdings (and an expansion in commercial farm soybean and wheat production), Zambia's agricultural GDP growth rate --averaging 2.2 percent per annum during the 1970s and 2.4 percent per annum in the 1980's-- failed to keep pace with the country's population growth. - 35 - Table 3.5: Share of Different Farming Subsectors in National Production (Early 1990s) Small-scale Farmers Emergent Farmers Commercial Farmers Maize Production 65 2 0 20 Maize Sales 55 20 25 Cotton 85 15 Groundnuts 75 22 3 Soybean 77 7 h8 85 Sorghum 85 10 5 Wheat 5 95 Millet 955 Sunflower 55 | 30 15 Milk 40 60 Coffee_ 5 95 Sources: MAFF, Final Crops Forecasts; ZNFU 3.44 Moreover, the controlled system supported behavior which undermined the ability of farmers to respond flexibly to altered circumstances. These perverse effects on behavior included: excessive farmer dependence upon government, an irresponsibly lax attitude toward credit repayment, an almost complete lack of understanding of the functioning of markets, a loss of fanner knowledge/skills related to crop rotations and storage, increased dietary concentration on subsidized mealie meal, and an almost complete absence of local commercial networks and rural enterprises. In some locations, the adopted production system was either economically or agro-ecologically unviable. Changes in Agricultural Institutions, 1991-1995 3.45 The new government which assumed power in 1991 was committed to liberalizing agricultural pricing and marketing and privatizing agro-processing and other parastatals. It planned to reduce the huge burden of subsidies and to stimulate decentralized, predominantly private-sector delivery of support and marketing services. As Table 3.6 shows, as of 1995 the government has indeed followed through with much of its proposed agenda of agricultural reform. However, reform has been far more difficult -- and its consequences more ambiguous -- than was anticipated at the outset of the process. After examining some of the unexpected challenges of institutional change, this section will delineate what has (and has not yet) been achieved in reforming trading networks and mechanisms of financial intermediation, and in aligning investments with the emerging needs in the new, market-oriented environment. - 36- Table 3.6: Agricultural Market Reform and Privatization Measures Year/Period Year Reform Measure Initiated Implemented Comments Permit private maize and fertilizer Mid/late 1990 No significant activity trade 1980s until 1992 Eliminate fertilizer subsidies 1990 1992 Indirect fertilizer I ________________________________ ______________ subsidies still in place. Eliminate mealie meal subsidies 1990 1992 Hammermill growth Decontrol maize producer price Mid/late 1993 1980s Eliminate maize transport Mid/late 1993 subsidies 1980s Lift sugar price controls 1991 1993 Reduced local consumption Privatize milling industry 1991 1994-95 Several mills won't survive. Privatize cotton ginning 1991 1995 Gins acquired by Lonrho and Clark Cotton Privatize dairy processing 1991 1995-96 Under negotiation Privatize oilseed expressing 1991 1995-96 Under negotiation Privatize Zamseed 1992 1996* New entrants competing Privatize fertilizer industry (NCZ) 1992 1996* New entrants now dominant * Expected Sources: Based on ZPA; Levine and Stathocos (1993) 3.46 The hazards of institutional change. Under the best of circumstances, shifting from an agricultural system organized around monopoly public institutions to one organized around markets and decentralized, predominantly private networks and institutions is a difficult task. But in Zambia reforn hardly took place under the best of circumstances. Not only does there not appear to have been any explicit strategy at the outset for sequencing the transition from control to market institutions, the inevitable difficulties of reform were compounded by a series of powerful "exogenous" shocks. 3.47 In each of the 1991/2, 1992/3 and 1993/4 agricultural seasons, exogenous shocks interacted with the incomplete development of the institutions for market agriculture to undercut radically the ability of Zambia's farmers to perform at anything close to their potential: In 1991/2, the country was struck by one of the most severe droughts this century, resulting in greatly reduced yields and large losses of livestock. In response, the government undertook a massive food import and distribution program involving both concessional and commercial supplies. Further, to attract available domestic - 37 - supplies of maize, it announced a 'floor' price which, consistent with deeply- ingrained expectations, came to be viewed as an official producer price. In the face of a continuing