Libya - Country economic report

Report No. 30295-LY Socialist People's Libyan Arab Jamahiriya Country Economic Report July 2006 Social and Economic Development Group Middle East and North Africa Region Document of the World Bank   ACKNOWLEDGEMENTS This report was preparedby a core team composed of: Aristomene Varoudakis (Task Team Leader), Samir El Daher, Najy Benhassine, David Robalino,Xavier Forneris, Pierre Messali, GerardMclinden, Gabriella Ferencz, Paul Brenton, Shane Streifel, Mariem Malouche, Saliha Mougas, Nisreen Farhan and Ramdan Abdoun (International Monetary Fund), Hjalte Sederlof (consultant), and David Sewell (consultant). Significant contributions were provided by Abdelouahab Keramane (consultant), Mohamed Cherif Belmihoub(consultant), andPatrickTardy (consultant). Researchassistancewas providedby FarukBaykal. Peer reviewers were Uri Dadush and Shahrokh Fardoust. Guidance was providedby Mustapha Nabli (Sector Directorand Chief Economist). Valuablecomments were providedby ZoubidaAllaoua, Marcos Ghattas, Linda English,and Mohamad Elhage (IMF). Valuablesupport from the counterpartteam organizedby the Ministry o f Finance in Libya is gratefully acknowledged.The reportwas producedfurther to apreparatory missionthat visitedTripoli from June 26 to July 8 2004 and produceda first draft inOctober 2004; a missionto discuss the preliminary draft, from November 26 to December 1 2005; and a follow-up mission, on March 27-30 2006. The team benefitedfrom discussionswith the following ministries,banks, and agencies (some of which provided written comments to the first draft ofthe report):Secretaryofthe GeneralPeople's Committee, General PlanningCouncil, General People's Committee for Economy and Trade, General People's Committee for Planning, General People's Committee for Finance, General People's Committee for Health, General People's Committee for Education, Central Bank of Libya, Commercial Banks, Customs administration, Libya Foreign Investment Board, Tripoli Chamber of Commerce, Board for the Transfer of Ownership, National Authority for Information and Documentation (NIDA), National Supply Company (NASCO), National Oil Company, General Electricity Company of Libya, Sha'beyat of Tripoli, Sha'beyat of Zaouia, Social Security Fund, Economic TransformationFund, State Owned Enterprises. CountryDirector: Theodore 0.Ahlers Sector Director: MustaphaNabli Sector Manager: MiriaPigato   SOCIALIST PEOPLE'SLIBYAN ARABJAMAHIRIYA COUNTRYECONOMIC REPORT Table of Contents EXECUTIVE SUMMARY ........................................................................................................................................ i I. TRENDSINSOCIALANDECONOMICDEVELOPMENT........................................ ........................................ 1 A. The Structure ofthe Economy................................................................................. B. The Economic and Political Regimeand Economic Development .. ......... C. Social Development.............................................................................................. D. Recent Economic Developments.............................................................................. E. The Qualityof EconomicInformation.................................................................. 11. LIBYA'S KEYDEVELOPMENTCHALLENGE: MAKINGOIL WORK FORGROWTH AND JOBS ...................13 A. Libya Holds StrongLong-TermPotentialFor RaisingHydrocarbonRevenu .............13 B. Making Optimal Use of the HydrocarbonFinancialResources,To Promote Cope With Volatility, and Secure Fiscal Sustainability ...................... 17 (i) Patterns of growth and volatility in the non-oil sector .................................................................. 18 (ii) Macroeconomic policies and the management of volatility ........................................................... I9 (iii) Strategic optionsfor the use of hydrocarbon financial resources.................................................. 21 C. EnablingThe "New Economy", LedBy The PrivateSector, To GainStrength-A Precondition For FasterNonOil Growthand Job Creation 27 D. The ChallengeofImproving The Quality of Governanceand Education 33 111. THECHALLENGEOFSTRENGTHENING PUBLICFINANCEMANAGEMENT..................... ..................... 41 A. Libya's Public ExpenditureSystemInThe InternationalContext............ ........................... 41 B. StrengtheningManagementof Oil Revenues C. CriteriaFor Long-TermFiscal Sustainabilit D. The Challenge o f StrengtheningBudg (i) Budget preparation andformulatio (ii) Budget execution (iii) Deconcentration d accounting.................................. .................................... ............................................ ....................................... expenditure discipline over ............................................................ 55 E. Improving Efficiency InThe Delivery of Public Services................................................................ ..56 Iv. BUILDING A STRONGINVESTMENTCLIMATE INOPENMARKETS REFORMINGSTATE-OWNED ENTERPRISES .......................................................................................................................................... AND 60 A. Main Pillarsofthe Transitionto aMarket-OrientedEconomy B. Recent ReformInitiatives and the Growing Size ofthe Private ..................... C. Improving BusinessRegulations and ReducingPolicy Uncertainty........................ D. StrengtheningMarketInstitutionsand Enforcingthe Ruleof Law .................................................... 67 E. Attracting ForeignDirect Investment(FDI) ................... (i) Admission of Investment into Libya under Law No. 5 (ii) Guarantees to investors ...... .......................................... (iii) Investment Incentives ..................................................................................................................... 73 F. The Public Sector and the Current PrivatizationStrategy................................................................... 74 G. Trade Policy Reformand CustomsAdministration............................................................................ 78 (i) Tradepolicy ................................................................................................................................... 78 (ii) Accession to the World Trade Organization.................................................................................. (iii) Customs administration ................................................................................................................ .83 80 V. PRIORITIESINFINANCIALSECTOR REFORM ........................................................................................ 86 A. Background......................................................................................................................................... 86 B. Strengtheningand Restructuringofthe BankingSystem: Governance, Portfolio and Ownership.....87 (i) Status of domestic banking............................................................................................................. 87  (ii) Legalframework .......................... sector reforms ................................................................................................................................ 89 (viii) Financial sector distortions and the structure of interest rates ..................................................... 90 (ix) Non-bank financial institutions...................................................................................................... 91 C. StrengtheningBanking Supervision..... (i) Moving Towards Supervision by (ii) Loan Classification & Provisioning: ........ (iii) Capacity Issuesfor the Banking ......................... 93 . ENHANCINGTHEEFFECTIVENESSOFSOCIAL PROTECTION .................................................................. 95 A. B. Social ProtectionInThe Transition.................................................................................................... 95 C. Social Insurance:Pensionsand Short-TermBenefits......................................................................... 97 LaborMarketRegulationsand Programs........................................................................................... 99 D. Social Assistance.............................................................................................................................. 100 ANNEXES Annex 1. Long-termhydrocarbonproductionandrevenueprojectionsfor Libya.................................... 105 Annex 2. A rule for long-termfiscal sustainabilitywith an exhaustiblehydrocarbonrevenuestream.....113 Annex 3. The mechanismsof socialprotectionschemes .......................................................................... 115 Annex 4. Productionand Consumptiontaxes, 2003 and 2005.................................................................. 117 References ...................................................................................................................................................... 120 FIGURES Figure I. 1: The share of oil in the Libyan economy ................................................................................ :....1 Figure I. 2: Libya Crude Oil Production........................................................................................................ 2 Figure I. 3: GDP components, Realterms..................................................................................................... 2 Figure I.4: GDP per capita PPP.................................................................................................................... 6 FigureI1. 2: Permanent HydrocarbonRevenue............................................................................................ 16 FigureI1. 1: Hydrocarbonreservesand cumulativeproduction.................................................................. 13 Figure I1. 3: Growthrequirements innon-oil sectors to reduceunemploymentrates ................................ 17 Figure I1. 4: RealNonhydrocarbonCarbonGDP growth (1991-2002)....................................................... 18 Figure I1. 5: Macro EconomicVolatility has beenhigh (1991-2002) ......................................................... 18 FigureI1. 8: Trends inlabor productivity growth FigureI1. 10: Employmentby economic activity FigureI1. 11: Domestic Credits, % of GDP Figure I1. 12: Libya governance indicatorsi FigureIV. 1: Enterpriseregistration, 1992- 2005....................................................................................... Figure 111.2: ORF assets and oil exports revenues 1996- 2003 62 Figure IV.2: Foreigndirect investment projects:2000-2004 ..................................................................... 63 FigureVI. 1: Income ReplacementRatesand ImplicitRatesof Returninthe SSF.................................... 98 FigureVI.2: Direct Consumer Subsidy inthe Electricity Sector ............................................................. 101 TABLES Table I. 1: Libya: Summary macroeconomicperformance 1991-2005........................................................ 10 Table I1. 1: EstimatedUndiscoveredHydrocarbonResourcesinLibya ...................................................... 14 Table I1.2: Projections of OPEC Productionand Capacity ......................................................................... 15 Table I1.3: Net PresentValue (NPV) of Government HydrocarbonIncometo 2060. (2003 US$ billion).16  TableI1. 4: Growthand volatility by sector of economic activity TableI1. 5: Non-Oil Investment, productivity. andNon-Oil GDP growth. TableI11.2: Budgetary Expenditure. InternationalComparison. % GDP. Average 2000-2004..................42 TableI11. 1: Budgetary and ExtrabudgetaryExpenditure.% GDP 1999- 2005 .................. TableI11. 3: Implicit subsidies for oil products and derivativesand associated deadweight loss estimated at average internationalprices in 2003..................................................................................... 43 . . BOXES Box I. 1: The structureand ideological Box I. 2: The Great Man Made River p Box I. 3: Libya-developments inCPI Box I1. 1: Calculatingthe presentva Box I1. 2: The adverse impact ofvol ..................... Box I1. 3: The Alaska permanent oil Box I1.4: Speedofreform and economic growth........................................................................................ 26 Box I1. 5: Estimations ofTotal FactorProductivity(TFP) inthe Libyannon-oil sector.............................. 29 Box I1. 6: Governanceand growth-empirical evidence............................................................................. 35 Box I1. 7: Political economy andpace of reformscan make or break the transition.................................... Box I11. 1: Calculatingthe cost of implicit energy subsidies inLibya ......................................................... 37 44 Box I11. 2: The first-roundinflationary impactof aremovalofpetroleumsubsidies................................... 45 Box I11. 3: The process ofbudgetpreparation.............................................................................................. 51 Box IV. 1: Structural reform initiativesto promoteprivate sector development ......................................... 61 Box I V. 2: Policy uncertaintyi s a top concern for investors in developingcountries.................................. 64 Box I V. 3: The CorporateIncomeTax inLibya .......................................................................................... 66 Box I V. 5: Methods ofprivatization:lessons learnedfrom the East Europeancountries............................ Box I V.4: Benefitsof liberalizing services ................................................................................................. 70 77 Box V. 1:The Libyan Development Bank................................................................................................... 89 Box VI. 1: Privatizationand Labor .............................................................................................................. 96   EXECUTIVE SUMMARY 1. The Libyan economy is dominated by hydrocarbons and the public sector. With the hydrocarbon sector representing about 72 percent o f GDP (in nominal terms), 93 percent o f government revenues, and 95 percent o f export earnings, Libya appears to be one o f the less diversified oil-producing economies in the world. Libya witnessed a growing government intervention in the economy after a socialist State was instituted in the early 1970s. But falling world oil prices in the early 1980s and the impact o f economic sanctions caused a serious decline ineconomic activity, eventually leading to a slow rehabilitation o f the private sector. Reflecting the heritage o f the command economy, three quarters o f employment i s still in the public sector, and private investmentremains dormant at around 2 percent o f GDP. ii. The sizeable oil wealth has supported decent living standardsfor Libya's population and socioeconomic development compares favorably with MENA standards. One o f the poorest countries in the world in the 1950s, Libya now ranks ahead o f several other oil-producing countries in terms o f per capita GDP, measured in purchasing power parity. Universal enrollment in primary education has been achieved and the illiteracy rate i s well below the regional average, even though quality i s an issue. Indicators o f health care provisionhave improved, while Libya has achieved some o f the lowest infant mortality rates among middle-income countries. Laws and regulations do not discriminate against women. But while female literacy i s above the MENA average, female participation inthe labor force is low because o f lack o f economic opportunities. ... 111. Economic performance has been shaped by changes in oil revenues- At 2.6 per cent peryear on average, real GDP growthwas modest andvolatile duringthe 1990s, reflecting the inefficiencies o f the state-driven economy, stagnant oil production and revenues, and the impact o f economic sanctions. Since 2000, real GDP growth has been boosted by high oil revenues, reaching 4.6 percent in 2004 and an estimated 3.5 percent in2005. -and the external balance has beenpreserved. Inflationhas been tame, as prices were controlled and wages frozen since 1981, while cost-driven deflation has surfaced since 2000, mainly due to the unification o f the exchange rate. Libya's external current account remained generally in surplus, also reflecting the restraining impact o f sanctions on imports, and gross official reserves have surpassed U S $39 billion in2005, equivalent to 31months o f imports. II.MakingOil Workfor GrowthandJobs iv. Libya has the potential to raise oil production and revenues significantly in coming years given its large reserve base- Cumulative oil production to date is equivalent to 60 percent o f present estimates o f recoverable reserves, but gas production i s less advanced than oil, with cumulative production only 12 percent o f reserves. Mean estimates o f yet undiscovered, recoverable reserves are significant, about 20 percent o f currently proven reserves. With current investment plans to raise capacity, Libya's production could increase substantially considering current OPEC quota shares. Over the long run, alternative scenarios project the net present value o f the government's hydrocarbon revenues at between 7.3 to 19.8 times the level o f 2005 GDP. Oil wealth  - 11- could generate a sizeable permanent income stream for Libya, ranging from 29 percent o f 2004 GDP in a conservative reserve/price scenario, to above 50 percent o f 2005 GDP inmorefavorable scenarios. -but the main challenge for Libya is to promote growth of the non-oil sector, and spur diversification of its economy. Growth o f about 6.5 percent in the non-oil sector would be needed to reduce the unemployment rate-currently estimated at around 25 percent-by half ina 10-year period. Projected highoil revenues will provide finance for growth but will not necessarily spur sustained growth in the non-oil sector. Libya's unsuccessful experiment with the state-driven model o f economic development, based on import substitution, has drawn attention to the limits o f using the oil revenues for financing investment o f public enterprises in selected industries. Such diversification will be achieved if far reaching reforms are put in place to facilitate private sector development inall sectors. v. Non hydrocarbon GDP growth has been weak and oil revenue volatility has been transmitted to non-hydrocarbon GDPgrowth. Since 2000, non hydrocarbon real growth has been boosted by high oil revenues, but has remained lower than in other comparators in MENA despite the lifting o f UN sanctions. Non hydrocarbon GDP growth, however, accelerated to 4-4.5 percent in 2004 and 2005. The volatility o f non hydrocarbon GDP growth has been relatively high, owing to swings o f domestic investment, dominated by the public sector, that have been closely associated with changes in oil revenues. Although an oil reserve fund was established in 1995, with implicit saving and stabilization objectives, the non-oil deficit has tended to increase when oil revenues are on the rise, and at times to decrease when oil revenues decline, impartingprocyclicalityto the fiscal stance. vi. Weak non-oil GDPgrowth reflects both insufficient private investment and low productivity of capital- At about 16.7 percent o f non oil GDP on average during 1998- 2003, investment inthe non oil sector remains low compared to neighboring countries in North Africa. Moreover, growth is hampered by poor productivity o f investment. The productivity o f labor in the non-oil sector points to a similar weak performance, with average annual growth hovering at around -2 percent. Negative productivity growth has persisted in manufacturing since the mid-l990s, and has been observed also in services (the main driver o f non-oil GDP growth) and agriculture. Weak productivity performance reflects the inefficiencies o f the state-driven model o f economic growth, but also the impact o f sanctions and o f the isolation from the international economy. vii. Improving efficiency and productivity growth is a precondition for faster growth and a greater investmenteffort. Over the medium term, sustaining faster growth would require a significant increase in the investment ratio, to around 25 percent o f GDP. But this would also call for a substantial improvement in productivity. With stagnant productivity, combined with distortions (administered prices, entry barriers) and dysfunctional product and factor markets, profitability remains low and there is little scope for the much needed greater private investment. viii. Strongproductivity growth is also aprerequisite for competitive diversification out of hydrocarbons. With open and well-functioning markets in place, private investment would take advantage o f unrealized potential for growth and diversification. Services i s a good example o f a sector where Libya presents unrealized potential in  -111- comparison to other oil-producing economies. Growth o f services would hold benefits for job creation and could offset part o f the adjustment costs o f the transition to the market. The potential for direct job creation i s important, because in Libya services provide jobs to a relatively smaller fraction o f the total employed population compared to countries with a similar level o fper capita GDP. ix. Projected high oil revenues will provide finance for growth but will not necessarily spur sustained growth in the non-oil sector. Bamng the state-driven model o f development o f the past, there seem to exist three broad strategic options for usingthe large financial resources from oil as a means to foster non-oil growth: 0 Using accumulated oil revenuesto expand public investment ininfrastructure as a means to directly propel non-oil sector growth; 0 Distributing part o f the oil windfalls to households, as a means o f bolstering incomes and phasing out other distorting subsidies, while possibly ensuring better stability inthe face o f oil revenue volatility. 0 Saving part o f the oil windfalls for the future; using the rest strategically to improve human capital and build strong social safety nets, while, at the same time, accelerating the pace o f structural reforms needed for a transition to a market-led economy integratedwith the rest o f the world. x. The decisions concerning public investment in (social and economic) infrastructure would better be de-linked from the presence of hydrocarbon windfalls. Using hydrocarbon windfalls to expand public investment would not insulate fiscal policy from the volatility o f oil revenues. Moreover, in Libya, the development budget already represents a fraction o f GDP significantly larger than in comparator countries, suggesting limited absorptive capacity for further increases and possibly low efficiency o f spending. Efficiency considerations would call for public investmentto be driven by the productivity and cost o fpublic capital. xi. Tofoster non-oil growth andjob creation in Libya, the oil windfalls should be used strategically, with the aim of facilitating the transition to a competitive, market- led economy. Contrary to other transition economies inthe early 1990s, Libya has built a comfortable financial position and can afford the cost o f safety nets needed to cushion the adjustment cost o f the transition. Making optimal use o f the hydrocarbon revenues would call for strengthening public finance management over the medium term, by adopting a transparent framework for budget formulation and execution, combined with expenditure discipline, and sound practices for management o f oil windfalls. This would help anchor the transition in macroeconomic stability, while securing the sustainability o f the required social safety nets and increased spending on human resources. In due time, a combination o f strategic options could be envisaged, with an increasing part o f surplus oil revenues progressively transferred to households. xii. Over the long term, the intermediation of hydrocarbon windfalls through the household and business sectors mightproduce superior long run growth performance, but should go in tandem with considerable strengthening of the investment climate. When oil windfalls are intermediated by households they can be potentially funneled to more productive-or welfare-enhancing-spending than when spent by the public sector. This is so especially when cash transfers to households replace distorting subsidies to energy or other consumption goods. Transferring oil windfalls to households  - iv - may also better insulate the economy from the volatility o f oil revenues, as temporary changes in oil revenues could spur savings rather than unsustainable public expenditure. A different model of intermediation of the hydrocarbon revenues may help unlock the economy's long-term productive potential, provided cash transfers are designed appropriately so as not to distort work incentives and reforms to strengthen the investment climate and promote the efficient use o f resources are implemented at the same time. xiii. Libya faces the challenge of enabling the "new economy", led by the private sector, to gain strength, a precondition for faster non oil growth and job creation. Main challenges include building a sound investment climate, with strong institutions to support open markets; reinforcing the banking system, to play fully its role in the financing o f the investment; and ensuring an effective and sustainable social protection for the most vulnerable, to facilitate a smooth transition. xiv. Enhancing the quality of Libya's human resources will be essential to impro.ve productivity, diversijj out of oil-especially in services-and compete in the global economy. The ability o f the education system to equip individuals with skills that allow them to take advantage o f the increased opportunities that a dynamic and changing economy offers i s also crucial for a successful transition to the market. Libya's public expenditure in education i s high but there are questions regarding quality and the efficient use o fresources. xv. Improving the quality of governance would also deserve particular attention because it underlies the development reform agenda. Progress on the three priority fronts will call for mutually reinforcing initiatives to promote transparency and predictability o f regulations, institutions to support the competitive functioning o f key markets, and reforms to improve public sector management and accountability. At the present time, various measures o f the quality o f governance rank Libya very poorly compared to other countries. IH. StrengtheningPublicFinanceManagement xvi. Public expenditure has been restrained in 2004-2005 despite booming oil revenues, but public finance management suffers from lack of transparency. Consolidated public expenditure (including net lending) was 43 percent o f GDP on average over 2001-2005, a level significantly higher than in comparator countries. Libya spends relatively more on wages and salaries than other economies in transition, while the development budget (public investment) is also large. The non-hydrocarbon deficit remains sizeable, at above 33 percent o f GDP, but despite booming oil revenues it has not increased in2004 and 2005. As a result o f relative fiscal restraint in 2004-2005, and with the price o f oil projected to remain at a highlevel, the downside risks to the budget seem small. A large share o f public expenditure-52 percent in 2003-was previously not integrated in the budget, undermining fiscal discipline and the effectiveness o f controls in budget execution. It i s noticeable, however, that most extra-budgetary expenditures have been included in the 2005 and 2006 budgets, in particular those related to defense and subsidies, with the share o f extra-budgetary spending dropping to 12 percent in 2005. Better transparency o f the budget would greatly facilitate fiscal policy formulation and help improve the efficiency o fpublic expenditure.  - v - xvii. Management of oil revenues should be underpinned by stabilization and savings objectives. Inline with this objective, the authorities are currently inthe process o f creating a Stabilization Fund. For it to play its role, it i s essential that such a Fundis designed with clear accumulation and withdrawal rules, a comprehensive legal status, managed transparently and integrated into the budget. Also, in order for the Fund to be successful in stabilizing the non-oil economy by insulating it from fluctuations inthe oil- economy, it i s essential that the Fund's investment strategy rules prohibit it from making investments inthe domestic market. The stabilization and savings objectives o f the Fund should inno case be mixedwith other economic objectives, which couldbe addressed by dedicated investment funds as part o f the budget process. xviii. To build appropriate safeguards for macroeconomic stability, the fiscal framework should be anchored on an indicator that is unaffected by the short-run changes in hydrocarbon revenues, such as the non-hydrocarbon primary fiscal de$cit, measured as a ratio to non-hydrocarbon GDP. An option to ensure long-term fiscal sustainability would be to target a non-hydrocarbon primary fiscal deficit that does not exceed a conservative estimate o f the "permanent hydrocarbon income stream" over an appropriately definedmedium-term time horizon. xix. The public financial management system has some strengths, but important challenges lie ahead. Budget preparation procedures are relatively simple and bottom- up driven, but nevertheless allow some substantive interaction with line-ministries. However, the budget i s fragmented, with no institutional mechanism in place for ensuring coordination between current and investment expenditures throughout budget preparation. The budget classification system should be improved to allow budget preparation on a programmatic basis. Reporting suffers from weaknesses, especially for capital expenditures and for decentralized spending. Budget information systems are rudimentary, with no integrated information system in place. Accounting i s cash-based and hamperedby frequent administrative changes while issuance o f financial statements i s irregular. The audit system i s mainly focused on the external Audit, which i s compliant with international standards. However, ex ante control and internal audit are ill-defined. xx. Appropriate mechanisms for expenditure management should be put in place to ensurefiscal discipline over the medium term. The rule that 70 percent o f budgeted oil revenues must be devoted to the development budget and 30 percent to other expenditures i s detrimental to public expenditure efficiency and budgetary planning. It could be replaced by spending ceilings for each region and ministry at the beginning o f the annual budget process. Conditional on the elimination of extrabudgetary spending practices, a medium-term rolling expenditure framework should be developed for a period o f 3-5 years to help prioritize programs that can be afforded over the medium term. At the same time, implicit and contingent liabilities such as those for pensions and non-performing loans o f public enterprises should be valued and recognized. xxi. Promoting efficiency in public expenditure would encompass a vast reform agenda. Increasing the transparency o f quasi-fiscal actions would facilitate better spending prioritizationand efficiency. Implicit subsidies are sizeable-in 2003, implicit subsidies to energy products are estimated at the equivalent o f 18.5 percent o f total government outlays, or about 7 percent o f GDP. Implicit subsidies to energy bear a significant efficiency cost, estimated at 3.7 percent of GDP in the case o f Libya. They  - vi - also have a questionable impact on income distribution. They could be converted into explicit subsidies and made transparent. Decentralization should be reassessed, but eventually the capacity o f local governments to collect their own revenues should be improved and incentives for fiscal discipline and efficient use o f resources should be established. Equalization transfers to less well-off local governments could be designed. Over time, the cost-effectiveness o f public spending could be increased by encouraging competition in theprovision of public services from the private sector, non-governmental organizations and even other levels o f government. I K Building a Strong Investment Climate xxii. The early stages of Libya's economic transition have witnesseda withdrawal of the Statefrom economic activity and gradual openingfor increasedprivate investment. Still, significant constraints to private sector development remain. Key priorities for reform include: 0 further simplifyingthe approval process for business entry incompetitive sectors, inparticularfor foreign investmentswhich are still subject to aprocessthat may lead to administrative discretion and uncertainty inthe selection o fprojects and sectors; 0 lifting any remaining restrictions on foreign participation inservices such as distribution, and finance, where there i s substantial scope for efficiency gains and employment creation; 0 reducing the ambiguity of laws governing land and property ownership and ability to rent; 0 reformingthe labor code to provide necessary flexibility to business operation while promoting appropriate working conditions and occupational safety standards; 0 replacing the progressive corporate tax rate with a low flat rate at a level comparable to that incountries with a favorable business environment; consolidating and harmonizing taxes levied on imports; and, 0 pursuingreforms incustoms administration with the aim oftackling informal trade and reducing excessive delays inclearance. xxiii. I t is however undeniable that much progress has been made over the past years. Recent progress includes simplifying business registration for local firms, towards a more declarative process; opening o f more sectors for foreign investment, including services, agriculture, telecommunications and real estate; reduction o f the minimumnumber o f shareholders in larger firms (Musahamat); introduction of almost all types o f legal commercial entities; reduction o f the corporate tax rate; trade liberalization and unification o f the exchange rate; a new competition law that has been submittedto the Cabinet; and unificationo fthe commercial and company laws. xxiv.. I n contrast with these improvements, the recent decision setting the minimum capital requirement for foreign investments at $50 million is, de facto, a ban on most foreign investments Libya could potentially attract in the non-oil sector. Despite progress on other fronts, this decision i s a serious setback to the reform agenda, which inevitably sends strong negative signals to foreign as well as local investors. Flows o f FDI in non-hydrocarbon sectors and intentions o f investment have already declined significantly in response to this decision. The Libyan authorities are currently  - vii - considering reverting to a more open regime, by reducing the minimum capital requirement for foreign investment. xxv. Morefundamentally, reinforcing key institutions to support the emergence of a market-oriented economy remains a challenge - in particular thejudiciary and public administrations dealing with firms. Promoting a system o f checks and balances and appeals in public administration would be an important underpinning for private sector development, to avoid abuse, arbitrariness and rent-seeking opportunities. It i s also essential to strengthen the independence and the governance o f the judiciary, so that the rule o f law i s in force for all, includingpublic administrations, large and small investors, and any other economic actors. xxvi. While the authorities are committed to privatizing the State-owned sector, the current strategy of ownership dilution by public sales is unlikely to lead to the type of efficiency improvements expected, at least for medium and large firms. Individual ownership remains limited to 10 percent o f capital - a constraint that i s inconsistent with the objective to move to a market economy, where limitson ownership shares should not be capped by law. International experience has shown that no institutional or legal arrangement can really enforce the independence o f State-owned enterprises (SOEs) and change their managers' incentives, until they are privately (majority-) owned by an individual or a firm shareholder, granting management control. Even if some progress has taken place since 2004-some SOEs have been privatized and/or financially restructured; some outstanding debts o f SOEs have been absorbed by the treasury; SOEs now fall under the commercial code and commercial companies laws; and the idea o f foreign participation inprivatization deals i s now accepted-it remains unclear whether sales to strategic majority investors will be authorized and to which extent hard budget constraints are imposed on the remaining state-owned firms in the course o f the transition, and how independent they are from Government interference. xxvii. I n parallel toprivatization, it is essential and urgent to improve the investment climatefor accelerating private sector development and toput in place a safety net to mitigate the transition's effect on employment. The current oil windfall gives Libya a unique window o f opportunity to put in place a generous safety net that can facilitate these reforms from a social standpoint, and therefore maintain, throughout the transition phase, the objective o f social justice and equity that are fundamental to the Libyan people. xxviii. On the trade liberalization front, while tarqfs have been recently abolishedfor all commodities, a list of products is still subject to a consumption tax and a production tax - which inefficiently protects existing domestic production. While some reasonable level o f protection may be warranted in this transition period, the current consumption-production tax scheme leads to distortions that penalize investment innewactivities while protectingexistingactivities, some ofwhichmaybeboundto fail. It is suggested that this distortionary tax be replaced by a reasonable uniform tariff structure. mix. Promoting Libya's multilateral trade policy commitments, especially through WTO accession, will be an important anchor of reform. Strong multilateral commitments will bolster the credibility o f Libya's reform process, thus fostering both domestic and foreign investor confidence. But WTO members will expect reforms inthe  - viii - basic structure o f economic management-including establishing the rule o f law as opposed to administrative discretion, guaranteeing national treatment in taxation, and fully implementing international agreements on customs valuation. WTO accession provides a good opportunity for comprehensive review and reform o f Libya's trade institutions. V. Financial Sector Reform xxx. Banking represents the backbone of the Libyan financial system. The Government i s in the process o f preparing a program o f financial sector reforms. A particular focus o f the program would be the restructuring o f state-owned banks and, for some o f them, an adjustment in ownership structure to include or increase private sector participation in the capital o f such banks. There i s acknowledgement o f the importance o f updating and strengthening the financial sector's legal, regulatory and supervisory environment. These initiatives should go in parallel with the efforts aimed at restructuring the banking system and addressing the portfolio problems besetting state- owned banks. Inthe absence o f reforms, the banking system would not be able to play fully its role in the intermediation of national savings and the financing o f economic growth inthe non-oil sector. xxxi. State-owned banks need a clear strategy and an effective corporate governance structure for their activities. Recent legislation setting corporate governance standards for financial institutions makes progress towards better management and greater operational independence o f public banks. However, Libyan public banks still need a management structure supported by up-to-date skills in such critical areas as credit, investment, risk management, and information and control systems. Privatization o f state-owned banks should be viewed as an opportunity to attract a qualified category o f strategic investors with a proven track record into the financial industry so as to improve banking sector efficiency. The current option o f privatizing through owner dilution to the public will not bring the efficiency improvements that are generally witnessed when banks' majority ownership i s transferred to a strategic investor o f good reputation and expertise inthe sector. xxxii. The new banking law reinforces the independence of the Central Bank of Libya (CBL) and offers a good legal framework for the regulation of banking activities, even if some provisions call for improvement. In particular, full independence inconducting monetary policy should be strengthened by ensuring that the representation o f the government (Secretariat o f Finance) in the Board o f Directors is limited, with no veto power. Also, the role o f the CBL in regulating the terms and conditions o f credit extension or investment by commercial banks, should be reduced. xxxiii. Despite the progress brought by the new banking Law that specifies and limits its duties and responsibilities,the CBL remains the owner of thepublic banks, with the associated potential conflict of interest between ownership and regulation. It is essential that the Libyan authorities consider separating ownership o f banks from their regulation by the CBL. Ownership should either be transferred to the General Secretary o f Finance or to an asset-management institution that the latter owns. Until such a transfer takes place, the CBL should under no circumstances be involved in operational decisions made by banks, or inindividual credit decisions.  - ix - xxxiv. Financial sector reform has also progressed with partial interest rate liberalization- Interest rates have been liberalized on deposits, while a ceiling on the lendingrate has been set above the discount rate. Progressively, this ceiling should be phased out, to prevent a possible erosion o f bank profitability in a competitive bid to attract deposits, and to allow banks to serve corporate clients with a wider range o f risk profiles. Initial steps for the establishment o f a stock exchange have been taken. -but for much-needed improvement in intermediation in Libya, it is important that an enabling environment for the operation of banks be established. For banks to lend prudently,they ought to operate within an environment that enables them to assess, price and manage risks. To do so, they need to rely on sound and standardized statements o f borrowers' operational and financial conditions. The seal o f independent, qualified auditors would be an added layer o f comfort. The faith in, and reliance on the rule o f law, enforced through a transparent and efficient judicial system would provide further guarantee to creditors that terms o f contracts would be adhered to, while security interests inloan collaterals canbe realized. xxxv. Banking supervision needs to be strengthened to foster the development of a soundfinancial sector. Current loan classification criteria and loan provisioningwould needto be enhanced to reflect adequatelythe true quality o fbanks' loan portfolios inline with international standards. Over the medium term, the focus should be placed on the overall effectiveness o f risk managementpractices inbanks, as banks can often be in full compliance with rules and regulations yet be at risk for insolvency due to poor risk management practices. VI. Enhancing the Effectiveness of Social Protection xxxvi. Establishing an effective social safety net will facilitate the transition to a market-led economy. Particular attention should be paid to adverse effects on vulnerable population groups from sudden drops in income during the transition period. The establishment of a continuous monitoring system o f the wellbeing o f the population would help target groups at risk. The 2003 household budget survey i s an indispensable starting point, and should be undertaken annually and be routinely used by government authorities inthe design o f public policy. xxxvii. A cash benefit system that is able to target needy households on short notice could be designed. The Government has the elements o f such a system near at hand, since the current distribution system for subsidized foodstuffs i s reputed to reach every household in Libya. Ifthis i s the case, adjustments that need to be made to this network to allow the targeted distribution o f cash benefits should be examined. xxxviii. Severance and retraining programs for civil servants and public enterprises employees would need to beformulated. Employees becoming redundant as a result o f the restructuring o f administrations or o f public companies will need to receive support to facilitate their transition to other occupations in the private sector. This would also require retraining to improve their employability inthe private sector. xxxix. Reforming the pension system to contain the accumulation of unfunded pension liabilities, improve efficiency, and equity should also be on the agenda. The Social Security Fund (SSF) is paying benefits that are too generous relative to  - x - contributions and current retirementages. As a consequence, the SSF i s accumulating an implicit pension debt that might already have attained 50 percent o f GDP. The system i s also prone to regressive redistribution and i s distorting labor supply and savings decisions. VII. Managing Reform Options xl. Structural reforms are highly complementary - Reducing the constraints to efficiency and private investment should not be done in a piece-meal manner, without addressing the fundamental underpinnings o f these constraints. The experience o f the transition economies underscores the importance o f pursuing rapid reforms on many fronts, inorder to send strong and credible signals to investors. -yet, the challenges raised by the reform process should be taken into account to prioritize and sequence the reform strategy. Prioritization o f a reform program i s difficult, for many reasons. All actions are important, and the right sequencing depends not only on the expected benefits from each action, but also on the difficulty o f implementation. Some reforms are politically sensitive (privatization, public employment downsizing) and require significant consensus-building, and strongpolitical will. Other reforms, especially in the investment climate, financial sector, and social protection, require considerable capacity building o f the public administration with respect to their new regulatory roles. Thus, reforms with even a modest pay-off may need to get high priority if they are quick and easy to implement, while others with higher benefits might be deferred if they are costly in terms o f administrative capacity and political capital. xli. To build credibility and reform momentum, it is recommended that the Libyan Government embark on a well-sequenced strategy to improve the investment climate, strengthen social sector policies, and reinforce public finance management: A core set o f options for short-term (up to 24 months) actions i s outlined, to send strong signals to investors and make decisive changes in the business environment. It i s recommended that this action planbe complemented by a medium-term(from 2 to 5 years) core reform agenda that addresses structural and institutional bottlenecks. Clearly the Government i s in a much better position to assess the proposed sequencing, especially on grounds of political feasibility. But this proposed sequencing o f reform options may be useful in laying out an agenda for consideration. The table that follows highlights main steps in such an agenda, based on the analytical findings inthis report. Additional reform options that the government may wish to consider as a complement o f the core reform agenda are outlined at the end o f each chapter.  