Madagascar - Second Structural Adjustment Credit (SAC-2) Project

Report No. PID7361 PID7361.TXT Project Name Madagascar-Second Structural Adjustment (@) Credit (SAC-2) Region Africa Region Sector Adjustment Operation Project ID MGPE57378 Borrower Republic of Madagascar Implementing Agency Prime Minister's Office Date this PID Prepared April 15, 1999 Projected Board Date May 20, 1999 1. Background. Madagascar has seen a marked decline in living standards during the last 30 years. Once a flourishing society, the country now ranks with the world's poorest. Education, nutrition and life expectancy indicators have deteriorated; lack of physical access to social services, financial services and agricultural markets has crippled development; and slash-and-burn agriculture has led to severe deforestation. At the same time, population growth has remained high, near 3 percent. The result: poverty has become entrenched in the social fabric. Three-fourths of all Malagasy are poor, and GDP per capita in 1998 prices, at $266, is three-fifths its level of the late 1960s. Poor performance can be linked to decades of policies of economic nationalism and self-sufficiency, and State intervention in key productive sectors. Yet, the country's economic potential is formidable. It enjoys rich mineral deposits; fertile land with abundant rain; an environment attractive to different types of tourists with a unique eco-system, varied topography, and several climatic zones; and a coastal perimeter of about 3,000 miles which provides access to rich maritime resources. 2. Madagascar has adopted an increasingly more pragmatic economic policy stance beginning in the late 1980s, but progress has been slow and marked with policy reversals. This reflects Madagascar's politics which are complex and marked by latent ethnic and regional divisions. Nevertheless, the macro framework is now substantially improved: inflation in single-digits and progress in fiscal management. On the macro stabilization front, inflation has declined, to 6.2w in late 1998 from a peak of 49t in 1995, reflecting decisive policy measures which halted erratic monetary expansion. Fiscal management has improved, with the fiscal deficit at 7.5w of GDP in 1998 compared to 11.4 percent in 1994. Revenues, again excluding grants, have increased from a historical low of 8.3 percent of GDP in 1994 to 10.6w in 1998. In the structural arena progress has also been marked. Non-traditional exports have increased their share in exports from 31t in 1986 to 86t in 1998, partly as a result of the adoption of a floating exchange rate. Market distortions that affected agricultural commodities have been removed: for example, export taxes and trading parastatals. The tax structure is more efficient, with an increased reliance on a VAT. Good sectoral policies have been triggers of growth (e.g., a doubling of the tourism sector in the last 3 years). 3. Project Scope and Objectives. The proposed SAC-2 supports the next phase  of Madagascar's reform program, following SAC-1 approved in 3/97 and fully disbursed in 4/97. The program rests on four pillars for high growth. First, macroeconomic stabilization is being consolidated, as fiscal imbalances, though lower, are still too large. Second, privatization of public enterprises is at the core of the reform program, thus signaling the State's willingness to disengage from key sectors and make room for private sector activity. Chief among them are the privatization of state institutions and companies in the banking, petroleum refining and distribution, air transport and telecommunications sectors, together with the introduction of competitive regulatory frameworks to ensure efficient operation of these sectors. The privatization process is supported by a fair and equitable program of severance payments. Third, an improved business environment is being put in place to boost private sector investment and job creation, emphasizing less discretion in administrative procedures and elimination of bottlenecks to private sector growth. Reforms are targeting promising sectors such as mining, tourism and fishing. Transparency in licensing for the exploitation of natural resources is in particular a priority. Finally, the program emphasizes strengthening of public finances. To increase revenues and eliminate opportunities for abuse, the tax base is being expanded and ad-hoc tax and tariff exemptions are being eliminated, while ensuring that revenues allocated to social sectors are in fact effectively used for the benefit of the poor, especially in primary education and basic health. Attention is also given to increasing non-tax revenues through reforms in the allocation of fishing licenses. 