government presence in the market, private traders for the most part stayed out. * In 1992/3, the agricultural season started favorably, with the return of normal rainfall, an expansion in agricultural credit and a large expansion in plantings. However, as Box 3.1 details, the interaction of continuing government intervention in marketing, delays in payment by public purchasers, and rapidly rising real interests plunged a substantial proportion of commercial farmers deep into a debt trap from which they have yet to emerge and led many smallholder farmers to revert to subsistence production. * In 1993/4, the MAFF announced the total decontrol of maize producer prices and the elimination of transport subsidies. Yet immediately there were mixed signals. Simultaneous with its announcement of decontrol, the MAFF made reference to 'floor' prices. Subsequently, fearing rising consumer costs, politicians 'announced' specified into-mill grain prices. Again, private confidence that the government would adhere to "free market" rules of the game was undermined, and private trading activity remained limited. An inflow of donor-supplied and other subsidized wheat interfered in the market for that crop and left farmers without a remunerative sales outlet. Table 3.7 depicts the erratic crop price movements since 1990 that resulted from the interaction of reform and exogenous shocks. Table 3.7: Indices of Real Producer Prices (1990-1991 = 100) | Marketed Output* 1990-1991 1992 1993 1994 1995 Maize 930,000 100 169 109 89 114 Wheat 69,000 100 1234 114 136 185 Soybeans 27,000 100 197 106 119 143 Groundnuts 18,000 100 96 88 147 144 Sunflower 13,000 100 192 71 80 116 Sorghum 8000 100 217 79 90 140 Va. Tobacco 3000 100 110 60 76 94 Sources: MAFF; CSO; ZNFU; TAZ and Private Trading Companies * Highest sales recorded in the period 1992/93 to 1994/95. - 38 - BOX3.3: 1992/3- Policy-InducedShocksforAgriculture In 1992/3, to fill an apparent vacuum in the market (and to ensure higher rates of credit repayment) the government appointed several ruralfinancial institutions and the Southern Province Cooperative Union as the 'primary buying agents 'for maize and selected other crops and then appointed localized 'secondary buying agents '. This caused confusion among would-be private traders who saw the buying agents as mere fronts for continued government marketing, Again, private sector activity was undermined. To make matters worse, crop marketing proved problematic with inefficiencies and misuse offunds in the buying agent system, and with the government being unable to defend the establishedfloor price. At the time, government was determined to stay within its "cash budget" in an effort to control inflation. Consequently, instead of cash or checks, many farmers were issued Promissory Notes, which were immediately redeemable only at discount. All of this took place against the hackdrop of an escalating financial crisis in ambia. In the middle of the season, regulated controls on bank interest rates:0 were lifted, at the same time as the overall money supply was being tightened to contain inflation. Within a four month period, interest rates on commercialfarm loans increasedfrom 50 to 120 percent. Most commercialfarmers hadfinanced their crop with an overdraft,; and most of these could not meet the payments and began incurring penalties. Rapidly increased debt placed many commercial farmers in a state of bankruptcy4which was forestalled only through negotiated debt l rescheduling measures with the banks. Producers of export crops werefurther adversely. affected by the sudden and significant:appreciation of the Zambian currency durin Jue to J September of 1993. 3.48 The emergence of private trading networks. 1994/95 was the first season in which the government refrained from announcing floor, into-mill, or any other prices. Over the course of the year, the government leased more than half of its (434) storage warehouses to private traders, transporters, and others, and accelerated or completed the privatization of maize milling, oilseed expressing, cotton ginning, and dairy processing facilities. It was the first season in which the private sector played a dominant role in inputs and commodity marketing. For the first time in close to three decades, Zambia has engaged in a process of price formation shaped by supply and demand conditions, by the extent of local competition, and by the actual costs of storage and transport. Consequently, maize and other crop prices have varied in economically rational ways by season and by region. 