fe, .-0 a a a a a a a 0 a  -0 8 x 1, 0 Y * 3 M c . . . . . . . . 0 I .3 X I . . 0 0 0 0 . 0 . 0 0 . 0  1 %   I. TRENDSSOCIALANDECONOMICDEVELOPMENT IN A. The Structure of the Economy 1. The Libyan economy is dominated by hydrocarbons- At the time o f independence (195l), the Libyan economy was based mainly on agriculture, which employed more than 70 percent o f the labor force; and contributed about 30 percent o f the GDP, dependent on climatic conditions. Before the discovery o f oil and gas, Libya was one o f the poorest countries in the world. However, by 1961 substantial quantities o f oil had been discovered and greatly supported the country's socio- economic development. Thus, with a population close to 5.5 million, Libya had an estimated per capita GDP of US$6,800 in 2005. Measured in nominal terms, and owing to the recent increase o f the price o f oil, the share o f the hydrocarbon sector has been constantly increasing, and represented an estimated 72.6 percent o f GDP at factor cost in 2005 (Figure 1.la). Oil also represented 93 percent o f government revenues and 95 percent o f export earnings. However, reflecting the impact o f sanctions and the lack o f investment in the hydrocarbon sector (see below), the share o f oil in the economy in constant prices has been on a slightly declining trend during the 1990s, before rising to 32 percent in 2004. When the size o f the oil sector i s measured innominal terms, Libya appears as one o f the less diversified oil-producing economies in the world. In2002, the share o f hydrocarbon revenues in Libyan GDP was almost double that o f Saudi Arabia and nearly threefold that o f Iran (Figure1.1b). Oil share in GDP, in nominal and constant Hydrocarbon'% GDP, 2003, Libya and corn parators 2. -although oilproduction has grown belowpotential. Libya's oil production rose rapidly during the 1960s to more than 3 mb/d by 1969, making it one o f the dominant members o f OPEC at the time. Libya became an OPEC member in 1962 and nationalized assets o f foreign oil companies in the mid-1970s. Libya's oil production has largely followed OPEC's overall production profile, although over the last fifteen years its output has grown only modestly, compared with OPEC's average growth o f around 3 per cent per annum. Libya's oil capacity has been constrained by lack o f investment, mainly due to economic sanctions. However the country's oil sector i s again attracting foreign capital and technology, and production i s rising. Current production o f 1.65 million barrels per day (mb/d) i s little more than half the  - 2 - peak o f the early 1970s.' However, the country has the resource base to raise production capacity significantly. FigureI.2: LibyaCrude Oil Production Figure I. 3: GDP components, Realterms and Export Revenue Libya Crude Oil Production khd and Export Revenue milt 30000 5 0 - 45 - 25000 ReYcr?tle- 40 - 35 - 20000 3 0 - 25 - 15000 20 - 1ow0 5000 0 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 3. Services is, by far, the second most important sector of economic activity. Measured in nominal terms, the contribution o f services to GDP declined to 16 percent in 2005, from 46 percent on average during 1990-99, reflecting the soaring price o f oil. However, in real terms, output in services grew faster than total GDP, so that the share o f services reached 45 percent o f GDP in 2005, from about 40 percent inthe early 1990s (Figure 1.3). Despite this increase, the contribution of services to GDP remains below the average inupper middle-income countries (53.8 percent) and MENA countries (49.5 percent). Construction and manufacturing each contribute around 7 percent to GDP (in real terms), a share that has remained largely constant over time. At 8 percent o f GDP, the Libyan agricultural sector contributes to the economy less than the average in MENA countries (12.5 percent) but more than the average o f upper middle-income countries (6 percent). B. The Economic and PoliticalRegimeand EconomicDevelopment 4. Libya witnessed a growing government intervention in the economy after it turned to a socialist State in the early 1970s. Duringthe decade after the discovery o f oil, Libya was operated as a dual economy, with little connection between the oil and the non-oil sectors. The oil companies employed limited quantities o f local labor andpaid a portion o f their profits to the government inroyalties and taxes. This model o f development came to an endwith the regime change o f September 1, 1969, led by Colonel Qadhafi. The economy, which was largely financed by the booming oil revenues o f the 1970s, was marked by two programs: 0 The "Libyanization"-the process o f replacing foreign-owned firms with Libyan nationals. ~~~ Libya's hydrocarbon export revenues have been dominated by petroleum, with only a tiny portion from natural gas (via (LNG). Crude oil accounted for 82 percent of export revenue in 2003, with 15 percent from refined petroleum products. Condensate, LPG and natural gas only account for a combined 3 percent of export revenues.  - 3 - 0 The nationalization program, embarked upon in the mid-1970s, along with the foreign direct investment prohibition. All commercial banks with foreign minority ownership were fully controlled by the government by the end o f 1970 and had been merged into five banks. The insurance industry was also totally nationalized and merged into two companies. Moreover, the government either nationalized oil companies or became a participant in their concessions and their production and transportation facilities (see Library o f Congress, 1987). 5. Nationalization went in tandem with an ambitious plan of economic modernization and industrialization. The industrialization plan was modeled largely on the experience o f neighboring Algeria. During the 1970s, industrialization mainly relied on the downstream oil industry and light processing.* In the late 1970s, the industrial sector was planned by the government, which had assumed control over those industries that were deemed sensitive or too large to be managed by the ' domestic private sector. The industrialization program had two major goals: the diversification o f income sources and import substitution. Considering these objectives, the plan met with some apparent success, as several categories o f imports began to decline in the late 1970s, but the impact on household welfare was questionable. From the early 1980s the government's priority shifted towards encouraging the development o f heavy industry. Indeed, duringthe period o f high oil prices the development o f import-dependent heavy industry seemed feasible, as Libya enjoyed cheap energy costs and possessed the foreign exchange to pay for raw material imports. 6. Economic policies were geared towards achieving an egalitarian society by washing out class differences. Many o f the regime's most radical economic policies began in 1978, soon after the codification o f the Libyan Leader's economic theories in the second volume o f his Green Book. Most o f the post-1977 economic policy innovations were designed to inhibit the private accumulation o f wealth, with the aim o f promoting a more equitable income distribution. Changes in the economic regime went in tandem with a radical redesign o f political institutions (Box 1.1). Most prominent changes inthe economic regime included: Rental payments for property were abolished, changing all residential tenants into instant owners. Ownership o f property was limited to one house or apartment per family. The private sector real estate industry was thus eliminated, and the new owners were required to pay monthly "mortgage" payments-usually amounting to about one-third o f their former rent- directly to the government. However, low-income families were exempted from this obligation. The employer-employee relationship was abolished, on the principle that a Libyan citizen could not hire another Libyan citizen to avoid any subordination relationship. Thus, Libyans had to be partners in order to do business. As a result, private ownership was banned for an individual but possible for a group o f Libyans. Workers were urged to participate in the Processingof foodstuffs was a high priority, and the largest number of plants built during the 1970s were in this area. Other major manufacturingprojects duringthe decade includedtextile complexes, an oil refinery,petrochemicalplants, a fertilizer factory, and an electricalcable plant (Library of Congress, 1987).  - 4 - management o f the enterprises in which they worked through "workers' committees" which, inprinciple at least, ran the most important companies. 0 Under the egalitarian socialist principle, women were expected to fully participate inall aspects o f life inthe same way than men did (see below). 7. During Libya's experiment with socialism private sector activity was stifled- In the most radical of the measures, all private property rights were eliminated in March 1978. Later in the year, most private trading, retail and wholesale, was abolished. The only type o f private sector activity that the government did not actively seek to eliminate was small service-providing firms (mostly self- employed), which were not viewed as inherently exploitative. Private savings accounts were eliminated, as was the right for professionals to maintain private practices. The Central Bank's credit policy was confined to supporting the government's development effort. It limited credit to the private sector and directed it instead to state entities. As a result o f the severe repression o f private business activity, a large number o f Libyan managers and skilled workers left the country. However, private investment and ownership were encouraged in agriculture, even for foreigners. Thus, Egyptian and Moroccan farmers could own a farm in Libya as long as they worked the land. 8. -but, owing to collapsing oil revenues in the 19SOs, the socialist experiment was short-lived. The last phase o f the socialist period was characterized by an intensive effort to build industrial capacity, but falling world oil prices in the early 1980s dramatically reduced government revenues and caused a serious decline inthe economic activity. The decline in oil prices during the 1980s reduced Libya's advantage in terms o f energy costs and greatly cut the supply o f foreign exchange. Whereas in the late 1970s it may have been possible both to import industrial raw materials and subsidize food imports, by 1987 it was becoming increasingly clear that foreign exchange earnings were insufficient to fund both industrial development and  - 5 - extensive subsidies. This led to a progressive rehabilitation o f private sector activity. Beginningin 1988, Libya took some steps towards liberalization with a greater scope allowed to private enterprise in the retail trade, small-scale industries and agricultural businesses. In September 1992, a privatization Law was passed, but this initiative had no impact on the structure o fthe economy. 9. The opening to the market in the early 1990s was hesitant and not sufficient to energize growth. A number o f factors explain the limited success o f the partial opening to private economic activity inthe early 1990s. First, key institutions for the market to play its role as an allocating mechanism had been removed (labor and real estate markets, credit markets) and replaced by a distributive state. Second, the State's intervention in the economy remained pervasive: Price controls for basic food products continued; tariff protection and non-tariff barriers remained high, so that parallel markets for consumer goods (brought in from Algeria and Tunisia) were thriving; banks were supporting public enterprises through directed allocation of credit; and the private sector's access to credit remained restricted. Third, property rights were not secure and regulatory uncertainty remained high. To these fundamental impedimentsto the functioning o f a market-oriented economy was added the impact o f the international sanctions. 10. Beginning in the mid-l980s, Libya was subject to both US and UN sanctions. The first U S sanctions were introduced in 1986, prohibitingU S companies from any trade or financial dealings with Libya, while freezing Libyan assets in the US. TheIran-Libya Sanctions Act of 1996 imposed extra-territorial measures against non-US firms investing more than US$20M in one year in Libya. It was renewedin 2001 for a further 5 years. UN sanctions came into effect in 1992, following the Lockerbie bombing in December 1988, prohibiting all international flights to Libya, stopping arms, aircraft and oil equipment sales (including spare parts) and freezing Libyan assets, except those necessary for oil transactions. Further to Libya's cooperation in the resolution o f the Lockerbie case, UN sanctions were suspended in 1999, and lifted in 2003. U S sanctions were lifted in 2004, as a result o f Libya's cooperation in international efforts aimed at non-proliferation o f Weapons o f Mass Destruction. 11. Sanctionsprimarily impacted oil companies doing business in Libya but also the rest of the economy. The Libyan economy was seriously affected during the 90s by a critical shortage o f spare parts and lack of access to raw materials and new technologies, which imposed serious limitations upon Libya's industrial infrastructure. Income from tourists also plummeted. Although major development projects seemed unaffected, such as the Great Made Man River (Box 1.2), smaller projects, including the construction o f desalination plants, were slowed down. The government was also forced to cut agricultural subsidies, thus stalling its effort to boost the agriculture sector. While sanctions did not prevent Libya from maintaining trade relations with Western European countries, they impacted growth during the 1990s, and were at the origin o f relatively higher domestic prices than in the past, due to shortages and a reduced variety o f products on the local market.  - 6 - 12. Reflecting the heritage of the command economy,public sector ownership in the economy still remains widespread. Three quarters o f employment i s inthe public sector, and private investment still remains dormant at around 2 percent o f GDP. Serious attempts at economic reform are now underway, with the aim o f promoting transition to a market-led economy and closer integration with the rest o f the world. Progress and challenges in the reform are analyzed in the following chapters o f this report. C. Social Development Figure I.4: GDP per capita PPP 13. The sizeable oil wealth has supported decent living standards GDP per capita PPP, international cornparidon, US$ constant prices (2000) for Libya's population- Libya ranks ahead o f several other oil- 7 w-.v 'Oman " c,-r 0 producing countries in terms o f per 6- : Trinidad and Tobago capita GDP adjusted for differences 10000 Libya in purchasing power parity (PPP 8000 . 6000 - lgeria GDP-Figure 1.4). Reflecting Venezuela 4000 - swings in oil revenues, per capita Azerbaijan 2000 - PPP GDP hovered around US$ I Angola 9,269 on average during 1990- ~ ~ ~ " " " ' " ' " ' ' 2002, reaching US$9,966 in 2004. About 67 percent of the water generated by the GMR was originally intended for uses in the agriculturalsector.  - 7 - This level o f per capita GDP in PPP is about 25 percent lower than in Saudi Arabia and Oman, about the same as in Trinidad and Tobago, and an estimated 30 percent higher than in Iran. As further discussed in chapters IV and V, despite frozen wages, living standards have been supported through an extensive social safety net, with the provision o f free housing, education and healthcare, subsidized food and utility prices and sizeable energy subsidies. 14. -but, as other MENA countries, Libya is coming under intense demographic pressures- Libya posted a 3.3 percent rate o f population growth during 1960-2003, higher than the MENA average. Demographic growth has recently slowed to the MENA average o f 2 percent, owing to the decline in the birth rate during the 80s, which went down from 49 per 1000people during the 60s and 70s to 27 per 1000 in2002. Libya also posts one o f the highest urbanization rates both inthe region and inthe world. In2003, 86 percent o f the population was urban, compared to 45 percent in 1970.4 15. -while tensions in the labor market are becoming acute. Although no reliable estimates are available, unemployment i s reportedly acute. With more than 50 percent of the population under the age o f 20, labor market tensions will increase in the future. Moreover, despite the bias o f the rigid labor market regulations in favor o f hiring Libyan workers, the mismatch o f the educational system with the needs o f the market (see below) has resulted in the perpetuation o f a large pool o f expatriate workers, with typically better-suited education and higher productivity. However, because o f labor shortages for hard manual work, Libya has also attracted important numbers of less skilled economic immigrants. Expatriate workers represent an estimated fifth o f the labor force, although, in the absence o f a labor force survey, estimates are surrounded by considerable uncertainty. Although significant, the proportion o f expatriate workers i s still lower than in oil producing countries in the Gulf.' Foreign workers mainly come from the Maghreb countries, Egypt, Turkey, India, the Philippines, Thailand, Vietnam, Poland, Chad and Sudan. They tend to earn relatively high wages as they take either skilled jobs or hard manual jobs with high pay. Census data for 2000 show that the share o f expatriates earning over LYD 300 (US$230) ,per month was 20 percent, compared to only 12 percent for Libyan nationals. In the absence o f employment opportunities in the private sector, Libyans seem to prefer the job security and fringe benefits offered inthe public sector, despite the relatively unattractive pay o f public sector jobs. A campaign encouraging conversion o f qualifiedcivil servants to entrepreneurship-in the face o f public sector over employment and a continuous fall in productivity-does not seem to be producing the desired results. 16. Educational attainment indicators are better than the region average. Libya has achieved universal enrollment in primary education and, the 14 percent illiteracy rate is below the regional average o f 34 percent. This i s an improvement relative to the early 1960's, when 40 percent o f the adult population was illiterate, and enrollment in primary education was only 60 percent. Secondary school enrollment ~~ ~ Comparatively,Tunisia and Egypt post lower rates of respectively64 and 42 percent, while Kuwait and Qatar post the highest rates inthe MENA region with respectively96 and 92 percent in 2003. InSaudi Arabia, foreigners accounted for 67 percent of the kingdom's labor force in 2004, holding a vast majority of the private sectorjobs inthe non-oil sector. Inthe United Arab Emirates, the share of foreign workers is even higherat 88 percent.  - 8 - substantially increased between 1970 and 2002, from 21 to 105 percent. Tertiary enrollment has recorded a similar pattern, increasing from 3 to 58 percent inthe same period. However, despite comparatively high school enrollment levels, the illiteracy rate in Libya is higher than that in upper middle-income countries, which post an average o f 9 percent in2002. Rates are even lower for selected countries such as Chili (4%)' Croatia (2%), and Argentina (3%). 17. The quality of education is, however, open to question. Although different options and curricula are available for Libyan students, there are concerns about the quality o f the content and the actual access to up-to-date knowledge and expertise. These concerns are related to (i) the country's isolation for more than a decade, (ii) the high unemployment rate combined with the displacement o f local workers by foreigners, and (iii) ban o f foreign languages from the curricula. Libya would need the a strong human capital foundation to respond to actual needs as the economy opens up further and private investment takes off. The education system will have to promote the kind o f skills needed in an economy where internationally competitive services and the private sector play a more dominant role. 18. Health care services have improved. Health care provision has apparently improved, with one physician per 770 people by 1997 (most recent available data), from one doctor per 3,860 people in 1965. There were 850 people for every nurse in 1965 and 350 per nurse in 1992, close to rates in the OECD countries. The infant mortality rate fell accordingly, from 160 per 1,000 in 1960 to 16 per 1,000 in 2002. However, although Libya, along with Tunisia, has achieved some o f the lowest infant mortality rates in the region, it i s performing below upper middle-income countries, such as Chili (10 per lOOO), Croatia (7 per lOOO), and Malaysia (8 per 1000). The life expectancy has increased as well, from 52 years in 1970 to 72 years in 2002. Better health outcomes also reflect the improvement o f sanitation facilities and access to safe water, for both urban and rural population, for which the gap has been substantially narrowed. However, Libya's health care system has suffered greatly since the mid 1980s because o f the sanctions and Libya's international isolation. It became difficult for Libyan health care workers to obtain medicine, surgical supplies and parts to repair medical equipment. Patients could not leave the country to get specialized treatment. The large number o f Libyan nationals who seek health care services in neighboring Tunisia points to continuing concerns about the quality o f health care in the country. Further analysis i s needed to assess the performance o f the health care system andbetter understandthese trends. 19. Libya gives almost the same rights to women and men. Libya, as many o f the MENA countries, signed in 1989 the UNConvention on the Elimination of all forms o f Discrimination against Women, with few reservations regarding marriage and family life. Legally, Libyan women are equal to men. Under the egalitarian socialist principle, women are expected to fully participate in all aspects o f life. They have access to education, as well as to political and social life, including military training. The Constitution (Article 4 and Principle 11) gives women the right to exercise the work o f their choice, in all sectors. Regulations explicitly state that men and women are treated equally with regard to freedom o f movement. Women have the right to conclude their own marriage contract and to get a divorce by the court.  - 9 - 20. Female participation in the labor force is low. Although Libya ranked high among MENA countries in the 1960s in terms o f women labor force participation, it fell behindby 2000. With a female participation rate o f 19.3 percent6, Libya currently ranks just before Oman, Iraq and West Bank and Gaza. One o f the explanations for this deterioration is the limited scope for private sector activity and especially the limited development o f activities that have traditionally been open to female participation, such as textiles and garment manufacturing. Italso reflects the impact o f restrictive regulations as well as social and cultural impediments as in many others countries inthe region. 21. Despite high girls school enrollment in comparison to the MENA region average, gender disparities still persist. As o f 2000, Libya had among the highest female primary, secondary and tertiary school enrollment ratios inthe MENA region. Those ratios have drastically improved since 1980, bridgingthe gap between men and women. As a consequence, at 71 percent, the women literacy rate i s above the MENA average o f 54.8 percent. However, the women literacy rate remains below that for men (91.8 percent). D. Recent Economic Developments 22. Macroeconomic performance has been shaped by fluctuations in oil revenues. Real GDP growth was modest and volatile during the 1990s, shaped by changes in the price o f oil and reflecting the decline in oil production as a consequence of economic sanctions enforced by the U S and the UNsince 1986.7 The average growth during that period was about 2.6 percent, with a peak o f 13.5 percent recorded in 1991 and downturns in 1994, 1998, and 1999. During the 1990s, non-oil GDP growth was slow and volatile as well, at 3 percent on average, owing to pervasive State controls and the decline o f government's revenues. As sanctions were suspended by the UN in 1999, and oil prices rose, growth has gradually picked up (Table 1.1). 23. Reflecting significantly higher oil production and prices, Libya's economic performance has recently improved. The macroeconomic situation remains strong , with real GDP growing at an estimated 3.5 percent in 2005, slightly down from 4.6 percent in 2004. Growth o f non-hydrocarbon GDP has accelerated to 4.6 percent in 2005 and 4.1 percent in 2004, up from 2.2 percent in 2003. Non-hydrocarbon GDP growth was broad-based, driven by construction and utilities, such as electricity, gas and water, but also trade, hotels, transportation, and other services. However, growth inmanufacturing and agriculture has remained tame.* Non oil growth would need to further accelerate on a sustained basis to absorb the labor force which is projected to grow by 3.3 percent inthe years ahead. 24. Inflation has been tame, as prices were controlled and wagesfrozen since 1981, while deflation has surfaced since 2000. During 2000-02, Libya posted an 'Basedon the 2003 Survey of Economic and Social Conditions. USsanctionswere introduced in 1986, prohibitingUScompaniesfrom any trade or financial dealings with Libya, while freezing Libyan assets inthe US.UNsanctions were imposed in 1992, suspendedin *1999, andlifted in 2003. US sanctions were lifted in2004. Reported estimates should be taken with caution because data weaknesses-especially in National Accounts compilation-remain prevalent.  - 1 0 - annual average deflation o f 7.2 percent (while money supply increased on average by 9.2 percent annually). The unification o f the Libyan dinar (between February 1999 and January 2002) has contributed to the deflation process (Box I.3).9 The unification o f the exchange rate induced a drop in the prices o f imported goods that were priced at the special rate-which appreciated by 132 percent between February 1999 and May 2003. The trend has been amplified by the cut in tariffs by 50 percent, and also by the one-off tariff exemptions granted to the State enterprises in 2002 in order to offset the devaluation o f the official exchange rate inJanuary 2002. Table I.1: Libya: Summary macroeconomic performance1991-2005 1991- 1995- 1999 2000 2001 2002 2003 2004I 2005 94 9R National Income and Prices (YOhange) RealGDP 3.4 1.8 -0.4 1.1 4.5 3.3 9.1 4.6 3.5 RealNon-HydrocarbonGDP 3.7 2.6 0.9 3 6.8 4.7 2.2 4.1 4.6 Real GDP per capita 1.4 -0.2 -2.3 -1.2 2.5 1.2 7.0 2.5 CPI 9.8 4.9 2.6 -2.9 -8.8 -9.9 -2.1 -2.2 2.5 Balanceof Payments@illi of US$unless otherwise noted) Current Account Balance -0.04 0.8 1.6 6.5 4.1 0.6 5.0 7.3 16.0 as a % of GDP -0.2 2.6 5.4 18.8 13.8 2.9 21.5 24.2 40.8 Gross Official Reserves 6.7 6.7 13.1 14.1 15 19.5 25.6 39.3 inmonthsof imports ofGNFS 11.4 14.1 26.7 19 20.5 21.9 23.9 31.5 External Debt (%of GDP) 18.8 15.3 19.2 28.7 23.4 Central Government Finances (YOof GDP) Revenue 30.6 365 39.8 45.7 43.1 51.4 54.4 59.1 73 Expenditure 30.7 34 32.8 31.3 44.3 41.2 44.6 444.0 41.2 Overall balance -0.1 2.5 6.9 14.4 -1.2 10.2 9.8 15.1 31.8 Non-hydrocarbonOverall Balance -16 -20.6 -10.5 -17 -30.3 -30.2 -37.6 -36.1 -36.0 Source:CentralBank of Libya (2005) and IMF (2006)) 25. More recently deflation has subsided. Although deflation continued during 2004, its rate slowed to about -2.2 percent. In 2005, the trend has reversed, with the CPI increasing by an estimated 2.5 percent. The temporary factors that contributed to deflation in 2001-2002, including the impact o f the appreciation o f the special exchange rate on import prices, have abated. However, downward pressures on prices persisted as increased competition from private sector imports, resulting from trade liberalization, has put significant pressure onpublic enterprises to lower their prices. InFebruary 1999, the Central Bank of Libya introduced a dual exchange rate regime by establishing a "special" rate close to the prevailing parallel market rate, to be used for transaction related to personal imports, travel, medical treatment abroad and pilgrimage. Since them, the exchange rate policy intended to narrow the spread between the official and the special rates through depreciations o f the former and appreciation o f the latter. In January 2002, the authorities unifiedthe exchange rate system through a one-step devaluation of the official rate.  - 11- 26. A significant cushion of reserves has been built. Contrary to other oil- producing countries that suffered crises following the oil price declines in the 1980s and early 1990s, Libya's external current account remained generally in surplus, also reflecting the restraining impact o f sanctions on imports. Thus, Libya was able to accumulate substantial foreign-exchange reserves. Gross official reserves were about US$ 6.7 billion (11.4 months o f imports) on average in 1995-98 (Table 1.1). With favorable oil prices Libya's reserves had more than doubled by 2002, reaching US$15 billion (the equivalent o f 20 months of imports). The current account surplus is estimated at about 40.8 percent o f GDP in 2005, and gross official reserves have surpassedUS$39 billion in2005, equivalent to 31 months o f imports-a highlevel of reserves when compared to other oil producer countries. 27. The $seal balance has been preserved, although public expenditure has been boosted by high oilprices. The government's budget has been, on average, balanced during the 1990s. Since 1999, the budget has posted a surplus, although the dependency on oil revenues is significant, with a sizable non-hydrocarbon budget deficit hovering at around 36 percent o f GDP since 2003. Boosted by steeply rising oil revenues, public expenditures increased from 31 percent o f GDP in 2000 to 44 percent in 2004, conveying to fiscal policy a resolutely expansionary stance. Public expenditure i s estimated to have declined to 41.2 percent o f GDP in2005, driven by a sharp decline o f extrabudgetary spending. With soaring hydrocarbon revenues, the overall fiscal surplus i s estimated at 31.8 percent o f GDP in2005, up from 9.8 percent in2003. 28. The economic outlook in 2006 is encouraging. Given data revisions and recent developments, real GDP i s expected to grow at close to 5 percent in2006, with growth of non-oil GDP remaining steady at around 4 percent, drivenby construction, mining, the services sector (mostly private activities), and transportation. The inflation outlook i s benign, with the CPI expected to increase by 3 percent in 2006. Due to higher oil prices and production, the current account surplus is expected to  - 12- further increase to close to 43 percent of GDP, while gross official reserves may furtherrise to cover 40 months ofimports. E. The Qualityof EconomicInformation 29. Weak data availability and quality callfor caution in analytical assessments. Although the government has recently made progress in improving statistics collection, there are still concerns regarding the unavailability o f some data, particularly in public finances as illustrated by the absence o f detailed data on local government expenditures. On the fiscal side, budgetary data lack transparency as extrabudgetary spending remained sizeable until 2004, at about 32 percent o f total public expenditures-see chapter V). Moreover, the quality o f the national account compilation i s questionable, owing to the significant delays in the receipt o f data, the use o f outdated surveys, and the lack o f internal consistency o f estimates. Reliable data related to unemployment are not available. Information on the incidence o f poverty i s also missing, making it difficult to appropriately target the welfare interventions o f the state. Inthe case o f the education and health sectors, there i s no reliable system to collect and transfer basic data on outcomes and expenditures from the regions to the center. One o f the consequences i s that there i s no information about the total level o f expenditures inthese sectors. Inthe case o f the Social Security Fund, information systems are also outdated and this makes it difficult to conduct any assessment o f the long-term financial sustainability o f the scheme.  - 13 - 11. LIBYA'S KEYDEVELOPMENTCHALLENGE: MAKING OILWORK FORGROWTHAND JOBS A. Libya Holds Strong Long-Term Potential For Raising Hydrocarbon Revenues 30. Libya is well endowed with oil and gas resources, and the country has great potential to increase oil and gas production in the future. With relatively modest domestic demand, it also has the potential to increase exports o f both fuels well into the future." Libya's current level o f recoverable crude oil reserves i s 39.1 billion barrels (Bbbl) and natural gas reserves are 51.3 billion cubic feet (bcf) or 1450 bcm. Known recoverable gas reserves are less than a quarter the size o f oil reserves on an oil equivalent basis. The estimates represent only proven, economic reserves that are planned for development. They do not include undeveloped proven reserves or estimates o f probable and possible reserves.l1Libya's profiles o f cumulative production to date differ for oil and gas, with cumulative oil production to date equivalent to 60 percent o f present estimates o f recoverable reserves (Figure 11.la). Gas production i s less advanced than oil, with cumulative gas production only 12 percent o f cumulative reserves (Figure 11.1b) Libya Oil Reserves & Libya Gas Reserves & 1960 1970 1980 1990 2000 1970 1980 1 W 2000 31. Estimates of yet undiscovered, recoverable reserves are significant. In the latest U.S. Geological Survey (USGS) assessment o f world oil and gas reserves, it places Libya's mean oil reserves o f undiscovered oil at 8.3 Bbbl (Table 11.1). The USGS includesprobabilityranges for reserves actually occurring, and places an upper estimate for oil at 15.3 Bbbl-at 5% probability. For natural gas reserves, the USGS shows a mean reserve estimate o f 21.1 tcf, or 600 bcm, with an upper limit o f 47.2 tcf. Natural gas liquids (NGL) have a mean estimate o f 0.9 Bbbl, with an upper limit o f 2.1 Bbbl. It should be stressed that reserve estimates tend to rise over time through greater knowledge from increased exploration and development. Since 1981, USGS estimates o f global oil and gas reserves have risen by 76 percent and 66 percent, loThe only caveat with regardto domestic demand is that enduring subsidieson domestic consumption havethe potentialto limit exports (see calculationsof implicitenergy subsidiesin chapter V). No estimates were providedfor reserves of LPG and condensate.  - 14- respectively, mainly because o f chronic underestimation o f reserve growth in already discovered fields. Table 11. 1: EstimatedUndiscoveredHydrocarbon Resources in Libya F95 F50 F5 Mean il (millionbarrels) 2,923) 7,4 181 15,3481 8,271 GL (million barrels) 23 6611 2,1141 91 F95 represents a 95 percent chance of at leastthe amount tabulated (other percentiles defined similarly). Source: US. Geological Survey, 2000 32. Libya has the potential to raise oil and gas production significantly in coming years given its large reserve base. The possibility o f significant reserve growth could also expand its capacity to produce and export hydrocarbon fuels into the future. The only limitation to oil production and exports over the past 20 years has beenthe lack o f upstream investment and the commitment to OPEC quotas. Given current investment plans to raise capacity, a major constraint mightbe adherence to its OPEC quota. Natural gas exports, on the other hand, have the potential to grow more freely without a policy constraint on output. Libya has the potential o f being a major low-cost gas supplier situated close to Europe, where gas demand i s expected to expand significantly in the coming two decades. However Libya will face increasing competition as the EU liberalizes its gas and electricity markets, and prices are likely to be increasingly de-linkedfrom oil prices. Infuture, maintenance o f large subsidies on domestic gas demand could distort the sector andpotentially limit exports. 33. Alternative scenariospoint to a steady increase in Libya's oilproduction up to 2025. The Libyan authorities expect oil production capacity to rise above 2.1 mb/d by 2010, from 1.65 mb/d presently, before falling to 1.8 mb/d in 2014.12 The Ministry's data for natural gas production is roughly twice as large as figures cited by several other reliable sources, e.g., the IEA, U S DOE, and various consultants. Projections are also provided by the U S Department o f Energy, based on three scenarios for the world oil market (Table 11.2). By 2025, forecasts o f OPEC production range from 40.4 mb/d to 67.6 mb/d. The comparable range for world oil demand is 108 mb/d to 132 mb/d, compared with around 85 mb/dtoday. There are no resource constraints on OPEC being able to produce these volumes over the forecast period-although the upper levels for oil demand growth and OPEC production are thought unrealistic. Under current OPEC quota shares, Libya's share o f 5.36 percent translates into a production range o f 2.2 mb/d to 3.6 mb/d in 2025. Though the DOE obviously feels that Libya's production capacity would not rise to the upper level, all scenarios indicate a significant increase inproduction. 12 Under the current World Bank oil price forecast-$59/bbl in 2006 falling to $47/bbl in 201@--0il revenues would average $30.0 billion per year over the 2004-2010 period, before falling to $17.4 billion in 2014 because of lower production and oil prices.  - 15 - Table 11. 2: Projectionsof OPEC Productionand Capacity High PriceCase OPEC Production 30.2 32.0 31.2 33.1 35.0 OPEC Capacity 30.6 35.0 35.1 37.8 40.4 of which Libya 1.6 I 1.8 I 1.8 1 2.0 I 2.2 Low PriceCase OPEC Production 28.3 43.4 50.3 58.7 67.6 OPEC Capacity 30.6 46.6 54.3 63.4 72.8 of which Libya 1.6 2.2 2.6 3.3 3.9 Productionincludesnatural gas liquidsandcondensate. Oil Price Assumptions in2025 (2003 $): Ref.$48; Hi$54;Lo $21 Source: USDOE, International Energy Outlook, July 2005. 34. Over the long run, the net present value of the government's hydrocarbon revenues is estimated at between 7.3 to 19.8 times the level of 2005 GDP. The estimation o f the net present value (NPV) o f government revenues from crude oil and natural gas production i s based on various assumptions o f reserves, production profiles, and oil and gas prices. The N P V o f government hydrocarbon revenues over a long-term time horizon, up to 2100, i s calculated on the basis o f three scenarios about reserves and three different assumptions about oil and gas prices (summary in Box 11.1 and details in Annex 1). The range o f estimates i s plausible, and assumes that additional reserves will be discovered under favorable investment and market conditions. The estimations o f the total N P V o f hydrocarbon revenue in 2005 US$, based on a 4 percent discount factor, range from US$287 billion to US$ 777 billion (Table II.3)-i.e., from 7.3 to 19.8 times the level o f 2005 estimated GDP.  - 16- Prices Low Mid High Reserves $25 $40 $55 Low 287.3 452.8 617.7 Mid 322.9 509.3 695.4 High 360.5 568.7 777.0 Oil prices constant 2005 $ per barrel. Gas prices constant 2005 $ per thousand cubic meters. Discount rate 4 percent. Government take = 60 percent of total production revenue Source: WorldBank 35. Oil wealth could generate a sizeable permanent income stream for Libya. Although oil wealth i s exhaustible, appropriate financial management-as explained further below-can help convert this exhaustible revenue into a permanent income stream that can be enioyed indefinitely by future generations. The permanent hydrocarbon revenue stream can be calculated FigureXI. 2: PermanentHydrocgrbon revenue (2005 prices, in % of 2005 GDP) as an annuity, over an infinite time horizon. The annuity i s equal to the present value o f the hydrocarbon revenue stream over the shorter extraction period (see technical details and link with long-term fiscal sustainability in I Oil price Annex 2). With a 4  - 17- percent discount rate, a permanent income o f US$11.5 billion i s estimated inthe low- case reserve and price scenario, corresponding to 29.3 percent o f estimated 2005 GDP. With a low-reserve and mid-price scenario, the permanent hydrocarbon income i s estimated at US$18.1 billion (46 percent o f 2005 GDP). The permanent hydrocarbon income stream could climb to as much as US$20.4 billion (52 percent o f 2005 GDP) in a mid-reserve and mid-price scenario and to much higher levels under more favorable reserves / price assumptions (Figure 11.2). 36. Production and revenue projections are surrounded by considerable uncertainty. There are significant risks to future levels o f Libya' oil production depending upon OPEC's pricing and production policy (and other market factors), and whether Libya remains a solid member o f OPEC and maintains its current share o f OPEC output. Should global demand become more sluggish at high prices than indicated above, it i s possible that the demand for OPEC oil will increase very little. Insuch case, Libya's oil revenues will be much lower than projected, and the country may end up with sizeable surplus capacity in the medium term. A large surplus may subsequently impinge upon foreign investment in the oil sector. In the more distant future, there are greater uncertainties about the growth o f global oil demand, especially in developing countries. But there are also uncertainties about the growth o f petroleum-based transport fuels, and growing environmental concerns over hydrocarbon use and global warming. There are no resource constraints far into the distant future, and new technologies continue to lower the cost o fproduction and shift supply curves outward. Thus crude oil prices are likely to remain extremely volatile, with economic forces exerting downward pressure on prices, while OPEC production restraint pushes prices upwards, often well above the costs o fproduction. B. MakingOptimalUse of the HydrocarbonFinancialResources,To PromoteNon-OilGrowth,CopeWith Volatility,and Secure Fiscal Sustainability 37. Libya's main development challenge is to promote growth andjob creation in the non-oil sector. Creating Figure 11.3: Growth requirementsin non-oil enough jobs for Libya's sectors to reduceunemploymentrates growing labor force will require the non-oil sector. The labor ---- force, which i s currently 35 0% - 3 5% growth In non-oilsectors c *,*- estimated at 1.8 million ,b 300%- _---* workers, i s expected to grow at . 25 0% - 5 ---.-`-.....