Tunisia - Economic Competitiveness Adjustment Loan

Report No. PIC3645 Project Name Tunisia-Economic Competitiveness Adjustment Loan (ECAL) Region Middle East and North Africa Sector Economic Management Project ID TNPA42287 Borrower Republic of Tunisia Principal Responsible Agency Ministry of International Cooperation and Foreign Investment Contact Mr. K. Ben Rejeb, Director General Ministry of International Cooperation Tel: 011.216.1.798.522 Fax: 011.216.1.799.069 Date this PID prepared April 1996 Projected Board Date June 1996 Country Background 1. Since 1986, when a decline in oil export earnings and excessive levels of public sector investments brought the country close to a balance of payments crisis, the Government of Tunisia has consistently and successfully pursued a program of macroeconomic stabilization and adjustment. The Bank supported this program through six adjustment loans, the most recent of which, the Economic and Financial Reform Support Loan (EFRSL), helped the country to overcome the aftermath of the Gulf war in 1991. In 1986, the IMF provided support with a Stand-by Arrangement followed, in 1988, by an Extended Arrangement. All the Bank and IMF programs were successfully concluded and are closed. The reforms have aimed at liberalizing the economy, which had been highly controlled, removing major distortions arising from taxes and subsidies, improving the allocation of resources and reducing the role of the public sector. The objectives of the reforms were substantially achieved, and their gradual implementation minimized social disruptions and conflicts. Moreover, the Government consistently pursued prudent macroeconomic management policies, leading to sound macroeconomic balances. Recent developments 2. Real GDP increased only by 3.5% in 1995, because of a 10% contraction in the agricultural sector due to the continuation of the drought, and a reduction in fixed investments. Inflation remained under control in spite of increases in the price of agricultural products. A shortfall in revenues, due to a prolonged stagnation in economic activity, resulted in a budget deficit higher than expected, 2.9% of GDP. Private sector investments continued a two-year decline. Investment decisions may have been delayed by the uncertainty surrounding the beginning of the Free Trade Agreement (FTA) with the EU. The introduction in the 1996 Finance law of measures to accelerate the  implementation of the FTA through the elimination of import duties on equipment goods, is expected to have positive effects on investment in the near future. 3. While sound, the external balances remain vulnerable. After a remarkable improvement in 1994 (see 1/), the current account deficit rose to 4.0- of GDP in 1995 because of a slowdown in the exports of olive oil and a drought-induced increase in cereals imports. However, the growth of manufactured exports remained strong, 7.6w in volume terms. External reserves reached 2.6 months of imports in 1995. The stock of external debt stood at 54.3w of GDP in 1995, down from an average of 63.7T during the period 1987-93. The debt service ratio also decreased steadily in the past five years, thanks to rapid export growth. The Government was also successful in penetrating recently the international capital market. The Free Trade Agreement 4. Tunisia was the first country in the North-Africa and Middle East Region to sign an FTA with the EU. The objective of the FTA, which complements the recent agreement under the GATT, is to fully integrate the economies of Tunisia and the EU through free movements of goods, and legislative, social and financial cooperation. Under the FTA, tariffs on imports (excluding agricultural goods) will be progressively eliminated over a 12 year period, starting with those on capital and intermediate goods and only subsequently (four years after the entry into force of the FTA) on most consumer goods. Although the transition to free trade is stretched out, the FTA is a major policy initiative for Tunisia. Its credibility is enhanced by the binding nature of the commitment, and by the implicit linkage between the financial assistance that the EU will provide in the coming years and the implementation of the reforms. 5. The benefits of the FTA and GATT agreements are potentially very large: import competition will induce enterprises to increase their efficiency and allocate resources where Tunisia has a comparative advantage; an improved regulatory environment, harmonized with the European one, will attract foreign investors; and the security of market access for Tunisian exports will be reinforced. There remains an issue of losses as a result of trade diversion, which is not, however, very important as trade with Europe accounts for about 75t of Tunisia's foreign trade. While envisaging unilateral liberalization against the rest of the world in the longer run, the Government believes that the benefits provided by the FTA are greater than those that would come from total liberalization: the FTA offers a credible anchor to economic reforms; it includes the harmonization of regulatory regimes pertaining to product standards, testing and certification procedures, legal framework etc.; it allows agreements on anti-dumping actions; and it involves significant financial and technical assistance. - 2 -  The Proposed Loan Objectives and Description 6. In the coming years Tunisia will need to: a) improve the international competitiveness of the economy; b) modernize services provision; and c) preserve the environment and improve the management of natural resources. The Government recognizes that these are the key conditions to increase economic growth and achieve full integration in the world economy. 