3.49 Both larger and smaller traders of commodities and agricultural inputs have come onto the scene. The emergent larger traders generally have experience as transporters and former agents for the cooperatives or Namboard. In 1994, these larger traders came together to form the Zambia Grain Growers and Marketing Association. Small, localized traders have emerged to serve as a link between farmers and newly emergent public markets and as stockers/distributors for the growing number of seed and fertilizer companies now operating in Zambia. Both the larger and smaller private traders have developed at the expense of cooperative unions and societies, many of which have experienced financial problems (with the withdrawal of subsidies) and been forced into - 39 - retrenchments and asset sales. Only a small number of cooperatives--mostly in Central Province-- have restructured themselves and adapted to the new market environment. 3.50 The (re-) establishment of a network of private traders has taken place at different paces around the country. In Eastern Province, where there is a relatively high population density and a long established private business community, network development has proceeded rapidly. In some districts of Central and Southem Provinces where there are many commercial farmers (i.e. Mazabuka, Kabwe Rural, Choma), farmer-based marketing companies have been established to handle input supply, crop marketing, and processing functions for local farmers. Still other areas have benefited from the support of NGOs or donor-sponsored projects in getting commercial networks established. In contrast, in several other Provinces such as Northern, with lower population densities, weaker infrastructure and little tradition of trading, the development of private trade networks has proceeded more slowly -- exacerbating the impact of the removal of pan- territorial pricing and leading large numbers of smallholder farrners in remote locations to revert to subsistence food production. 3.51 The special problems of rural finance. The 1994/95 season also witnessed the initial restructuring of the rural finance delivery system, albeit featuring substantially reduced public and private lending to agriculture. Zambia's system of rural finance confronts especially severe difficulties -- a consequence of farmer indebtedness, the (near) bankruptcy of all parastatal and cooperative financial institutions (which historically have been willing to lend to agriculture), and recurrent drought. Under present conditions, the commercial banking sector considers itself to be overexposed to agricultural risk. 3.52 Partly in response to these failures of the formal financial system, new forms of contracting have begun to emerge between farmers on the one hand, and more cash-rich parties on the other. Some of these are relatively simple, and involve small traders who themselves have weak access to finance -- for example barter deals involving the exchange of second hand clothes for agricultural commodities. Other schemes have involved the provision of fertilizer to farmers in exchange for the subsequent supply of maize. One large transport company is doing this on a significant scale in Eastern Province while there are many smaller efforts elsewhere. Still other initiatives have focused on specific cash crops (i.e., soybeans, tobacco, paprika, cotton), either involving the pre-financing of crops against commitments of future deliveries, or featuring more complex arrangements embodying input supply, advisory services and crop collection and marketing. (See Box 3.4). The Supply Response 3.53 During the early 1990s, Zambian farmers have thus experienced a series of shocks. Positive (planned) shocks included the freeing-up of markets, and the sharp shift of the barter terms of trade in favor of agriculture. Some of the negative shocks were unexpected, such as the repeated droughts and wide swings in interest rates and the - 40 - exchange rate; others were foreseen, including the removal of fertilizer subsidies, and the withdrawal of parastatal and cooperative marketing. All had sharp impacts on the profitability of farming and the access of farmers to resources and markets. Depending upon location and the skills and financial circumstances of individual farmers, the responses to these shocks and to recent gains in the emergence of private marketing channels have varied. Some farmers have been forced to cut back on production and sell assets; others have made shifts amnong crops and reverted to more subsistence patterns of production; still others have been in a position to expand and diversify production to take advantage of available market opportunities. 