-__ _L__r-- r ----______------___ 3.3 percent per year over the B2c d---. 2oo%. 4 5% growth In non-oll sectors- medium-term. Labor force 1 1 5 0 % - *. growth i s also likely to be bolstered by greater B 10 0% - .-. participation o f women, given 5 0 0 .- 5 5% growth in non-oil ..``.- \ the low current levels o f the sectors oox,  - 1 8 - productive non-oil sectors will need to grow at least at 4.5 percent per year to absorb new entrants to the labor market and to avoid an increase in the unemployment rate (Figure 11.3). Much higher growth, o f about 6.5 percent, would be needed to reduce the unemployment rate+urrently estimated at around 25 percent-by half in a 10- year period. ( z j Patterns of growth and volatility in the non-oil sector 38. Non-oil GDP growth has been weak, compared to other oil-producing countries and transition economies. At about 2.8 percent since the early 199O's, Libya's non hydrocarbon real GDP growth has been at the Figure 11.4: Real Nonhydrocarbon Carbon GDP growth (1991-2002) low end o f growth seen inother - - oil-dependent economies and 'Teal NonhydrocarbonCarbonGDP growth(1991-2002) 0.15 7 below population growth. Since 0.1 2000, non hydrocarbon real 0.05 growth has been boosted by 0 high oil revenues, but has 0.05 remained lower than in other -0.1 comparators in MENA despite 0.15 the lifting o f UN sanctions -0.2 (Algeria, Iran-Figure 11.4). 0.25 ,,-"Azerbaijan Other oil-producing economies -0.3 that have adopted market- 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 oriented reforms, (Kazakhstan, Azerbaijan) have seen significantly faster non hydrocarbon GDP growth, offsetting the adjustment costs inthe initial phase o f the transition. 39. Oil revenue volatility has been transmitted to non-hydrocarbon GDPgrowth. As other oil-producing countries, Libya was exposed during 1991-2002 to important terms-of-trade shocks, stemming from the volatility o f the price o f oil. But Libya's exposure to terms-of-trade volatility was particularly strong, reflecting the poor diversification o f the economy out of hydrocarbons (Figure IISa). Large terms o f trade shocks translated into relatively highvolatility o f non hydrocarbon GDP growth (Figure 11.5b). As suggested by international experience, high volatility is a factor o f poor long-term growth performance and might be painful for the society as a whole (Box 11.2). Figure 11.5: Macro Economic Volatility has been high (1991-2002) - Volatility of Tern ofTmde Inckx (1995=loo), GmWhRate (Oh!,(StdDev.1991 ZWZ) - 0.35 I 0 3 025 12% 0 2 10% 68Yo Yo 0 I5 0 1 4yo 0os 2% 0 0Yo  - 19- Box 11.2: The adverse impact of volatility on growth Evidence across a large group of countries, over 1981-2000, suggests that higher volatility, as measured by the changes in the terms of trade, was associated with lower long-run growth (Figure), although other variables may explain this negative correlation, such as weak governance and bad investment climate. Volatility in key macroeconomic variables such-astheterms of trade, inflation and real exchange rate, heightens uncertainty, F. ... . . . . .. lowering the risk-adjusted returns on investment, Average per capda GDP grovdh per and hence leading to lower private investment. , , year (1981-2000) High volatility also increases bank exposure to 11 *... * * credit risks and impedes the development of an efficient banking system. Banks are more ~ 4 4 1 ' . . inclinedexpense of tolong-termsupply short-termfinancing. Thiscredit,potentiallyat the raises the cost of financing of long-term 20- .*hd**., 1 . productive investment. High risks of financial -2- intermediation also increase the level of -4- - collateral required by the banks, thus hampering access to finance by small and medium 0 10 20 30 40 50 Terms of Traae Vo at ty enterprises. 40. I n the non hydrocarbon sector, volatility has been particularly acute in industry and construction. Since the early 1990s, in industry and construction the standard deviation o f growth has been more than three times higher than the average growth rate, a volatility comparable to that o f the oil sector (Table 11.4). By contrast, the volatility o f growth has been much smaller in agriculture, and even less so in services-the sector that has contributed most to growth o f non-oil GDP. Although the higher volatility o f growth in industry, relative to services, is not unlike the patterns seen elsewhere, the very high level seen in Libya may further increase the risk premia faced by investors, thus hampering efforts to promote private investment inthe years ahead. Table 11.4: Growth and volatility by sector of economic activity 1991-2003 Growth rate standard Coefficient of 1991-2003 deviation variation Agriculture 1.6 2.8 1.8 Oil & Mining 2.4 8.0 3.3 Construction 4.8 14.8 3.1 Industry(Utilities + Manufacturing) 1.8 6.3 3.5 Services 3.6 3.3 0.9 GDP I 2.8 I 2.9 1.1 (ii) Macroeconomic policies and the management of volatility 41. Appropriate government policies, and strong social and economic institutions, can mitigate the impact of volatility on growth. International experience suggests that prudent fiscal policies are key to insulating the economy from external  - 20 - shocks. Prudent fiscal policies provide room for absorbing the shocks, without placing excessive strains on domestic demand in order to maintain a sustainable fiscal and external position. Moreover, strong financial systems will be in a better position to cushion the impact o f volatility on growth, by allowing more efficient allocation o f resources across economic sectors in the face o f greater uncertainty. Flexible labor markets also help cushion the impact o f shocks on employment and, thus, on domestic demand and growth. of oil. Changes in domestic - investment, with a Figure 11.6: Gross Fixed Investment and Export Revenues, YOGDP % - - 90 multiplier impact on 45% domestic demand, have 40% *--80 been the main source of 35% -- volatility o f non 30% -- hydrocarbon GDP growth. --ExportsRevenues (right axis) Swings o f domestic investment have been 15%- --30 closely associated with ... 10% -- --20 volatility in oil revenues 5 ~ - -10 (Figure 11.6). Domestic oohT 0 ~ ~ I ~ ~ ~ ~ ~ ~ I ~ ~ investment, dominated by 1991 1992 19931994 1995 1996 1997 1998 19992000 2001 2002 200320042005 (OW) was established in 1995 with implicit saving and stabilization :Volatility of Oil Revenue and the Non- Million LD Oil Fiscal Balance objectives, in periods o f highoil prices, % of GD 40000 - public expenditure was allowed to rise 35000 -- substantially, financed by the fund. By 30000 -- Non-oil Fiscal Balance contrast, because o f the large share of 25000 --.. , government expenditures financed by 20000 -- . , % hydrocarbon revenues, when these I 5 O o 0 -- revenues were on the decline, fiscal looo0 -'Oilrevenue balance was only at times preserved through expenditure compression. The non-oil deficit has thus tended to 9\9Z9'5$96 29 @ (9 @ @ ,99,99\."s,992."2."20"2."200200 6 'I0 9 Q \ Z '5 b 6 increase when oil revenues are on the 44. Since 2000 the non-oil dejkit has increased dramatically. From 1997 to 2001, the ORF operated in practice as a stabilization fund. When oil prices were relatively low during 1998-1999, there were net withdrawals from the fund (at a modest rate o f 2 percent of GDP). Following the surge in oil prices in 2000, the OW'Sbalance almost doubled. However, with a surge o f extra-budgetary expenditure  -21 - starting in 2001, discretionary financing o f such expenditures from the fund reached about 14 percent o f GDP in 2003. The non-hydrocarbon fiscal deficit has thus hovered around 35 percent o f GDP during 2002-2005, up from 17 percent in 2000. Moreover, current expenditure, particularly wages and salaries, has grown very rapidly over time to exceed their earmarked allocation from the budgeted oil revenue (30 percent o f budgeted oil revenues). On the contrary, development expenditure, reflecting the limited absorptive capacity o f the Libyan economy, fell short o f the earmarked oil revenue allocation (70 percent o f budgeted oil revenues). Thus, as further discussed in the next chapter, efficiency o f public expenditure has become problematic. 45. The impact of oil revenues on the money supply has been imperfectly sterilized through imports. Increases inLibya's non-oil fiscal deficit have generally resulted in an increase in money supply. But, at the same time, expenditures have resulted in higher imports, partly sterilizing the increase in money supply through a decline in net foreign assets o f the banking system. As a result, the driving force behindthe monetary expansion inLibya has been the part o f the impulse imparted by the non oil fiscal deficit that did not leak through the balance o f payments. However, the current situation o f excess liquidity could pose a risk for macroeconomic ~tabi1ity.l~The rise in liquidity has not resulted in inflation pressures, as inflation has been disconnected from monetary developments-also reflecting the still pervasive controls on the economy. However, as the factors that led to deflation since 2000 are non-recurrent in nature, it i s expected that in the period ahead, the inflation outcome will depend to a large extent on monetary developments. Over the mediumterm, until effective monetary instruments are developed, the most effective measure to control the rapidgrowth inmoney supplyis to prevent an overly expansive fiscal stance. 46. The downside risks to the fiscal and external positions seem relatively limited. With the price of oil projected to remainat a highlevel, o f around US$60 per barrel in a baseline simulation, the downside risks to the budget seem limited. A sensitivity analysis based on a US$15 decline in oil prices off the baseline shows that the overall fiscal surplus would still remain at around 22 percent o f GDP (IMF,2006). The external current account would also remain in surplus, projected at 27 percent of GDP, so that foreign exchange reserves would continue to build up under this scenario. On current policies, a decline in the oil price o f US$30 below the baseline projection would be required for the fiscal surplus to be absorbed. The required drop inthe oil price for the external current account to turn into deficit would be, all else equal, around US$33. (iii) Strategic optionsfor the use of hydrocarbonfinancial resources 47. Projected high oil revenues will provide finance for growth but will not necessarily spur sustained growth in the non-oil sector. Libya's unsuccessful experiment with the state-driven model o f economic development based on import 13The requiredreservesresultingfrom CentralBank of Libya regulationsare high, representingabove 8 percent of broad money supply. But because of limited lendingopportunities,by the end of 2003, the excess liquidity of commercial banks (as measuredby commercial banks deposits with Central Bank minus requiredreserves) was also high, amountingto 2,8 billion LYD and representing 20 percent of broadmoney supply. InMay 2004, the government boughtback its debt from the bankingsystem, and, as a result, the excess liquidity reached34 percent of broadmoney supply.  - 22 - substitution (see chapter I) drawn attention to the limits o f using the oil revenues has for financing investment o f public enterprises in selected industries. Barring this model o f development, and based on experience and lessons from other oil-producing countries, there seem to exist three broad strategic options for usingthe large financial resources from oil as a means to foster non-oil growth: (i)Using accumulated oil revenues to expand public investment in infrastructure as a means to directly propel non-oil sector growth-but also increase household revenues and thus provide a multiplicative impulse to growth. (ii)Distributingoil windfalls to households, as a means o f bolstering incomes and domestic demand growth, while possibly ensuring a better stabilization mechanism against oil revenue volatility. (iii)Savingpartoftheoilwindfallsforthehture;usingthereststrategicallyto improve human capital and build strong social safety nets, while, at the same time, accelerating the pace o f structural reforms needed for a transition to a market-led economy integrated with the rest o f the world. OptionA 48. I t could be argued that using surplus oil revenues to fund higher public investment may have a better growth pay-off than accumulating savings- Libya uses a large fraction o f oil revenues to finance current and capital public expenditures and the associated non-oil fiscal deficit. Surplus oil revenues are being saved in the Oil Reserve Fund. I s there scope for stimulating growth by using these accumulated savings to expand public investment in infrastructure? Indeed, higher public investment could generate productivity gains by filling "infrastructure gaps" that may increase the cost o f business operation and reduce competitiveness. Filling such infrastructure gaps, especially in transport and Information and Communications Technology, could also contribute to better integration into international trade. Public investment could also contribute to upgrade and expand housing where social needs may be acute. It could also be argued that higher public investment (especially innon- traded goods sectors such as housing) would also contribute to increasing household incomes and could thus have a multiplicative impact on non-oil GDP growth-though at the expense o f higher imports and possibly balance-of-payments vulnerabilities. 49. -but the decisions concerning public investment in (social and economic) infrastructure would better be de-linked from the presence of hydrocarbon windfalls. Despite the attractiveness o f using hydrocarbon windfalls to fill infrastructure gaps and as a direct stimulus o f growth, several considerations would argue for de-linkingoil revenues andpublic investment ininfrastructure: Using hydrocarbon windfalls to expand public investment, instead o f saving part o f the surplus revenues, would not insulate fiscal policy from the volatility o f oil revenues. Demand-driven growth in the non-oil sector would be vulnerable to a downturn inthe price o f oil as past episodes o f shrinking oil revenues have demonstrated. Efficiency considerations would call for public investmentto be driven by the productivity and cost o f public capital. Although the presence o f hydrocarbon windfalls could temporarily lower the cost o f financing public investment, eventually the decisions whether the return to investments i s worth the  - 23 - expense is independent o f hydrocarbon wealth and should be better taken in the context o f medium-termexpenditure planning. InLibya, the development budget already represents a fraction o f GDP significantly larger than in comparator countries, which may suggest limited absorptive capacity for further increases and low efficiency o f spending. 0 Using oil windfalls to finance increases in domestic demand would risk exerting pressure on domestic costs (once most o f the slack inthe labor market i s absorbed). Higher domestic costs, along with a possible exchange rate appreciation due to current account surpluses, would expose the economy to the "Dutch Disease" syndrome-unless strong efficiency and productivity gains offset the increase inunit labor costs. OptionB 50. The intermediation of part of hydrocarbon windfalls through the household and business sectors might produce superior growth performance in the long run. The way hydrocarbon revenues are intermediated matters for economic performance. When the hydrocarbon revenues are exclusively intermediated by the state, as is the case in Libya, the pattern o f expenditures and the amounts allocated to savings and investment may be different from the patterns that would prevail if the rents were transferred to the private sector. Hydrocarbon windfalls may be transferred to households and businesses through different channels-such as lower personal and corporate income taxes; lower indirect and payroll taxes; or through direct transfers. In the case of Libya in particular, direct transfers of hydrocarbon revenues to households could be considered as a welfare-improving substitute to the distorting energy and consumption food subsidies (see chapters I11and V). Although the various instruments have a different impact, when hydrocarbon windfalls accrue to households and businesses private consumption and investment will increase directly, stimulating economic activity in the short run.Increasedhousehold savings out o f oil revenue transfers would also funnel investment, if properly intermediated by the financial system, thus expanding productive capacity and output in the long term. Simulations for some countries have established that when a temporary windfall i s intermediated by the government, the impact i s likely to die out almost completely in the long term. By contrast, with intermediation by the household and business sector the long-term increase in GDP might be sustained (see, for example, World Bank 2003f for the case o f Algeria).14 The dividend distribution policy implemented by the Alaskan Permanent Oil Fund i s an example o f a broad-based intermediation by households (Box 11.3). l4When the windfall accrues to the government, productive capacity increases only indirectly, to the extent public investment in infrastructure boosts private sector productivity, thus producing a somewhat limited impact on output inthe long run. By contrast, when the windfall i s intermediatedby the privatesector investment and productivecapacity expanddirectly in the longterm.  - 24 - ilaska permanent oil fund example of dividend dismbution from oil revenues to rgest oil fields in North America, Alaskans decided to inent Fund each year to eligible Alaskans as a dividend httu:,,'ww\~.apfc.org)was establishedin 1976 in order to :wable source of wealth for future generations. Basically, cording to the law) of all mineral leaserentals, royalties, -sharingpayments, and bonusesreceived by the State are f which is to be used only for those income-producing i eligiblefor permanent fund investments. The fund has permanently and cannot be spent without a vote of the nd decisionsregarding its use are made each year by the State revenue received from oil taxes and royalties goes mding, and 0.5% goes into the Public School Trust Fund. itably distributes resource rents to the people, thereby o land and natural resources. Practically, oil income goes mg Alaskan citizens, not from current oil revenues, but Alaska permanent fund dividends, $2,000 - 1982-2004 $1,500 1 $1,000 3 $500 - 51. Transferring oil windfalls to households may also better insulate the economyfrom the volatility of oil revenues. Effectively insulating the economy from volatile oil revenues calls for saving temporary revenues for the future, with a view to stabilizing expenditure-which should be financed by the estimated permanent oil revenue stream. Experience suggests that governments often fail to do so, either owing to poor governance, or because they find it hard to resist pressures from various constituencies when sizeable financial assets have been accumulated. Governments thus often resort to procyclicalpolicies that exacerbate the cycle o f oil. Libya i s no exception to that rule as examined in the previous chapter. By contrast, there i s ample empirical evidence that the consumption behavior o f households is precisely grounded on their perception o f permanent income. Temporary changes in oil revenues, if intermediated by households, could thus spur savings rather than unsustainable domestic expenditure. and with freedom of capital movements inplace,  - 25 - increased household savings could be diversified in a foreign held portfolio, thus effectively sterilizing the higher oil revenue inflows. Still another option would be to transfer to households the income stream from the accumulated oil revenue savings- as in the case o f the Alaskan Permanent Oil Fund described above. This would mitigate the procyclicalityo f the transfers since the income stream out o f accumulated savings would not be relatedto the cycle o f the price o f oil (see Figure inBox 11.3). 52. Increased household intermediation of hydrocarbon revenues is an option that requires careful design and should go in tandem with considerable strengthening of the investment climate. Direct transfers o f hydrocarbon rents to households should be appropriately designed so as not to distort incentives to work. In addition, if the investment climate i s weak, higher household and business sector revenues out o f hydrocarbon windfalls may boost private consumption but fail to be spontaneously converted into productive investment. This risk may be especially relevant in Libya, where-as further explained in chapter IV-weaknesses in the investment climate, constraints to the efficient use o f resources, and still poorly functioning institutions (including the banking system) hinder the mobilization o f savings and private investment. Shifting to a different model o f intermediation o f the hydrocarbon revenues may thus help unlock the economy's long-term productive potential, provided the necessary reform initiatives to strengthen the investment climate and promote the efficient use o f resources are phased inat the same time. The authorities are encouraged to consider the possibility o f implementing this option in the long term, accompanied by progress on the structural reform front. Option C 53. Using the oil windfalls strategically, to facilitate the transition to a competitive, market-led economy, is a superior optionfor fostering non-oil growth and job creation in Libya. As further explained in the next section, achieving fast and sustained growth over the medium term would call for well-coordinated initiatives to accelerate the transition to a market-led economy fully integrated with the rest of the world. Contrary to the transition economies in Eastern Europe and Central Asia in the early 199Os, Libya has built a comfortable financial position, thanks to high oil prices since 2000, and can afford the cost o f safety nets needed to cushion the adjustment o f the transition to the market. This would greatly help step up the pace o f required reforms-an important condition for a successful transition to a dynamic market-oriented economy. Indeed, evidence from the economies intransition suggests that the quicker a high level o f liberalization i s reached and sustained, the sooner the economy can attain higher growth (Box 11.4). Strengthening Libya's human capital assets i s also an important requirement for improved competitiveness and successful integration in the international economy. This third option would therefore call for using part o f Libya's surplus oil revenues both for designing efficient safety nets and for enhancing the quality o f human capital. The rest o f surplus revenues should be saved for stabilization purposes or for future generations. A variant o f this option could also allow some fraction o f the oil revenues to be reinvested in the oil sector, to expand and modernize production capacity and take advantage o f high oil prices. Increasing investment inthe exporting sector would not risk boosting domestic costs and disruptingcompetitiveness, as long as the extra oil revenues from greater production capacity are saved. In due time, a combination o f  - 26 - options B and C could be envisaged, with an increasing part o f surplus oil revenues progressively transferredto households. 54. Making strategic use of the hydrocarbon revenues calls for strengthening public finance management over the medium term. The analysis o f the reform agenda associated with the third option outlined above constitutes the main thrust o f this report. However, a prerequisite for implementing this option is a serious reinforcement o f public finance management. A strong framework for budget formulation and execution, combined with expenditure discipline and sound practices for management o f oil windfalls, would help meet several simultaneous challenges: 0 Establishing strategic priorities in the use o f oil revenues, to improve human capital and buildsocial safety nets for the transition; 0 Anchoring the transition on macroeconomic stability-by insulating the fiscal stance from volatile oil fiscal revenues, and securing fiscal sustainability inthe face o f a possible fall in the price o f oil, social expenditure pressures, and the contingent liabilities o f the public sector (e.g., the non-performing loans o f public banks). Macroeconomic stability i s an important anchor o f the transition as it allows to: (i)improvevisibilityandmitigaterisksforinvestors; (ii)hedge against external current account pressures incase of a sustained drop in the price o f oil, which could put the reform program and Libya's trade integration at a risk o f backtracking; (iii)secure the sustainability of social protection expenditures and safety nets designed with the aim o f absorbing the social cost o f the transition. 0 Coping with domestic cost pressures that stem from overspending large oil revenues ("Dutch disease" effects); 0 Saving for future generations in order to secure long-term fiscal sustainability and preserve inter-generational equity.  - 27 - 55. Maintaining long-termfiscal sustainability would require a savings strategy over time, because hydrocarbonfiscal revenues are exhaustible. Libya, as most oil- producing economies, can afford the "luxury" o f a large non-oil fiscal deficit, to the extent the revenues from oil resources can secure a sufficient and stable financing over time. However, although in practice oil reserves may extend over a long period o f time, based on inter-generational equity considerations, the country should eventually prepare for being an economy without oil. The savings strategy should aim at accumulating substantial assets, with two options inmindregarding the use o f these savings inthe long term: 0 The income stream from the accumulated assets could be used to finance the non-hydrocarbon fiscal deficit once hydrocarbon resources have been depleted. In a sense, this strategy would aim at transforming an exhaustible stream o f hydrocarbon revenue into a perpetual stream o f financial revenue through appropriate savings over time. This would allow maintaining a large non-oil deficit even after the country runs out o f oil revenues and keeping taxes low. 0 The alternative would be to finance the non-hydrocarbon deficit by gradually drawing down accumulated assets once hydrocarbon resources are exhausted, while, at the same time, progressively increasing taxation to ensure long-term fiscal sustainability, when the accumulated savings are depleted. This option mightbe considered ifthe real rate o f return on accumulated savings (a mix o f bonds, stocks and real assets) were significantly lower than the rate o f return on productive investments that could be financed by drawing down savings. The level o frequired savings accumulation would be different ineach case. Issues related to public finance management are discussed in further detail inthe next chapter. C. EnablingThe "New Economy", LedBy The PrivateSector, To Gain Strength-A PreconditionFor Faster NonOil GrowthandJob Creation 56. Weak non-oil GDP growth reflects both insufficient investment and low productivity of capital- At about 16.7 percent o f non oil GDP on average during 1998-2003, investment in the non hydrocarbon sector remains low compared, for example, to neighboring countries inNorth Africa (Table 11.5). The weak investment effort i s holding back non oil growth. But an additional drag on growth comes from poor productivity, as reflected in the very high Incremental Capital Output Ratio  - 28 - (ICOR-the inverse o f the marginal productivity o f inve~tment).'~The ICOR remains about 60 percent higher than in Algeria and 90 percent higher than in Tunisia, signaling a low return to non hydrocarbon sector investment. This reflects the inefficiencies o f the state-driven model o f economic growth, but also the impact o f sanctions and o f the isolation from the international economy. Libya 1.8 16.7 9.4 Tunisia 4.8 23.6 4.9 Algeria 4.2 24.8 5.9 57. -while the growth of laborproductivity in the non-oil sectors has also been negative- The low capital productivity observed in Libya may, to some extent, reflect the use o f capital-intensive methods o f production-a heritage o f the command economy o f the past. However, the productivity o f labor inthe non-oil sector points to a similar weak performance, with negative growth during most o f the 1990s and average annual growth hovering at around -2 percent (Figure II.8a). Negative productivity growth has persisted inmanufacturing since the mid-I990s, and has been observed also in services (the main driver o f non-oil GDP growth) and agriculture (Figure II.8b). Usual caveats apply to these estimations due to the weak quality o f data-especially on employment. Figure II.8: Trends in labor productivity growth (a> LaborpmdwhwtygmMhinIte mfvilseclor(1997pnces, in%) - _ _ _ Laborpmductivitygrowth bysecbr(1997prices,in%) .............. .-................................ _......_. 61 .*J V 95 8 2oi Manulactunw . ..... -_ 1991 1992 1993 1994 1995 1996 1997 1998 1999 2030 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 58. - a n d tentative estimations suggest negative Total Factor Productivity (TFP) growth in the non-oil sector. Estimations o f TFP in Libya are much more hazardous, owing to the absence o f reliable capital stock estimations. Some very tentative calculations-based on a hypothetical capital/output ratio o f 2-suggest a 15 The GDP growth rate in the non hydrocarbon sector can be calculated as the ratio between the investmentratio andthe ICOR. For a given investmentratio, the higherthe ICOR, the lower the growth rate.  - 29 - slightly negative growth o f TFP over the 1990s (Box 11.4). Non-oil GDP growth seems to have been mainly driven by employment growth, in line with the negative growth o f labor productivity recorded during most o f this period (Figure II.4a). The contribution o f capital accumulation to non-oil GDP growth seems rather limited (less than half the contribution o f labor), in keeping with the relatively low investment ratios observed inthe past (Table 11.5). Ccnbibdior6loNan011GDP gmw (1997 pnces,in%) 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 59. Improving efficiency and productivity growth is the precondition for faster growth and a greater investment effort. Over the medium term, sustaining a growth rate o f about 5.5 percent would require a significant increase in the investment ratio, to around 25 percent o f GDP. But this would also call for a substantial improvement inproductivity, bringing the ICOR down to around 4.5, a level similar to that seen in comparators. This would require significant improvements in efficiency, leading to sustained, positive TFP growth. Indeed, faster GDP growth, in the short term, will come from efficiency gains and a turnaround in productivity growth. With stagnant productivity, combined with distortions (administered prices, entry barriers) and dysfunctional product and factor markets, profitability remains low and there i s little scope for the much needed greater private investment. As explained in chapter IV, important regulatory and institutional reforms would be required to strengthen the investment climate, promote efficiency, and increase the productivity o f investment. 60. I n Libya, as in other oil-producing economies, strongproductivity growth is also a prerequisite for competitive diversification out of hydrocarbons. Large hydrocarbon revenues often make it difficult for oil-producing economies to achieve competitive diversification out o f hydrocarbons in traded goods. These revenues tend to exert pressure on domestic costs and the exchange rate, thus hampering the competitiveness o f traded goods sectors ("Dutch disease" effect). This may be particularly true in Libya, where highper capita oil revenues would tend to increase  - 30 - real wages in the long tern. It i s thus particularly important that competitiveness be supported by strong labor productivity growth, driven by improved corporate efficiency, use o f modern technology, performing business services, and continuous improvement inlabor force skills. fUF2CtiOniHg markets in place, Figure 11.9: Oil revenuesand growth potential in services private investment would take 4500 - - - .-.-- - - __ advantage of unrealized potential 4ooo . Per capita GDP inServices(in US $.) for growth and diversification. High per capita oil revenues may exert pressure on labor costs, but 2000 . 3500;/ they also create potential for growth 1500 ~ 1000 - in non traded sectors, such as 4 4 500 - construction and services. Services i s .* a good example o f a sector where 0 1000 2000 3000 400C Per capita hydrocarbon revenues(in US $, 2002) Libya presents unrealized potential 62. Growth of services would hold benefits for job creation- Growth in services will directly create employment for Libya's population. The potential for direct job creation i s important, because inLibya services provide jobs to a relatively smaller fraction o f - the total employed population compared to Figure11. 10: Employmentby economic activity countries with a similar level o f per -. - . :mploymnt by economic activity (in % of total) capita GDP (Figure 11.10). In comparison to these countries, Services IIndustryandconstruction OAgnculture Libya's employment i s relatively higher in industry and construction 60 50 (also reflecting large public work 40 programs such as the Great Man- 30 Made River) and about the same in 20 10 agriculture. Moreover, efficient 0 services-especial1 y in transportation, trade, and information and communications technologies- will improve efficiency and productivity growth in the industrial sector o f the economy, and thus contribute to a much needed improvement incompetitiveness. The competitiveness o f the tourism sector, that has a great potential to expand, will also be enhanced. Efficient services are thus an important precondition for an increase in private investment andjob creation inthe economy as a whole. 63. -and could offset part of the adjustment costs of the transition to the market. With the fraction o f employment in services in total employment about 10 percentage points lower than in other upper middle-income countries, diversification and growth in services i s strategically important in the transition to the market. In comparison to this unrealized potential in services, employment in manufacturing-  - 31 - where jobs, in state-owned enterprises, are most vulnerable during the transition- represents only 12 percent o f total employment. Realizing the potential for employment growth in services would provide an important cushion to job losses in manufacturing, even in the extreme case where 8 out o f 10 manufacturingjobs were to be temporarily lost. 64. Efficiency in sewices would be a key determinant of Libya's long-term living standards, requiring a strong investment climate, close integration with the world economy- With a given hydrocarbon endowment per capita and oil prices, in the long run, productivity in services will be a critical determinant o f income per capita and living standards. Efficiency in services would require competition- supported by dismantling state monopolies and promoting a liberal FDI regime-and a high-quality legal and regulatory infrastructure. Accession to the WTO would provide a coherent framework for promoting both the trade liberalization agenda and a strong investment climate in services. With the right framework in place, Libya could also develop potential for services exports, exploiting its proximity and links with Europe, the Arab world, and Africa (for example, in high-end tourism, transportation, finance). 65. -and a steady improvement of workers' skills. Developing excellence in services requires a conducive regulatory environment, but experience suggests that human capital i s among the main drivers o f service performance (Pilat, 2000). This i s so for several reasons: (i) traditional services are labor-intensive and people are Many the main resource; (ii) Innovation in services i s strongly dependent on the skills, expertise and experience o f service workers, as their tacit knowledge and experience with customers are crucial to the development o f new service products or processes; (iii) performanceiscloselylinkedtotheinteractionbetweentheconsumer Service and the service provider, with the quality o f the service provided depending greatly on service workers' skills; (iv) The extensive use o f ICT in many services requires workers who are sufficiently skilled and familiar with these technologies. Investment inhuman capital is thus an important component of services sector performance and calls for continuous training and updating o f skills. A broad education policy, emphasizing multidisciplinary, lifelong learning, will be crucial to developing such skills. 66. Furthering the transition to a market-oriented economy is the key to improve efficiency andproductivity growth. The transition to a market-led economy will encourage private (domestic and foreign) investment and the creation o f new firms willing and able to compete in open markets. It will also support the much needed improvement in efficiency and productivity growth, by removing existing constraints to the efficient use o f production factors. The Government has embarked on an important program o f first-generation reforms to promote a more competitive environment for doing business, by reducing trade protection and unifying the exchange rate. It also intends to accelerate the pace of privatization o f public enterprises. Key initiatives undertaken by the government are reviewed inchapter IV. 67. Establishing a framework that guarantees property rights and the rule of law is the precondition for the transition to a market-led economy- In market economies, law defines the rules o f the game and gives individuals the rights and tools to enforce them. Where the rule o f law i s in force, laws and regulations are  - 32 - applied fairly and transparently. The state becomes mainly responsible for enforcing the law. Legal frameworks are particularly important to create the right incentives for private sector development, because transition involves changes that require entry o f new firms, exit o f unviable firms and increased competition. To that purpose, economic laws have at least four functions: defining and protecting property rights; setting rules for exchanging these rights; establishing rules for entry into and exit out o f productive activities; and promoting competition by correcting market failures. Early on, transition economies have to draft and enact legislation inthe fundamentals areas o f property, contracts, company organization, bankruptcy, and competition. Moreover, in an environment o f transfer o f assets from the state to private hands, in conjunction with price and trade liberalization, enforcing the rule o f law i s crucial to avoid asset stripping, impose discipline and encourage private initiatives. 68. -and should go in tandem with continuing reforms on twofronts: Creating a strong investment climate, by promoting a high-quality regulatory framework for investment (limiting regulatory risk and discretion), with open and functional product and factor markets. This would be key to encourage domestic investment and attract foreign investment-which Libya needs not mainly as a source o f finance but as a source o f improved technical and business know-how. Pursuing public enterprise reform and privatization. With about 75 percent o f total employment inthe broader public sector, reforming public enterprises i s key to fostering efficiency and productivity growth. Privatization o f public enterprises is an important element in any effort to improve corporate efficiency and performance, but has to go intandem with the creation o f open and competitive markets for all potential investors. At the same time, it i s important that hard budget constraints be imposed on distressed public enterprises, so that they face sufficient incentives to restructure and compete in open markets. The main lines o f the reform agenda on these two fronts are further elaborated in chapter IV. 69. Promoting a financial system providing payments services, mobilizing savings, and efficiently allocating financing for investment is a key underpinning of a well-functioning market economy. Well-functioning financial systems ensure firms the ability to seize emerging investment opportunities and reduce the reliance o f small firms to internally generated cash. They alsoimpose on firms, discipline Figure11.11: Domesticcredits,YOof GDP thus drivingefficiency, both directly and Domedic credit in%of GDP (2003) by facilitating new investment and 1 4 0 ~-- .. market entry. According to empirical I :::I evidence, doubling private credit as a share o f GDP i s associated with an increase in average long-term growth o f almost two percentage points (World Bank, 2004). InLibya there is substantial room for gains, as credit to the private sector i s still very limited, and total domestic credit is a small fraction o f  - 33 - GDP compared to other upper middle-income countries-including oil-producing countries (Figure 11.11). Banking represents the backbone o f the Libyan financial system, but the operation o f banks has been hamperedby widespread state ownership, a long tradition o f directed credit to state-owned enterprises, controlled interest rates, and absence o f credit culture. The government has embarked on a program to strengthen the banking system, privatize the state-owned banks, and promote the financial industry outside the banking system. Priorities in financial sector reform are reviewed inchapter V. 70. Effective and sustainable social protection would facilitate a smooth transition to a market-oriented economy. The positive effects o f the transition on the economy and on standards o f living will be balanced by greater economic risk and uncertainty among the population. The social protection system takes on an important role inmitigating economic shocks to individuals and households, when the economy will observe reallocations o f labor and capital across sectors. Particular attention needs to be given to vulnerable population groups, which have fewer means to deal with risks and are less well equipped to take advantage o f new economic opportunities. Within a sound fiscal framework that secures fiscal sustainability, Libya's comfortable financial position associated with sizeable oil revenues could be used strategically, with the aim o f reducing the social cost o f the transition to a competitive market economy, by financing well-designed safety nets, tax reform, and investment in human capital. These issues are discussed in further detail in chapter VI. 71. Summing up, Libya faces a simultaneous policy challenge in the years ahead: 0 Making optimal use o f the hydrocarbon financial resources, to facilitate the transition to a market-led economy, cope with volatility, and secure fiscal sustainability over the medium- and long-term. Enabling the "new economy", led by the private sector, to gain strength-a precondition for faster non oil growth andjob creation. Risingup to the first challenge calls for strengthening public finance management, as further explained in chapter 111. Addressing the challenge of the transition requires well coordinated initiatives on the three-pronged reform agenda outlined above: (i) Buildinga strong investment climate; (ii) promoting financial sector reforms; and (iii) designing an efficient social protection system. Challenges in theses areas are reviewed in chapters IV, V, and VI. At the same time, improving the quality o f Libya's human resources and the quality o f governance are crucial undercutting issues o f the reform agenda over the medium term. These issues have not been analyzed in depth at the current stage, so that the report i s limited to some preliminary observations summarizedbelow. D. The Challengeof ImprovingThe Qualityof GovernanceandEducation 72. To implement the reform agenda outlined above, the role of the State would have to change. Over and above the need for strong political will to spearhead and champion the reforms, the State would also have to rise up to the double challenge o f increasing its role as a regulator while decreasing its role as an interventionist. This would entail an increase in the capacity to regulate markets, enforce decisions, and  - 34 - ensure a level-playing field among market participants by providing strong, effective and reliable public services and market institutions (customs, tax authority, competition authority, judicial bodies). It would likewise mean that the State accepts to let the private sector play a stronger role in land and credit markets, in the investment process and in the provision o f services to enterprises and o f infrastructure, and in the production o f those goods and services that do not exhibit public good or strategic features. (i) Governance 73. Improving the quality of governance deservesparticular attention because it underlies the development reform agenda. Progress on the three priority fronts (improving the investment climate, enhancing social protection, strengthening public finance management) will call for mutually reinforcing initiatives to improve the quality o f governance. There i s growing evidence that good economic governance i s critical to foster private investment; take advantage o f increased global flows o f information, goods, and capital; and improve resilience to shocks (World Bank, 2003a, also see Box 11.6). and experience from the transition economies in the 1990s has shown that key to a successful transition i s the quality o f governance in a country (World Bank, 2002). As discussed below, establishing an enabling environment for a competitive private sector would call for initiatives to promote transparency and predictability of regulations, and institutions to support the competitive functioning of key markets (efficient judiciary; regulatory framework for labor and land markets). Transparency and effective enforcement o f "hard budget constraints" would also be a key underpinning o f a successful public enterprise reform and privatization program. The challenge o f improved governance i s also at the core o f the financial sector reform agenda-for example to strengthen governance and operational autonomy o f public banks; upgrade banking supervision on a risk-based approach; and improve corporate transparency. Libya i s also facing challenges in public sector management and internal accountability. Rising to the growth challenges would call for further strengthening public sector governance in a number o f areas. As explained below, initiatives should focus on improving the comprehensiveness and transparency o f the budget, by eliminating off-budget spending practices and integrating the Oil Reserve Fund in the budget. Public finance management should be cast in an appropriate medium-term framework that takes into account the need to insulate the economy from the volatility o f oil revenues and ensure fiscal sustainability. Strengthening the efficiency o f public service delivery, especially in social sector policies, would call for transparent interventions by eliminating the extensive implicit subsidies, appropriate incentives in the civil service, and better institutional arrangements for fiscal decentralization. 