4. The credit would be disbursed in three tranches: US$25 million at effectiveness and in two "menu-based" tranches of US$30 million and US$43.8 million, and includes the re-financing of two PPFs totaling US$ 1.2 million. The measures to be supported are "menu-based", allowing access to resources based on the readiness and internalization of the reform measures supported by the operation. Key aspects of the operation will be defined jointly by the Government and the private sector, thus helping to build internal support. 5. Environmental Aspects. In accordance with the Association's Operational Directive on Environmental Assessment (O.D. 4.01, Annex E), the proposed operation has been placed in Category C and does not require an environmental assessment. These have been carried out in several related sectoral reforms, however, mostly in the context of other operations. 6. Benefits. The proposed two-year credit aims to create the necessary conditions for increased growth, which will drive poverty reduction. The government will: visibly and fully disengage from key sectors; unblock private sector activity; and do fewer things better. The key expected outcomes are higher private investment, FDI in particular, and job creation. The direct impact of policy reforms on stabilization, structural change and improved public service delivery will be felt in many areas, including lower airfares, more efficient and improved access to telecom services, higher customs collections, and increased budget allocations (and actual spending) for basic education and health. 7. The reforms envisaged are at the heart of the Country Assistance Strategy, discussed by the Board in February 1997. SAC-2's focus on privatization of key, visible sectors and actions to improve governance and transparency is expected not only to help transform the economy but also to maximize the impact of change signals on investor confidence. Further, the - 2 -  government is now embarked on possibly the most challenging phase of the adjustment agenda, in terms of political courage; selective targeting of high- payoff reforms is expected to bring rewards in setting important precedents and easing the path of future adjustment. Payoff is seen to be high both in terms of the choice of sectors to be privatized, and the reforms' strong links to governance (measures remove discretion, promote transparency and automaticity in decisions affecting the private sector, reducing opportunities for corruption). 8. Risks. The nature of risk - wavering government commitment causing interruption or reversal of reforms - is the same as in the CAS; but prospects for SAC-2 implementation seem brighter. The reform program aims at the core of the vestiges of the old system of governance, and could encounter formidable opposition from vested interests. Madagascar is still perceived as an unwilling reform partner, introducing change often only because of pressures from abroad. Now, however, political stability is more favorable than at any time since the transition to democracy in the early nineties. No national- level elections - which slowed follow-through of earlier reforms - are foreseen over the next three years. In addition, difficult political decisions have been already taken and announced, while the required technical capacity to implement them is in place. There is also a growing realization within civil society that better governance and an open economy are key to development, with the press and young entrepreneurs being at the forefront of change. Such awareness, moreover, is being reinforced: the ultimately well- received privatization of banks - longstanding bastions of corruption, privilege and financial favors - and early evidence that even modest growth can open up opportunities for many more Malagasy (e.g., EPZ and tourism jobs). 9. Apart from improved prospects for sustained reform, several design features of the proposed operation should help reduce risks: (i) a flexible design, with "menu-based" policy reform measures in the second and third tranches (to accommodate political timing considerations), and government leeway in defining certain reforms (to promote ownership, while also ensuring participation from other stakeholders); (ii) substantial up-front actions demonstrating commitment to reform and safeguards against backtracking, including a tranche structure aimed at providing increased financial support only as the policy environment improves; (iii) a program of severance payments and retraining and mechanisms to facilitate local ownership opportunities, to make privatization socially sustainable; (iv) a focus on few, high-payoff reform areas to maximize the impact of change and increased openness; and (v) existence of adequate technical assistance support. Contact Point: The InfoShop The World Bank 1818 H. Street NW Washington, DC 20433 Telephone: (202) 458-5454 Fax: (202) 522-1500 Team Leader Mr. Juan Zalduendo Telephone: (202) 473-9431 Fax: (202) 473-8466 - 3 -  Note: This is information on an evolving project. Certain activities and/or components may not be included in the final project. Processed by the InfoShop week ending May 7, 1999. - 4 -