3.54 According to official data, the total planted area in Zambia has declined by some 10 percent since 1990/91 and by more than 15 percent from the 1985-90 average (see Annex A, Table 8). Contributing factors have included drought, significant losses of livestock for draft power (due to drought and disease), commercial farmer indebtedness, the reduction of lending for agriculture and the removal of subsidies which supported non-economic production in areas remote from markets. This aggregate decline, however, is accounted for almost entirely by reduced maize plantings. For most other major crops, plantings have remained stable or have increased over the past five years. As a result, the share of maize in total plantings fell from 68 percent over the 1985-90 period to 56 percent in 1994/95. Box 3.4: Contract Farmingfor Cotton Under Lonrho Since 1985,: Lonrho has operated a ginnery at Mumbwa. For many years, the company. merely served as a ginning agentfor the parastatal Lintco which held a monopsony on seed cotton. Although Lintco provided inputr to farmers, maintained alimitedfeId. advisory staff andprovided an assured marketoutlet at officially determined prices, production incentives were inadequate and the productivity of Zambian smallholder cotton farmers remained well below those of their counterparts elsewhere in Africa. With the recent decontrol of the cotton market, Lonrho decided to organize its own outgrower scheme, initially within Central Province, Starting with 8,500 farmers in 1993/94, the company has contracted some 35,000 smallholderfarmers (and a limited number of commercial armers) for the 1995/96 season. Lonrho has drawn away experienced stafffrom Lintco and the official extension service and has developed a variant of the Training and Visit (T& a9 extension system involving one extension agent per 500farmers and having staff earnings linked to farmer performance. The company has made bulk import orders of seeds, pesticides, and other inputs and distributes these at cost and on credit to farmers. A basic producer price is offered, together with possible bonuses linked to yields and to the realized international prices for cotton lint. In addition to input supply and crop marketing services the company also offers cattle dipping services. Due to drought and otherfactors, Lonrho 's outgrower scheme has yet to make a breakthrough in raisingfarmer productivity, yet the company's recent acquisition of several Lintco ginneries is part of its investment in expanding cotton production in the center and south of the country. - 41 - 3.55 While maize production has been adversely affected by both drought and the reduced availability of agricultural credit, the share of production actually entering the formal market has also declined. One reason for this is the dismantling of market support (such as panterritorial pricing and cooperative crop buying services) for farmers in remote areas. There is evidence of increased on-farm storage of maize and a reduced practice of selling maize and then buying mealie meal as prices have begun to reflect actual storage, transport and milling costs. A second reason is a consumer shift to less costly, less refined maize meal products -- and a consequent increase in the number of micro and small-scale milling operations. Nation-wide, the number of hammermills increased from 1745 in 1989 to 4156 in 1992 to over 6000 by the end of 1994. The importance of small-scale processors has risen especially in rural areas and in small towns. Larger industrial milling firms have seen their market share decline dramatically and several of the recently privatized mills appear unlikely to survive.'2 During the last two seasons the quantity of maize marketed through formal channels averaged'410,000 MT -- less than half that recorded during the late 1980s (see Annex A, Table 9). 3.56 Recent plantings of virtually all major crops other than maize crops are at or above the average for the late 1980s. For groundnuts, millet, and mixed beans, in particular, total plantings have increased significantly. CSO data suggest considerable increases during the past three years in marketed sales of groundnuts, mixed beans, sorghum, and millet. Marketed tobacco and seed cotton production have been variable yet below late 1980s levels, partly due to the reduction of plantings in more remote and/or less ecologically suitable locations. A recovery has occurred during the 1995/96 season. 