74. Unfortunately, at the present time, various measures of the quality of governance rank Libya very poorly compared to other countries. Although there seems to be an improvement, since 1998, in the different measures, except voice accountability, Libya consistently appears in the group o f countries rated as having  - 35 - very poor governance (Figures 11.12a-f). l6 These indicators o f course only reflect perceptions o f international investors, rather than actual facts and data on corruption and government efficiency. However, such perceptions are extremely important to investors, and they usually reflect a significant share o f the reality o f governance in a country. A weighted average o f three indexes: rule of law, bureaucratic quality and corruption, as measured in 1982. Source: World Bank, 2003a l6These indicators (compiled by D. Kaufmann, A. Kraay, and M. Mastruzzi, 2003) reflect the statistical compilation of responses on the quality o f governance perception drawn from 25 separate data sources constructed by 18 different organizations: large number of enterprises, citizens, expert survey respondents in industrial and developing countries, survey institutes, commercial risk-rating agencies, think tanks, non-governmental organizations, and international organizations. The ranking is presented in percentile. It indicates the percentage of countries worldwide that rate below the selected countryiregion (subject to a margin of error) at a certain level of confidence. For instance, a rate of 75% means that 75% of the countries rate worse and an estimated 25% of the countries rate better than the consideredregiodcountry. Higher values imply better governance ratings.  - 3 6 - 75. Unless the state of governance and the efficacy of the government are improved, even a technically well-designed economic reform program is likely to fail. The Government should embark on an ambitious administrative reform program to fight against corruption, to promote transparency and accountability. The actual effects o f such programs will only materialize over the medium to long run, but the impact on the perception o f foreign investors who are today quite hesitant towards the Libyan market should be significant. Figure 11.12: Libya governance indicatorsin international perspective Control of Corruptlon Rule of Law 90 80 1 80 1 70 70 60 60 50 50 40 40 30 30 20 20 10 10 0 0 l l 9 9 6 0 1 9 9 6 02000 0 2 0 0 2 1 2 0 0 4 1996 1998 ozooo ozooz m2004 (b) Government Effectlvenerr 8o 1 Rugalatory Quallty 70 60 dl 60 70 50 60 40 50 30 40 30 20 20 10 10 0 0 I 1 9 9 6 0 1998 0 2 0 0 0 0 2 0 0 2 1 2 0 0 4 1 1 9 9 6 0 1 9 9 8 0 2 0 0 0 02002 1 2 0 0 4 Polltlcal Stablllty Volce and Accountability 80 1 ' O 1 b . - 6 I 1996 0 1998 02000 02002 m2004 B 1996 0 1998 02000 02002 .ZOO4 (e) (0 Source: D. Kaufmann, A. Kraay, and M.Mastruzzi, 2003  - 37 - 76. Improving governance is key to successfully managing thepolitical economy of reforms in the transition to the market. Dealing with political economy issues is perhaps the single most important determinant o f a successful transition to the market (Box 11.7). This i s so because the transition to the market entails costs and benefits which are unevenly distributed. Disciplining the "old economy" entails short-term costs, while gains from the emergence o f the "new economy" will require a longer term horizon to accrue. Moreover, winners tend to be a diffuse constituency (because o f the longer term horizon o f the gains from reforms), while losers are concentrated. The uneven time profile o f costs and benefits, along with the uneven distribution o f winners and losers, may reduce the pace o f reforms needed to discipline the old sector. However, experience from transition economies suggests that, despite the costs involved, policies to encourage the emergence o f the "new economy" have to go hand-in-hand with enforcing discipline on the "old economy". It is important that reforms lead to a rapid establishment and effective functioning o f the institutions that encourage entry and competition and to implement policies that offset the costs o f the transition to vulnerable groups. 0 R - Extentofreforms %eseaorwoka they exit the state sector. Moreover, they realize policy and institutional reforms to promote and prchs and insiders have de factor control rights of liberalization and privatization. They gain in discipline and encouragement. But these gains 3n and market entry. at winners and losers from reforms do play a d managers may oppose enterprise restructuring ies leading to price increases such as removal of Ierty rights before privatization allows insider ~lishmentof clear property rights and corporate rmfreeze", a situation of partial reforms towards nment characterized by an uneven playingfield. mswhen they reach acertaindegree ofreforms, ;ee reforms stopped is highconsidering that two ig incomes after R,. This has led to a so-called nainly CIS countries, in which governments lack appear credible to potential new entrants in its ficult process of economic reform. Government )rn usingtheir initial advantages to ruinhrther  - 38 - 77. Civil societyparticipation in thepolicy making, monitoring and evaluation is invaluable to the success of reforms in transition. Key among components o f a vibrant civil society are NGOs, consumer and producer associations, and the media. Their participation tends to foster a public debate whereby the nature o f the costs and benefits o f reforms, as well as their respective horizons, are unveiled. Broad and genuine representationi s also key to constrain the power o f interest groups to capture the state duringthe transition. (ii) Education 78. Improving the quality of education is a key enablingfactor for medium-term growth. Improving the quality o f Libya's human resources will be essential for it to improve labor productivity, diversify its economy-especially in services-and compete in the global economy. The ability o f the education system to equip individuals with skills that allow them to take advantage o f the increased opportunities that a dynamic and changing economy offers i s also crucial for a successful transition to the market. With high enrollment rates at all levels o f the system and thus highcompletion rates the Government and families should be ready to turntheir attentionto continually improvingthe quality o f schools and learning. 79. The model of public provision andfinancing of education services in Libya has been successful in expanding access and improving macro indicators of educational attainment, but gender and regional inequalities persist. The country has achieved universal enrollment in primary education and, at 14 percent o f the population older than 15 years o f age, the illiteracy rate is among the lowest in the region. This i s an impressive improvement relative to the early 1960's when 40 percent o f the adult population was illiterate and only 60 percent of the relevant age group enrolled in primary education. The illiteracy rate among women, however, i s still more than twice than among men (22% Vs. 8%). There are also large variations by region. In Sharatat Elula, Jabel Elgharbi, and Kahlij Sirte illiteracy rates are above the national average.  - 39 - 80. The level of public expenditure in the sector is among the highest in the world. In 1997, Libya spent 7 percent o f its GDP inthe education sector - all levels comprised - o f which 82 percent were allocated to current education expenditures. The few countries with similar or higher levels o f spending include Sweden (7.7%), Denmark (8.8%), Malaysia (7.9%), and Lesotho (10%). Rich countries with traditionally generous education systems such as France and Germany spend 5.8 and 4.6 percent o f GDP respe~tive1y.l~While the current level o f spending i s unknown," it is likely to be higherthan before. Indeed, the number o f teachers has been growing at an average o f 7 percent per year while real GDP stagnated. Thus, unless wages have sharply deteriorated in real terms, their share in GDP must have increased. At the sametime, the development budgethasbeen growing faster than real GDP. 81. I n basic and intermediate education there are concerns regarding quality and the efJicient use of resources. As shown in Figure 11.8, student teacher ratios have fallen sharply over the past 10 years, leading one to think that learning and other indicators would be improving concomitantly. However, standard measures of internal-efficiency o f the education system such as repetition and dropout rates and international comparisons o f learning assessments in math and sciences are not yet available in Libya. Without information to diagnose adequately the quality o f the Libyan education system, policy makers cannot make sound decisions on what needs to be done to improve the system. It i s not clear what impact low student teacher ratios have had on school quality. Teachers reportedly have little motivation to promote students excellence, as remuneration and promotion policies are disconnected from their performance in class. While the Government has rightly sought to give more autonomy to schools, governance structures and budget allocation policies do not provide incentives to use resources efficiently and contain costs. Schools managers are appointed and removed by the municipalities and often have pressure to act as employers o f last resort. It i s estimated that 20-30 percent o f teachers are not teaching. Parents do not participate in the governing body o f the schools. Budgets to schools are allocated on a historical basis taking into account new hiring o fteachers and administrative staff. 90191 91/92 92193 93194 94/95 95196 96197 97198 98/99 Source: World Bankcalculationsonthe basis ofhouseholdsurveyreport. Clearly, a better measure for international comparisons i s the level of expenditures per student expressed as a share o f GDP per capita. Unfortunately for other countries this information is disaggregated by education level, which is not the case in Libya. 18 . Since 1998, the government has been devolving management responsibilities to local governments (municipalities), ineducation and other sectors. Mechanisms to ensure that expenditures at the sectoral level are reported back to the central level still needto be put inplace.  - 40 - 82. I n higher education, centralized planning is generating an oversupply of graduates who, in the absence of government intervention, would fill the ranks of the unemployed. Among those high school graduates who continue their studies, 82 percent enroll in universities, compared to 50 percent in the 80s. It i s estimated that each year there are 27,000 new university graduates entering the labor market - or close to 1.5 percent o f the labor force. Most o f them seem to have trouble finding a job inthe private sector. The public sector has been the employer o f last resort. The problem is that investments inhigher education are being distorted by artificially low costs and the prospects o f job security in the public sector. Without mechanisms to ensure that university programs are preparing students for jobs in the private sector, there will continue to be a mismatch between the number o f university graduates and their skills andthe demands ofthe private sector. 83. If the economy is to diversib away from the public sector and gain competitiveness while improving opportunities to vulnerable groups, the education system will need to adapt. Some o f the issues that will need to receive attention include: (i) reviewing governance, management and budget allocation processes to promote a continual focus on improving quality and efficiency inresource utilization; (ii)improving the relevance and pertinence o f programs at the post-primary levels to improve young people's chances o f finding a job in the private sector and better respond to future market demands; and (iii) buildingcapacity to set educationpolicies and to measure and monitor educational outcomes at the school and regional level. Further analytical work and policy dialog will be required to define a comprehensive reform strategy for the education sector.  -41 - 111. THECHALLENGEOFSTRENGTHENING PUBLICFINANCE MANAGEMENT A. Libya'sPublicExpenditureSystemInThe InternationalContext 84. Public expenditure in Libya is high by international standards. Consolidated public expenditure and net lending (General Government level, including extrabudgetary spending and transfers from the Figure111. 1: International ComparisonTotal social security fund, but Expenditure,% ofGDP, average 2000-2004 excluding implicit subsidies) i s estimated at 41 percent o f GDP on average during 2000-2004. This level o f public spending 41 42 exceeds levels recorded in -33 - - 36 36 - economies in transition in East 24 - 21 1 - Europe and Central Asia and in -8 fast-growing MENA countries such as Tunisia (Figure 111.1). I - Propped up by buoyant hydrocarbon revenues, public expenditures have soared by 128 percent innominal terms between 2001 and 2005, while the size o f nominal non hydrocarbon GDP over the same periodhas grown by only 36 percent. Judgments on whether the consolidated level o f public expenditures i s "right" in any particular country are difficult, because much depends on cultural factors, the extent o f social safety nets, and the efficiency o f public expenditures. In view o f existing distortions in the mechanisms for allocating public resources in Libya (sizeable off-budget spending; implicit subsidies; overstretched decentralization-see below) the potential for efficiency gains in public expenditure management seems significant. Realizing this potential would allow significant savings in public spending. and increasing efficiency inpublic expenditure would allow better management o f the non-oil fiscal deficit, the latter being a precondition for macroeconomic stability and for the sustainability o fpublic expenditure inthe face o f volatile oil revenues. 85. Initiatives are being taken to reduce the large part of expenditure that was off budget. Almost a third o f government expenditure was off budget in 2004, whereas in 1999, extrabudgetary expenditure was only 6 percent o f GDP. Off-budget spending has increased over time to reach a peak o f 23 percent o f GDP in 2003 and half o f total general government expenditure (IMF, 2006). This trend is associated with the increase in hydrocarbon revenues over time. (Table 111.1). Attaining fiscal discipline i s difficult when such a large share o f expenditure i s not integrated in the budget.Further, extrabudgetary spending decreases transparency in the allocation o f public outlays among alternative ends, thereby complicating the formulation o f fiscal policy and increasing the likelihood o f inefficiency in public expenditure. Recent developments indicate an improvement as estimated extrabudgetary expenditure has beenreduced in2005 to 4.2 percent o f GDP.  - 42 - Table 111. 1: Budgetary and ExtrabudgetaryExpenditure,YOGDP 1999-2005 1999 2000 2001 2002 2003 2004 2005 Total expenditure 32.8 31. 3 44.3 41.2 44.6 44.0 41.2 Current 26.0 21.1 34.3 27.5 35.2 26.2 16.4 Capital 6.9 10.2 10.0 13.7 9.4 17.6 19.3 Net lending 0.0 0.0 0.0 0.0 0.0 0.3 5.4 Budgetary 26.6 25.9 28.0 29.1 21.4 32.1 33.4 Extrabudgetary 6.3 5.3 13.9 17.1 18.7 9.2 1.6 Source:IMF(2006) 86. Lib a spends relatively more on wages and salaries than other economies in transition.' The government wage bill was about 11 percent o f GDP on average over 2000-2004, lower than in some MENA countries, but above levels seen in transition economies in Eastern Europe and Central Asia (Table 111.2). Given the substantial volatility o f oil revenues, this high level o f expenditure on wages and salaries adds rigidity to Libya's budget. Moreover, the size o f the wage bill could further increase in the near future because government wage levels have not been increased since 1981 and may needto be adjusted. Table 111.2: Budgetary Expenditure,International Comparison,YOGDP, Average 2000-2004 Other Wages Purchasesof Subsidies Capital and Goods and and Current Expenditure Salaries Services Transfers* Azerbaijan 4.3 4.6 5.1 9.7 Estonia 3.2 7.6 9.3 15.8 Georgia 1.6 3.3 5.5 5.7 Latvia 3.6 7.0 7.8 16.5 Moldova 3.3 7.1 7.5 11.6 Poland 3.0 6.8 10.2 19.5 Tunisia 7.7 12.1 2.1 2.7 Libya 12.2 10.6 3.9 1.9 'Includes Subsidies andother Transfers, Social Transfers and Subsidies to the economy 87. Libya's development budget is relatively large compared to that in other economies in transition. Over the period 2000-2004, the share o f capital expenditure inGDP was well below 8 percent inmost ofthe comparator countries shown inTable 111.2, while Libya allocated 12 percent on average o f its GDP to the development budget.The efficiency o f allocating such a large proportion of GDP to investment in Libya i s questionable, given the limited capacity o f the economy to absorb investment. l 9These international comparisons on the allocation of public expenditures should be interpretedwith caution, owing to the significant size of extrabudgetary expenditure in Libya. Moreover, the preparatory mission was not in a position to review in a meaningful way the functional allocation of public expenditures, because for a significant part of the administrativebudget (60 percent) executed by the regions the information on the allocation of expenditure by government functions is not readily available.  - 43 - 88. Explicit subsidies and transfers have grown significantly. In2004, subsidies, mainly for food, and other transfers in the budget represented 2.1 percent o f GDP. Food subsidies have grown by a factor o f 5.5 between 2000 and 2005, boosted by large hydrocarbon revenues. In 2005 flour subsidies (amounting to half of food subsidies) were almost equivalent to the administrative budgets for justice and foreign affairs combined. Inefficiencies related to the design o f food subsidies are further examined in chapter VI. Pension benefits paidby the Libyan Social Security Fund are the equivalent o f 1.4 percent o f GDP (see chapter VI). Other transition economies with a strong tradition o f social protection spend more than 15 percent o f GDP in transfers, and the relative share o f transfers i s also higher in the neighboring country o f Tunisia. 89. -but implicit subsidies are sizeable. Implicit subsidies are channeled to the economy mainly through fixed low consumer prices, for example for gasoline-and production subsidies, for example for fuel used in electricity production. Directives to state-owned enterprises to charge below-market prices to consumers provide benefits that might otherwise be financed directly by subsidies from the budget.The pricing o f petroleum products in Libya involves large quasi-fiscal expenditures o f this type. In late 2003, for instance, the price o f gasoline at the retail level was around half the free on board price inthe Mediterranean. Thus, in2003, implicit subsidies are estimatedto be equal to just under a fifth of total government outlays (18.5 percent), or about 7 percent o f GDP (Table III.3).20 Table 111.3: Implicit subsidies for oil productsand derivativesand associated deadweightloss estimatedat average international prices in 2003 Note: See Box 111.1 for methodof calculation. 90. Implicit energy subsidies result in significant efficiency costs- Subsidization keeps the price o f energy products (and thus the marginal utility to consumers) at below marginal revenue (the export price in the free market), and therefore results in efficiency costs. Because o f the diminishing marginal value o f increased domestic consumption o f energy products to consumers, the loss in government (export) revenue from the subsidization outweighs the associated increase inthe consumer surplus (also see Gupta et al., 2002). The resulting"deadweight loss" i s a non-linear function o f the gap between the domestic and the border price o f energy products. In2003, the efficiency loss inLibya i s estimated at about 3.7 percent The costs to Libya would have been far greater if May 2004 international prices had applied. Inthis case, subsidies implicit in 2003 consumption were roughly 123% of 2003 government capital expenditure, over half (55%) of total budgetary expenditures, and over a quarter (29%) of total government outlays.  -44 - o f GDP for the four main subsidized energy products (excluding kerosene, see Table 111.3, and also Box 111.1). 91. -and missed opportunities to improve consumer welfare. The estimated efficiency cost corresponds to foregone government revenue that could have been used either to increase productive spending (such as on human capital or infrastructure), or to increase household revenue through direct transfers or lower taxes. Had the foregone government revenue (corresponding to the estimated deadweight loss o f 3.5 percent o f GDP) been transferred to households, the possibilities for increased private consumption or savings would have considerably expanded. As a result, consumer welfare would have improved. Box 111.1: Calculatingthe cost of implicit energy subsidiesin Libya * Estimations of implicit subsidies Subsidy calculations are based on domestic price and tax data supplied by the National Oil Company (NOC) for heavy fuel oil, diesel, gasoline, kerosene and liquefied petroleum gas (LPG). There is price discrimination betweenend users according to sector-depending on whether users are consumers, the public sector, electricity production or the armed forces. Consumption ofeach product was weighted by the price including tax in each sector to obtain the Libyan domestic price in 2003. International spot prices collected for the various fuels free on board inthe Mediterraneanare an annual averagefor 2003. It was assumed that if fuels were imported by Libya they would bear the same taxes as the domestic product. Incalculating international prices for these products in 2003 the exchangerate usedwas 1.256 LYDper $US.The estimatedimplicit subsidiesare shown inTable 111.3. * Deadweight loss estimations The deviation from efficient pricing results in a deadweight welfare loss, where the government revenue loss exceeds the domestic consumers' surplus driven by the subsidized domestic price below the free market (export) price. Estimations of the deadweight loss (DWL) have triggered considerable attention. The loss has been approximated usingthe traditional methodelaboratedby Harberger (1964), assumingperfectly elastic supply I. This linear approximation is precisely accurateinthe case ofsmall deviations from the optimum and for the case of two goods (which is close to the present case). The deadweight loss is defined by D W L=-% ?CY 1,where is the subsidy rate, defined by r = (pi -pd) / Pd I ,with pithe free-market (export) price and p d the domestic (subsidized) price; CY is the domestic consumption share inthe GDP, (pa C) / GDP; and 7 is the long-run uncompensatedprice elasticity of * oil demand, assumed equal to -0.5. The deadweight loss was calculated for heavy fuel oil, diesel, gasoline, and liquefied petroleum gas (LPG). Kerosenewas excluded becauseof concerns that the large price discrepancy associatedwith a relatively low domestic consumption would tilt the loss erratically up. Because of the large discrepancy between the domestic and the free-market price of energy products, the estimationsare sensitive to the choice ofbase for the calculation of the subsidy rate (Pd or pi). Therefore, the subsidy rate used inthe calculations is the average of the one calculated relatively to domestic prices and the one based on the fke-market price, (pi - Pd) / pi. Results are sensitive to the choice o f elasticity. For productswith higherelasticity the loss will behigher. ' Although approximations are subject to criticism, they remain popular and are useful and relatively easy and quick means of gauging the magnitudeofthelossesimposedby variousdistortions. 92. Implicit subsidies to energy and infrastructure have a questionable impact on income distribution. The usual motive behind subsidization o f energy and utility services i s to aid those with low incomes. But household expenditure data from various counties show those with higher incomes usually benefit more because consumption rises with income. For example, in Mexico and Ecuador, the top decile o f the population accounts for over 30 percent o f household electricity consumption (Gupta et al. 2002). More targeted means o f helping those with low incomes are preferable to subsidies for consumption as discussed inchapter VI.  - 45 - 93. The authorities may want to consider making the sizeable energy subsidies transparent in the budget. Making the energy subsidies transparent would support better expenditure prioritization, in a context where improving the efficiency o f spending for social protection i s a priority to facilitate Libya's transition to the market. This would not necessarily affect the budget deficit. Prices to domestic users could be kept regulated if so desired, but budgetary transfers to the electricity production or gas distribution companies would have to compensate for the higher cost o f oil products in the face o f regulated prices. These transfers would be matched by extrarevenues for the NOC that couldbe allocatedto the budget. 94. Transparency of energy subsidies would set the stagefor broader domestic energyprice reform. Eliminating energy subsidies would support greater efficiency, by promoting a shift out o f energy-intensive methods o f production and consumption patterns. The benefits for environmentally sustainable growth would also be substantial. Reform should go in tandem with appropriate compensation schemes, to cushion the impact o f the elimination o f the subsidies on the most vulnerable. This would be welfare-improving, as transfers would broaden the scope o f household consumption choice compared to support through subsidized prices. An assessment o f the inflationary impact o f phasing out the subsidies and o f the incidence on the vulnerable would be a prerequisite o f reform. Box 111.2 offers some estimations o f the first-round inflationary impact o f removing subsidies to petroleum products. Of course, domestic energy price reform i s a difficult issue and considerable care mustbe taken in designing its "road map". A careful evaluation o f the domestic and international situation would be needed to decide on the appropriate phasing strategy and the design o f the necessary social safety net measures. 95. Risks to medium-term jlscal sustainability in Libya resultfrom implicit and contingent liabilities of the public sector. Their adverse repercussions may not be apparent in the near term, but they may surface later, causing financial distress that would require much costlier remedies. Significant contingent liabilities in Libya originate in the non-performing loans to public enterprises, accumulated in the portfolios o f public banks. Ifcertain loss-making public enterprises were to be kept in operation for social or other sectoral policy reasons, it would be important that public bank loans (even provisioned by the Treasury) be replaced by transparent subsidies in  - 46 - the budget. This would help recognize an important implicit liability o f the state and contribute to sounder budget management. This would also effectively severe the linksofthese enterprises with the banks and helprestorethe soundness of the banking system on a permanent basis. 96. Implicit liabilities also arise from the financial situation of the pension system. As discussed in chapter VI, the pay-as-you-go pension system currently operating in Libya i s equivalent to a government bond. The public sector borrows fi-om contributors and then repays them back when they retire, at an implicit rate o f return. Other countries in the region with less generous systems and lower coverage rates have accumulated implicit pension debts often above 50 percent o f GDP. The size o f the pension liability in Libya (Le., the value o f the implicit government bond) for both civil servants and private sector workers could be as high. Infact, it could be even higher if one adds the pension liability o f the military whose pensions are financed directly from the general budget. 97. Ensuring sustainability of public expenditures and efficient delivery of public services are Libya's two main fiscal challenges. Attaining these goals would appear to require substantial changes in budget preparation and management, with a view to introducing forward planning. That should be underpinned by reforms in budget formulation and management to meet three requirements for well-performing budgetary systems: 0 control o fpublic resources-especially o f oil revenues; 0 prioritization o f the allocation o f resources with the aim o f maintaining expenditure discipline; 0 management o f programs and delivery o f services effectively and efficiently. B. Strengthening Management of Oil Revenues - 99. I n establishingthe ORF in Figure 111. 2: ORF assets and oil exports . . 15 _revenner.* r 80 1995, through a budgetary rule - 13 Oil exports revenues -/YL - 4 -.70 but without explicit objectives, the Cumulative, 1996-2003 -- 60 Libyan authorities were aiming at 11 -- 0 -- 50 reducing the substantial volatility of the oil revenue stream, and 7 -- -- , 40 saving oil resources over the long -- 20 .- /- run. If, from 1997 to 2001, the -- I O -0RF Assets ORF operated as a stabilization b o 1996 1997 1998 1999 2000 2001 2002 2003 fund, it failed since 2001 to  - 47 - accumulate resources on a net basis, due to the financing o f huge discretionary extrabudgetary expenditure. Over the period, about US$ 9 billion was accumulated, based on favorable oil prices. However, the O W balance has remained relatively constant since 2000, despite the exceptional increase in oil export revenues (Figure 111.2). Fiscal management has also been complicated by the recent creation o f a new extra budgetary hnd, the Investment Fund (IF), with unclear investment objectives and rules governing its operations and accumulation o f assets. In addition, a new extrabudgetary fund o f US$5 billion, the Libya Africa Development Fund (LAIF), was established inFebruary 2006.*l 100. On the basis ofpast experience, it is recommendedto create (or to transform the ORF into) a stabilization fund with clear and precise accumulation and withdrawal rules. The Government is currently considering options for the establishment o f a Savings and Stabilization Fund in replacement o f the OW. The rules o f accumulation (and withdrawal) can be stated according to different technical schemes: 0 Adopting a conservative but realistic oil reference price in the budget (the stabilization fund will then be a price-contingent fund); 0 Setting appropriate targets for the non-hydrocarbon budget deficit, (measured as a ratio o f non-hydrocarbon GDP); 0 Estimating a "permanent hydrocarbon income stream"-with the aim o f targeting a non-hydrocarbon fiscal deficit that does not exceed the "permanent hydrocarbon income stream" over an appropriately defined medium-term time horizon. The rationale o f fiscal rules anchored on the non-hydrocarbon budget deficit is further elaborated in the next section. The schemes outlined above will determine reference values, above which exceeding oil revenues will be transferred to the fund for accumulation; or, on the contrary, below which appropriate withdrawals will be transferred to the budget. The reference values will have to be assessed periodically on the basis o f a rolling medium-term framework. 101. I t is important to ensure that withdrawal rules avoid financing of extrabudgetary discretionary spending. The stabilization function i s achieved if the withdrawals are strictly reserved to transfers from the Fund to the overall budget, according to the reference value within the scheme adopted. The Government's decision in 2005 to eliminate extrabudgetary spending financed by the O W i s a step inthe right direction. However, discretion inthe operation ofthe O W still remains as it was also decided to allocate off-budget LYD 3 billion o f ORF resources to specialized banks, to finance a housing program and subsidized loans to farmers and SMEs. 102. The revenues belonging to the Fund should be maintained in an account, with the Central Bank, that is separatefrom the main treasury account. The Fund should be kept as a separate entity and integrated into the budget: all transfers to and from the Fund's account should appear as explicit line items in the budget ("transfers to the Fund" and transfers from the Fund"). `I The LAIF can invest domestically and abroad, and has started its activities with two major projects: the building of a Qadafi tower in Dakar (Senegal) and a canal in Mali.  - 48 - 103. The Fund should receive a comprehensive legal status and be transparent. A law should clearly state the nature androle of the Fund,with precise rules, purposes and objectives, and define its auditing and control. Whatever detailed scheme is adopted, it i s important to ensure that it will be transparent; there should be regular disclosure o f its inflows and outflows and the Fund'sactivities should be submittedto an independent auditor. 104. Adding a savingsfunction. After satisfactory performance o f the stabilization function o f the Fund, providedby a fiscal accumulation rule, a saving function can be added to reflect on a longer term basis the non renewable character o f oil wealth on a longer term basis. An approach based on the estimation o f the "permanent hydrocarbon revenue stream" could be used for saving purposes, with "temporary" oil revenues-those in excess of the permanent revenue stream-saved for future generations (see next section). 105. The oil reserve fund is a necessary, but not sufficient condition forfiscal sustainability. Oil reserve funds cannot by themselves substitute for the commitment o f the government to pursue a sound fiscal policy. Oil funds are also subject to considerable pressure for spending, once they have accumulated significant reserves. The necessity to maintain fiscal discipline over the medium term i s a prerequisite for fiscal sustainability. This would call for combined initiatives towards (i) a rules-based approach to fiscal policy, and (ii)the adoption o f a framework to maintain expenditure discipline over time. C. Criteria For Long-TermFiscalSustainability 106. To build appropriate safeguards for macroeconomic stability, the fiscal framework should be anchored on an indicator that is unaffected by the short-run changes in hydrocarbon revenues. Such an indicator should provide a good measure o f the fiscal stance and the underlying pressures on the fiscal accounts. The non- hydrocarbon primary fiscal deficit, measured as a ratio to non-hydrocarbon GDP, would be the strongest anchor for fiscal policy. Setting appropriate targets for the level o f the primary non-hydrocarbon deficit would allow the de-linking expenditure from volatile hydrocarbon revenues, thus reinforcing macroeconomic stability. Changes in the non-hydrocarbon primary balance should be used as a basis for measuringchanges inthe fiscal stance (also see Barnett and Ossowski, 2002). 107. I t is important to secure the sustainability of the non-hydrocarbon fiscal deficit in the long term. This calls for deciding "the right size" o f the non- hydrocarbon primary deficit. Moreover, quasi-fiscal operations and fiscal risks stemming from the contingent and implicit liabilities o f the government should be properly valued and taken into account when deciding about a prudent permissible level o f the non-hydrocarbon primary deficit. Improving the visibility o f quasi-fiscal operations, and monitoring government contingent liabilities is important in order to resist the pressure to increase public expenditures in "good times", when oil revenues go UP. 108. A rules-basedfiscalpolicy in Libya could be anchored on the concept of the "permanent hydrocarbon income stream ". Roughly stated, the rule could target a non-hydrocarbon primary fiscal deficit that does not exceed the "permanent  - 49 - hydrocarbon income stream " over an appropriately defined medium-term time horizon. Surplus hydrocarbon revenues (Le., revenues in excess o f the "permanent hydrocarbon income stream") should be saved. Linking primary government expenditures to the "permanent hydrocarbon income stream" would set an upper limit to the non-hydrocarbon primary fiscal deficit over time, in a way that would be consistent with long-term fiscal sustainability. As indicated in the intertemporal solvency framework in Annex 2, the rule would ensure that existing debt i s matched by future primary surpluses, whose present value exceeds the value of the debt. At the same time, such' a rule could provide a useful anchor for stabilization purposes. This would help smooth out public expenditures over time and prevent unwanted expenditure cuts in case o f sharp oil price reversals, thus reducing the pro-cyclicality o f the budget. 109. Operationalizing that fiscal rule would require estimating Libya's `$permanent income" from hydrocarbon production, based on an estimation of the net present value (NPV) of government's hydrocarbon revenue over a long period. These calculations invariably rely on estimates o f remaining recoverable reserves, and a production profile o f the depleting resource over a long period. They are also based on assumptions about government take, resource price, costs, and the discount rate. As mentioned in the previous chapter, any estimate is subject to considerable uncertainty about the quantity o f reserves and prices, discount rates, and other factors (such as costs and taxes). 110. Despite "upside uncertainty", fiscal prudence would require using conservative estimates of the permanent hydrocarbon income stream, combined with periodic reassessments. "Upside uncertainty" pervades "permanent hydrocarbon income" calculations as reserve estimates at any single point in time reflect what i s then known, and do not depict ultimate recovery, which i s unknowable. However, missing some upside potential for government spending, due to underestimation o f "permanent hydrocarbon fiscal revenues", would not put long- term fiscal sustainability at risk. By contrast, overspending, based on unrealistic projections o f hydrocarbon revenues, would pose fiscal risks-as corroborated by the experience o f many oil-producing countries. Fiscal prudence would thus call for considering conservative estimates o f ermanent hydrocarbon revenue in assessing the sustainability o f the fiscal position. 21: Over time, and depending on changes inthe long-term outlook for prices and reserves, the fiscal rule could be adjusted with periodic updates o f the underpinnings o f the "permanent hydrocarbon income" calculations. 111. Except under very conservativeprice and reserve criteriafor the estimation of permanent hydrocarbon revenue, the currentfiscal position would be sustainable in the long run. Reflecting higher spending, with support from strong oil revenues, Libya's non hydrocarbon budget deficit has steadily increased since 2001, hovering at around 35 percent o f GDP since 2003.. The current fiscal position would be sustainable in the mid- and high-price scenarios for the price o f oil, regardless o f the 22 Using non-conservative scenarios as a "speed limit" for targeting the right size of the non hydrocarbon fiscal deficit would pose two risks: First, the accumulation of savings would be slower, compromising the achievement of inter-generational equity objectives. Second, the fiscal position would be imperfectlyinsulated from the volatility in oil revenues, since a lower than expectedprice of oil would, sooner or later, trigger acompressionof public expenditures.  - 50 - scenario for the level o f reserves. The fiscal position would not be sustainable over the long run only under a very conservative (low-case) price scenario, and a low- or mid-case scenario about the recoverable oil and gas reserves (shaded boxes in Table 11.3). The non oil deficit would be only marginally sustainable in the low-price/high- case reserve scenario. The existing fiscal margin o f comfort points to the simultaneous challenge o f maintaining fiscal responsibility and discipline, while using hydrocarbon revenues strategically to finance productive expenditures and facilitate the transition to the market. Appropriate prioritization o f investments would be needed to ensure that the economy has the absorptive capacity to efficiently use the available financial resources inthe short run. D. The Challengeof StrengtheningBudgetManagement 112. The legalframework of thepublicfinancial management system is governed by a comprehensive Financial Management Law. This law embraces all aspects o f the financial management system, such as budget preparation, formulation, approval by the Legislative, budget execution, accounting, reporting, auditing. Many decrees and circulars also govern the related procedures and processes. The analysis below provides a summary assessmento f the framework, but a thorough review o f this set o f laws and rules should be undertaken in order to assess its robustness and provide guidance about possible updates or modifications. (0 Budgetpreparation andformulation 113. Budget preparation is swijit- The budget preparation process starts in mid- year-in June for the current expenditures and August for development expenditures. The main steps o f the process are outlined in Box 111.3. The procedure i s relatively simple and bottom-up driven, but nevertheless enriched with some real discussion with line-ministries, that could be an indicator o fthe ownership of their budget and its execution during the year. To strengthenbudget preparation, a review o f the realism o f the macroeconomic forecasts and the related budgeted revenues would be advisable, to assess the quality o f this forecasting that conditions the realism o f the entire budget and its downstream execution. 114. -but fragmented. A segregation o f management between the current budget and development budget all along the preparation process, i s potentially a concern in particular because: (i) institutional mechanism seems to be in place for ensuring no the adequate fit between current and investment expenditures starting with the very formulation stage o f the budget; and, (ii) Government i s committed to allocating the automatically each year 30 percent o f budgeted oil revenues to current expenditures and 70 percent to development, which may be a source o f inefficiency in the . allocation o f resources; (iii) the fragmentation o f the budget makes it difficult to adequately program expenditures for operation and maintenance, which i s key for the efficient operation o f public capital. The budget i s not built on the basis o f a Medium Term Expenditure Framework (MTEF), but a first step o f Medium Term Fiscal Framework (MTFF) i s already completed, which could make further reform toward a MTEFeasier and smoother.  - 5 1 - 115. The budget still lacks transparency. The budget law includes two different types o f sub-budgets: the current budget and the development budget. Extra- budgetary funds were equivalent o f 52 percent o f total government outlays in 2003, but their size has been reduced (Table 111.1). They are still not mentioned in the budget law, so that the comprehensiveness o f the budget i s compromised. Such extensive extrabudgetary fundingprovided a huge incentive to evade budget controls, undermining the effectiveness o f controls in budget execution, and eventually undercutting the credibility o f the entire budget process. In addition, a consolidated budget at the General Government level i s still missing.This makes it difficult to get a accurate view o f the size o f Government and expenditure allocations in view o f the considerable decentralization o f expenditures to local administrations. 