7. The proposed Economic Competitiveness Adjustment Loan (ECAL) would support a reform program aimed at achieving a sustainable increase in the rate of economic growth while improving the international competitiveness of the economy. The ECAL is the first among a series of operations to upgrade the private sector and to prepare it for the establishment of free trade under the implementation of the FTA. It has been prepared in cooperation with the EU and in collaboration with the IMF. The specific policy measures concern the following areas: a) a sound macroeconomic and fiscal framework, including measures to replace revenues lost from the expected reduction in tariffs and tariff surcharges; b) the acceleration in the implementation of the FTA; c) the acceleration of the privatization program in competitive sectors; d) the improvement of the regulatory and administrative environment in which enterprises work, including actions to reduce transport costs, to facilitate the passage of goods through ports and customs and to improve the legislative framework; and e) a greater flexibility in the labor market while protecting dismissed workers and containing labor costs. Project Cost and Financing 8. The proposed Bank loan is tentatively placed at US$75 million, with cofinancing from the European Union. Project Implementation 9. The borrower will be the Government of Tunisia. The loan will be made on a two tranche basis. The first tranche of US$40 million will be eligible for disbursement upon effectiveness. The second tranche of US$35 million will be conditional upon satisfactory macroeconomic performance and a limited number of specific measures. The projected date for second tranche release would be 12 months after loan effectiveness. Program Objective Category 10. The overall impact on poverty of the reform program supported by the ECAL is expected to be positive as improvements in macroeconomic balances and in the performance of the private sector would create new jobs and expand employment. Losses of jobs may however occur in the short term. The Government is preparing, with Bank support, an Employment and Training Project to facilitate the placement of unemployed people and to increase the productivity of existing workers. The ECAL would also support the creation of a fund providing severance packages to the workers of insolvent firms. The fiscal adjustments that -3 -  will occur under the loan will not affect social expenditure. The European Union is also helping the authorities to improve the design and management of the existing social safety net. Benefits and Risks 11. The principal benefits that would derive from the implementation of the reform program supported by the Loan would be: a) to increase the efficiency of resource allocation in the economy and the productivity of the private sector; b) to facilitate the integration of Tunisia with world markets; and c) to strengthen Tunisia's balance of payments and to consolidate its access to private capital markets. Two main risks are associated with the proposed loan. First, there could be delays in the ratification of the FTA by some European countries which, in turn, could entail a postponement of the trade liberalization program. Although the probability associated with this risk is certainly positive, the Government's early implementation of the FTA, starting in January 1996, makes this risk manageable. Moreover, the last ten years show that the Government's commitment to the reforms has remained firm even during prolonged droughts and political crisis in the region. The second risk relates to the difficult implementation of labor market reforms, in particular the legislation related to the status of dock workers, that are essential to allow a fast restructuring of private enterprises and an increase in productivity. Although a careful handling of these reforms will be necessary, the risk of not succeeding is low because of i) the ability of the Government to build consensus among the parties interested in the reforms, and ii) the existing social safety net and the additional measures that will be put in place to protect the welfare of dismissed workers. Environmental Assessment 12. The project is consistent with the Bank's environmental policies and will follow accepted Bank procedures concerning the environment. It is expected that this project will be classified under category C (no significant environmental impact). 1/ This was due to a slow import growth, a sharp increase in the exports of olive oil and a good tourism season. Contact Point: Public Information Center The World Bank 1818 H Street N.W. Washington D.C. 20433 Telephone No.: (202)458-5454 Fax No.: (202)522-1500 Note: This is information on an evolving project. Certain components may not necessarily be included in the final project. - 4 -