3.57 One reason for the shift from maize seems to be a preference by farmers (now that the system of maize subsidies is gone) for more drought-tolerant crops. In the drought- prone Southern and Western Provinces, there is some apparent shift from maize to sorghum, millet, and groundnuts. In Eastern Province, large reductions of maize plantings have been partly compensated for by increases in groundnut and cotton plantings, both higher value and more drought tolerant crops. And groundnut plantings have increased considerably in both Luapula and Northern Provinces. Another factor relates to finance or financial risk. Most of the oilseed and smallgrain crops entail lower production costs (and material input purchases) than does maize as commonly grown in Zambia. 3.58 A third reason for the expansion of non-maize farming is a recent spate of export-oriented agribusiness investments. By far the largest single such investment is that being undertaken by the Zambia Sugar Company. This $38 million, multi-year 12 Production of breakfast and roller meal by the major millers peaked in 1988-89 at over 522,000 MT. By 1992, production was down by 10 percent and by 1993 by nearly 50 percent. This decline continued into 1994 when it was estimated that the hammermills accounted for virtually all maize milled in rural areas and as much as 60 percent in urban areas. Even in 1992, before the market share of the hammermillers was high, parastatal industrial mills operating off the line of rail were operating at less than 50 percent of capacity due to equipment breakdowns, management problems, and limited finance. - 42 - investment is geared toward expanding the area of sugarcane cultivation (including both plantation and outgrower initiatives) and increasing the processing capacity of the factory at Mazabuka. Other significant agribusiness investments made in the past three years include: more than a dozen cut flower development or expansion projects (see Box 3.5), several dairy and poultry ventures, a few meat or fish processing ventures, and several investments in groundnut deshelling/packing facilities. In 1994, the Zambia Investment Center issued investment approvals for some 100 agricultural projects, having a planned investment value of $50 million. Interestingly, many of such planned investments involved one or more foreign partners, with one-fourth of the ventures involving South Africans and one-fifth involving Britons. 3.59 Table 3.8 below summarizes the apparent 'winners' and 'losers' from the process of agricultural market and broader economic reform thus far. It indicates a very mixed pattern with a limited number of clear 'winners', a large number of people and organizations which have been provided with both new opportunities and new risks/pressures, and another significant set of stakeholders for whom the reforms have predominantly had an adverse effect, either on a temporary or more permanent basis. Box.L3: 3 Floriculture Development in Zambia While: Zambia sfirstfloricultural investment dates back to 1984, this export-oriented sub-sector can trace its start to the establishment of two rose farms near Lusaka in 1987. T7he owners of these farms hadprior experience exportingfresh vegetables and entered into floriculture, npart in orderto obtain theforeign rencyneeded to import machinery and other equipment to run their broader commercialfarming operations. Both of these investments were selfnancedD From this very small base Zambian floriculture has experienced rapid expansion during the early 1990s. By 1994/95, there were 11 commercial growers cultivating 30 ha. of roses in greenhouses and some 100 ha. of open-field 'summer flowers Important catalysts and acilitating mechanisns for this growth have included: imported technical hknow-how and inputsfrom Zimbabwe and South Afica, low cost off-shore loans from donor and quasi- commercial sources, inexpensive and underutilized north-bound airfreight, and the high:: profitability offloriculture relative to other commercialfarming or industrial ventures in Zambia. Many of the new entrants into this industry come from afinancial or industrial background rather than beingfull-time farmers. - 43 - Table 3.8: Stakeholder 'Winners' and 'Losers' from Market Reforms, 1991-95 'Winners' 'Losers' Mixed Experience Small/micro agro-processors Large industrial millers Local transport companies Export crop producers Remote area farmers Central food growing farmers Small/large traders Cooperatives Consumers Corporate agribusiness Lima/CUSA/ZCF Commercial banks EIQi Factors* Factors: Factors: Elimination of market Elimination of market Increased market controls controls competition Access to/retention of forex Loss of official privileges Wider range of available Privatization/leasing process Higher transport/other costs foods Specialized finance/TA lines Increased market Food imports competition Financial market ________ _______ _______ _ _________ I deregulation - 44 - 4. KEY PERFORMANCE ISSUES - 1990-1995 4.1 As discussed in