116. The budget classification system should be improved. The budget classification i s not compliant with GFS 2001 and does not include a functional classification o f expenditures. As a consequence, a programmatic approach o f the budget is currently uneasy to implement. (io Budget execution 117. The budget is executed according to mixed methods following traditional and more modern procedures. Budget funds are first allotted to the line-ministries' budgets and then released to the budget authorizers. The execution i s different according to the nature o f expenditures. Current expenditures are executed on a quarterly basis, without significant delay for allotting and releasing the funds to the line-ministries. At the end o f the fiscal year, no carry-over i s allowed for financing the payment arrears. However, the budgetlaw includes an item appropriation (unique and global) aimed at financing the arrears o f different budgets. This procedure i s a positive sign o f the concern o f the Ministry o f finance about the risk o f accumulation o f arrears. The amount o f appropriation i s 29 milliondinars in2006.  - 52 - 118. Development expenditures carried on by line-ministries must be first authorized by the Ministry of planning, prior to the allotment of funds. The Ministry of Planning examines each project and its full documentation in order to ensure the readiness and maturity o f the project to be launched, before authorizing the release o f funds to the budget ministry. The real functioning o f this procedure o f authorization (content, delay) remains to be assessed since it may be a crucial factor o f the efficiency o f the subsequent project expenditure implementation. The regime o f prior authorization indicates a mixed system combining heavy involvement o f the Ministry of Planning and probable lack of autonomy o f the line-ministry. This is likely to be a factor o f slowness of the implementation process without providing real quality guarantees. Such a situation may be an obstacle to the set-up o f any budget management reform, more focused on the performance and responsibility o f the budget officer. Development expenditures are managed under a so-called multi-year framework. The quality o f the procedure remains to be assessed, but a first positive and convergent element could be the automatic cany-over o f unspent funds at the end o f the year, which i s typically a component o f a multi-year approach. 119. The budget execution is monitored by the Budget Directorate and the Planning Committee. A mid-year report is sent to the Cabinet and Legislative but no debate i s organized. The quality o f the information o f this report very much depends on the quality o f the reporting (see below). But an interesting tool o f the monitoring procedure i s a provision o f the budget law setting-upa fund-reserve to be used incase o f contingency but to be fiozen and cancelled in case o f deviation o f the budget execution. This procedure, rare in the region, i s compliant with more recent evolutions o f the international budget management benchmarks tending to make monitoring more predictable and less disrupting for the budget officers. A well- organized procedure appears to also exist in case o f deviation (memorandum to the government, new circular to line-ministries). 120. A standard cycle of expense is being followed. The different steps include: commitment, tender committee, purchase order, committee for service delivery check and certification, payment order, and payment. The autonomy o f the budget officer within line-ministries seems to be well-defined by the rules. The payment procedure i s secured by the obligation to get two different signatures for the issuance o f the check (signature o f the budget authorizer, signature o f the accountant). The occurrence o f fraudulent practices seems low with regard to the institutional mechanism^.^^ (iii) Deconcentration and decentralization 121. Decentralization in Libya has been ambitious. Decentralization has been said to represent the public sector equivalent o f privatization, and it i s o f interest that Libya i s doing both. But the scale o f decentralization in Libya appears to have been exceptional: 50 percent o f the administrative budget and 60 percent o f the development budget have been decentralized. The procedure o f expenditures' delegation to the 20 regional entities, the Sha'beyat (their number has been reduced 23 The function of ex ante control (pre-disbursementaudit) needs to be reviewedand assessed, either at the central or at the locallevel.This hasnot beenundertakenas part ofthis study.  - 53 - from 35 to 20 at present), seems smooth and relatively secured by the setup, in each region, of a Regional Committee directly linked to the Ministry o f Finance. 122. Assessment of the institutional capacities of deconcentrated budget units is needed. The Regional Committees are in charge o f the payments for all line- ministries expendituresat the local level. They report their activities to the Ministryo f Finance and they are subject to a financial control. An assessment o f the institutional and financial capacities o f these deconcentrated units needs to be undertaken inview o f their heavy responsibilities. The fact that most staff employed at this level were previously posted at the central level in the ministries reduces, however, the risk o f structural and permanent local deficiencies. The decentralized expenditures, i.e. expenses financed either by regional revenues or by transfers o f the national central budget and implemented by local entities (municipalities, districts), are also important. An assessment of the institutional and financial capacities o f these local entities (municipalities, districts) i s also needed. 123. Decentralization has put pressure on public expenditure. Assessments o f institutional capacity are needed also because the decentralization initiative has been blamed for excessive increases inthe public sector wage bill in Libya, resulting from massive hiringby the regions. Increases inthe wage bill since 2001 point to some loss o f budgetary control over regional expenditure. Decentralization should hardly have led to any increase inpublic sector staffing in Libya, however, since decentralization here has only involved deconcentration, or the dispersion o f responsibilities within the central government to regional branch offices. 124. The authorities have recently come to the conclusion that their decentralized system needs to be redesigned. Consequently, they have decided to undertake a major administrative reform that strengthens the role o f the central government, and aims to improve governance, which has significantly deteriorated under the previous decentralized system (fragmented projects, waste o f resources, regional vested interests). Under the new system, in addition to reducing the number o f regions, the position o f secretary o f region (the equivalent o f a prime minister for the region) has been abolished, and all the regional sectoral secretaries (regional sectoral ministers) have now to report to the central government. Also, seven ministries have been reestablished. (iv) Reporting and accounting 125. Reporting suffers from weaknesses, especially for capital expenditures and for decentralized spending. The reporting i s based on a monthly centralized collection o f information about payments made both at central and local levels. For the latter, information comes from the 20 Regional Committees. It is uncertain whether the payments reported are reconciled with the payment orders (issued by the budget authorizers) and with the banking statements o f payment. Commitments are not reported. From the own evaluation o f the Ministry o f Finance, the quality o f this reporting in terms o f accuracy and timeliness i s low, in particular as regards capital expenditures. These are reported on a half-yearly basis, instead o f monthly for current expenditures.  - 54 - 126. Accounting is cash-based and hampered by frequent administrative changes. The accounting i s based on quarterly collection o f information for more security given the low reliability o f the monthly collection. It i s uncertain whether the accounting is based on a double entry system. It i s based on cash-basis system, so that commitments are not accounted for, and accruals, assets and liabilities are ignored. This rudimentary level o f reporting and accounting is confirmed by the fact that no financial statements have been issued since 2002, the last available statements being related to the fiscal year 2001. It seems that the frequent changes o f the administrative structures are worsening the issuance o f financial statements. 127. I nformation systems are rudimentary. Budget management and reporting functions are mostly manual. No integrated information system i s in place. Some ministries report an in-house computerization o f some components o f budget management and reporting functions (Access systems), but no integration with the Ministry of Finance has been designed. So far, no credible plan of computerization has been issuedand a hugetask i s still to be tackled. 128. The cash management system lacks clarity. The implementation o f a real Unified Treasury system (Treasury Single Account) remains uncertain. Apparently each line-ministry and public entity registered at the budget hold an account at the Central bank, but it i s not clear how the centralization and the daily balance i s operated for the whole sector. In addition, it i s uncertain whether the ministries hold other accounts inthe banking system which escape from the unified circuit. (v) Auditing 129. The audit system is mainly focused on the external Audit, the ex ante control and the internal audit being ill-defined. The external audit i s operated by the General People's Committee Institution for Auditing and Technical Supervision (named below as Office). This Office i s compliant with most o f International Organization o f Supreme Audit Institutions (INTOSAI) criteria, in terms o f institutional and financial independence. Thus, the Office i s referring to the Legislative, its President i s appointed by the Legislative, while its budget i s approved by the Legislative through a dedicated committee. The Office has a network of 32 local offices over the regions, with an average o f 40 staff by office. 130. The methods of audit of the Office also are reported to be compliant with INTOSAI inparticular: o The work-program of audit is established on a risk-based approach for some entities and controls, while all entities subject to public audit (around 400 entities) are effectively audited each year. o The methodology o faudit includes its 3 required categories: ...Compliance audit Financial audit Performance audit o The Office formulates an opinion about the audited accounts o The Office can adjust the inaccurate accounts and get the money back if fraudulent or send back the accounts to the Budget Committee (Legislative).  - 55 - 131. Given the absence since 2002 o f financial statements for the budget, the Office reports numerous controls about the inventory o f temporary and intermediate accounts. The Office issues an annual report to the Legislative, which i s simultaneously disclosed to the public. This indeed fulfills a major recommendation o f INTOSAI. This report gathers the main results, findings and recommendations o f the annual activity o f the Office. 132. Human and institutional capacity of the audit office seems satisfactory. The human capacities o f the Office are reported to stand at a high level: 350 auditors, 20 audit assistants and 200 administrative staff. The recruitment o f the auditors i s made at a highlevel o f skills: master's degree plus 2-year experience minimum,while some 50 auditors have a higher level of instruction. Training also seems important: The Office claims yearly training o f 50 percent o f the staff, whether it i s through internal workshops, training o f trainers or training o f auditors in international audit cabinets (45 auditors in 2006).24 Therefore, the assessment o f the Office as regard to the benchmark INTOSAI i s quite good and largely above the average o f the Middle-East region with comparable systems o f audit. However, the Office has never been assessed by an independent reviewer, such as a peer-reviewer. A more thorough field assessment o f the Office's capacity would be required to confirm these preliminary findings. 133. The internal audit units in line-ministries remain ill-defined and uneven depending on the ministry. The assessment o f their capacity and methodology remain to be done. However, an important and negative element for the assessment o f their efficiency is the fact that they report to the Financial head o f the Ministry and not the Ministeritself, which i s non compliant with the criteria o f independence. (vi) Maintaining expenditure discipline over the medium term 134. There have been several attempts at attainingfiscal discipline in Libya that have not achieved the desired results. Most notable has been the experience with the rule that 70 percent o f budgeted oil revenues must be devoted to the development budget and 30 percent to the administrative budget. This rule was instituted after a burst o f hiring and the resulting increased wage bill, together with outlays on what was in effect consumption by bureaucrats. Experience in 2003 indicated, however, that the government o f Libya could not live within this constraint, and expenditure categories such as medicines and food subsidies had to be reclassified in the development budget to meet the 70/30 rule. 135. A "top down" planning process with respect to planning and budgeting, based on fiscal limitations and accountability, should be established. By way o f contrast, the present approach to budgetingin Libya might be described as a "bottom up" process, driven by the accumulation o f existing commitments that need to be financed in any particular year and by availability o f unforeseen revenues in the immediate budget period. An important initial step inbudget preparation would be for the government to establish spending ceilings for each region and ministry at the 24Another aspect o f the institutional and financial capacity of the Office is related to the fact that the Office holds the Secretariat general o f AFROSAI (as the Tunisia Court o f Accounts holds the secretariat o f ARABOSAI).  - 5 6 - beginning o f the budget process. To ensure that ministers feel committed to the ceilings, this initial allocation should be anchoredina specific cabinet decision. 136. A Medium Term Expenditure Framework (MTEF) should be developedas a main tool of fiscal planning. The MTEF should be anchored on sound budget formulation and execution principles, conditional on the elimination o f extrabudgetary spending practices. It should include both existing expenditure commitments as reflected in approved policies and reserves for other purposes, including new activities and contingency reserves for unforeseen events. A medium term expenditure framework shows what programs can be afforded over the medium term: it is a policy-determined limit to the total expenditures that are to be undertaken during a defined time frame. Its foundations are an assessment o f future revenues available to the State and estimates o f on-going expenditure commitments. The preparation o f a MTEF i s an important contribution to ensuring that current fiscal policies are sustainable, providing more stability for budget planning and allowing budget prioritizationto be done on the basis of more complete information. Three to five years is the range typically adopted in such medium term expenditure frameworks and reflects the normal time horizon over which one can expect government organizations to plantheir activities indetail. 137. An MTEF would also help with other objectives of fiscal management. Elsewhere, for instance, a MTEF has also been found to be one o f the best methods o f linking capital spending to associated recurrent spending. As in many countries, responsibility for capital and recurrent budgets i s now separated in Libya and there i s little coordination at the operation level between the Ministries in charge o f these budgets. International experience suggests that these "dual budgets" may well be the single most important culprit inthe failure to link planning, policy and budgeting, and i s often at the origin o f poor budgetary outcomes. The most important cause o f these problems may be the tendency for project capital expenditure to be approved without proper consideration o f the ongoing operating cost consequences. Medium term expenditure plans should bring together current and capital budgets and show the consequences for operating expenditures o fnew project spending. E. Improving Efficiency In The Delivery of Public Services 138. Increasing the transparency of quasi-fiscal actions would facilitate better spendingprioritization and efficiency. Countries that are less well off than Libya are making such quasi-fiscal actions visible and transparent2' By making subsidies transparent, decision-makers may better assess the strategic allocation o f public expenditures, while the possible impact o f the subsidies on the government's fiscal position can also be evaluated. The most important potential benefit from transparency i s that the subsidies are no longer open-ended. Getting the subsidies out inthe open usually leads to questions as to whether the objective ofthe subsidy could be achieved more efficiently by other means. 139. A number of other public sector management issues bear on the question of improvement of the delivery andfinancing ofpublic services, including: ''Yemenalso used to provide a subsidy to electricity production by charging its electricity utility a below-market price for its fuel. This practicewas replacedinYemen's 2002 budget by provisionof an explicit subsidyto the Public Electricity Company.  - 57 - 0 fiscal decentralization 0 payment for public services 0 privatization o fproduction o f non-public goods and services 140. Although decentralization is in the process of being redesigned, measures could be considered to raise the capacity of local governments to collect their own revenues. Libya's deconcentrated subnational governments, the Sha'beyat, are assigned the national wage taxes collected in each o f these jurisdictions to finance their activities. This system of returning revenues to the regions in which they are collected was common in many former socialist states, and has the problem that it benefits the richer regions or those that have the most economic activity. The Government o f Libya was aware o f this problem, and tried to temper the outcome by use o f a formula that provided additional assistance to low-income Sha'beyat. This system was abandoned after experiencing some difficulties, however, and was replacedby the current formula where the amount o f additional assistance provided to the Sha'beyat is 70 percent weighted by population. Further adjustments to this formula are now being studied, but the central government should not reward negative behavior intransfers to subnational governments. 141. Revenues for local governments could be collected either by user fees or taxes that correspond to the benefits receivedfrom the services theyprovide. Where benefits o f their infrastructure services are captured by local users in proportion to use, user fees should often finance provision o f most o f the services. Where direct user fees are inappropriate (e.g., local roads), local governments should have access to a suitable tax base that i s a proxy for use o f local services. The property tax i s generally considered to be appropriate for this purpose: unlike the more mobile things that national governments can tax such as the income o f taxpayers, property can not move around. For these reasons, the property tax i s usually reserved exclusively for local government use. 142. Conditional transfers enable national interests to influence subnational government actions without central government micromanagement of thefunctions concerned. There are good reasons for some o f these transfers. When local governments are responsible for education, health or even infrastructure services that have effects that spill over outside the local community, they are usually supported financially by national or intermediate levels o f government. This financial support takes the form o f grants, revenues from shared taxes or access to taxes related to ability to pay. The central government can encourage the provision o f services with such externalities by offering to share particular costs provided that the project or program meets certain conditions or minimum standards. 143. Creating an equalization fund would be a necessary step for effective fiscal decentralization. Subnational governments in less well-off areas cannot afford to offer the services supplied by better off localities. The solution to this problem that i s a feature o f intergovernmental finance throughout the world i s "equalization" transfers to poorer subnational governments, which have the objective o f enabling all subnational governments to supply essential services with the same local tax effort. Equalization payments are common in developed, developing and transitional countries. Such "equalization" payments (so-called because they are intended to equalize the per capita fiscal capacity o f subnational governments) are often provided  - 58 - by other members o f the same level o f government infederal states, or by the central government inothers. They are unconditional, since they are intendedto solve a fiscal problem and not encourage the provision o f particular services. Such formula-based equalization payments do not adversely affect the local accountability for local spending decisions whose desirability was stressed earlier. 144. The transition to a market-oriented economy could be supported, and the quality of public services improved, by promoting competition between the private sector, NGOs and even other levels of government in theprovision of public sector services. Contracting out production o f public services to the private sector i s widespread for services such as trash collection, road maintenance and janitorial services for public facilities. Competitive contracting for infrastructure construction i s also common. International experience shows that the private sector i s consistently superior to the public sector in delivering capital projects on time and within budget. Insome cases, notably water and sewerage works, the public sector may hire private firms to operate publicly owned facilities. 145. Eventually, the goal of budgeting should shqt towards getting resultsfrom the spending of public resources rather thanjust allocating inputs. While Libya i s a long way from results-oriented budgeting, this goal should be kept in mind as being that to which the country should be striving. It is not too early to start toward this goal in Libya, for instance, by beginning to incorporate some performance indicators as part of the budget. The long-term objective should be to have a comprehensive budget system that gives a complete breakdown o f all budget expenditures, the activities they finance, the outputs that are produced and the outcomes that are realized and the linkages betweenthe different parameters. 146. Summing up, core reform options and complementary initiatives the government may wish to consider in the short term and over the medium term, in order to strengthen the public finance management system, are as follows. Core reform options (i) In the short term Transform the Oil Reserve Fund into a Stabilization Fund with clear accumulation and withdrawal rules Adopt a comprehensive legal status for the ORF, clarify its rules and purposes, ensure transparency o f its operations and integrate the fund into the budget Eliminate practice o fusingthe O W for fundingextra-budgetary expenditures Set appropriate targets for the non oil budget deficit as a ratio to non oil GDP Initiate an analysis o f public expenditures with a view to assessing their effectiveness and matching o f the government's economic and social priorities (ii) Over the medium term Add a saving function to the Oil Reserve Fund-to reflect the non-renewable character o f oil wealth-based on a conservative estimation o f permanent hydrocarbon revenue Elaborate a rolling Medium Term Expenditure Framework (MTEF) for a period o f 3-5 years as a main tool o f fiscal planning Make implicit subsidies explicit and transparent inthe Budget  - 5 9 - Evaluate implicit and contingent liabilities such as those for pensions and non- performing loans o f public enterprises Reconsider the appropriate scope for public expenditure decentralization Complementary reform initiatives (i) In the short term Establish spending ceilings for each region and ministry at the beginning o f the annual budget process Eliminate the rule that 70 percent o f budgeted oil revenues must be devoted to the development budget and 30 percent to other expenditures (ii) Over the medium term Develop plans to address the implicit and contingent liabilities of the public sector Raise the capacity o f local governments to collect revenues that correspond to the benefits received from the services they provide Encourage the introduction o f user fees to finance provision o f most local infrastructure services Consider assigning to local governments a suitable tax base, such as the property tax, to finance local services Introduce appropriate equalization transfers to less well-off local governments Encourage competition in the provision of public services from the private sector, non-governmental organizations and other levels o f government  - 60 - Iv. BUILDINGA STRONGINVESTMENT CLIMATE INOPENMARKETS AND REFORMINGSTATE-OWNED ENTERPRISES A. MainPillars of the Transition to a Market-Oriented Economy 147. The transition to a market-oriented economy will rest on building up a sound investment climate, market incentives for entrepreneurs and open markets with equal treatment to all investors. Whether it i s in (i)easing barriers to investment through simplified administrative procedures, or (ii) improving access to quality factors o f production (land, infrastructure, human resources), or (iii)building strong market institutions (e.g. the customs, the judiciary, the public administration, the market information system), or (iv) improving the functioning o f the credit market; the ability o f Libya to conduct successfully these structural reforms will determine the success o f its transition. 148. The core of this transition will involve a major review of the legal framework for investment, and the strengthening of the capacity and the independence of the judicial system to enforce the rule of law. Despite recent improvements, the laws and regulations governing business activity remain inconsistent with the requirements o f a market-oriented system. Beyond the legislative apparatus, it i s essential to the fbnctioning o f a market economy that the rule o f law i s enforced equally to all. This requires improving the capacity o f the judicial system to resolve business disputes, but - most importantly - strengthening the independence and the governance o f the judiciary, so that the rule o f law i s in force for all, includingpublic administrations, large and small investors, and any other economic actors. 149. I n addition to facilitating new investments, improving efficiency among existing firms will also be key in this transition, in particular among public enterprises which currently dominate the Libyan industrial sector. Such improvements will best be attained by transferring ownership to private, strategic investors, foreign or local. Before such privatization program progresses, it will be key to: (i) hard budget constraints on public enterprises, (ii) impose strengthen their operational independence, and (iii) that the State does not intervene in the ensure credit market to support loss-making enterprises. 150. Promoting Libya's multilateral trade policy commitments, through WTO accession and a possible association agreement with the EU, will be an important anchor of reform. Experience from neighboring countries (Tunisia and Morocco) shows that multilateral commitments, especially the EU association agreement, have been strong anchors o f reforms. They have provided a comprehensive direction on reforms supported by technical assistance and flow o f funds. Strong multilateral commitments are essential to provide a great deal o f credibility to Libya's reform process. Libyan international commitments will in turn bolster investor confidence, both internally and abroad. Evidence shows that the lack o f credibility i s a key factor of the policy uncertainty that often hampers investor sentiment (Box IV.2).  -61 - B. Recent Reform Initiatives and the Growing Size of the Private Sector 151. The early stages of Libya's economic transition have witnessed a withdrawal of the State from economic activity and gradual opening for increased private investment. Major bottlenecks to private sector activity that were in effect for a long time are progressively being lifted with an acceleration o f the process in the recent months. Recent progresses o f particular note are summarized inBox IV.l. The speed and decisiveness o f the changes indicate a commitment o f the authorities to further much-needed reforms. The authorities are strongly encouraged to maintain this momentum, as many challenges and important reforms still lie ahead.  - 62 - 151. These reforms have contributed to increasing the role of theprivate sector in economic activity. This i s indeed reflected in the number o f registrations that took place in the recent years, most o f them being Fardi, Usari and ' Tasharuki micro- enterprises, as opposed to larger Musahama firms (Figure IV.1). Figure IV. 1: Enterprise registration, 1992 2005- Fardi and Tasharuki Eumulative registrations: 1992-2005' Musahama cumulative registrations: I992-2005 Tashamki 20000 E! Fardi 15000 2500 2000 10000 1500 5000 1000 500 0 0 1992 1593 1994 1995 1936 1997 1998 1999 2000 2031 2032 2033 2M)4 2035 *: years 2003 and 2004 extrapolated. *: years 2003 and 2004 extrapolated. 152. Still, the size of the Small and Medium Enterprises (SME) sector remains small and the private sector is still overwhelmingly dominated by small micro- enterprises, traders and artisans. Among registered private Libyan enterprises, around 98.6 percent are micro-enterprises o f the Fardi, Usari or Tasharuki type, the rest are mostly shareholding companies (Musahama). In fact, based on a study conducted in 2003, only about one third o f registered firms had filled a tax return that year, suggesting that many may actually not be opearating. Most o f the potential for further private sector growth lies ahead - in particular with the development o f the small SME sector - as many areas are clearly underexploited, particularly inservices. 153. Despite attractive incentives offered by Law No. 5/1997, foreign direct investment outside of the hydrocarbon sector is picking up only slowly. The recent measure imposing a minimum investment amount of US$50 million has reduced drastically the inflow of foreign investment proposals - the current project of reducing this requirement will send a strong positive signal. Since the opening to foreign investment that followed the passing o f law #5 in 1997, 187 projects have been approved. Out o f these, 55 projects have been cancelled for not being in accordance with the Law No. 5. Among the 132 projects approved (totaling slightly more than 5 billionLYD, 96 percent o f which being foreign capital - and about 12700 jobs, 83 percent o f which national), only 38 projects are under operation, while 52 are beingimplemented and 42 are being constituted (Figure IV.2). Given the small size o f the local industry, this performance i s much below the potential o f the Libyan economy. Among the reasons cited by foreign investors who back-tracked from their initial interest or cancelled their projects are: the difficulty to access industrial land and the lack o f clarity in the property-right status; and the bureaucratic processes. As further explained below, a number o f dimensions o f the regulatory environment for  - 63 - foreign direct investment can be improved. Moreover, Libya still suffers from a mixed perception by foreign investors regarding the credibility o f the reform agenda and the soundness o f the overall business environment as it relates to the quality o f economic governance (see below). Figure IV. 2: Foreign direct investment projects: 2000-2006 200 Approved projects 1 180 160 Cancelled projects 140 Projects under inception 120 / 100 Projects under / areoaration 80 60 40 20 0 1 2 3 4 1 Source:Libyan ForeignInvestment Board(dataas of February 2006). C. ImprovingBusinessRegulationsand ReducingPolicyUncertainty 154. The State has begun to withdrawfrom economic activity, but the regulatory framework that supports the transition to the market, suffers from major deficiencies. In particular, private sector activity is still heavily dependant on discretionary decisions and approval procedures on behalf o f the administration. This i s compounded by the fact that the laws and regulations governing business activity are changing rapidly, while the decrees and texts that should detail how these laws should be applied and enforced, are lagging behind. Moreover, key regulations regarding the land and labor markets, taxation and the trade regime, need to be reviewed to be consistent with the functioning o f a market economy. 155. Discretionary power to public administrations (in particular, local authorities) appears in many areas of business activity, despite recent improvement in business creation procedures. Such leeway and non-clarity in the regulations inevitably lead to rent-seeking situations, corruption, opportunities to limit competition and protect existing businesses, and considerable uncertainty to entrepreneurs. International experience suggests that firms in developing countries rate policy uncertainty as their dominant concern among investment climate constraints (Box IV.2). The most notable examples o f policy uncertainty for business operation inLibya include: 0 The approval process for foreign investment under Law No. 5, even if the Libyan Foreign Investment Board plays a positive role o f facilitation, the regulations are still far from best practice; The positive list o f sectors open to foreign investment;  - 64 - 0 Minimumcapital requirements for Musahamas and foreign companies; 0 Ambiguityinthe laws governing landproperty and ability to rent; 0 The rapid change in the legal apparatus is creating increased uncertainty as many decrees o f application o f the new laws remain unpublished, and some new laws appear to be inconsistent with old, outdatedlaws26. nrernfor investorsindevelopingcountries shows that for firms in developing countries, policy jtment constraints, such as skills, regulation, tax and Itymay influence investment indifferentways: firms Intenment climate concerns of firms oCrime 8 W ' S 0 Electricit) -- 2 3 % 19% 156. Despite recent improvements that led to a more declarative process, the approvalprocess in business creation remains intrusive- Whether creating a Fardi, Tasharukyia, Usari or Musahama firm, investors and entrepreneurs request approval to operate. This request i s accompaniedby clearances regarding the suitability of the premises, evidence of qualification and health certificate. A committee then decides 26A case in point is that the Libyan Commercial Code dates back to 1955, and the labor code dates back to 1970 (Law No. 58). Recent changes - most notably laws 21/2002 and 2112004 - partially supercedethese outdatedlaws, but not completely.  - 65 - whether to approve the request, based on unclear criteria. International best practice shows that business entry in unregulated sectors (Le. excluding, for example, health and sanitation, or environmentally sensitive sectors) should be made on a declarative basis, with a clear list o f documents to be submitted that give automatic right to the business license. Verifications o f conformity to environmental, security, health and construction standards should be made ex-post, to verify that the investor i s abiding by the law. No assessment o f the feasibility o f the project or the skills' fit o f the investors should be made by the administration. While the decentralization o f the process for local investment can be instrumental in speeding business entry, such discretionary powers to public officials can also increase uncertainty for investors or create opportunities for rent seeking and abuse at the local level. While maintaining such a decentralization process, the uncertainties and opportunities for arbitrariness in business entry should be significantly reduced, while installing a (central) appeal systemfor rejected applicants, for example, by expandingthe role o f LFIB. 157. -as is the approval process for foreign investment under Law No. 5. Similarly to local investment procedures, and despite an attractive framework, approval o f a foreign investment follows from a careful analysis from the Libyan Foreign Investment Board. As further explained inthe next section, this practice i s not consistent with international best practice (resting on simple registration or notificationrather than approval procedures) and shouldbe reviewed. 158. Thepositive list of sectors open toforeign investment is restrictive. Article 8 o f Law No. 5 provides that foreign investment is allowed in "....Industry, Health, Tourism, Services, Agriculture.. ..." and any other area determinedbythe GPC-areas that have recently been expanded to include telecommunications and transport, but not retail trade. However, as further explained below, when regulations beyond Law No. 5 are examined, it appears that ina number o f key sectors with great potential for attracting foreign direct investment and realizing efficiency gains market access is restricted. 159. Minimum capital requirements for Musahamas and foreign companies are unclear or way too high. These are not specified by the law (except for foreign investments, for which the minimumcapital required i s US$50 million) and are left to the discretion o f public officials at the time o f the investment proposal. To avoid any opportunities to create barriers to entry, the international best practice i s to set a low level o f minimum capital requirement, leaving to investors the freedom to choose the level required for their activity. 160. Ambiguity in the laws governing landproperty and ability to rent. While the law recently allowed administrations and public enterprises to rent land and premises, no indication was made on how the rent i s estimated, the type or term o f concession contracts, the ability to use the land as collateral. In fact all o f these are left to the discretion o f the local authorities. A similar ambiguity limits the development o f a private rental market, as formally only leasing agreements are accepted for private land and houses, with no obligation to buy at the end o f the leasing period (defacto mimicking a rental contract).  - 66 - 161. I n addition to removing the uncertainty related to existing laws, there is a need to review key regulations governing the labor market, the land market, the trade regime, and corporatetaxation: 0 The labor regulation. The government is currently in the process o f reviewing the labor code. It is important that the new legislation gives flexibility to firms to control the size and quality o f their labor force. At the same time the labor code should mandate employers to provide appropriate working conditions to their employees and to adopt occupational safety standards. 0 The land market. A private land market coexists with a public land market, with a price gap that leads to distortions and speculation. The market needs to be unified and the legal framework for industrial land revamped. Industrial zones with independent (private) management should be developed. Parallel to this, the service and maintenance o f infrastructure inindustrial zones should be opened to private participation. 0 The trade regime. Important initiatives to promote openness to trade have been implemented. To improve the transparency o f import duties and reduce the scope for discretion, it is advisable that import duties and other taxes levied on imports be consolidated and harmonized. Although a reasonable degree o f protection may be sought at the initial stages o f the transition to the market, it is important that a credible and ambitious time-frame for reducing protection be announced to create sufficient incentives for restructuring and efficiency gains. 0 The tax regulation. The progressive corporate income tax should be replaced by a flat tax, because it provides incentives to split companies, thus impeding corporate growth, and increases the room for discretion in the interaction with the tax administration (see Box IV.3). This tax rate should be reduced to levels comparable to countries with a favorable business environment (currently the top rate i s at 40 percent - plus 4 percent Jihad tax-among the ' highestinthe region).  - 67 - 162. All of these weaknesses may not be constraining at the present stage since private sector development outside of micro-enterprises is in its infancy, but authorities should start addressing these in the very short term. At the outset, they represent significant uncertainty to local and foreign investors. Most o f these reforms require institution strengthening, legislation review and investments. These are time consuming reforms and often politically difficult changes to implement. Unless these are addressed in the short-term, these issues will start to be increasingly constraining to private investment. The result would be a private sector dominated by a few large firms, with no opportunities for healthy competition and productivity growth. D. Strengthening Market Institutionsand Enforcingthe Ruleof Law 163. While progress in the regulatory apparatus is undeniable, reinforcing the necessary institutions to support the emergence of a market economy is lagging behind. Whether in the judicial sector, the public administration, the customs, the competitive framework, or the market information framework, the withdrawal o f the State from economic activity has to be accompanied by a reinforcement o f its regulatory role and the improvement o f its administrative services to enterprises. 164. I n parallel to opening-up to private investment, strengthening the institutions supporting the functioning of competitive markets, should be a short- term priority. Inparticular, the authorities should reinforce the following institutions, which have been identifiedas weaknesses inthe current investment climate: 0 Thejudiciary. With the transition, the legal framework i s evolving rapidly. There may be a need to strengthen the judiciary as a key institution for sustainable economic development. A thorough review o f the judicial system would be advisable to confirm the need for and design a judicial modernizatiodstrengthening program based on actual needs and constraints and benefiting from lessons o f experience o f other transition countries.. 0 The public administration. While the full decentralization o f the administration can help spur local investment, a system o f checks and balances, and appeals, need to be put inplace to avoid abuse, arbitrariness and rent-seeking opportunities at the local level. Moreover, strengthening the administrations that interact with firms i s needed. This will require reviewing the administrative processes in order to move from the current culture of control and approval, towards a more business-friendly culture o f public service and ex-post control that enterprises are abiding by the law. It will also require extensive training as the laws and regulations are changing rapidly. 0 The customs. Reforms in customs administration should be pursued to improve professional and technical skills and operational capacity with the aim o f tackling informal trade; improving coordination across all border management agencies to reduce excessive delays in clearance; adopting  - 68 - modem, risk-based approaches to clearing imports and exports (see section 6 below). 0 The competitive framework. A competition law i s under preparation. It i s important that competition policy be consistent with international best practice, to create contestable markets and facilitate market entry and the growth o f new, innovative companies. This will be a key factor to promote sound private investment and productivity growth. In the medium term, a strong, independent, and well-endowed competition authority should be put in place. 0 The market information framework For a market economy to function well, investors, bankers and other market players need to have access to reliable information, in particular sectoral information. Currently, the availability o f recent and reliable information i s lacking in Libya. The information system needs to be strengthened and be made available to all market participants. 165. Market institutions need to be strengthened in Libya, but only the enforcement of the rule of law will give these institutions the independence and the legitimacy toplay their role. Enforcingthe rule o f law equally to all economic actors, as well as the administration, i s at the heart o f a well functioning market economy. This is particularly the case for the judicial system, which is central to any market economy, but i s even more important in the context o f a transition, where laws are changing rapidly, major ownership transfers take place - in particular through privatization -,and competition increases. Currently, very few business disputes are settled through Libyan courts. This i s likely to change as the markets develop. Also, the capacity o f the judiciary to enforce the rule o f law - often more so than the laws themselves - i s a key ingredient to reinforce investors' confidence, particularly foreign investors. E. AttractingForeignDirectInvestment(FDI) 166. Despite the signijkant steps towards liberalization of foreign investment, Libyan authorities seem to favor an interventionist approach to attracting foreign investment,promoting largeprojects, after careful screening, in sectors where there is no or little domesticproduction. With the exception o f this fundamental flaw, Law No. 5 i s rather liberal. A Libyan investor, repatriating capital from a foreign country, can be considered as a foreign investor for the purpose o f the law, a clear signal to the Libyan diasp~ra*~.Many guarantees critical for foreign investors are enshrined in the law, with the notable exception o f the "national treatment" guarantee. Incentives are also sub-optimal and not inline with best international practice. Clearly, this i s more a policy issue than a problem with the law itself. Investment Laws are as good or bad as the policies they are designed to implement. What needs to change is the investment policy and the attitude towards FDI. Changes to the law will naturally follow. The regulatory framework for FDIi s assessed below with regard to three critical issues: ,(i) Admission o f Investment; (ii) Guarantees accorded to investors; and (iii) issue o f The Investment Incentives. *'LawNo. 7 of 2003 also allows Libyans to invest in joint ventures with foreign investors (in local currency, or inkind), andbenefit from the incentives of LawNo. 5.  - 69 - 167. On the positive side, foreign investment has recently been opened to new sectors, including transport, oil refining, and insurance. These sectors have also been opened up for privatization. However, the retail trade sector remains closed to foreign investment, although it has the potential to promote significant efficiency improvements, as well as job creation. Also, joint ventures between Libyan and foreign investors are now permitted to benefit from the incentives o f Law #5, with no limit on their respective shares. In line with these positive developments, the authorities should consider reforming Law No. 5 so that its provisions be extended to all investments, whether local or foreign. 168. However, in contrast with these improvements, the recent decision setting the minimum capital requirement for foreign investments to US$50 million is, de facto, a ban on mostforeign investmentsLibya could potentially attract in the non- oil sector. Despite progress on other fronts, this decision i s a serious setback to the reform agenda, which inevitably sends strong negative signals to foreign as well as local investors. Flows o f FDI in non-hydrocarbon sectors and intentions o f investment have already declined significantly in response to this decision. The Libyan authorities are currently considering reverting to a more open regime, independent of investment size. (9 Admission of Investment into Libya under Law No. 5 a) Sectors open toforeign investment: 169. A number of key sectors are, either by law or,defacto, closed to foreign direct investment. Law No. 5 is somehow deceptive in this regard. Art. 8 provides that foreign investment i s allowed in ". ...Industry, Health, Tourism, Services, Agriculture ....." and any other area determined by the GPC. A rapid reading o f the law may lead the casual observer to conclude that Libya i s filly open to FDIgiven the fact that industry, services (which tourism and health are subsets of) and agriculture are the three components o f any economy. When the regulatory framework beyond Law No. 5 i s examined, however, it appears that: 0 FDI is not allowed in the trade/distribution sector, both retail and wholesale; and commercial agents can only be Libyannationals; 0 Telecommunications (both the fixed line and mobile network) are still a State monopoly, thereby depriving foreign investors from an opportunity to invest in a sector that has attracted considerable amounts of FDIaround the world, including most developing and transition countries; 0 Foreign participation in the banking and financial sector, while not formally forbidden, does not seem to be currently consideredby the authorities. 170. For FDI to flourish and Libya to realize its potential for growth, especially in services, there should be as few restrictions as possible. Closing entire sectors to foreign investment, de facto or de jure, conflicts with the stated governmental objective o f attracting more FDI outside the oil sector and diversifying the economy in services. Experience from developing countries suggests that injecting greater competition in services holds important potential for efficiency gains that benefit the economy as a whole (Box N.4).The Government might want to consider lifting some o f these restrictions by opening more sectors to foreign participation, either through  - 70 - liberalization (allowing private sector involvement in former monopolistic sectors or activities), new `greenfield' investment, or the acquisition o f existing companies (for instance through the privatization program). The Law i s as good or bad as the investment policy it seeks to implement. A decision to change the investment policy has to be made first; then the law can be easily and quickly revised to reflect the new policy. vice liberalization. General equilibrium model estimations tatic gains estimated at 9.4 percent of GDP on a baseline countries from service liberalization are almost six times figure). xies of iervices, Ed those xeover, rt and j the iervices, y. East :started :tor and im with Fcreign t e n k x w in pecrnt3g2 OS mal ten kasw m 60 m QJ 30 a 10 0 K;Y; Latln MENAII MEHAI art A rrerta Asia  - 71 - 171. The system of positive list that is used in Law No 5 is sub optimal. Best practice i s to clearly state in the FDI Legislation what the sectoral restrictions are, using a negative list system to do so. The best investment codes provide in unambiguous terms that "foreign investment is free in the country in all sectors and activities except in a number o f sectors where some restrictions exist". Then these sectoral restrictions are listed, preferably in a document attached to the Law as annex and with executive rather than legislative value (such as a decree or governmental decision). The benefit o f having the list itself in an executive level document i s that, as the country advances inits liberalization program, it will be easier to revise the list than if it were included inthe body o f the law itself. Experience suggests that the list should be as short as possible. A long list o f sectors where there are restrictions will send a very negative signal to the investor community, Le., that in spite o f official pronouncements, the country i s not really open to foreign investment. (3) Majority ownership i 172. Majority ownership is an issue where Law No. 5follows bestpractice. There i s under Law No. 5 no limit on equity participation o f foreign investors. This corresponds to best international practice and constitutes a very significant progress vis-a-vis the previous situation.28 (c) Theprocedure to invest 173. The procedure in place for FDI admission into Libya is one of screening/approval. In short, the foreign investor has to submit an official application to LFIB, including a detailed feasibility study and 5-year financial and economic projection^.^' The LFIB reviews the application and submits its recommendations to the Secretary who makes a determination. The Board also determines the minimumcapital that the Libyan corporation to be formed should have (recently a minimum capital requirement o f US$50 million has been imposed, which i s way too high, but the authorities are currently considering reducing this to about US$5 million which would still remain quite highby international standards. Inmany countries, a limited liability or even a joint-stock company can be formed with only a fraction o f this amount. The authorities are thus explicitly favoring large investments in sectors where local industry is not present). The business license is granted for 5 years, renewable, and gives access to the investment incentives discussed in a subsequent section. No other registration i s in theory required from the foreign investor. 174. system could cause unnecessary delays and uncertainty for investors, even if the I n addition to not being consistent with international best practice, this Libyan Foreign Investment Board's mandate is precisely tofacilitate theprocess - moving to a higher rate of foreign investment will require less intrusion in the investment process. As it is designed, the process will inevitably lead to biased ** Under the 1970 legislation, foreign investors were forced into joint venture arrangements with Libyan (public) investors and the foreign party's participation could not exceed 49% thus leaving the majority and control of thejoint venture to the Libyan partner(s). Needlessto say this double constraint of forcedjoint venture and of minority foreign ownership did little to attract FDIinto Libya. 29 A Libyan Foreign Investment Board (LFIB) was establishedunder the Ministry (General People's Committee) of Planning, Economy and Commerceto implementLaw No. 5.  - 72 - decisions to protect local companies when foreign investment will increase and projects will be submitted to compete with already existing businesses. Once they will secure a large FDIproject ina sector they want to expand, it i s unclear whether other authorizations will be issued for projects inthe same sector, be they domestic or foreign. Such a strategy hasfailed in most countries that experimented with it. It can also create rents and private monopolies and thus it minimizes the efficiency gains that should result from increased private investment. Also what a Government views as a priority may not always coincide with foreign investor's perceptions o f what constitute an interesting opportunity. Because o f this unfortunate choice o f approach and procedure, Law No. 5 - that was designed to signal to the foreign investor community that Libya was open for business- does not place Libya among the most attractive destinations for foreign investment when compared to neighboring countries like Egyptand Tunisia. 175. The international trend is to replace the screeningprocedure andfeasibility study with a simple notijkation or registration system. Egypt, for instance, did away with the screening procedure/approval requirements for all new projects in 1996/97. Turkey abolished it in 2003. These are two examples that hlly reflect international trends. The procedure can be the same as that in place to form a company under domestic law. People who oppose the abrogation o f the screening and feasibility procedures often cite the linkage to investment incentives. The fact i s that incentives, if any are offered, should be granted as automatically as possible. In other words, there should be clear guidelines and criteria for the eligibility to incentives and all investors meeting these criteria should have access to them without a discretionary decision. (ii) Guarantees to investors 176. Law No. 5 provides several key guarantees that foreign investors expect to find-even though the guarantee is not always as broad as it could have been: The right to open an account in a convertible currency in a Libyan commercial bank for the needs o f the project (art. 16) The right to repatriate profits (art. 12.C). This i s apparently allowed once a year only ("annually"). Protection against expropriation . A very good standard o f protection i s recognized by Law No. 5 (art. 25) and can be considered as equivalent to best international practice. The right to employ expatriates (art 12. D) "when local workers are not available". More liberal investment regimes do not place any restriction on expatriate employment. Employing expatriate workers i s very costly and experience shows that foreign investors spontaneously limit the number o f expatriates they employ and try to fill as many positions as possible with local employees. Rightto own or lease land is guaranteed (art. 15). Finally, access to arbitration i s also recognized (art. 24).  - 73 - 177. However, one of the mostfundamental guarantees, and one offered in many countries around the world which is missing is the guarantee of "National Treatment". National treatment guarantees that there shall be no discrimination between a foreign and a domestic investor and this has many concrete implications. It also helps judges or arbitrators interpret a specific legislative provision in disputes opposing the investor and the State or a governmental agency. National treatment should be grantedto foreign investment without reservations or exclusions. (iii) Investment Incentives 178. Law No. 5 provides for a rather generous package of investment incentives. Under Art. 10, the foreign investment project that i s authorized by LFIBreceives: 0 An exemption from corporate income tax (tax holiday) for 5 years, with a possible 3-year extension, provided that net profits are re- invested in the project; during this period losses can be carried forward. The exemption covers CIT and stamp duties on legal documents. 0 An exemption from customs duties and taxes on the imports o f machinery, tools and equipment needed for the execution o f the project. An exemption from customs duties and taxes on the imports o f equipment, spare part, and primary materials i s also granted for the operation o f the project, for a period o f 5 years. 0 Exemptionfrom excise taxes for goods that are exported. 179. The tax incentive regime is not consistent with best practice. First, identical incentives are not available to domestic investors in Libya. It i s strongly recommends that all investors be treated equally, regardless o f nationality, to ensure a level-playing field and competitive operation o f markets. Thus it i s advisable to harmonize the tax incentives across all investors. A second issue i s the proper place for any incentives: fiscal incentives, if any, should be authorized in the tax code while any other incentives should be in other appropriate legislation - not in the foreign investment law. 180. Although some tax incentives can be useful at the beginning of a country's efforts to attract FDI, they are not without risks and negative implications, especially tax exemptions. Tax incentives introduce distortions in the economy and across sectors (between firms that receive them and those that do not). They are fiscally costly. They generate a strong opportunity o f corruption and nepotism. They have no proven efficacy in attracting FDI. Experience suggests that incentives are effective when they are: (i) simple; (ii) in terms o f who gets them; (iii) precise clear on the benefits they offer; (iv) targeted to specific aspects o f investments rather than being too general; (v) post facto, that is, extended after the targeted investment is made; (vi) transparent, allowing for little or no discretionary decisions and (vii) involve lower rates o f taxation. 181. A wiser strategy, that an increasing number of countries are opting for, consists in putting in place a more competitive business environment through a series of targeted reforms. There are many things that investors find more attractive than a tax exemption granted through a lengthy and discretionary process, including  - 74 - better quality infrastructure, more qualified labor, easier access to land, less burdensome administrative procedures, etc. In the tax area, it may be argued that lowering the CIT rate and abrogating the Jihad tax while at the same time fostering transparency in the tax procedures would be a reform that would appeal to many potential investors. Experience shows that when a better business environment and more competitive tax system i s in place-which can be achieved in progressive stages-tax holidays can be abrogated without harmful consequences on FDI promotion efforts. Tax holidays can also be replaced by tax credits, allowances, or accelerated depreciation, all instruments that investors find very attractive and that create less distortion inthe economy. 182. To the extent that Libya wishes to offer tax incentives to potential foreign investors, such incentivesshould be offered: 0 equally to domestic and foreign investors 0 equally across sectors/activities 0 made available in the form o f tax credits, tax allowances, or accelerated depreciation (rather than tax holidays or exemptions) 183. Summing up, there is realpotential for moreforeign investment into Libya's economy. The country enjoys significant mineral resources (this factor alone offers cheap and abundant sources o f energy as well as opportunities to provide a range of services to the oil industry), a large territory close to the European market, as well as a rich cultural heritage and beautiful natural features (a long coastline and the Sahara desert). Together the last two assets, ifproperly managed, offer clear opportunities for quality investmentsinthe tourism sector. 184. -but, in the context of stiff competition, Libya's only chance to realize this untappedpotential is to put in place a first-class business environment, free of the constraints that currently make Libya a difficultplace to invest. Inparticular, some o f Libya's assets (such as proximity to Europe) can legitimately be claimed by Libya's neighbors in the Maghreb and Mashreq. These countries can also claim to enjoy a better business environment, more liberal economic policies, and more favorable investors' perceptions; they already have significant FDI inflows, having joined the "race" for FDImuch earlier than Libya. F. The Public Sector and the Current PrivatizationStrategy 185. With a public sector representing a large share of non-hydrocarbon GDP and 70 percent of employment, opportunities for new private `entrants', whether foreign or domestic, are necessarily limited. The State retains strong monopolistic positions in key infrastructure sectors such as telecommunications, electricity, ports, roads, etc. Public utilities seem to be, by and large, inefficient; they often provide low-quality public services, consume extensive subsidies, and are reported to have obsolete equipment. But, as already mentioned, these public utilities, that could strongly benefit from foreign participation (because o f their urgent need for advanced management techniques, technology, and capital infusions) and that are o f high interest to foreign investors in many countries are currently closed to foreign investment. Public utilities are not the only problem. The State also owns or controls many normally private commercial activities (such as commercial banks). Many foreign investors are not attracted to countriedsectors in which they will have to  - 75 - compete with Government-owned entities that may enjoy large subsidies, state protection or other advantages that will distort competition. The current plans to restructure the public sector, privatize or liquidate many SOEs, and open more sectors (such as telecom, banking and other service sectors) to competition and foreign participation may change this state o f things and open more `space' for the private sector, including FDI, to flourish. 186. The general framework for privatization was established in 2000, however the strategy is not fine-tuned and a pragmatic, learning-by-doing approach has been adopted. There i s no privatization law per se, but a framework has been adopted which defines the overall strategic approach. The program i s ambitious in scope as it intends to sell out all 360 enterprises in those sectors, which do not include the utilities (electricity, gas, and telecoms), the oil and gas sector, the banking sector and the air and maritime transport sectors. Most o f these enterprises are overstaffed and incur recurrent losses, as recruitment in the past was based on social grounds rather than on economic efficiency. Moreover ongoing trade liberalization since 2001 has ledmany o fthem to stop operations as their products were no longer marketable. 187. While the authorities are committed to privatizing the State-owned sector, the current strategy of ownership dilution by public sales is unlikely to lead to the efficiency improvements expected, at leastfor medium and large firms. Individual ownership remains limited to 10 percent o f capital - a constraint that i s inconsistent with the objective to move to a market economy, where ownership shares should not be capped by law. International experience has shown that no institutional or legal arrangement can really enforce the independence o f SOEs and change their managers' incentives, until they are privately (majority-) owned by an individual or a firm since 2004 - some State-owned enterprises (SOE) have been privatized and/or shareholder, granting management control. Even if some progress has taken place financially restructured; some outstanding debts o f SOEs have been absorbed by the treasury; SOEs now fall under the commercial code and commercial companies laws; and the idea o f foreign participation in privatization deals i s now accepted -, it remains unclear whether sales to strategic majority investors will be authorized and to which extent hardbudget constraints are imposed on the remaining state-owned firms in the course of the transition, and how independent they are from Government interference. 188. I n parallel to privatization, it is essential and urgent to improve the investment climatefor accelerating private sector development and toput inplace a safety net to mitigate the transition's effect on employment. The current oil windfall gives Libya a unique window o f opportunity to put inplace a generous safety net that can facilitate these reforms from a social standpoint, and therefore maintain, throughout the transition phase, the objective of social justice and equity that are fundamental to the Libyan people. 189. To that effect, two new Funds have been introduced in 2003 as a support to the privatization program. The first fund i s aimed at supporting new activities by employees in overstaffed public enterprises in the process o f privatization. A second fundhelpspublic companies to improve their financial situation, level o f activity, and the quality o f their products. This fund i s financed from: revenues from import taxes levied on luxury goods, the sale o f enterprise's inventories, part o f the recent increase  - 76 - inthe price of cement and steel, part of the revenues from the privatization of public companies, and the government budget. 190. Two strategic priorities motivate the way the authorities intend to conduct privatizations: first, employment protection coupled with a generous social safety net for employees who will be - as a last resort - displaced. Second, as a general rule, and as far as this i s feasible, shares are to be divestedto a large number of individual owners to avoid concentrated ownership and to favor Libyan ownership. 191. Lessonsfrom international experience in privatization are in many aspects in contradiction with the current strategy (also see Box IV.5). Given that the process i s at its early stages, the authorities are encouraged to reassess the current privatization method and have the Government Board for Ownership Transfer (GBOT) seek expert advice in the areas o f firm evaluation, competitive bidding, and to draft a comprehensive privatization law. e I n general, privatization through employees' ownership does not produce good outcomes. It usually leads to poor corporate governance. As a general rule, it i s important that one or a group o f investors acquire a significant share o f capital and get corporate control over the privatized companies. Only then can these main shareholders interests be aligned with management interest. The authorities are encouraged to review the privatization strategy for Libyan public SMEs, to allowfor local investors to acquire significant shares of capital at the initial shares' offering stage. The sales process to foreign investors should be based on international competitive biding. This is not only important to allocate the capital to the most promising investor and maximize the sales value, but also as a strong signal o f good governance towards international investors, which is important beyond the privatization transactions per se. Prior to privatization, public enterprises should be partly restructured. Large SOEs are often overly integrated, highly indebted, and overstaffed. The authorities should, prior to privatization, engage inthe difficult tasks of (i) reducing SOE debt (at least the short term debt resulting from accumulated losses); (ii) non-core activities selling and services; (iii)selling unused assets (land and buildings); (iv) starting to reduce overstaffing; and (v) settling titling and ownership issues. The process should be time-bound with clear verifiable steps. Important in any transition i s to build consensus for the benefit o f reforms, and sendingclear and credible signals for investors. Defining a time-bound and credible privatization program with a dedicated communication strategy (inclusive o f all stakeholders) are key in this regard.  - 77 - e The privatization agency should have clear rules and an explicit mandate. For example, it should have an independent legal existence, and its CEO should have all incentives to maximize the probability o f success. Its financing should partly be based on the privatization receipts and it should report directly to the highestauthorities. ,I n the transitionperiod toprivatization, public enterprisesshould be faced by market-oriented incentives. In particular, it will be key to: (i) hardbudgetconstraintsonpublicenterprises,(ii) impose strengthen their operational independence, and (iii) that the State does not ensure intervene inthe credit market to support loss-making enterprises.  - 78 - G. Trade Policy Reformand CustomsAdministration (i) Tradepolicy 192. Libya has taken steps topromote openness to trade. Licenses were abolished and tariffs eliminated on all goods, except cigarettes for health purpose^.^' This i s a unique case in the region and very rare worldwide (only Hong-Kong, Macao, Singapore and Switzerland have currently set tariffs to zero). Trade restrictions on some products remain. There are four products for which imports are reservedto State enterprises: raw gold, tobacco, veterinary medicines and vaccines (besides oil and security related products). Import bans also remain for 18 items (down from 31 in 2003). While some are for religious, health, ecological and ideological considerations, others are aimed at protecting the local industry (telephone equipment for fixed lines, liquid pasteurized milk, mineral water, flexible PVC plastic pipes, etc.). Export bans apply to iron, copper, aluminum scrap and coal. 193. Exemptionsfrom import duties granted to public sector companies to offset the impact of exchange rate unification in 2002 have been abolished. Activities remaining exempted from import duties are those related to diplomatic exemptions, migrants' belongings, investment incentives, external financing, grants and assistance, non governmental agencies and conditional exemptions. 194. However, the discriminatory Consumption Tax and Service Fee is equivalent to tradeprotection and reduces the transparency of the trade regime. For selected sensitive imported goods that are also produced locally, the Authorities levy the Consumption Tax on imports (mostly at 25 percent and for some products at 50 percent). A production tax at a uniform rate o f only 2 percent3' i s levied on the equivalent local production o f these g ~ o d s . ~ ~ Tdistortion serves to create an h i s obvious protection o f local production from imports. An additional 4 percent charge i s levied on all imports to cover customs fees (Service fee). An importer thus potentially faces two add-on charges: the servicefee and the consumption tax, both collected by the Customs Department.33Indeed, the authorities justify these taxes by the need to provide temporary protection to newly privatized firms and to reduce fraud and corruption at the Customs Department. 195. The classification of goods subject to the consumption tax lacks transparency. A hundred products (up from 76 in 2003) broadly defined are concerned (see Table in Annex 4). As a result o f the 2005 reclassification o f goods subject to the two taxes, the average consumption tax rate increased to 29.1 percent, 30 In 2003, import tariffs ranged between zero and 100% (compared to tariff peaks of 425% previously).The simple average tariff rate was 16.5%, down from 17% in 2002. The trade-weighted average tariff (based ontrade values for 2002) was higher at 19.9%. 31Upto 2005, the consumption and production taxes dispersion was higher: 10, 15, 20, 25, 30, 40 and 50% for the former, and 2, 3, and 5 % for the latter. 32A rough calculation suggests that the consumption tax increasedthe simple average duty applied to imports from 16.5 to 18.5% in 2003. The trade weighted average duty rises from 19.9to 23.4% once the discriminatory consumption tax is taken into account. Hence, the consumption tax leads to a significant increaseinthe burdenof taxation of imports. 33Customs Departmentused to collect an additional tax, the regional and social solidarity tax that was a percentageof the import duty. Since import duties per se do not exist anymore, this tax does not exit anymore.  - 79 - from 26.5 percent in2003, while the average production tax was reduced to 2 percent, from 2.6 percent in 2003. The authorities are however currently working on identifying these products following the trade nomenclature (Harmonized System) as previously recommended by the IMF and World Bank. The new classification (HS 6 digit) will likely reveal a higher number o fproducts subject to the consumption tax. 196. As a first step, it is advisable that taxes levied on imports be converted into tariff rates. The consumption and production taxes create strong incentives for discretionary interpretation, misclassification, lobbying from local producers seeking protection, and, ultimately, corruption. To promote a sound investment climate, these taxes should be .integrated into the tariff rate structure. This would ensure greater transparency and a more realistic and accurate picture o f the protection level. Moreover, these taxes violate one basic WTO principle, that o f national treatment, and will have to be removed when Libya negotiates WTO accession. This will also be an obstacle to a possible negotiation o f an Association Agreement with the EU. 197. As a second step, harmonized tariff rates (or currently Consumption tax) should be reduced within a clearly announced timeframe. Although a modest degree of protection may be sought at the initial stages o f adjustment towards a market-oriented economy, it i s important that a credible and ambitious time-frame for reducing protection be announced to create sufficient incentives for restructuring. International experience suggests that high levels o f protection usually delay adjustment, as they prolong the life o f inefficient public enterprises without providing strong enough incentives for more ambitious restructuring. High protection also weakens incentives o f private sector companies to improve efficiency and become competitive in open markets. Reduced protection will also guarantee Libyan citizens access to a wide range o f goods at internationally competitive prices and better quality. The fact that the reduction in tariffs o f imported raw materials and intermediate inputs increases the effective protection o f domestic producers should also be factored in when designing an appropriate schedule for the reduction o f nominal tariff protection for goods with locally produced substitutes. Exporters should be compensated (for example, with an appropriately designed duty drawback scheme) for the tariffs paid on imported capital goods and raw materials so that they are competitive on the international market. 198. Efforts should be continued to reduce protection dispersion. Taxes and tariffs should be set as uniform a rate as possible. The government should bring down the highest rates first and increase the uniformity o f the tariff schedule. Social costs created by taxes are proportional to the square o f the tax rate, so reducing the highest rates brings the greatest static welfare gains. Moreover, it i s the best known way to reduce the discretion and potential administrative bottlenecks in the trade system. A wide range o f tariff rates increases the administrative burden in applying trade policy and collecting tariff revenue and is less effective in preventing smuggling and corruption. In general, a given amount o f tariff revenue will be more efficiently collected through a small number o f tariff bands. These efforts should be accompaniedby a more simplified and better-defined classification o f goods. 199. State import monopolies have been reduced butprice distortions still remain in a number of markets. State-owned companies now face competition from the private sector, which can freely import and/or produce these goods. However, price  - 80 - and profit margin controls still remain in a number o f markets (for example, for private sector imports o f subsidized consumption goods), although enforcement capacity o f these controls seems weak. Import bans that cannot be justified on the basis o f religious reasons should be eliminated as they directly affect consumer welfare. Health and ecological issues should be addressed through appropriate product standards. 200. Opening to competition key backbone services-such as telecommunications, financial services, and transport-is an important condition for competitiveness and growth. Regulatory reforms that will inject more competition in markets for services and network industries, through private sector participation in the provision o f services, will force operators to improve efficiency and pass on the lower production costs to users. As already discussed, creating more opportunities for private sector investment in services will also generate more jobs and help offset the short-term adjustment costs from the reduction o f protection for import-competing industries (World Bank, 2003a). 201. Complementary reforms tackling behind-the border impediments to trade are crucial for trade reform success. Trade reform works best for economic efficiency and productivity growth when it goes in tandem with complementary reforms to eliminate behind-the-border impediments in customs, standards, ports, communications, and other barriers to trade. These barriers are the less tangible but a recent survey o f 230 companies in eight Arab countries34shows that (i) on average, one percent o f the value o f imports is paid as "additional payments" to customs officials; (ii)it takes two to five days on average to release goods importedby freight from customs and two to ten days for sea shipment. Incontrast, the norm i s less than six hours to clear air freight, less than 24 hours to clear sea freight, and less than four hours to clear shipment by road. Removing these barriers will considerably improve Libya's attractiveness to foreign investment while promoting the competitiveness o f domestic companies. (ii) Accession to the World Trade Organization 202, WTO accession provides a good opportunity for comprehensive review and reform of Libya's trade institutions. One benefit o f the accession process i s that it forces the government to examine all laws, policies, and institutions affecting international trade and investment. It provides the opportunity to integrate trade policy into the country's overall strategy for economic reform. Libya will be expected to make bindingcommitments on more thanjust the levels o f customs duties. Libya will need to reform laws and institutions inmany policy areas traditionally thought o f as purely domestic concerns. It will give the opportunity to Libya to send a message to foreign investors that it i s open for business and accepts international discipline in crucial areas. As a consequence, this means that WTO accession cannot be the sole concern o f the trade ministry. Experience from other countries shows that institutionalized inter-ministerial cooperation and participation o f the private sector are necessary ifLibya i s to avoid delays in accession negotiations. 34 Countries are: Egypt, Gaza-West Bank, Jordan, Lebanon, Saudi Arabia, Syria, Tunisia, UAE (Zarrouk, 2003)  - 81 - 203. WTO accession negotiations will place a high demand on administrative resources. Like all other candidate countries, Libya will be expected to first undertake a thorough review o f all laws, regulations, and policies that affect international trade and investment. Known as the Memorandum o f the Foreign Trade Regime (MFTR), this review follows a standard format and must contain all o f the following: 0 a general description o f Libya's economy, economic policies, political structure, and the framework o f its basic laws, 0 a description o f all policies that affect trade in goods, whether traditional trade policies (e.g., import and export licensing, customs duties, other charges, export taxes, quantitative restrictions, regional agreements) or internal policies that have even indirect effects on goods trade (e.g., industrial and agricultural subsidies, intellectual property rights, standards, commodity taxation, government procurement), and 0 a description o f all laws, regulations and policies affecting internationally tradable services (e.g., banking, insurance, telecommunications, transportation, business services), whether these affect cross-border trade in services, the establishment and operation of enterprises to provide services within Libya, or the movement o f individuals into Libya to provide services. 204. Assistance from experts knowledgeable about WTO documentary requirements can reduce delays in accession negotiations. WTO submissions must follow a prescribed format. The methodology used to calculate agricultural subsidies, for example, i s unique to the WTO. Libya can substantially reduce frictions in the early years o f accession negotiations by relying on international experts who have prepared similar documents inother countries. 205. WTO members will expect reforms in the basic structure of economic management. After the review o f the MFTR i s concluded, WTO members will ask Libya to ensure that its economic policies conform to basic WTO norms o f transparency and nondiscrimination, and to the terms o f specific WTO agreements. While reforms will be necessary in many areas, the ones that may attract the most attention inLibya's accession negotiations are the following four: Establishing the rule of law. As other sections o f this report point out, administrative discretion rather than the rule o f law shapes many private sector decisions in Libya. WTO members will expect Libya to ensure that all economic policies affecting international trade and investment have a clear legal basis, are applied equally to foreign and domestic firms with minimal discretion by government officials, and incorporate clear appeals procedures. 0 National treatment in internal taxation. Certain internal taxes are applied on imports but not on domestically supplied goods. Such provisions violate WTO rules; their elimination will be a priority for WTO members. Rationalizing the current system o f commodity taxation will also increase transparency o f the incentive structure affecting domestic and international trade, and should therefore be a priority for Libya as well.  - 82 - 0 Customs valuation. WTO members will require Libya to hlly implement the WTO Agreement on Customs Valuation as a condition o f membership. A central tenet o fthis agreement is that imports be valued according to the price actually paid or payable. The government should treat this as an integral part o f the broader customs reform agenda outlined in the previous section o f this report. 0 Intellectual property rights (IPRs). Certain WTO members will place great importance on Libya bringing its IPR regime in line with international best practices. This will require Libya to accede to the major IPR treaties and conventions, write or revise laws on copyrights, patents, integrated circuits, trade secrets, trademarks, plant variety protection, and geographical indications. To ensure that the Libyaneconomy benefits from these legal reforms, the government should expand its capacity to administer IPRs, develop extension programs to the business community about the commercial application o f IPRs, and foster the emergence o f market institutions that connect inventors with entrepreneurs. 206. Additional reform issues. WTO members will also insist that Libya undertake reforms in a number o f other areas as a condition o f accession, including inter alia laws on special economic zones, government procurement, standards, and anti- dumping. WTO rules also ban the use o f quantitative import restrictions and export subsidies in manufactured goods trade. All o f these are conditions o f accession, though arguably less urgentfor Libya than the priority areas discussed above. 207. WTO members will request Libya to make commitments in market access, service sector liberalization, and agricultural subsidies. The particular commitments will emerge during the course o f mostly bilateral negotiations with WTO members. (One should note that only the candidate country makes concessions in these negotiations, not the existingmembers.) 0 WTO memberswill ask for greater access to the Libyan market for goods and services o f interest to their exporters. Based on other accession negotiations, one can expect WTO members to ask Libya to open its banking and telecommunications sectors. Members will also request Libya to eliminate all special charges or duties imposed solely on imports other than ordinary customs duties. Inaddition, members will ask Libya to reduce certain types o f government support to agriculture. 0 The World Bank stands ready to assist Libya in developing the analytical capacity to assess the economic impact o f these commitments. Experience in other countries suggests that Libya would benefit from reducing barriers to FDIinfinancial services, telecommunications, andtransportation. 0 One problem that will affect Libya's negotiations on agricultural subsidies i s the government's reliance on off-budget, implicit `subsidies.The government can address this problem through reforms in public expenditure management outlined inthe last chapter o f this report.  - 83 - 208. Other commitments. In addition to the priority areas above, WTO members will also request commitments in a number o f other areas. These might include the reduction in the number o f goods that face testing requirements, acceding to plurilateral codes such as the Information Technology Agreement and the Government Procurement Agreement, permanent elimination o f export taxes, and specific regulations that affect trade ingoods o f interest to WTO members. (iii) Customs administration 209. Customs administrations around the world play a vitally important role in the implementation of a range of critically important government policies such as revenue collection, tradefacilitation, theproduction of accurate trade statistics, and the protection of society from a range of social and national security concerns. Without an effective, efficient, responsive and ethical Customs administration Libya will be unable to establish a business environment that ensures its business community can compete on equal terms with foreign commercial interests and will be unable to attract the quality and quantity o f foreign investment necessary to ensure the establishment o f a vibrant and productive domestic private sector. Likewise, it will frustrate Libya's plans to join the WTO as membership entails the implementation o f a number o f Customs and border management relatedrequirements. 