the previous two chapters, the Zambian economy has been going through a period of deep structural change and far reaching policy reform. In the first decade after Independence, manufacturing expanded, but since the mid-I 970s, it stagnated and experienced major compositional change with many subsectors actually contracting in recent years. Agriculture achieved some growth over most of the period but did not focus on areas of greatest comparative advantage. Mining has steadily declined. In an attempt to achieve more rapid and sustained growth, the government has now undertaken a major move from direct control toward a more market-based economy. However, reforms have not been as successful in increasing growth and reducing poverty as was hoped. Disappointment with the results of this effort has touched many parts of Zambian society - urban and rural, public and private sectors, government officials and NGOs, agriculture and industry etc. - as well as the international community. This chapter focuses on why policy reform to date has not yielded the growth that was hoped for, with special emphasis on the current economic status of the poor. A. WHY HAS ATTAINING GROWTH THROUGH POLICY REFORM BEEN SO DIFFICULT? 4.2 Chapter 3 has discussed this issue in terms of the agricultural and manufacturing sectors. Here we examine this question in terms of the economy as a whole. (i) The elusiv2ness of stabilization 4.3 One of the key reasons why growth, investment, and employment expansion have not been what was hoped for has been that stabilization of consumer prices has still not been assured. As discussed in Chapter 2, inflation fluctuated between 40 and 200 percent between 1985 and 1994 (see Figure 2.3). Only in 1995 has it fallen below 40 percent. This delay has been very costly in terms of increased uncertainty, delayed investment, and foregone economic growth. 4.4 Part of the explanation for these high inflation rates can be traced to the removal of price controls, to the elimination of consumer and producer subsidies as part of the reform program, and to external shocks such as the drought of 1992. Frequent adjustments in civil service wages also contributed to the situation, as workers may have been influenced by self-fulfilling expectations of higher inflation in the future and tried to adjust before it catches up. However, persistent large fiscal deficits and expansion of the money supply provide most of the explanation. Sustained rapid inflation would not have - 45 - been possible without significant monetary growth, and the data show a strong relationship between monetary expansion and inflation'. 4.5 During most of the decade after 1986, monetary expansion has been driven in large part by fiscal developments (including the off-budget financing of parastatals such as ZIMOIL) as Government borrowed from the Central Bank to finance most of its deficits2. Central Government borrowing accounted for an average of 65 percent of the change in assets of the Bank of Zambia (BOZ) between 1987 and 1989. Although the ratio fell to 35 percent in 1990, it climbed to 87 percent in 1991. Foreign borrowing beyond the aid flows was not possible, and Treasury Bills sales could generate only limited net resources (netting for domestic interest payments). In 1992, the Government was a net creditor to BOZ because of the large aid flows to offset the impact of the drought, but in 1993, the share of Government borrowing exceeded 100 percent of total asset creation (due to the decline in Net International Reserves). 4.6 The fiscal causes of the monetary expansion, and in turn, the relationship between monetary expansion and inflation, were well recognized by the fiscal and monetary authorities in Zambia by the end of the 1980s. As a result, how to improve fiscal and monetary policies have been central in the economic policy dialogue since then. The cash budget system, the Treasury Bill auction, and the Zambian Revenue Authority were responses designated to improve fiscal performance. It has been a long and difficult road, but performance is finally improving. The overall deficit (before grants and after interest payments) was around 13 percent of GDP in 1990 and 1991, dropped to 9-10 percent in 1992 and 1993, and rose again to about 12 percent in 1994. It was 9 percent in 1995. (See Table 4.1). The monetary impact of the deficit has been moderated by grants, which exceeded 10 percent of GDP in 1992, and by the sale of Treasury Bills after 1993. A regression relating the growth of money (defined as M2 -- the sum of cash and demand, time and savings deposits) to inflation for the period 1980-94 indicates the existence of a strong positive correlation (R-Squared of 0.85). 