210. While the Libyan Customs administration's strengths provide a sound foundation for the establishment of a comprehensive reform and modernization program, it is also characterized by a number of fundamental weaknesses that require urgent attention. Addressing these weaknesses would require a comprehensive vision and business plan for the future matched to a sound planning and resource allocation framework necessary to ensure effective design, and implementation o f a reform and modernization strategy. Main weaknesses include:35 The lack of an integrated IT strategy, system and associated infrastructure necessary to facilitate the adoption o f modern approaches to Customs administration such as risk management, post clearance audit,.and the use o f commercial intelligence; The current import/export process i s entirely paper- based with information technology employed only for statistical recording purposes. It i s characterized by excessive documentation, repeated checking o f the same information and extremely highlevels o fphysicalverification; Inadequate attention to identijjing, collecting and analyzing key operational statistics, compliance records andperformance indicators relating to a range of important Customs activities. Such information should include such indicators as the time taken fi-om lodgment of Customs declaration to release o f goods; the percentage o f consignments selected for physical verification, the results o f such verifications, and the compliance record o f individual traders; 35 The International Monetary Fund undertook a comprehensive review o f the Libyan Customs administration in 2004 (IMF, 2004). The present assessment endorses the Customs-related conclusions and recommendations contained inthe IMFreport and notes that a number o f the key recommendations have already been implemented. The priority areas for reform outlined below aim to ensure the effective implementation o f the I M F recommendations.  - 84 - The lack of a formal compliance management or improvement strategy designed to identijj and differentiate between traders that are compliant and those that are not. As a result, incentives to reward high compliance and disincentives to reduce non-compliance are almost non-existent. All traders, regardless o f their compliance record, currently face similar administrative procedures and regulatory controls. Ensuring effective enforcement capacity would be key to tackle the reportedly high levels o f informal trade and . smugglingthat occur between Libya and neighboring countries. Inadequate coordination and integration between Customs and other border management agencies including Agriculture, Health and Standards leading to . excessive delays inclearance; Inadequate physical infrastructure, technical aids, and professional and technical skill levels. Non-intrusive contraband detection equipment, combined with upgraded technical and professional skills would be necessary to facilitate the transition between current systems and procedures and those . necessary to cope with an increasingly sophisticated trading environment; A control mentality that pervades all border management agencies and prevents the adoption o f modem, risk based approaches to clearing imports and exports. . 211. At the operational level it is recommended that Customs: Establish a high level Reform and Modernization Committee made up of representatives of all key operational areas. The Committee, with external expert assistance, should articulate and gain agreement to a future vision and business model for Customs and border management in Libya. It will also be responsible for developing the 3 - 5 year strategy necessary to achieve effective . implementation o f the vision; and Convene a high level Border management Reference Group or steering committee led by the Secretary o f the Libyan Customs administration and made up o f high level representatives o f the business community and all other government agencies involved inborder management. The role o f the group will be to oversee the work o f the Reform and Modernization Committee and to guide the development o f the future vision and reform strategy. 212. Summing up, core reform options and complementary initiatives the government may wish to consider in the short term and over the medium term, in order to builda strong investment climate, are as follows. P Core reform options (i) I n the short term 0 Furtherstreamline administrative barriers to business entry and operation. 0 Eliminate restrictions to investment in service sectors in foreign investment law and relatedregulations (example: trade, distribution).  - 85 - 0Begin the restructuring o f public enterprises by: (i) reducing debt; (ii) selling off non-core activities and services; (iii)selling unused assets (land and buildings); (iv) reducing overstaffing; (v) clarifying titling and ownership issues. 0 Abolish the consumptiodproduction taxes and service fees and replace them with a low-tariff trade regime, also ensuringlow tariff dispersion. (ii) Over the medium term Launch a full review of the business legal framework in order to harmonize and modernize legislation. 0 Complete the restructuring o fpublic enterprises 0 Privatize state-owned SMEs ina 5-year time-frame 0 Launch liberalization o f telecommunications and create independent regulatory body Undertake a thorough review o f all laws, regulations, and policies that affect international trade and investment, in preparation for WTO accession negotiation Complementary reform initiatives (i) I n the short term Eliminate progressivity in corporate tax rate and set rate at a low, competitive level, for both domestic and foreign investors Replace positive list o f allowed sectors in Investment Law #5, by negative list o f limitedscope. Set minimumcapital requirement for joint-stock and partnership company to a fixed, and small amount. Reviewprivatization strategy andpossibly issue new privatization law. Simplifyand better define the classification o f goods inthe customs code and reduce the dispersion o f tariffs Pursue reforms in customs administration with the aim o f tackling informal trade and improving coordination across all border management agencies (ii) Over the medium term Launch a large scale judicial reform (capacity building, training and judicial organization reform) Initiate programs o f capacity building o f market-supporting institutions: customs, regulatory institutions, public administration. Launch administrative reform in government agencies dealing with the enterprise sector. Launch a long-term plan for upgrading the infrastructure inindustrial zones. Reform the industrial land market and create privately-managed new industrial zones. Open utilities sectors to private participation Announce a plan for reduced tariff protection to create adequate incentives for public enterprise restructuringand efficiency  - 86 - V. PRIORITIES INFINANCIALSECTORREFORM A. Background 213. The Government and the Central Bank of Libya (CBL) have launched a series of measures in support of financial sector reforms. A particular focus o f the program i s the restructuring o f state-owned banks and, for some o f them, an adjustment in ownership structure to include or increase private sector participation in the capital o f such banks. In this context, the authorities have already embarked on significant steps in: e re-assessing the legal framework for the banking system, with the passing o f the new Banking Law No. 1/2005, as well as the Anti- Money Laundering Law No. 2/2005; partial privatization through .public sale o f shares o f the AI Sahari Bank, and preparation for the privatizationo f the Wihda Bank. recapitalization o f all five public banks; licenses granted to four private banks and one foreign bank; merging o f 21 regionalbanks into one bank; reinforcingo f banking supervision capacity; partial interest rate liberalization (see below); exchange rate unification and foreign exchange liberalization (adherence to Article VI11o f IMF); grating o f independence to public commercial banks to close non- profitable branches; e authorizing Libyan commercial banks to lend to foreign firms operating inLibya; strengthening regulatory and prudential oversight; devising plans for balance sheet restructuring o f state-owned banks; charting the path for privatization o f state-owned banks. building the legal and regulatory underpinnings for the insurance industry; and, e setting-up the legal and institutional framework for the launch o f the equities market. 214. There is acknowledgement of the importance of updating and strengthening the financial sector's legal, regulatory and supervisory environment. These initiatives should go in parallel with the efforts aimed at restructuring the banking system and addressing the portfolio problems besetting state-owned banks. In the absence o f reforms, the banking system would not be able to play filly its role in the intermediation o f national savings and the financing o f economic growth in the non- oil sector.  - 87 - B. Strengthening andRestructuringof the BankingSystem: Governance, PortfolioandOwnership (i) Status of domestic banking 215. Banking represents the backbone of the Libyan financial system. Insurance i s small and the equities market i s nonexistent while fixed income instruments are limited to a small stock o f outstanding government securities. In addition to the Central Bank, there are a dozen financial institutions including commercial and specialized banks (in addition to the regional banks). Commercial banks have some LYD14 billion inaggregate assets; the three specialized banks have LYD4 billion and the regional banks LYD 0.25 billion. In aggregate, banking system assets are equivalent to about 60 percent o f GDP, indicating that the domestic banking system has considerable potential for growth particularly for a middle income, oil producing country. Commercial bank loanportfolio accounts inaggregate for LYD7 billion i.e. a loaddeposit ratio o f about 50 percent in gross value. On a net basis, when adjusting for the stock o f non-performing loans (NPLs), the ratio would further decrease. (ii) Legalframework 216. The new banking law reinforces the independence of the Central Bank of Libya (CBL) and offers a good legal framework for the regulation of banking activities, even if some provisions call for improvement. In particular, full independence in the operational conduct o f monetary policy should be further strengthened by ensuring that the representative o f the government in the Board o f Directors (Secretariat of Finance) i s not involved in operational decisions related to monetary policy (Article 14 o f Law No. 1 o f 1373 P.D.). Once the goals o f monetary policy have been set in a consultative manner between the Government and the CBL, policy implementation (and accountability) should rely solely with the CBL. Also, the role o f the CBL in regulating the terms and conditions o f credit extension or investment by commercial banks, should be reduced (Article 56). 217. Despite the progress brought by the new banking Law that specifies and limits its duties and responsibilities, the CBL remains the owner of the public banks, with the associated potential conflict of interest between ownership and regulation. It i s essential that the Libyan authorities consider separating ownership o f banks from their regulation by the CBL. Ownership should either be transferred to the General Secretary o f Finance or to an asset-management institution that the latter owns. Until such transfer takes place, the CBL should under no circumstances be involvedinoperational decisions made by banks, or in individual credit decisions. (iii) Institutional strengthening and the structure of governance of publicfinancial institutions 218. State-owned banks need a clear strategy and an effective governance and managerial structure for their activities. After the lax lending practices to SOEs o f the 1980's and early ~O'S,which are responsible for a major share o f bank NPLs, the tightening o f credit policies, and more strict management oversight, have led over the past few years to progress in addressing portfolio and operational problems. Nonetheless, the road to satisfactory and sustainable performance for state-owned  - 88 - banks i s still long and steep. Further strengthening o f these banks i s still required so they may operate and grow inan environment likely to become increasingly open and competitive. Assistance would be required for the state-owned banks in their drive towards building a strong management structure adequately supportedby professional banking teams, enhancing corporate governance, developing a clear business strategy, and building more up-to-date skills in such critical areas as credit, investment, risk management, and management informationand control systems. (iv) Regional banks 219. Libya has 48 so-called regional banks operating and providing services across the country, including some remote areas. Over a short period o f time, these banks have reportedly shown a relatively good record in terms o f deposits collection, offering thus an outlet for savings to low income households especially in traditionally underserved areas. Their activities are also somewhat coordinated through the National Banking Corporation (NBC) which offers them a number o f corporate services (accounting, training,. ..). A number o f these regional banks however are too small and inefficient; some would probably be insolvent but are allowed to maintain their activities as a result o f regulatory forbearance driven by social considerations. Given their large number, they undoubtedly place a heavy burdenon existing supervisory capacity. The banking authorities are presently inthe process o f consolidating these institutions under the umbrella o f the N B C (21 have been merged so far), o f which they would become full branches rather than stand- alone financial entities. Such a decision will help ease the burden on the supervisory authorities. (v) Non-performing loans and needfor portfolio restructuring 220. The issue of non-performing loans and distressed assets needs to be - and is reportedly being - addressed by the authorities. Various schemes relating to the non- performingloans o f SOEs are beingdiscussed within the government, some involving for instance an exchange o f the NPLs o f specific SOEs for debt issued by the Treasury or the Central Bank, depending on which o f the two entities would be the shareholder. It would be useful that the restructuring plans be based on thorough and independent audits o fthe bank portfolios, and on a clear view by the authorities on the future governance structure of, and decisionmakingprocesses within, the state-owned banks to ensure that the errors and transgressions o f the past, particularly as far as credit extension (especially to SOEs) is concerned, are not to re-occur. Financing o f SOEs, which represent a significant portion o f the country's economic base, should be subject to rigorous credit underwriting and repayment standards, while their operations should be subject to hardbudget constraints. (vi) Privatization of state-owned banks 221. The authorities have embarked on a privatization strategy through dilution of ownership by selling shares to thepublic - most recently with the Sahara Bank, and in preparationfor the Wahda Bank. Special committees have been appointed to assess the values at which bank shares may so be transferred. Experience intransition economies has shown that some privatization schemes are more likely to be successful than others in achieving the efficiency gains that are usually sought from  - 89 - ownership transfer and change. Inparticular securing the interest and participation o f strategic investors and partners appears to be one o f the critical elements o f success in bank privatization. Divesting government holdings in financial institutions to unspecified, let alone unqualified, private interests would by itself not be sufficient a condition for ensuring the success o f privatization. The opportunity to attract a well qualified category o f investors with a proventrack record inthe financial industry into the ownership and governance structure o f state-owned banks has been the most reliable ingredient o f successful bank privatizations. The objectives and benefits to be achieved by bank privatization - Le. generating revenues for the government, simply transferring ownership, improving banking sector efficiency, etc.. .-- ought to be clearly defined by policy makers. Inthis regard, the experience o f many countries has shown that merely diluting ownership away from government holding in favor o f disparate and inexperienced interests would not yield the anticipated outcomes in terms o f improved banking sector efficiency measured by higher levels o f financial intermediation, credit extension, resource mobilization andbanking services. (vii) Promoting access to jkance: the link between strengthening the banking sector and corporate sector reforms 222. A key determinant to the success of theprivate sector-led growth approach, will be to improve the capacity of theJnancial system to channel savings toprivate sector investment. Untilrecently, the public enterprise sector in Libya was the only beneficiary o f corporate lending by banks. The banking sector administratively channeled funds to public enterprises, while the marginal private sector consisted only o f micro-enterprises with no formal access to finance. For the new private sector to grow, banks need to acquire the capacity to serve this new segment, and need to operate inan environment prone to the development o f a sound credit market.  - 9 0 - 223. Efficient financial intermediation to the private sector requires that the Libyan banks be reinforced and equipped to serve the growing segment of private enterprises, in particular small and medium sized firms. It requires that bank staff be trained in modem credit management techniques; that banks be reorganized to better serve the private sector; that the banks be equipped by modem information systems and risk assessment tools; and finally that incentives o f bankers - in particular loan officers - be reviewed to ensure that they adapt to this new clientele, and strike a good balance between private sector portfolio growth and prudent lending. The weaknesses o f the Development Bank (see Box V.l), the major provider o f lending to small and medium enterprises in Libya, illustrate the need for such restructuring and capacity buildingo f banks. 224. For banks to efficiently intermediatefinance to theprivate sector, they ought to operate within an environment that enables them to assess, price and manage risks, in order to lendprudently. To do so, they need to conduct analyses and due diligence based on reliable, representative and standardized statements o f borrowers' operational and financial conditions. The seal o f independent, qualified auditors would be an added layer o f comfort. The faith in, and reliance on the rule o f law, enforced through a transparent and efficient judicial system would provide further guarantee to creditors that terms o f contracts would be adhered to, security interests in loan collaterals can be realized, and, in short, debt obligations would be repaid. Operating and extending credit without such a framework may simply imply that banks are transgressing their prudential obligations, violating their fiduciary responsibilities towards depositors, and sowing the seeds for future portfolio problems. Reform o f corporate sector regulations should thus go hand in hand with banking sector reforms. 225. The development of a reliable and comprehensivecredit information system, as well as a good market information system is essential to a well-functioning credit market. Credit information i s key for good risk-assessment and for the development o f the credit market. It i s also essential that credit bureaus be functioning at the early stages of this transition as this is a period o f increased enterprise creation and intensified transaction flows - a time where a lot o f credit information can be built. Currently, the credit information provided by the Central Bank o f Libya to commercial banks i s limited to an "attestation o f non-indebtedness o f firms".36 Finally, the lack o f good market and sector information in Libya, and its importance to enterprises i s equally important for bankers who need it to assess the expected profitability o f the investment projects that are submitted to them. (viii) Financial sector distortions and the structure of interest rates 226. Financial sector reform has also progressed with partial interest rate liberalization - interest rates have been liberalized on deposits, while a ceiling on the lending rate has been set above the discount rate. Progressively, this ceiling should be phased out, to prevent a possible erosion o f bank profitability in a competitive bidto attract deposits, and to allow banks to serve corporate clients with a wider range o f risk profiles. Spreads should also properly cover administrative costs (to the extent that banks operate efficiently) and provide an acceptable return on 36 Sha'hadat aadam al'madyounyia.  - 9 1-' shareholder equity. Steps to liberalize further interest rates would be conditioned by the development o f a well-functioning, liquid money market. This would also facilitate the management o f bank liquidity in the face o f significant swings in oil revenues. 227. Currently the Central Bank of Libya (CBL) does not pursue an active monetary policy and its tools to conduct monetary operations are limited. Direct instruments have played a prominent role in the conduct o f monetary policy, particularly interest rate controls and, to a lesser extent, directed credit. Inflows o f oil income, budgetary operations, together with private sector demand for foreign exchange, have determined the monetary outcome in Libya. To more effectively manage excess bank liquidity, the conduct o f monetary policy should be improved within a well-defined framework, through the development o f indirect monetary instrumentsand of a money market. The possibility granted by the draft bankinglaw to the C B L to issue certificates o f deposit is a first measure in the right direction in order to better manage bank liquidity. (ix) Non-bankfinancial institutions 228. There is considerablepotential for development and growth of thefinancial industry outside the banking system. Insurance is small with total premia accounting for less than one percent o f GDP. There i s no domestic equities market. Besides commercial bank loans there i s no debt market beyond a limited stock o f outstanding government securities. There are no corporate or mortgage bonds, while collective investment schemes such as mutual funds play a marginal role. Leasing i s hardly developed. The authorities recognize the potential for growth in the non-bank sector and have started to chart the path towards establishing the appropriate legal and regulatory framework for the industry.Amongst the recent initiatives inthis context i s the nomination o f an Insurance Commissioner within the Companies Division o f the Ministryof Economy. The Insurance Law, which dates back to 1970, would need to be revised to reflect updated practices. The insurance supervisory framework would needto be enhanced and modernizedinline within international standards. Interms o f capital market development, the nucleus o f a unithas been establishedwithin the CBL to initiate the upstream process leading eventually to the creation o f a stock exchange inLibya. Were the role and mandate of this unit to evolve from a focus on legal and regulatory analyses towards an operational phase involving market transactions, it would be crucial that the unitbe moved out o f the Central bank. C. Strengthening BankingSupervision (i) Moving Towards Supervision by Risk 229. Libya's current compliance orientation toward banking inspection and supervision is a critical function of any banking supervision system. Banking supervision and inspection seem largely oriented towards ensuring that bank branches are in compliance with rules, regulations, policies and procedures. It is' vital that  - 92 - supervisors verify that banks are operating within the legislative and regulatory framework and that they adhere to effective policies and procedure^.^^ 230. However, the current approach needs to be enhanced to include a focus on the overall effectiveness of risk management practices in banks - something the CBL has recently been focusing on and building capacity for. Global experience has shown that banks can often be in full compliance with rules and regulations yet are at risk for insolvency due to weak risk management practices, especially in credit risk which is the single largest cause of non-performing loans and bank failures around the world. Recognizing that a compliance based supervisory framework has its strengths and limitations, many countries have adopted a risk based approach to banking supervision. Enhancing the current approach to bank inspection by adding a risk based approach would be more effective in identifying and addressing critical weaknesses in banks' practices such as credit risk management, bank corporate governance, operational risk, and all other risks. 231. I n practice, in a risk based supervisoryframework, thefocus is at the Bank level versus at the branch level. A risk based approach does not preclude compliance inspections and, in fact, assessing for compliance continues to be a critical supervisory function in a risk based framework. Inspectors should continue to inspect a sample o f key branches o f a bank to ensure that there i s adherence to a bank's own policies and procedures, as well as compliance with laws, regulations and supervisory policies and procedures. This should be a complement to banks' own internal controls. 232. I n a risk based approach, banks are responsible for developing their own risk management practices, together with policies and procedures with which to conduct them. Therefore, banks themselves will need to ensure that they are managing risk prudently and monitoring compliance on an ongoing basis. They will need to regularly perform internal audit and internal control inspections o f their own branches. The draft o f the new banking law will require each bank to have a compliance unit.This i s a positive step toward assuring that the primary responsibility for compliance with policies and proceduresrests with the banks themselves. 233. I n a risk based supervisory framework, the role of banking inspection expands to review the adequacy of banks' risk management systems. InLibya there are at least two years between inspections o f a branch so there i s a need to rely on banks' own internal control, internal audit and compliance functions to review operations with much greater frequency. An additional level o f oversight i s provided by external auditors. However, at present, audits o f bank financial statements are not being conducted ina timely manner. 234. I n order to conduct risk based supervision, supervisors need to be reliable and accurate consolidatedfinancial information from the banks. There should be a review o f the quantity and quality o f the current information that is being received by the Banking Supervision Division to ensure that it is timely, and accurately reflects the financial condition o f banks in order to facilitate a risk based approach to 37The preparatory mission of the report has not had a chance to assess the level and depth of the analysesperformedduringinspections.  - 93 - supervision. The authorities need to ensure that international accounting standards are being adhered to by the banks but also by bank borrowers to facilitate sound credit decisions. (ii) Loan ClassiJication & Provisioning: 235. The current loan classification criteria need to be enhanced to meet international standards. Based on current classification criteria, loan `loss provisioning does not adequately reflect the true quality of banks' loan portfolios. The present criteria do not fully allow for timely recognition o f deterioration o f credits, which i s likely to have adverse consequences for banks performance and the quality o f their loan portfolios. Banks may not take sufficiently proactive measures to recover loans in a timely manner if they are not deemed seriously deficient. It would be important to confirm the accuracy o f the current level o f non-performing loans through an independent audit. 236. Banks'judgment should be relied on more when they are considering more severe classifications than allowed by thepresent guidelines. Currently, they cannot do so without administrative appeals and the process should be less cumbersome. Generally, banks will know more about a borrower's financial condition, and in a more timely manner, than an inspector or other thirdparty will. (iii) Capacity Issuesfor the Banking Supervision Division 237. Currently, the sheer number of branches currently under supervision makes it difficultfor the Banking Supervision Division toprovide effective oversight of the banking sector. Additional staffing, alone, would not adequately address the process o f banking supervision in its present mode o f operation. Supervising the Agriculture Bank, the SREIB, and the Development Bank will only add to the burden. 238. With 391 bank branches in Libya, of which 350 are under supervision, the Banking Supervision Division is to be commendedfor having inspected as many as half the branches under its supervision in the past year. The Banking Supervision Division recently developed its own inspection manual which addresses banks' administration, organization, training, financial ratios, and compliance matters. Since the manual expands the functions o f inspectors during on site examinations, there i s likely to be a further strain on the capacity o f banking supervision as inspections now will take 4 weeks versus 2 weeks. It i s important to ensure that the new inspection manual, which should serve as a very useful guide to inspectors, as well as the proposed amendments to the Banking Law are consistent with international best practice. 239. Recent initiatives go in the right direction and should be strengthened. Particularly commendable i s the initiative, already submitted to the legislature, to have the Banking Supervision Division responsible for inspection o f the Agriculture Bank, the SREIB or the Development Bank (except for Letters o f Credit issued by Development Bank). As Libya's banking system moves toward a market orientation it needs to ensure that policies and procedures, and laws and regulations are evenly applied across the sector to enable a level playing field in the banking sector. The authorities should also finalize plans to merge the 48 regional banks under one  - 94 - umbrella which would facilitate their oversight and supervision by the Banking Supervision Division ina risk based framework. 240. Main areas where technical capacity should be upgraded in order to move to a more risk based approach to banking supervision include: (i) developing risk based policies and procedures for banking supervision; (ii)training o f banking supervisors, especially in the areas o f asset quality, loan portfolio management and overall credit risk management as well as bank corporate governance; (iii) enhancing current loan classification and provisioning to meet international standards; and (iv) developing supervisory guidelines for the oversight by banks o f their compliance, internal audit and internal control functions. 241. Summing up, core reform options and complementary initiatives the government may wish to consider in the short term and over the medium term, in order to strengthen the banking sector and lay the groundwork for financial sector development, are as follows. Core reform options (i) I n the short term Strengthen corporate governance o f state-owned banks and define a clear strategy for these banks Enhance loan classification criteria and loan provisioning in line with international standards Take steps to strengthen banking supervision Amend the Banking Law to: (i) full independence o f the CBL from the grant Secretariat o f Finance in conducting monetary policy; (ii) reduce significantly the provisions that regulate credit policies o f commercial banks. (ii) Over the medium term Open the banking system to foreign bank participation Seek strategic investors for the privatization o f state-owned banks Initiate corporate sector reforms (accounting, auditing and the rule o f law) as a complement to banking sector reform Develop the credit informationsystems o f the Central Bank Complementary reform initiatives (i) I n the short term Transfer ownership o f public banks away from the CBL to the Secretariat o f Finance or a dedicated asset-management institution Take steps to develop an active interbank market Further liberalize interest rates offered by banks (ii) Over the medium term Consider moving toward a framework o f supervisionbased on risk Liberalize interest rates  - 95 - VI. ENHANCING EFFECTIVENESSOFSOCIALPROTECTION THE 242. As the Government of Libya moves towards a more open economy and greater dependence on market forces, the positive effects on the economy and on standards of living will be balanced by greater economic risk and uncertainty among the population. Under such circumstances, human development - the ability o f the education and health care systems to equip individuals with skills that allow them to take advantage o f the increased opportunities that a dynamic and changing economy offers in terms o f more productive and better-paid jobs - becomes crucial. Likewise, the social protection system takes on an important role in helping individuals and households manage economic shocks. Particular attention needs to be given to vulnerable population groups, which have fewer means to deal with risks and are less well equipped to take advantage o f new economic opportunities. The reminder o f this chapter presents a general assessment o f the social protection systems inLibya. A. Social Protection In T h e Transition3* 243. The social protection system is particularly important during the transition phase, when the economy will observe reallocations of labor and capital across sectors. Social protection programs help people manage economic risk by alleviating poverty and reducing the likelihood o f falling into poverty. They mitigate the effects o f drops in incomes o f individuals and households and seek to ensure minimum standards o f living; and they enhance the ability o f workers to find their way in the new economy through interventions in the labor market and re-training programs. Combined with effective education and health systems, social protection programs are essential inmanaging economic risk and ensuring that all members o f society become partners in the economic growth process. Social protection programs may include a variety o f interventions, as further explained inAnnex 3. 244. Libya is beginning the transition towards a more open economy with a relatively regulated formal economy and an extensive social infrastructure. This includes low-cost housing and utilities, free education and health services, subsidized foodstuffs, relative job security in the public sector (covering 70 percent o f recorded employment) and a fairly generous pension system for public sector employees, as well as short-term benefits such as sick pay and maternity leave. Moreover, informal intra-family support mechanisms are said to play a prominent role in ensuring well- being. As a consequence, Libya appears to have reasonable social indicators, given income levels inthe country, including highlevels o f education, core healthindicators at reasonable levels, and some expectations among the population regarding the Government's role inreducing risk. Other formal social protection programs, such as active labor market programs and targeted assistance programs, have not developed. Little i s currently known about poverty and inequality, although analysis o f the 2003 38 In reviewing the social protection sector, the preparatory mission was not able to have discussion in a number of areas, notably employment authorities, the national food corporation, social benefit services and formal charities. The mission also learned prior to leaving o f a rural bank, serving micro-project initiatives. This should not, however, materially affect the general thrust o f the conclusions in the report.  - 96 - household budget survey should be able to provide useful information in those areas once the informationhas beenprocessed. 245. The transition can be expected toput the current social protection system to test. While an open economy and greater reliance on market forces i s likely to produce beneficial outcomes such as higher productivity and faster rates o f growth, it may also increase inequality and exacerbate poverty, as well as increase economic insecurity. Privatization may cause major job losses as divesting governments cut the workforce to prepare for privatization, or as new owners o f privatized firms shed excess labor to improve efficiency (Box VI.l). It becomes increasingly important to be able to identify population groups and households at special risk and focus assistance at them. 246. However, in contrast with most other transition countries, Libya has and will continue to have significant oil resourcesfor a long time to come. This will  - 97 - allow the Government a much broader scope for effective action than i s usually the case in transition economies, and it may make poverty targeting less urgent. The challenge for the Government will therefore not necessarily be to make difficult trade- offs between competing interests, but rather to increase the efficiency with which resources are used to mitigate the adverse effects o f the transition, and provide a post- transition safety net that i s appropriate to the needs o f the vulnerable segments o f the population, and at the same time not excessive. 247. Whateversafety net is designed, whatever socialprograms are implemented, they should be calibrated with particular care to the incentives they provide to the population. Are the programs sufficient to provide adequate protection, and do they at the same time encourage work? If not, resources will be wasted. Much o f the structural unemployment experienced in Europe today reflects inadequate attention to this aspect, as well as illustrating the difficulties o f correcting the situation once such policies take root. B. Social Insurance: Pensionsand Short-TermBenefits 248. TheLibyan Social Security Fund (SSF) covers 75percentof the laborforce, the highest coverage rate in the region, and pays benefits equivalent to 1.4percent of GDP. The high level o f coverage i s achieved given the importance o f the public sector as an employer. The SSF provides pensions and various cash assistance benefits for all categories o f workers, finances health services, and a basic pension- currently set at LYD 40 per month-for all elderly poor. The main revenues o f the SSF come from a 15 percent (16.5 percent for the self-employed) wage tax. The systemi s mandatory for the entire employed population. Thus, it covers civil servants, private sector and state-owned enterprise employees, and the self-employed. Under a separate law, the SSF manages the pension scheme for the military. 249. Financially, the SSF is unsustainableand it is likely to have accumulateda substantial implicit pension debt that threatensfiscal sustainability as well as the welfare of future generations. The reason i s the generosity o f the system that targets highreplacement rates and is paying an implicit real rate of return on contributions above 5.5 percent per year (Figure VI.l). Countries in the region with similar demographic structures, lower coverage rates, and less generous systems (e.g., Morocco and Jordan) have implicit pension debts above 50 percent o f GDP. The implicit debt o f the SSF could be larger.39 This debt represents the amount o f resources owed to current plan members, without taking into consideration further accrual o f pension rights. Infact, the SSF is already displaying an operational deficit o f LYD 19.6 million or 0.18 percent o f GDP, which i s being covered by using the SSF reserves. Over the medium term, the gap between contributions and benefits i s expected to continue widening despite a still-low dependency ratio. ~ ~~ 39 Information systems are underdeveloped and the demographic and financial data necessary to compute this liability are currently not available. The SSF has not had an actuarial valuation for the past 16 years.  - 98 - FigureVI. 1: IncomeReplacement Rates and ImplicitRatesof Returninthe SSF 1 250. The government is accumulating arrears with the SSF, but these are not the only cause of the financial problems. In 2003 new arrears reached LYD 111.8 million. For instance, military pensions should be financed by the central budget. Yet, in2003, out o f LD 48 million in expenditures, the government only transferred LYD 5.4 millionto the SSF. However, even ifthe government were to normalize its contributions, a deficit o f 0.16 percent o f GDP would persist. This i s because, in retaliation to the moratoria, the SSF i s not paying its contributions to the Ministry o f Health. In 2003 these contributions represented LYD 100.9 million - a similar amount to the new government arrears for that year. 251. As in other countries in the region, the system is prone to adverse distributional transfers and is a source of economic inefficiencies. In terms o f equity, benefit formulas and eligibility conditions create highheterogeneity inrates o f return as a function o f wage histories and enrollmenthetirement strategies. Hence, while redistribution takes place within the system it i s unclear who benefits the most. Transfers might not necessarily go from high- to low-income workers. The fact that the system i s accumulating an unfunded pension debt also implies a transfer from future generations (including low-income workers) to the present generation (including high-income workers). In terms o f efficiency, the system provides incentives for evasion, the strategic manipulationo f wages, and retirement over work. This is explained, inpart, by the fact that only the last three years o f salaries count toward the pensionand by the absence o f penalties for early retirement. 252. There are also concerns regarding current governance structures, which are likely precluding the management of thefunds in the best interest ofplan members.  - 99 - The SSF has assets equivalent to 4.7 percent o f GDP, the majority composed o f government debt and real estate. Bank deposits constitute only 8 percent o f total SSF assets. The SSF was originally created with a Tri-partite Board, including representatives from employees, employers, and the government. The Prime Minister appoints and removes the Chairman o f the Board. Thus, the SSF i s not insulated from political influence. The fact that the government has seized a large share of the SSF reserves actually reflects the conflict between plan members' interests and government's interests. Today there i s no governing body inplace. Thus, the level o f accountability o f the Chairman o f the SSF to planmembers i s further diluted. 253. The government is undertaking a detailed assessment of the SSF. The authorities are committed to introducing a series o f reforms to improve management and investment policies, as well as to control the growth o f the implicit pension debt. The World Bank is ready to provide technical assistance in a number o f areas identified with the authorities: (i)assess the financial situation o f the SSF while building internal capacity in actuarial analysis; (ii)audit and evaluate the current portfolio o f investments, assess current strategies in terms o f investment policies and provide training for fund's management; (iii) design a comprehensive reform package for the SSF and an implementation plan; (iv) guide the design and implementation o f an integratedinformation system-particularly duringthe early stages. C. Labor Market Regulationsand Programs 254. The gradual integration of Libya in the global economy will also require appropriate programs to facilitate the reallocation of the labor force across sectors.40 First, to diversify the economy and improve competitiveness the government will have to reconsider the size o f the public sector and restructure SOEs, which often implies reducing the number o f employees. Second, as a result o f increased competition there will be a movement o f resources, labor and capital, from economically non-viable to viable sectors. Because more flexibility for firms implies higher risks for workers who are no longer guaranteed jobs for life, it i s essential to put in place an efficient and financially sustainable unemployment beneJit ~ystem.~' Employees affected by reallocations will need support to preserve their levels o f consumption during the transition and to improve their employability. This usually takes the form o f severance package and retraining programs, as well as unemployment beneJit schemes. A wealth of international experiences is now available to design these programs. ~~~~ ~ ~ 40 The preparatory missionhas hadlimited information regarding the current labor code, a part from the fact that a minimum wage (currently set at LYD 85 per month) is enforced. The labor code, however, i s known to be a complex piece o f legislation and foreign investors are usually advised to obtain expert advise before engaging inlabor contracts. The government is currently reviewing this labor code. 41 The purpose o f an unemployment benefit system i s to facilitate job search for laid-off workers over relatively short periods o f unemployment. It is not a mechanism for dealing with long-term unemployment, for which special social assistance schemes are used. The unemployment benefit can take the form o f either insurance, where workers contribute through a payroll tax, or assistance, where a benefit is paid from general budget revenues. To the extent that enterprises cannot pass on labor costs, i.e. the scheme raises the cost o f labor to the enterprise and contributes to discouraging hiring, an assistancescheme might be preferable. Inany case, in designingthe scheme, attention needs to be paid to eligibility (Le. extent o f work history needed), the replacement rate in relationship to the wage, and the duration o f the benefit, which usually i s interms ofmonths and linkedto a gradual reductioninthe benefit. In addition, unemployment benefit schemes are often tied to active job search by the beneficiary, as well as participation intraining and re-training programs.  - 100- 255. The only government initiative so far has been the establishment of the so- called Economic Transformation Fund (ETF) that provides credit to prospective entrepreneurs (public sector workers transiting to the private sector or the unemployed, as well as graduates entering the labor market). I t has several design problems. First, the ETF:s mandate appears too broad: it targets population groups that cover a variety o f different needs, skill levels and socioeconomic backgrounds; and investmentproposals that range from LYD 15,000 to LYD 3 million. Clients in such circumstances will have a broad variety o f needs to be met to be successful, including equipment finance, startup and working capital, skill needs and advice. The ETF provides only medium-term equipment loans. Second, it focuses its support on initiatives inprotected sectors, where the incentives to be efficient and innovative can be expected to be slight. As the economy liberalizes and competition increases, it i s unlikely that many o f those enterprises will survive. 256. I n general, international experience with credit programs of the ETF type, even well-designed ones that offer a variety of necessary services, have a modest impact on job creation. This does not mean that they should not be undertaken; however, they have to have the capacity to tailor closely their assistance to the particular needs o f their clients. This is critical, if they are going to successfully promotejob creation. D. SocialAssistance 257. The Libyanformal social assistancesystem emphasizessubsidies: it provides untargeted consumer subsidies for food, utilities and housing, as well as supply-side subsidies that implicitly favor the consumer. While the subsidies may represent an important andjustifiable transfer o f public resources to the population, neither the size nor the impact o f the subsidy i s easy to determine: the system lacks sufficient transparency to evaluate either its effectiveness or its costs, and it offers little opportunity for informed policy making by the authorities. While specific numbers are difficult to come by, because o f the lack o f transparency o f the system, it i s not unlikely that the current subsidy system may have significant adverse effects on labor supply inthe economy. (a) The consumerfood subsidy 258. Generally, systems of universal consumer food subsidies will be regressive when wealthier population groups consume more of the subsidizedproduct. At the same time, the welfare impact i s higher on the poor, as their share intotal spending on food i s usually higher, and their caloric intake i s increased by the subsidy. If the subsidy is focused on foods that are more likely to be consumed by the poor, the welfare effect onpoor households i s further strengthened. 259. The Libyan food subsidy system appears to dampen the regressive effect of the subsidy - every individual gets the same amount. It i s not entirely clear whether the selection o f items is pro-poor, but to the extent that the subsidized food basket represents a fair selection o f staples, it should not have an adverse poverty effect. 260. The fiscal costs of the food subsidy amount to some 5 percent of current budget expenditures. While relatively modest, they do impose financing  - 101- requirements on the budget and inthat way may affect the tax structure. To the extent the subsidy inhibits the development o f domestic production or distorts consumption patterns as these respond to government-set prices rather than market signals, distortions also may be carried into the macro-economy. 261. Efficiency considerations may argue for moving to cash transfers, and possibly even targeted transfers: a universal subsidy i s an expensive way o f ensuring basic consumption needs, including maintaining an extensive distribution chain from importers to cooperatives, and creating opportunities for leakages and even intermediary payments, as well as distorting prices in the market place.42 Transparency considerations would also argue for a cash transfer, as cash transfers render the cost to society explicit. and welfare considerations would argue for a cash transfer, as cash transfers would increase incomes and consumer choice. 262. The Libyan authorities are in the process of reconsidering the currentfood subsidy system, including shifting to cash benefits. Reform o f the system will be challenging: consumers' expectations are conditioned by the current, quite generous, program; and the administrative experience is largely limited to the present system, which may place constraints on the institutional capacity to implement more than marginal reforms, at least inthe short term. (b) Utility subsidies43 263. Utility pricing involves across-the-board subsidies. These are financed from the Oil Fund and in the case o f electricity through favorable pricing o f oil products, which are the principal inputs in electricity production in Libya. It i s estimated that the subsidy elements in electricity i s some 60 percent (Figure VI.2). This leads to over-consumption, especially among residential users. Figure VI. 2: Direct Consumer Subsidy inthe Electricity Sector S 1 r a . t I l g h t i n g St.1. of1icl.l C o m m e r c i a l L a r g e i n d u e t r y S m a l l I n d u s t r y L a r g . . g r l s " l t " , . s m a l l . g r t c " l t " r . D o m e s t i c 0 2 0 4 0 8 0 8 0 1 0 0 1 2 0 P r I o . b y K w h ( L Y D ) Source: World Bankcalculationson the basis ofinformationprovidedby the GeneralElectncity Company o fLibya 264. The Government is considering introducing life-line tariffs to curb excess consumption. However, without some prior knowledge about beneficiaries, especially such aspects as utility connection ratios, household expenditures, and the 42Beyond these aspects, some consideration should be given to the composition o f the food subsidy. Currently, the calorie count o f the package is estimated at 3,300 calories. This compares with the 2,100 calorie per person per day nutritional minimumthat is accepted internationally according to FA0 and WHO recommendations. 43The preparatory mission has only had the opportunity to review the situation in the electricity sector, but the comments on electricity may well also apply to the water supply sector. Calculations of implicit energy subsidies are presented inchapter V.  - 102 - potential impact o f subsidy mechanisms on the poor and the non-poor, any interventions risk being either inadequate or excessive. Here, the results o f the 2003 household budget survey may be invaluable in guiding policy making and subsidy design. More generally, any utility subsidy mechanisms under consideration should be guidedby the following considerations (usinghouseholdbudget survey data and other available statistical informationingovernment ministries and statistical bureaus): (i) extenttowhichthepoorarebeingreached(coverage); the (ii) leakageofthesubsidytothenon-poor(targeting); the (iii) predictability o f the benefit for the poor; (iv) fiscal impact; (v) impact on the financial position o f the utility; (vi) the extent o f pricing distortions and other unintended side-effects due to the subsidy; (vii) administrative simplicity. 265. A note of caution: international experience shows that subsidy mechanisms thatperform well according to some of the criteria may perform poorly according to others (e.g., highcoverage i s usually associated with low targeting). Furthermore, not all subsidy mechanisms are applicable or perform equally well across all utility services (the lack o f metering, for example, may pose a problem for life-line tariffs). Therefore, it has not been possible to identify one subsidy mechanism that outperforms all other mechanisms irrespective o f country circumstances and preferences. It i s possible, however, to identify subsidy mechanisms that, drawing on the above criteria, are unlikely to be top performers. These are the mechanisms o f no- disconnection, across-the-board price subsidy funded from cross-subsidy, and burden limit. (e) Housing subsidies 266. Responsibility for housing production appears to be mainly with the government44An extensive and hard-to-quantify subsidy element facilitates access to housing: input subsidiesand an absence o f interest payments on deposits appear to be passed on by the public Housing Bank to the benefit o f the consumer; likewise, the consumer has access to long-term (thirty-year) housing loans on concessional terms. In some instances, it appears that the repayment of such loans is waived. Public sector workers receive a monthly housing allowance that ranges from 12percent to 25 percent o f salary.45 267. The system of housing subsidies raises several concerns. From the perspective o f a social safety net, the main justification for providing housing assistance (of any kind) i s that adequate shelter i s a basic need that governments have a responsibility to fulfill. This appears to be the motivation behind the Libyan government's interventions in the housing market. Main concerns with the current system include: (i) the lack o f transparency inthe subsidy; (ii) potential inefficiencies arising from insufficient competition in primary and secondary housing markets; and 44The preparatory mission did not have access to data on the housing market, but there is anecdotal evidence of an activeprivate sector inboththe primary andthe secondarymarket. 45Of course, this housing allowance covers "housing" in a broad sense, including rent or mortgage payments,as well as utility fees.  - 103 - (iii) provisionoflong-termloansonconcessional terms, whichovertimemay the adversely influence the financial viability o f public financing o f housing production, as inflationerodes the value o f repayments. (d) Directionsfor reform 268. The absence of transparency in the subsidy system makes it dijjkult to determine either effectiveness or cost, consequently offering little opportunity for informed policy making.'It also argues for abolishing subsidies and replacing them with targeted support mechanisms, either by means o f direct cash transfers or mechanisms that allow utility services to poor households to be maintained. In any case,46 the transition towards a market economy can be expected to put the current system o f social protection to test. It will inparticular require a better understanding o f the impact o f various social protection programs, and in particular the adequacy and relevance o f various consumer-oriented subsidies in protecting the population against economic shocks. It will therefore be important to review the current subsidy system with a view to increasing its transparency, inparticular with regard to the true costs o f the subsidies; or, as the case may be, move altogether towards a system o f cash transfers, either targeted or unlimited A main issue inmoving towards a system o f cash transfers may be ensuring access to the benefit, i.e. a benefit delivery system that can reach all potential beneficiaries 269. The objectives for the food subsidy should be reviewed and agreed on in order to form a basis for a reform of the subsidy, including an adjustment o f its calorie content to better coincide with WHO recommendations. The groundwork should be laid for a better understanding o f the impact o f transfer payments and subsidies on the well-being of households. This should include the undertaking o f household budget surveys on a regular basis to allow the identification o f at-risk households and monitor the effects o f social protectionprograms on their well-being. 270. Three main lines of action should be pursued. As the Government pursues the transition to a market economy, critical public initiatives will need to be introduced early on to facilitate the reallocation o f labor and protect vulnerable population groups when necessary. The authorities are encouraged to focus on three priority areas at an early stage: 271. The establishment of a continuous monitoring system of the well-being of thepopulation. The 2003 household budget survey is an indispensable starting point, as the information gathered through the survey should be able to provide a baseline o f the welfare situation o f the population, as well as identifying households at risk for subsequent targeting o f benefits. The household budget survey should be undertaken annually, and the information become available to and routinely used by government authorities inthe shaping o f public policy. 272. A cash benefit system that is able to target needy households on short notice. The Government has the elements o f such a system near at hand, since the current distribution system for subsidized foodstuffs i s reputed to reach every household in Libya. If this is the case, the Government should immediately examine the 46Such subsidies may take different forms: life-line tariffs, price discounts for selected groups, burden limits and earmarked transfers  - 104 - adjustments that need to be made to this network to allow the targeted distribution o f cash benefits. 273. Severance and retraining programs for civil servants and public enterprise employees. Employees losing their jobs as a result o f civil service reform or the restructuring o f public companies will need to receive support to facilitate their transition to other occupations in the private sector. This involves not only income support, but also retraining to improve their employability inthe private sector. 274. Summing up, core reform options and complementary initiatives the government may wish to consider in the short term and over the medium term, in order to design an efficient system o f social protection, are as follows. Core reform options (i) In the short term Establish a continuous monitoring system o f the well-beingo f the population Design severance and retraining programs for civil servants and public enterprise employees (ii) Over the medium term Establish a cash-benefit system that i s able to target needy households on short notice Adopt plan to gradually phase out indirect subsidies Complementary reform initiatives (i) I n the short term Update the demographic and financial data o f the SSF and conduct analysis o f the long-tern financial situation o fthe fund Design mechanism to refinance the debt o f the government with the SSF Prepare proposal for the design o f a new management and information system (ii) Over the medium term Adopt plan to gradually phase out indirect subsidies Review current governance structures and investment policies and prepare recommendations to create incentive to manage the funds in the best interest o fplanmembers Draft integratedreform program and necessary legislation Prepare regulation to support the emergence o f private providers o f pensions - on a voluntary basis.  - 105 - Annex 1. Long-termhydrocarbonproductionandrevenueprojections for Libya PermanentIncome Calculations There are various attempts to estimate a country's "permanent income" from hydrocarbon production. They invariably rely on estimates o f remaining recoverable reserves, and a production profile o f the "fixed", depleting resource over a long period. Given assumptions o f government take, resource price, costs, and the discount rate, the present value o f the government's "permanent" revenue stream is calculated. Needless to say, any estimate i s surrounded by uncertainty o f the quantity o f reserves, while the results are sensitive to assumptions o f prices, discount rates, and other factors. In addition, some o f the basic assumptions such as costs, prices and taxes are held constant, when, in fact, they are likely to change. We attempted a simple calculation o f the net present value (NPV) o f government revenues from Libya's crude oil and natural gas production to 2060, based on various assumptions of reserves, production profiles, and oil and gas prices. Production profiles were sketched to 2100, reflecting that production does not suddenly run out, but rather has a "long tail" even after suffering a large period o f decline, as reserves continue to be added from new or existing pools. However, the bulk o f the reserves inthese scenarios are producedby 2060, and revenues are calculated for the period to 2060. Government take was assumed at 60 percent o f total production value, close to the average share from limited data received from Libyan authorities, and similar to levels in other counties (e.g., 63.5 percent in Algeria). There was n o attempt to look at export revenues only, because if resources are priced at international levels, it does not matter (for this calculation) whether the resources are for export or domestic use. Real oil prices per barrel are set at $25, $40, and $55 per barrel, and the discount rate i s 4 percent. Gas prices are increasingly de-linked from oil and reflect more competitive markets in all three scenarios. Oil reserves in l o w case are set at the current estimate o f recoverable reserves o f 39 Bbbl. Two higher scenarios o f 44 Bbbl and 49 Bbblwere chosen, based on reasonable expansion o f recoverable reserves, and partly reflect estimates o f undiscovered oil reserves in Libya by the United States Geological Survey4'. For gas, the low case reserves were set at 1450 bcm, the current level of known recoverable reserves. Mid-case reserves are set at 1900 bcm, and high-case reserves are 2500 bcm, again partly reflective o f the USGS estimate o f undiscovered reserves. The range o f estimates i s plausible, and indicates that additional reserves will be discovered under favorable investment and market conditions. Condensate and LPGs are not included, but these could add significantly to aggregate hydrocarbonproduction and revenues. 41 US.Geological Survey, 2000. 105  - 106- NPV of GovernmentHydrocarbonIncometo 2060 (2003 $ million) I Low I 287.296 I 452,803 617,748 ~ Mid 322,902 509,290 II 695,394 1High I 360.452 I 568.716 I Oilprices constant 2005 $ per barrel. Gas prices constant 2005 $ per thousand cubic meters. Discount rate 4 percent. Government take = 60.0 percent of total production revenue Source: World Bank The results depend heavily on reserve estimates and production profiles, and are highly sensitive to oil prices and discount rates (effects o f the latter not shown). The mid-case results show the NPV o f total government revenues from oil and gas to 2060 o f $509 billion, in constant 2005 dollars. Gas revenues are a small fraction o f that for oil, because of the relatively low levels o f current and future gas production, which are largely determined by expected levels o f developed reserves. Total revenues across cases range from $287 billion to $777 billion, with oil providing the bulk o f revenues in all cases. Note that the projections are significantly above projections from the draft in 2004, because o f large revisions to oil and gas price assumptions. Oil prices in the low, middle, and highcases are higher by 39 percent, 60 percent and 72 percent, respectively. An attempt was also made to calculate net revenues after cost, assuming oil development and production costs o f $5 per barrel, and corresponding gas costs o f $0.50 per million btu. Assuming 89 percent government take after cost (as in the case of, say, Algeria), mid-case revenues are $663 billion, which i s 30 percent higher than the above estimate-suggesting that development and operating costs are over-stated. Using an assumption o f government take o f 60 percent o f net revenue, yields a much lower level o f revenues o f $447 billion, indicating the sensitivity o f key assumptions. The results are surrounded with considerable uncertainty and should be used with caution for a number of reasons. Remaining recoverable reserves are unknown and u n k n o ~ a b l e ~Estimates ~ . at any single point in time reflect what i s then known, and does not depict ultimate recovery, which again i s unknowable. For the oil industry, reserves are inventory (a flow) which are constantly being consumed and replaced. Thus it i s common to have a reasonably steady reserve- to-production ratio (UP)o f some 10-15 years (in OPEC countries it i s much higher but the same 48Adelman, M.A. The Economics of Petroleum Supply,MIT Press, 1991. 106  - 107 - investment rules for development apply). In the US, which has been heavily explored and developed, reserves in 1950 were 25 billion barrels; but over the 1950-1994 period the industry extracted over five times that amount and it still had nearly 24 billion barrels on the shelf". Importantly, the U S FUP ratio stood around 10 years over the entire period. In2006. the U S still had more than 21 billion barrels o f oil reserves and an R/P ratio o f nearly 9 years. Thus, taking a reserve estimate asfixed or ultimate at any point intime, even in a mature producing country like the US, can generate very misleading results. Global reserves and production have tended to grow over time, the result o f increasing investment, knowledge, and new technology. In the history o f the conventional oil industry that is approaching 150 years, the current level o f global reserves o f 1.1trillion barrels exceeds the total amount o f oil that has been produced by around 100 billion barrels. That is, to date the industryhas replaced more than the world has consumed. Moreover, costs have generally declined, shifting supply curves to the right inmany regions5'. It indicates that untilnow, increasing knowledge has greatly overwhelmed the effect o f diminishing returns. More recently, development costs have been increasing due to rising prices o f energy and materials, shortage o f equipment, services, and technical personnel, and increasing taxes. However new technologies and increasing capacity o f the service and materials sectors can reverse these costs increases. Natural gas reserves are even more speculative because gas resources are US Crude Oil Production(mbld) much less developed than for oil, partly 10 I reflecting the greater difficulty o f getting gas to market. The first attempt to compile a global inventory o f gas reserves was not completed until the early 1960s by the Oil and Gas Journal. For 2004, the global UP ratio for gas was 67 years (versus 41 years for oil), and for many countries it exceeds 100 years51. This reflects the relatively low volume o f production compared to the size o f reserves, and inDart i s due to the fact that 1860 1880 1900 1920 1940 1960 1980 2000 the reserves are far from lucrative markets (hence the phrase "stranded gas"). InIran and Qatar, the 2"d and 3rdlargest holders o f gas reserves after Russia, FUP ratios are more than 300 and 600 years, respectively. For Libya, its gas R/p ratio i s 213 years, according to BP figures, reflecting its low level o fproduction. The production profiles chosen are quite arbitrary, and the bulk o f production i s "squeezed" into fifty-five year period to 2060 (see graphs). In most cases production declines at a rate o f 5 percent in later years in order to exhaust the reserves, but this may be unrealistic for total production (although it may be reflective o f specific pools). Even in very mature areas, it i s possible to add reserves and mitigate a sharp fall-off in output (e.g., in the US, where production has declined on average by 1.8 percent per year since 1970 (see graph), and new reserves continued to be added). 49 Streifel, Shane S. Review and Outlook for the World Oil Market, World Bank Discussion Paper 301, 1995. 50 Watkins, G.C. and Shane Streifel, World Crude Oil Resources: Evidence from Estimating Supply Functionsfor 41 Countries, PolicyResearchWorking Paper 1756, WorldBank, 1997. 51 BP.BP Statistical Review ofWorld Energy, June 2005. 107  - 108 - With low reserve assumptions, production profiles peak at relatively low levels and easily fall toward zero by 2100. For higher reserve assumptions, production mustbulge upward and decline more rapidly to fit into the period. This results in an apparent exaggeration for the high-case gas scenario. However, in the case o f Algeria, its production surged above this level over a similar period. Looking at the low case oil reserves, the production profile appears reasonable, although crude oil output does not return its previous peak. In the high-case scenario, production rises above the earlier peak. For government revenues, the level o f oil and gas prices affects government revenues significantly. Government revenues are calculated at 60.0 percent o f total production, which assumes domestic consumption priced at international levels. Large domestic subsidies will result inlower government revenue than indicated, particularly for gas. Real oil prices range from $25 to $55, and in all cases assumes continued oligopoly power by oil producers. However, recent prices have been above this band, and as recently as 2002 prices have been below this range. Sustained real oil prices above $55 are thought unlikely given the negative impact on demand, and the additional increases in supply from high prices. As markets adjust, prices would be expected to fall. The World Bank base case has real prices falling to the l o w $ 3 0 ~per barrel in the longer term. In addition, artificially sustaining prices well above the costs o f production i s difficult and, as has been seen in the past, can become unsustainable. While OPEC has abandoned a target range for oil prices, many think OPEC will want to keep real prices between $40 and $50/bbl. The low price scenario might appear unreasonable as a price floor, given recent developments in global oil markets, but nominal prices in 2010 would be $26.8/bbl-above the average level o f $17.6/bbl between 1986 and 1999. It i s not unreasonable to think that prices could fall below this level by 2010. There are also risks to natural gas prices over the forecast period. In the absence o f a producer cartel, prices could increasingly become de-linked from oil, and more closely reflect supply costs and supply and demand conditions in individual markets. Increasing use o f iquefied natural gas will tend to globalize natural gas markets, but it i s not thought to become large enough in the medium term to effectively "set" prices. Nevertheless future price levels remain uncertain. The level o f government take i s reasonable, but if one attempts to fine-tune the calculations by looking at development and production costs, it would need to model the supply side in greater detail and more closely assess royalties, taxes, and other charges. Costs will not remain static, perhaps rising in the near term from shortages and rising prices o f services, materials and labor, but later falling from advances in technology and increasing capacity o f those factors o f production now in short supply. In later year, costs could again rise as more "permanent" depletion sets in. But the timingo f these transitions i s highlyuncertain. 108  nd ~ ~ v e ~OilnRevenue (2005 $m) ~ e ~ t 1500 7'0000 . 60000 1000 500 0 so000 4 ~ 0 0 0 30000 200R0 10000 0 1 1 2020 2 1960 1%0 2000 2020 2040 2060 2080 210 ~ ~ v e r ~ mOilnRevenue (2005 $m) e t 7C))! 50000 51000 4 3003 33013 2000: 10030 3 1960 1980 2000 2050 2040 2060 2080 2100 19430 1388 21700 2020 2M0 2060 2080 2100  Libya Gas Producf G ~ vGas ~Revenue (2005 $ ~rn) ~ ~ ~ ~ f eo 1 3000 (Resewer 1400BCM) 10000 70 6fl B000 t 50 ` I 40 - 6000 Annual I503 3l? 1@@@ 4000 7C 2000 ` G 500 0 b 1960 1980 2000 2020 2040 2063 2080 210c Libya Gas Production 80 7960 1980 2000 2040 2060 2100 80 -" 18000 711 i 16000 14000 12000 1Do00 8000 6000 4000 2000 0 1 2 21 1960 1980 2000 2020 2040 2060 2080 210(  - 111 - The discount rate o f 4 percent is an appropriate level in general. However, whether the demand for oil will continue to rise over the forecast period is highly uncertain, given uncertainties o f new technologies, environmental considerations, and policies o f both oil consumer and producers (e.g., persistent cartel behavior seeking high prices). A higher discount factor than4 percent could also be considered. Finally, this exercise only looked at crude oil and natural gas, and excluded condensate (sometimes referred to as NGLs) and LPG, inpart to focus on crude oil which is under OPEC quota, and because o f more limited data for these resources. However, these liquids would have to be included in any "permanent income" calculations, as they can be a significant source o f revenue. In 2003, condensate exports were $156 million, and LPG exports were $51 million. This compares with $95 million for LNGexports and $10.7 billion for crude and petroleumproduct exports combined. Uncertaintyof LongTerm HydrocarbonRevenues It is difficult to judge future long-term revenues for Libya's oil and gas exports, inpart due to the uncertainty o f international prices and export volumes. It is important to stress that both elements are at risk. For most o f the past 30-35 years, oil prices have been broadly determined by OPEC production restraint. Recently, strong demand in China has helped to significantly tighten the global oil balance, and OPEC is presently trying to keep prices from going too high, which could impact global economic activity and oil demand. However, with limited spare capacity OPEC has more difficulty controlling the upside to prices. On the production side, a sharp rise in Libya's oil production capacity, from expected inflows o f foreign investment, may exceed its prevailing quota and production could be forced to be shut-in ifit adheres to its quota. . Gas export volumes are not producer-constrained as for oil, and strong growth in European gas demand is expected to necessitate higher imports. Gas export prices to Europe, as well as LNG, are tied to oil prices, but this may change as Europe continues to liberalize its gas markets and as a global "spot" market for LNG develops. Increasingcompetition is likely to result in lower gas prices. OilPrices If OPEC continues to restrain output to keep prices significantly above the costs of production, oil prices will remain extremely volatile and lnherently unstable. Highprices will dampen the demand for OPEC oil, which could impinge on its market share andultimately on it pricing power. An optimum OPEC strategy might be to select a price that is reasonably high, yet allows the demand for OPEC oil to grow moderately. Whether OPEC will choose, or can indeed maintain, such a path is uncertain. At present, strong growth in China is helping OPEC achieve much higher prices. Inthe long term, OPEC faces the possibility o f a structural shift in oil demand (e.g., major advance innon-oil transport, or from environmental pressures), in which case an optimum growth path would prove more difficult. But even without such shifts, the ability of OPEC to manage prices effectively is questionable. The group might choose to simply fixate on high prices and let its production stagnate. Or its market power may erode from supply competition from within, resulting in much lower prices. Inmost commodity markets, prices are not artificially determined. The World Bank projects that real prices for most, commodities will continue their long-term decline, as new technologies help lower the costs o f production and shift supply curves outwards-even though periods o f fluctuating demand will contribute to cyclical price patterns. In the long term, the level o f demand generally determines the volumes supplied, and prices broadly follow the costs of production. However, interventions in the market which significantly distort prices, e.g. OPEC production restraint, can unleash powerful economic forces that, in the long run, can render such interventions unsustainable.  - 112- OilProduction As a member o f OPEC, Libya's production volumes are at risk, as high prices limit current and f u m e production levels. Ifcountries develop productive capacity faster than the growth indemand, surplus capacity will develop. This could occur inLibyaifit adopts anaggressive investment strategy. If the rapid increase in investment is from foreign companies, tensions could develop if foreign companies cannot recoup their investments because o f OPEC production quotas-even though terms relating to OPEC quotas may be spelled out at the onset. The government and companies may feel that increasing world demand (plus a somewhat higher OPEC quota) will allow production to increase in a timely fashion. However OPEC's high-price policy could thwart demand growth, and may result in large volumes o f shut-in resources. Either investment might have to slow to reduce surplus capacity, or supply competition within the organization could put considerable strain on the organization's ability to sustain highprices. Libya's future productive capacity will depend-in addition to the level o f demand-on its resource endowment, level o f investment, and government policies. At present there is potential to significantly increase productive capacity, limited only by the level o f investment. For the distant future, physical reserves play an important role, but it is difficult to judge the size o f ultimate recoverable reserves. Certainly it will be higher than today's estimate o f 39 Bbblo frecoverable reserves. But what the status o freserves andproduction mightbe in, say 2060, is difficult to judge. Natural Gas Volumesand Prices Libya's future gas revenues will largely depend on the volume o f export growth, given the present low level o f exports. Should export levels rise significantly, they are likely to be less at risk than for oil, as there is no quota system in place for gas. Moreover, gas demand in Europe and the world in general is expected to grow strongly as the environmentally preferred fuel o f choice. Natural gas prices are often directly linked to oil prices through long-term contract, thus any risk to oil prices is a risk to gas prices. However, gas (and other energy) markets are being liberalized around the world, and increasingly gas prices will be determined by gas-on-gas competition. While gas and oil prices will continue to compete for the same user in some markets, increasingly gas prices will be "de-linked'' from o i l prices-including for LNG. As spot markets developincluding for LNG-there will be a tendency to move away from long term contracts, now the norm for LNG and gas imported into Europe. One upside risk to prices would be if gas exporters formed a quasi-cartel similar to that o f OPEC. However, as for oil, artificially highprices require a trade-off o f lower production.  - 113 - Annex 2. A rule for long-term fiscal sustainability with an exhaustible hydrocarbon revenue stream A fiscal rule i s derived with the aim o f meeting two parallel goals inthe presence o f an exhaustible hydrocarbon revenue stream: 0 Saving for future generations; 0 Securing long-term fiscal sustainability Savingfor future generationsbased on thepermanent hydrocarbonrevenue stream The net present value (NPVo)o f the hydrocarbon revenue stream consistent with the extraction horizon (N)o f the depleting reserves is: NPV, =z- 2, ,=, (1+ r)' where, 2, i s the projected value o f the hydrocarbon revenue stream based on a discount factor r, and on the projected extraction volume and the path for the real price o f hydrocarbons (as a ratio to the GDP deflator). The permanent hydrocarbon income stream (z,) i s the annuity over an horizon stretching beyond N, whose present value i s equal to that o f the projected hydrocarbon revenue stream (NPVo). Assuming an infinite time horizon, the permanent hydrocarbon revenue i s givenby: A policy aimed at saving part of the exhaustible hydrocarbon revenue stream to support the living standards o f future generations would consist o f depositing each year in a contingency fund the surplus o f hydrocarbon revenues over the permanent hydrocarbon revenue stream. To meet the first goal above, savings could be used to pay down debt, or to finance future expenditures. Annual savings = S, = Z, - z, Long-term f m a l sustainability With savings for future purposes deposited in a contingency fund, the government's annual budget constraint would be given by (lower case letters denote ratios to GDP): where, b, =public debt as a share o f GDP; T, = non-hydrocarbon fiscal revenues inper cent o f GDP;  - 114- gt = primary public expenditures in per cent of GDP (current and capital expenditures); Z, =permanent hydrocarbonrevenue inper cent o f GDP as estimated at t. y= projected long-term GDP growth rate Or, with 0,= z, -g, denoting the primary non-hydrocarbon fiscal deficit inper cent o f GDP: Maintaining long-term fiscal sustainability i s the second goal pursued by the . government. Given the initial debt ratio (bo); the permanent hydrocarbon revenue stream as a ratio to GDP (Z,); the projected non-hydrocarbon primary fiscal deficits (a);and the projected long-term real interest rate and GDP growth rate-securing long-term fiscal sustainability would call for a path o f primary fiscal surpluses (Zo+q) such that: ;with r-y9 An option would be a fiscal policy rule that requires a constant non-hydrocarbon primary deficit in per cent o f GDP (0, = z, -g, = A). Securing long-term fiscal sustainability would then involve a rule that meets the following criterion: bo I- or, equivalently, z0+a Y - Y According to that rule, the permanent hydrocarbon income should at least cover the excess of government primary expenditures over non-hydrocarbon Jiscal revenues, including an adjustment that ensures a constant debt-to-output ratio, given the difference between the long-term real interest rate and growth rates.  - 115- Annex 3. The mechanisms of social protection schemes Main interventions inthe area o f social protection include: (a) social insurance schemes, involving labor pensions, short term benefits (Le. sickness and maternity benefits) and unemployment insurance; these are based on insurance principles and usually financed by participants by means o fpayroll taxes; (b) social assistance beneJits, which may consist o f cash transfers and in-kind benefits (the latter consist o f a range o f goods and services that may be directly provided, subsidized or paid for by means o f vouchers); financed from general tax revenues and usually targeted at poor households in order to raise their consumption to or maintain it at socially acceptable levels. Cash transfers aim at raising incomes o f beneficiaries, while in-kind benefits usually aim at increasing consumer access to particular goods or services. In general, cash transfers represent a more efficient and welfare enhancing way o f transferring resources to the population than in-kindbenefits. The cost o f cash transfers to society i s transparent, and they provide the beneficiaries with a greater freedom o f choice; (c) Employment promotion andfacilitation through active labor market programs (training, placement services, information, etc) and job creation schemes (public works, micro-credit, production funds, etc) that enable current workers to take advantage o f the gains inthe new economy. (d) Informal social safety nets, relating to community and kinship support, may also form an important part o f the social protection system. Social insurance and employment promotion and facilitation schemes are employment related programs, i.e. in most instances the beneficiaries have a work history that justifies their eligibility. Social assistance schemes (together with informal social safety nets) form a basic social safety net to cope with the issue o f limited resources at the individual or household level. They are either universal, i.e. available to all families, as i s the for instance the case with the Libyan basic food package, or targeted to confer benefits disproportionately on families with limited resources. Targeting requires the identification o f eligible people, usually through household budget surveys that allow the determination o f household characteristics that are highly correlated with poverty and vulnerability. The rationale for targeting i s the existence o f a budget constraint that makes broader provision o f a social assistancebenefit unaffordable.  - 116- Typology of targeting mechanisms 0 Means testing involves testingthe household for income 0 Proxy means-testing determines eligibility on the basis o f one or more indicators correlated with poverty, which are easier to observe than income, f.i.householdsize, location, levelofeducation, etc 0 Self-targeting, where individuals declare eligibility based on their own choices, f.i.in the case o f subsidizing products that are more attractive to poor households than to wealthier ones. Targeting also requires the determination o f eligibility for a social assistance benefit. While there i s no inherently correct means o f determining eligibility, it i s usually measured using an absolute poverty line, often related to a minimum level o f nutritional and social need5', or a relative poverty line, related to prevailing income levels, for instance 50 percent o f the mean per capita income. Anyone below the poverty line would be eligible for a social assistance benefit. 52For instancethe daily cost of a representative food basketprovidinga minimumdaily calorie count (abasic nutritionalrequirement)plusessentialnon-foodgoods and services.  - 117- Annex 4. Production and Consumptiontaxes,2003 and 2005 2003 list 2005 list Production Consumptlon Production Consumption Products tax tax tax tax Mineral and sparkling water for non medical use 2 30 2 25 Lemonade, perfumedwater and beveragesfor non medical use 5 30 2 25 Ice cream 5 35 2 25 Juices 5 30 2 25 Animal food 3 15 Sweet products 5 30 2 25 Biscuits 5 30 2 25 Cigarettes 3 35 Clothes 2 20 Cotton towels 2 30 2 25 Printed cotton fabrics 2 30 2 25 diapers 3 20 2 25 Cosmetics cotton 3 25 2 25 Fillings and nets for medical use 3 25 Blankets 3 20 Carpets 3 25 2 25 Shoes (except women and kids shoes) 2 25 Wooden Furniture 2 20 2 25 Wooden doors 2 40 School books 2 15 Papertissue 2 25 2 25 Cement (Portland, black) 2 20 Cement (Portland) 2 20 limestone 3 50 Plaster in bags 2 25 Bricks 2 25 FloorTiles 2 25 Ceramicfloor and wall tiles 2 25 Glass sheets (not colored, colored, .....) 2 20 Sanitary ceramic items 2 10 Marble 2 30 Salt 2 30 2 25 Caustic Soda 2 50 Hypochlorite Sodium (Potassium) 3 50 2 25 HydrochlorideSodium 2 25 HydrochlorideAcid 2 25 2 25 Varnish paint (except maritime and airplanevarnish) 3 25 Perfumes 5 50 2 25 Shampoo 2 50 5 25 Solid Soap 3 25 2 25 Green Soap 3 25 2 25 Powder Soap 3 25 2 25 Externaland internal tires for transport vehicles 3 10 Multivinyl chloride 2 30 2 25  - 118- 2003 list 2005 list Production Conoumptlon Production Consumption Products tax tax tax tax Liquid Chlorine 2 25 2 25 Various plastic pipes (in 2005, limited to 0.750 to 400mm pipes) 2 30 2 25 various plastic products (boxes, bottles, bags,chairs.. ..), limited in size in 2005 2 30 2 25 Industrialfoam (sponge) 3 25 2 25 Bedstead 3 10 Water disposal pipes 3 25 ElectricalWires 2 25 Trailers 2 25 2 25 Countryside cars 2 20 2 25 wheelbarrows 2 20 2 25 Trucks (in 2005, limited to weight largerthan 1.5 tons) 2 25 2 25 Vehicules for merchandisetransportation (more than 3 tons) 2 25 2 25 "Manual" cars 2 40 2 25 Ironfor arms 2 20 Radio receivers 2 30 2 25 Recorders 3 30 2 25 Standard fans 2 40 Trays 2 40 2 25 Heaters (Oil, Electric) 2 15 2 25 HomeWater heaters 3 25 Home Stoves 3 15 2 25 Home Freezers 3 25 2 25 Home Refrigerators 3 15 2 25 Welded spiral pipes 2 25 2 25 Welded vertical pipes 2 25 2 25 Aluminum spraying pipesfor irrigation 2 25 2 25 Trailers for living, camping and transportation 2 25 2 25 Metallic tanks (all kinds) 3 25 2 25 Barbe wires 3 30 2 25 Ordinary wired equipments and switchboardsof less than 60 extensions 2 20 2 25 Sheets??? except plated 2 25 Iron pieces (angles and other specials forms) 2 25 Separate metallic sheets 2 25 2 25 Nails 2 25 Cooking Utensils and other aluminum) 3 30 Aluminum doors and windows 2 40 2 25 Bikes (normal of all kinds) 5 30 2 25 Gas cylinders 3 25 2 25 Electrical cables (average and high intensity) (in 2005, limited for more than 1000volts) 2 20 2 25 Irrigation pumps (high and medium pressure) 3 40 Irrigation pumps for pushing water (more than 7 horsepower) 3 10 Irrigation pumps for extracting water (from 3.5 to 30 horsepower) 3 10 Home Air conditioning 3 25 Bread/Bakingtin rectangularand round (plated or unplated) 2 25 Assembled or not 2 25 2 25  - 119- 2003 list 2005 list New Products Production Consumption Production Consumption tax tax tax tax Pure honey 2 25 butter 2 25 Spaghettis 2 25 Semolina 2 25 Medical Alcohol 2 25 "Harissa", hot pepper paste 2 25 Mobilefreezers 2 25 Paper bags for cement, and plaster 2 25 Control room's ???? for health,sanitation, and telecommunications 2 25 Boxes for trucks and transportation cars 2 25 Electric towers 2 25 Improved wheat and barley grains 2 25 Chicken farming 2 25 Motor-cycle more than 250 CC 2 50 Vehicles for transportation than 3000 CC 2 50 Yacht more than 75 horsepower, 10 meters and 6 persons weight 2 50 ash trays 2 50 Industrial alcohol 2 50 fluff and feather birds 2 50 Wig, eyebrow and eyelash 2 50 magic games 2 50 jet ski 2 50 Pictures and statutes 2 50 Home and healthy utensils 2 50 Ivory and derivatives 2 50 Clothes and stuff from ???? 2 50   - 120- References Arabsheibani G. 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