2 Claims on Central Government (i.e., borrowing by the Central Government) averaged over 95% of total claims between 1986-93. The trend in total claims to GDP ratio was dictated by the trend in claims by Government. - 46 - Table 4.1: Selected Fiscal Indicators, 1990-1995 1990 1991 1992 1993 1994 1995 Total Government Revenues/GDP 20.3 18.7 18.4 14.4 19.3 16.8 Total Government Expenditures/GDP 46.6 44.7 33.1 26.1 31.1 25.8 Overall Fiscal Deficit before Grants/GDP 26.3 26.0 14.7 11.8 11.9 9.0 Overall Fiscal Deficit after Grants/GDP 18.1 21.6 5.7 1.6 4.6 1.9 Inflation (average) 117.4 92.6 197.4 189.0 53.3 30.7 Nominal Exchange rate (Kwacha per US$) 1/ 30.3 64.6 177.0 460.0 669.0 835.5 1/ Year average. Source: Central Statistics Office and Bank of Zamnbia. (ii) The Credit Crunch 4.7 A second important aspect has been the timing of financial sector liberalization. Financial sector liberalization, together with the persistent fiscal deficits discussed above, has led to an increase in interest rates which has both exacerbated fiscal management and limited the ability of firms to adapt to the more open policy environment. This raises the question of whether the government should have decontrolled interest rates before the deficit and the inflation rate were brought under control, or should this decontrol have occurred later? This decontrol amounted to the loss of inflation tax (however clumsy and inequitable), and made financing the deficit more difficult. When the government decided to remain firm on monetary policy, even when the budget deficit and hence public sector borrowing remained large, this put extraordinary pressure on the new Treasury Bill market and generated very high real interest rates. The very high real and nominal interest rates had a detrimental effect on investment and production in the real sector and contributed to the delay in achieving a sustained and broad-based supply response for the reform program. 4.8 On the other hand, after the exchange rate became market determined, decontrolled interest rates helped to stabilize the foreign exchange markets and to fight the threat of hyperinflation. This early liberalization of interest rates also demonstrated that the government was serious about decontrol and was committed to an open economy. As such, it may have helped avoid an even worse scenario and contributed to the ultimate achievement of macroeconomic stability. (iii) Anti-Export Bias 4.9 Despite substantial trade policy liberalization, there has not been a sustained real depreciation, trade policy is still not export friendly, and selected import competing activities have experienced a sharp increase in import competition. The real exchange rate was above the level of the 1985/86 forex auction throughout the 1991-95 reform period and sometimes well above (see Figure 2.4). One would normally expect trade liberalization to be accompanied by a steady and sustained real depreciation of the exchange rate. However, a sluggish economy combined with efforts to tighten monetary policy have offset the effects of trade liberalization in this regard. The Government's - 47 - commitment to meet monetary targets and hold down inflation appear to have resulted in net sales of foreign exchange being higher than balance of trade considerations alone would warrant and led to periodic bursts of currency appreciation. 4.10 With the erosion of import protection, one might expect to see a surge in non- mineral exports. However, non-traditional export growth was constrained by both the continued anti-export bias inherent in current tariff policy (prior to the 1996 reforms, tariffs were in the range of 0 to 45 percent) and the lack of sustained real depreciation of the exchange rate over the past decade. Furthermore exportingactivities still face negative effective protection because duty drawback provisions are not providing effective and timely relief from duties, and hence exporters cannot get access to materials and intermediate goods at world prices. There has been some impressive growth in non- traditional exports, but this has been confined to a few activities that are very closely linked to Zambia's resource base, and the overall amount is still very small (see Figure 4.1). Even so, this growth has raised the share of non-traditional exports from less than 10 percent of total exports in the late 1980s to 15 percent in the mid-1990s. Figure 4.1 Growth of Selected Non-Traditional Exports 100.0 - - - 90.0 -_ _ 80.0 - - /|
Groupe de la Banque mondiale · Pre-2003 Economic or Sector Report
Zambia - Prospects for sustainable growth : 1995-2005
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